Chapte

r 16

Financial Leverage and

Capital Structure Policy

16-1
McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline
The Capital Structure Question
The Effect of Financial Leverage
Capital Structure and EBIT
M&M Propositions I and II with
Corporate Taxes
Bankruptcy Costs

16-2

Chapter Outline
(continued)
The Optimal Capital Structure
The Pie Again
The Pecking-Order Theory
A Quick Look at the Bankruptcy
Process

16-3

Capital Restructuring
We are going to look at
how changes in capital
structure impact the
value of the firm,
all else equal.

16-4

Capital restructuring
involves changing the
amount of leverage a firm
has without changing the

Choosing a Capital
Structure
What is the primary goal of
financial managers?

Maximize stockholder
wealth!
We want to choose the
capital structure that will
maximize stockholder
wealth.
16-5

We can maximize stockholder

The Effect of
Leverage
When we increase the amount of debt
financing, we increase the fixed
interest expense
If we have a really good year, then we
pay our fixed cost and we have more
left over for our stockholders
If we have a really bad year, we still
have to pay our fixed costs and we
have less left over for our
stockholders
16-6

The Effect of
Leverage
How does leverage impact the
EPS and ROE of a firm?
Leverage amplifies the variation
in both EPS and ROE. A small
change in leverage generates a
large change in profits.

16-7

Example: Financial
Leverage, EPS and
ROE: Part I
(We will ignore the effect of taxes at
this stage.)
What happens to EPS and ROE when we
issue debt and buy back shares of
stock?
Financial Leverage Example

16-8

Example: Financial
Leverage, EPS and
ROE: Part II
Variability in ROE
Current: ROE ranges from 6% to 20%
Proposed: ROE ranges from 2% to 30%

Variability in EPS
Current: EPS ranges from $0.60 to
$2.00
Proposed: EPS ranges from $0.20 to
$3.00
16-9

The variability in both ROE and

Break-Even EBIT
We are trying to find the
Earnings Before Interest
and Taxes (EBIT) where the
Earnings Per Share (EPS) is
the same under both the
current and proposed
capital structures.
16-10

Break-Even EBIT
If we expect the EBIT to be greater
than the break-even point, then
leverage may be beneficial to our
stockholders.
If we expect the EBIT to be less than
the break-even point, then leverage
is detrimental to our stockholders.
16-11

Example: Break-Even
EBIT
EBIT
EBIT 250,000

500,000
250,000
500,000
EBIT 250,000
EBIT

250,000
EBIT 2EBIT 500,000
EBIT $500,000
Break-even Graph
500,000
EPS
$1.00
500,000
16-12

Homemade
Leverage and ROE
Current Capital
Structure
Investor borrows $500
and uses $500 of her
own to buy 100 shares
of stock
Payoffs:
Recession: 100(0.60)

- .1(500) = $10
Expected: 100(1.30) - .
1(500) = $80
Expansion: 100(2.00)
- .1(500) = $150
Mirrors the payoffs
16-13

from purchasing 50
shares of the firm
under the proposed

Proposed Capital
Structure
Investor buys $250
worth of stock (25
shares) and $250
worth of bonds paying
10%.
Payoffs:
Recession: 25(.20) + .

1(250) = $30
Expected: 25(1.60) + .
1(250) = $65
Expansion: 25(3.00) + .
1(250) = $100
Mirrors the payoffs

from purchasing 50
shares under the

Capital Structure
Theory
Modigliani and Miller
(M&M) have proposed a
two-part
Theory of Capital
Structure

Proposition I Firm
value
16-14

Capital Structure
Theory
Proposition I Firm
value
The value of the firm is

determined by the cash flows

to the firm and the risk of the
assets
The firms value will change
due to:
16-15

1. The changing risk of the cash

flows

Capital Structure
Theory
Proposition II WACC
The Weighted Average Cost
of Capital (WACC) of the firm
is NOT influenced by the
capital structure.

16-16

Theory Under Three

Special Cases
Case
I
Case
II
Case
III
16-17

No Corporate or
personal taxes
No bankruptcy costs
Corp. taxes; no
personal taxes
No bankruptcy costs
Corp. taxes; no
personal taxes
Bankruptcy costs

Proposition I + Case
I
The value of the firm is
NOT affected by changes
in the capital structure
The cash flows of the firm
do not change; therefore,
value doesnt change

16-18

Prop I + Case I
Equations
WACC = RA = (E/V)RE + (D/V)RD
RE = RA + (RA RD)(D/E)
RA is the cost of the firms
business risk, i.e., the risk of the
firms assets

16-19

(RA RD)(D/E) is the cost of the

firms financial risk, i.e., the
additional return required by
stockholders to compensate for the

Cost of Capital versus D/E

Ratios

16-20

Proposition I + Case I
Example 1
Data:
Required return on assets =

16%

cost of debt = 10%

percent of debt = 45%

What is the cost of equity?

RE = RA + (RA RD)(D/E)
RE = 16 + (16 - 10)(.45/.55)
16-21

= 20.91%

Proposition I + Case
II
Interest is now tax deductible
Therefore, when a firm adds debt, it
reduces taxes, all else equal
The reduction in taxes increases the
cash flow of the firm
How should an increase in cash flows
change the value of the firm?

