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1616Chapt
er
Chapt
er Capital Structure and
LeverageCapital Structure and
Leverage
Slides Developed by:
Terry FegartySeneca College
© 2006 by Nelson, a division of Thomson Canada Limited 2
Chapter 16 – Outline (1)
• Background Capital Structure and Financial Leverage The Central Issue Risk in the Context of Leverage
• Financial Leverage Financial Leverage and Financial Risk Putting the Ideas Together—The Effect on Share
Price Real Investor Behavior and the Optimal Capital
Structure
© 2006 by Nelson, a division of Thomson Canada Limited 3
Chapter 16 – Outline (2) Finding the Optimum—A Practical Problem The Target Capital Structure The Degree of Financial Leverage (DFL)—A
Measurement• EBIT-EPS Analysis• Operating Leverage
Breakeven Analysis The Effect of Operating Leverage The Degree of Operating Leverage (DOL)—A
Measurement Comparing Operating and Financial Leverage The Compounding Effect of Operating and Financial
Leverage
© 2006 by Nelson, a division of Thomson Canada Limited 4
Chapter 16 – Outline (3)
• Capital Structure Theory Background—The Value of the Firm The Early Theory by Modigliani and Miller Relaxing the Assumptions—MM Theory with Taxes Relaxing the Assumptions—MM Theory with Taxes
and Bankruptcy Costs Other Considerations
© 2006 by Nelson, a division of Thomson Canada Limited 5
Capital Structure and Financial Leverage
• Capital structure: mix of firm’s debt and common equity Preferred shares treated as part of firm’s debt
• Financial leverage: using borrowed money to enhance effectiveness of invested equity Financial leverage of 10% means firm’s capital
structure contains 10% debt and 90% equity
© 2006 by Nelson, a division of Thomson Canada Limited 6
The Central Issue
• Can use of debt increase value of firm’s equity? Specifically, firm’s share price?
• Under certain conditions, changing leverage increases share price An optimal capital structure maximizes share price
• Relationship between capital structure and share price not precise nor fully understood
© 2006 by Nelson, a division of Thomson Canada Limited 7
Risk in the Context of Leverage
• Leverage influences share price Alters risk/return relationship in equity investment
• Measures of performance Earnings Before Interest and Taxes (EBIT)
• Unaffected by leverage because calculated prior to deduction for interest
Return on Equity (ROE) • Net Income Shareholders’ Equity
Earnings per Share (EPS) • Net Income number of shares• Investors regard EPS as important indicator of future
profitability
© 2006 by Nelson, a division of Thomson Canada Limited 8
Risk in the Context of Leverage
• Leverage-related risk is variation in ROE and EPS
• Two components Business risk—variation in EBIT
• Influenced by operating leverage—presence of fixed costs
Financial risk—additional variation in ROE and EPS from using financial leverage (debt)
© 2006 by Nelson, a division of Thomson Canada Limited 9
Figure 16.1: Business and Financial Risk
© 2006 by Nelson, a division of Thomson Canada Limited 10
Financial Leverage
• Under certain conditions, financial leverage can improve firm’s EPS and ROE If shares are replaced with debt, number of
shares and equity are reduced, increasing EPS and ROE
May increase share price
• However, at other times it may worsen EPS and ROE
• Financial leverage increases risk
© 2006 by Nelson, a division of Thomson Canada Limited 11
Table 16.1: Effect of Increasing Financial Leverage When the Return on Capital Employed Exceeds the Cost of Debt
As the firm’s debt ratio rises, both EPS and ROE
rise dramatically. While NI falls, the number of shares outstanding falls at a faster rate as
debt replaces equity.
© 2006 by Nelson, a division of Thomson Canada Limited 12
Financial Leverage
• Return on Capital Employed (ROCE) Measures profitability of operations before financing charges,
but after taxes, on basis comparable to ROE
EBIT 1 - tax rateROCE =
debt + equity
When ROCE more than after-tax cost of debt, more leverage improves ROE and EPS Increase borrowing?
When ROCE less than after-tax cost of debt, more leverage makes ROE and EPS worse Avoid borrowing?
