INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Prepared by
Ken Hartviksen
CHAPTER 21
Capital Structure Decisions
Lecture Agenda
•
•
•
•
•
•
•
•
•
•
Learning Objectives
Important Terms
Financial Leverage
Determining Capital Structure
M&M Irrelevance Theorem
Impact of Taxes
Financial Distress, Bankruptcy and Agency Costs
Other Factors affecting Capital Structure
Capital Structure in Practice
Summary and Conclusions
– Concept Review Questions
– Appendix 1 – Thunder Bay Industries – Indifference Analysis
CHAPTER 21 – Capital Structure Decisions
21 - 3
Learning Objectives
1.
2.
3.
4.
5.
6.
7.
How business risk and financial risk affect a firm’s ROE and EPS
How indifference analysis may be used to compare financing
alternatives based on expected EBIT levels
Modigliani and Miller’s irrelevance, argument, as well as the key
assumptions upon which it is based
How the introduction of corporate taxes affects M&M’s irrelevance
argument
How financial distress and bankruptcy costs lead to the static trade-off
theory of capital structure
How information asymmetry problems and agency problems may lead
firms to follow a pecking order approach to financing
How other factors such as firm size, profitability and growth, asset
tangibility, and market conditions can affect a firm’s capital structure.
CHAPTER 21 – Capital Structure Decisions
21 - 4
Important Chapter Terms
•
•
•
•
•
•
•
•
•
•
•
Agency costs
Bankruptcy
Business risk
Cash flow-to-debt ratio
Corporate debt tax shield
Direct costs of bankruptcy
EPS indifference point
Financial break-even points
Financial distress
Financial leverage
Financial leverage risk
premium
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Financial risk
Fixed burden coverage ratio
Homemade leverage
Indifference point
Indirect costs of bankruptcy
Invested capital
M&M equity cost equation
Modigliani and Miller
Pecking order
Profit planning charts
Return on equity (ROE)
Return on invested capital
Risk value of money
Static tradeoff
CHAPTER 21 – Capital Structure Decisions
21 - 5
The Focus of this Chapter
• You know:
– It is the responsibility of the financial manager to maximize
shareholder wealth.
– The after-tax cost of debt is significantly lower than the cost of
equity primarily because of the tax-deductibility of interest
expense…therefore, using debt has a cost advantage over
equity.
– The lower the cost of capital, the greater the value of the firm.
– This chapter addresses the question:
Does the relative mix of financing used by a firm affect its value?
If so, how and why and are what are the other impacts that
capital structure can have on the firm?
CHAPTER 21 – Capital Structure Decisions
21 - 6
In this Chapter You Will Learn
1. The optimal (target) capital structure is the one that
maximizes the value of the firm and minimizes the cost
of capital.
2. How lenders seek to protect themselves from excessive
use of corporate leverage through the use of protective
covenants.
3. The tax advantage to debt is offset at higher levels of
financial leverage by costs associated with financial
distress and bankruptcy.
4. Firms depart from the target capital structure in
practice because of financing preferences and capital
market conditions.
CHAPTER 21 – Capital Structure Decisions
21 - 7
Leverage
What is it?
• The increased volatility in operating income
over time, created by the use of fixed costs in
lieu of variable costs.
– Leverage magnifies profits and losses.
• There are two types:
– Operating leverage
– Financial leverage
• Both types of leverage have the same effect on
shareholders but are accomplished in very
different ways, for very different purposes
strategically.
CHAPTER 21 – Capital Structure Decisions
21 - 8
Leverage Effects on Operating Income
When
a firm
increases
Normal
volatility
of the
use of fixed costs it
operating
income
increases the volatility of
operating income.
Operating
Income
+
0
Years
CHAPTER 21 – Capital Structure Decisions
21 - 9
Operating Leverage
What is it? How is it Increased?
• Operating leverage is:
– The increased volatility in operating income caused by fixed
operating costs.
• You should understand that managers do make decisions
affecting the cost structure of the firm.
• Managers can, and do, decide to invest in assets that
give rise to additional fixed costs and the intent is to
reduce variable costs.
– This is commonly accomplished by a firm choosing to become
more capital intensive and less labour intensive, thereby
increasing operating leverage.
CHAPTER 21 – Capital Structure Decisions
21 - 10
Operating Leverage
Advantages and Disadvantages
Advantages:
– Magnification of profits to the shareholders if the firm is
profitable.
– Operating efficiencies (faster production, fewer errors, higher
quality) usually result increasing productivity, reducing
‘downtime’ etc.
Disadvantages:
– Magnification of losses to the shareholders if the firm does not
earn enough revenue to cover its costs.
– Higher break even point
– High capital cost of equipment and the illiquidity of such an
investment make it:
• Expensive (more difficult to finance)
• Potentially exposed to technological obsolescence, etc.
CHAPTER 21 – Capital Structure Decisions
21 - 11
Financial Leverage
What is it? How is it Increased?
• Your textbook defines financial leverage as:
– The increased volatility in operating income caused
by the corporate use of sources of capital that carry
fixed financial costs.
• Financial leverage can be increased in the firm
by:
– Selling bonds or preferred stock (taking on financial
obligations with fixed annual claims on cash flow)
– Using the proceeds from the debt to retire equity (if
the lenders don’t prohibit this through the bond
indenture or loan agreement)
CHAPTER 21 – Capital Structure Decisions
21 - 12
Financial Leverage
Advantages and Disadvantages
Advantages:
– Magnification of profits to the shareholders if the firm is
profitable.
