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Leverage and capital structure
Chapter 13
Key concepts and skills
• Understand the effect of financial leverage on cash flows and cost of equity
• Understand the impact of taxes and bankruptcy on capital structure choice
• Understand the basic components of bankruptcy
13-2Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Chapter outline
• The capital structure question• The effect of financial leverage• Capital structure and the cost of equity capital• Corporate taxes and capital structure• Bankruptcy costs• Optimal capital structure• Observed capital structures• A quick look at the bankruptcy process
13-3 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Capital structure
• Capital structure—percentage of debt and equity used to fund the firm’s assets– ‘Leverage’ = use of debt in capital structure
• Capital restructuring—changing the amount of leverage without changing the firm’s assets– Increase leverage by issuing debt and
repurchasing outstanding shares– Decrease leverage by issuing new shares and
retiring outstanding debt
13-4 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Capital structure and shareholder wealth
• What is the primary goal of financial managers?– To maximise shareholder wealth
• We want to choose the capital structure that will maximise shareholder wealth.
• We can maximise shareholder wealth by maximising firm value or minimising WACC.
13-5 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
The effect of financial leverage• How does leverage affect the earnings per share
(EPS) and return on equity (ROE) of a firm?• When we increase the amount of debt financing,
we increase the fixed interest expense.• If we have a really good year, we pay our fixed
costs and we have more left over for our shareholders.
• If we have a really bad year, we still have to pay our fixed costs and we have less left over for our shareholders.
• Leverage amplifies the variation in both EPS and ROE.
13-6 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Financial leverage, EPS and ROE example—Table 13.1
• We will ignore the effect of taxes at this stage.• What happens to EPS and ROE when we issue debt and buy back
shares?• Eagles Air Services
13-7 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Table 13.1
Current ProposedAssets $8,000,000 $8,000,000Debt $0 $4,000,000Equity $8,000,000 $4,000,000Debt/Equity Ratio 0.0 1.0Share Price $20 $20Shares Outstanding 400,000 200,000Interest rate 10% 10%
Eagles Air ServicesCapital structure scenarios—Table 13.2
13-8 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Table 13.2
Recession Expected ExpansionEBIT $500,000 $1,000,000 $1,500,000Interest 0 0 0Net Income $500,000 $1,000,000 $1,500,000ROE 6.25% 12.50% 18.75%EPS $1.25 $2.50 $3.75
Current Capital Structure: No Debt
Recession Expected ExpansionEBIT $500,000 $1,000,000 $1,500,000Interest 400,000 400,000 400,000Net Income $100,000 $600,000 $1,100,000ROE 2.50% 15.00% 27.50%EPS $0.50 $3.00 $5.50
Proposed Capital Structure: Debt = $4 million
Financial leverage, EPS and ROE—Example
• Variability in ROE– Current: ROE ranges from 6.25% to 18.75%– Proposed: ROE ranges from 2.50% to 27.50%
• Variability in EPS– Current: EPS ranges from $1.25 to $3.75– Proposed: EPS ranges from $0.50 to $5.50
• The variability in both ROE and EPS increases when financial leverage is increased.
13-9 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Break-even EBIT
• Find EBIT where EPS is the same under both the current and proposed capital structures.
• If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our shareholders.
• If we expect EBIT to be less than the break-even point, then leverage is detrimental to our shareholders.
13-10 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Break-even EBIT—ExampleEPS = for both capital structures
13-11 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
$2.00400,000
800,000EPS
$800,000EBIT
800,000EBIT2EBIT
400,000EBIT200,000
400,000EBIT
200,000
400,000EBIT
400,000
EBIT
Break-even EBIT (cont.)
• If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our stockholders.
• If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders.
13-12 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Eagle Air Services—Conclusion
1. The effect of leverage depends on EBIT:When EBIT is higher, leverage is beneficial.
2. Under the ‘expected’ scenario, leverage increases ROE and EPS.
3. Shareholders are exposed to more risk with more leverage.
ROE and EPS more sensitive to changes in EBIT.4. Capital structure is an important
consideration owing to the impact of financial leverage.
13-13 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Homemade leverage and ROE—Example
• Homemade leverage– The use of personal borrowing to change the overall amount of financial
leverage to which the individual is exposed.
Conclusion:• Any stockholder who prefers leverage can create their own
‘homemade’ leverage and replicate the payoffs.• Eagle Air Services’ capital structure is irrelevant to shareholders.
