Week 12 13 Chapter 17

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

Ross, Thompson, Christensen, Westerfield and Jordan
Slides prepared by Sue Wright
20-1
Chapter Seventeen

Financial Leverage and
Capital Structure Policy
20-2
20.1 The Capital Structure Question
20.2 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 Costs
20.6 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
20-3
Chapter Objectives
Understand the impact of financial leverage on a
firms 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.
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 target
capital structure.
20-5
ExampleComputing Break-even
EBIT
ABC Company currently has no debt in its capital
structure. The company has decided to restructure,
raising $2.5 million debt at 10 per cent. ABC
currently has 500 000 shares on issue at a price of
$10 per share. As a result of the restructure, what is
the minimum level of EBIT the company needs to
maintain EPS (the break-even EBIT)? Ignore taxes.
20-6
EBIT (continued)
With no debt:
EPS = EBIT/500 000

With $2.5 million in debt @ 10%:
EPS = (EBIT $250 000
1
)/250 000
2

1
Interest expense = $2.5 million 10% = $250 000
2
Debt raised will refund 250 000 ($2.5 million/$10)shares, leaving
250 000 shares outstanding
20-7
EBIT (continued)

These are then equal:
EPS = EBIT/500 000 = (EBIT $250 000)/250 000

With a little algebra:
EBIT = $500 000
EPS
BE
= $1.00 per share
20-8
Financial Leverage, EPS and EBIT
EBIT ($ 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

20-9
ExampleHome-made Leverage and
ROE
Home-made leverage is the use of personal borrowing to alter
the degree of financial leverage. Investors can replicate the
financing decisions of the firm in a costless manner.

Example
Original capital structure and home-made leverage investor
uses $500 of their own and borrows $500 to purchase 100
shares.
Proposed capital structure investor uses $500 of their own,
together with $250 in shares and $250 in bonds.
20-10
Original Capital Structure and Home-
made Leverage
20-11
Proposed Capital Structure
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 flows
to the firm and the risk of the assets

Changing firm value:
Change the risk of the cash flows
Change the cash flows
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%
20-14
M&M Proposition II
Because of Proposition I, the WACC must be constant, with no
taxes:

WACC = R
A
= (E/V) R
E
+ (D/V) R
D

where R
A
is the required return on the firms assets

Solve for R
E
to get M&M Proposition II:

R
E
= R
A
+ (R
A
R
D
) (D/E)
20-15
The Cost of Equity and the WACC
Debt-equity ratio, D/E
Cost of capital
WACC = R
A
R
D
R
E
=R
A
+(R
A
R
D
) x (D/E)
The firms overall cost of capital is unaffected by its capital structure.
20-16
Business and Financial Risk
By M&M Proposition II, the required rate of return on equity
arises from sources of firm risk. Proposition II is:

R
E
= R
A
+ [R
A
R
D
] [D/E]

Business riskequity risk arising from the nature of the firms
operating activities (measured by R
A
).

Financial riskequity risk that comes from the financial policy
(i.e. capital structure) of the firm
(measured by [R
A
R
D
] [D/E]).
20-17
The SML and M&M Proposition II
How do financing decisions affect firm risk in both
M&Ms Proposition II and the CAPM?

Consider Proposition II: All else equal, a higher
debt/equity ratio will increase the required return on
equity, R
E
.

R
E
= R
A
+ (R
A
R
D
) (D/E)
20-18
The SML and M&M Proposition II
Substitute R
A
= R
f
+ (R
M
R
f
)
A
and by replacement R
E
= R
f
+ (R
M
R
f
)
E

The effect of financing decisions is reflected in the
equity beta, and, by the CAPM, increases the
required return on equity.

E
=
A
(1 + D/E)

Debt increases systematic risk (and moves the firm
along the SML).

20-19
Corporate Taxes
The interest tax shield is the tax saving attained by
a 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.
20-20
Corporate Taxes
Firm U Firm L
EBIT $200 $200
Interest 0 40
Taxable income $200 $160
Tax (@ 40%) 80 64
Net profit $ 120 $ 96
Cash flow from assets $ 120 $136

Tax saving = $16 = 0.40 x $40 = T
C
R
D
D
20-21
Corporate Taxes
What is the link between debt and firm value?
Since interest creates a tax deduction, borrowing creates a
tax shield. The value added to the firm is the present value of
the annual interest tax shield in perpetuity.

