Chapter Nineteen
Financial Leverage and Capital
Structure Policy
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Chapter Organisation
19.1 The Capital Structure Question
19.2 The Effect of Financial Leverage
19.3 Capital Structure and the Cost of Equity Capital
19.4 M&M Propositions I & II With Corporate Taxes
19.5 Bankruptcy Costs
19.6 Optimal Capital Structure
19.7 The Pie Again
19.8 Imputation and M&M
19.9 Observed Capital Structures
Summary and Conclusions
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Chapter Objectives
• Understand the impact of financial leverage on a
firm’s capital structure.
• Illustrate the concept of home-made leverage.
• Outline both M&M Proposition I and M&M
Proposition II.
• Discuss the impact of corporate taxes on M&M
Propositions I and II.
• Understand the impact of bankruptcy costs on the
value of a firm.
• Identify a firm’s optimal capital structure.
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The Capital Structure Question
• Key issues
–
–
What is the relationship between capital structure and
firm value?
What is the optimal capital structure?
• Capital structure and the cost of capital
–
The optimal capital structure is chosen if WACC is
minimised.
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The Effect of Financial Leverage
• Financial leverage refers to the extent to which a firm
relies on debt.
• The more debt financing a firm uses in its capital
structure, the more financial leverage it employs.
• Financial leverage can dramatically alter the payoffs
to shareholders in the firm.
• However, financial leverage may not affect the overall
cost of capital.
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Example—Computing Breakeven EBIT
ABC Company currently has no debt in its capital
structure. The company has decided to restructure,
raising $2.5 million debt at 10 per cent. ABC currently
has 500 000 shares on issue at a price of $10 per
share. As a result of the restructure, what is the
minimum level of EBIT the company needs to maintain
EPS (the break-even EBIT)? Ignore taxes.
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Example—Computing Breakeven EBIT (continued)
• With no debt:
EPS = EBIT/500 000
• With $2.5 million in debt @ 10%:
EPS = (EBIT – $250 0001)/250 0002
1
2
Interest expense = $2.5 million × 10% = $250 000
Debt raised will refund 250 000 ($2.5 million/$10) shares, leaving
250 000 shares outstanding
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Example—Computing Breakeven EBIT (continued)
• These are then equal:
EPS = EBIT/500 000 = (EBIT – $250 000)/250 000
• With a little algebra:
EBIT = $500 000
 EPSBE = $1.00 per share
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Example—Computing Breakeven EBIT (continued)
EPS ($)
3
D/E = 1 (with debt)
2.5
2
D/E = 0 (no debt)
1.5
1
Break-even point
0.5
0
– 0.5
–1
EBIT ($ millions, no taxes)
0
0.2
0.4
0.6
0.8
1
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The Effect of Financial Leverage
• The effect of financial leverage depends on the
company’s EBIT.
• The break-even EBIT is where a firm makes a return
just sufficient to pay the interest on debt.
• If EBIT is above the break-even point, leverage is
beneficial.
• If EBIT is below the break-even point, leverage is not
beneficial.
• With financial leverage, shareholders are exposed to
more risk because EPS and ROE are more sensitive
to changes in EBIT.
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Corporate Borrowing and Homemade Leverage
• Despite the effects of financial leverage it does not
necessarily follow that capital structure is an
important consideration.
• Why? Because shareholders can adjust the amount
of financial leverage by borrowing and lending on
their own.
• Home-made leverage is the use of personal
borrowing to alter the degree of financial leverage to
which an individual is exposed.
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Example—Home-made Leverage
and ROE
• Original capital structure and home-made leverage
 investor uses $500 of their own and borrows
$500 to purchase 100 shares.
• Proposed capital structure  investor uses $500 of
their own, together with $250 in shares and $250 in
bonds.
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Original Capital Structure and
Home-made Leverage
Recession
Expected
Expansion
EPS of unlevered firm
Earnings for 100 shares
Less interest on $500
@ 10%
$0.60
$60.00
$50.00
$1.30
$130.00
$50.00
$1.60
$160.00
$50.00
Net earnings
ROE
$10.00
2%
$80.00
16%
$110.00
22%
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Proposed Capital Structure
Recession
Expected
Expansion
EPS of levered firm
Earnings for 25 shares
Plus interest on $250
@ 10%
$0.20
$5.00
$25.00
$1.60
$40.00
$25.00
$2.20
$55.00
$25.00
Net earnings
ROE
$30.00
6%
$65.00
13%
$80.00
16%
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Capital Structure Theory
• Modigliani and Miller (M&M) Theory of Capital
Structure:
– Proposition I—firm value
– Proposition II—WACC
• The value of the firm is determined by the cash flows
to the firm and the risk of the assets.