13-14 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Capital structure theory
• Modigliani and Miller – M&M Proposition I—The pie model– M&M Proposition II—WACC
• The value of the firm is determined by the cash flows to the firm and the risk of the firm’s assets.
• Changing firm value– Change the risk of the cash flows– Change the cash flows
13-15 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Capital structure theory Three special cases
• Case I—Assumptions– No corporate or personal taxes– No bankruptcy costs
• Case II—Assumptions– Corporate taxes, but no personal taxes– No bankruptcy costs
• Case III—Assumptions– Corporate taxes, but no personal taxes– Bankruptcy costs
13-16 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case I—Propositions I and II
• Proposition 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 doesn’t change.
• Proposition II– The WACC of the firm is NOT affected by
capital structure.
13-17 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case I—Equations
• WACC = RA = (E/V)RE + (D/V)RD
• RE = RA + (RA – RD)(D/E)
– RA is the ‘cost’ of the firm’s business risk, i.e. the risk of the firm’s assets.
– (RA – RD)(D/E) is the ‘cost’ of the firm’s financial risk, i.e. the additional return required by stockholders to compensate for the risk of leverage.
13-18 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case I—Example• Data
– Required return on assets = 16%, cost of debt = 10%, percentage of debt = 45%
• What is the cost of equity?– RE = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91%
• Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?
– .25 = .16 + (.16 - .10)(D/E)– D/E = (.25 - .16) / (.16 - .10) = 1.5
• Based on this information, what is the percentage of equity in the firm?
– E/V = 1 / 2.5 = 40%
13-19 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
M&M Propositions I and IIFigure 13.3
• The change in the capital structure weights (E/V and D/V) is exactly offset by the change in the cost of equity (RE), so the
WACC stays the same.
13-20 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
The CAPM, the SML and Proposition II
• How does financial leverage affect systematic risk?
• CAPM: RA = Rf + A(RM – Rf)– Where A is the firm’s asset beta and measures
the systematic risk of the firm’s assets.
• Proposition II– Replace RA with the CAPM and assume that the
debt is riskless (RD = Rf).
– RE = Rf + A(1+D/E)(RM – Rf)
13-21 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Business risk and financial risk
• RE = Rf + A(1+D/E)(RM – Rf)
• CAPM: RE = Rf + E(RM – Rf)– E = A(1 + D/E)
• Therefore, the systematic risk of the share depends on:– Systematic risk of the assets, A (business risk)
– Level of leverage, D/E (financial risk)
13-22 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case II—Corporate taxes
• Interest on debt is tax deductible.• When a firm adds debt, it reduces taxes, all
else being equal.• The reduction in taxes increases the cash
flow of the firm.• The reduction in taxes reduces net income.
13-23 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case II—Example
13-24 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Unlevered firm Levered firm
EBIT 5000 5000
Interest 0 500
Taxable Income 5000 4500
Taxes (30%) 1500 1350
Net Income 3500 3150
CFFA 3500 3650
Interest tax shield
• Annual interest tax shield– Tax rate times interest payment– 6250 in 8% debt = 500 in interest expense– Annual tax shield = .30(500) = 150
• Present value of annual interest tax shield– Assume perpetual debt for sake of simplicity– PV = 150 / .08 = 1875– PV = D(RD)(TC)/RD = DTC = 6250(.30) = 1875
13-25 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
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-T)/RU
– VL = VU + DTC
13-26 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case II—Proposition I (cont.)
• Data– EBIT = $25 million; tax rate = 30%; debt = $75
million; cost of debt = 9%; unlevered cost of capital = 12%
• VU = 25(1-.30) / .12 = $145.83 million
• VL = 145.83 + 75(.30) = $168.33 million
• E = 168.33 – 75 = $93.33 million
13-27 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
M&M Proposition I with taxesFigure 13.4
13-28 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case II—Proposition II
• The WACC decreases as D/E increases because of the government subsidy on interest payments.– RA = (E/V)RE + (D/V)(RD)(1-TC)– RE = RU + (RU – RD)(D/E)(1-TC)
• Example:– RE = .12 + (.12-.09)(75/86.67)(1-.35) = 13.69%– RA = (86.67/161.67)(.1369) + (75/161.67)(.09)
(1-.35)– RA = 10.05%
13-29 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case II—Proposition II (cont.)
• Suppose that the firm changes its capital structure so that the debt-to-equity ratio becomes 1.
