Ch 16 Financial Leverage and Capital Structure

1. Capital structure question

• Financial managers want to set up a capital structure that will maximize the firm and stock value.

• Changing capital structure influences the cost of capital. Basing on discounted cash flow approach, it is clear that the minimum level of cost of capital would maximize the value of firm.

• 1) The Effect of Financial Leverage.

• Def of financial leverage: the extent to which a firm relies on debt. The more debt financing a firm uses in its capital structure, the more financial leverage it employs.

• Why it is important to firm value or stock value?

• Ex)

Current ProposedAsset 8000000 8000000Debt 0 4000000Equity 8000000 4000000Debt-Equity 0 1Share Price 20 20Shares outstanding 400000 200000Interest rate 10% 10%

Current Capital Structure: No Debt Recession Expected Expansion

EBIT 500000 1000000 1500000Interest 0 0 0Net Income 500000 1000000 1500000ROE 6.25% 12.50% 18.75%EPS 1.25 2.5 3.75

Proposed Capital Structure: Debt = $4 million Recession Expected Expansion

EBIT 500000 1000000 1500000Interest 400000 400000 400000Net Income 100000 600000 1100000ROE 2.50% 15.00% 27.50%EPS 0.5 3 5.5

• Lessons: • (1) Variability of EPS and ROE is much larger

under the proposed capital structure with debts, more risk.

• (2) The effect of financial leverage depends on the company’s EBIT. When EBIT is relatively high, leverage is beneficial.

• 2) Homemade leverage: The use of personal borrowing to change the overall financial leverage to which the individual is expected.

• Ex) with the previous example, Assume two cases. Investors A and B have $2000. First one is that investor A buys 100 shares of a firm with debts. Second one is that investor B buys 200 shares of a firm without debts and borrows $2000 at 10%.

• The investor B could generate the same net earnings as that of investor A. The capital structure does not matter to investors.

Proposed Capital StructureRecession Expected Expansion

EPS 0.5 3 5.5Earnings for 100 shares 50 300 550Net Cost = 100 share * $20 = $2000

Original Capital Structure and Homemade LeverageEPS 1.25 2.5 3.75Earnings for 200 shares 250 500 750Less Interest on $2000 at 10% 200 200 200Net Earnings 50 300 550Net cost = 200 shares * $20 - Amount Borrowed = 4000-2000=2000

• 2. Capital Structure and the cost of equity capital.• M & M (Miller and Modigliani) proposition I:• Under certain conditions – (e.g. no taxes,

bankruptcy costs, no brokerage costs, same information for investors), the firm value has nothing to do with capital structure – concept of splitting a pie. The cash flow (EBIT) is unaffected by the capital structure. Regardless of debt amounts, the firm value is same.

• VL = VU = SL + D

• M&M proposition II: see what happen to cost of equity and debt under M&M I – irrelevance.

• Due to cheaper cost of debts, the weight for cost of debts increases but the cost of debts will be the same under no tax and no bankruptcy. Due to increasing risk, the cost of equity would also increase with debt to equity ratio. But the cost of equity would increase up to the level generating the same WACC regardless of debt to equity ratio.

– WACC is a required return on the firm’s overall assets. Thus WACC = RA, the cost of the firm’s business risk (the firm’s assets)

– (RA – RD)(D/E) is the cost of the firm’s financial risk (the additional return required by stockholders to compensate for the risk of leverage)

Figure 16-3

Example• Data

– Required return on assets (RA)= 12%, cost of debt = 8%; percent of debt = 20%

• What is the cost of equity and WACC?– RE = 12 + (12 - 8)(20/80) = 13%– WACC=0.8*13%+0.2*0.08=12%

• Suppose instead that the cost of equity is 16%, what is the debt-to-equity ratio?– 16 = 12 + (12 - 8)(D/E)– D/E = 1

• Based on this information, what is the percent of equity in the firm? And WACC?– E/V = 1 / 2 = 50%– WACC=0.5*16%+0.5*0.08=12%

• 3. M&M propositions I and II with corporate taxes.

• When we consider taxes, key issues are that an interest paid is tax deductible. And if the interest is not paid, a firm would go bankrupt. These would change M&M propositions.

• Ex) assume two firms, firm U and firm L. Two firms have EBIT of $1000. Firm L issued $1000 worth of perpetual bonds at 8%. We also assume no depreciation and no change in NWC.

• Here, difference is 24 = 724-700. It comes from reduced taxable income because of interest payment. 24 = (1000*0.08)*0.3

• It is called “interest tax shield.”