© 2006 by Nelson, a division of Thomson Canada Limited 13
Table 16.2: Effect of Increasing Financial Leverage When the Cost of Debt
Exceeds the Return on Capital Employed
ABC is now doing rather
poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE
decrease.
© 2006 by Nelson, a division of Thomson Canada Limited 14
Example 16.1: Financial Leverage
Q: Financial information for the Scanterbury Corporation follows:
Exa
mpl
e
Share price = $10 ROE = NI equity = $13,500 $90,000 = 15%EPS = Ni number of shares = $13,500 9,000,000 = $1.50
$13,500NI
9,000,000Number of shares=9,000Tax (@40%)
$100,000Capital$22,500EBT
90,000Equity1,200Interest (@12%)
$10,000Debt $23,700EBIT
Scanterbury Corporation at $10M Debt($000 except for per-share amounts)
Will borrowing more money and retiring shares raise EPS, and if so what capital structure will achieve an EPS of $2.00?
© 2006 by Nelson, a division of Thomson Canada Limited 15
Example 16.1: Financial LeverageE
xam
ple
The after-tax cost of debt is 12% x (1 – 0.4), or 7.2%. Since 7.2% < 14.2%, trading equity for debt will increase EPS.
Using trial and error, we can determine that $45 million of debt is the approximate amount of debt that makes the firm’s EPS equal $2.00.
A: EPS will rise if ROCE exceeds the after-tax cost of debt.
ROCE $23.7M(1 0.4)
14.2%100.0M
© 2006 by Nelson, a division of Thomson Canada Limited 16
Example 16.1: Financial Leverage— An Alternate Approach
A: If we set EPS to $2 we can solve for the value of Debt
0$45,156,25 Debt
10$Debt - $100.0M
.4) - )(1(.12)(Debt - $23.7M 2$
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 17
Financial Leverage and Financial Risk• Financial leverage is a two-edged sword
Multiplies good results into great results Multiples bad results into terrible results
• Leverage magnifies changes in EBIT into larger changes in ROE and EPS
• Financial risk is increased variability in financial results that comes from additional leverage
© 2006 by Nelson, a division of Thomson Canada Limited 18
Table 16.3: Financial Leverage and Risk
© 2006 by Nelson, a division of Thomson Canada Limited 19
Putting the Ideas Together—The Effect on Share Price
• Leverage enhances performance while it adds risk, pushing share prices in opposite directions Enhanced performance makes expected
return on shares higher, driving up share’s price
Increased risk drives down share’s price• Which effect dominates, and when?
© 2006 by Nelson, a division of Thomson Canada Limited 20
Real Investor Behavior and the Optimal Capital Structure• When leverage is low, increase in debt
has positive effect on investors• At high debt levels, concerns about risk
dominate and adding more debt decreases share’s price
• As leverage increases, effect goes from positive to negative, which results in an optimal capital structure
© 2006 by Nelson, a division of Thomson Canada Limited 21
Figure 16.2: The Effect of Leverage on Share Price
© 2006 by Nelson, a division of Thomson Canada Limited 22
Finding the Optimum—A Practical Problem
• No way to determine exact optimum amount of leverage for particular company at particular time Appropriate level tends to vary according to
• Nature of company’s business• If firm has high business risk it should use less leverage
• Economic climate• If outlook is poor investors are likely to be more sensitive
to risk
© 2006 by Nelson, a division of Thomson Canada Limited 23
Finding the Optimum—A Practical Problem• General guidelines
1. Profitable firm with little or no debt should probably increase borrowing if interest rates are reasonable
2. For most businesses, optimal capital structure is somewhere between 30% and 50% debt
3. Debt levels above 60% create excessive risk and should be avoided unless cash flows are very stable (for example, those of a public utility)
© 2006 by Nelson, a division of Thomson Canada Limited 24
The Target Capital Structure
• Firm’s target capital structure is management’s estimate of optimal capital structure An approximation as to amount of debt that
will maximize firm’s share price
© 2006 by Nelson, a division of Thomson Canada Limited 25
The Degree of Financial Leverage (DFL)—A Measurement• Financial leverage magnifies changes in EBIT
into larger changes in ROE and EPS The degree of financial leverage (DFL) relates
relative changes in EBIT to relative changes in EPS
% EPSDFL = or % EPS = DFL % EBIT
% EBIT
Somewhat
tedious
Easier method of calculating DFL is:
EBITDFL =
EBIT - Interest
© 2006 by Nelson, a division of Thomson Canada Limited 26
Example 16.2: The Degree of Financial Leverage (DFL)—A Measurement
Q: Selected income statement and capital information for the Mallaig Manufacturing Company follow ($000):
Currently 700,000 common shares are outstanding. The firm pays 15% interest on its debt.. The income tax rate is 40%
Management is considering restructuring capital to 50% debt in the hope that the increased EPS will have increase the price of its shares. Mallaig’s shares sell for their book value of $10 per share.
