of capital Lower financial leverage Bondholder claim Bankruptcy claim Tax claim Stockholder claim Higher financial leverage Bondholder claim Bankruptcy claim Tax claim

Document Sample

```					                                     Chapter 16
Financial Leverage and Capital Structure Policy

 16.1 The Capital Structure Question
 16.2 The Effect of Financial Leverage
 16.3 Capital Structure and the Cost of Equity Capital
 16.4 M&M Propositions I and II with Corporate Taxes
 16.5 Bankruptcy Costs
 16.6 Optimal Capital Structure
 16.7 The Pie Again
 16.8 Observed Capital Structures
 16.9 Summary and Conclusions

Vigdis Boasson                                        Mgf301, school of Management, SUNY at Buffalo
16.4 Example: Computing Break-Even EBIT

 Ignoring taxes:

A. With no debt:
EPS = EBIT/500,000

B. With \$2,5000,000 in debt at 10%:
EPS = (EBIT - \$___________)/250,000

C. These are equal when:
EPSBE = EBITBE/_______ = (EBITBE - \$250,000)/250,000

D. With a little algebra:
EBITBE = \$500,000

So EPSBE = \$________/share

Vigdis Boasson                                Mgf 301, School of Management, SUNY at Buffalo
16.5 Financial Leverage, EPS and EBIT

EPS (\$)

3                                           D/E = 1
2.5

2
D/E = 0
1.5

1

0.5

0

– 0.5

–1                                              EBIT (\$ millions, no taxes)
0     0.2    0.4     0.6   0.8   1

Vigdis Boasson                                     Mgf 301, School of Management, SUNY at Buffalo
16.6 Example: Homemade Leverage and ROE

 Firm does not adopt proposed capital structure
Investor put up \$500 and borrows \$500 to buy 100 shares

EPS of
unlevered firm           \$0.60       \$1.30                  \$1.60
Earnings for
100 shares              \$60.00     \$130.00             \$160.00
less interest on
\$500 at 10%            \$50.00      \$50.00               \$50.00

Net earnings              \$10.00      \$80.00             \$110.00
ROE                           2%        16%                    22%

Vigdis Boasson                                Mgf 301, School of Management, SUNY at Buffalo
16.6 Homemade Leverage: An Example (concluded)

 Firm adopts proposed capital structure
Investor puts up \$500, \$250 in stock and \$250 in bonds

EPS of
levered firm              \$0.20         \$1.60                 \$2.20
Earnings for
25 shares                 \$5.00        \$40.00               \$55.00
plus interest on
\$250 at 10%            \$25.00         \$25.00               \$25.00

Net earnings              \$30.00         \$65.00               \$80.00
ROE                           6%           13%                    16%

Vigdis Boasson                                   Mgf 301, School of Management, SUNY at Buffalo
16.7 Milestones in Finance: The M&M Propositions

 Financial leverage and firm value: Proposition I

Since investors can costlessly replicate the financing
decisions of the firm (remember “homemade leverage”?),
in the absence of taxes and other unpleasantries,
the value of the firm is unaffected by its capital structure.

Vigdis Boasson                                     Mgf 301, School of Management, SUNY at Buffalo
16.7 Milestones in Finance: The M&M Propositions (concluded)

The cost of equity and financial leverage: Proposition II
 A. Because of Prop. I, the WACC must be constant. With
no taxes,
WACC = RA = (E/V)      RE + (D/V)          RD
where RA is the return on the firm’s assets

 B. Solve for RE to get MM Prop. II
RE = RA + (RA - RD)      (D/E)
( ) Cost of equity has two parts:
2. D/E and “financial” risk

Vigdis Boasson                                         Mgf 301, School of Management, SUNY at Buffalo
16.8 The Cost of Equity and the WACC (Figure 16.3)

Cost of capital

RE = RA + (RA – RD ) x (D/E)

WACC = RA

RD

Debt-equity ratio, D/E

Vigdis Boasson                                          Mgf 301, School of Management, SUNY at Buffalo
16.9 The CAPM, the SML, and Proposition II

M&M Proposition II:           RE = RA + (RA - RD)           (D/E)

CAPM:                 RE = RF + (RM - RF)         E

RA = RF + (RM - RF)         A,

where   A   is the beta of the firm’s assets.

