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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

20-1

Chapter Seventeen

Financial Leverage and

Capital Structure Policy

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20-2

20.1 The Capital Structure Question20.2 The Effect of Financial Leverage

20.3 Capital Structure and the Cost of Equity Capital

20.4 M&M Propositions I & II With Corporate Taxes

20.5 Bankruptcy Costs20.6 Optimal Capital Structure

20.7 The Pie Again

20.8 Corporate versus Personal Borrowing

20.9 Observed Capital Structures

20.10 Summary and Conclusions

Chapter Organization

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20-3

Chapter Objectives

Understand the impact of financial leverage on afirms capital structure.

Illustrate the concept of home-made leverage.

Outline both M&M Proposition I and M&M

Proposition II. Discuss the impact of corporate taxes on M&M

Propositions I and II.

Understand the impact of bankruptcy costs on the

value of a firm. Identify a firms optimal capital structure.

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20-4

The Capital Structure Question

Key issues What is the relationship between capital structure and

firm value?

What is the optimal capital structure?

Cost of capital A firms capital structure is chosen if WACC is

minimized.

This is known as the optimal capital structure or targetcapital structure.

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20-5

ExampleComputing Break-evenEBIT

ABC Company currently has no debt in its capitalstructure. The company has decided to restructure,raising $2.5 million debt at 10 per cent. ABCcurrently has 500 000 shares on issue at a price of$10 per share. As a result of the restructure, what isthe minimum level of EBIT the company needs tomaintain EPS (the break-even EBIT)? Ignore taxes.

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20-6

ExampleComputing Break-evenEBIT (continued)

With no debt:

EPS = EBIT/500 000

With $2.5 million in debt @ 10%:EPS = (EBIT $250 0001)/250 0002

1 Interest expense = $2.5 million 10% = $250 0002 Debt raised will refund 250 000 ($2.5 million/$10)shares, leaving

250 000 shares outstanding

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20-7

ExampleComputing Break-evenEBIT (continued)

These are then equal:

EPS = EBIT/500 000 = (EBIT $250 000)/250 000

With a little algebra:EBIT = $500 000

EPSBE = $1.00 per share

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20-8

Financial Leverage, EPS and EBIT

EBIT ($ millions, no taxes)

EPS ($)

0 0.2 0.4 0.6 0.8 1

3

2.5

2

1.5

1

0.5

0

0.5 1

D/E = 1

D/E = 0

B/E point

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20-9

ExampleHome-made Leverage andROE

Home-made leverage is the use of personal borrowing to alterthe degree of financial leverage. Investors can replicate thefinancing decisions of the firm in a costless manner.

Example

Original capital structure and home-made leverage investoruses $500 of their own and borrows $500 to purchase 100shares.

Proposed capital structure investor uses $500 of their own,together with $250 in shares and $250 in bonds.

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20-10

Original Capital Structure and Home-made Leverage

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20-11

Proposed Capital Structure

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20-12

Capital Structure Theory

Modigliani and Miller Theory of Capital Structure Proposition Ifirm value

Proposition IIWACC

The value of the firm is determined by the cash flowsto the firm and the risk of the assets

Changing firm value:

Change the risk of the cash flows Change the cash flows

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20-13

M&M Proposition I

Shares

40%

Debt

60%

(The size of the pie does not depend on how it is sliced.)

The value of the firm is independent of its capital structure.

Value of firm Value of firm

Shares

60%

Debt

40%

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20-14

M&M Proposition II

Because of Proposition I, the WACC must be constant, with notaxes:

WACC = RA = (E/V)RE+ (D/V)RD

where RAis the required return on the firms assets

Solve forRE to get M&M Proposition II:

RE= RA + (RARD) (D/E)

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20-15

The Cost of Equity and the WACC

Debt-equity ratio, D/E

Cost of capital

WACC = RA

RD

RE = RA + (RA RD ) x (D/E)

The firms overall cost of capital is unaffected by its capital structure.

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20-16

Business and Financial Risk

By M&M Proposition II, the required rate of return on equityarises from sources of firm risk. Proposition II is:

RE= RA + [RARD] [D/E]

Business riskequity risk arising from the nature of the firms

operating activities (measured by RA).

Financial riskequity risk that comes from the financial policy

(i.e. capital structure) of the firm(measured by [RARD] [D/E]).

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20-17

The SML and M&M Proposition II

How do financing decisions affect firm risk in bothM&Ms Proposition II and the CAPM?

Consider Proposition II: All else equal, a higher

debt/equity ratio will increase the required return onequity, RE.

RE= RA + (RARD) (D/E)

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20-18

The SML and M&M Proposition II

Substitute RA = Rf+ (RMRf)Aand by replacement RE= Rf+ (RMRf)E

The effect of financing decisions is reflected in the

equity beta, and, by the CAPM, increases therequired return on equity.

E= A(1 + D/E)

Debt increases systematic risk (and moves the firmalong the SML).

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20-19

Corporate Taxes

The interest tax shield is the tax saving attained bya firm from interest expense.

Assumptions: perpetual cash flows

no depreciation

no fixed asset or NWC spending.

For example, a firm is considering going from $0

debt to $400 debt at 10 per cent.

