Chapter 17
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
POLICY
SLIDES
17.1
17.2
17.3
17.4
17.5
17.6
17.7
17.8
17.9
17.10
17.11
17.12
17.13
17.14
17.15
17.16
17.17
17.18
17.19
17.20
17.21
17.22
17.23
17.24
17.25
17.26
17.27
17.28
17.29
17.30
17.31
17.32
17.33
17.34
17.35
17.36
17.37
17.38
Key Concepts and Skills
Chapter Outline
Capital Restructuring
Choosing a Capital Structure
The Effect of Leverage
Example: Financial Leverage, EPS & ROE – Part I
Example: Financial Leverage, EPS & ROE – Part II
Break-Even EBIT
Example: Break-Even EBIT
Example: Homemade Leverage and ROE
Capital Structure Theory
Capital Structure Theory Under Three Special Cases
Case I – Propositions I and II
Case I – Equations
Figure 17.3
Case I – Example
The CAPM, the SML and Proposition II
Business Risk and Financial Risk
Case II – Cash Flow
Case II – Example
Interest Tax Shield
Case II – Proposition I
Example: Case II – Proposition I
Figure 17.4
Case II – Proposition II
Example: Case II – Proposition II
Figure 17.5
Case III
Bankruptcy Costs
More Bankruptcy Costs
Figure 17.6
Figure 17.7
Conclusions
Figure 17.8
Managerial Recommendations
Figure 17.9
The Value of the Firm
Observed Capital Structure
A-224 CHAPTER 17
SLIDES – CONTINUED
17.39
17.40
17.41
17.42
Work the Web Example
Bankruptcy Process – Part I
Bankruptcy Process – Part II
Quick Quiz
CASES
The following cases from Cases in Finance by DeMello can be used to illustrate concepts
discussed in this chapter:
Debt vs. Equity Financing
EBIT-EPS Analysis
Bankruptcy
CHAPTER WEB SITES
Section
17.5
17.8
17.9
End-of-chapter material
Web Address
www.abiworld.org
yahoo.marketguide.com
www.sec.gov/investor/
www.bankruptcydata.com
www.amex.com
CHAPTER ORGANIZATION
17.1
The Capital Structure Question
Firm Value and Stock Value: An Example
Capital Structure and the Cost of Capital
17.2
The Effect of Financial Leverage
The Basics of Financial Leverage
Corporate Borrowing and Homemade Leverage
17.3
Capital Structure and the Cost of Equity Capital
M&M Proposition I: The Pie Model
The Cost of Equity and Financial Leverage: M&M Proposition II
Business and Financial Risk
17.4
M&M Propositions I and II with Corporate Taxes
The Interest Tax Shield
Taxes and M&M Proposition I
Taxes, the WACC, and Proposition II
CHAPTER 17 A-225
17.5
Bankruptcy Costs
Direct Bankruptcy Costs
Indirect Bankruptcy Costs
17.6
Optimal Capital Structure
The Static Theory of Capital Structure
Optimal Capital Structure and the Cost of Capital
Optimal Capital Structure: A Recap
Capital Structure: Some Managerial Recommendations
17.7
The Pie Again
The Extended Pie Model
Marketed Claims versus Nonmarketed Claims
17.8
Observed Capital Structures
17.9
A Quick Look at the Bankruptcy Process
Liquidation and Reorganization
Financial Management and the Bankruptcy Process
Agreements to Avoid Bankruptcy
17.10 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Slide 17.1
Slide 17.2
17.1.
Key Concepts and Skills
Chapter Outline
The Capital Structure Question
A.
Firm Value and Stock Value: An Example
The value of the firm equals the market value of debt plus the
market value of equity (firm value identity). Notationally, this is
just V = D + E. When the market value of debt is given and
constant, any change in the value of the firm results in an identical
change in the value of the equity. The key to this reasoning lies in
the fixed nature of debt and the derivative nature of stock.
Slide 17.3
Slide 17.4
Capital Restructuring
Choosing a Capital Structure
A-226 CHAPTER 17
B.
Capital Structure and the Cost of Capital
The “optimal” or “target” capital structure is that debt/equity mix
that simultaneously (a) maximizes the value of the firm, (b)
minimizes the weighted average cost of capital, and (c) maximizes
the market value of the common stock.
Maximizing the value of the firm is the goal of managing capital
structure.
Lecture Tip, page 569: Students sometimes fail to understand the
mechanics of why “minimizing WACC maximizes firm value.”
