Week 10
Lecture 10
Ross, Westerfield and Jordan 7e
Chapter 17
Financial Leverage and
Capital Structure Policy
17-0
Last Lecture..
•
•
•
•
Cost of Equity
Cost of Preferred Stock
Cost of Debt
Proportion or weight of each form of
financing
• Cost of Capital = WACC
• Unadjusted/Adjusted
• When should we use WACC?
• Other approaches: pure play and subjective
• Flotation Costs
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Chapter 17 Outline
• The Capital Structure Question
• The Effect of Financial Leverage
• Capital Structure and the Cost of Equity
Capital
• M&M Propositions I and II with Corporate
Taxes
• Bankruptcy Costs
• Optimal Capital Structure
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Choosing a Capital Structure
• What is the primary goal of financial
managers?
• Maximize stockholder wealth
• Choose the optimal capital structure
• Maximize the value of the firm
• Minimize the WACC
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Capital Restructuring
• Financial leverage = the extent to which a firm
relies on debt financing
• Capital restructuring involves changing the
amount of leverage a firm has without changing
the firm’s assets
• The firm can increase leverage by issuing debt
and repurchasing outstanding shares
• The firm can decrease leverage by issuing new
shares and retiring outstanding debt
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The Effect of Leverage
• How does leverage affect the EPS and ROE of a
firm?
• More debt financing, means more fixed interest
expense
• In expansion, we have more income after we pay
interest, have more left over for stockholders
• In recession, we still have to pay our costs
therefore we have less left over for stockholders
• Leverage amplifies the variation in both EPS and
ROE
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Example: Financial Leverage, EPS and ROE
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Break-Even EBIT
• Break-Even EBIT where:
EPS debt = EPS no debt
• If expected EBIT > break-even EBIT, then
leverage is beneficial to our stockholders
• If expected EBIT < break-even EBIT, then
leverage is detrimental to our stockholders
17-7
Example: Break-Even EBIT
EPS no debt  EPS debt
earnings earnings interest

shares
shares
Numbers in thousands
EBIT EBIT  250

500
250
250EBIT  500EBIT  250 
250EBIT  500EBIT  125000
250EBIT  125000
$125000
EBIT 
 $500
250
EPS with No Debt = $500/500 = $1
EPS with Debt = ($500-$250)/250 = $1
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Break Even EBIT
With debt
With no debt
17-9
Capital Structure Theory
• Modigliani and Miller Theory of Capital
Structure
• Proposition I – firm value
• Proposition II – cost of equity & 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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Capital Structure Theory Under
Three Special Cases
• Case I – Assumptions
• No taxes
• No bankruptcy costs
• Case II – Assumptions
• With taxes
• No bankruptcy costs
• Case III – Assumptions
• With taxes
• With bankruptcy costs
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Case I – No Taxes
• Proposition I
• The value of the firm is NOT affected by
changes in the capital structure
• The cash flows of the firm do not change;
therefore, value doesn’t change
• Proposition II
• Cost of Equity increases as Debt increases
• The WACC of the firm is NOT affected by
capital structure
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Case I - No Taxes - Equations
• WACC = RA = (E/V)RE + (D/V)RD
• RE = RA + (RA – RD)(D/E)
• RA is the “cost” of the firm’s business risk, i.e.,
the risk of the firm’s assets
• (RA – RD)(D/E) is the “cost” of the firm’s
financial risk, i.e., the additional return
required by stockholders to compensate for
the risk of leverage
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Figure 17.3
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Case I - No Taxes - Example
• Data
• Required return on assets = WACC = RA = 16%,
• Cost of debt = RD = 10%
• Percent of debt = D = 45%
• E = 1 - 0.45 = 0.55 or 55%
• D/E = 0.45/0.55 = 0.82
• What is the cost of equity?
• RE = RA + (RA – RD)(D/E)
• RE = 0.16 + (0.16 – 0.10)(.45/.55) = 20.91%
• Proof for WACC:
• WACC = RA = (E/V)RE + (D/V)RD
• WACC = RA = 0.55 * 20.91% + 0.45 * 10% = 16%
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Case I – No Taxes
Example continued..
• What happens if the firm increases leverage so
that D/E = 1.5? (before D/E = 0.82 when D=45%,E=55%)
• What is the cost of equity?
• RE = RA + (RA – RD)(D/E)
• RE = 0.16 + (0.16 – 0.10)(1.5) = 0.25 or 25%
• Proof for WACC:
• WACC = RA = (E/V)RE + (D/V)RD
E
1

