FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY

Conducted by Ranjika Perera & Chanaka Karunasena

AN OVERVIEW TO FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY

The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure Observed Capital Structures Long-term Financing under Financial Distress and Bankruptcy

Capital Structure of a firmCapital structure Mixture of debt and equity maintain by the firm. (Financial structure) In other words, firms debt/equity ratioCapital srtucture Capital srtucture

20% Debt Equity 80% 80%

20% Debt Equity

Capital RestructuringCapital restructuring firm substitutes one capital structure for another while leaving the firms assets unchanged. Firm can consider capital restructuring decisions in isolation from its investment decisions. e.g.

Capital Structure QuestionHow should a firm go about choosing its debt/equity ratio? Primary objective of the firm Maximizes the value of the firm => Maximizes the shareholder wealth. Then, Capital structure Maximizes the value of the firm Maximizes the shareholder wealth

e.g.Debt plus dividendNo debt Debt Equity Firm value 0 1000 1000 500 750 1250

Possible firm values

500 500 1000

500 250 750

Possible payoffs to shareholdersEquity value reduction Dividends Net effect

Debt plus dividend -250 500 +250 -500 500 0 -750 500 -250

Capital structure and the cost of capitalWeighted average cost of capital (WACC) The weighted average of the cost of equity and the after tax cost of debt. WACC = (E/V ) * RE + ( D/V ) * RD * ( 1- Tc ) Optimal capital structure/target capital structure will receive at the lowest possible WACC.

The effect of financial leverageFinancial leverage the use of debt in a firms capital structure. More debt a firm has, the greater is its degree of financial leverage Financial leverage increases the potential rewards to shareholders, but it also increases the potential for financial distress and business failure. Financial leverage may not affect the overall cost of capital.

Financial leverage, EPS and ROEEPS = Net income Shares outstanding ROE = Net income Total equity Ignoring the impact of taxes for now.

When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE

e.g.W.Reed & Company is an all-equity firm with 20,000 shares of common stock outstanding. The market value per share is $25, so the market value of the firm is ($2520;000) = $500;000: The CFO has proposed a capital restructuring which would involve issuing $300,000 of debt in order to purchase($300,000/$25)=12000 shares of the firms outstanding stock; the interest rate on the debt is 10%. The restructuring would leave (20,000-12,000)=8000 shares outstanding. The current and proposed capital structures are summarized in the following:

Current and proposed capital structures

The impact of the restructuring on ROE and EPSCurrent Capital Structure: No DEBT

The impact of the restructuring on ROE and EPSCurrent Capital Structure: Debt = $300,000

Degree of financial leverage and Break-Even EBITThe Degree of Financial Leverage is measured as Percentage Change in EPS Percentage Change in EBIT A convenient alternative calculation is Percentage Change in EPS Percentage Change in EBIT Break-Even EBIT (Indifference 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 stockholders If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders

Financial leverage : EPS and EBITEBIT/20 000=(EBIT-30 000)/8 000 EBIT = 50 000

Corporate borrowing and homemade leverageShareholders can adjust the amount of leverage in their position by borrowing or lending on their own, thereby creating homemade leverage. Homemade leverage the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed. E.g. Say an investor who owns 100 shares of Reed company . The tables below illustrates what happens under the assumption that the firm adopts the proposed restructuring.

Proposed capital structure verses original capital structure with homemade leverage

Unlevering the stockIf the firm adopts the proposed capital structure, the shareholder can unlever the position by lending an amount sufficient to duplicate the earnings the shareholder would receive under the capital structure. e.g. Say if a shareholder were to sell 60 shares, for a total of ($25 60) = $1500; and then lend this $1500 at a 10% interest rate.

Unlevering the stock

PART II

Capital Structure TheoryModigliani 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

Capital Structure Theory Under Three Special CasesCase I AssumptionsNo corporate or personal taxes No bankruptcy costs

Case II AssumptionsCorporate taxes, but no personal taxes No bankruptcy costs

Case III AssumptionsCorporate taxes, but no personal taxes Bankruptcy costs

Case I Propositions I and IIProposition Ivalue 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 The

Proposition II The

WACC of the firm is NOT affected by capital structure

Case I - EquationsWACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA RD)(D/E) 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

Figure

Case I - ExampleData Required

return on assets = 16%, cost of debt = 10%; percent of debt = 45%RE = RA + (RA RD)(D/E)

What is the cost of equity?

RE

= 16 + (16 - 10)(.45/.55) = 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 percent of equity in the firm? E/V

= 1 / 2.5 = 40%

The CAPM, the SML and Proposition IIHow does financial leverage affect systematic risk? CAPM: RE = Rf + FE(RM Rf) CAPM: RA = Rf + FA(RM Rf)

Where FA is the firms asset beta and measures the systematic risk of the firms assets

Proposition IIReplace RA with the CAPM and assume that the debt is riskless (RD = Rf) RE = Rf + FA(1+D/E)(RM Rf)

Business Risk and Financial RiskRE = Rf + FA(1+D/E)(RM Rf) CAPM: RE = Rf + FE(RM Rf) FE

= FA(1 + D/E)

Therefore, the systematic risk of the stock depends on: Systematic

risk of the assets, FA, (Business risk) Level of leverage, D/E, (Financial risk) How does financial leverage affect systematic risk?