– Lower cost of capital at low to moderate levels of financial
leverage because interest expense is tax-deductible.
Disadvantages:
– Magnification of losses to the shareholders if the firm does not
earn enough revenue to cover its costs.
– Higher break even point.
– At higher levels of financial leverage, the low after-tax cost of
debt is offset by other effects such as:
• Present value of the rising probability of bankruptcy costs
• Agency costs
• Lower operating income (EBIT), etc.
CHAPTER 21 – Capital Structure Decisions
21 - 13
Effects of Operating and Financial Leverage
Summary
•
Equity holders bear the added risks associated with the use
of leverage.
•
The higher the use of leverage (either operating or financial)
the higher the risk to the shareholder.
•
Leverage therefore can and does affect shareholders
required rate of return, and in turn this influences the cost of
capital.
HIGHER LEVERAGE = HIGHER COST OF CAPITAL
CHAPTER 21 – Capital Structure Decisions
21 - 14
Business Risk
• All firms experience variability in sales and operating
(fixed and variable) operating costs over time.
– Some firms operate in a highly volatile industry (for example oil
and gas) and we would say the firm has a high degree of
business risk.
– Other firms operate in a very stable industry where revenues and
expenses don’t change much from year to year throughout the
business cycle; these firms have low business risk.
• Business risk is the variability of a firm’s operating
income caused by operational risk.
– Business risk is measured by the standard deviation of EBIT.
CHAPTER 21 – Capital Structure Decisions
21 - 15
Financial Leverage
Risk and Leverage
•
Lenders to the firm insulate themselves from risk
through financial contracting:
•
•
•
•
•
Lending money through a formal, legally-binding contract.
Demanding a fixed rate of return on the money they lend to the
firm, in-keeping with their required return on monies borrowed.
Demanding other promises that will protect the lender’s interests
over the life of the loan/investment.
Demanding a high priority in the priority of claims list in the event
of corporate dissolution/bankruptcy.
Shareholders bear the risk associated with business
risk, and the added risks associated with the use of
leverage because they are residual claimants of the
firm.
CHAPTER 21 – Capital Structure Decisions
21 - 16
Return on Investment (ROI)
Financial Leverage
Return on Investment (ROI)
–
–
is the return on all the capital provided by investors; EBIT
minus taxes divided by invested capital.
Invested Capital (IC) is a firm’s capital structure consisting of
shareholders’ equity and short- and long-term debt.
[ 21-2]
EBIT (1  T )
ROI 
SE  B
CHAPTER 21 – Capital Structure Decisions
But we know the claims
on the numerator
(operating income after
taxes) are very
different, and so too are
the risks each provider
of capital is exposed.
21 - 17
Return on Equity (ROE)
Financial Leverage
ROE – is the return earned by equity holders on
their investment in the company
– ROE = net income divided by shareholders’ equity.
[ 21-1]
( EBIT  RD B )(1  T )
ROE 
SE
CHAPTER 21 – Capital Structure Decisions
21 - 18
ROI versus ROE
Financial Leverage
•
•
If the firm is completely financed by equity:
ROE = ROI.
Let us examine the effects of sales volatility on
ROI and ROE given different levels of financial
leverage.
CHAPTER 21 – Capital Structure Decisions
21 - 19
Financial Leverage
Risk and Leverage
•
Using this base income statement:
Table 21-1 Example Income Statement
Sales
Variable costs
Fixed costs
EBIT
Interest
Taxable Income
Tax (40%)
Net Income
•
$1,000
300
158
$542
42
$500
200
$300
The following three slides show three different financing strategies
and the impacts on ROE, ROI, EPS for break-even, normal, and high
sales levels:
CHAPTER 21 – Capital Structure Decisions
21 - 20
Financial Leverage
Income Statement – No Financial Leverage
Table 21-1 Example Income Statement
Sales
Variable costs
Fixed costs
EBIT
Interest
Taxable Income
Tax (40%)
Net Income
Invested capital =
Debtholders' investment =
Shareholders' Equity =
ROI =
ROE =
EPS (1,700 shares) =
-77.5%
100.0%
140.0%
$225
68
158
-$1
0
-$1
0
-$0
$1,000
300
158
$542
0
$542
217
$325
$1,400
420
158
$822
0
$822
329
$493
$1,700
$0
$1,700
0.0%
0.0%
$0.00
This
a 0.0 no use
ROE assumes
= ROI because
100.0%
debt/equity ratio
0.0%of debt financing.
100.0%
19.1%
19.1%
$0.19
CHAPTER 21 – Capital Structure Decisions
29.0%
29.0%
$0.29
21 - 21
Financial Leverage
Income Statement – Base Case
Table 21-1 Example Income Statement
Sales
Variable costs
Fixed costs
EBIT
Interest
Taxable Income
Tax (40%)
Net Income
Invested capital =
Debtholders' investment =
Shareholders' Equity =
ROI =
ROE =
EPS (1000 shares) =
-71.5%
100.0%
140.0%
$285
86
158
$42
42
-$0
0
-$0
$1,000
300
158
$542
42
$500
200
$300
$1,400
420
158
$822
42
$780
312
$468
$1,700
$700
$1,000
1.5%
-0.1%
$0.00
ROE
This is
assumes
levered acompared
0.70
to
100.0%
ROIdebt/equity
because ofratio
the moderate
41.2%
use of debt financing.
