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16. Financial leverage and capital
structure policy
This chapter deals with the capital structure decision and the consequences of this
decision. The ideal mixture of debt and equity for a firm—its optimal capital
structure—is the one that maximizes the value of the fi rm and minimizes the overall
cost of capital. If we ignore taxes, financial distress costs, and any other
imperfections, there is no ideal mixture. Under these circumstances, the firm’s capital
structure is irrelevant. However, the tax deductibility of interest on debt generates
tax savings equal to the interest payment multiplied by the corporate tax rate,
referred to as the interest tax shield. This tax deductibility means that the WACC
decreases when leverage increases. Bankruptcy costs counteract the tax advantage
of debt. A firm will incur costs when it goes bankrupt: since leverage increases the
probability of bankruptcy, the costs associated with bankruptcy increase the WACC
when a firm uses more leverage. Given that the tax deductibility of interest on debt
increases firm value when more debt financing is used, but the probability of
incurring bankruptcy costs decreases firm value when more debt financing is used,
there seems to be an optimal capital structure where firm value if maximized. This is
the basic idea behind the static tradeoff theory. The pecking-order theory is a second
theory about the optimal capital structure, which states that firms have a preference
for certain sources of financing over others. This theory suggests that firms will use
internal fi nuancing as much as possible, followed by debt fi nuancing if needed.
Equity will not be issued if possible. The result is that there is no optimal capital
structure. Some patterns in observed capital structures are that on average firms
have low debt-equity ratios, suggesting that there is a limit to the use of debt
financing to generate tax shields, and that these ratios vary considerably across
industries, suggesting that the nature of their assets and operations is an important
determinant of capital structure.
16.1. The capital structure question
The goal when setting a firm’s capital structure is to maximize the value of its stock,
which is equal to maximizing the value of the firm or minimizing the value of the
WACC.
A firm should choose its debt-equity ratio, or capital structure, such that it maximizes
the value of its stock. When discussing capital structure, maximizing the value of a
share of stock is equal to maximizing the value of the firm. The value of the firm is
maximized when the WACC is minimized: since the WACC is the appropriate discount
rate, minimizing this discount rate will maximize the value of the firm’s cash flows. The
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debt-equity ratio where the WACC is minimized is called the optimal capital structure
or target capital structure.
16.2. The effect of financial leverage
Financial leverage is the extent to which a firm relies on debt. Financial leverage
affects earnings by increasing the potential profits but also increasing the potential
losses. Investors can use homemade leverage to undo any capital structure decision
by the firm’s management.
Financial leverage refers to the extent to which a firm relies on debt: the more debt
financing a firm uses, the higher its leverage. Financial leverage acts as a lever: the
higher the leverage, the more gains and losses are magnified. More leverage is
therefore beneficial if earnings are positive, but detrimental when earnings are
negative.
Investors can adjust the amount of financial leverage of a firm by borrowing and
lending on their own. This is called homemade leverage. For example, if an investor
desires a higher level of leverage than the firm currently has, he can borrow money
and invest it in shares in the firm together with his own money to increase the amount
of leverage.
16.3. Capital structure and the cost of equity capital
Franco Modigliani and Merton Miller came up with a theory stating that a firm's
capital structure does not affect the value of the firm or the WACC. The theory also
states that the cost of equity is a positive linear function of the firm’s capital
structure.
Since investors can undo any capital structure decision by the firm by borrowing or
lending on their own account, it does not matter what capital structure the firm
chooses. This is the basis for M&M Proposition I (M&M stands for Franco Modigliani
& Merton Miller, two Nobel laureates who made important contributions to economic
science), which states that the value of the firm is independent of its capital structure.
A pie model is often used to illustrate this proposition: no matter how you slide the
pie, i.e. divide the firm between equity and debt, the total size of the pie does not
change.
Although changing the capital structure does not matter for total firm value, it does
change the firm’s debt and equity. The WACC can be interpreted as the required
return on the firm’s overall assets, which will be denoted by R A. Ignoring taxes, the
WACC, or return on assets, can be written as: WACC = RA = (E / V) x RE + (D / V) x RD.
Rearranging gives: RE = RA + (RA – RD) x (D / E). The cost of equity is thus a positive
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linear function of the firm’s capital structure: an increase in leverage increases the risk
of equity and thus increases the required return on equity. This is M&M Proposition II.
M&M proposition II show that the firm’s cost of equity can be broken down into two
components:
1. Business risk: the risk inherent in a firm’s operations, represented by the
required return on assets RA. Business risk does not depend on the firm’s
capital structure.
2. Financial risk: the risk due to the firm’s financial policy, represented by (R A –
RD) x (D / E).
16.4. M&M propositions I and II with corporate taxes
The tax deductibility of interest on debt generates tax savings equal to the interest
payment multiplied by the corporate tax rate, referred to as the interest tax
shield. This tax deductibility means that the WACC decreases when leverage
increases.
There are two features of debt that should be taken into account when determining
the optimal capital structure:
1. Interest on debt is tax deductible.
2. Failure to meet debt obligations can result in bankruptcy.
The tax deductibility of interest on debt generates tax savings equal to the interest
payment multiplied by the corporate tax rate, referred to as the interest tax shield.
The present value of the interest tax shield is: (Tc x D x RD) / RD = TC x D. D is the
(perpetual) amount of debt. The value of the levered firm in the presence of taxes is
the value of the unlevered firm plus the present value of the tax shield: VL = VU + TC x
D.
In the presence of taxes, the WACC will become: WACC = RA = (E / V) x RE + (D / V) x
RD x (1 – TC). The cost of equity will become: RE = RU + (RU – RD) x (D / E) x (1 – TC).
RU is the unlevered cost of capital, i.e. the cost of capital for a firm that has no debt.
So in the presence of taxes:


The WACC decreases when leverage increases.
The cost of equity increases when leverage increases.
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16.5. Bankruptcy costs
A firm will incur costs when it goes bankrupt: since leverage increases the probability
of bankruptcy, the costs associated with bankruptcy increase the WACC when a firm
uses more leverage.
Then leverage increases, the probability that a firm will default increases. In a perfect
world, there are no costs associated with bankruptcy: the only thing that happens is
that ownership is transferred from the equity holders to the creditors, who will then
own assets of equal value to what is owed on the debt. However, in the real world
there are several costs associated with bankruptcy:


Direct bankruptcy costs: for example legal and administrative expenses.
Indirect bankruptcy costs: for example the resources spend to avoid
bankruptcy costs, the loss of customers/suppliers when a firm is financially
distressed, the loss of valuable employees or the foregoing of positive NPV
projects.
The direct and indirect costs of bankruptcy are also referred to as financial distress
costs.
16.6. Optimal capital structure
The static trade-off theory states that the optimal capital structure is the point
where the marginal benefits of the tax shield exactly offset the marginal costs of
bankruptcy.
Given that the tax deductibility of interest on debt increases firm value when more
debt financing is used, but the probability of incurring bankruptcy costs decreases firm
value when more debt financing is used, the answer seems to lie somewhere in the
middle. This is the basic idea behind the static theory of capital structure: that there is
an optimal capital structure where the marginal benefit of the tax shield is exactly
offset by the marginal cost of the increased probability of financial distress. This point
is also where the WACC is the lowest.
Some managerial pointers are:


The tax advantage of debt is only important for tax paying companies, and less
important for companies that experience losses, have substantial tax shields
from other sources (e.g. depreciation), or have a lower tax rate.
The greater the risk of financial distress, the less a firm should borrow.
Additionally, financial distress can be more costly for some firms than for
others.
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16.7. The pie again
The pie as metaphor to represent the value of the firm is still valid in the presence of
taxes and bankruptcy costs if you recognize that bondholders and equity holders are
not the only recipients of cash flow.
Critics of the M&M theorems argue that they break down once real-world factors are
incorporated. However, if you recognize that bondholders and equity holders are not
the only recipients of cash flow (another recipient is for example the state), the notion
that the value of the firm depends only on the total cash flow to all recipients still
stands. An important distinction is the one between marketed claims, which can be
bought and sold on the financial markets, and non-marketed claims, which cannot.
The value of the marketed claims (generally speaking debt and equity) can be altered
by changing the capital structure, but the combined value of the marketed and nonmarketed claims cannot.
16.8. The pecking-order theory
The pecking-order theory is a second theory about the optimal capital structure,
which states that firms have a preference for certain sources of financing over
others.
The static trade-off theory does not explain the observed capital structures very well.
As an alternative, the pecking order theory has been developed. The pecking order
theory states that firms prefer certain sources of financing over others. In order from
most preferable to least preferable, these sources are:
1. Internal financing.
2. Debt.
3. Equity.
The reason behind this order is that raising external financing can be costly. Secondly,
if a firm is undervalued a manager would sell a portion of the cash flow for less than
its value. If however, a firm is overvalued, raising external financing would indicate to
investors that the firm is probably overvalued so the stock price will take a hit.
The pecking-order theory has several important implications:



There is no target capital structure.
Profitable firms use less debt as they have more internal financing available.
Companies will want financial slack, i.e. stockpile internally generated cash.
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There is no definite answer yet as to which theory is correct. However, the static
trade-off theory seems to be more concerned with long-run financial goals, whereas
the pecking-order theory is more concerned with the short-run.
16.9. Observed capital structures
Some patterns in observed capital structures are that on average firms have low
debt-equity ratios and that these ratios vary considerably across industries.
Several remarkable observations about observed capital structure are:


Firms have relatively low debt-equity ratios.
Deb-equity ratios vary considerable across industries.
16.10. A quick look at the bankruptcy process
Once a firm files for bankruptcy, the firm can be liquidated, which means termination
of the firm as a going concern, or reorganized. When a firm files for liquidation, a
trustee-in-bankruptcy is elected by the creditors, the assets of the firm are sold and
the proceedings of this sale are distributed among the creditors. When a firm files for
reorganization and this filing is approved by a federal judge, the firm submits a
reorganization plan and after acceptance of the plan management continues to run
the business according to the provisions of the reorganization plan.
Financial distress can be defined in several ways:




Business failure.
Legal bankruptcy.
Technical insolvency: a firm is unable to meet its financial obligations.
Accounting insolvency: total book liabilities exceed the book value of total
assets.
When a firm goes bankrupt, there are two options:
1. Liquidation: termination of the firm as a going concern, whereby all assets will
be sold.
2. Reorganization: keeping the firm a going concern, whereby often new
securities are issued.
In the U.S., liquidation is governed by Chapter 7 of the Federal Bankruptcy Reform
Act of 1978. This procedure involves the following steps:
1. The firm files for bankruptcy in a federal court.
2. A trustee-in-bankruptcy is elected by the creditors.
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3. The proceedings of selling the assets are distributed among the claimants.
The proceedings of selling the firm’s assets are distributed in the following order of
priority:
1.
2.
3.
4.
5.
6.
7.
8.
9.
Administrative expenses associated with the bankruptcy.
Other expenses arising after the filing of an involuntary bankruptcy petition.
Wages, salaries, and commissions.
Contributions to employee benefit plans.
Consumer claims.
Government tax claims.
Payment to unsecured creditors.
Payment to preferred stockholders.
Payment to common stockholders.
This list follows from the absolute priority rule (APR), the rule establishing priority of
claims in liquidation.
Reorganization is governed by Chapter 11 of the Federal Bankruptcy Reform Act of
1978. This procedure involves the following steps:
1.
2.
3.
4.
5.
The firm files for bankruptcy in a federal court.
A federal judge approves of denied the petition.
The corporation continues to run the business.
The corporation submits a reorganization plan.
Creditors and shareholders are divided into classes: a class of creditors accepts
the plan if a majority of the class agrees to the plan.
6. After acceptance by creditors, the plan is confirmed by court.
7. Payments are made to creditors and shareholders and possibly new securities
are issued.
8. For some length of time the firm operates according to the provisions of the
reorganization plan.
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