Estimate the effect of the proposed restructuring on EPS. Then use the degree of financial leverage to assess the increase in risk involved.
$8,000Total$1,380EBIT
7,000 Equity4,200Cost/expense
$1,000 Debt$5,580Revenue
Capital
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 27
Example 16.2: The Degree of Financial Leverage (DFL)—A Measurement
A:
Exa
mpl
e
400,000700,000Shares outstanding
ProposedCurrent
$8,000$8,000Total
4,0007,000 Equity
$4,000$1,000 Debt
Capital
$1.170$1.054EPS
$468$738NI
ProposedCurrent
312492Tax (@40%)
$780$1,230EBT
600150Interest (15% of debt)
$1,380$1,380EBIT
If business conditions remain unchanged, more debt will result
in a higher EPS
© 2006 by Nelson, a division of Thomson Canada Limited 28
Example 16.2: The Degree of Financial Leverage (DFL)—A Measurement
A: Next, calculate DFL:
Exa
mpl
e
Current
Proposed
$1,380DFL = 1.12
$1,380 - $150
$1,380DFL = 1.77
$1,380 - $600
EPS will be much more volatile under the proposed plan. EPS will change by a factor of 1.77 vs. 1.12.
© 2006 by Nelson, a division of Thomson Canada Limited 29
EBIT-EPS Analysis
• Managers need way to quantify and analyze tradeoffs between risk and results when changing leverage levels
• Analysis provides graphical portrayal of the trade-off Involves graphing EPS as function of EBIT for each
leverage level
• Portrays results of leverage and helps to decide how much to use
© 2006 by Nelson, a division of Thomson Canada Limited 30
Graphical Analysis of EBIT - EPS
EPS
EBIT
Debt Financing
EquityFinancing
IndifferencePoint
Advantage toequity financing
Advantage todebt financing
© 2006 by Nelson, a division of Thomson Canada Limited 31
Figure 16.3: EBIT – EPS Analysis for ABC Corporation
The indifference point occurs
when the two plans offer the
same EBIT
The 50% Debt and No Leverage lines intersect. At the
point of intersection ABC is indifferent between the two
plans. To the left of the intersection the 50% Debt plan is preferable. To the
right of the point the No Leverage plan
is preferable.