58.8%
19.1%
42.9%
$0.30
CHAPTER 21 – Capital Structure Decisions
29.0%
66.9%
$0.47
21 - 22
Financial Leverage
Income Statement with High Financial Leverage
Table 21-1 Example Income Statement
Sales
Variable costs
Fixed costs
EBIT
Interest
Taxable Income
Tax (40%)
Net Income
Invested capital =
Debtholders' investment =
Shareholders' Equity =
ROI =
ROE =
EPS (300 shares) =
-65.4%
100.0%
140.0%
$346
104
158
$84
84
$0
0.08
$0
$1,000
300
158
$542
$84
$458
183.2
$275
$1,400
420
158
$822
$84
$738
295.2
$443
$1,700
$1,400
$300
3.0%
0.0%
$0.00
ROE is more volatile than
100.0%
ROI because of the high use
82.4%
of financial leverage.
17.6%
19.1%
91.6%
$0.92
CHAPTER 21 – Capital Structure Decisions
29.0%
147.6%
$1.48
21 - 23
Financial Leverage
Risk and Leverage
• Consider the equation for ROE:
EBT
(1 – T)
= Net Income
EBITtimes
– Interest
expense
= EBT
[ 21-1]
ROE 
( EBIT  RD B )(1  T )
SE
The equation reduce to net income
divided by BV of shareholders’ equity.
CHAPTER 21 – Capital Structure Decisions
21 - 24
Financial Leverage
Risk and Leverage
• Equation 21 – 2 is the definition of ROI:
[ 21-2]
EBIT (1  T )
ROI 
SE  B
• If we re-express EBIT (1-T) in the ROE equation,
we get:
CHAPTER 21 – Capital Structure Decisions
21 - 25
Financial Leverage
Risk and Leverage
• This is the financial leverage equation:
[ 21-3]
B
ROE  ROI  ( ROI  RD (1  T )
SE
• ROI measures the return that the firm earns
from operations, but DOES NOT explicitly
considered how the firm is financed.
CHAPTER 21 – Capital Structure Decisions
21 - 26
Financial Leverage
Risk and Leverage
• If we rearrange Equation 21 – 3, grouping like terms
involving ROI we get:
[ 21-4]
B
B
ROE  ROI  (1 
)  RD (1  T )
SE
SE
• The second term is fixed.
• The first term depends on the firm’s uncertain ROI.
• This means we can graph ROE against ROI as a straight
line.
See Figure 21 -1 on the following slide.
CHAPTER 21 – Capital Structure Decisions
21 - 27
Financial Leverage
Risk and Leverage
21 - 1 FIGURE
ROE
80
D/E =0.70
60
All Equity
40
20
ROI
-16
-20
-40
-12
-8
-4
0
4
8
12
16
20
24
28
32
36
40
Slope
D/E = of
0.70.
the
all equity
Slope
line is of
= 1.0.
the
line > 1.0.
In this case
ROI
Above
= ROE.
the
intercept
with the
horizontal
axis, ROE
>ROI.
Indifference
Financial
Break-even
point where
pointsfor
ROEs
where
different
ROE financing
=0
strategies are equal.
-60
CHAPTER 21 – Capital Structure Decisions
21 - 28
Financial Leverage
Risk and Leverage
Financial Break-even point:
– Points at which a firm’s ROE is zero.
Indifference Point:
– Points at which two financing strategies provide the
same ROE.
CHAPTER 21 – Capital Structure Decisions
21 - 29
Financial Leverage
The Rules of Financial Leverage
•
For value-maximizing firms, the use of debt
increases the expected ROE so shareholders
expect to be better off by using debt financing,
rather than equity financing.
•
Financing with debt increases the variability of the
firm’s ROE, which usually increases the risk to the
common shareholders.
•
Financing with debt increases the likelihood of the
firm running into financial distress and possibly
even bankruptcy.
CHAPTER 21 – Capital Structure Decisions
21 - 30
Financial Leverage
The Rules of Financial Leverage
Table 21-2 Varying ROI Values
ROI (%)
10
30
Range
70% D/E Ratio
100% Equity
ROE (%)
14.48
48.48
34
10
30
20
ROI reflects the business risk of the firm.
ROE =ROI in the all equity firm.
ROE increases as the firm finances with more debt.
CHAPTER 21 – Capital Structure Decisions
21 - 31
Financial Leverage
The Rules of Financial Leverage
Table 21-3 Wider Variation ROI Values
ROI (%)
-10
40
Range
70% D/E Ratio
100% Equity
ROE (%)
-19.52
65.48
85
-10
40
50
Wider variation in ROI means magnified ROE over a still
wider range than ROI.
CHAPTER 21 – Capital Structure Decisions
21 - 32
Financial Leverage
Investing Using Leverage
•
Figure 21-2 illustrates the monthly returns from
investing in the S&P/TSX Composite Index
using two different financing strategies:
1. Investing in the index (all equity)
2. Investing in the index with 80% borrowed on margin.
•
•
The added volatility of gains and losses over
time is clearly evident.
These principles of leverage apply to
corporations as well as households
(See Figure 21 – 2 on the following slide)
CHAPTER 21 – Capital Structure Decisions
21 - 33
Financial Leverage
Investing Using Leverage
21 - 2 FIGURE
CHAPTER 21 – Capital Structure Decisions
21 - 34
Financial Leverage
Indifference Analysis
• Is a profit planning technique used to forecast
the EPS-EBIT relationships under different
financing scenarios.
