Ch 16
April 20th, 2012
Ch. 16 Financial Leverage & Capital Structure
I. The Effect of Financial Leverage on EPS and ROE
II. Capital Structure Theory (Merton Miller and Franco Modigliani 1958):
a) M&M Proposition I & II without taxes
b) M&M Proposition I & II with Taxes and Bankruptcy Cost
III. Bankruptcy Cost and the Static Theory of Capital Structure
IV. The Pecking-Order theory of CS
V. Observed Capital Structures
VI. The Bankruptcy Process
Ch. 16 Capital Structure Policy
How much debt vs. equity a firm has is called capital structure.
The chapter discusses how fin. manager decides on the cap. structure.
A firm can change its C/S by selling stocks and use the $ to repurchase
debt or issue debt and repurchase equity (substituting debt for equity and
vice versa: restructuring)
Goal: maximize shareholder wealth = max. firm value (because equity
holders get the residual CF after the bondholders are paid fixed interest)
What is effect of C/S on WACC: WACC is discount rate appropriate for
overall CFs.
Since values (PV) and discount rates move in opposite direction: value of
firm is maximized when WACC is minimized. Where WACC is minimized is
optimal capital structure.
I. The Effect of Financial Leverage on EPS and ROE
Financial leverage = degree to which debt is used
p. 539, Table 17.3 (NO TAXES): write on board
two C/S: current = green = no leverage (no debt)
proposed = blue = leverage (use 4,000,000 to repurchase
4,000,000/20=200,000 shares)
p. 539, Table 17.4 : three scenarios or states of the economy: recession,
expected, expansion (difference in scenarios is different EBITs)
look at ROE (net income/equity) and EPS (net income/# of shares)
if recession: (green) ROE and EPS are higher for no leverage
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if expansion: (blue) ROE and EPS are lower for no leverage
conclusion=>
with leverage = variability of EPS and ROE goes up (firm does better in a
good scenario but also does worse in a bad scenario)
leverage is like a magnifying glass for gains and losses
leverage “amplifies” the variation in both ROE and EPS.
p. 540, figure 17.1 EBIT & EPS are plotted on graph:
steeper line = debt (leverage)
flatter line = no debt (no leverage)
the two lines cross at EBIT = $800,000. (break-even or indifference point)
Below this point : no-debt is better
Above this point : debt is better
Indifference point:
(EBIT / # of shares nodebt ) = (EBIT - interest / # of shares debt )
solve for EBIT
EBIT/400,000 = (EBIT – 400,000) / 200,000
example:
currently a firm uses no debt but considers restructuring
after restructuring, debt will be $500,000 (interest on debt is 8%)
the firm has currently 120,000 shares outstanding, price per share is $17.
What is the minimum level of EBIT that the firm must earn so that the
restructuring will increase EPS?
uses $500,000 of debt
to repurchase shares ($17)
EBIT / 120,000 = [EBIT - (500,000 x .08)] / [120,000 - (500,000/17)]
EBIT / 120,000 = [EBIT - 40,000] / 90,588
EBIT = [EBIT - 40,000] / 90,588 x 120,000
EBIT = [EBIT - 40,000] x 1.3247
EBIT = 1.3247 EBIT - 52,988
52,988 = .3247 EBIT
163,191 = EBIT
We said that leverage creates more variability of firm’s EPS and ROE.
Does this create more risk for individual investors? If they don’t do
anything about it yes, but the investor can borrow or lend out money and
can create “home made leverage”. (borrow on margin)
p. 542 (earnings are $50, 300, and 550 under both scenarios)
= stock price will be the same no matter what the leverage is: basis for MM
I without taxes.
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II. Capital Structure and Cost of Equity
a) M&M Proposition I & II without taxes
M&M Proposition I
Because of home made leverage: stock price does not change, C/S does
not matter. This is what Franco Modigliani and Merton Miller state in their
proposition I:
V L = VU
pie model, no matter how pie is split up: the size of pie does not change
WACC is same for all levels of debt
M&M Proposition II
This proposition states that R E depends on the C/S
If we rearrange WACC formula:
R E = R A + (R A - R D ) x (D/E)
if debt increases cost of equity increases: because the risk increases for
equity holders (debt holders are paid off first)
Note: cost of equity is comprised of “business risk” R A and financial risk
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b) M&M Propositions I & II with Taxes and Bankruptcy Cost
MM I with taxes:
So far we ignored taxes
But if taxes are considered debt is better than equity because interest
payments are tax deductible.