Remind students that a firm is just a portfolio of projects, some
with positive NPVs and some with negative NPVs when evaluated
at the WACC. The value of the firm is the sum of the NPVs of its
component projects. We already know that lower discount rates
increase NPVs, consequently, decreasing the WACC will increase
firm value.
17.2.
The Effect of Financial Leverage
A.
The Basics of Financial Leverage
Slide 17.5 The Effect of Leverage
Slide 17.6 Example: Financial Leverage, EPS & ROE – Part I Click on
the Excel icon to go to a spreadsheet that contains the example information
for the example presented below.
Slide 17.7 Example: Financial Leverage, EPS & ROE – Part II
Example (additional example from the one in the book)
Assets
Debt
Equity
D/E ratio
Share price (assume it doesn’t change when shares are
repurchased)
Shares outstanding
Interest Rate
Current
Proposed
$5,000,000 $5,000,000
0 2,500,000
5,000,000 2,500,000
0
1
$10
$10
500,000
N/A
250,000
10%
CHAPTER 17 A-227
Current capital structure: No debt
Recession Expected Expansion
EBIT
$300,000 $650,000 $800,000
Interest Expense
0
0
0
Net Income
$300,000 $650,000 $800,000
ROE
6%
13%
16%
EPS
$0.60
$1.30
$1.60
Proposed capital structure: D/E = 1; interest rate = 10%
Recession Expected Expansion
EBIT
$300,000 $650,000 $800,000
Interest Expense
250,000 250,000
250,000
Net Income
$50,000 $400,000 $550,000
ROE
2%
16%
22%
EPS
$0.20
$1.60
$2.20
Lecture Tip, page 571: You may wish to provide the following
example to better solidify the students’ understanding of the
variability in ROE due to leverage. Ask the class to consider the
difference between ROE and ROA for an all equity firm given
various sales levels. It’s easy to show that ROE = ROA in this case
because total equity = total assets. The substitution of debt for
equity results in ROE equaling ROA at only one level of sales. The
fixed interest expense and lower number of common shares
outstanding cause ROE to change by a larger percentage than the
change in ROA, for any given change in sales.
Slide 17.8 Break-Even EBIT
Slide 17.9 Example: Break-Even EBIT Click on the Excel icon to see the
graph that illustrates the cross-over point.
We can conclude that:
-The effect of financial leverage depends on EBIT
-Financial leverage increases ROE and EPS when EBIT is
greater than the cross-over point
-The variability of EPS and ROE is increased as leverage
increases
Lecture Tip, page 573: Many students feel that if a company
expects to achieve the break-even EBIT, it should automatically
issue debt. You should emphasize that this is a break-even point
relative to EBIT and EPS. Beyond this point, EPS will be larger
under the debt alternative, but with additional debt, the firm will
have additional financial risk that would increase the required
return on its common stock. A higher required return might offset
A-228 CHAPTER 17
the increase in EPS, resulting in a lower firm value despite the
higher EPS. The M&M models, described in upcoming sections,
will offer key points to make about this relationship.
B.
Corporate Borrowing and Homemade Leverage
Homemade leverage – if all market participants have equal access
to the capital markets, there’s nothing special about corporate
borrowing.
Slide 17.10 Example: Homemade Leverage and ROE
Suppose the firm in the previous example does not change its
capital structure. An investor can replicate the returns of the
proposed borrowing by making her own D/E ratio equal to 1 for
the investment. Suppose an investor buys 50 shares with her own
money and 50 shares by borrowing $500 at 10% interest. The
payoffs are:
Recession Expected Expansion
EPS – unlevered firm
$0.60
$1.30
$1.60
Earnings for 100 shares
$60.00 $130.00
$160.00
Less interest on $500 at 10%
50.00
50.00
50.00
Net earnings
$10.00
$80.00
$110.00
Return on investment = net earnings / $500
2%
16%
22%
The investor has been able to convert her return to what she would
have gotten if the company had undertaken the proposed capital
structure.
Suppose instead the firm does switch to the proposed capital
structure. An investor can “unlever” the firm by purchasing both
the firm’s stock and bonds. Consider an investor who invests $250
in the stock and $250 in the bonds paying 10%. (Note that in both
situations, the investor’s total cash outlay is $500.)
Recession Expected Expansion
EPS – levered firm
$0.20
$1.60
$2.20
Earnings for 25 shares
5.00
40.00
55.00
Plus interest on $250 at 10%
25.00
25.00
25.00
Net earnings
$30.00
$65.00
$80.00
Return on investment = net earnings / $500
6%
13%
16%
CHAPTER 17 A-229
In this case, the investor is able to earn the same return as she
would have earned if the firm did not change capital structure and
she just invested in stock.
17.3.
