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Prepared byKen Hartviksen
INTRODUCTION TO
CORPORATE FINANCELaurence Booth W. Sean Cleary
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CHAPTER 21
Capital Structure Decisions
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CHAPTER 21 Capital Structure Decisions 21 - 3
Lecture Agenda
Learning Objectives
Important Terms
Financial Leverage
Determining Capital Structure
M&M Irrelevance Theorem Impact of Taxes
Financial Distress, Bankruptcy and Agency Costs
Other Factors affecting Capital Structure
Capital Structure in Practice Summary and Conclusions
Concept Review Questions
Appendix 1 Thunder Bay Industries Indifference Analysis
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CHAPTER 21 Capital Structure Decisions 21 - 4
Learning Objectives
1. How business risk and financial risk affect a firms ROE and EPS
2. How indifference analysis may be used to compare financing alternativesbased on expected EBIT levels
3. Modigliani and Millers irrelevance, argument, as well as the key assumptions
upon which it is based4. How the introduction of corporate taxes affects M&Ms irrelevance argument
5. How financial distress and bankruptcy costs lead to the static trade-off theoryof capital structure
6. How information asymmetry problems and agency problems may lead firms tofollow a pecking order approach to financing
7. How other factors such as firm size, profitability and growth, asset tangibility,and market conditions can affect a firms capital structure.
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CHAPTER 21 Capital Structure Decisions 21 - 5
Important Chapter Terms
Agency costs Bankruptcy Business risk Cash flow-to-debt ratio
Corporate debt tax shield Direct costs of bankruptcy EPS indifference point Financial break-even points Financial distress
Financial leverage Financial leverage risk
premium
Financial risk Fixed burden coverage ratio Homemade leverage Indifference point
Indirect costs of bankruptcy Invested capital M&M equity cost equation Modigliani and Miller Pecking order Profit planning charts
Return on equity (ROE) Return on invested capital Risk value of money Static tradeoff
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CHAPTER 21 Capital Structure Decisions 21 - 6
The Focus of this Chapter
You know: It is the responsibility of the financial manager to maximize
shareholder wealth.
The after-tax cost of debt is significantly lower than the cost of
equity primarily because of the tax-deductibility of interestexpensetherefore, using debt has a cost advantage overequity.
The lower the cost of capital, the greater the value of the firm.
This chapter addresses the question:
Does the relative mix of financing used by a firm affect its value?If so, how and why and are what are the other impacts thatcapital structure can have on the firm?
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CHAPTER 21 Capital Structure Decisions 21 - 7
In this Chapter You Will Learn
1. The optimal (target) capital structure is the one thatmaximizes the value of the firm and minimizes the cost ofcapital.
2. How lenders seek to protect themselves from excessive useof corporate leverage through the use of protectivecovenants.
3. The tax advantage to debt is offset at higher levels offinancial leverage by costs associated with financial distress
and bankruptcy.4. Firms depart from the target capital structure in practice
because of financing preferences and capital marketconditions.
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CHAPTER 21 Capital Structure Decisions 21 - 8
LeverageWhat is it?
The increased volatility in operating income overtime, created by the use of fixed costs in lieu ofvariable costs. Leverage magnifies profits and losses.
There are two types: Operating leverage
Financial leverage
Both types of leverage have the same effect onshareholders but are accomplished in very differentways, for very different purposes strategically.
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CHAPTER 21 Capital Structure Decisions 21 - 9
Leverage Effects on Operating Income
Years
When a firm increases the
use of fixed costs it
increases the volatility of
operating income.
Normal volatility ofoperating income
Operating
Income
+
0
-
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CHAPTER 21 Capital Structure Decisions 21 - 10
Operating LeverageWhat is it? How is it Increased?
Operating leverage is:
The increased volatility in operating income caused by fixedoperating costs.
You should understand that managers do make decisionsaffecting the cost structure of the firm.
Managers can, and do, decide to invest in assets that giverise to additional fixed costs and the intent is to reducevariable costs.
This is commonly accomplished by a firm choosing to becomemore capital intensive and less labour intensive, therebyincreasing operating leverage.
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CHAPTER 21 Capital Structure Decisions 21 - 11
Operating LeverageAdvantages and Disadvantages
Advantages: Magnification of profits to the shareholders if the firm is
profitable.
Operating efficiencies (faster production, fewer errors, higher
quality) usually result increasing productivity, reducingdowntime etc.
Disadvantages: Magnification of losses to the shareholders if the firm does not
earn enough revenue to cover its costs.
Higher break even point High capital cost of equipment and the illiquidity of such an
investment make it: Expensive (more difficult to finance)
Potentially exposed to technological obsolescence, etc.
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CHAPTER 21 Capital Structure Decisions 21 - 12
Financial LeverageWhat is it? How is it Increased?
Your textbook defines financial leverage as: The increased volatility in operating income caused
by the corporate use of sources of capital that carry
fixed financial costs. Financial leverage can be increased in the firm by:
Selling bonds or preferred stock (taking on financialobligations with fixed annual claims on cash flow)
Using the proceeds from the debt to retire equity (ifthe lenders dont prohibit this through the bondindenture or loan agreement)
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CHAPTER 21 Capital Structure Decisions 21 - 13
Financial LeverageAdvantages and Disadvantages
Advantages: Magnification of profits to the shareholders if the firm is
profitable.