Tax saving from using debt (= interest tax shield) = I x T = D x R D x T
PV of interest tax shield (is perpetuity)= D x T x R D / R D = D x T
VL
= VU + D x T
= EBIT(1-T)/RE + DxT
(value of leveraged firm is more than the unleveraged by tax shield) =>
firms should use 100% debt
The more debt the more the value of firm the lower the WACC
Example: EBIT per year = 25 million; Tax rate = 35%; Debt = $75 million;
(Cost of debt = 9%); Unlevered cost of capital = 12%
VU = 25(1-.35) / .12 = $135.42 million
VL = 135.42 + 75(.35) = $161.67 million
(E = 161.67 – 75 = $86.67 million)
MM II with taxes
Implication of taxes on R E :
R E =R U + (R U - R D ) x (D/E) x (1-T)
The effect of leverage is same on R E whether or not taxes are considered
The higher the debt the higher the R E
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So far we have also ignored bankruptcy costs
If firm used more debt the chance of going bankrupt is increased: firm
cannot use 100% debt.
Bankruptcy in economic sense: Value of firm = value of debt, equity has no
value
Bankruptcy costs are direct (legal & administrative) and indirect (cost of
avoiding bankruptcy filing)
Financial distress costs = direct & indirect bankruptcy costs
At the “optimal” leverage ratio, the additional value of the interest tax
shield will be offset by the bankruptcy cost
III. Optimal Capital Structure (Static Theory of Capital Structure)
Using more debt => value of firm goes up due to interest tax shield
but at a certain level: too much debt creates the chance of going bankrupt
and incurring bankruptcy costs (tradeoff)
At optimum level: tax benefit of one more dollar = cost from increased
chance of bankruptcy
=> STATIC THEORY OF C/S
Summary p. 557
red line is value of firm (considers taxes & bankruptcy)
at maximum: optimal capital structure
blue line (considers taxes only)
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red line is WACC or R A . It is minimized where value is maximized.
bottom blue line: after-tax cost of debt. Goes up because of bankruptcy
top blue line: cost of equity goes up with leverage (equity holders incur
more risk)
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IV. The Pecking-Order Theory of CS
What we actually observe in terms of CS is not what we would expect from
the Static theory model. Why do highly profitable firms have low debt
ratios?
Another more recent theory offers an explanation for that observation and
is an alternative to the static theory: The Pecking-Order Theory of CS.
It says there is a pecking order to how capital is raised. This is a more
short tem theory where as the Static Theory is a more long-term theory.
How the firm raises capital follows an order of “priority”:
1. At first, the firm will use internal financing (retained earnings). Because
this is the cheapest way to “obtain” funds.
2. If necessary and no internal funds are available, the firm will use external
funds and use the cheaper form of debt financing first.
3. As a last resort (debt may be too expensive or unavailable because of
high credit risk), equity financing is used.
V. Observed Capital Structures (look at slides from MBA class!!!)
so far we discussed theories
what about real world?
firms have relatively low debt/equity ratios:
(firms use less debt than equity)
Differences in C/S exist between industry groups & countries
(Usually firms that use intangible/specialized assets use less debt because
of loss of value once they are sold (risky operations).
Main conclusion: other factors besides tax & bankruptcy explain C/S
Note: If company is in higher tax bracket: borrowing more beneficial,
higher leverage
Higher variability of EBIT: more bankruptcy risk: use less leverage (drug
and computer industries)
The opposite is true for Electric Utilities and Department stores, they have
low EBIT variability and high debt ratios. The airlines have seen lower
profitability and had to use more debt financing in recent years (high gas
prices and high competition).
Differences according to Cost of Capital
Yearbook by Ibbotson Associates, Inc
Show that drug, computer and fabric companies have low
debt/total capital (=debt + market value of equity)
Electric Utilities & department stores, airlines and cable
have high levels of debt.
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Studies has also shows that in certain countries, the debt levels are higher
than in other countries. For example, in the US and Germany the debt
levels are very low and in many of the Asian countries such as Korea,
China, and Japan, the debt levels are considerably higher. There are two
main reasons for that: the countries’ tax laws and how the countries’ legal
system protects creditors. In countries where the legal system has better
protection for financial claimants, such as the US and Germany, the debt
ratio is typically lower.
V. Bankruptcy Process:
If company uses debt : possibility of financial distress
If firm cannot pay creditors: it is bankrupt
It can be liquidated or reorganized
Liquidation (Ch 7 of Bankruptcy Act):
Firm is worth more dead than alive
all assets are sold and proceeds given to creditors in order of priority:
Admin. & legal expenses; employee compensation; taxes; senior debt,
junior debt, pref. stock, common stock
(according to absolute priority rule) but is not always followed
Reorganization (Ch 11): if firm is worth more alive than dead:
reorganization is likely; old securities are replaced with new ones, new
management.
Some repayment of creditors
An example: GM was restructured in a Chapter 11 reorganization in 2008
with the help of the US government.
At the end of Nov 2011, AMR corp, the parent company of American
Airlines filed for Ch 11 bankruptcy protection (mainly to reduce labor costs
in the negotiations with creditors and unions).
Agreements with creditors (extension of pay period) can avoid costly
bankruptcy procedures.
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