16-22

Proposition I + Case
II Example 1
Unlevered Firm
EBIT

16-23

Levered Firm

5,000

5,000

Interest

500

Taxable
Income

5,000

4,500

Taxes (34%)

1,700

1,530

Net Income

3,300

2,970

CFFA

3,300

3,470

Interest Tax Shield I

Annual interest tax
shield =
Tax rate times
interest payment
$6,250 in 8% debt
= $500 in interest
expense

16-24

Annual tax shield =

.34(500) = $170

Interest Tax Shield II

Present value of
annual interest tax
shield:
Assume perpetual debt
for simplicity
PV =
PV =
(.34)
PV =
16-25

D(RD)(TC) / RD
$6,250(.08)
/ .08
170 / .08 = $2,125

(But RD (.08) is in both the

Proposition I + Case
II
The value of the firm increases by
the present value of the annual
interest tax shield
Value of a levered firm = value of an
unlevered firm + PV of interest tax shield
Value of equity = Value of the firm Value
of debt

16-26

(Assuming perpetual cash

flows)
V = EBIT(1-T) / R

Proposition I + Case
II Example 2
Data:
EBIT = $25 million; Tax rate =
35%; Debt = $75 million; Cost of
debt = 9%; Unlevered cost of
capital = 12%

16-27

VU = 25(1-.35) / .12 = $135.42

million
VL = 135.42 + 75(.35) =
$161.67 million

M&M Proposition II +
Case II
The WACC decreases as D/E
increases because of the
government subsidy on interest
payments
RE = RU + (RU RD)(D/E)(1-TC)
RA = (E/V)RE + (D/V)(RD)(1-TC)

Example

16-28

RE = 12 + (12-9)(75/86.67)(1-.35) =
13.69%
RA = (86.67/161.67)(13.69) +
(75/161.67)(9)(1-.35)

M&M Proposition II +
Case II
RA = (E/V)RE + (D/V)(RD)(1-TC)
RE = RU + (RU RD)(D/E)(1-TC)
Example:
RE = 12 + (12-9)(75/86.67)(1-.35)
= 13.69%
RA = (86.67/161.67)(13.69) +
(75/161.67)(9)(1-.35)
16-29

M&M Proposition II +
Case II Example
Continued
Suppose that the firm changes its
capital structure so that the debtto-equity ratio becomes 1.0 (50%
D + 50% E)
What will happen to the cost of
equity under the new capital
structure?
16-30

RE = 12 + (12 - 9)(1)(1-.35) =

M&M Proposition II +
Case II Example
Continued
Suppose that the firm changes its
capital structure so that the debtto-equity ratio becomes 1.0 (50%
D + 50% E)
What will happen to the weighted
average cost of capital?

16-31

RA = .5(13.95) + .5(9)(1-.35) =
9.9%

WACC and Leverage

16-32

M&M Proposition II
+Case III

Now we add bankruptcy costs

As the D/E ratio increases, the
probability of bankruptcy
increases
16-33

This increased probability will

increase the expected

M&M Proposition II
+Case III
At some point, the
additional value of the
interest tax shield will
be offset by the
increase in expected
bankruptcy cost
At this point, the value
of the firm will start to
decrease, and the
WACC will start to
increase as more debt

16-34

Bankruptcy Costs
Direct costs:
Legal and
administrative
costs
Ultimately cause
bondholders to
incur additional
losses
16-35

Disincentive to

Bankruptcy Costs
Financial
distress:
Significant
problems in
meeting debt
obligations

16-36

Firms that
experience
financial distress

More Bankruptcy
Costs
Indirect bankruptcy costs
Larger than direct costs, but
more difficult to measure and
estimate
Stockholders want to avoid a
formal bankruptcy filing

16-37

Bondholders want to keep

existing assets intact so they
can at least receive that money

Even More
Bankruptcy Costs
Indirect bankruptcy costs
Assets lose value as
management spends time
worrying about avoiding
bankruptcy instead of running
the business

16-38

The firm may also lose sales,

experience interrupted
operations and lose valuable
employees

Maximize the Value of

the Firm

16-39

Optimal Capital
Structure to Minimize
the WACC

16-40

Capital Structure
with M&M
Case
I
Case
II
Case
III
16-41

No optimal
capital structure
predicted
Optimal capital
structure is
almost 100%
debt
Optimal capital
structure is part
debt and part
equity

Graphical
Presentat
ion of
M&Ms
Cases I,
II, & III

16-42

The Pecking-Order
Theory
Theory stating that
firms prefer to issue
debt rather than equity
if internal financing is
insufficient.

16-43

Rule 1
Use internal financing
first
Rule 2
Issue debt next,

The Pecking-Order
Theory
The pecking-order theory is
at odds with the tradeoff
theory:
There is no target D/E ratio
Profitable firms use less
debt
Companies like financial
slack

16-44

Comprehensive
Problem
Assuming perpetual cash flows in Case II Proposition I, what is the value of the
equity for a firm with:
EBIT = $50 million
Tax rate = 40%
Debt = $100 million
cost of debt = 9%
and unlevered cost of capital = 12%

16-45