What is the relationship between debt and systematic
risk?

Vigdis Boasson                                         Mgf 301, School of Management, SUNY at Buffalo
16.10 Business Risk and Financial Risk

 Systematic risk and financial leverage

Assume the debt is riskless, so that RD = RF, and
substitute for RA in Prop. II:

RE = RF + (RM - RF)           A       (1 + D/E)
( )   E   =   A   (1 + D/E) =       A   +    A      D/E

( ) Systematic risk for the firm’s stock has two parts:

2. D/E and “financial” risk

Vigdis Boasson                                                   Mgf 301, School of Management, SUNY at Buffalo
16.11 Debt, Taxes, and Firm Value

 The interest tax shield and firm value
For simplicity:        (1) perpetual cash flows
(2) no depreciation
(3) no fixed asset or NWC spending
A firm is considering going from zero debt to \$400 at 10%:
Firm U             Firm L
(unlevered)          (levered)
EBIT                             \$200                  \$200
Interest                            0                   \$40
Tax (40%)                         \$80                   \$64
Net income                       \$120                   \$96
Cash flow
from assets                      \$120              \$_____

Tax saving = \$16 = ______         \$40 = TC   RD      D

Vigdis Boasson                                        Mgf 301, School of Management, SUNY at Buffalo
16.11 Debt, Taxes, and Firm Value (concluded)

 What’s the link between debt and firm value?

Since interest creates a tax deduction, borrowing
creates a tax shield. Its value is added to the
value of the firm.
 MM Proposition I (with taxes)

PV(tax saving) = \$16/________ = \$________
= (TC      RD   D)/RD = TC D

VL = VU + TC D

Vigdis Boasson                                         Mgf 301, School of Management, SUNY at Buffalo
16.12 Example: Debt, Taxes, and the WACC

 Taxes and firm value: an example
   EBIT = \$100
   TC   = 30%
   RU   = 12.5%

Q. Suppose debt goes from \$0 to \$100 at 10%, what
happens to equity value, E?
VU = \$100     (________________)/.125 = \$560
VL = \$560 + .30      \$________ = \$590, so E = \$________.

Vigdis Boasson                                   Mgf 301, School of Management, SUNY at Buffalo
16.12 Example: Debt, Taxes, and the WACC (concluded)

 WACC and the cost of equity (MM Proposition II with taxes)

With taxes:

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

RE      = _____+ (_____- .10)        (_____/_____)            (1 - .30)
= 12.86%

WACC = (____/____)         .1286 + (100/590)         .10       (1 - .30)
= 11.86%

( ) The WACC decreases as more debt financing is used.
Optimal capital structure is all debt!
Vigdis Boasson                                         Mgf 301, School of Management, SUNY at Buffalo
16.13 Taxes, the WACC, and Proposition II

Cost of capital

RE

P
WACC

RD (1 – TC)

Debt-equity ratio, D/E

Vigdis Boasson                                       Mgf 301, School of Management, SUNY at Buffalo
16.14 Modigliani and Miller Summary (Table 16.6)

   I. The No-Tax Case
A. Proposition I: The value of the firm levered equals the value of the firm unlevered:

VL = VU
Implications of Proposition I:
1. A firm’s capital structure is irrelevant.
2. A firm’s WACC is the same no matter what mix of debt and equity is used.
B. Proposition II: The cost of equity, RE, is
RE = RA + (RA - RD) D/E
where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity ratio.
C. Implications of Proposition II
1. The cost of equity rises as the firm increases its use of debt financing.
2. The risk of equity depends on the risk of firm operations and on the degree of
financial leverage.