• What will happen to the cost of equity under the new capital structure?– RE = .12 + (.12 - .09)(1)(1-.35) = 13.95%
• What will happen to the weighted average cost of capital?– RA = .5(.1395) + .5(.09)(1-.35) = 9.9%
13-30 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Illustration of Proposition II
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M&M summaryTable 13.4
13-32 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
M&M summaryTable 13.4 (cont.)
13-33 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Bankruptcy costs
• Direct costs– Legal and administrative costs
• Enron = $1 billion; WorldCom = $600 million– Bondholders incur additional losses– Disincentive to debt financing
• Financial distress– Significant problems meeting debt obligations– Most firms that experience financial distress
do not ultimately file for bankruptcy
13-34 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Indirect bankruptcy costs• Indirect bankruptcy costs
– Larger than direct costs, but more difficult to measure and estimate
– Stockholders wish to avoid a formal bankruptcy – Bondholders want to keep existing assets intact so
they can at least receive that money– Assets lose value as management spends time
worrying about avoiding bankruptcy instead of running the business
– Lost sales, interrupted operations, loss of valuable employees, low morale, inability to purchase goods on credit
13-35 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Case IIIWith bankruptcy costs
• D/E ratio → probability of bankruptcy• probability → expected bankruptcy
costs• At some point, the additional value of the
interest tax shield will be offset by the expected bankruptcy costs.
• At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added.
13-36 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Optimal capital structureFigure 13.5
13-37Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Conclusions• Case I—no taxes or bankruptcy costs
– No optimal capital structure• Case II—corporate taxes but no bankruptcy costs
– Optimal capital structure = 100% debt– Each additional dollar of debt increases the cash flow
of the firm• Case III—corporate taxes and bankruptcy costs
– Optimal capital structure is part debt and part equity– Occurs where the benefit from an additional dollar of
debt is just offset by the increase in expected bankruptcy costs
13-38 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
The capital structure questionFigure 13.6
13-39 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Observed capital structures
• Capital structure differs by industry• Example:
– Differences in Australian industries according to Table 13.5
• Media classification—Brisbane Broncos—0% debt• Utilities classification—Envestra—398.9% debt
13-40 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Example: Work the Web
• You can find information about a company’s capital structure relative to its industry and sector using industry centre or sector analysis through Yahoo! Finance.
• Click on the information icon to go to the site– Choose a company and get a quote– Perform sector and industry comparisons
13-41 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Bankruptcy process
• Business failure—business has terminated with a loss to creditors
• Legal bankruptcy—petition federal court for bankruptcy
• Technical insolvency—firm is unable to meet debt obligations
• Accounting insolvency—book value of equity is negative
13-42 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Liquidation and reorganisation• Companies Act 1993 and the Liquidation
Regulations 1994.• Process
– A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation by several of its creditors.
– An administrator is appointed by the court or the creditors to take over the assets of the debtor. The administrator will attempt to liquidate the assets.
– When the assets are liquidated, after payment of the bankruptcy administration costs, the proceeds are distributed among the creditors.
– If any proceeds remain, after expenses and payments to creditors, they are distributed to the shareholders.
13-43 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Liquidation and reorganisation (cont.)
• The distribution of liquidation proceeds is made according to section 556 of the Australian Government Corporations Law.
• Brief priority list (absolute priority rule)– 1. Administrative expenses associated with the bankruptcy.– 2. Other expenses arising after the filing of a bankruptcy petition, but before the
appointment of an administrator.– 3. Wages, salaries and superannuation contributions for employees owed before the
company goes into liquidation.– 4. Amounts due in respect of injury compensation owed before the company goes into
liquidation.– 5. Amounts due to employees for leave of absence owed before the company goes into
liquidation.– 6. Retrenchment payments payable to employees of the company. In New Zealand the
preferential payment under 3, 4, 5 and 6 is limited to $15 000 per employee.– 7. Payment to unsecured creditors.– 8. Payment to preference shareholders.– 9. Payment to ordinary shareholders.
13-44 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Quick quiz
• Explain the effect of leverage on EPS and ROE.• What is break-even EBIT?• How do we determine optimal capital structure?• What is the optimal capital structure in the three
cases that were discussed in this chapter?• What is the difference between liquidation and
reorganisation?• What are the direct and indirect costs of
bankruptcy?
13-45 Copyright © 2011 McGraw-Hill Australia Pty LtdPPTs t/a Essentials of Corporate Finance 2e by Ross et al.Slides prepared by David E. Allen and Abhay K. Singh
Chapter 13
END
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