Capital Structure and the Cost of Equity Capital
A.
M&M Proposition I: The Pie Model
M&M Proposition I – without corporate taxes and bankruptcy
costs, the firm cannot affect its value by altering its capital
structure.
Slide 17.11 Capital Structure Theory
Slide 17.12 Capital Structure Theory Under Three Special Cases
B.
The Cost of Equity and Financial Leverage: M&M Proposition II
M&M Proposition II – a firm’s cost of equity capital is a positive
linear function of its capital structure (still assuming no taxes):
WACC = RA = (E/V)RE + (D/V)RD;
RE = RA + (RA – RD)(D/E)
As more debt is used, the return on equity increases, but the change
in the proportion of debt versus equity just offsets that increase and
the WACC does not change.
Lecture Tip, page 576: Many students wonder why we are even
considering a situation in which taxes do not exist. We are trying
to determine what risk-return trade-off is best for the firm’s
stockholders. One way to get a good understanding of what is
relevant to the capital structure decision is to start in a “perfect”
world and then relax assumptions as we go. By relaxing one
assumption at a time, we can get a better idea of the impact on the
capital structure decision. This is the classic process of “model
building” in economics – start simple and add complexity one step
at a time.
Slide 17.13
Slide 17.14
Slide 17.15
Slide 17.16
Case I – Propositions I and II
Case I – Equations
Figure 17.3
Case I – Example
A-230 CHAPTER 17
Lecture Tip, page 577: According to Proposition II,
RE = RA + (RA – RD)(D/E). An alternative explanation is as
follows: In the absence of debt, the required return on equity
equals the return on the firm’s assets, RA. As we add debt, we
increase the variability of cash flows available to stockholders,
thereby increasing stockholder risk.
C.
Business and Financial Risk
You may wish to skip over the distinction between the asset beta
and the equity beta. The key point is that Proposition II shows that
return on equity depends on both business risk and financial risk.
Business risk – the risk inherent in a firm’s operations; it depends
on the systematic risk of the firm’s assets and it determines the first
component of the required return on equity, RA
Financial risk – the extra risk to stockholders that results from debt
financing; it determines the second component of the required
return on equity, (RA – RD)(D/E)
Slide 17.17 The CAPM, the SML and Proposition II
Slide 17.18 Business Risk and Financial Risk
Lecture Tip, page 579: Some students may confuse the concepts of
financial risk and default risk. Proposition II suggests that even if
a firm could issue risk-free debt, its financial risk would exceed
zero. Point out that the focus here is on the risk (and required
return) to the shareholder. Regardless of the certainty associated
with the promised returns to bondholders (default risk), higher
levels of debt imply greater volatility of earnings to stockholders.
17.4.
M&M Propositions I and II with Corporate Taxes
Slide 17.19 Case II – Cash Flow
A.
The Interest Tax Shield
Tax savings arising from the deductibility of interest. It is the key
benefit from borrowing over issuing equity.
Real-World Tip, page 579: “Wall Street Concocts New TaxSaving Ploy … Treasury Attacks Clever Way to Let Borrower
Deduct Both Principal, Interest.” So reads a headline from the
CHAPTER 17 A-231
November 6, 1997 issue of The Wall Street Journal. How is this
accomplished?
Here’s how it works.
“First, the borrower and an investor each put up a certain amount,
say $100, to create a real estate investment trust. The investor, a
state pension fund or other tax-exempt organization, does so by
buying preferred stock in the REIT.
Next, in a typical case, the REIT lends its entire $200 to the
borrower.
The borrower pays the interest, but no principal, on the loan.
The REIT, whose income isn’t taxable, passes all this money on to
the investor in the form of high preferred-stock dividends.
These dividends ‘step-down’ steeply to almost nothing after 10
years. By then, the investor has gotten most of its money back. It
gets the rest back by selling the REIT preferred stock to the
borrower.
Finally, the REIT is merged into the borrower, giving the
borrower its initial $100 back. Result, the borrower had a $100
loan for 10 years, a loan that is now paid off. It could deduct all
payments, since none were principal repayments.”
Slide 17.20 Case II – Example
Slide 17.21 Interest Tax Shield
B.
Taxes and M&M Proposition I
Annual interest tax savings = D(RD)(TC)
If we assume perpetual debt, then the present value of interest tax
savings = D(RD)(TC) / RD = DTC
We also assume perpetual cash flows to the firm. This is done for
simplicity, but the ultimate result is the same even if you use finite
cash flows.
Value of an unlevered firm, VU = EBIT(1 – TC)/RU; where RU is
the cost of capital for an all equity firm.
