Financial Leverage and Capital Structure

Policy

Chapter 16
Key Concepts and Skills
1. Pie Theory of capital structure
2. Understand the effect of financial leverage on
shareholder return (on equity)
3. Capital structure theories
▪
Homemade leverage and unleverage
▪
Miller & Modigliani cases and propositions with and
without taxes
▪
Static theory
▪
Pecking order theory
1. The Pie Theory
 The Capital Structure Queestion - Pie theory

• Changes in capital structure benefit the

stockholders if and only if the value of the
firm increases.
• The value of a firm is defined to be the sum of
the value of the firm’s debt and the firm’s equity.
V=D+E
• If the goal of the firm’s management is to make
the firm as valuable as possible, then the firm
should pick the debt-equity ratio that makes
the pie as big as possible.
• We can maximize stockholder wealth by
maximizing cashflow to firm or minimizing
WACC
2. Financial leverage
& stockholder
return
5
Capital Restructuring
looking at how changes in capital structure affect the value of the
firm, all else being equal

involves changing the amount of leverage (debt) a firm has without

changing the firm’s assets

Increase leverage - issue debt and repurchase outstanding

shares using the proceeds

Decrease leverage - issue new shares and retire outstanding debt

using the proceeds
 The Effeect of Leverage
▪
How does leverage affect the EPS and ROE of a firm?
▪ With increased debt financing, the fixed
interest expense increases
▪ In a ‘good year’ (high earning), more is left-over
for stockholders after paying the fixed costs
▪ In a ‘poor year’ (low earning), the fixed costs still
must be paid, and less is left over for the
stockholders
▪
Leverage amplifies the variation in both EPS and ROE
 Financial Leverage and Firm Value
Current Proposed
Assets $20,000 $20,000
ABC Co is an all-equity firm that is Debt $0 $8,000
considering going into debt. Equity $20,000 $12,000
The proposed change includes issuing
Debt/Equity ratio 0 2/3
$8,000 debt @8% and using the proceeds to repurchase shares from the market.
This is a tax-free universe. Interest rate n/a 8%
Shares outstanding 400 240
Share price $50 $50

Shares repurchased in restructuring= 8,000/50 = 160

Shares outstanding after restructuring = 400 -160 = 240
Earning in Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Current
Interest 0 0 0
(No Debt) Net
Structure income $1,000 $2,000 $3,000

EPS $2.50 $5.00 $7.50

ROA 5% 10% 15%
ROE 5% 10% 15%

Shares Outstanding = 400 shares

Earning in Proposed (With Debt) Structure
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640
Net
income $360 $1,360 $2,360

EPS $1.50 $5.67 $9.83

ROA 1.8% 6.8% 11.8%
ROE 3.0% 11.3% 19.7%

Shares Outstanding = 240 shares

Financial Leverage
and EPS
Break-Even EBIT ▪ Level of earning (EBIT) where EPS is
the same under both the current and
proposed capital structures
▪If expected EBIT is greater than
the break-even point, then
leverage is beneficial to
stockholders
▪If expected EBIT is less than the
break- even point, then leverage is
detrimental to stockholders
 From the previous example in expected conditions:

EPS in all-equity firm = EPS in firm with debt

EBIT/#of shares = (EBIT – Interest)/#of
shares EBIT/400 = (EBIT-640)/240
Break-Even EBIT IfBreak-even
EBIT = $1,600,
affect EPS
EBITthe
= capital structure does not
If EBIT > $1,600, more debt in capital structure
increases EPS
If EBIT < $1,600, more debt in capital structure
decreases EPS
 Homemade ▪ Individual shareholder preferring ROE like a levered
firm would provide but the firm remains unlevered.
Leverage: ▪ Own investment of $1,200 and borrow $800 to make
$2000 investment in buying 40 shares @ $50.
An ▪ She gets the same ROE as if she bought into a
levered firm.
Example

Recession Expected Expansion

EPS of Unlevered Firm $2.50 $5.00 $7.50
Earnings for 40 shares $100 $200 $300
Less: interest on $800 (8%) $64 $64 $64
Net Profits $36 $136 $236
ROE (Net Profits / $1,200) 3.0% 11.3% 19.7%

Choice of borrowing to replicate a personal capital structure of D/E = $800/$1,200 = 2/3

 Homemade ▪ Individual shareholder preferring ROE like an
unlevered firm would provide but the firm remains
Unleverage: levered.
An Example ▪ From own investment of $2,000, invest in 24 shares @
$50 (=$1,200) and lend $800 @ 8%
▪ She gets the same ROE as if she bought into an
unlevered firm.

