mcgraw-hill/irwin ©2001 the mcgraw-hill companies all rights reserved 13.0 chapter 13 leverage and...
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McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved
13.1
Chapter
13Leverage and Capital Structure
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13.2
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 the bankruptcy process
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13.3
Chapter Outline
The Capital Structure QuestionThe Effect of Financial LeverageCapital Structure and the Cost of Equity CapitalCorporate Taxes and Capital StructureBankruptcy CostsOptimal Capital StructureObserved Capital StructuresA Quick Look at the Bankruptcy Process
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13.4
Capital Restructuring
We are going to look at how changes in capital structure affect the value of the firm, all else equal
Capital restructuring involves changing the amount of leverage a firm has 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
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13.5
Choosing a Capital Structure
What is the primary goal of financial managers?Maximize stockholder wealth
We want to choose the capital structure that will maximize stockholder wealth
We can maximize stockholder wealth by maximizing firm value or minimizing WACC
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13.6
The Effect of Leverage
How does leverage affect the EPS and ROE of a firm?When we increase the amount of debt financing, we
increase the fixed interest expenseIf we have a really good year, then we pay our fixed
cost and we have more left over for our stockholdersIf 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
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13.7
Example: Financial Leverage, EPS and ROEWe will ignore the effect of taxes at this stageWhat happens to EPS and ROE when we issue
debt and buy back shares of stock?
Financial Leverage Example
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13.8
Example: Financial Leverage, EPS and ROEVariability in ROE
Current: ROE ranges from 6.25% to 18.75%Proposed: ROE ranges from 2.50% to 27.50%
Variability in EPSCurrent: EPS ranges from $1.25 to $3.75Proposed: EPS ranges from $0.50 to $5.50
The variability in both ROE and EPS increases when financial leverage is increased
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13.9
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 stockholders
If we expect EBIT to be less than the break-even point, then leverage is detrimental to our stockholders
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13.10
Example: Break-Even EBIT
$2.00400,000
800,000EPS
$800,000EBIT
800,0002EBITEBIT
400,000EBIT200,000
400,000EBIT
200,000
400,000EBIT
400,000
EBIT
Break-even Graph
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13.11
Example: Homemade Leverage and ROE Current Capital Structure
Investor borrows $2000 and uses $2000 of their own to buy 200 shares of stock
Payoffs: Recession: 200(1.25)
- .1(2000) = $50 Expected: 200(2.50)
- .1(2000) = $300 Expansion: 200(3.75)
- .1(2000) = $550 Mirrors the payoffs from
purchasing 100 shares from the firm under the proposed capital structure
Proposed Capital Structure Investor buys $1000 worth of
stock (50 shares) and $1000 worth of Trans Am bonds paying 10%.
Payoffs: Recession: 50(.50) + .1(1000)
= $125 Expected: 50(3.00) + .1(1000)
= $250 Expansion: 50(5.50)
+ .1(1000) = $375 Mirrors the payoffs from
purchasing 100 shares under the current capital structure
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13.12
Capital Structure TheoryModigliani and Miller Theory of Capital
StructureProposition I – firm valueProposition II – WACC
The value of the firm is determined by the cash flows to the firm and the risk of the assets
Changing firm valueChange the risk of the cash flowsChange the cash flows
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13.13
Capital Structure Theory Under Three Special CasesCase I – Assumptions
No corporate or personal taxesNo bankruptcy costs
Case II – AssumptionsCorporate taxes, but no personal taxesNo bankruptcy costs
Case III – AssumptionsCorporate taxes, but no personal taxesBankruptcy costs
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13.14
Case I – Propositions I and II
Proposition IThe value of the firm is NOT affected by changes in
the capital structureThe cash flows of the firm do not change, therefore
value doesn’t change
Proposition IIThe WACC of the firm is NOT affected by capital
structure
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13.15
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
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13.16
Case I - ExampleData
Required return on assets = 16%, cost of debt = 10%; percent 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 percent of equity in the firm? E/V = 1 / 2.5 = 40%
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13.17
Figure 13.3Cost of capital(%)
Debt-equity ration(D/E)
RE
RD
WACC = RA
RE = RA + (RA – RD) X (D/E) by M&M Proposition IIRA = WACC = (E/V) X RE + (D/V) X RD
where V = D + E
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13.18
The CAPM, the SML and Proposition IIHow 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 IIReplace RA with the CAPM and assume that the debt is
riskless (RD = Rf)
RE = Rf + A(1+D/E)(RM – Rf)
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13.19
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 stock depends on:Systematic risk of the assets, A, (Business risk)Level of leverage, D/E, (Financial risk)
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13.20
Case II – Cash Flows
Interest is tax deductibleTherefore, when a firm adds debt, it reduces
taxes, all else equalThe reduction in taxes increases the cash flow
of the firmHow should an increase in cash flows affect
the value of the firm?
