University of Kelaniya, Sri Lanka
Dilrukshi Yapa Abeywardhana (PhD, UK)
Professor
Department of Accountancy,
University of Kelaniya
dilyapa@kln.ac.lk
Leverage and Capital
Structure Policy
Learning outcome
• At the end of the session students should be able to;
1. Describe the role of debt ratings in capital structure
policy.
2. Explain the Modigliani–Miller propositions
relevant to the capital structure,
3. Explain factors an analyst should consider in
evaluating the impact of capital structure policy on
valuation.
4. Demonstrate international differences in financial
leverage and their implications for investment
Department of Mass Communication,
University of Kelaniya, Sri Lanka
What is the Target Capital
Structure?
Basic Definitions
• V = value of firm
• FCF = free cash flow
• WACC = weighted average cost of capital
• rs and rd are costs of stock and debt
• ws and wd are percentages of the firm that
are financed with stock and debt.
How can capital structure affect
value?
∞
V
=
∑
t=1
FCFt
(1 + WACC)t
WACC= wd (1-T) rd + wsrs
The impact of capital structure on value depends
upon the effect of debt on:
WACC
FCF
The Effect of Additional Debt on
WACC
• Debtholders have a prior claim on cash flows
relative to stockholders.
• Debtholders’ “fixed” claim increases risk of
stockholders’ “residual” claim.
• Cost of stock, rs, goes up.
• Firm’s can deduct interest expenses.
• Reduces the taxes paid
• Frees up more cash for payments to investors
• Reduces after-tax cost of debt
(Continued…)
The Effect on WACC (Continued)
• Debt increases risk of bankruptcy
• Causes pre-tax cost of debt, rd, to increase
• Adding debt increase percent of firm
financed with low-cost debt (wd) and
decreases percent financed with high-cost
equity (ws)
• Net effect on WACC = uncertain.
(Continued…)
The Effect of Additional Debt on
FCF
• Additional debt increases the
probability of bankruptcy.
• Direct costs: Legal fees, “fire” sales, etc.
• Indirect costs: Lost customers, reduction in
productivity of managers and line workers,
reduction in credit (i.e., accounts payable)
offered by suppliers
(Continued…)
• Impact of indirect costs
• NOPAT goes down due to lost customers and
drop in productivity
• Investment in capital goes up due to increase
in net operating working capital (accounts
payable goes down as suppliers tighten
credit).
(Continued…)
Consider Two Hypothetical Firms Identical
Except for Debt
Firm U
Firm L
Capital
Rs.3500,000
Rs.3500,000
Debt
Rs.0
Rs.1750,000 (12%
rate)
Equity
Rs.3500,000
Rs.1750,000
Tax rate
40%
40%
EBIT
Rs.525,000
Rs.525,000
NOPAT
Rs.315,000
Rs.189,000
ROIC
9%
11.4%
Impact of Leverage on Returns
Firm U
Firm L
EBIT
Interest
525,000
0
525,000
210,000
EBT
525,000
315,000
Taxes (40%)
210,000
126,000
NI
315,000
189,000
9.0%
9.0%
11.4%
10.8%
ROIC (NI+Int)/TA]
ROE (NI/Equity)
Impact of Leverage on Returns if
EBIT Falls
Firm U
EBIT
346,500
Interest
0
EBT
346,500
Taxes (40%)
138,600
NI
207,900
ROIC
5.94%
ROE
5.94%
Leverage magnifies risk and return!
Firm L
346,500
210,000
136,500
56,400
80,100
8.28%
4.57%
Impact of Leverage on Returns if
EBIT Rises
Firm U
EBIT
699,000
Interest
0
EBT
699,000
Taxes (40%)
279,600
NI
419,400
ROIC
11.98%
ROE
11.98%
Leverage magnifies risk and return!
Firm L
699,000
210,000
489,000
195,600
293,400
14.38%
16.79%
14
Leverage
Example
• Suppose a new firm is being formed. The
management of the firm is expecting a before tax
rate of return of 24% on the estimated total
investment of Rs. 500000. It is considering two
alternative financial plans i)either to raise the
entire funds by issuing 50000 common shares at
Rs. 10 per share, or ii) to raise Rs. 250000 by
issuing 25000 common shares at Rs. 10 per share
and borrow Rs. 250000 at 15% rate of interest.
Tax rate is 60%. What are the effects of the
alternative plans for the shareholders earnings?
What is operating leverage, and how
does it affect a firm’s business risk?
• Operating leverage is the use of fixed costs
rather than variable costs. Operating
leverage is the change in EBIT caused by a
change in quantity sold.
• The higher the proportion of fixed costs
relative to variable costs, the greater the
operating leverage.
• If most costs are fixed, hence do not
decline when demand falls, then the firm
has high operating leverage.
• More operating leverage leads to
more business risk, for then a small
sales decline causes a big profit
decline.
Rev.
Rev.
Rs.
Rs.
}
TC
Profit
TC
FC
FC
QBE
Sales
◼What happens if variable costs change?
QBE
Sales
Problem 1
• Alfa Ltd needs Rs.1000,000 for expansion. The
expansion is expected to yield an annual EBIT of Rs.