Recession Expected Expansion

EPS of Levered Firm $1.50 $5.67 $9.83
Earnings for 24 shares $36 $136 $236
Add: interest on $800 (8%) $64 $64 $64
Net Profits $100 $200 $300
ROE (Net Profits / $2,000) 5% 10% 15%
Choice of lending to undo company capital structure of D/E = 2/3 by lending 40%
3. Capital Structure Theories

16
 Modigliani and Miller (M&M) Theory of Capital Structure
Proposition I – firm valueProposition II – WACC, RE

M&M
Capital The value of the firm is determined by the cash flows to

Structure the firm and the risk of the assets

Theory
Changing firm value
Change the risk of the cash flows Change
(WACC) the cash flows (CFA)
(Restrictive) Assumptions of the M&M Model

▪
Homogeneous Expectations
▪
Homogeneous Business Risk Classes
▪
Perpetual Cash Flows
▪
Perfect Capital Markets:
▪
Perfect competition
▪
Firms and investors can borrow/lend at the
same rate
▪
Equal access to all relevant information
▪
No transaction costs
▪
No taxes
 ▪Case I – Assumptions
▪No corporate or personal taxes
▪No bankruptcy costs
Capital Structure ▪Case II – Assumptions
▪Corporate taxes, but no
Theory Under personal taxes
▪No bankruptcy costs
Three Cases ▪Case III – Assumptions
▪Corporate taxes, but no
personal taxes
▪Bankruptcy costs
▪ Proposition I
▪ The value of the firm is NOT affected
by changes in the capital structure
▪ The cash flows of the firm do not
Case I
change, therefore value doesn’t change
▪ Proposition II
No Taxes
▪ The WACC of the firm is NOT affected
by capital structure
or
▪ Cost of equity increases with the use
of debt Bankruptcy
Costs
 ▪
We can create a levered or unlevered position
by adjusting the trading in our own account
▪
This homemade leverage suggests that capital
structure is irrelevant in determining the value
of the firm:
Case I
Proposition I Vu = EBIT/R Eu = V L = E L + D L
Where: Vu = Value of the unlevered firm
VL = Value of the levered firm
EBIT = Perpetual operating income
REu = Equity required return for the unlevered firm
EL = Market value of equity of levered firm
DL = Market value of debt
Example: Case I Prop I
ABC Co is an all-equity firm with a required
return on assets of 14% and an annual EBIT of
$35,000. Currently the firm pays no taxes.
▪
What
▪
V is= the value
EBIT/R of the
E = 35,000/0.14 = $250,000
▪
Suppose the firm decides to go through with
a capital restructure such that its D/E is 0.20
and the annual interest expense is $2,500.
What is the value of the firm now?
▪
In a world without taxes, VL = Vu
▪
VL = V = $250,000
 Proposition II - Leverage increases the risk and return to
stockholders
Case I Cost of Capital, WACC = RA = (E/V) *RE + (D/V)*RD

Proposition II Cost of Equity, RE = RA + (RA – RD)*(D/E)

Financial risk
Business risk
Cost of equity depends on three things:
▪ the rate of return on the firm's assets, RA
▪ the firm's cost of debt, RD
▪ the firm's debt/equity ratio, D∕E

Why WACC stays unchanged - Increased use of the cheaper debt is compensated
by the diminishing use of increased cost of equity
 Example:
Case I Prop
II Required return on assets = 16%, cost of debt =
10%; percent of debt = 45%
•
What is the cost of equity?
•
RE = 0.16 + (0.16 - 0.10)*(0.45/0.55) = 0.2091 = 20.91%
•
Suppose instead that the cost of equity is 25%, what is
the debt-to-equity ratio?
•
0.25 = 0.16 + (0.16 - 0.10)*(D/E)
•
D/E = (0.25 - 0.16) / (0.16 - 0.10) = 1.5
•
Based on this information, what is the percent of equity
in the firm?
•
E/V = 1 / 2.5 = 40%
Case II ▪
Proposition I