• The indifference point is where:
EPS(Financing strategy 1)=EPS(Financing strategy 2)
CHAPTER 21 – Capital Structure Decisions
21 - 35
Financial Leverage
Indifference Analysis
•
The formula for EPS, given EBIT, interest on debt (RDB), the corporate
tax rate (T), and the number of common shares outstanding (#):
[ 21-5]
•
( EBIT  RD B )(1  T )
EPS 
#
We can rearrange the definition of EPS and show how it varies with
EBIT:
CHAPTER 21 – Capital Structure Decisions
21 - 36
Financial Leverage
Indifference Analysis
• EPS is a simple linear function of EBIT:
[ 21-6]
 RD B (1  T ) EBIT (1  T )
EPS 

#
#
• This is illustrated in the EPS-EBIT graph in
Figure 21 – 3 found on the following slide:
CHAPTER 21 – Capital Structure Decisions
21 - 37
Financial Leverage
EPS-EBIT (Profit Planning) Charts
21 - 3 FIGURE
0.8
0.6
Indifference
point.
0.4
0.2
0
-567-397-312-227 -142
-0.2
-0.4
-0.6
57
28
113
198
283
368
453
538
623
708
793
878
963 1048 1133
The horizontal intercept of the 70% D/E line is
greater by the added interest expense that must be
covered before producing earnings available for
common shareholders.
EPS 0% D/E
EPS 70% D/E
CHAPTER 21 – Capital Structure Decisions
21 - 38
Financial Leverage
EPS-EBIT (Profit Planning) Charts
• The slope of the lines are a function of the
number of common shares outstanding (dilution
of EPS).
– The all equity line will have a lower slope because
every dollar of net income is divided by more common
shares.
• The horizontal intercept is greater for the debt
financing line because the firm must cover its
interest expense before earnings begin to
accrue to the benefit of shareholders.
CHAPTER 21 – Capital Structure Decisions
21 - 39
Determining Capital Structure
• Table 21 – 4 demonstrates the 1990 results of a
Conference Board survey of 119 U.S.
companies to determine their capital structure.
• External sources of information include:
– (#2) checking with their advisors, and
– (#5) examining other firms in the industry.
• The three primary sources of information are:
– (#4) impact on profits
– (#3) risk
– (#1) analysis of cash flows
CHAPTER 21 – Capital Structure Decisions
21 - 40
Determining Capital Structure
Table 21-4 Determinants of Capital Structure
1.
2.
3.
4.
5.
6.
Analysis of cash flows
Consultations
Risk considerations
Impact on profits
Industry comparisons
Other
23.0%
18.3%
16.5%
14.0%
12.0%
3.4%
Source: Data from Conference Board, 1990
Primary sources include:
• Analysis of cash flows
• Risk consideration
• Impact on profits
CHAPTER 21 – Capital Structure Decisions
21 - 41
Determining Capital Structure
Useful Ratios
• Stock ratios (balance sheet ratios) that are
helpful include:
– Total debt to total assets
– Debt to equity ratio
• Flow ratios make use of information taken from
the income statement and when combined with
balance sheet data help to determine the ability
of the firm to service its debt.
CHAPTER 21 – Capital Structure Decisions
21 - 42
Determining Capital Structure
• Fixed Burden Coverage Ratio:
[ 21-7]
EBITDA
Fixed Burden Coverage 
I  (Pref.Div.  SF ) /(1  T )
– An expanded interest coverage ratio that looks at a
broader measure of both income and the
expenditures associated with debt.
CHAPTER 21 – Capital Structure Decisions
21 - 43
Determining Capital Structure
• Cash-flow-to-debt ratio (CFTD)
[ 21-8]
CFTD 
EBITDA
Debt
– A direct measure of the cash flow over a period that is
available to cover a firm’s stock of outstanding debt.
CHAPTER 21 – Capital Structure Decisions
21 - 44
Determining Capital Structure
Table 21-5 Moody's Average Credit Ratios
Coverage
Leverage (%)
Cash flow-to-debt (%)
Liquidity (%)
Profit margin (%)
Return on assets (%)
Sales stability
Total assets ($ billion)
Altman Z score
IG
Non-IG
4.01
46.2
18.3
3.66
6.26
8.41
7.14
6.31
2.17
1.45
67.4
8.10
4.45
1.39
6.92
5.60
1.19
1.62
So urce: Data fro m M o o dy's Investo r Services, "The Distributio n o f Co mmo n Financial Ratio s by Rating and
Industry fo r No rth A merican No n-Financial Co rpo ratio ns," December 2004.
CHAPTER 21 – Capital Structure Decisions
Investment
grade (IG)
companies
have at
least a BBB
bond rating.
Altman Z score is
a weighted
average of
several key ratios
and is a useful
predictor of a
firm’s probability
of bankruptcy.
21 - 45
Determining Capital Structure
Altman Z Score
• Altman’s prediction of bankruptcy equation:
[ 21-9]
Z  1.2 X 1  1.4 X 2  3.3 X 3  0.6 X 4  0.999 X 5
• Where:
X1 = working capital divided by total assets
X2 = retained earnings divided by total assets
X3 = EBIT divided by total assets
X4 = market values of total equity divided by non-equity book liabilities
X5 = sales divided by total assets
CHAPTER 21 – Capital Structure Decisions
21 - 46
The Modigliani and Miller Irrelevance
Theorem
Capital Structure Decisions
The Modigliani and Miller (M&M)
Irrelevance Theorem
M&M and Firm Value
• The theorem that concludes (under some
simplifying assumptions) that the value of the
firm should not be affected by the manner in
which it is financed.
– How the firm is financed is irrelevant.