• Changing firm value:
– Change the risk of the cash flows
– Change the cash flows
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M&M Proposition I
Value of firm
Value of firm
Debt
40%
Shares
40%
Debt
60%
Shares
60%
• The size of the pie does not depend on how it is sliced.
• The value of the firm is independent of its capital structure.
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M&M Proposition II
• Because of Proposition I, the WACC must be
constant, with no taxes:
WACC = RA = (E/V) × RE + (D/V) × RD
where RA is the required return on the firm’s assets
• Solve for RE to get M&M Proposition II:
RE = RA + (RA – RD) × (D/E)
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The Cost of Equity and the
WACC
Cost of capital
RE = RA + (RA – RD ) x (D/E)
WACC = RA
RD
Debt-equity ratio, D/E
• The firm’s overall cost of capital is unaffected by its capital structure.
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Business and Financial Risk
• By M&M Proposition II, the required rate of return on
equity arises from sources of firm risk. Proposition II
is:
RE = RA + [RA – RD] × [D/E]
• Business risk—equity risk arising from the nature of
the firm’s operating activities (measured by RA).
• Financial risk—equity risk that comes from the
financial policy (i.e. capital structure) of the firm
(measured by [RA – RD] × [D/E]).
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The SML and M&M Proposition II
• How do financing decisions affect firm risk in both
M&M’s Proposition II and the CAPM?
• Consider Proposition II: All else equal, a higher
debt/equity ratio will increase the required return on
equity, RE.
RE = RA + (RA – RD) × (D/E)
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The SML and M&M Proposition II
(continued)
• Substitute RA = Rf + (RM  Rf)βA
and by replacement RE = Rf + (RM  Rf)βE
• The effect of financing decisions is reflected in the
equity beta, and, by the CAPM, increases the
required return on equity.
βE = βA(1 + D/E)
• Debt increases systematic risk (and moves the firm
along the SML).
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Corporate Taxes
• The interest tax shield is the tax saving attained by a
firm from interest expense.
• Assumptions:
– perpetual cash flows
– no depreciation
– no fixed asset or NWC spending.
• For example, a firm is considering going from $0 debt
to $400 debt at 10 per cent.
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Corporate Taxes (continued)
EBIT
Interest
Taxable income
Tax (@ 40%)
Net profit
Cash flow from assets
Firm U
$200
0
$200
80
$ 120
$ 120
Firm L
$200
40
$160
64
$ 96
$136
Tax saving = $16 = 0.40 x $40 = TC × RD × D
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Corporate Taxes (continued)
• What is the link between debt and firm value?
– Since interest creates a tax deduction, borrowing creates a tax
shield. The value added to the firm is the present value of the
annual interest tax shield in perpetuity.
• M&M Proposition I (with taxes):
PV tax saving   $16
 $160
0.10
 TC  RD  D /RD
 TC D
• Key result:
VL = VU + TCD
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M&M Proposition I with Taxes
Value of the
firm (VL)
VL = VU + TC x D
= TC
TC x D
VL= VU + $160
VU
VU
VU
Total debt (D)
$400
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Taxes, WACC and Proposition II
• Taxes and firm value: an example
– EBIT = $100
– TC = 30%
– RU = 12.5%
• Suppose debt goes from $0 to $100 at 10 per cent.
What happens to equity value, E?
VU = $100 × (1 – 0.30)/0.125 = $560
VL = $560 + (0.30 × $100) = $590
 E = $490
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Taxes, WACC and Proposition II
• WACC and the cost of equity (M&M Proposition II
with taxes):
RE = RU + (RU – RD) × (D/E) × (1 – TC)

RE  0.125  0.125  0.10   $100
$490
 1  0.30
 12.86%

WACC  $490

 0.10  1  0.30
 0.1286  $100
$590
$590
 11.86%
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Taxes, WACC and Proposition II
Cost of capital (%)
RE
RE
RU
WACC
RD  (1 –
TC)
RU
WACC
RD  (1 – TC)
Debt-equity ratio, D/E
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Taxes, WACC and
Propositions I and II—Conclusions
• The no-tax case:
– Implications of proposition I:
 A firm’s capital structure is irrelevant
 A firm’s WACC is the same no matter what the mixture of debt
and equity is used to finance the firm.