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20-21

Corporate Taxes

What is the link between debt and firm value?

Since interest creates a tax deduction, borrowing creates atax shield. The value added to the firm is the present value ofthe annual interest tax shield in perpetuity.

M&M Proposition I (with taxes):

Key result VL = VU+ TCD

DT

/RDRT

.

PV

C

DDC

160$100

16$savingtax

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20-22

Total debt (D)

Value of thefirm (VL)

VU

VL = VU + TC x D

= TC

VU

TC x DVL= VU + $160

VU

$400

M&M Proposition I with Taxes

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20-23

Taxes, the WACC and Proposition II

Taxes and firm value: an example

EBIT = $100

TC= 30%

RU= 12.5%

Suppose debt goes from $0 to $100 at 10 per cent. Whathappens to equity value, E?

VU= $100 (1 0.30)/0.125 = $560

VL = $560 + (0.30

$100) = $590 E = $490

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20-24


WACC and the cost of equity (M&M Proposition II with taxes):

RE= RU+ (RURD) (D/E) (1TC)

%8611

3001100590$

100$12860590$

490$WACC

%8612

3001490$100$10012501250

.

...

.

....RE

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20-25

Taxes, the WACC andPropositions I and IIConclusions

The WACC decreases as more debt financing is used.

Optimal capital structure is all debt.

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20-26

Debt-equity ratio, D/E

Cost of capital (%)

RU

RD (1TC)

RE

WACC

RE

RU

WACC

RD (1TC)


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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e

Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

20-27

Bankruptcy Costs

Borrowing money is a good news/bad newsproposition. The good news: interest payments are deductible and

create a debt tax shield (TCD). The bad news: all else equal, borrowing more money

increases the probability (and therefore the expectedvalue) of direct and indirect bankruptcy costs.

Key issue: The impact of financial distress on firmvalue.

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20-28

Direct versus Indirect Bankruptcy

Costs Direct costs

Those costs directly associated with bankruptcy,

(e.g. legal and administrative expenses).

Indirect costsThose costs associated with spending resources to

avoid bankruptcy.

Financial distress: significant problems in meeting debt obligations

most firms that experience financial distress do recover.

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20-29

Direct versus Indirect Bankruptcy

Costs The static theory of capital structure:

A firm borrows up to the point where the tax benefit

from an extra dollar in debt is exactly equal to the

cost that comes from the increased probability offinancial distress. This is the point at which WACC

is minimised and the value of the firm is

maximised.

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20-30

Value ofthe firm

(VL )

Debt-equity ratio, D/EOptimal amount of debtD/E

Present value of tax

shield on debtFinancialdistress costs

Actual firm value

VU = Value of firmwith no debt

VL = VU +TC D

Maximumfirm value VL*

VU

The Optimal Capital Structure and theValue of the Firm

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20-31

Cost ofcapital

(%)

Debt/equity ratio(D/E)D*/E*

The optimal debt/equity ratio

RUWACC

RD (1TC)

RE

RU

WACC*Minimumcost of capital

The Optimal Capital Structure and theCost of Capital

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20-32

Value ofthe firm

( VL )

Totaldebt (D)D*

PV of bankruptcy costs

Case IIIStatic Theory

Case IM&M (no taxes)

VL*

VU

Case IIM&M (with taxes)

Net gain from leverage

The Capital Structure Question

Value of

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20-33

the firm( VL )

Totaldebt (D)D*

PV of bankruptcy costs



VL*

VU


Net gain from leverage

D*/E*

The optimal debt/equity ratio

Minimumcost ofcapital

Cost ofcapital

(%)

Debt/equity ratio(D/E)




WACC*

Capital

StructureRe-Cap

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20-34

Managerial Recommendations

The tax benefit is only important if the firm has alarge tax liability.

Risk of financial distress:

The greater the risk of financial distress, the less debt willbe optimal for the firm.

The cost of financial distress varies across firms andindustries.

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20-35

Lower financial leverage

Bondholder

claim

Bankruptcyclaim

Tax

claim

Shareholderclaim

Higher financial leverage

Bondholder

claim

Bankruptcyclaim

Taxclaim

Shareholderclaim

The Extended Pie Model

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20-36

The Value of the Firm

Value of the firm = marketed claims + non-

marketed claims: Marketed claims are the claims of shareholders and

bondholders.

Non-marketed claims are the claims of the governmentand other potential stakeholders.

The overall value of the firm is unaffected bychanges in the capital structure.

The division of value between marketed claims andnon-marketed claims may be impacted by capitalstructure decisions.

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20-37

Corporate Borrowing and PersonalBorrowing

Without tax, corporate and personal borrowing areinterchangeable.

With corporate and personal tax, there is anadvantage to corporate borrowing because of theinterest tax shield.

With corporate and personal tax, and dividendimputation, shareholders are again indifferentbetween corporate and personal borrowing.

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Ross Thompson Christensen Westerfield and Jordan 20 38

Dynamic Capital Structure Theories

Pecking order theory Investment is financed first with internal funds, then debt,

and finally with equity.

Information asymmetry cost Management has superior information on the prospects of

the firm.

Agency costs of debt These occur when equity holders act in their own best

interests rather than the interests of the firm.

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