CHAPTER 21 – Capital Structure Decisions
21 - 48
(M&M) Irrelevance Theorem
Assumptions
Assumptions about the Real World:
• Markets are perfect in the sense that there are no
transactions costs or asymmetric information problems
• No taxes
• There is no risk of costly bankruptcy or associated financial
distress
Modeling Assumptions:
• There exist two firms in the same “risk class” with different
levels of debt
• The earnings of both firms are perpetuities
CHAPTER 21 – Capital Structure Decisions
21 - 49
(M&M) Irrelevance Theorem
Arbitrage Argument
Arbitrage is a powerful economic force in capital
markets.
Where two identical assets trade at different prices,
market traders will spot the opportunity to earn
riskless profits.
• Traders will sell the overvalued asset and buy the
undervalued asset.
• This activity will cause the price of the overvalued asset to
fall, and the price of the undervalued asset to rise until the
two are priced the same.
• The traders will earn abnormal profits from these trades until
the prices of the two securities move into equilibrium.
Table 21 – 6 illustrates the two different positions and the equal payoffs
CHAPTER 21 – Capital Structure Decisions
21 - 50
(M&M) Irrelevance Theorem
Arbitrage Argument
Market participants who find levered investments
trading for a greater value, can undo the leverage and
earn abnormal profits.
Arbitrage will force assets with equal payoffs to trade for
the same price.
Table 21 – 6 illustrates the two different positions and the equal payoffs
CHAPTER 21 – Capital Structure Decisions
21 - 51
(M&M) Irrelevance Theorem
M&M and Firm Value
Table 21-6 M&M Arbitrage Table I
Portfolios (Actions)
Portfolio A:
Cost
Payoff
α VU
α EBIT
Buy α of unlevered firm
Net payoffs
are equal
Portfolio B:
Buy α of levered firm's equity
αSL
α(EBIT αKD D )
Buy α of levered firm's debt
αD
αKD D
α(SL + D)
α EBIT
Total portfolio
Portfolio A and B must be priced equally despite their different financial
structures because the payoffs are equal.
CHAPTER 21 – Capital Structure Decisions
21 - 52
(M&M) Irrelevance Theorem
M&M and Firm Value
Where payoffs are identical for two different assets, both
should be priced the same.
[ 21-10]
VU  S L  D  VL
The value of the levered firm (VL) is equal to the value of its debt plus
the value of its equity (SL + D) and this must equal the value of the
unlevered firm (VU).
Debt cannot destroy value.
CHAPTER 21 – Capital Structure Decisions
21 - 53
(M&M) Irrelevance Theorem
Personal Leverage and Corporate Leverage
Table 21-7 M&M Arbitrage Table II
Portfolios (Actions)
Cost
Payoff
αSL
α(EBIT - KD D )
Buy α of levered firm's equity
αVU
α EBIT
Buy α of levered firm's debt
αD
- αK D D
α(VU - D)
α(EBIT - KD D )
Portfolio C:
Buy α of unlevered firm
Portfolio D:
Total portfolio
CHAPTER 21 – Capital Structure Decisions
21 - 54
(M&M) Irrelevance Theorem
Homemade Leverage
• Homemade leverage is the creation of the same
effect of a firm’s financial leverage through the
use of personal leverage.
• This means that individuals can:
– Buy an unlevered firm, and through the use of
personal debt, replicate corporate leverage, or
– Buy a levered firm, and undo its effects.
CHAPTER 21 – Capital Structure Decisions
21 - 55
(M&M) Irrelevance Theorem
M&M and The Cost of Capital
• M&M made a modeling assumption (to simplify the calculations
and focus analysis on the leverage issue) that the firm’s
earnings represent a perpetuity:
[ 21-11]
(EBIT-K D D)
SL 
Ke
CHAPTER 21 – Capital Structure Decisions
21 - 56
(M&M) Irrelevance Theorem
M&M and The Cost of Capital
• The cost of equity capital is simply the earnings yield and is
estimated as follows:
[ 21-12]
Ke 
(EBIT-K D D)
SL
CHAPTER 21 – Capital Structure Decisions
21 - 57
(M&M) Irrelevance Theorem
M&M and The Cost of Capital
• Since the value of the firm is unchanged by leverage, we can
define the unlevered value (VU) by discounting the firm’s
expected EBIT by it unlevered equity cost (KU):
[ 21-13]
EBIT
VU 
 S L  D  VL
VU
CHAPTER 21 – Capital Structure Decisions
21 - 58
(M&M) Irrelevance Theorem
M&M Equity Cost Equation
• To determine who equity cost varies with the debt-equity ratio,
we solve for EBIT, and substitute it for EBIT in the leveraged
equity cost equation:
[ 21-14]
K e  K u  ( KU  K D ) D / S L
• If the firm has no debt, the equity investor requires KU (cost of
unlevered equity).
• KU depends on business risk of the firm.
• As the firm uses debt, the equity cost increases due to the
financial leverage risk premium.
CHAPTER 21 – Capital Structure Decisions
21 - 59
(M&M) Irrelevance Theorem
M&M and The Cost of Capital
• In a world without taxes, the WACC (KU) is simply the weighted
average of the cost of debt and the cost of equity:
[ 21-15]
KU  K E
S
D
 KD
V
V
• Figure 21 – 4 illustrates M&M without corporate taxes (the
irrelevance model) where the cost of equity (KE) rises in a
prescribed manner to offset the lower cost of debt (KD)
producing WACC that remains unchanged by the use of
financial leverage.