Lower cost of capital at low to moderate levels of financial
leverage because interest expense is tax-deductible.Disadvantages: Magnification of losses to the shareholders if the firm does not
earn enough revenue to cover its costs.
Higher break even point.
At higher levels of financial leverage, the low after-tax cost ofdebt is offset by other effects such as: Present value of the rising probability of bankruptcy costs
Agency costs
Lower operating income (EBIT), etc.
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CHAPTER 21 Capital Structure Decisions 21 - 14
Effects of Operating and Financial LeverageSummary
Equity holders bear the added risks associated with the use ofleverage.
The higher the use of leverage (either operating or financial) the
higher the risk to the shareholder. Leverage therefore can and does affect shareholders required rate
of return, and in turn this influences the cost of capital.
HIGHER LEVERAGE = HIGHER COST OF CAPITAL
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CHAPTER 21 Capital Structure Decisions 21 - 15
Business Risk
All firms experience variability in sales and operating (fixedand variable) operating costs over time.
Some firms operate in a highly volatile industry (for example oiland gas) and we would say the firm has a high degree ofbusiness risk.
Other firms operate in a very stable industry where revenues andexpenses dont change much from year to year throughout the
business cycle; these firms have low business risk.
Business risk is the variability of a firms operating incomecaused by operational risk.
Business risk is measured by the standard deviation of EBIT.
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CHAPTER 21 Capital Structure Decisions 21 - 16
Financial LeverageRisk and Leverage
Lenders to the firm insulate themselves from risk throughfinancial contracting:
Lending money through a formal, legally-binding contract.
Demanding a fixed rate of return on the money they lend to thefirm, in-keeping with their required return on monies borrowed.
Demanding other promises that will protect the lenders interestsover the life of the loan/investment.
Demanding a high priority in the priority of claims list in the eventof corporate dissolution/bankruptcy.
Shareholders bear the risk associated with business risk,and the added risks associated with the use of leveragebecause they are residual claimants of the firm.
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CHAPTER 21 Capital Structure Decisions 21 - 17
Return on Investment (ROI)Financial Leverage
Return on Investment (ROI) is the return on all the capital provided by investors; EBIT
minus taxes divided by invested capital.
Invested Capital (IC) is a firms capital structure consisting of
shareholders equity and short- and long-term debt.
)1(
BSE
TEBIT
ROI
[ 21-2]
But we know the claims
on the numerator
(operating income after
taxes) are very
different, and so too arethe risks each provider
of capital is exposed.
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CHAPTER 21 Capital Structure Decisions 21 - 18
Return on Equity (ROE)Financial Leverage
ROE is the return earned by equity holders ontheir investment in the company
ROE = net income divided by shareholders equity.
)1)((
SE
TBREBITROE D
[ 21-1]
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CHAPTER 21 Capital Structure Decisions 21 - 19
ROI versus ROEFinancial Leverage
If the firm is completely financed by equity: ROE =ROI.
Let us examine the effects of sales volatility on ROIand ROE given different levels of financialleverage.
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CHAPTER 21 Capital Structure Decisions 21 - 20
Financial LeverageRisk and Leverage
Using this base income statement:
The following three slides show three different financing strategies and theimpacts on ROE, ROI, EPS for break-even, normal, and high sales levels:
Sales $1,000Variable costs 300
Fixed costs 158
EBIT $542
Interest 42
Taxable Income $500
Tax (40%) 200
Net Income $300
Table 21-1 Example Income Statement
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CHAPTER 21 Capital Structure Decisions 21 - 21
Financial LeverageIncome Statement No Financial Leverage
-77.5% 100.0% 140.0%
Sales $225 $1,000 $1,400
Variable costs 68 300 420
Fixed costs 158 158 158
EBIT -$1 $542 $822
Interest 0 0 0
Taxable Income -$1 $542 $822
Tax (40%) 0 217 329
Net Income -$0 $325 $493
Invested capital = $1,700 100.0%
Debtholders' investment = $0 0.0%Shareholders' Equity = $1,700 100.0%
ROI = 0.0% 19.1% 29.0%
ROE = 0.0% 19.1% 29.0%
EPS (1,700 shares) = $0.00 $0.19 $0.29
Table 21-1 Example Income Statement
This assumes a 0.0
debt/equity ratio
ROE = ROI because no use
of debt financing.
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CHAPTER 21 Capital Structure Decisions 21 - 22
Financial LeverageIncome Statement Base Case
-71.5% 100.0% 140.0%
Sales $285 $1,000 $1,400
Variable costs 86 300 420
Fixed costs 158 158 158
EBIT $42 $542 $822
Interest 42 42 42
Taxable Income -$0 $500 $780
Tax (40%) 0 200 312
Net Income -$0 $300 $468
Invested capital = $1,700 100.0%
Debtholders' investment = $700 41.2%Shareholders' Equity = $1,000 58.8%
ROI = 1.5% 19.1% 29.0%
ROE = -0.1% 42.9% 66.9%
EPS (1000 shares) = $0.00 $0.30 $0.47
Table 21-1 Example Income Statement
This assumes a 0.70
debt/equity ratio
ROE is levered compared to
ROI because of the moderateuse of debt financing.