Value of a levered firm, VL = VU + DTC
Slide 17.22 Case II – Proposition I
Slide 17.23 Example: Case II – Proposition I
Slide 17.24 Figure 17.4
A-232 CHAPTER 17
Lecture Tip, page 580: Slides 13.25 through 13.27 provide a
discussion of the effect of corporate taxes on Proposition II. These
slides can be hidden if you don’t wish to discuss it in class.
Slide 17.25 Case II – Proposition II
Slide 17.26 Case II – Proposition II Example
Slide 17.27 Case II – Graph of Proposition II
Lecture Tip, page 581: This is a good point at which to digress a
bit on the idea that financing decisions can generate positive
NPVs. Put simply, a positive NPV decision is one for which the
firm obtains something for less than market value. Just as the
relative inefficiency of the physical asset markets makes the search
for positive NPV projects worthwhile, the efficiency of the financial
markets makes positive NPV financing projects unlikely. This can
change in the presence of financial market imperfections; and
differential tax treatment between interest and dividends is a big
market imperfection. Further discussion of the successes and
failures of financial engineering in the last two decades may serve
to illustrate the core concepts: (1) firm value comes largely from
the asset side of the balance sheet and (2) positive NPV financing
projects can also be created, but in general, financing is a zeroNPV proposition.
Slide 17.27 Figure 17.5
17.5.
Bankruptcy Costs
Real-World Tip, page 584: In 1997, the remaining assets of
Fruehauf Corporation, described by Barrons as “the oncedominant” manufacturer of truck trailers, were sold off for a mere
$50 million, bringing an end to the story of a great firm laid low by
over-reliance on debt financing.
Founded in the 1940’s, the firm controlled one-third of the
trailer market in the early 1980’s, but then went private in a
leveraged buyout in 1986 to avoid a hostile takeover bid. Saddled
with debt it found it difficult to service, the firm went through a
number of restructurings until, by 1996, the firm filed for chapter
11, at which time its shares were delisted from the NYSE. And, as
Barrons notes, “… the shareholders had been wiped out, leaving
the carcass to be picked over by those with secure claims to
Fruehauf’s assets … [b]lood was in the water.” By 1997, the last
division was sold and the remaining assets were sold to Wabash
National.
CHAPTER 17 A-233
Slide 17.28 Case III
A.
Direct Bankruptcy Costs
The key disadvantage to the use of debt is bankruptcy costs.
Direct bankruptcy costs are the legal and administrative expenses
directly associated with bankruptcy. Generally, these costs are
quantifiable and measurable.
Real-World Tip, page 585: As noted in the text, bankruptcy costs
can be direct or indirect. Examples of direct costs such expenses as
legal and accounting fees incurred by the firm upon filing for
bankruptcy. Both empirical and anecdotal evidence indicate that
direct costs can run into tens of millions of dollars, even for
relatively small firms. For example, Apex Oil in St. Louis incurred
over $20 million in legal and accounting claims before it emerged
from bankruptcy. The key point is that those funds represented
value not captured by the firm’s shareholders.
Slide 17.29 Bankruptcy Costs
Slide 17.30 More Bankruptcy Costs
B.
Indirect Bankruptcy Costs
Indirect bankruptcy costs (e.g., difficulties in hiring and retaining
good people because the firm is in financial difficulty) are hard to
measure and generally take the form of foregone revenues,
opportunity costs, etc.
Financial distress – the direct and indirect costs of avoiding
bankruptcy.
17.6.
Optimal Capital Structure
A.
The Static Theory of Capital Structure
-Firms borrow because tax shields are valuable
-Borrowing is constrained by the costs of financial distress
-The optimal capital structure balances the incremental benefits
and costs of borrowing
Slide 17.31 Figure 17.6
A-234 CHAPTER 17
B.
Optimal Capital Structure and the Cost of Capital
The optimal capital structure is that debt-equity mix at which the
WACC is minimized.
Slide 17.32 Figure 17.7
C.
Optimal Capital Structure: A Recap
Case I – No taxes or bankruptcy costs; firm value is unaffected by
the choice of capital structure
Case II – Corporate taxes, no bankruptcy costs; firm value is
maximized when the firm uses as much debt as possible due to the
interest tax shield
Case III – Corporate taxes and bankruptcy costs; firm value is
maximized where the additional benefit from the interest tax shield
is just offset by the increase in expected bankruptcy costs – there is
an optimal capital structure
Slide 17.33 Conclusions
Slide 17.34 Figure 17.8
D.
