Lecture Essentials of corporate finance (2/e) – Chap 13: Leverage and capital structure

In this chapter you will 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 bankruptcy.

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Leverage and capital

structure

Chapter 13

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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

bankruptcy

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Chapter outline

• The capital structure question

• The effect of financial leverage

• Capital structure and the cost of equity

capital

• Corporate taxes and capital structure

• Bankruptcy costs

• Optimal capital structure

• Observed capital structures

• A quick look at the bankruptcy process

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PPTs t/a Essentials of Corporate Finance 2e by Ross et al.

Slides prepared by David E Allen and Abhay K Singh

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Capital structure

• Capital structure—percentage of debt

and equity used to fund the firm’s

assets

– ‘Leverage’ = use of debt in capital

structure

• Capital restructuring—changing the

amount of leverage 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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Capital structure and shareholder wealth

• What is the primary goal of financial

managers?

– To maximise shareholder wealth

• We want to choose the capital structure that will maximise shareholder wealth.

• We can maximise shareholder wealth

by maximising firm value or minimising WACC.

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The effect of financial

leverage

• How does leverage affect the earnings per

share (EPS) and return on equity (ROE) of a

firm?

• When we increase the amount of debt

financing, we increase the fixed interest

expense.

• If we have a really good year, we pay our fixed costs and we have more left over for our

shareholders.

• If we have a really bad year, we still have to

pay our fixed costs and we have less left over for our shareholders.

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Financial leverage, EPS and

ROE example—Table 13.1

• We will ignore the effect of taxes at this stage.

• What happens to EPS and ROE when we issue debt and buy back shares?

• Eagles Air Services

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Table 13.1

Current Proposed Assets $8,000,000 $8,000,000

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Eagles Air Services

Capital structure scenarios—Table

Current Capital Structure: No Debt

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Financial leverage, EPS and

– Current: EPS ranges from $1.25 to $3.75

– Proposed: 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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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 shareholders.

• If we expect EBIT to be less than the

break-even point, then leverage is

detrimental to our shareholders.

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Break-even EBIT—Example

EPS = for both capital structures

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$2.00 400,000

800,000 EPS

$800,000 EBIT

800,000 EBIT

2 EBIT

400,000

EBIT 200,000

400,000 EBIT

200,000

400,000

EBIT 400,000

EBIT

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Break-even EBIT (cont.)

• 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,

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Eagle Air Services—

Conclusion

1.T

he effect of leverage depends on EBIT:

When EBIT is higher, leverage is beneficial.

1.U nder the ‘expected’ scenario, leverage

increases ROE and EPS.

2.S hareholders are exposed to more risk

with more leverage.

ROE and EPS more sensitive to changes in

EBIT.

4 Capital structure is an important

consideration owing to the impact of

financial leverage.

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Homemade leverage and ROE

—Example

• Homemade leverage

– The use of personal borrowing to change the overall amount of

financial leverage to which the individual is exposed.

Conclusion:

• Any stockholder who prefers leverage can create their own

‘homemade’ leverage and replicate the payoffs.

• Eagle Air Services’ capital structure is irrelevant to

shareholders.

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Capital structure theory

• Modigliani and Miller

– M&M Proposition I—The pie model

– M&M Proposition II—WACC

• The value of the firm is determined by the cash flows to the firm and the risk of the

firm’s assets.

• Changing firm value

– Change the risk of the cash flows

– Change the cash flows

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Capital structure theory

Three special cases

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Case I—Propositions I and

II

• 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.

• Proposition II

– The WACC of the firm is NOT affected by capital structure.

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Case I—Equations

• WACC = R A = (E/V)R E + (D/V)R D

• R E = R A + (R A – R D )(D/E)

– R A is the ‘cost’ of the firm’s business risk,

i.e the risk of the firm’s assets.

– (R A – R D )(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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M&M Propositions I and II

Figure 13.3

• The change in the capital structure weights (E/V and D/V)

is exactly offset by the change in the cost of equity (RE),

so the WACC stays the same

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The CAPM, the SML and

Proposition II

• How does financial leverage affect

systematic risk?

• CAPM: R A = R f + A (R M – R f )

– Where A is the firm’s asset beta and

measures the systematic risk of the firm’s

assets.

• Proposition II

– Replace R A with the CAPM and assume that

the debt is riskless (R D = R f ).