(from Table 13.1, Columns 1 and 2)
© 2006 by Nelson, a division of Thomson Canada Limited 32
EBIT-EPS Analysis
• Comparing two capital structures, indifference point is level of EBIT where EPS is same under both
(EBIT- )(1- )EPS=
Number of shares
I T
Capital Structure A Capital Structure B
(EBIT- )(1- )
Number of shares
I T (EBIT- )(1- )=
Number of shares
I T
Solve for EBIT
© 2006 by Nelson, a division of Thomson Canada Limited 33
EBIT-EPS Analysis
For ABC Corporation:
No Leverage 50% Debt
(EBIT-$0)(1-0.4)
100,000(EBIT-$50,000)(1-0.4)
= 50,000
EBIT = $100,000
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 34
Operating Leverage
• Terminology and Definitions Business Risk—Risk in Operations
• Defined as variation in EBIT• Most is caused by changes in sales level
Fixed and Variable Costs and Cost Structure•Fixed costs don’t change with level of sales,
while variable costs do• Fixed costs include rent, amortization, utilities, salaries• Variable costs include direct labour, direct materials,
sales commissions
• Mix of fixed and variable costs in a firm’s operations is its cost structure
© 2006 by Nelson, a division of Thomson Canada Limited 35
Figure 16.4: Fixed, Variable, and Total Cost
© 2006 by Nelson, a division of Thomson Canada Limited 36
Operating Leverage
• Terminology and Definitions Operating Leverage
• Refers to amount of fixed costs in the cost structure
• Increases business risk• May combine with financial leverage for very
volatile ROE and EPS
© 2006 by Nelson, a division of Thomson Canada Limited 37
Breakeven Analysis
• Used to determine level of activity firm must achieve to stay in business in long run
• Shows mix of fixed and variable cost and volume required for zero profit/loss Profit/loss generally measured by EBIT
© 2006 by Nelson, a division of Thomson Canada Limited 38
Breakeven Analysis
• Breakeven Diagrams Breakeven occurs at intersection of revenue
and total cost • Represents level of sales at which revenue equals
cost
© 2006 by Nelson, a division of Thomson Canada Limited 39
Figure 16.5: The Breakeven Diagram
© 2006 by Nelson, a division of Thomson Canada Limited 40
Breakeven Analysis
• The Contribution Margin Every sale makes contribution (Ct) of
difference between price (P) and variable cost (V)• Ct = P – V
Can be expressed as percentage of revenue• Known as contribution margin (CM)
M
(P-V)C =
P
© 2006 by Nelson, a division of Thomson Canada Limited 41
Example 16.3: Breakeven Analysis
Q: Suppose a company can make a unit of product for $7 in variable labour and materials, and sell it for $10. What are the contribution and contribution margin?
A: The contribution per unit is $3, or $10 - $7, while the contribution margin is $3 $10, or 30%.
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 42
Breakeven Analysis
• Calculating Breakeven Sales Level EBIT is revenue minus cost, or
• EBIT = PQ – VQ – FC
Breakeven occurs when revenue (PQ) equals total cost (VQ + FC), or
Breakeven tells us how many units have to be sold to contribute
enough money to pay for fixed costs
Can also be expressed in terms of dollar sales
CBE
FQ =
(P-V)
C CBE
M
P(F ) FS = =
(P-V) C
© 2006 by Nelson, a division of Thomson Canada Limited 43
Example 16.4: Breakeven Analysis
Q: What is the breakeven sales level in units and dollars for a company that can make a unit of product for $7 in variable costs and sell it for $10, if the firm has fixed costs of $1,800 per month?
A: The breakeven point in units is $1,800 ($10 - $7) = 600 units. The breakeven point in dollars is $10 per unit times 600 units, or $6,000, which could also be calculated as $1,800 0.30. Thus, the firm must sell 600 units per month to cover fixed costs.
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 44
The Effect of Operating Leverage
• As sales volume moves away from breakeven, profit or loss increases faster with more operating leverage
• The Risk Effect More operating leverage leads to larger variations in
EBIT, or business risk
• The Effect on Expected EBIT Above breakeven, more operating leverage implies
higher operating profit• If firm is relatively sure of sales level, should trade
variable costs for fixed cost
© 2006 by Nelson, a division of Thomson Canada Limited 45
Breakeven at Low Operating Leverage
Revenue
Total Cost
Fixed Cost
Quantity
Dollars
Breakeven Quantity
Low Fixed Costs with High Variable Costs
Low Breakeven; Profits/Losses Increase Slowly
Variable Cost
Profit
© 2006 by Nelson, a division of Thomson Canada Limited 46
Breakeven at High Operating Leverage
Revenue
Total Cost
Fixed Cost
Quantity
Dollars
Breakeven Quantity
High Fixed Costs with Low Variable Costs
High Breakeven; Profits/Losses Increase Quickly
Variable Cost
Profit
© 2006 by Nelson, a division of Thomson Canada Limited 47
Example 16.5: The Effect of Operating Leverage
Q: Suppose Firm A has fixed costs of $1,000 per period, sells its product for $10, and has variable costs of $8 per unit. Further, suppose Firm B has fixed costs of $1,500 and also sells its product for $10 a unit. Both firms are at the same breakeven point. What variable cost must Firm B have if it is to achieve the same breakeven point as Firm A? State the trade-off at the breakeven point. Which structure is preferred if there’s a choice?