M&M Proposition I (with taxes):

Key result V
L
= V
U
+ T
C
D
( )
( )
D T
/R D R T

.
PV
C
D D C
=
=
= = 160 $
10 0
16 $
saving tax
20-22
Total debt (D)
Value of the
firm (V
L
)
V
U
V
L
=V
U
+T
C
x D
=T
C
V
U
T
C
x D
V
L
= V
U
+ $160

V
U
$400

M&M Proposition I with Taxes
20-23
Taxes, the WACC and Proposition II
Taxes and firm value: an example
EBIT = $100
T
C
= 30%
R
U
= 12.5%
Suppose debt goes from $0 to $100 at 10 per cent. What
happens to equity value, E?

V
U
= $100 (1 0.30)/0.125 = $560
V
L
= $560 + (0.30 $100) = $590
E = $490
20-24
WACC and the cost of equity (M&M Proposition II with taxes):
R
E
= R
U
+ (R
U
R
D
) (D/E) (1 T
C
)

( ) ( ) ( )
( ) ( ) ( )
% 86 11
30 0 1 10 0
590 $
100 $
1286 0
590 $
490 $
WACC
% 86 12
30 0 1
490 $
100 $
10 0 125 0 125 0
.
. . .
.
. . . . R
E
=
+ =
=
+ =
20-25
Taxes, the WACC and
Propositions I and IIConclusions
The WACC decreases as more debt financing is used.

Optimal capital structure is all debt.
20-26
Cost of capital (%)
R
U

R
D

(1 T
C
)
R
E
WACC
R
E
R
U
WACC

R
D

(1
T
C
)

20-27
Bankruptcy Costs
Borrowing money is a good news/bad news
proposition.
The good news: interest payments are deductible and
create a debt tax shield (T
C
D).
The bad news: all else equal, borrowing more money
increases the probability (and therefore the expected
value) of direct and indirect bankruptcy costs.

Key issue: The impact of financial distress on firm
value.
20-28
Direct versus Indirect Bankruptcy
Costs
Direct costs
Those costs directly associated with bankruptcy,
(e.g. legal and administrative expenses).
Indirect costs
Those costs associated with spending resources to
avoid bankruptcy.
Financial distress:
significant problems in meeting debt obligations
most firms that experience financial distress do recover.
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 of
financial distress. This is the point at which WACC
is minimised and the value of the firm is
maximised.

20-30
Value of
the firm
(V
L
)
Optimal amount of debt D/E
Present value of tax
shield on debt
Financial
distress costs
Actual firm value
V
U
= Value of firm
with no debt
V
L
= V
U
+ T
C
D
Maximum
firm value V
L
*
V
U
The Optimal Capital Structure and the
Value of the Firm
20-31
Cost of
capital
(%)
Debt/equity ratio
(D/E)
D*/E*
The optimal debt/equity ratio
R
U
WACC
R
D
(1 T
C
)
R
E
R
U
WACC*
Minimum
cost of capital
The Optimal Capital Structure and the
Cost of Capital
20-32
Value of
the firm
( V
L
)
Total
debt (D)
D*
PV of bankruptcy costs
Case III
Static Theory
Case I
M&M (no taxes)

V
L
*
V
U
Case II
M&M (with taxes)
Net gain from leverage
The Capital Structure Question
20-33
Value of
the firm
( V
L
)
Total
debt (D)
D*
PV of bankruptcy costs
Case III
Static Theory
Case I
M&M (no taxes)

V
L
*
V
U
Case II
M&M (with taxes)
Net gain from leverage
D*/E*
The optimal debt/equity ratio
Minimum
cost of
capital
Cost of
capital
(%)
Debt/equity ratio
(D/E)
Case I
M&M (no taxes)
Case III
Static Theory
Case II
M&M (with taxes)
WACC*
Capital
Structure
Re-Cap
20-34
Managerial Recommendations
The tax benefit is only important if the firm has a
large tax liability.

Risk of financial distress:
The greater the risk of financial distress, the less debt will
be optimal for the firm.
The cost of financial distress varies across firms and
industries.
20-35
Lower financial leverage
Bondholder
claim
Bankruptcy
claim
Tax
claim
Shareholder
claim
Higher financial leverage
Bondholder
claim
Bankruptcy
claim
Tax
claim
Shareholder
claim
The Extended Pie Model
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 government
and other potential stakeholders.

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

The division of value between marketed claims and
non-marketed claims may be impacted by capital
structure decisions.
20-37
Corporate Borrowing and Personal
Borrowing
Without tax, corporate and personal borrowing are
interchangeable.

With corporate and personal tax, there is an
advantage to corporate borrowing because of the
interest tax shield.

With corporate and personal tax, and dividend
imputation, shareholders are again indifferent
between corporate and personal borrowing.
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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PPTs t/a Fundamentals of Corporate Finance 3e

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