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13.21
Case II - Example
Unlevered Firm Levered Firm
EBIT 5000 5000
Interest 0 500
Taxable Income 5000 4500
Taxes (34%) 1700 1530
Net Income 3300 2970
CFFA 3300 3470
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13.22
Interest Tax ShieldAnnual interest tax shield
Tax rate times interest payment6250 in 8% debt = 500 in interest expenseAnnual tax shield = .34(500) = 170
Present value of annual interest tax shieldAssume perpetual debt for simplicityPV = 170 / .08 = 2125PV = D(RD)(TC) / RD = DTC = 6250(.34) = 2125
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13.23
Case II – Proposition I
The 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 shieldValue of equity = Value of the firm – Value of debt
Assuming perpetual cash flowsVU = EBIT(1-T) / RU
VL = VU + DTC
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13.24
Example: Case II – Proposition I
DataEBIT = 25 million; Tax rate = 35%; Debt = $75
million; Cost of debt = 9%; Unlevered cost of capital = 12%
VU = 25(1-.35) / .12 = $135.42 million
VL = 135.42 + 75(.35) = $161.67 millionE = 161.67 – 75 = $86.67 million
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13.25
Figure 13.4Value ofthe firm(VL)
VL = VU + TC + X D = Value of firm with debt
VU = Value of firm with no debt
Total debt(D)
VU
= TC
= TC
TC X D = Present value of tax shield on debtVU
The value of the firm increases as total debt increases because ofthe interest tax shield. This is the basis of M&M Proposition I with taxes.
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13.26
Case II – Proposition II
The WACC decreases as D/E increases because of the government subsidy on interest paymentsRA = (E/V)RE + (D/V)(RD)(1-TC)
RE = RU + (RU – RD)(D/E)(1-TC)
ExampleRE = .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%
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13.27
Case II – Proposition II Example
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%
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13.28
Case II – Graph of Proposition IICost of Capital
D/E
RU
RE
RA
RD(1-TC)
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13.29
Case III
Now we add bankruptcy costsAs the D/E ratio increases, the probability of
bankruptcy increasesThis increased probability will increase the expected
bankruptcy costsAt some point, the additional value of the interest tax
shield will be offset by the expected bankruptcy costAt 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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13.30
Bankruptcy Costs
Direct costsLegal and administrative costsUltimately cause bondholders to incur additional
lossesDisincentive to debt financing
Financial distressSignificant problems in meeting debt obligationsMost firms that experience financial distress do not
ultimately file for bankruptcy
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13.31
More Bankruptcy Costs
Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and
estimate Stockholders wish 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
Also have lost sales, interrupted operations and loss of valuable employees
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13.32
Figure 13.5
Value ofthe firm(VL) VL = VU + TC X D
= Value of firm with debt
Financial distresscosts
VU = Value of firm with no debt
Actual firm value
Maximumfirm value VL*
D* Optimal amount of debt
Total debt(D)
Present value of taxshield on debt
According to the static theory, the gain from the tax shield on debt is offset by financial distress cost.An optimal capital structure exists that just balances the additional gain from leverage against theadded financial distress cost.
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13.33
Conclusions
Case I – no taxes or bankruptcy costs No optimal capital structure
Case II – corporate taxes but no bankruptcy costs Optimal capital structure is 100% debt Each additional dollar of debt increases the cash flow of
the firmCase 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
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13.34
Figure 13.6
Valueof thefirm(VL) PV of bankruptcy
costs
Net gain fromleverage
Case IIM&M (with taxes)
Case IIIStatic theoryCase IM&M (no taxes)
VL*
VU
Totaldebt (D)D*
Weightedaverage cost ofcapital(%)
Case IM&M (no taxes)
Case IIIStatic theory
Case IIM&M (with taxes)
WACC*
D*/E*Debt-equity ratio(D/E)
Case 1With no taxes or bankruptcy costs, the value of the firm and its weighted average costof capital are not affected by capitalstructures.
Case 2With corporate taxes and no bankruptcy costs,the value of the firm increases and the weightedaverage cost of capital decreases as the amountof debt goes up.
Case 3With corporate taxes and bankruptcy costs,the value of the firm, VL, reaches a maximum atD*, the optimal amount of borrowing. At the sametime, the weighted average cost of capital, WACC,is minimized at D*/E*.
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13.35
Additional Managerial RecommendationsThe tax benefit is only important if the firm has
a large tax liabilityRisk 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
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13.36
Observed Capital Structure
Capital structure does differ by industriesDifferences according to Cost of Capital 2000
Yearbook by Ibbotson Associates, Inc.Lowest levels of debt
Drugs with 2.75% debt Computers with 6.91% debt
Highest levels of debt Steel with 55.84% debt Department stores with 50.53% debt
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13.37
Bankruptcy Process – Part I
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
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13.38
Bankruptcy Process – Part II
LiquidationChapter 7 of the Federal Bankruptcy Reform Act of
1978Trustee takes over assets, sells them and distributes
the proceeds according to the absolute priority ruleReorganization
Chapter 11 of the Federal Bankruptcy Reform Act of 1978
Restructure the corporation with a provision to repay creditors
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13.39
Chapter 13 Quick Quiz
Explain the effect of leverage on EPS and ROEWhat is the break-even EBIT?How do we determine the 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
reorganization?