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 48
Example 16.5: The Effect of Operating Leverage
A: Both firms have a breakeven point of 500 units (Firm A: $1,000 $2). We need to solve the breakeven formula for Firm B’s variable costs per unit:
QB/E = FC (P – V)500 units = $1,500 ($10 – V)V = $7Change in V = $8 - $7 = $1
The preferred structure depends on volatility—if sales are expected to be highly volatile, the lower fixed cost structure might be better in the long run.
Thus, at breakeven, a $1differential in contribution
makes up for a $500difference in fixed cost.
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 49
The Degree of Operating Leverage (DOL)—A Measurement• Operating leverage amplifies changes in
sales volume into larger changes in EBIT• DOL relates relative changes in volume
(Q) to relative changes in EBIT
C
% EBIT Q(P - V)DOL = or
% Q Q(P - V) - F
MCor
EBIT
© 2006 by Nelson, a division of Thomson Canada Limited 50
Example 16.6: The Degree of Operating Leverage (DOL)—A Measurement
Q: The Cowichan Corp. sells its products at an average price of $10. Variable costs are $7 per unit and fixed costs are $600 per month. Evaluate the degree of operating leverage when sales are 5% and then 50% above the breakeven level.
A: Breakeven volume = $600 ($10 - $7) = 200 units. Breakeven plus 5% = 200 x 1.05 or 210 unitsBreakeven plus 50% = 200 x 1.50 or 300 units. DOL at 210 units is:
DOL at 300 units is: DOL decreases
as the output levelincreases above
breakeven.
Q=210
210($10 - $7)DOL = 21
210($10 - $7) - $600
Q=300
300($10 - $7)DOL = 3
300($10 - $7) - $600
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 51
Comparing Operating and Financial Leverage
• Both operating and financial leverage can enhance results while increasing variation Operating leverage magnifies changes in
sales into larger changes in EBIT Financial leverage magnifies changes in EBIT
into larger changes in ROE and EPS
© 2006 by Nelson, a division of Thomson Canada Limited 52
Comparing Operating and Financial Leverage
• Both methods substitute fixed cash outflows for variable cash outflows Operating leverage substitutes fixed costs for
variable costs in cost structure Financial leverage involves substitutes fixed
interest on debt for discretionary dividends on shares in capital structure
© 2006 by Nelson, a division of Thomson Canada Limited 53
Comparing Operating and Financial Leverage• Both kinds of leverage increase risks as
the levels of leverage increase However, no financial risk if no debt Business risk would still exist even if no
operating leverage
• Financial leverage is more controllable than operating leverage Debt used at management’s discretion Technology may require fixed costs
© 2006 by Nelson, a division of Thomson Canada Limited 54
Figure 16.7: The Similar Functions of Operating and Financial Leverage
© 2006 by Nelson, a division of Thomson Canada Limited 55
The Compounding Effect of Operating and Financial Leverage• Effects of financial and operating leverage
compound one another• Changes in sales are amplified by operating
leverage into larger relative changes in EBIT Which in turn are amplified by financial leverage
into still larger relative changes in ROE and EPS Modest changes in sales can lead to dramatic
changes in ROE and EPS
• The combined effect can be measured using degree of total leverage (DTL) DTL = DOL × DFL
© 2006 by Nelson, a division of Thomson Canada Limited 56
Figure 16.8: Risk and Cost Relationships Between Operating and Financial
Leverage
© 2006 by Nelson, a division of Thomson Canada Limited 57
The Compounding Effect of Operating Leverage and Financial Leverage
Type of leverage
% Change in
Causes a bigger % change in
Operating Sales EBITFinancial EBIT EPS
Total Sales EPS
© 2006 by Nelson, a division of Thomson Canada Limited 58
Degree of Total Leverage
%Change in Sales
%Change in EBIT
%Change in EPS
DOL DFL
DTL
© 2006 by Nelson, a division of Thomson Canada Limited 59
Example 16.7: The Compounding Effect of Operating and Financial Leverage
Q: The Carragana Company is considering replacing a manual production process with a machine. The money to buy the machine will be borrowed. The firm’s cost structure will be altered in favour of fixed cost. The capital structure will include more debt. Leverage positions with and without the project are:
The economic outlook is uncertain and some managers fear a decline in sales of as much as 10% in the coming year. Evaluate the effect of the proposed project on risk in financial performance.