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CHAPTER 21 Capital Structure Decisions 21 - 23
Financial LeverageIncome Statement with High Financial Leverage
-65.4% 100.0% 140.0%
Sales $346 $1,000 $1,400
Variable costs 104 300 420
Fixed costs 158 158 158
EBIT $84 $542 $822
Interest 84 $84 $84
Taxable Income $0 $458 $738
Tax (40%) 0.08 183.2 295.2
Net Income $0 $275 $443
Invested capital = $1,700 100.0%
Debtholders' investment = $1,400 82.4%Shareholders' Equity = $300 17.6%
ROI = 3.0% 19.1% 29.0%
ROE = 0.0% 91.6% 147.6%
EPS (300 shares) = $0.00 $0.92 $1.48
Table 21-1 Example Income Statement
ROE is more volatile than
ROI because of the high useof financial leverage.
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CHAPTER 21 Capital Structure Decisions 21 - 24
Financial LeverageRisk and Leverage
Consider the equation for ROE:
)1)((
SE
TBREBITROE D
[ 21-1]
EBIT Interest expense = EBTEBT times (1 T) = Net Income
The equation reduce to net income
divided by BV of shareholders equity.
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CHAPTER 21 Capital Structure Decisions 21 - 25
Financial LeverageRisk and Leverage
Equation 21 2 is the definition of ROI:
If we re-express EBIT (1-T) in the ROE equation, weget:
)1(BSETEBITROI
[ 21-2]
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CHAPTER 21 Capital Structure Decisions 21 - 26
Financial LeverageRisk and Leverage
This is the financial leverage equation:
ROI measures the return that the firm earns fromoperations, but DOES NOT explicitly consideredhow the firm is financed.
)1((SEBTRROIROIROE D
[ 21-3]
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CHAPTER 21 Capital Structure Decisions 21 - 27
Financial LeverageRisk and Leverage
If we rearrange Equation 21 3, grouping like terms involvingROI we get:
The second term is fixed. The first term depends on the firms uncertain ROI. This means we can graph ROE against ROI as a straight line.
See Figure 21 -1 on the following slide.
)1()1( SE
B
TRSE
B
ROIROE D [ 21-4]
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CHAPTER 21 Capital Structure Decisions 21 - 28
Financial LeverageRisk and Leverage
21 - 1 FIGURE
ROE
80
60
40
20
ROI
-20
-40
-60
All Equity
D/E =0.70
-16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40
Slope of the
all equity
line is = 1.0.
In this case
ROI = ROE.
D/E = 0.70.
Slope of the
line > 1.0.
Above the
intercept
with the
horizontal
axis, ROE
>ROI.
Financial Break-even
points where ROE = 0
Indifference point where
ROEs for different financing
strategies are equal.
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CHAPTER 21 Capital Structure Decisions 21 - 29
Financial LeverageRisk and Leverage
Financial Break-even point:
Points at which a firms ROE is zero.
Indifference Point: Points at which two financing strategies provide the
same ROE.
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CHAPTER 21 Capital Structure Decisions 21 - 30
Financial LeverageThe Rules of Financial Leverage
For value-maximizing firms, the use of debt increasesthe expected ROE so shareholders expect to be betteroff by using debt financing, rather than equity financing.
Financing with debt increases the variability of the firmsROE, which usually increases the risk to the commonshareholders.
Financing with debt increases the likelihood of the firmrunning into financial distress and possibly evenbankruptcy.
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CHAPTER 21 Capital Structure Decisions 21 - 31
Financial LeverageThe Rules of Financial Leverage
70% D/E Ratio 100% Equity
ROI (%)10 14.48 10
30 48.48 30
Range 34 20
Table 21-2 Varying ROI Values
ROE (%)
ROI reflects the business risk of the firm.
ROE =ROI in the all equity firm.
ROE increases as the firm finances with more debt.
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CHAPTER 21 Capital Structure Decisions 21 - 32
Financial LeverageThe Rules of Financial Leverage
70% D/E Ratio 100% Equity
ROI (%)-10 -19.52 -10
40 65.48 40
Range 85 50
Table 21-3 Wider Variation ROI Values
ROE (%)
Wider variation in ROI means magnified ROE over a still
wider range than ROI.
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CHAPTER 21 Capital Structure Decisions 21 - 33
Financial LeverageInvesting Using Leverage
Figure 21-2 illustrates the monthly returns frominvesting in the S&P/TSX Composite Index usingtwo different financing strategies:
1. Investing in the index (all equity)
2. Investing in the index with 80% borrowed on margin.
The added volatility of gains and losses over timeis clearly evident.
These principles of leverage apply to corporationsas well as households
(See Figure 21 2 on the following slide)
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CHAPTER 21 Capital Structure Decisions 21 - 34
Financial LeverageInvesting Using Leverage
21 - 2 FIGURE
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CHAPTER 21 Capital Structure Decisions 21 - 35
Financial LeverageIndifference Analysis
Is a profit planning technique used to forecast theEPS-EBIT relationships under different financingscenarios.
