Ch. 16: Financial Leverage and Capital Structure Policy

Capital Structure

• Capital Structure is the amount of debt and equity a firm uses as its sources of capital.
• How should a manager decide between debt and equity financing?
  • What should the manager’s goal be?
    • Maximize shareholder value.
    • When does this differ from maximizing firm value?
    • How does maximizing firm value relate to WACC?
  • Management should choose capital structure to maximize shareholder wealth. This can be achieved by maximizing firm value or minimizing WACC.
• How can management alter capital structure?
  • Increase leverage
    • Increase debt
    • Reduce equity by repurchasing shares (paying a dividend)
  • Decrease leverage
    • Retire outstanding debt
    • Issue new equity

Effect of Leverage

• Leverage amplifies the variation in both EPS and ROE.
• Example: See Table 16.3 and Table 16.4.

Break-even EBIT

• We are trying to find the Earnings Before Interest and Taxes (EBIT) where the Earnings Per Share (EPS) is the same under both the current and proposed capital structures.
• See Figure 16.1.
• If we expect the EBIT to be greater than the break-even point, then leverage may be beneficial to our stockholders.
• If we expect the EBIT to be less than the break-even point, then leverage is detrimental to our stockholders.
• Conclusions
  • The effect of financial leverage depends on the company’s EBIT. When EBIT is relatively high, leverage is beneficial.
  • Under the expected scenario, leverage increases the returns to shareholders, as measured by both ROE and EPS.
  • Shareholders are exposed to more risk under the proposed capital structure because the EPS and ROE are much more sensitive to changes in EBIT in this case.
  • Because of the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock, capital structure is an important consideration.

Homemade Leverage

• Why is this last conclusion not the case?
• As an investor, I can use personal borrowing to undo the capital structure decisions of the manager.
• If the proposed capital structure from the previous example is not implemented, how can I get equivalent exposure to the levered case?
  • I am interested in owning 100 shares in the levered firm.
  • I can achieve this payoff by buying 100 shares outright and buying 100 shares by borrowing at 10%.

Modigliani-Miller Theorem

• Three cases
  • No corporate taxes, no personal taxes, no bankruptcy costs
  • Corporate taxes, no personal taxes, no bankruptcy costs
  • Corporate taxes, no personal taxes, Bankruptcy costs
• Two Propositions
  • Firm Value
    • Can change due to the riskiness of cash flows
    • Can change due to changing the cash flows (amounts and timing)
  • WACC and Systematic Risk

Capital Structure Theory without Taxes

• Modigliani-Miller Proposition 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 doesn’t change.
• Modigliani-Miller Proposition II
  • WACC is not influenced by capital structure.
  • $WACC = R_A = \frac{E}{V} R_E + \frac{D}{V} R_D$
  • $R_E = R_A + \frac{D}{E}(R_A-R_D)$
  • See Figure 16.3.
  • Examples
    • Required return on assets = 16%; Cost of debt = 10%; Percent of debt = 45%. What is the cost of equity?
    • Required return on assets = 16%; Cost of debt = 10%; Cost of equity = 25%. What is the Debt-to-Equity ratio?
  • How does financial leverage change systematic risk?
    • Plug CAPM into above equation.
    • $\beta_E = \beta_U + \frac{D}{E}(\beta_U - \beta_D)$
    • If debt is riskless, $\beta_E = \beta_U (1 + \frac{D}{E})$.

Capital Structure Theory with Taxes

• Modigliani-Miller Proposition I
  • When a firm adds debt, it reduces taxes.
  • The reduction in taxes increase the firm’s cash flows.
  • The value of the firm increases by the present value of the annual interest tax shield ($(T_c \times D \times R_D)/R_D = T_c \times D$).
  • $V_L = \frac{EBIT(1-T_c)}{R_U} + DT_c$
  • Example: EBIT = $\$$25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%.
  • See Figure 16.4.
• Modigliani-Miller Proposition II
  • WACC decrease with leverage because the government subsidizes interest expenses.
  • $WACC = R_A = \frac{E}{V} R_E + \frac{D}{V} (1-T_c) R_D$
  • $R_E = R_U + \frac{D}{E}(1-T_c)(R_U-R_D)$
  • See Figure 16.5.
  • How does financial leverage change systematic risk?
    • Plug CAPM into above equation.
    • $\beta_E = \beta_U + (1-T_c) \frac{D}{E} (\beta_U - \beta_D)$

Trade-off Theory of Capital Structure

• As leverage increases, the probability of bankruptcy increases.
• The increase probability of bankruptcy increases the expected bankruptcy costs.
• Bankruptcy Costs
  • Direct
    • Legal and administrative costs
    • Liquidity costs of selling
  • Indirect
    • 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.
• The value of the firm is maximized when the costs of bankruptcy exactly offset the present value of the interest tax shield.
• See Figure 16.6.
• See Figure 16.7.

Managerial Recommendations

• The tax benefit is only important if the firm has a large tax liability.
• The risks 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.

Pecking-Order Theory

• According to Pecking-Order Theory:
  • Use internal financing first.
  • Issue debt next.
  • Issue new equity as a last resort.
• This theory is at odds with tradeoff-theory:
  • There is no target D/E ratio.
  • Profitable firms use less debt.
  • Companies like financial slack (cash on hand).