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2201AFE Corporate FinanceWeek 11:Financial Leverage and Capital Structure Policy

Readings: Chapter 19

AgendaLast WeekFinancial Leverage and Capital Structure PolicyKey Concepts and SkillsReal World ApplicationCDO101 A primer on collateralised debt obligations!Next Week

Approved list of deferred exam sitting is published on Learning@GU > Assessment

2Last LectureCost of EquityCost of Preferred StockCost of DebtProportion or weight of each form of financingCost of Capital = WACCUnadjusted/AdjustedWhen should we use WACC?Other approaches: pure play and subjectiveFlotation Costs

3Financial Leverage and Capital Structure Policy

Chapter 19451. Introduction & Financial Statements2. Time Value of Money3. Valuing Shares & Bonds7. Mid-semester Exam 8. Some Lessons from Capital Market History11. Financial Leverage & Capital Structure Policy13. Options & Revision9. Return, Risk & the Security Market Line5. Making Capital Investment Decisions & Project Analysis12. Dividends & Dividend Policy6. Revision for Mid-sem Exam4. Net Present Value & Other Investment Criteria10. Cost of CapitalKey Concepts and SkillsThe Capital Structure QuestionThe Effect of Financial LeverageCapital Structure and the Cost of Equity CapitalM&M Propositions I and II with Corporate TaxesBankruptcy CostsOptimal Capital Structure

6Choosing a Capital StructureWhat is the primary goal of financial managers?

Maximize stockholder wealth

Choose the optimal capital structure

Maximize the value of the firm

Minimize the WACC

7Capital RestructuringFinancial leverage = the extent to which a firm relies on debt financing.

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

The firm can increase leverage by issuing debt and repurchasing outstanding shares.

The firm can decrease leverage by issuing new shares and retiring outstanding debt.

8The Effect of LeverageHow does leverage affect the EPS and ROE of a firm?

More debt financing, means more fixed interest expense.

In expansion, we have more income after we pay interest, have more left over for stockholders.

In recession, we still have to pay our costs therefore we have less left over for stockholders.

Leverage amplifies the variation in both EPS and ROE.

9Example: Financial Leverage, EPS and ROE10CurrentProposedAssets$5,000,000$5,000,000Debt$0$2,500,000Equity$5,000,000$2,500,000Debt/Equity Ratio01Share Price$10$10Shares Outstanding500,000250,000Interest RateN/A10%Current Capital Structure: No DebtRecessionExpectedExpansionEBIT$300,000$650,000$1,000,000Interest000Net Income$300,000$650,000$1,000,000ROE6.00%13.00%20.00%EPS$0.60$1.30$2.00Proposed Capital Structure: Debt = $2.5 millionRecessionExpectedExpansionEBIT$300,000$650,000$1,000,000Interest$250,000$250,000$250,000Net Income$50,000$400,000$750,000ROE2.00%16.00%30.00%EPS$0.20$1.60$3.00Break-Even EBITBreak-Even EBIT where: EPS debt = EPS no debt

If expected EBIT > break-even EBIT, then leverage is beneficial to our stockholders.

If expected EBIT < break-even EBIT, then leverage is detrimental to our stockholders.

11Example: Break-Even EBITNote: Numbers in thousands

Outcomes:EPS with No Debt = $500/500 = $1EPS with Debt = ($500-$250)/250 = $1

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Break Even EBIT13

Capital Structure TheoryModigliani and Miller Theory of Capital Structure.Proposition I firm valueProposition II cost of equity & 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.

14Capital Structure Theory Under Three Special CasesCase I Assumptions:No taxesNo bankruptcy costs

Case II Assumptions:With taxesNo bankruptcy costs

Case III Assumptions:With taxesWith bankruptcy costs

15TaxesBankruptcy costsCase ICase IICase IIIProposition I firm valueProposition II cost of equity & WACC

Case I No TaxesProposition 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.

Proposition II:Cost of Equity increases as Debt increases.The WACC of the firm is NOT affected by capital structure.

16Case I No Taxes EquationsProposition I (firm value):V = EBIT/RAif no debt, RA= RE

Proposition II (RE & WACC):WACC = RA = (E/V)RE + (D/V)RDRE = RA + (RA RD)(D/E)

Where:RA is the cost of the firms business risk, i.e., the risk of the firms assets. (RA RD)(D/E) is the cost of the firms financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage (D/E).