The indifference point is where:
EPS(Financing strategy 1)=EPS(Financing strategy 2)
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CHAPTER 21 Capital Structure Decisions 21 - 36
Financial LeverageIndifference Analysis
The formula for EPS, given EBIT, interest on debt (RDB), the corporate taxrate (T), and the number of common shares outstanding (#):
We can rearrange the definition of EPS and show how it varies with EBIT:
#
)1)(( TBREBITEPS D
[ 21-5]
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CHAPTER 21 Capital Structure Decisions 21 - 37
Financial LeverageIndifference Analysis
EPS is a simple linear function of EBIT:
This is illustrated in the EPS-EBIT graph in Figure21 3 found on the following slide:
#)1(
#)1( TEBITTBREPS D [ 21-6]
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CHAPTER 21 Capital Structure Decisions 21 - 38
Financial LeverageEPS-EBIT (Profit Planning) Charts
21 - 3 FIGURE
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6 EPS 0% D/E EPS 70% D/E
-567-397-312-227 -142 57 28 113 198 283 368 453 538 623 708 793 878 963 1048 1133
Indifference
point.
The horizontal intercept of the 70% D/E line isgreater by the added interest expense that must be
covered before producing earnings available for
common shareholders.
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CHAPTER 21 Capital Structure Decisions 21 - 39
Financial LeverageEPS-EBIT (Profit Planning) Charts
The slope of the lines are a function of the numberof common shares outstanding (dilution of EPS).
The all equity line will have a lower slope becauseevery dollar of net income is divided by more commonshares.
The horizontal intercept is greater for the debtfinancing line because the firm must cover itsinterest expense before earnings begin to accrue tothe benefit of shareholders.
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CHAPTER 21 Capital Structure Decisions 21 - 40
Determining Capital Structure
Table 21 4 demonstrates the 1990 results of aConference Board survey of 119 U.S. companies todetermine their capital structure.
External sources of information include: (#2) checking with their advisors, and
(#5) examining other firms in the industry.
The three primary sources of information are:
(#4) impact on profits (#3) risk
(#1) analysis of cash flows
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CHAPTER 21 Capital Structure Decisions 21 - 41
Determining Capital Structure
1. Analysis of cash flows 23.0%
2. Consultations 18.3%3. Risk considerations 16.5%
4. Impact on profits 14.0%
5. Industry comparisons 12.0%
6. Other 3.4%
Source: Data from Conference Board, 1990
Table 21-4 Determinants of Capital Structure
Primary sources include:
Analysis of cash flows
Risk consideration
Impact on profits
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CHAPTER 21 Capital Structure Decisions 21 - 42
Determining Capital StructureUseful Ratios
Stock ratios (balance sheet ratios) that are helpfulinclude:
Total debt to total assets
Debt to equity ratio
Flow ratios make use of information taken from theincome statement and when combined with balance
sheet data help to determine the ability of the firm toservice its debt.
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CHAPTER 21 Capital Structure Decisions 21 - 43
Determining Capital Structure
Fixed Burden Coverage Ratio:
An expanded interest coverage ratio that looks at abroader measure of both income and theexpenditures associated with debt.
)1/()Pref.Div.( TSFIEBITDACoverageBurdenFixed
[ 21-7]
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CHAPTER 21 Capital Structure Decisions 21 - 44
Determining Capital Structure
Cash-flow-to-debt ratio (CFTD)
A direct measure of the cash flow over a period that isavailable to cover a firms stock of outstanding debt.
DebtEBITDACFTD[ 21-8]
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CHAPTER 21 Capital Structure Decisions 21 - 45
Determining Capital Structure
IG Non-IG
Coverage 4.01 1.45
Leverage (%) 46.2 67.4Cash flow-to-debt (%) 18.3 8.10
Liquidity (%) 3.66 4.45
Profit margin (%) 6.26 1.39
Return on assets (%) 8.41 6.92
Sales stability 7.14 5.60
Total assets ($ billion) 6.31 1.19
Altman Z score 2.17 1.62
Table 21-5 Moody's Average Credit Ratios
Source: Data from M oo dy's Investo r Services, "The Distribution o f Co mmon Financial Ratios by Rating and
Industry fo r No rth American No n-Financial Corporations," December 2004.
Investment
grade (IG)
companies
have at
least a BBB
bond rating.
Altman Z score is
a weighted
average of
several key ratios
and is a useful
predictor of afirms probability
of bankruptcy.
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CHAPTER 21 Capital Structure Decisions 21 - 46
Determining Capital StructureAltman Z Score
Altmans prediction of bankruptcy equation:
Where:X1 = working capital divided by total assets
X2 = retained earnings divided by total assetsX3 = EBIT divided by total assets
X4 = market values of total equity divided by non-equity book liabilities
X5 = sales divided by total assets
999060334121 54321 X.X.X.X.X.Z [ 21-9]
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The Modigliani and Miller Irrelevance
Theorem
Capital Structure Decisions
The Modigliani and Miller (M&M)
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CHAPTER 21 Capital Structure Decisions 21 - 48
The Modigliani and Miller (M&M)Irrelevance Theorem
M&M and Firm Value
The theorem that concludes (under some simplifyingassumptions) that the value of the firm should not beaffected by the manner in which it is financed.
How the firm is financed is irrelevant.
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CHAPTER 21 Capital Structure Decisions 21 - 49
(M&M) Irrelevance TheoremAssumptions
Assumptions about the Real World: Markets are perfect in the sense that there are no
transactions costs or asymmetric information problems
No taxes There is no risk of costly bankruptcy or associated financial
distress
Modeling Assumptions: There exist two firms in the same risk class with different
levels of debt
The earnings of both firms are perpetuities
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CHAPTER 21 Capital Structure Decisions 21 - 50
(M&M) Irrelevance TheoremArbitrage Argument
Arbitrage is a powerful economic force in capitalmarkets.