Firm U Firm LEBIT 1000 1000Interest 0 80Taxable Income 1000 920Tax (30%) 300 276Net Income 700 644

Operating cash flowEBIT 1000 1000Taxes 300 276Total 700 724

• If the same amount of tax shield happens forever, we can write:

• Thus M&M proposition I with corporate tax says that as debts increase, the firm value increases. It means that the capital structure does matter in the firm value. It is not the same as the original proposition.

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• M&M a little bit expanded the previous model with corporate tax (Tc), considering personal taxes on income from stocks (Ts) and on income from debt (Td). They pointed out the deductibility of interests favors the use of debt but the more favorable tax treatment of income from stocks favors the use of equity financing.

• VL = VU + [1-(1-Tc)(1-Ts)/(1-Td)] D

• M&M proposition II with corporate taxes: Cost of equity would increase with debts. Due to tax sheltering, After tax cost of debts will be lower and WACC will go down.

• Ru is an unlevered cost of capital• WACC and RE change with debts associated

with tax shelter. The firm value would improve with corporate taxes. Figure 16.5

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Figure 16-5

Example• Format Co has only debts and equity. Its

debts are $500. Its EBIT (perpetuity) is $151.52. Tax rate is 34%. Ru is 20%. Cost of capital is 10%. No depreciation and additional investments are assumed.

• 1) what is the value of Format’s equity?

• Vu= OFC/ Ru

• = (EBIT+Depreciation –Tax)/Ru

• =EBIT*(1-Tax rate)/Ru=100/0.2=500.

• VL =Vu+T*D =500+0.34*500 =670.

• E=VL-D=670-500 =170.

• 2) What is cost of equity

• RE=Ru+(Ru-RD)*(D/E)*(1-tax rate)

• =0.2+(0.2-0.1)*(500/170)*(1-0.34)=39.4

• 3) What is WACC

• (170/670)*39.4%+(500/670)*10%*(1-0.34)=14.92%

• WACC is lower than cost of capital without debts (Ru=20%). Thus debt financing improves value of the firm.

• 4. Bankruptcy costs• 1) direct bankruptcy costs: costs that are directly

associated with bankruptcy, such as legal and administrative expenses.

• Ex) Enron spent more than $1 billion on laywers, accountants, consultants… Lehman supposedly spent almost $2 billion

• 2) Indirect bankruptcy costs: the costs of avoiding a bankruptcy filing incurred by a firm.

• 3) Financial distress: both direct and indirect bankruptcy costs such as losing market shares, inability to purchase goods on credit.

• These costs would increase cost of debt when debt increases.

• 5. Optimal Capital Structure• 1) Static (or Trade-off) theory of capital

structure: • firms borrow up to the point where the tax

benefit from an extra in debt is equal to the cost that comes from the increased probability of financial distress. Thus firm value would hit the optimal level of debt to equity ratio and then decrease as debt increases.

• At the optimal level of debt to equity ratio, WACC would be minimum.

• 6. Revisit to pie • Total value of firm would be determined by cash

flow (CF). • CF = payments to stockholders + payments to

bond holders + payment to the government + payment to bankruptcy courts and lawyers + payment to other claims.

• Marketed claims = payment to stockholders and payment to bondholders.

• When we say the value of firm, it typically refers to marketed claims. Optimal capital structure relates to the marketed claims.

• 7. Signaling theory: the level of information (symmetric or asymmetric) about valuation will affect the capital structure.

• A firm with very positive prospects would avoid to issue share not to share potential future profits. A firm with a negative prospects would prefer to issue equity to share risk. Thus the announcement of stock or debt financing signal to the market the firm’s prospects seen by its own management.

• 8. Pecking order theory.• In reality, many firms carry less debt despite

of the advantages of having debts inside.• Theory : due to floatation costs or

information asymmetry, the firm will use internal financing first. Then they will issue debt if necessary. As a last resort, equity would be sold.

• Potential explanation: signaling effect of selling overvalued equity to the market.

• 9. Reserve Borrowing Capacity

• A firm wants to maintain a reserve borrowing capacity. Thus in normal time, he or she use more equity and less debt.

• 10. Using debt financing to constrain management.

• Due to agency problem associated with extra free cash in the firm, owners want to increase debts to reduce extra free cash or relevant agency problem.

• 11. investment opportunity set• If a firm has more investment opportunity,

he or she use low amount of debts and maintain reserves. Otherwise, he or she will use more debts.