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Case I No Taxes ExampleDataRequired return on assets = WACC = RA = 0.16Cost of debt = RD = 0.10Percent of debt = D = 0.45E = 1 0.45 = 0.55 or 55%D/E = 0.45/0.55 = 0.82What is the cost of equity?RE = RA + (RA RD)(D/E)RE = 0.16 + (0.16 0.10)(0.45/0.55) = 0.2091Proof for WACC:WACC = RA = (E/V)RE + (D/V)RDWACC = RA = 0.55 0.2091 + 0.45 0.10 = 0.16 or 16%

19Case I No Taxes ExampleWhat happens if the firm increases leverage so that D/E = 1.5? (before D/E = 0.82 when D = 45%, E = 55%)

What is the cost of equity? RE = RA + (RA RD)(D/E)RE = 0.16 + (0.16 0.10)(1.5) = 0.25 or 25%

Proof for WACC:WACC = RA = (E/V)RE + (D/V)RDFrom D/E = 1.5, D = 60%, E = 40%WACC = 0.4 25% + 0.6 10% = 16%

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The CAPM, Business Risk, Financial Risk and Proposition IIHow does financial leverage affect systematic risk?

CAPM: RE = Rf + E(RM Rf) for equityCAPM: RA = Rf + A(RM Rf) for assetsWhere A is the firms asset beta and measures the systematic risk of the firms assets, also called unlevered beta the risk of the assets if the firm would have no debt ( in essence E = A if no debt)

RE = RA + (RA RD)(D/E)RE = RA + (RA Rf)(D/E) assume RD = Rf21The CAPM, Business Risk, Financial Risk and Proposition IIProposition IIAs we introduce debt in the firm:RE = Rf + A(1+D/E)(RM Rf)E = A(1 + D/E)

Therefore, the systematic risk of the stock depends on:Systematic risk of the assets, A, (Business risk)Level of leverage, D/E, (Financial risk)

22Its all about pizzaYogi Berra* was once asked whether he wanted his pizza sliced into four pieces as usual

He replied, No, slice it into eight pieces Im hungry tonight.

Hmm?

*Lawrence Peter "Yogi" Berra (born May 12, 1925 in St. Louis, Missouri) is a former Major League Baseball player and manager. He played almost his entire career for the New York Yankees and was elected to the baseball Hall of Fame in 1972.http://en.wikipedia.org/wiki/Yogi_Berra

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Pizza and Capital Structure Theory Assuming perfect capital markets, Modigliani and Miller found, without taxes, the total value of a firm is unaffected by its capital structure.Whether or not an investment makes sense does not depend on how we are going to raise the money to pay for it.

Why is this true?A firm's cash flow is like a pizza: to change the firm's capital structure is to change the size of individual pizza slices.This does not change the overall size of the pizza, nor does it change the overall value of the firm.24Pizza and Capital Structure Theory PizzaWe might have an unsliced pizza, but want slices we can then always cut it up ourselves.Or, we have a bunch slices, but want a whole pizza: we can always stick them back together.

LearningWe should be willing to pay the same price for one whole pizza or an equivalent bunch of slices.

25Quick QuizUnder Case I, what are the values of the firm with debt (levered) and without debt (unlevered)?26Case II Introducing TaxesWhat happens to the firms cash flows?Interest is 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 affect the value of the firm?

27Case II with Taxes ExampleTax saving = $170 = 0.34 x $500 = TC RD D

28Unlevered Firm (No Debt)Levered Firm (With Debt)EBIT5,0005,000Interest0500 (6,250 @ 8%)Taxable Income5,0004,500Taxes (34%)1,7001,530Net Income3,3302,970CFFA=EBIT-Tax3,3003,470Interest Tax ShieldAnnual interest tax shieldTax rate times interest payment$6,250 in 8% debt = 500 in interest expenseAnnual tax shield = 0.34(500) = 170Present value of annual interest tax shieldAssume perpetual debt for simplicityPV = 170 / 0.08 = 2,125

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Case II with Taxes Proposition IThe value of the firm increases by the present value of the annual interest tax shieldValue of a levered firm = Value of an unlevered firm + PV of interest tax shield

Assuming perpetual cash flowsVU = EBIT(1-T) / RU with no debt RU = RA= RE and VU = E

VL = VU + DTCE = VL - D

30Case II with Taxes Proposition I ExampleData Inc. has earnings of $25 million per year every year. The firm has no debt and the cost of capital is 12%. If tax is 35% what is the value of the firm?EBIT = 25 million; Tax rate = TC= 35%; Unlevered cost of capital = RU = 12% = RA = RE VU = ?