– Implications of proposition II:
 The cost of equity rises as the firm increases its use of debt
financing
 The risk of the equity depends on two things: the riskiness of
the firm’s operations (business risk) and the degree of financial
leverage (financial risk).
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Taxes, WACC, and
Propositions I and II—Conclusions
• With taxes:
– Implications of proposition I:
 Debt financing is highly advantageous, and, in the extreme, a
firm’s optimal capital structure is 100 per cent debt.
 A firm’s WACC decreases as the firm relies on debt financing.
– Implications of proposition II:
 Unlike proposition I, the general implications of proposition II
are the same whether there are taxes or not.
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Bankruptcy Costs
• Borrowing money is a good news/bad news
proposition:
– The good news: interest payments are deductible and create
a debt tax shield (TCD).
– The bad news: all else equal, borrowing more money
increases the probability (and therefore the expected value)
of direct and indirect bankruptcy costs.
• Key issue: The impact of financial distress on firm
value.
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Direct versus Indirect
Bankruptcy Costs
• Direct bankruptcy costs are costs directly associated
with bankruptcy such as legal and administrative
expenses.
• Indirect bankruptcy costs are costs associated with
spending resources to avoid bankruptcy.
• Financial distress:
– significant problems in meeting debt obligations
– most firms that experience financial distress do recover.
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Optimal Capital Structure
• The static theory of capital structure:
– A firm borrows up to the point where the tax benefit from an
extra dollar in debt is exactly equal to the cost that comes
from the increased probability of financial distress. This is
the point at which WACC is minimised and the value of the
firm is maximised.
– It is called the static theory because it assumes that the firm
is fixed in terms of its assets and operations and it only
considers possible changes in the debt/equity ratio.
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The Optimal Capital Structure and
the Value of the Firm
Value of
the firm
(VL )
Maximum
firm value VL*
VL = VU + TC  D
Present value of tax
shield on debt
Financial
distress costs
Actual firm value
VU
D/E
VU = Value of firm
with no debt
Optimal amount of debt
Debt-equity ratio, D/E
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The Optimal Capital Structure and
the Cost of Capital
Cost of
capital
(%)
RE
RU
WACC
RD  (1 – TC)
RU
Minimum
cost of capital WACC*
D*/E*
The optimal debt/equity ratio
Debt/equity ratio
(D/E)
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The Capital Structure Question
Value of
the firm
( VL )
VL*
Case II
M&M (with taxes)
PV of bankruptcy costs
Net gain from leverage
VU
D*
Case III
Static Theory
Case I
M&M (no taxes)
Total
debt (D)
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Managerial Recommendations
• Taxes
– The tax benefit is only important if to firms in a tax-paying
position.
– The higher the tax payable, the greater the incentive to
borrow.
• Financial distress:
– The greater the risk of financial distress, the less debt will be
optimal for the firm.
– All other things equal, the greater the volatility in EBIT, the
less a firm should borrow.
– The costs of financial distress depend primarily on the firm’s
assets and how easily ownership to those assets can be
transferred.
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The Extended Pie Model
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Corporate Borrowing and Personal
Borrowing
• Without tax, corporate and personal borrowing are
interchangeable.
• With corporate and personal tax, there is an
advantage to corporate borrowing because of the
interest tax shield.
• With corporate and personal tax, and dividend
imputation, shareholders are again indifferent
between corporate and personal borrowing.
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Dynamic Capital Structure
Theories
• Pecking order theory:
– Investment is financed first with internal funds, then debt,
and finally with equity.
• Information asymmetry cost:
– Management has superior information on the prospects of
the firm.
• Agency costs of debt:
– These occur when equity holders act in their own best
interests rather than the interests of the firm.
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Debt-to-Equity Ratios for Selected
Australian Industries, 2006
Industry
Debt/Equity %
Banks
129
Coal
10
Engineering
31
Gas
141
Gold
15
Medical
11
Oil
8
Property trusts
69
Real Estate
40
Retail
28
Telecommunications
17
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Summary and Conclusions
• The optimal capital structure for a firm is one that
maximises the value of the firm and minimises the overall
cost of capital.
• If taxes, financial distress costs, and any other
imperfections are ignored, the firm’s capital structure is
simply irrelevant.
• If company taxes are considered, capital structure matters
a great deal.
• Bankruptcy or financial distress costs reduce the
attractiveness of debt financing.
• Australian firms typically do not use great amounts of debt
(but pay substantial taxes) and firms in similar industries
tend to have similar capital structures.
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19-42