• 12. Market timing theory.• When stock market prices are high, a firm

will issue equity. When interest rate is low, he or she will issue debts.

• Observed Capital Structure: Table 16.7

• 13. Bankruptcy Process

• 1) Terminologies• Business failure: a business is terminated with

losses to creditors.• Bankruptcy: Legal proceeding in order to

liquidate or reorganize the firm.• Technical insolvency: a firm is unable to meet its

financial obligations.• Accounting insolvency: book value of liabilities

exceeds book value of total asset.

2) Chapter 7: Liquidation – termination of the firm as a going concern.

• (1) Procedure: petition -> bankruptcy trustee -> liquidation • (2) Order: • Administrative and relevant legal costs.• Wages, salaries and commissions.• Employee benefit plans• Consumer claims• Government tax claims• Unsecured creditors• Preferred stockholders• Common stockholders

• (3) Absolute Priority Rule establishing priority of claims in liquidation

3) Chapter 11: Reorganization plan – financial restructuring of a failing firm to attempt to continue operations as a going concern.

(1) Order: petition -> approval/denial -> reorganization plan -> accepted by creditors and court -> payment to creditors or stockholders

(2) Prepacked deal.

• 14. Estimating the optimal capital structure

• Cost of debt: investment bankers decide lending rates, basing on their analysis of a firm and relevant industry. E.g) credit rating, accounting ratios, etc.

• Cost of equity: Hamada equation

• b = bu [1+(1-t)(Wd/Ws)]. Here Ws =We.

• Recapitalization means issuing more debts to optimize its capital structure, and use the debt proceeds to repurchase stock.

E.g) one example (Financial Management 14th edition by Brigham and Ehrhardt).

Here a firm currently has 20% of debts. It is considering optimal capital structure through recap.

Wd 0% 10% 20% 30% 40% 50% 60%Ws 100% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0%rd 7.70% 7.80% 8% 8.50% 9.90% 12% 16%b 1.09 1.16 1.25 1.37 1.52 1.74 2.07rs 12.82% 13.26% 13.80% 14.50% 15.43% 16.73% 18.69%rd(1-t) 4.62% 4.68% 4.80% 5.10% 5.94% 7.20% 9.60%WACC 12.82% 12.40% 12.00% 11.68% 11.63% 11.97% 13.24%Vop 234.01 241.90 250.00 256.85 257.86 250.73 226.65Debt 0.00 24.19 50.00 77.05 103.15 125.37 135.99Equity 234.01 217.71 200.00 179.79 154.72 125.37 90.66# of shares 12.72 11.35 10 8.69 7.44 6.25 5.13Stock price 18.40 19.19 20.00 20.68 20.79 20.07 17.67Net income 30.00 28.87 27.60 26.07 23.87 20.97 16.94EPS 2.36 2.54 2.76 3.00 3.21 3.36 3.30

Risk free rate is 6.3% and a market risk premium is 6%. tax rate is 40%Value of operation, Vop = [FCF(1+g)]/(WACC-g), where FCF= $30 million and growth rate is 0%.# of shares after recap = # of share before recap *(VopNew - new debt)/(VopNew - old debt)# of shares after recap = # of share before recap - (new debt -old debt)/price of share before repurchaseEBIT is assumed to be $50 million

• Major findings: (1) As debt amounts change, WACC also changes. (2) value of operation (Vop) increases, (3) stock price increases.

More about recapitalization (repurchase):

•New debt will be recorded as short term investment.

•# of outstanding shares remaining after the repurchase = # of outstanding shares before the repurchase – (new debt – old debt)/ stock price before the repurchase.

•Repurchase did not affect shareholder wealth or the price per share.

Before issung additional debt After debt issue, but prior to repurchase Post repurchaseWd 20% 40% 40%Value of operation 250 257.86 257.86+ value of st investment 0 53.14 0Total Intrinsic value 250 311.004 257.86- Debt 50 103.14 103.14Intrinsic value of equity 200 207.86 154.72/ number of shares 10 10 7.44price per share 20.00 20.79 20.79Value of stock 200 207.86 154.716+ cahs distributed in repurchase 0 0 53.14wealth of shareholders 200 207.86 207.86

• Basing on no change in stock price in the previous slide, we can calculate the number of shares remaining after the repurchase.

• (Vop new – new debt)/Npost =(Vop new –old debt)/Nprior

• Npost = Nprior *(Vop new-new debt)/(Vop new-old debt)