Where two identical assets trade at different prices,market traders will spot the opportunity to earn
riskless profits. Traders will sell the overvalued asset and buy the
undervalued asset.
This activity will cause the price of the overvalued asset tofall, and the price of the undervalued asset to rise until the
two are priced the same. The traders will earn abnormal profits from these trades untilthe prices of the two securities move into equilibrium.
Table 21 6 illustrates the two different positions and the equal payoffs
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CHAPTER 21 Capital Structure Decisions 21 - 51
(M&M) Irrelevance TheoremArbitrage Argument
Market participants who find levered investmentstrading for a greater value, can undo the leverage andearn abnormal profits.
Arbitrage will force assets with equal payoffs to trade forthe same price.
Table 21 6 illustrates the two different positions and the equal payoffs
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CHAPTER 21 Capital Structure Decisions 21 - 52
(M&M) Irrelevance TheoremM&M and Firm Value
Portfolios (Actions) Cost Payoff
Portfolio A: VU EBIT
Buy of unlevered firm
Portfolio B:
Buy of levered firm's equity SL (EBIT KD D )
Buy of levered firm's debt D KD D
Total portfolio (SL + D) EBIT
Table 21-6 M&M Arbitrage Table I
Net payoffs
are equal
Portfolio A and B must be priced equally despite their different financial
structures because the payoffs are equal.
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CHAPTER 21 Capital Structure Decisions 21 - 53
(M&M) Irrelevance TheoremM&M and Firm Value
Where payoffs are identical for two different assets, bothshould be priced the same.
The value of the levered firm (VL)is equal to the value of its debt plusthe value of its equity (SL + D)and this must equal the value of theunlevered firm (VU).
Debt cannot destroy v alue.
LLU VDSV [ 21-10]
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CHAPTER 21 Capital Structure Decisions 21 - 54
(M&M) Irrelevance TheoremPersonal Leverage and Corporate Leverage
Portfolios (Actions) Cost Payoff
Portfolio C: SL (EBIT - KD D )
Buy of unlevered firm
Portfolio D:
Buy of levered firm's equity VU EBIT
Buy of levered firm's debt D - KD D
Total portfolio (VU - D) (EBIT - KD D )
Table 21-7 M&M Arbitrage Table II
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CHAPTER 21 Capital Structure Decisions 21 - 55
(M&M) Irrelevance TheoremHomemade Leverage
Homemade leverage is the creation of the sameeffect of a firms financial leverage through the use
of personal leverage.
This means that individuals can: Buy an unlevered firm, and through the use of
personal debt, replicate corporate leverage, or
Buy a levered firm, and undo its effects.
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CHAPTER 21 Capital Structure Decisions 21 - 56
(M&M) Irrelevance TheoremM&M and The Cost of Capital
M&M made a modeling assumption (to simplify the calculations andfocus analysis on the leverage issue) that the firms earnings
represent aperpetuity:
K
D)(EBIT-KS
e
DL
[ 21-11]
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CHAPTER 21 Capital Structure Decisions 21 - 57
(M&M) Irrelevance TheoremM&M and The Cost of Capital
The cost of equity capital is simply the earnings yield and isestimated as follows:
S
D)(EBIT-KK
L
De
[ 21-12]
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CHAPTER 21 Capital Structure Decisions 21 - 58
(M&M) Irrelevance TheoremM&M and The Cost of Capital
Since the value of the firm is unchanged by leverage, we can definethe unlevered value (VU) by discounting the firms expected EBIT byit unlevered equity cost (KU):
VDSV
EBITV LL
U
U [ 21-13]
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CHAPTER 21 Capital Structure Decisions 21 - 59
(M&M) Irrelevance TheoremM&M Equity Cost Equation
To determine who equity cost varies with the debt-equity ratio, wesolve for EBIT, and substitute it for EBIT in the leveraged equity costequation:
If the firm has no debt, the equity investor requires KU (cost of
unlevered equity). KU depends on business riskof the firm.
As the firm uses debt, the equity cost increases due to the financialleverage risk premium.
/)( SDKKKK LDUue [ 21-14]
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CHAPTER 21 Capital Structure Decisions 21 - 60
(M&M) Irrelevance TheoremM&M and The Cost of Capital
In a world without taxes, the WACC (KU) is simply the weightedaverage of the cost of debt and the cost of equity:
Figure 21 4 illustrates M&M without corporate taxes (theirrelevance model) where the cost of equity (KE) rises in a prescribedmanner to offset the lower cost of debt (KD) producing WACC thatremains unchanged by the use of financial leverage.
VDK
VSKK DEU [ 21-15]
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CHAPTER 21 Capital Structure Decisions 21 - 61
(M&M) Irrelevance TheoremM&M and The Cost of Capital
20 - 4 FIGURE
Debt-Equity Ratio
Debt Cost KD
Equity Cost KE
WACC
%
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CHAPTER 21 Capital Structure Decisions 21 - 62
(M&M) Irrelevance TheoremM&M and The Cost of Capital
If WACC remains the same regardless of the financialstrategy used by the firm:
VL = VU
Financial strategy is irrelevant As the use of debt financing is increased, the cost of equity
will riseso even if EPS is increased through the use of debt
financing, that benefit is offset by a higher discount rate.