Corporate The value of the firm increases with

▪

the increased use of debt

▪
The cash flows of the firm increases with

Taxes but no interest tax shield in presence of

corporate taxes

Bankruptcy
▪
Proposition II
▪
The WACC of the firm decreases with
the increased use of debt

Costs Cost of equity STILL increases with the

▪

use of debt
What happens with corporate
Debt increases interest expense. Interest ex
taxes

When a firm adds debt, it reduces taxes, all e

The reduction in taxes increases the cash flow

Increases in cash flows raises the value of the

 ABC Co is an all-equity firm with an annual EBIT of $5,000. It pays taxes at 34%. The
firm is considering issuing $6,250 debt with a coupon of 8%.

Unlevered Firm Levered Firm

EBIT $5,000 $5,000
Example: Interest Interest @10% (A) 0 500
Tax Shield Taxable Income 5,000 4,500
Taxes @34% 1,700 1,530
Net Income (B) $3,300 $2,970
CFA (A+B) $3,300 $3,470
 Example: Interest Tax Shield
▪
Annual interest tax shield
▪interest payment times tax rate
▪$6,250 in 8% debt = $500 in interest payment
▪Annual interest tax shield = 0.34*(500) = $170
▪
Present value of annual interest tax shield
▪Assume perpetual debt
▪PV = 170 / 0.08 = $2,125
▪Alternatively, PV = D*(RD)*(TC) / RD = D*TC = 6,250*0.34 = $2,125
 Case II – Proposition I
▪ 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
▪ Assuming perpetual cash flows
▪ VU = EBIT*(1- TC) / RU
▪ VL = VU + D*TC
▪ VE = VL - D
Example – Case II – Prop I
Find the following if EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%;
Unlevered cost of capital = 12%

▪ What is the value of the firm?

▪ VU = EBIT*(I-TC)/ RU = 25*(1-0.35) / 0.12 = $135.42 million
▪ VL = VU + D*TC = 135.42 + 75*(0.35) = $161.67 million
▪ What is the equity in the firm worth?
▪ VE = VL – D = $161.67 – 75 = $86.67 million
 Case II – Proposition II

▪ The WACC decreases as debt increases

▪
WACC = (E/V)*RE + (D/V)*(RD)*(1-TC)
▪ Cost of equity increases as it gets riskier with higher debt
▪
RE = RU + (RU – RD)*(D/E)*(1-TC)
▪ Why does WACC decrease?
▪
The effect of increased use of cheaper after-tax cost of
debt outweighs the decreased use of more expensive
cost of equity as more debt is added to the capital
structure
 Example: Case II –
Prop II
Find the following if EBIT = $25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost
of capital = 12%; Firm value = $161.67 million; Levered equity = $86.67 million

▪ What is the cost of equity?

▪ RE = RU + (RU – RD)*(D/E)*(1-TC) = 0.12 + (0.12-0.09)(75/86.67)(1-.35) = 13.69%
▪ What is the WACC?
▪ WACC = (E/V)*RE + (D/V)*(RD)*(1-TC) = (86.67/161.67)*(0.1369) + (75/161.67)*(0.09)*(1-0.35) = 10.05%
▪ Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1. What is
the new cost of equity? New WACC?
▪ RE = 0.12 + (0.12 - 0.09)*(1)*(1-0.35) = 13.95%
▪ WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9%
 ▪
In CAPM, we have thus far used ‘asset beta’, a.k.a., unlevered beta
to estimate required return of the equity-holder.
Tangent CAPM: R * = R + 𝗉 (R – R )
– E f A M f