VU = EBIT(1-T) / RUVU = 25(1-0.35) / 0.12 = $135.42 millionVU = E

31Case II with Taxes Proposition I ExampleData Inc. decides to issue bonds that have a market value of $75 million at a cost of 9%. What is the value of the firm? What will be the value of equity?D = $75 million, RD= 9%, VL = ?, E = ? VU = 135.42 (calculated on previous slide)

VL = VU + tax shieldVL = VU + DTCVL = 135.42 + 75(0.35) = 135.42+26.25 = $161.67 m

E = VL - DE = 161.67 75 = $86.67 million

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Case II with Taxes Proposition IIRecap: In case I Proposition II - no taxes:RE increases as Debt increasesWACC is unchanged

When taxes are introduced in Case II:RE increases as Debt increases RE = RU + (RU RD)(D/E)(1-TC)

WACC decreases as D/E increases RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)

34Case II with Taxes Proposition II ExampleData Inc. info from Case II proposition I:EBIT = 25 million; TC= 35%; D = $75 million; RD= 9%; Unlevered cost of capital = RU= 12% E = $86.67m; VL = $161.67m (slide 32)D/E = 75/86.67 = 0.87, E/V = 86.67/161.67 = 0.54,D/V = 75/161.67 = 0.46RE = RU + (RU RD)(D/E)(1-TC) RE = 0.12 + (0.12-0.09)(0.87)(1-0.35) = 13.69%

RL = WACC = (E/V)RE + (D/V)(RD)(1-TC) RL = WACC = (0.54)(0.1369) + (0.46)(0.09)(1-0.35) = 10.05%

35Case II with Taxes Proposition II ExampleSuppose Data Inc. changes its capital structure so that the debt-to-equity ratio becomes 1.Before: D/E = 0.87 E = 54%, D = 46%Now: D/E = 1 E = 50%, D = 50%What will happen to the cost of equity under the new capital structure? (previously 13.69%)RE = 0.12 + (0.12 0.09)(1)(1-0.35) = 13.95%What will happen to the weighted average cost of capital? (previously 10.05%)WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9%What if D/E = 1.25? RE = ? WACC = ?

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Quick QuizUnder Case II, it is beneficial and should firms take on more debt?

What sort of industries typically have high D/E ratio?

What is the capital structure of Apple Inc (APPL)?38Case III with Bankruptcy CostsNow we add bankruptcy costs.As the D/E ratio increases, the probability of bankruptcy increases.This increased probability will increase the expected bankruptcy costs.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 is added.

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Bankruptcy CostsDirect costsLegal and administrative costs.

Indirect costsLarger than direct costs & more difficult to measure and estimate.

Financial distress costsAll costs associated with going bankrupt and/or avoiding bankruptcy.

42ConclusionsCase I no taxes or bankruptcy costs.No optimal capital structure.

Case II corporate taxes but no bankruptcy costs.Optimal capital structure is almost 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 just offsets the increase in expected bankruptcy costs.

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Managerial RecommendationsThe 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 and as a manager you need to understand the cost for your industry.

45Real World ApplicationCDO101: A primer on collateralised debt obligations!

46CDO101What is a CDO?An arbitrage cash flow Collateralised Debt Obligation (or CDO) is a structured pool of below investment grade corporate loan and bond assetsThe Fund, which is a special purpose entity (SPV), issues various tranches of debt and equity to fund its purchase of corporate loans and bondsThis pool of loans and bonds acts as collateral for the Funds liabilitiesBecause the majority of these liabilities are rated investment grade, the Fund equity benefits from the difference between the income generated by the collateral pool and the Funds liability costsCDO funds issued today are generally $300-500 million in size. The underlying collateral typically represents 100-200 obligors in 20-30 industries.Below is a typical CDO structure:

Source: http://www.octagoncredit.com/cdo-basics.htm

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The Funds indenture governs the order in which cash generated by the Fund is paid to the various tranchesGenerally, the higher the tranches rating, the higher its position in the Funds cash flow waterfallResidual cash generated by the collateral assets after paying the Funds required principal and interest payment to the liabilities and the management fee is distributed to the holders of the Fund equity

Who Buys CDO debt?The liabilities of CDO funds are typically purchased by banks, hedge funds, insurance companies and pension fundsThe equity tranche of CDOs are generally purchased by banks, insurance companies, high net worth individuals, hedge funds, and the manager of the CDOHow do CDOs work?Initially, all the cash flows from a CDO's collection of assets are pooled togetherThis pool of payments is separated into rated tranchesEach tranche also has a perceived (or stated) debt rating to it. The highest end of the credit spectrum is usually the 'AAA' rated senior trancheThe middle tranches are generally referred to as mezzanine tranches and generally carry 'AA' to 'BB' ratings and the lowest junk or unrated tranches are called the equity tranchesEach specific rating determines how much principal and interest each tranche receivesSub-prime CDO exampleThe 'AAA'-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed paymentsAs such, it has the most predictable cash flow and is usually deemed to carry the lowest riskOn the other hand, the lowest rated tranches usually only receive principal and interest payments after all other tranches are paidFurthermore they are also first in line to absorb defaults and late paymentsDepending on how spread out the entire CDO structure is and depending on what the loan composition is, the equity tranche can generally become the "toxic waste" portion of the issue

Source: http://www.octagoncredit.com/cdo-basics.htm and http://www.investopedia.com/articles/07/cdo-mortgages.asp

48Next WeekNext week we look at the role of dividends and how firms set dividend policy.

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