Lecture 12: Financial Leverage and Capital
Structure Policy
•
The Capital Structure Question
•
The Effect of Financial Leverage
•
Capital Structure and the Cost of Equity Capital
– M&M Propositions I and II ( NO Corporate Taxes )
– M&M Propositions I and II ( WITH Corporate Taxes )
•
Bankruptcy & Optimal Capital Structure
•
The Extended Pie Model
Lecture 12: Capital Structure Policy
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The Capital Structure Question
•
Given a particular mix of debt and equity used to finance the firm,
we now know how to find the cost of capital.
•
But what mix of debt and equity should the financial manager
choose?
Ø Capital Structure ? Financial Structure
Ø What D/E ratio should the firm aim for?
Ø What is the optimal amount of Financial Leverage
• A measure of the amount of debt used to finance the firm
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Optimal Capital Structure
•
•
•
Remember the goal of the manager: Maximize the value of the firm’s
shares.
But since shareholders are residual claimants on the firm’s cash flows:
Ø Maximizing the value of the firm is the same as maximizing the value of
the firm’s shares.
Value of firm = Value of equity + Value of debt
Ø Since the debt holder's claim is fixed (guaranteed in advance), any
change to the value of the firm can change only the value of the equity.
Ø To maximize the value of the equity, we should maximize the value of
the firm.
• (Exception: If the firm is very risky and may have difficulty paying off its
debt, the value of the debt will no longer be fixed and changes in firm
value may be reflected in the value of debt.)
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WACC and Capital Structure
•
Maximizing firm value ó minimizing WACC.
– WACC is the discount rate for firm’s overall cash flows.
– Lowering WACC raises PV of firm’s cash flows
• Ignoring taxes:
WACC =
E
D
* RE + * RD
V
V
• Since RD < RE, can’t we minimize WACC simply by increasing
debt?
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The Effect of Financial Leverage
• Debt is the fixed financial cost of the firm (like the fixed costs
in operating leverage).
• As debt increases, changes in firm cash flows cause larger
swings in cash flows to equity.
• Degree of financial leverage
DFL =
Percentage _ change _ in _ EPS
EBIT
=
Percentage _ change _ in _ EBIT
EBIT − Interest
• Consider a firm currently financed with all equity. It considers
issuing debt and using the proceeds to buy back shares. The
interest rate on the firm’s debt would be 10%.
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Leverage Example (Table 16.3)
Current
Equity Value
Proposed
8,000,000
4,000,000
0
4,000,000
400,000
200,000
Debt Value
Shares Outstanding
Recession
Normal
Boom
EBIT
500,000
1,000,000
1,500,000
CF to Equity (no Debt)
500,000
1,000,000
1,500,000
6.25%
12.5%
18.75%
Interest
400,000
400,000
400,000
CF to Equity (with Debt)
100,000
600,000
1,100,000
2.5%
15%
27.5%
ROE (no debt)
ROE (with Debt)
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Homemade Leverage
•
Definition: The use of personal borrowing to change the
overall amount of financial leverage to which the individual is
exposed.
•
Example: Firm stays all-equity financed.
–
Investor pays $2000 for 100 shares and borrows $2000 @10%
to buy 100 more shares.
Recession
Normal
Boom
EPS of unlevered firm
$1.25
$2.50
$3.75
Earnings for 200 shares
$250
$500
$750
less interest
-$200
-$200
-$200
Net earnings
$50
$300
$550
ROE
2.5%
15%
27.5%
•
Investors could also undo leverage by holding 50% shares, 50%
debt.
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Modigliani and Miller (M&M) Proposition 1
• Note: No Taxes!
Financial leverage and firm value: Proposition I
•
Since investors can add or undo leverage to get the effective capital
structure they desire, then in the absence of taxes and other such
complications, the value of the firm is unaffected by its capital
structure.
Vu = EBIT / RE u = VL = EL + DL
• Cash flows are cash flows; regardless of how we add them up,
they always total the same.
Ø It doesn’t matter how you slice it, a pizza is still a pizza.
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M&M Proposition 2
The cost of equity and financial leverage:
Proposition II
A. Because of Prop. I, the WACC must be constant. With
no taxes,
WACC = R A = (E/V) x RE + (D/V) x RD
where RA is the return on the firm’s assets
B. Solve for R E to get MM Prop. II
RE = R A + (R A - RD) x (D/E)
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The Cost of Equity and WACC
Cost of capital
R E = RA + (RA – R D ) x (D/E)
WACC = R A
RD
Debt-equity ratio, D/E
RE = Rf + (RM − Rf ) * βE
βE = βA * (1+ D / E)
βE = βA + β A * D / E
Lecture 12: Capital Structure Policy
Cost of equity has two parts:
1.
2.
RA and “business” risk
D/E and “financial” risk
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M&M Propositions ( WITH corporate taxes)
• Debt allows the firm to deduct interest payments and thus pay
less tax. The resulting tax savings are called the interest tax
shield.
• The value of this shield is just the PV of all relevant CFs.
PV = annual interest tax shield / RD = ( RD * D * TC ) / RD = D*TC
• Since the tax shield adds value to the firm,
M&M proposition I becomes:
VL = VU + D * TC
where
ρ
V u = EBIT * (1 − TC ) / ρ
is the unlevered cost of capital (CC of a firm with no debt)
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M&M Propositions ( WITH corporate taxes)
Value of the firm
VL
Vu
D/E
•
As leverage increases, the value of the firm increases and
WACC decreases. The Optimal capital structure is all debt!