Asset Beta Where 𝗉A measures the systematic risk of the firm’s assets; the
underlying assumption is that the company uses only equity financing.
VS ▪
In contrast, the equity beta, a.k.a., levered beta considers different
Equity Beta levels of the company's debt in estimating the required return of
the equity-holder.
RE = Rf + 𝗉A(1+D/E)(RM – Rf), where 𝗉E = 𝗉A(1 + D/E)
▪
𝗉E = 𝗉A(1 + D/E) means that the systematic risk of the stock depends on:
▪
Systematic risk of the assets, 𝗉A, (Business risk)
▪
Level of leverage, D/E, (Financial risk)
 ▪
Proposition I
▪ The value of the firm increases with the
increased use of debt initially, but added
debt causes bankruptcy costs to
increase and lowers the firm value
eventually
▪ Tradeoff between increased cash flow
from interest tax shield and decreased
Case III – cash flow from bankruptcy costs
Corporate taxes & ▪
Proposition II
Bankruptcy costs
▪ The WACC of the firm decreases with the
increased use of cheaper debt initially only
to increase eventually as increased use of
debt causes cost of debt to increase due
to associated bankruptcy costs
▪ Cost of equity STILL increases with the
use of debt
What happens with bankruptcy costs?

• As the D/E ratio increases, the probability of bankruptcy increases

• This increased probability will increase the expected bankruptcy costs
• At some level of debt, the additional value of the interest tax shield will be offset by
the 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 is added
 Financial distress
•
Significant problems in meeting
debt obligations
•
Most firms that experience financial distress
Bankruptcy & do not ultimately file for bankruptcy

Costs Direct costs

•
Legal and administrative costs
•
Ultimately cause bondholders to
incur additional losses
•
Disincentive to debt financing
 Indirect Bankruptcy Costs

Examples: lost asset value as management spends time worrying about avoiding bankruptcy instead of running the busines

Larger than direct costs, but more difficult to measure and estimate as they are often not out-of- pocket costs

Stockholders wish to avoid a formal bankruptcy filing

Bondholders want to keep existing assets intact so they can at least receive that money
 Optimal Capital
Structure: Static
Theory

▪
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 where the
firm’s WACC is minimized, and
CFA is maximized
Static
Theory
and Firm
Value
Static
Theory
and Cost
of Capital
M&M - Takeaway

I II III
Case I Case II Case III
no taxes or bankruptcy costs corporate taxes but no bankruptcy costs corporate taxes and bankruptcy costs
No optimal capital structure Optimal capital structure is 100% Optimal capital structure is part
debt debt and part equity
Each additional dollar of debt increases the cash flow
Occurs
of the
where
firmthe benefit from an additional dollar of debt
M&M -
Takeawa
y
 Many large, profitable firms
use little debt. Why?
Static Theory
VS Ground Selling securities is expensive and
time consuming
Reality
If a firm is very profitable,
it might never need
external financing
Pecking Order Firms will use internal financing first.

Theory:
Making Then, they will issue debt if

meaning of
reality necessary. Equity is sold as a last

resort.
Managers are
sensitive to the
signals that they send
with the issue of new
securities.
Signaling and ▪
A company announces it is selling stock
Pecking Order ▪
Investors believe managers (and thus the
company) will sell when shares are
Theory ▪
overpriced
The stock price falls as the
announcement sends a negative signal to
the market

▪
Managers do not want the stock price to
fall, so they prefer internal financing
since it does not send a negative signal
▪
If external financing is required, firms prefer
debt
▪
External equity is issued as a last resort

The most profitable firms borrow less not

because they have lower target debt ratios but
because they don't need external financing
Observed Capital Structures
▪
Capital structure does differ by industry
▪
Firms and lenders look at the industry’s debt/equity ratio as a guide
▪
Changes in financial leverage affect firm value
▪
Stock price increases with increases in leverage and vice-versa
▪
Consistent with M&M with taxes
▪
Another interpretation is that firms signal good news when they lever up
▪
There is evidence that firms behave as if they had a target D/E ratio
Summary

You should know

▪ The effect of leverage on EPS and ROE – cost of
equity increases with increased debt in capital
structure
▪ The optimal capital structure is the mix of debt
and equity that maximizes the value of the firm
and minimizes the cost of capital
▪ Ignoring taxes, capital structure is irrelevant (Case I)
▪ With corporate taxes, the optimal structure is
100% debt (Case II)
▪ With corporate taxes and financial distress, the
optimal structure exists when marginal tax savings
equals marginal financial distress costs (Case III, a.k.a.,
static theory)
▪ Ground reality, Signaling and Pecking order theory –
the cohesive trinity