2.53.5Proposed
1.52.0Current
DFLDOL
Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 60
Example 16.7: The Compounding Effect of Operating and Financial Leverage
A: The firm’s current DTL is 2 x 1.5 = 3. A 10% decline in sales could result in a 30% decline in EPS. Under the proposal, the DTL will be 3.5 x 2.5 = 8.75. A 10% drop in sales could lead to a 87.5% drop in EPS.
87.5%8.75Proposed
30%3Current
EPSDTL ∆Exa
mpl
e
© 2006 by Nelson, a division of Thomson Canada Limited 61
Capital Structure Theory
• Studies the relationship between:
Capital structure• Mix of debt & equity securities in capital
Cost of capital• Return demanded by investors
• Impacts on value of firm
© 2006 by Nelson, a division of Thomson Canada Limited 62
Capital Structure Theory
• Does capital structure affect share price and market value of firm?
• If so, is there optimal capital structure that: Minimizes firm’s weighted average cost of
capital (WACC)? Maximizes share price and value of firm? Or both?
© 2006 by Nelson, a division of Thomson Canada Limited 63
Background—The Value of the Firm• Notation
Vd = market value of firm’s debt Ve = market value of firm’s shares or equity Vf = market value of firm in total
• Vf = Vd + Ve
• Investors’ returns on firm’s securities will be kd = return on investment in debt ke = return on investment in equity
• Theory begins by assuming a world without taxes or transaction costs Investors’ returns are exactly component capital costs ka = average cost of capital
© 2006 by Nelson, a division of Thomson Canada Limited 64
Background—The Value of the Firm• Value (Vf) is based on cash flow which comes
from income (Operating income or OI) Earnings ultimately determine value because all cash
flows paid to investors come from earnings Consists of dividends (D) and interest payments (I)
(both assumed to be perpetuities)• The firm’s market value is the sum of their present values
Returns drive value in an inverse relationship.
fd e a
I D OIV = + =
k k k
© 2006 by Nelson, a division of Thomson Canada Limited 65
Figure 16.10: Variation in Value and Average Return with Capital Structure
The value of the firm and the firm’s share
price reach a maximum when the
average cost of capital is minimized.
© 2006 by Nelson, a division of Thomson Canada Limited 66
The Early Theory by Modigliani and Miller • Modigliani & Miller (MM) were the
pioneers in developing the theory of capital structure
• MM began by assuming perfect capital markets
• MM also recognized that debt will always cost less than equity because: Interest is tax deductible Debt securities are less risky than equity
securities
© 2006 by Nelson, a division of Thomson Canada Limited 67
The Early Theory by Modigliani and Miller • Restrictive Assumptions in the Original
Model (1958) No income taxes Securities trade in perfectly efficient capital
markets with no transaction costs No bankruptcy costs
• No administrative costs • No losses on sale of assets
Investors and companies can borrow as much as they want at same interest rate
© 2006 by Nelson, a division of Thomson Canada Limited 68
MM’s Two Propositions
• Under MM’s initial set of restrictions:• Proposition #1:
Market value of firm is independent of capital structure. Therefore, capital structure is irrelevant
• The independence hypothesis
• Proposition #2: The cost of capital remains constant as capital
structure changes. As quantity of debt rises, return demanded by shareholders increases because of increased risk, exactly offsetting benefit due to the lower cost of debt
© 2006 by Nelson, a division of Thomson Canada Limited 69
Figure 16.11: The Independence Hypothesis
© 2006 by Nelson, a division of Thomson Canada Limited 70
The Early Theory by Modigliani and Miller • The Arbitrage Concept
Arbitrage means making profit by buying and selling same thing at same time in two different markets
MM proposed that arbitrage by equity investors would hold value of firm constant as debt levels changed