CHAPTER 21 – Capital Structure Decisions
21 - 60
(M&M) Irrelevance Theorem
M&M and The Cost of Capital
20 - 4 FIGURE
%
Equity Cost KE
WACC
Debt Cost KD
Debt-Equity Ratio
CHAPTER 21 – Capital Structure Decisions
21 - 61
(M&M) Irrelevance Theorem
M&M and The Cost of Capital
• If WACC remains the same regardless of the financial
strategy used by the firm:
– VL = VU
– Financial strategy is irrelevant
• As the use of debt financing is increased, the cost of
equity will rise…so even if EPS is increased through the
use of debt financing, that benefit is offset by a higher
discount rate.
• From a shareholder wealth perspective, under the M&M
assumptions, financing strategy is irrelevant.
CHAPTER 21 – Capital Structure Decisions
21 - 62
The Impact of Taxes
Introducing Corporate Taxes
• The value of firms drop in the presence of corporate taxes.
• The higher the tax rate, the lower the value of the firm.
[ 21-16]
EBIT (1  T )
VU 
KU
CHAPTER 21 – Capital Structure Decisions
21 - 63
The Impact of Taxes
Corporate Tax Effect on Levered Equity
Table 21-8 M&M with Taxes
Portfolios (Actions)
Portfolio E:
Cost
Payoff
αSL
α(EBIT - KD D )(1-T)
αVU
α EBIT(1-T)
αD(1-T)
- αK D D
α(VU - D)(1-T)
α(EBIT - KD D )(1-T)
Buy α of unlevered firm
Portfolio D:
Buy α of levered firm's equity
Buy α of levered firm's debt
Total portfolio
CHAPTER 21 – Capital Structure Decisions
21 - 64
The Impact of Taxes
Introducing Corporate Taxes
•
To avoid arbitrage the value of the firm must equal:
VU – D(1-t) = SL
VL = SL + D, therefore:
Corporate Debt
Tax Shield
[ 21-17]
VL  VU  DT
The value of the firm with leverage is the value without leverage plus
the corporate debt tax shield from debt financing.
CHAPTER 21 – Capital Structure Decisions
21 - 65
The Impact of Taxes
Introducing Corporate Taxes
• The total claims of corporate taxes, debt
holders, and equity holders are borne by the
pre-tax cash flow produced by the firm.
• If the firm uses more debt, and interest on that
debt is tax-deductible, this produces a greater
tax shield, reducing the government share of
the value of the private enterprise, the WACC
must go down.
– Here we assume a zero-sum game (that value is not
destroyed through the use of financial leverage)
CHAPTER 21 – Capital Structure Decisions
21 - 66
The Impact of Taxes
Firm Value with Corporate Taxes
21 - 5 FIGURE
Equity
Debt
Taxes
CHAPTER 21 – Capital Structure Decisions
21 - 67
The Impact of Taxes
Introducing Corporate Taxes
•
The tax –corrected value of Equation 21-14 is:
[ 21-18]
•
•
K e  KU  ( KU  K D )(1  T ) D / S L
Both the interest cost and the financial leverage risk-premium on the
equity cost are reduced by (1- T)
As the use of debt increases, WACC decreases, and therefore the
value of the firm in a world with corporate taxes should increase
(See Figure 21 – 6 on the following slide)
CHAPTER 21 – Capital Structure Decisions
21 - 68
The Impact of Taxes
M&M with Corporate Taxes
21 - 6 FIGURE
%
Equity Cost KE
WACC
Debt Cost KD(1-T)
Debt-Equity Ratio
CHAPTER 21 – Capital Structure Decisions
21 - 69
The Impact of Taxes
WACC with Corporate Taxes
• WACC declines continuously with the use of debt financing.
• WACC equation corrected for the tax-deductibility of interest
expense is:
[ 21-19]
S
D
WACC  K e  K D (1  T )
V
V
CHAPTER 21 – Capital Structure Decisions
21 - 70
The Impact of Taxes
Tax-Extended M&M Equity Cost Equation
•
The ‘beta’ version of Equation 21 – 18 allows us to adjust for the
systematic risk of the firm:
[ 21-20]
•
•
•
•
K e  RF  MRP  U (1  (1  T ) D / S L )
Equity cost without any debt is the risk-free rate plus the market risk
premium (MRP) times the unlevered beta coefficient.
This equation allows us to unlever betas to get the unlevered equity
cost.
There is one important flaw in this equation – it is assumed that 100%
debt financing is optimal.
To address that issue, we must relax M&M’s assumptions regarding
risk of financial distress or bankruptcy.
CHAPTER 21 – Capital Structure Decisions
21 - 71
Bankruptcy
Introduction
• Bankruptcy is a state of insolvency that occurs
when a firm commits an act of bankruptcy, such
as non-payment of interest, and creditors
enforce their legal rights to recoup money, or
when a firm voluntarily declares bankruptcy in
an effort to be protected while reorganizing to
become solvent again.
CHAPTER 21 – Capital Structure Decisions
21 - 72
Reorganization
• Firms can be reorganized under:
– Companies Creditors Arrangements Act (CCAA)
• Used by larger more complex firms with debt > $5m
• Flexible – allowing the firm to pursue agreements with
creditors/employees, to raise new financing
• Trustee is appointed by the court and there is a stay-ofproceedings
– Bankruptcy Insolvency Act (BIA)
• Limited scope to prevent creditors from seizing assets
• No DIP financing
• No provision to impose a settlement on all creditors
CHAPTER 21 – Capital Structure Decisions
21 - 73
Costs of Bankruptcy
Direct Costs
Direct Costs:
– Costs incurred as a direct result of bankruptcy
including:
• Liquidation of assets
• Loss of tax losses (potential tax shield benefits)
• Legal and accounting costs
CHAPTER 21 – Capital Structure Decisions
21 - 74
Costs of Bankruptcy
Indirect Costs
Indirect Costs:
– Financial distress costs are losses to a firm prior to declaration of
bankruptcy including:
• Agency costs
• Increasing costs of doing business:
– Creditors tightening trade credit terms
– Lending increasing risk premiums and increasing monitoring
surveillance
– loss of key staff and increases in recruitment and retention costs
– Distracted management focused on financing and not on management
of business operations.