V 1  D/E
• From D/E = 1.5, D = 60%, E = 40%
• WACC = 0.4 * 25% + 0.6 * 10% = 16%
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The CAPM, Business Risk, Financial Risk
and Proposition II
•
How does financial leverage affect systematic risk?
•
CAPM: RE = Rf + E(RM – Rf) – for equity
•
CAPM: RA = Rf + A(RM – Rf) – for assets
•
Where A is the firm’s asset beta and measures the systematic risk of the firm’s
assets, also called unleverred beta – the risk of the assets if the firm would have no
debt ( in essence E = A if no debt)
• RE = RA + (RA – RD)(D/E)
• RE = RA + (RA – Rf)(D/E) - assume RD = Rf
•
•
Proposition II
•
As we introduce debt in the firm:
•
RE = Rf + A(1+D/E)(RM – Rf)
•
E = A(1 + D/E)
Therefore, the systematic risk of the stock depends on:
•
Systematic risk of the assets, A, (Business risk)
•
Level of leverage, D/E, (Financial risk)
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Case II – Introducing Taxes
• What happens to the firm’s cash flows?
• Interest is tax deductible
• Therefore, when a firm adds debt, it reduces
taxes, all else equal
• The reduction in taxes increases the cash flow
of the firm
• How should an increase in cash flows
affect the value of the firm?
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Case II - with Taxes - Example
Unlevered Firm
No Debt
EBIT
Interest
Levered Firm
With Debt
5000
0
5000
(6250@8%)
500
Taxable
Income
Taxes (34%)
5000
4500
1700
1530
Net Income
3300
2970
CFFA
3300
3470
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Interest Tax Shield
• Annual interest tax shield
• Tax rate times interest payment
• 6250 in 8% debt = 500 in interest expense
• Annual tax shield = 0.34(500) = 170
• Present value of annual interest tax shield
• Assume perpetual debt for simplicity
• PV = 170 / 0.08 = 2125
6250  0.08  0.34
PV 
 6250  0.34  2125
0.08
D  R D  TC
PV 
 D  TC
RD
17-20
Case II - with Taxes - Proposition I
• The value of the firm increases by the
present value of the annual interest tax
shield
• Value of a levered firm = value of an unlevered
firm + PV of interest tax shield
• Assuming perpetual cash flows
• VU = EBIT(1-T) / RU
with no debt
RU = RA= RE and VU = E
• VL = VU + D*TC
• E = VL - D
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Case II – with Taxes
Proposition I - Example
• Data Inc. has earnings of 25 million per
year every year. The firm has no debt and
the cost of capital is 12%. If tax is 35%
what is the value of the firm?
• EBIT = 25 million; Tax rate = TC= 35%;
Unlevered cost of capital = RU= 12% = RA = RE
VU = ?
• VU = EBIT(1-T) / RU
• VU = 25(1-0.35) / 0.12 = $135.42 million
• VU = E
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Case II – with Taxes
Proposition I - Example (cont.)
• Data Inc. decides to issue bonds that have a
market value of 75 million at a cost of 9%. What
is the value of the firm? What will be the value of
equity?
• D = $75 million, RD= 9%, VL = ?, E = ?
VU = 135.42 (calculated on previous slide)
• VL = VU + tax shield
• VL = VU + D*TC
• VL = 135.42 + 75(0.35) = $161.67 million
• E = VL - D
• E = 161.67 – 75 = $86.67 million
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Figure 17.4 Case II - with Taxes
Proposition I
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Case II – with Taxes - Proposition II
• Recap: In case I – Proposition II - no taxes:
• RE increases as Debt increases
• WACC is unchanged
• When taxes are introduced in Case II:
• RE increases as Debt increases
RE = RU + (RU – RD)(D/E)(1-TC)
• WACC decreases as D/E increases because
the cost of debt decreases
RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)
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Case II – with Taxes
Proposition II - Example
• Data Inc. info from Case II proposition I:
• EBIT = 25 million; TC= 35%; D = $75 million;
RD= 9%; Unlevered cost of capital = RU= 12%
E = $86.67m; VL = $161.67m
D/E = 75/86.67 = 0.87,
E/V = 86.67/161.67 = 0.54,
D/V = 75/161.67 = 0.46
• RE = RU + (RU – RD)(D/E)(1-TC)
• RE = 0.12 + (0.12-0.09)(0.87)(1-0.35) = 13.69%
• RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)
• RL = WACC = (0.54)(0.1369) + (0.46)(0.09)(1-.35) =
10.05%
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Example: Case II – Proposition II
• Suppose Data Inc. changes its capital structure
so that the debt-to-equity ratio becomes 1.
• Before: D/E = 0.87, E= 54%, D=46%
• Now: D/E = 1, E= 50%, D=50%
• What will happen to the cost of equity under the
new capital structure? (previously 13.69%)
• RE = 0.12 + (0.12 – 0.09)(1)(1-0.35) = 13.95%
• What will happen to the weighted average cost of
capital? (previously 10.05%)
• WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9%
• What if D/E = 1.25?, RE = ?, WACC = ?
17-27
Figure 17.5 - Case II with Taxes
Proposition II
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Case III – with Bankruptcy Costs
• Now we add bankruptcy costs
• As the D/E ratio increases, the probability of
bankruptcy increases
• This increased probability will increase the
expected bankruptcy costs
• At some point, the additional value of the interest
tax shield will be offset by the increase in
expected bankruptcy cost
• At this point, the value of the firm will start to
decrease and the WACC will start to increase as
more debt is added
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Figure 17.6
– Case III with Bankruptcy costs
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Figure 17.7
Case III with Bankruptcy costs
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Bankruptcy Costs
• Direct costs
• Legal and administrative costs
• Indirect costs
• Larger than direct costs & more difficult to
measure and estimate
• Financial distress costs
• All costs associated with going bankrupt
and/or avoiding bankruptcy
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Conclusions
• Case I – no taxes or bankruptcy costs
• No optimal capital structure
• Case II – corporate taxes but no bankruptcy costs
• Optimal capital structure is almost 100% debt
• Each additional dollar of debt increases the cash flow
of the firm
• Case III – corporate taxes and bankruptcy costs
• Optimal capital structure is part debt and part equity
• Occurs where the benefit from an additional dollar of
debt just offsets the increase in expected bankruptcy
costs
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Figure
17.8
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Managerial Recommendations
• The tax benefit is only important if the firm
has a large tax liability
• Risk of financial distress
• The greater the risk of financial distress, the
less debt will be optimal for the firm
• The cost of financial distress varies across
firms and industries and as a manager you
need to understand the cost for your industry
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End Chapter 17
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