Capital Structure

Benefits of Using Other People’s MoneyDebt

→Financial leverage is the ability that owners have, to use other people’s money at fixed rates to make higher rates of return than would have been possible by using all of their own money. It represents one of the main benefits of taking on debt.  

→Firms that take on debt as part of their capital structure are therefore known as leveraged firms while those that do not are known as unlevered firms.

How does the mechanism work?

Earnings per Share as a Measure of the Benefits of Borrowing

®One way to measure the benefits of leverage is to compare the EPS of firms with different capital structures under good and bad economic conditions.

®Let us consider 3 equal-sized firms: one with no debt, one with 50% debt, and one with 99.75% debt.

Capital Structure Three Identical Firms

Earnings per Share as a Measure of the Benefits of Borrowing

Company needs to raise $10,000 capital, its shares are sold @ $25

→ Assuming a cost of debt of 10% for all firms and identical EBIT ($2000), EPS is calculated and shown

→ Earnings per Share of Firms with Different Capital Structures

→ If the firm’s EBIT covers its interest cost, higher leverage benefits the stockholders resulting in higher EPS

Earnings per Share as a Measure of the Benefits of Borrowing

→ However, if the firm’s EBIT does not cover its interest cost, the reverse is true, as shown

Earnings per Share of Firms with Different Capital Structures

Bottom-lineLeverage is a two-edged sword; benefiting firms in good times and hurting them in bad times

Earnings per Share as a Measure of the Benefits of Borrowing

®The search continues for seeking that level of EBIT that makes the capital structure decision irrelevant, resulting in similar EPS

®The Break Even EBIT has an answer

To calculate the break-even EBIT, we use the following method: 1. We first calculate the EPS of two firms, Company 1 and

Company 2; set them equal; and solve for the EBIT:EPS = (EBIT – I)/no: of sharesEPS* =( EBIT – 0)/400 = (EBIT -$500)/200400(EBIT-$500) = 200(EBIT-0)2EBIT-$1000 = EBITEBIT = $1000

2. Next, we calculate each firm’s EPS at the break-even EBIT, i.e., $1000: 

Company 1’s EPS = 1000/400 = $2.50Company 2’s EPS = (1000-500)/200 = $2.50Company 3’s EPS = (1000-997.5)/1= $2.50

Break-Even Earnings for Different Capital Structures

Break-Even Earnings for Different Capital Structures

→At a certain level of EBIT, known as the break-even EBIT, all three firms will have the same EPS, as shown  

→Earnings per Share of Firms with Different Capital Structures

→Below an EBIT of $1000, e.g., $800, leverage hurts and vice-versa, as shown

Earnings per share and earnings for three different capital structures.

Break-Even Earnings for Different Capital Structures

Bottom line

®At an EBIT of $1,000, capital structure of the firm becomes irrelevant, justified by the fact at the different capital structure leads to the same EPS value

1. In order to meet its financing requirements, Google is contemplating at two possible capital structures. Presently the firm is an all equity firm with a $12 million in assets and 2 million shares outstanding. The market value of each stock is $6.0. the CEO is thinking of leveraging the firm by selling 6 million of debt financing and retiring the stock in debt for equity swap. The annual cost of debt is 8%. What is the break – even EBIT for Google with the two possible capital structures.

EBIT = $960,000, EPS = 0.48

2. Which capital structure should the company choose if the anticipated EBIT for the coming year is $1,000,000?

EPS = $0.50, $0.52

The intriguing question®How much debt should a company

carry and from whom®Basis for “Pecking order Hypothesis”

Firm Value in Miller – Modigliani Framework

®Firm E is an all equity firm with a required rate of return on its assets of 8%. Firm L is a leveraged firm and can borrow in the debt market @6%, what is the cost of equity as the firm L borrows more and more in the debt markets? Solve for each of the three different capital structures:

A. 100% equityB. 50% equity, 50% debtC. 10% equity and 90% debtThe firm earn $100,000 every year forever

Steps 1. Find Cost of Equity of the firm at each capital

structure2. Find WACC of the firm at each capital

structure3. Find the value of the firm using the

appropriate discount rate

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“Our performance in 2000 was a success by any measure…The company’s net income reached a record in 2000. We are laser-

focused on earnings per share, and we expect to continue strong earnings performance.”

Debt and the Tax ShieldEBIT Distribution to Claimants under Different Funding Structures

Effect of increasing debt levels on the distribution of a firm’s EBIT

As the firm’s debt level goes from 0% to 90%, with EBIT staying constant at $100,000, government’s share of EBIT (taxes) dwindles from $25,000 to $2,500. The equity holders’ share also gets smaller and smaller as the debt holders receive their interest payments.

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Impact of Capital Structure on Firm Value ®Does Debt / Equity policy affect the overall

firm value?®Does Minimizing WACC always result in

maximizing value?