Case II Cash FlowInterest 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?

Case II - ExampleThe levered firm has $6,250 worth of perpetual bonds on which it pays 8% interest, So the interest expense = .08(6,250) = $500 Corporate tax rate is 34% No depreciation of assets.

Case II - ExampleUnlevered Firm Levered Firm EBIT Interest(8%) Taxable Income Taxes (34%) Net Income 5,000 0 5,000 (1,700) $ 3,300 5,000 (500) 4,500 (1,530) $ 2,970

Case II - ExampleCash flow from Unlevered Assets(CFFA) Firm EBIT -Taxes(34%) Total 5,000 (1,700) $ 3,300 Levered Firm

5,000 (1,530) $ 3,470

Case II - ExampleCash flow To Stockholders To bondholders Total Unlevered Firm $ 3,300 0 $ 3,300 Levered Firm $ 2,970 $ 500 $ 3,470

Total cash flow difference=(3470-3300) =$170

Interest Tax ShieldAnnual interest tax shieldrate times interest payment 6,250 in 8% debt = 500 in interest expense Annual tax shield = .34(500) = 170 Tax

Present value of annual interest tax shield Assume

perpetual bond with 8% interest for simplicity PV = 170 / .08 = 2,125 PV = D(RD)(TC) / RD = DTC = 6,250(.34) = $ 2,125

Case II Proposition IThe 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

Example: Case II Proposition IData EBIT

= 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% VU = EBIT(1-T) / RU VL = VU + DTC

VU = 25(1-.35) / .12 = $135.42 million VL = 135.42 + 75(.35) = $161.67 million E = (VL D)=161.67 75 = $86.67 million

Case II Proposition IIThe WACC decreases as D/E increases because of the government subsidy on interest payments WACC=RA

= (E/V)RE + (D/V)(RD)(1-TC) RE = RU + (RU RD)(D/E)(1-TC)

Example Firm L is worth $7300 total. Value of debt is $1000 with interest of 8%. Without debt WACC (RU) is 10%.Find FirmLs Cost of equity (RE)? WACC(RA)?

Example

V=$ 7300 D=$ 1000 E=V-D=$ 6300 RU =10% RD =8% TC =30%

RE

= RU + (RU RD)(D/E)(1-TC) RE = 10 + (10-8)($1000/$6300)(1-.30) = 10.22% RA

= (E/V)RE + (D/V)(RD)(1-TC) RA = ($6300/$ 7300)(10.22) + ($1000/$ 7300)(8)(1-.30) RA =WACC= 9.6%

Example: Case II Proposition IISuppose 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

= 10 + (10 - 8)(1)(1-.30) = 11.4%

What will happen to the weighted average cost of capital? RA

= .5(11.4) + .5(8)(1-.30) = 8.5% WACC(RA) =8.5% much lower than RU (RU=10%). So debt financing is highly advantageous.

Figure

Case III (Consider tax & Bankruptcy cost)Now 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

Bankruptcy CostsDirect costs Legal

and administrative costs Ultimately cause bondholders to incur additional losses Disincentive to debt financing

Financial distress Significant

problems in meeting debt obligations Most firms that experience financial distress do not ultimately file for bankruptcy

More Bankruptcy CostsIndirect bankruptcy costs Cost of avoiding a filing incurred by a financially distressed firm.

Larger than direct costs, but more difficult to measure and estimate Stockholders want to avoid a formal bankruptcy filing 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 The firm may also lose sales, experience interrupted operations and lose valuable employees

Figure

Figure

ConclusionsCase I no taxes or bankruptcy costs

No optimal capital structure

Case II corporate taxes but no bankruptcy costsOptimal capital structure is almost 100% debt Each additional dollar of debt increases the cash flow of the firm

Case III corporate taxes and bankruptcy costsOptimal 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

Figure

Managerial RecommendationsThe tax benefit is only important if the firm has a large tax liability Risk of financial distressgreater 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 The

Figure

The Value of the FirmValue of the firm = marketed claims + nonmarketed claimsMarketed claims are the claims of stockholders and bondholders Nonmarketed claims are the claims of the government and other potential stakeholders

The overall value of the firm is unaffected by changes in capital structure The division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions

Observed Capital StructureCapital structure does differ by industries Differences according to Cost of Capital 2004 Yearbook by Ibbotson Associates, Inc. Lowest

levels of debt

Drugs with 6.38% debt Paper and computers with 10.24 10.68% debt Highest

levels of debt

Airlines with 64.22% debt Electric utilities with 49.03% debt

Bankruptcy Process Part IBusiness 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