Chapter 16 - Financial Leverage and Capital Structure Policy
Chapter 16
FINANCIAL LEVERAGE AND CAPITAL STRUCTURE
POLICY
SLIDES
16.1
16.2
16.3
16.4
16.5
16.6
16.7
16.8
16.9
16.10
16.11
16.12
16.13
16.14
16.15
16.16
16.17
16.18
16.19
16.20
16.21
16.22
16.23
16.24
16.25
16.26
16.27
16.28
16.29
16.30
16.31
16.32
16.33
16.34
16.35
16.36
16.37
16.38
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 16.3
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 16.4
Case II – Proposition II
Example: Case II – Proposition II
Figure 16.5
Case III
Bankruptcy Costs
More Bankruptcy Costs
Figure 16.6
Figure 16.7
Conclusions
Figure 16.8
Managerial Recommendations
Figure 16.9
The Value of the Firm
The Pecking-Order Theory
Chapter 16 - Financial Leverage and Capital Structure Policy
SLIDES – CONTINUED
16.39
16.40
16.41
16.42
16.43
16.44
Observed Capital Structure
Work the Web Example
Bankruptcy Process – Part I
Bankruptcy Process – Part II
Quick Quiz
Ethics Issues
CHAPTER WEB SITES
Section
16.9
16.10
Web Address
www.reuters.com
www.sec.gov
www.bankruptcydata.com
CHAPTER ORGANIZATION
16.1
The Capital Structure Question
Firm Value and Stock Value: An Example
Capital Structure and the Cost of Capital
16.2
The Effect of Financial Leverage
The Basics of Financial Leverage
Corporate Borrowing and Homemade Leverage
16.3
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
16.4
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
Conclusion
16.5
Bankruptcy Costs
Direct Bankruptcy Costs
Indirect Bankruptcy Costs
16.6
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
Chapter 16 - Financial Leverage and Capital Structure Policy
16.7
The Pie Again
The Extended Pie Model
Marketed Claims versus Nonmarketed Claims
16.8
The Pecking-Order Theory
Internal Financing and the Pecking Order
Implications of the Pecking Order
16.9
Observed Capital Structures
16.10 A Quick Look at the Bankruptcy Process
Liquidation and Reorganization
Financial Management and the Bankruptcy Process
Agreements to Avoid Bankruptcy
16.11 Summary and Conclusions
ANNOTATED CHAPTER OUTLINE
Slide 16.1
Slide 16.2
16.1.
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 the debt plus the
market value of the equity (firm value identity). 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. (In a future
chapter, you will cover the topic of viewing a firm’s equity as a
call option on the firm’s assets.)
Slide 16.3
Capital Restructuring
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.
Chapter 16 - Financial Leverage and Capital Structure Policy
Maximizing the value of the firm is the goal of managing capital
structure.
Slide 16.4
Choosing a Capital Structure
Lecture Tip: 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.
16.2.
The Effect of Financial Leverage
A.
Slide 16.5
The Basics of Financial Leverage
The Effect of Leverage
Slide 16.6 Example: Financial Leverage, EPS & ROE – Part I Click on
the Excel icon to open a spreadsheet containing the example information.
Slide 16.7 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
Current capital structure: No debt
Recession Expected Expansion
EBIT
$300,000 $650,000 $1,000,000
Interest Expense
0
0
0
Net Income
$300,000 $650,000 $1,000,000
ROE
6%
13%
20%
EPS
$0.60
$1.30
$2.00
250,000
10%
Chapter 16 - Financial Leverage and Capital Structure Policy
Proposed capital structure: D/E = 1; interest rate = 10%
Recession Expected Expansion
EBIT
$300,000 $650,000 $1,000,000
Interest Expense
250,000 250,000
250,000
Net Income
$50,000 $400,000
$750,000
ROE
2%
16%
30%
EPS
$0.20
$1.60
$3.00
Lecture Tip: 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 16.8 Break-Even EBIT
Slide 16.9 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: 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
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.
Chapter 16 - Financial Leverage and Capital Structure Policy
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 16.10 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
$2.00
Earnings for 100 shares
$60.00 $130.00
$200.00
Less interest on $500 at 10%
50.00
50.00
50.00
Net earnings
$10.00
$80.00
$150.00
Return on investment = net earnings / $500
2%
16%
30%
The investor has been able to convert her return to what she would
have gotten if the company had undertaken the proposed capital
structure and she had just purchased $500 worth of stock.
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
$3.00
Earnings for 25 shares
5.00
40.00
75.00
Plus interest on $250 at 10%
25.00
25.00
25.00
Net earnings
$30.00
$65.00
$100.00
Return on investment = net earnings / $500
6%
13%
20%
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.
