Fundamentals of Corporate Finance/3e,ch20

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

20-1

Chapter Twenty

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 Organisation


20-3

Chapter Objectives• Understand the impact of financial leverage on a firm’s 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 firm’s 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 firm’s capital structure is chosen if WACC is

minimised.– This is known as the optimal capital structure or target

capital structure.


20-5

Example—Computing 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

Example—Computing Break-even EBIT (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


20-7

Example—Computing Break-even EBIT (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


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


20-9

Example—Home-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

Recession Expected Expansion

EPS of unlevered firm $0.60 $1.30 $1.60 Earnings for 100 shares $60.00 $130.00 $160.00 Less interest on $500 @ 10%

$50.00 $50.00 $50.00

Net earnings $10.00 $80.00 $110.00 ROE 2% 16% 22%


20-11

Proposed Capital Structure

Recession Expected Expansion

EPS of levered firm $0.20 $1.60 $2.20 Earnings for 25 shares $5.00 $40.00 $55.00 Plus interest on $250 @ 10%

$25.00 $25.00 $25.00

Net earnings $30.00 $65.00 $80.00 ROE 6% 13% 16%


20-12

Capital Structure Theory

• Modigliani and Miller Theory of Capital Structure– Proposition I—firm value– Proposition II—WACC

• 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

(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


20-14

M&M Proposition II

• Because of Proposition I, the WACC must be constant, with no taxes:

WACC = RA = (E/V) × RE + (D/V) × RD

where RA is the required return on the firm’s assets

• Solve for RE to get M&M Proposition II:

RE = RA + (RA – RD) × (D/E)


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 firm’s 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:

RE = RA + [RA – RD] × [D/E]

• Business risk—equity risk arising from the nature of the firm’s operating activities (measured by RA).

• Financial risk—equity risk that comes from the financial policy (i.e. capital structure) of the firm (measured by [RA – RD] × [D/E]).


20-17

The SML and M&M Proposition II

• How do financing decisions affect firm risk in both M&M’s Proposition II and the CAPM?

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

RE = RA + (RA – RD) × (D/E)


20-18

The SML and M&M Proposition II

• Substitute RA = Rf + (RM Rf)βA

and by replacement RE = Rf + (RM Rf)βE

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

βE = βA(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

Tax saving = $16 = 0.40 x $40 = TC × RD × 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 VL = VU + TCD

DT

/RD R T

. PV

C

DDC

160$10016$savingtax


20-22

Total debt (D)

Value of the firm

(VL)

VU

VL = VU + TC x D

= TC

VU

TC x DVL= VU + $160

VU

$400

M&M Proposition I with Taxes


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. What happens to equity value, E?

VU = $100 × (1 – 0.30)/0.125 = $560

VL = $560 + (0.30 × $100) = $590

E = $490


20-24


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

RE = RU + (RU – RD) × (D/E) × (1 – TC)

%8611

3001100590$100$12860590$

490$WACC

%8612

3001490$100$10012501250

.

. . .

.

. . . . RE


20-25

Taxes, the WACC and Propositions I and II—Conclusions

• The WACC decreases as more debt financing is used.

• Optimal capital structure is all debt.


20-26

Debt-equity ratio, D/E

Cost of capital (%)

RU

RD (1 – TC)

RE

WACC

RE

RU

WACC

RD (1 –

TC)



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 (TCD).

– 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 ofthe firm

(VL )

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

Present value of taxshield on debt

Financial distress costs

Actual firm value

VU = Value of firm with no debt

VL = VU + TC D

Maximumfirm value VL*

VU

The Optimal Capital Structure and the Value of the Firm


20-31

Cost ofcapital

(%)

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

The optimal debt/equity ratio

RU

WACC

RD (1 – TC)

RE

RU

WACC*Minimum cost of capital

The Optimal Capital Structure and the Cost of Capital


20-32

Value ofthe firm

( VL )

Total debt (D)D*

PV of bankruptcy costs

Case III Static TheoryCase IM&M (no taxes)

VL*

VU

Case IIM&M (with taxes)

Net gain from leverage

The Capital Structure Question


20-33

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.


20-34

Lower financial leverage

Bondholderclaim

Bankruptcyclaim

Taxclaim

Shareholderclaim

Higher financial leverage

Bondholderclaim

Bankruptcyclaim

Taxclaim

Shareholderclaim

The Extended Pie Model


20-35

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.


20-36

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.


20-37

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.

Date post:	06-May-2015
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Fundamentals of Corporate Finance/3e,ch20

Economy & Finance