From a shareholder wealth perspective, under the M&M
assumptions, financing strategy is irrelevant.
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CHAPTER 21 Capital Structure Decisions 21 - 63
The Impact of TaxesIntroducing Corporate Taxes
The value of firms drop in the presence of corporate taxes.
The higher the tax rate, the lower the value of the firm.
)1(
K
TEBITV
U
U
[ 21-16]
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CHAPTER 21 Capital Structure Decisions 21 - 64
The Impact of TaxesCorporate Tax Effect on Levered Equity
Portfolios (Actions) Cost Payoff
Portfolio E: SL (EBIT - KD D )(1-T)
Buy of unlevered firm
Portfolio D:
Buy of levered firm's equity VU EBIT(1-T)
Buy of levered firm's debt D(1-T) - KD D
Total portfolio (VU - D)(1-T) (EBIT - KD D )(1-T)
Table 21-8 M&M with Taxes
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CHAPTER 21 Capital Structure Decisions 21 - 65
The Impact of TaxesIntroducing Corporate Taxes
To avoid arbitrage the value of the firm must equal:
VU D(1-t) = SL
VL = SL + D, therefore:
The value of the firm with leverage is the value without leverage plus thecorporate debt tax shield from debt financing.
DTVV UL [ 21-17]
Corporate DebtTax Shield
Th I f T
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CHAPTER 21 Capital Structure Decisions 21 - 66
The Impact of TaxesIntroducing Corporate Taxes
The total claims of corporate taxes, debt holders,and equity holders are borne by the pre-tax cashflow produced by the firm.
If the firm uses more debt, and interest on that debtis tax-deductible, this produces a greater tax shield,reducing the government share of the value of theprivate enterprise, the WACC must go down.
Here we assume a zero-sum game (that value is notdestroyed through the use of financial leverage)
Th I t f T
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CHAPTER 21 Capital Structure Decisions 21 - 67
The Impact of TaxesFirm Value with Corporate Taxes
Taxes
EquityDebt
21 - 5 FIGURE
Th I t f T
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CHAPTER 21 Capital Structure Decisions 21 - 68
The Impact of TaxesIntroducing Corporate Taxes
The taxcorrected value of Equation 21-14 is:
Both the interest cost and the financial leverage risk-premium on the equitycost are reduced by (1- T)
As the use of debt increases, WACC decreases, and therefore the value ofthe firm in a world with corporate taxes should increase
(See Figure 21 6 on the following slide)
/)1)(( SDTKKKK LDUUe [ 21-18]
Th I t f T
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CHAPTER 21 Capital Structure Decisions 21 - 69
The Impact of TaxesM&M with Corporate Taxes
21 - 6 FIGURE
Debt-Equity Ratio
Debt Cost KD(1-T)
Equity Cost KE
WACC
%
Th I t f T
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CHAPTER 21 Capital Structure Decisions 21 - 70
The Impact of TaxesWACC with Corporate Taxes
WACC declines continuously with the use of debt financing. WACC equation corrected for the tax-deductibility of interest
expense is:
)1( TKV
DK
V
SWACC De
[ 21-19]
Th I t f T
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CHAPTER 21 Capital Structure Decisions 21 - 71
The Impact of TaxesTax-Extended M&M Equity Cost Equation
The beta version of Equation 21 18 allows us to adjust for the systematicrisk of the firm:
Equity cost without any debt is the risk-free rate plus the market riskpremium (MRP) times the unlevered beta coefficient.
This equation allows us to unlever betas to get the unlevered equity cost.
There is one important flaw in this equation it is assumed that 100% debtfinancing is optimal. To address that issue, we must relax M&Ms assumptions regarding risk of
financial distress or bankruptcy.
)/)1(1( SDTMRPRFK LUe [ 21-20]
B k t
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CHAPTER 21 Capital Structure Decisions 21 - 72
BankruptcyIntroduction
Bankruptcy is a state of insolvency that occurs whena firm commits an act of bankruptcy, such as non-payment of interest, and creditors enforce their legal
rights to recoup money, or when a firm voluntarilydeclares bankruptcy in an effort to be protectedwhile reorganizing to become solvent again.
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CHAPTER 21 Capital Structure Decisions 21 - 73
Reorganization
Firms can be reorganized under:
Companies Creditors Arrangements Act (CCAA) Used by larger more complex firms with debt > $5m
Flexible allowing the firm to pursue agreements with
creditors/employees, to raise new financing
Trustee is appointed by the court and there is a stay-of-proceedings
Bankruptcy Insolvency Act (BIA)
Limited scope to prevent creditors from seizing assets No DIP financing
No provision to impose a settlement on all creditors
C t f B k t
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CHAPTER 21 Capital Structure Decisions 21 - 74
Costs of BankruptcyDirect Costs
Direct Costs:
Costs incurred as a direct result of bankruptcyincluding:
Liquidation of assets Loss of tax losses (potential tax shield benefits)
Legal and accounting costs
C t f B k t
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CHAPTER 21 Capital Structure Decisions 21 - 75
Costs of BankruptcyIndirect Costs
Indirect Costs: Financial distress costs are losses to a firm prior to declaration of
bankruptcy including: Agency costs Increasing costs of doing business:
Creditors tightening trade credit terms
Lending increasing risk premiums and increasing monitoringsurveillance
loss of key staff and increases in recruitment and retention costs Distracted management focused on financing and not on management
of business operations.