• Reduced sales revenue:
– Management is distracted by financial issues
– Customers may become wary and look for other suppliers
(Figure 21 – 8 illustrates the rising value of distress costs with increasing debt)
CHAPTER 21 – Capital Structure Decisions
21 - 75
Static Tradeoff
Firm Value and Financial Distress Costs
21 - 8 FIGURE
VU + DT
Value
Distress Costs
Debt Ratio
CHAPTER 21 – Capital Structure Decisions
21 - 76
Costs of Bankruptcy
Agency Costs
Agency Costs:
– It is possible for shareholders (and Board of Directors) to act in their
own best interests at the expense of debt holders.
– When under financial stress sometimes:
• Preferential treatment of creditors.
• Assets may be dissipated to related but solvent companies.
• Moral hazard (where management may take extraordinary risks that will be
ultimately borne by the debt holders, not the equity holders) (asymmetric
payoff of an option)
– Being aware of these risks, lenders take action to protect their interests
including:
•
•
•
•
Moratorium on further debt.
Increases in rates on adjustable-rate debt.
Demands for additional surveillance of financial performance.
Take the firm to court to enforce rights.
(Figure 21 – 7 illustrates the shareholder’s one year call option value on the underlying firm)
CHAPTER 21 – Capital Structure Decisions
21 - 77
Financial Distress, Bankruptcy, and
Agency Costs
The Firm Value as a Call Option for Shareholders
21 - 7 FIGURE
No limited
liability
Equity
Payoff
0
$50 million debt
CHAPTER 21 – Capital Structure Decisions
Underlying
Firm Value
21 - 78
Costs of Bankruptcy
Summary
Costs of Bankruptcy are very high.
Probability of Bankruptcy and Financial Distress
costs rise exponentially as the use of debt
increases.
These costs rob value from both shareholders and
potentially debt holders.
CHAPTER 21 – Capital Structure Decisions
21 - 79
Costs of Bankruptcy
Static Tradeoff Model
Figure 21 – 9 illustrates the impact of bankruptcy and
financial distress costs on M&M with corporate taxes.
– Cost of equity rises throughout as more debt is added.
– The cost of debt rises at higher levels of debt.
– WACC falls initially because the benefits of the tax-deductibility
of interest expense out-weigh the marginal increases in
component costs, however, at higher levels of debt, the taxadvantage of debt is offset and the value of the firm falls when
WACC starts to rise.
CHAPTER 21 – Capital Structure Decisions
21 - 80
Static Tradeoff Model
21 - 9 FIGURE
Cost (%)
Ke
WACC
KD
Debt-to-equity
D/E*
Firm
Value
CHAPTER 21 – Capital Structure Decisions
21 - 81
Other Factors Affecting Capital Structure
Pecking Order
•
Static Trade off model ignores two issues:
1. Information asymmetry problems
2. Agency problems
•
•
These factors are likely responsible for what
Myers and Donaldson call the pecking order.
The pecking order is the order in which firms
prefer to raise financing
1. starting with internal cash flow,
2. debt and
3. finally issuing common equity.
CHAPTER 21 – Capital Structure Decisions
21 - 82
Capital Structure in Practice
• Factors favouring corporate ability and
willingness to issue debt:
– Profitability (so the firm can use the tax shield benefit
of interest-deductibility).
– Unencumbered tangible assets to be used as
collateral for secured debt.
– Stable business operations over time.
– Corporate size.
– Growth rate of the firm.
– Capital market conditions
CHAPTER 21 – Capital Structure Decisions
21 - 83
Summary and Conclusions
In this chapter you have learned:
– The three effects of leverage: expected ROE tends to increase,
the variability of the ROE increases, and the risk of financial
distress increases.
– The major determinants of the firm’s capital structure decision
are its impact on profits, risk and cash flows.
– Impacts can be assessed by profit planning charts, financial
break-even analysis and use of standard ratios
– Debt creates value because interest on debt is tax-deductible
– The tax incentive to use debt is offset by the resulting financial
distress and bankruptcy costs
– In a dynamic world, firms depart from the static trade-off optimal
debt ratio over time, then refinance to bring it back in line with
the target debt ratio.
– Actual capital structures are constantly changing as firms take
advantage of market conditions.
CHAPTER 21 – Capital Structure Decisions
21 - 84
Appendix 1
Thunder Bay Industries
Exercise in Indifference Analysis
Thunder Bay Industries
The Problem
Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years.
The company is now operating at 100% of capacity and must expand in order to meet the
demand for its new line of video games.
The current financial statements for Thunder Bay Industries are as follows:
Thunder Bay Industries
Balance Sheet
as at December 31, 20xx
($ '000s Cdn.)