M&M proposition II:
RE = REU + ( REU - RD) * (D/E) * (1 - TC )
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M&M Summary – No Taxes
Proposition I: The value of the firm levered equals the value of the firm
unlevered:
VL = VU
Implications of Proposition I:
1. A firm’s capital structure is irrelevant.
2. A firm’s WACC is the same no matter what mix of debt and equity is
used.
Proposition II:The cost of equity, R E , is
RE = R A + (RA - RD) × D/E
where R A is the WACC, R D is the cost of debt, and D/E is the
debt/equity ratio.
Implications of Proposition II
1. The cost of equity rises as the firm increases its use of debt financing.
2. The risk of equity depends on the risk of firm operations and on the
degree of financial leverage.
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M&M Summary – With Taxes
Proposition I with Taxes: The value of the firm levered equals the value
of the firm unlevered plus the present value of the interest tax shield:
VL = VU + Tc*D
where Tc is the corporate tax rate and D is the amount of debt.
Implications of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s
optimal capital structure as much debt as possible.
2. A firm’s WACC decreases as the firm relies more heavily on debt.
Proposition II with Taxes:
RE = REU + ( REU - RD ) * (D/E) * (1 - TC )
– Implications same as before
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What about the Real World?
•
•
In the real world, we have taxes, but most firms use both debt
and equity financing.
How do we reconcile this with M&M+Taxes?
By looking at costs of financial distress.
1. Direct bankruptcy costs
2. Indirect bankruptcy costs
•
•
Firms must balance the tax advantages of debt financing with
the increased bankruptcy costs as leverage increases
In addition, while firms are taxed more on equity, the opposite
is true for investors; the personal-tax treatment of debt and
equity may offset some advantages of debt.
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Bankruptcy and Financial Distress
•
•
“Bankruptcy” does not mean “going out of business”.
In fact, bankruptcy is a process to protect the firm from its creditors
so that it can reorganize and, hopefully, survive.
•
A firm may request bankruptcy protection when it has insufficient
cash flows to meet its obligations to creditors (interest payments)
This happens only when the value of the firm is less than the value
of its debts. (Why?)
•
•
•
Firms can try to avoid bankruptcy by negotiating with creditors
If the judge grants the company bankruptcy protection, then one of
the following will happen:
– Reorganization: the firm renegotiates with its creditors and
emerges from bankruptcy.
– Liquidation: the assets of the firm are sold and the proceeds paid
out according to priority rules.
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Priority in Bankruptcy
1.
2.
3.
4.
5.
6.
Bankruptcy costs (lawyers)
Debtor in possession financing
Employees
Government
Debt holders (senior then subordinate)
Equity holders (preferred then common)
– Secured creditors get first crack at the security assets.
– Equity holders are last in priority, and since the firm can’t pay
all its creditors, their equity is technically worthless.
– But they retain power during the bankruptcy process,
because they control the business and can force a “cramdown” liquidation.
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Costs of Financial Distress
•
Direct costs:
– Bankruptcy procedures can takes years and often involve
hundreds of lawyers.
– In case of liquidation, it may be difficult to sell assets at true
value.
– For solvent business, calculate as
Probability of Bankruptcy * Direct Costs of Bankruptcy
•
Indirect costs:
– Costs from anticipation of possible bankruptcy
– Other firms do not want to deal with unreliable firms
– Agency costs: Management takes actions that are in their own
best interest (reduce risk) or in the best interest of the equity
holders (increase risk) rather than in the interest of the firm as a
whole.
– These costs are incurred whether or not the firm goes bankrupt
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Implications of the
Static Theory of the Capital Structure
• In Theory:
– 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.
• In Practice:
– Can’t precisely estimates marginal costs of financial
distress.
• Makes theory hard to test, hard to use.
– The higher the tax rate, the greater incentive to borrow.
• Firms with high depreciation rates or large accumulated
losses have less incentive to borrow.
– The greater the risk of financial distress, the lower the D/E
• More volatile EBIT should mean lower D/E
• More tangible assets (e.g. higher liquidation values)
should mean higher D/E.
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The Static Theory of Capital Structure
•
The optimal capital structure and the value of the firm
Value of
the firm
(VL )
VL = VU + T C
Present value of tax
shield on debt
D
Financial
distress costs
Actual firm value
VU
VU = Value of firm
with no debt
Debt-equity ratio, D/E
D/E
Lecture 12: Capital Structure Policy
Optimal amount of debt
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The Static Theory of Capital Structure
• The optimal capital structure and the cost of capital
Cost of
capital
(%)
RE
RU
RU
WACC
Minimum
cost of capital WACC*
RD
(1 – T C)
Debt/equity ratio
(D/E)
D*/E*
The optimal debt/equity ratio
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The Extended Pie Model
Lower financial leverage
Bondholder
claim
Stockholder
claim
Bankruptcy
claim
Tax
claim
•
Higher financial leverage
Bondholder
claim
Stockholder
claim
Bankruptcy
claim
Tax
claim
The optimal capital structure is thus the one that maximizes the
value of marketed claims ( bondholders’ and shareholders’ claims)
or the one that minimizes the value of non-marketed claims
(government’s and potential litigants’ claims)
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What we know now
• Capital Structure / Financial Structure / Financial Leverage
discusses the optimal mix of financing (primarily debt and
equity) for the firm.
• Management should maximize the value of the whole firm,
which will lead to the maximum value for shareholders as
residual claimants.
• M&M tell us that, without taxes, the capital structure decision
is irrelevant: pick whatever you want.
• But with taxes and bankruptcy costs, we must balance to find
the optimal capital structure.
• As we increase the financial leverage, the riskiness and
consequently the cost of equity will increase.
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