• If adding leverage increased value of firm, equity investors could maximize returns by selling shares and borrowing to buy shares in unleveraged firm
• Would lower price of leveraged firm and raise price of unleveraged firm
• Value of firm should be constant as leverage increases
© 2006 by Nelson, a division of Thomson Canada Limited 71
The Early Theory by Modigliani and Miller • The Assumptions and Reality
Realistically income taxes exist Realistically costs of bankruptcy are quite large Realistically individuals cannot borrow at the same
rate as companies and interest rates usually rise as more money is borrowed
• Interpreting MM Result Leverage does affect value because of market
imperfections• Such as taxes and transaction costs (including bankruptcy)
© 2006 by Nelson, a division of Thomson Canada Limited 72
Relaxing the Assumptions—MM Theory with Taxes• Financing and the Tax System
Tax system favours debt financing over equity financing• Interest expense on debt is tax deductible while
dividends on shares are not
© 2006 by Nelson, a division of Thomson Canada Limited 73
Table 16.4: The Tax System Favours Debt Financing
The All Equity firm pays more taxes
because it receives no interest expense
deduction.
Total payments to investors are higher
for the leveraged company.
© 2006 by Nelson, a division of Thomson Canada Limited 74
Relaxing the Assumptions—MM Theory with Taxes• Including Corporate Taxes in the MM
Theory When taxes exist, operating income (OI) split
between investors and government• Reduces firm’s value
• Amount of reduction depends on firm’s use of leverage (debt)
• Interest on debt reduces taxable income which reduces taxes
© 2006 by Nelson, a division of Thomson Canada Limited 75
Relaxing the Assumptions—MM Theory with Taxes• Interest provides tax shield that reduces
government’s share of firm’s earnings When firm uses debt financing, government’s take is
reduced by (corporate tax rate × interest expense) every year
• Present value of tax shield = (corporate tax rate × interest expense) kd
• Since interest expense is amount of debt (B) times interest rate on debt, equation can be written as
d
d
corporate tax rate x B x kPV of tax shield = = TB
k
© 2006 by Nelson, a division of Thomson Canada Limited 76
Relaxing the Assumptions—MM Theory with Taxes• Having debt in capital structure increases
firm’s value by amount of debt times tax rate
• Benefit of debt accrues entirely to shareholders because bond returns are fixed
• In theory, firm can increase value of shares by replacing equity with debt
© 2006 by Nelson, a division of Thomson Canada Limited 77
Figure 16.12: MM Theory with Taxes
In the MM model with taxes, value increases steadily as leverage is added. Thus, the firm’s value is
maximized with 100% debt. Note that kd remains constant across all
levels of debt.
© 2006 by Nelson, a division of Thomson Canada Limited 78
Relaxing the Assumptions—MM Theory with Taxes• If the value of firm increases with debt,
should conclusion be that all firms should be financed with 100% debt?
• Conclusion defies logic and is counter to customary practice
• What are we missing?
© 2006 by Nelson, a division of Thomson Canada Limited 79
Relaxing the Assumptions—MM Theory with Taxes and Bankruptcy Costs• As leverage increases past a certain point,
probability of bankruptcy failure increases Investors raise required rates of return However, effect on cost of capital offset by growing
tax shield
• Eventually average cost of capital will be minimized and firm value will be maximized This is optimal capital structure Additional leverage beyond this point increases cost
of capital and reduces value
© 2006 by Nelson, a division of Thomson Canada Limited 80
Figure 16.13: MM Theory with Taxes and Bankruptcy Costs
© 2006 by Nelson, a division of Thomson Canada Limited 81
Other Considerations
• Industry effects Firms with stable cash flows tend to have
more debt More profitable firms tend to have less debt
ratios Market appears to reward firms with capital
structures appropriate to their industry