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Effect on Operations

• Business risk is 20%• Financial risk is 50%

Business Outcome

Operating cash flow

Interest Cash to shareholders

Bad $ 80 $ 60 $ 20Expected $ 100 $ 60 $ 40Good $120 $ 60 $ 60

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Impact of leverage on firm’s cost of capital

Case 1®Firm uses equal levels of debt & equity in its

capital structure®Given tax rate is 40%®Kd is 10%®KE is 16%®WACC is {D/(D+E)} Kd(1-t) + (E/D+E) KE

®WACC = 11%

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Case 2®Firm uses 60 % debt – 40 % equity in its capital

structure®Tax rate is 40%®KE is 18%®Kd is 10%®WACC = 10.8%Case 3®All else being equal, KE changes to 20%®New WACC is 11.6%

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Let us examine

Should I®Pick the financing mix that maximizes firm

value®Rely on ROE & EPS as appropriate measures of

value®No, they only measure the returns & ignores

the all important element of risk®So, increased earnings does not necessarily

increase firm value if it comes at a cost of increased debt levels

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Value

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The Epicenter of value®Value that eventually goes to all the claimants ®Earnings Before Interest & Tax (EBIT)

Government Tax

Shareholders Dividends

Debt holders Interest

EBIT

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®Investment decision decides the Size of the pie®The Financing decisions decides how the slice

is to be cut®Can firms increase the slice of residual claims

by restricting the outflow in the form of corporate taxes?

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Unlevered Firm Levered Firm$ 3,000* @ 10 %

Earnings before Interest & Taxes - EBIT

1,000 1000

Interest on Debt 0 300

Pretax profits 1,000 700

Tax rate @ 40 % 400 280

Profits after taxes 600 420

Payments made to debt & equity

600 720

®Maintaining a target capital structure ®Entire PAT paid out as dividends

The levered firm’s increase in value to the extent of 120 is in essence exactly the amount arising out of tax shield on interest0.10(3,000)(0.4)

Thus Government’s tax revenues decline by 120 (600 – 480)

Capital Structure in a World of Corporate Taxes and no Bankruptcy

Value of firms in world of corporate taxes

As the firm issues more debt, its tax shield increases, and the government’s share of the pie decreases, increasing the value of the equity-holders.→All debt financing is optimal.→The WACC of the firm falls as more debt is added.

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® So, can we safely say®VL = VUL + Present value of Tax shield on Debt® VL = VUL + DT

Case®Given: EBIT = 1,000®Tax rate (T) = 40 %® So, Post tax EBIT = 1,000(0.4) = 600®KD = 10%, KEU 12%®V denotes firm value &®CFD & CFE denotes cash floes to debt and equity

holders respectively

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Financial Policy Cash Flows Values Unlevered Firm CFD = 0

CFE = 600Taxes = 400

D = CFD / KD =0E = CFE / KEU = 600 / 0.12 = 5,000Value (V) = D+E= 0+5,000 = 5,000

Levered Firm 3,000 Debt issues

CFD = 300CFE = 420Taxes = 280

D = CFD / KD =300 / 0.10 = 3,000VL = VUL + DT = 5,000 + (120) / 0.10VL = 6,200Since, VL = D + E6,200 = 3,000 +ESo, E = 3,200

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The Benefit – Cost Tradeoff

Value of the Firm

VU

VL

Leverage

D*

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Leverage and tax benefits & its implication on firm value and investors’ cost of capital

• With added leverage, the KE for the levered firm changes, but the question is to what extent

From our earlier calculations,• Market value of equity was $ 3,200• Expected cash flow to equity holders was $ 420• So, the implied cost of equity for the levered firm

(KEL) is,

• E = CFE/KEL, 3,200 = 420/KEL, KEL = 13.125

• So, the additional debt has altered the KE from 12% to 13.125%

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®The additional 1.125% (13.125 – 12) is the additional risk premium for financial risk and increases directly with the D/E ratio

Recall,®KEL = Rf + Rbus + Rfin ®Where, Rfin denotes financial risk®Thus: KEL = KEU + Rfin

In this case,®13.125% = 12% + 1.125%

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Inference

®The value of the firms, either levered of unlevered can be estimated by discounting its Post tax EBIT with the appropriate WACC

®Value of the firm will be maximum where the WACC is minimum

®Challenge is to estimate the minimum WACC that maximizes the firm value

Debt (D)

Cost of Debt (KD)

Equity Cost of Equity (KE )

WACC

Unlevered Firm

0 10% $5,000 12% 12%

Levered Firm $3,000 10% $3,200 13.125% 9.68%

WACC = (D/D+E)*KD(1-t) + (E/D+E)(KE )

Cost of Capital & Debt Policy

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Final Thoughts ® Financial leverage magnifies the variability of operating

income, thus increasing the riskiness of the return o equity® As financial leverage, the risk & return required by the

equity holders increases® Financial leverage affects the value of the firm because the

tax deductibility of interest acts as a subsidy to the firm® offsetting the benefits of tax are the costs of financial

distress, agency problem and reduced flexibility® In principal, an optimum debt level exists beyond which

the tax benefits of additional debt are outweighed by its costs