Reduced sales revenue: Management is distracted by financial issues
Customers may become wary and look for other suppliers
(Figure 21 8 illustrates the rising value of distress costs with increasing debt)
Static Tradeoff
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CHAPTER 21 Capital Structure Decisions 21 - 76
Static TradeoffFirm Value and Financial Distress Costs
21 - 8 FIGURE
Distress Costs
VU + DT
Debt Ratio
Value
Costs of Bankruptcy
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CHAPTER 21 Capital Structure Decisions 21 - 77
Costs of BankruptcyAgency Costs
Agency Costs: It is possible for shareholders (and Board of Directors) to act in their
own best interests at the expense of debt holders. When under financial stress sometimes:
Preferential treatment of creditors. Assets may be dissipated to related but solvent companies. Moral hazard (where management may take extraordinary risks that will be
ultimately borne by the debt holders, not the equity holders) (asymmetricpayoff of an option)
Being aware of these risks, lenders take action to protect their interestsincluding:
Moratorium on further debt. Increases in rates on adjustable-rate debt. Demands for additional surveillance of financial performance. Take the firm to court to enforce rights.
(Figure 217 illustrates the shareholders one year call option value on the underlying firm)
Financial Distress, Bankruptcy, and
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CHAPTER 21 Capital Structure Decisions 21 - 78
, p y,Agency Costs
The Firm Value as a Call Option for Shareholders
21 - 7 FIGURE
UnderlyingFirm Value
No limitedliability
$50 million debt
EquityPayoff
0
Costs of Bankruptcy
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CHAPTER 21 Capital Structure Decisions 21 - 79
Costs of BankruptcySummary
Costs of Bankruptcy are very high.
Probability of Bankruptcy and Financial Distress costs
rise exponentially as the use of debt increases.These costs rob value from both shareholders and
potentially debt holders.
Costs of Bankruptcy
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CHAPTER 21 Capital Structure Decisions 21 - 80
Costs of BankruptcyStatic Tradeoff Model
Figure 21 9 illustrates the impact of bankruptcy and financialdistress costs on M&M with corporate taxes.
Cost of equity rises throughout as more debt is added.
The cost of debt rises at higher levels of debt.
WACC falls initially because the benefits of the tax-deductibilityof interest expense out-weigh the marginal increases incomponent costs, however, at higher levels of debt, the tax-advantage of debt is offset and the value of the firm falls when
WACC starts to rise.
Static Tradeoff Model
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CHAPTER 21 Capital Structure Decisions 21 - 81
Static Tradeoff Model21 - 9 FIGURE
WACC
Ke
D/E*
Cost (%)
KD
Debt-to-equity
FirmValue
Other Factors Affecting Capital Structure
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CHAPTER 21 Capital Structure Decisions 21 - 82
Other Factors Affecting Capital StructurePecking Order
Static Trade off model ignores two issues:
1. Information asymmetry problems
2. Agency problems
These factors are likely responsible for what Myersand Donaldson call the pecking order.
The pecking order is the order in which firms preferto raise financing
1. starting with internal cash flow,2. debt and
3. finally issuing common equity.
C S
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CHAPTER 21 Capital Structure Decisions 21 - 83
Capital Structure in Practice
Factors favouring corporate ability and willingness toissue debt:
Profitability (so the firm can use the tax shield benefitof interest-deductibility).
Unencumbered tangible assets to be used ascollateral for secured debt.
Stable business operations over time.
Corporate size.
Growth rate of the firm.
Capital market conditions
S d C l i
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CHAPTER 21 Capital Structure Decisions 21 - 84
Summary and Conclusions
In this chapter you have learned: The three effects of leverage: expected ROE tends to increase,
the variability of the ROE increases, and the risk of financialdistress increases.
The major determinants of the firms capital structure decisionare its impact on profits, risk and cash flows.
Impacts can be assessed by profit planning charts, financialbreak-even analysis and use of standard ratios
Debt creates value because interest on debt is tax-deductible The tax incentive to use debt is offset by the resulting financial
distress and bankruptcy costs
In a dynamic world, firms depart from the static trade-off optimaldebt ratio over time, then refinance to bring it back in line withthe target debt ratio.
Actual capital structures are constantly changing as firms takeadvantage of market conditions.
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Appendix 1Thunder Bay Industries
Exercise in Indifference Analysis
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 86
Thunder Bay IndustriesThe Problem
Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years. Thecompany is now operating at 100% of capacity and must expand in order to meet the demand for its newline of video games.
The current financial statements for Thunder Bay Industries are as follows:
Thunder Bay IndustriesBalance Sheet
as at December 31, 20xx($ '000s Cdn.)