Chapter 16 - Financial Leverage and Capital Structure Policy
16.3.
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 16.11 Capital Structure Theory
Slide 16.12 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: 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 16.13
Slide 16.14
Slide 16.15
Slide 16.16
Case I – Propositions I and II
Case I – Equations
Figure 16.3
Case I – Example
Chapter 16 - Financial Leverage and Capital Structure Policy
Lecture Tip: 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 16.17 The CAPM, the SML and Proposition II
Slide 16.18 Business Risk and Financial Risk
Lecture Tip: Some students may be confused by 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.
16.4.
M&M Propositions I and II with Corporate Taxes
Slide 16.19 Case II – Cash Flow
A.
The Interest Tax Shield
Tax savings arise from the deductibility of interest. It is the key
benefit from borrowing over issuing equity.
Slide 16.20 Case II – Example
Slide 16.21 Interest Tax Shield
Chapter 16 - Financial Leverage and Capital Structure Policy
B.
Taxes and M&M Proposition I
Annual interest tax savings = D(RD)(TC)
If we assume perpetual debt, then the present value of the 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 cash
flows that change through time.
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 16.22 Case II – Proposition I
Slide 16.23 Example: Case II – Proposition I
Slide 16.24 Figure 16.4
Lecture Tip: Slides 16.25 through 16.27 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 16.25 Case II – Proposition II
Slide 16.26 Example Case II – Proposition II
Lecture Tip: 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.
C.
Conclusion
Chapter 16 - Financial Leverage and Capital Structure Policy
Slide 16.27 Figure 16.5
16.5.
Bankruptcy Costs
Real-World Tip: In 1997, the remaining assets of Fruehauf
Corporation, described by Barrons as “the once-dominant”
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 difficult to service, the firm went through a number of
restructurings until the firm filed for chapter 11 in 1996. At that
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.
Slide 16.28 Case III
A.
Direct Bankruptcy Costs
The key disadvantage of 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.
Slide 16.29 Bankruptcy Costs
Slide 16.30 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 forgone revenues,
opportunity costs, etc.
Financial distress – the direct and indirect costs of avoiding
bankruptcy.
Chapter 16 - Financial Leverage and Capital Structure Policy
16.6.
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 16.31 Figure 16.6
B.
Optimal Capital Structure and the Cost of Capital
The optimal capital structure is the debt-equity mix that minimizes
the WACC.
Slide 16.32 Figure 16.7
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 16.33 Conclusions
Slide 16.34 Figure 16.8
D.
Capital Structure: Some Managerial Recommendations
Taxes – tax shields are more important for firms with high
marginal tax rates
Financial distress – the lower the risk (or cost) of distress, the more
likely a firm is to borrow funds
Chapter 16 - Financial Leverage and Capital Structure Policy
Slide 16.35 Managerial Recommendations
International Note: In theory, the static model of capital structure
described in this section applies to multinational firms as well as
to domestic firms. The multinational firm should seek to minimize
its global cost of capital by balancing the debt-related tax shields
across all of the countries in which the firm does business against
global agency and bankruptcy costs. 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.
16.7.
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 16.36 Figure 16.9
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.
Chapter 16 - Financial Leverage and Capital Structure Policy
Slide 16.37 The Value of the Firm
16.8.
The Pecking-Order Theory
Asymmetric information between buyers and sellers means that
existing firm owners know more than potential investors. The view
is that existing owners will sell equity when it is overvalued, which
is a negative signal to investors. Thus, this is avoided at all costs,
particularly since equity issuance is also costly.
A.
Internal Financing and the Pecking Order
Rules of the pecking order:
#1: Use internal financing first
#2: Issue debt next and new equity last
B.
Implications of the Pecking Order
The pecking-order theory is in contrast to the tradeoff theory in
that:
-there is no target D/E ratio
-profitable firms will use less debt
-companies like financial slack
Slide 16.38 The Pecking-Order Theory
16.9.
Observed Capital Structures
Table 16.7 lists ratios of debt to total capital for several U.S.
industries.
Slide 16.39 Observed Capital Structure
Slide 16.40 Work the Web Example
16.10. 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 –when total book liabilities exceed total book assets
Chapter 16 - Financial Leverage and Capital Structure Policy
-Bankruptcy – the transfer of some, or all, of the firm’s assets to creditors
Slide 16.41 Bankruptcy Process – Part I
Slide 16.42 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
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: 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
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. An
extension postpones the date of payment, while composition
involves a reduced payment.
Chapter 16 - Financial Leverage and Capital Structure Policy
16.11. Summary and Conclusions
Slide 16.43 Quick Quiz
Slide 16.44 Ethics Issues