Capital Structure: Some Managerial Recommendations
Taxes – the higher the firm’s tax rate, the more important are tax
shields
Financial distress – the lower the risk of distress, the more likely a
firm is to borrow funds
Slide 17.35 Managerial Recommendations
International Note, page 590: In theory, the static model of capital
structure described in this section applies to multinational firms as
well as to domestic firms. That is, the multinational firm should
seek to minimize its global cost of capital by balancing the debtrelated tax shields across all of the countries in which the firm
does business against global agency and bankruptcy costs. Among
other things, however, this assumes that worldwide capital markets
are well-integrated and that foreign exchange markets are highly
efficient. In such an environment, financial managers would seek
the optimal global capital structure. In practice, of course, the
existence of capital market segmentation, differential taxes and
regulatory frictions make the determination of the global optimum
much more difficult than the theory would suggest.
CHAPTER 17 A-235
17.7.
The Pie Again
A.
The Extended Pie Model
Cash Flow = Payments to stockholders (E) + Payments to creditors
(D) + Payments to the government (G) + Payments to bankruptcy
courts and lawyers (B) + Payments to all other claimants
Slide 17.36 Figure 17.9
B.
Marketed Claims versus Nonmarketed Claims
Marketed claims – claims against cash flow that can be bought and
sold (bonds, stock)
Nonmarketed claims – claims against cash flow that cannot be
bought and sold (taxes)
VM = value of marketed claims
VN = value of nonmarketed claims
VT = value of all claims = VM + VN = E + D + G + B + …
Given the firm’s cash flows, the optimal capital structure is the one
that maximizes VM or minimizes VN
Slide 17.37 The Value of the Firm
17.8.
Observed Capital Structures
Table 17.7 lists ratios of debt to total capital for several U.S.
industries.
Slide 17.38 Observed Capital Structure
Slide 17.39 Work the Web Example
17.9.
A Quick Look at the Bankruptcy Process
Financial distress
-Business failure – business terminates with a loss to creditors
-Legal bankruptcy – bankruptcy is a legal proceeding for liquidating or
reorganizing
-Technical insolvency – when a firm defaults on a legal obligation
-Accounting insolvency – happens when total book liabilities exceed total
book assets
A-236 CHAPTER 17
Bankruptcy – the transfer of some or all of the firm’s assets to creditors
Slide 17.40 Bankruptcy Process – Part I
Slide 17.41 Bankruptcy Process – Part II
A.
Liquidation and Reorganization
Liquidation – termination of the business, selling off all assets
Reorganization – keeping the business going, often issuing new
securities to replace old
Real-World Tip, page 595: On March 29, 1996 The Wall Street
Journal announced that the trust set up to distribute the assets of
Drexel Burnham Lambert, one of the most (in)famous investment
banks of the 1980s, would complete the task ahead of schedule.
Even more surprising to some was the fact that creditors received,
on average, nearly 80 cents on the dollar for their claims. When
the trust was established in 1992, experts had predicted that
creditors would receive less than 20 cents on the dollar. Why was
this liquidation so successful? Largely because securities values in
general have risen nearly continually since the inception of the
trust. Unfortunately, this case is an exception to the rule. Average
receipts of 10 to 30 cents on the dollar are more typical.
Bankruptcy liquidation (Chapter 7 or straight liquidation) – assets
are sold and distributed to creditors in the order of the absolute
priority rule
Bankruptcy reorganization (Chapter 11) – involves a legal
proceeding in which the company restructures its debt obligations.
A plan is filed with the court and the various stakeholders have to
agree on the plan.
Lecture Tip, page 597: It has been said that Carl Icahn’s takeover
of TWA in the early 1980s represents the quintessential example of
the “80s two-step” – borrow extensively to take the firm private,
then file for bankruptcy. Icahn, one of the most noted takeover
artists of the period, was not as successful at running TWA as he
had been with some of his other businesses. Following repeated
losses, he sold the firm to the employees, who struggled mightily to
put the firm back on its feet. Nonetheless, TWA filed for bankruptcy
reorganization in 1992 and again in 1995. In each case, a portion
CHAPTER 17 A-237
of firm ownership was transferred from the owners to the creditors
in return for the latter’s willingness to eliminate a portion of the
outstanding debt.
B.
Financial Management and the Bankruptcy Process
The right to go bankrupt is valuable because it stops creditors from
further draining assets from the firm, and may be used to improve
the firm’s strategic position vis-à-vis its competitors.
C.
Agreements to Avoid Bankruptcy
Voluntary arrangements to restructure debt are often made.
Extension postpones the date of payment, while composition
involves a reduced payment.
17.10. Summary and Conclusions
Slide 17.42 Quick Quiz