Assets: Liabilities and Owner's Equity:Cash 1,000 Accounts payable 550
Accounts receivable 2,100 Accruals 249Inventories 2,766 Other current liabilities 1Net Fixed Assets 16,244 8% bonds maturing in 10 years 5,000
_______ Common stock (100,000 outstanding) 1,000Retained earnings 15,310
Total Assets $22,110 Total Liabilities and Owner's Equity $22,110
The most recent income statement is found on the following slide:
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 87
Thunder Bay IndustriesThe Problem
Thunder Bay IndustriesIncome Statement
for the year ended December 31, 20xx($ '000s Cdn)
Sales $25,002Cost of Goods Sold 18,252
Gross Margin on Sales $ 6,750Administrative and Selling Expenses 4,000Earnings before Interest Expense and Taxes 2,750Interest expense 400Earnings before tax $ 2,350Taxes 1,011Net Income $1,339
If the firm does not expand, it sales growth will stall at the current $25m level orless. If the company undertakes the planned expansion management hasidentified a probability distribution for possible EBIT levels:
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 88
Thunder Bay IndustriesThe Problem
If the firm does not expand, it sales growth will stall at the current $25m level or less. If thecompany undertakes the planned expansion management has identified a probabilitydistribution for possible EBIT levels:
Possible EBIT Probability$2,200 .1$2,700 .4
$3,200 .4$3.700 .1
The planned expansion will require Thunder Bay Industries to raise $10,000,000 in newcapital. If raised in the form of bonds, the bonds would carry a 6.5% coupon rate. Newcommon stock could be sold for $250.00 per share.
Find the EBIT/EPS indifference point. What is the probability that EBIT will be greater thanthe indifference point? Which method of financing is most likely to maximize earnings pershare? What method of financing do you recommend? Why? Discuss the limitations ofindifference analysis. Prepare a properly labeled diagram of the EBIT/EPS analysis.
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 89
Thunder Bay IndustriesThe Solution
You can first determine the expected EBIT for next year and using that, determine thestandard deviation of that EBIT. These calculations will be useful later when we try todetermine the probability that EBIT will be less than, or greater than the indifferencepoint.
Possible EBIT Probability Wtd EBIT
$2,200,000 10.0% $220,0002,700,000 40.0% 1,080,0003,200,000 40.0% 1,280,0003,700,000 10.0% 370,000
Expected EBIT = $2,950,000
110,403$
11.403
500,162
56250000,25000,2556250
)750(1.)250(4.)250(4.)750(1. 2222
EBIT
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 90
Thunder Bay IndustriesThe Solution
Next set up equations for EPS for each alternative source offinancing, equate them, substitute in known values and solvefor the common EBIT.
000,675,2$
000,100
)43.1)(000,650000,400(
000,40000,100
)43.1)(000,400(
)1)(()1)((
)1)((
)1)((
1
21
21
1
1
21
21
1
EBIT
EBITEBIT
n
TBRBREBIT
nn
TBREBIT
EPSEPS
n
TBRBREBITEPS
nn
TBREBITEPS
DDD
debtcommon
DD
debt
D
common
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 91
Thunder Bay IndustriesThe Solution
Our prediction for EPS at EBIT=$2,675,000 for the common sharefinancing alternative is:
26.9$000,100
)43.1)(000,050,1$000,675,2($
26.9$000,140
)43.1)(000,400$000,675,2($
Debt
ecommonshar
EPS
EPS
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 92
Thunder Bay IndustriesThe Solution
The probability than EBIT will favour common stock financing (ie. beless than the indifference point) is:
Where:z= the number of standard deviations away from the mean
X= the point of interest= the standard deviation of the probability distribution
= the mean of the probability distribution
X
z 6822.0110,403
000,950,2000,675,2
z
Thunder Bay Industries 110403000,950,2000,675,2
z
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CHAPTER 21 Capital Structure Decisions 21 - 93
Thunder Bay IndustriesThe Solution
The negative sign indicates that the point of interest (X) or (indifference point)lies on the left-hand side of the mean. It lies .6822 of 1 standard deviation awayfrom the mean.
Going to the table for Values of the Standard Normal Distribution Function we
find the area under the curve between the point of interest and the mean of thedistribution to be:
.2517 or 25.27%
Therefore, the probability that EBIT will exceed the indifference point (favouringdebt financing) is 75.17% The probability that EBIT will be below the
indifference point (favouring equity financing is (1- .7517) 24.83%.
(These normal distribution is plotted on the following chart.)
6822.0
110,403
Thunder Bay Industries 110403000,950,2000,675,2
z
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CHAPTER 21 Capital Structure Decisions 21 - 94
Thunder Bay IndustriesThe Solution
(These relationships are now plotted on the following indifference chart.)
6822.0
110,403
=$2,950,000X=$2,675,000
Area =
.2517
Area = .5
Thunder Bay Industries
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CHAPTER 21 Capital Structure Decisions 21 - 95
Thunder Bay IndustriesThe Solution
(This chart illustrates that debt financing is forecast to produce higher EPS than the equityalternative.)
=$2,950,000
X=$2,675,000
Area =.2517
Area = .5
EPS
EquityFinancing
DebtFinancing
$400,000 $1,050,000
$9.26
Copyright
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Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved.Reproduction or translation of this work beyond that permitted by AccessCopyright (the Canadian copyright licensing agency) is unlawful.Requests for further information should be addressed to the PermissionsDepartment, John Wiley & Sons Canada, Ltd. The purchaser may makeback-up copies for his or her own use only and not for distribution or
resale. The author and the publisher assume no responsibility for errors,omissions, or damages caused by the use of these files or programs orfrom the use of the information contained herein.
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