– R E = R f + A (1+D/E)(R M – R f ) 13-21

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Business risk and financial

risk

• R E = R f + A (1+D/E)(R M – R f )

• CAPM: R E = R f + E (R M – R f )

– E = A (1 + D/E)

• Therefore, the systematic risk of the

share depends on:

– Systematic risk of the assets, A (business risk)

– Level of leverage, D/E (financial risk)

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Case II—Corporate taxes

• Interest on debt is tax deductible.

• When a firm adds debt, it reduces

taxes, all else being equal.

• The reduction in taxes increases the

cash flow of the firm.

• The reduction in taxes reduces net

income.

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Case II—Example

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Interest tax shield

• Annual interest tax shield

– Tax rate times interest payment

– 6250 in 8% debt = 500 in interest expense – Annual tax shield = 30(500) = 150

• Present value of annual interest tax

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Case II—Proposition I

• The value of the firm increases by the

present value of the annual interest tax

shield.

– Value of a levered firm = value of an

unlevered firm + PV of interest tax shield.

– Value of equity = Value of the firm – Value of

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Case II—Proposition I

(cont.)

• Data

– EBIT = $25 million; tax rate = 30%; debt =

$75 million; cost of debt = 9%; unlevered

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M&M Proposition I with taxes

Figure 13.4

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Case II—Proposition II

• The WACC decreases as D/E increases

because of the government subsidy on

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Case II—Proposition II

(cont.)

• 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?

– R E = 12 + (.12 - 09)(1)(1-.35) = 13.95%

• What will happen to the weighted

average cost of capital?

– R A = 5(.1395) + 5(.09)(1-.35) = 9.9%

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Illustration of Proposition II

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M&M summary

Table 13.4

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M&M summary

Table 13.4 (cont.)

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Bankruptcy costs

• Direct costs

– Legal and administrative costs

• Enron = $1 billion; WorldCom = $600 million

– Bondholders incur additional losses

– Disincentive to debt financing

• Financial distress

– Significant problems meeting debt

obligations

– Most firms that experience financial

distress do not ultimately file for

bankruptcy

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Indirect bankruptcy costs

• Indirect bankruptcy costs

– Larger than direct costs, but more difficult to

measure and estimate

– Stockholders wish to avoid a formal bankruptcy

– 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

– Lost sales, interrupted operations, loss of

valuable employees, low morale, inability to

purchase goods on credit

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Case III

With bankruptcy costs

•  D/E ratio → probability of

bankruptcy

•  probability → expected

bankruptcy costs

• At some point, the additional value of

the interest tax shield will be offset by

the expected bankruptcy costs.

• At this point, the value of the firm will

start to decrease and the WACC will

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Optimal capital structure

Figure 13.5

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• Case I—no taxes or bankruptcy costs

– No optimal capital structure

• Case II—corporate taxes but no bankruptcy costs

– Optimal capital structure = 100% debt

– Each additional dollar of debt increases the cash flow of the firm

• Case 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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The capital structure question

Figure 13.6

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Observed capital structures

• Capital structure differs by industry

• Utilities classification—Envestra—398.9% debt

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Example: Work the Web

• You can find information about a

company’s capital structure relative to

its industry and sector using industry

centre or sector analysis through

Yahoo! Finance.

• Click on the information icon to go to

the site

– Choose a company and get a quote

– Perform sector and industry comparisons

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Bankruptcy process

• 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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Liquidation and reorganisation

• Companies Act 1993 and the Liquidation

Regulations 1994.

• Process

– A petition is filed in a federal court A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation by several of its creditors – An administrator is appointed by the court or the

creditors to take over the assets of the debtor The

administrator will attempt to liquidate the assets.

– When the assets are liquidated, after payment of the

bankruptcy administration costs, the proceeds are

distributed among the creditors.

– If any proceeds remain, after expenses and payments

to creditors, they are distributed to the shareholders.

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Liquidation and reorganisation

(cont.)

• The distribution of liquidation proceeds is made according

to section 556 of the Australian Government Corporations Law

• Brief priority list (absolute priority rule)

– 1 Administrative expenses associated with the bankruptcy.

– 2 Other expenses arising after the filing of a bankruptcy petition, but before the

– 7 Payment to unsecured creditors.

– 8 Payment to preference shareholders.

– 9 Payment to ordinary shareholders.

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Quick quiz

• Explain the effect of leverage on EPS and

ROE.

• What is break-even EBIT?

• How do we determine 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 reorganisation?

• What are the direct and indirect costs of

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