Assets:
Cash
Accounts receivable
Inventories
Net Fixed Assets
Total Assets
1,000
2,100
2,766
16,244
_______
$22,110
Liabilities and Owner's Equity:
Accounts payable
550
Accruals
249
Other current liabilities
1
8% bonds maturing in 10 years
5,000
Common stock (100,000 outstanding) 1,000
Retained earnings
15,310
Total Liabilities and Owner's Equity
$22,110
The most recent income statement is found on the following slide:
CHAPTER 21 – Capital Structure Decisions
21 - 86
Thunder Bay Industries
The Problem
Thunder Bay Industries
Income Statement
for the year ended December 31, 20xx
($ '000s Cdn)
Sales
Cost of Goods Sold
Gross Margin on Sales
Administrative and Selling Expenses
Earnings before Interest Expense and Taxes
Interest expense
Earnings before tax
Taxes
Net Income
$25,002
18,252
$ 6,750
4,000
2,750
400
$ 2,350
1,011
$1,339
If the firm does not expand, it sales growth will stall at the current $25m
level or less. If the company undertakes the planned expansion
management has identified a probability distribution for possible EBIT
levels:
CHAPTER 21 – Capital Structure Decisions
21 - 87
Thunder Bay Industries
The Problem
If the firm does not expand, it sales growth will stall at the current $25m level or less.
If the company undertakes the planned expansion management has identified a
probability distribution for possible EBIT levels:
Possible EBIT
$2,200
$2,700
$3,200
$3.700
Probability
.1
.4
.4
.1
The planned expansion will require Thunder Bay Industries to raise $10,000,000 in
new capital. If raised in the form of bonds, the bonds would carry a 6.5% coupon
rate. New common stock could be sold for $250.00 per share.
Find the EBIT/EPS indifference point. What is the probability that EBIT will be
greater than the indifference point? Which method of financing is most likely to
maximize earnings per share? What method of financing do you recommend? Why?
Discuss the limitations of indifference analysis. Prepare a properly labeled diagram
of the EBIT/EPS analysis.
CHAPTER 21 – Capital Structure Decisions
21 - 88
Thunder Bay Industries
The Solution
You can first determine the expected EBIT for next year and using that,
determine the standard deviation of that EBIT. These calculations will be useful
later when we try to determine the probability that EBIT will be less than, or
greater than the indifference point.
Possible EBIT
$2,200,000
2,700,000
3,200,000
3,700,000
Probability
10.0%
40.0%
40.0%
10.0%
Expected EBIT =
Wtd EBIT
$220,000
1,080,000
1,280,000
370,000
$2,950,000
 EBIT  .1(750 2 )  .4(250 2 )  .4(250 2 )  .1(750 2 )
 56250  25,000  25,000  56250
 162,500
 403.11
 $403,110
CHAPTER 21 – Capital Structure Decisions
21 - 89
Thunder Bay Industries
The Solution …
Next set up equations for EPS for each alternative source
of financing, equate them, substitute in known values and
solve for the common EBIT.
EPScommon 
EPSdebt 
( EBIT  RD B1 )(1  T )
n1  n2
( EBIT  RD B1  RD B2 )(1  T )
n1
EPScommon  EPSdebt
( EBIT  RD B1 )(1  T ) ( EBIT  RD B1  RD B2 )(1  T )

n1  n2
n1
( EBIT  400,000)(1  .43) ( EBIT  400,000  650,000)(1  .43)

100,000  40,000
100,000
EBIT  $2,675,000
CHAPTER 21 – Capital Structure Decisions
21 - 90
Thunder Bay Industries
The Solution …
Our prediction for EPS at EBIT=$2,675,000 for the common
share financing alternative is:
($2,675,000  $400,000)(1  .43)
 $9.26
140,000
($2,675,000  $1,050,000)(1  .43)

 $9.26
100,000
EPScommonshare 
EPSDebt
CHAPTER 21 – Capital Structure Decisions
21 - 91
Thunder Bay Industries
The Solution …
The probability than EBIT will favour common stock financing (ie.
be less than the indifference point) is:
z
X 

2,675,000  2,950,000
z
403,110
 0.6822
Where:
z = the number of standard deviations away from the mean
X = the point of interest
= the standard deviation of the probability distribution
 = the mean of the probability distribution
CHAPTER 21 – Capital Structure Decisions
21 - 92
Thunder Bay Industries
The Solution …
2,675,000  2,950,000
403,110
 0.6822
z
The negative sign indicates that the point of interest (X) or (indifference
point) lies on the left-hand side of the mean. It lies .6822 of 1 standard
deviation away from the mean.
Going to the table for Values of the Standard Normal Distribution
Function we find the area under the curve between the point of interest
and the mean of the distribution to be:
.2517 or 25.27%
Therefore, the probability that EBIT will exceed the indifference point
(favouring debt financing) is 75.17% The probability that EBIT will be
below the indifference point (favouring equity financing is (1- .7517)
24.83%.
(These normal distribution is plotted on the following chart.)
CHAPTER 21 – Capital Structure Decisions
21 - 93
Thunder Bay Industries
The Solution …
Area =
.2517
2,675,000  2,950,000
403,110
 0.6822
z
Area = .5
=$2,950,000
X=$2,675,000
(These relationships are now plotted on the following indifference chart.)
CHAPTER 21 – Capital Structure Decisions
21 - 94
Thunder Bay Industries
The Solution …
EPS
Debt
Financing
$9.26
Area =
.2517
$400,000
$1,050,000
Equity
Financing
Area = .5
=$2,950,000
X=$2,675,000
(This chart illustrates that debt financing is forecast to produce higher EPS than the
equity alternative.)
CHAPTER 21 – Capital Structure Decisions
21 - 95
Copyright
Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
addressed to the Permissions Department, John Wiley & Sons
Canada, Ltd. The purchaser may make back-up copies for his or her
own use only and not for distribution or resale. The author and the
publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
CHAPTER 21 – Capital Structure Decisions
21 - 96