160,000. In choosing a financial plan Alfa has an
objective of maximising EPS. It is considering the
possibility of issuing equity shares and raising debt of
Rs. 100000 or Rs. 400000 or Rs. 600000. The current
market price per share is Rs. 25 and is expected to
drop to Rs. 20 if the funds are borrowed in excess of
Rs. 500000. Funds can be borrowed at the rates
indicated below.(a) Up to 100000 at 8%; (b) Over Rs.
100000 to Rs 500000 at 12%; (c) Over Rs. 500000 at
18%. Tax rate is 50%. Determine EPS for 3
alternatives.
Problem 2
• A company needs Rs. 500000 for construction of a
new plant. The following 3 financial plans are
feasible. (i) The company may issue 50000 common
shares at Rs. 10 per share. (ii) The company may issue
25000 common shares at rs. 10 per share and 2500
debentures of Rs. 100 denominations bearing a 8% of
interest. (iii) The company may issue 25000 common
shares at Rs. 10 per share and 2500 preferance shares
bearing a 8% rate of dividend.
• If the company’s EBIT are Rs. 10000, Rs 20000,
Rs.40000, Rs.60000 and Rs. 100000 what are the EPS
under each of the 3 financial plans? Which alternative
would you recommend and why? Assume corporate
tax rate is 50%.
Problem 3
• Money incorporation has no debt outstanding and a total
market value of Rs. 150000. Earnings before interest and
taxes are projected to be Rs. 14000 if economic conditions
are normal. If there is a strong expansion in the economy,
then EBIT will be 30% higher. If there is a recession, then
EBIT will be 60% lower. Money is considering a Rs. 60000
debt issue with a 5% interest rate. The proceeds will be
used to repurchase shares of stock. There are currently
2500 shares outstanding. Ignore taxes for this problem.
• (a) Calculate earning per share under each of the above 3
economic scenarios before any debt is issued. Also
calculate the % changes in EPS when the economy expands
or enters a recession.
MM with Zero Taxes (1958)
Proposition I:
VL = VU.
Proposition II:
ksL = ksU + (ksU - kd)(D/S).
Given the following data, find V, S,
ks, and WACC for Firms U and L.
Firms U and L are in same risk class.
EBITU,L = Rs.500,000.
Firm U has no debt; ksU = 14%.
Firm L has Rs.1,000,000 debt at kd = 8%.
The basic MM assumptions hold.
There are no corporate or personal taxes.
1. Find VU and VL.
VU =
EBIT
ksU
VL = VU
Questions: What is the derivation of
the VU equation? Are the MM
assumptions required?
2. Find the market value of Firm
L’s debt and equity.
VL = D + S
3.
Find ksL.
ksL = ksU + (ksU - kd)(D/S)
4.
Proposition I implies WACC = ksU.
Verify for L using WACC formula.
WACC
= wdkd + wceks = (D/V)kd + (S/V)ks
MM relationships between capital costs
and leverage as measured by D/V.
Without taxes
Cost of
Capital (%)
26
ks
20
WACC
14
kd
8
0
20
40
60
80
100
Debt/Value
Ratio (%)
Find V, S, ks, and WACC for Firms U and L
assuming a 40% corporate
tax rate.
With corporate taxes added, the MM
propositions become:
Proposition I:
VL = VU + TD.
Proposition II:
ksL = ksU + (ksU - kd)(1 - T)(D/S).
1. Find VU and VL.
VU =
EBIT(1 - T)
ksU
Note: Represents a 40% decline from the no taxes
situation.
VL = VU + TD
2. Find market value of Firm L’s debt
and equity.
VL = D + S
3. Find ksL.
ksL = ksU + (ksU - kd)(1 - T)(D/S)
4. Find Firm L’s WACC.
WACCL
= (D/V)kd(1 - T) + (S/V)ks
When corporate taxes are considered, the WACC is
lower for L than for U. WHY?
MM relationship between capital
costs and leverage when
corporate taxes are considered.
Cost of
Capital (%)
ks
26
20
14
8
0
20
40
60
80
WACC
kd(1 - T)
Debt/Value
100
Ratio (%)
MM relationship between value and debt when
corporate taxes are considered.
Value of Firm, V (%)
4
VL
3
TD
VU
2
1
Debt
0
0.5
1.0
1.5
2.0
2.5 (Millions of Rs.)
Under MM with corporate taxes, the firm’s value increases
continuously as more and more debt is used.
Trade-off Theory
• MM theory ignores bankruptcy (financial distress)
costs, which increase as more leverage is used.
• At low leverage levels, tax benefits outweigh
bankruptcy costs.
• At high levels, bankruptcy costs outweigh tax
benefits.
• An optimal capital structure exists that balances
these costs and benefits.
Signaling Theory
Signaling Theory
Signaling Theory
• MM assumed that investors and managers have the
same information.(Symmetric information)
• But, managers often have better information. Thus,
they would:
• Sell stock if stock is overvalued.
• Sell bonds if stock is undervalued.
• Investors understand this, so view new stock sales
as a negative signal.
• Implications for managers?
Pecking Order Theory
• Managers have more information than investors
(asymmetry of information)
• Managers prefer to use internal finance
• Then issuing debt
• At a last resort, issue shares
Pecking Order
Theory
Market
Timing
Theory
Market
Timing
Theory
• The market timing theory of capital
structure argues that firms time their
equity issues in the sense that they
issue new stock when the stock price is
perceived to be overvalued, and buy
back own shares when there is
undervaluation.
Consequently,
fluctuations in stock prices affect firms
capital structures.