Vigdis Boasson                                              Mgf 301, School of Management, SUNY at Buffalo
16.14 Modigliani and Miller Summary (Table 16.6) (concluded)

   II. The Tax Case

A. Proposition I with Taxes: The value of the firm levered equals the value of
the firm unlevered plus the present value of the interest tax shield:
VL = VU + TcD
where Tc is the corporate tax rate and D is the amount of debt.
B. Implications of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s
optimal capital structure is 100 percent debt.
2. A firm’s WACC decreases as the firm relies more heavily on debt.

Vigdis Boasson                                              Mgf 301, School of Management, SUNY at Buffalo
16.15 The Optimal Capital Structure and the Value of the Firm (Figure 16.6)

Value of
the firm
(VL )
VL = VU + TC       D

Present value of tax                        Financial
Maximum shield on debt                                 distress costs
firm value VL*

Actual firm value
VU                                              VU = Value of firm
with no debt

Debt-equity ratio, D/E
D/E           Optimal amount of debt

Vigdis Boasson                                             Mgf 301, School of Management, SUNY at Buffalo
16.16 The Optimal Capital Structure and the Cost of Capital (Figure 16.7)

Cost of
capital
(%)

RE

RU                                                     RU
WACC
Minimum                                                                    RD (1 – TC)
cost of capital WACC*

Debt/equity ratio
D*/E*                            (D/E)
The optimal debt/equity ratio

Vigdis Boasson                                               Mgf 301, School of Management, SUNY at Buffalo
16.17 The Extended Pie Model

Lower financial leverage      Higher financial leverage

Bondholder                     Bondholder
claim                          claim

Stockholder       Bankruptcy
claim                       Stockholder
claim                             Bankruptcy
claim
claim
Tax
claim                          Tax
claim

Vigdis Boasson                            Mgf 301, School of Management, SUNY at Buffalo
16.18 Chapter 16 Quick Quiz

1. Why does the firm’s cost of equity increase with leverage?

2. What are direct bankruptcy costs?

3. What kinds of firms would be most likely to suffer indirect
bankruptcy costs?

4. Name three types of financial distress.

Vigdis Boasson                                  Mgf 301, School of Management, SUNY at Buffalo
16.19 Solution to Problem 16.1

 Probit, Inc. has no debt and a total market value (MV) of
\$70,000. EBIT is projected to be \$4,000 if economic
conditions are normal. EBIT is expected to be 30% higher if
the economy is strong, or 60% lower if a recession occurs.
Probit is considering a \$35,000 debt issue with a 4%coupon.
The proceeds will be used to repurchase outstanding stock.
There are now 2,000 shares outstanding. Ignore taxes for
this problem.

a. Calculate EPS under each of the three economic scenarios
before any debt is issued. Also calculate the percentage
changes in EPS when the economy expands or enters a
recession.

b. Repeat part (a) assuming that Probit goes through with the
recapitalization. What do you observe?

Vigdis Boasson                                     Mgf 301, School of Management, SUNY at Buffalo
16.19 Solution to Problem 16.1 (continued)

a. EBIT:          \$1,600        \$4,000          \$____

Interest:                 0        0                  0

Taxes:                    0        0                  0

NI:              \$____        \$4,000          \$____

EPS:               \$ .80       \$2.00           \$2.60

EPS:           -40%            ---          +30%

Vigdis Boasson                                        Mgf 301, School of Management, SUNY at Buffalo
16.19 Solution to Problem 16.1 (concluded)

b. \$70,000/2,000 shares = \$35 per share
\$35,000/\$35 = 1,000 shares bought back

EBIT:            \$1,600       \$4,000         \$5,200
Interest:          ____        ____             ____
Taxes:                    0        0                  0
NI:                \$200       \$2,600         \$3,800
EPS:              \$0.20        \$2.60           \$3.80
 EPS:        -92.31%            ---     +46.15%

Vigdis Boasson                                       Mgf 301, School of Management, SUNY at Buffalo

```
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
 views: 2 posted: 8/31/2012 language: English pages: 24
How are you planning on using Docstoc?