Lecture Essentials of corporate finance - Chapter 13: Leverage and capital structure

Chapter 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.

Leverage and Capital Structure

Chapter 13

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

affect the value of the firm, all else equal

leverage a firm has without changing the firm’s assets

outstanding shares

outstanding debt

Choosing a Capital Structure

• What is the primary goal of financial managers?

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

• We can maximise shareholder wealth by

maximising firm value or minimising WACC

The Effect of Leverage

the fixed interest expense

we have more left over for our shareholders

costs and we have less left over for our shareholders

• We will ignore the effect of taxes at this stage

• What happens to EPS and ROE when we issue

debt and buy back shares?

Financial Leverage Example

• Variability in EPS

• The variability in both ROE and EPS increases

when financial leverage is increased

• 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

Example: Break-Even EBIT

$2.00400,000

800,000EPS

$800,000EBIT

800,0002EBIT

EBIT

400,000

EBIT200,000

400,000EBIT

200,000

400,000

EBIT400,000

EBIT

Break­even Graph

Example: Homemade Leverage and ROE

• Current Capital Structure

– Investor borrows $2000

and uses $2000 of their

own to buy 200 shares

purchasing 100 shares

from the firm under the

proposed capital structure

• Proposed Capital Structure

– Investor buys $1000 worth of shares (50 shares) and $1000 worth

of Trans Am bonds paying 10%.

Capital Structure Theory

• Modigliani and Miller Theory of Capital Structure

– Proposition I – firm value

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

• Changing firm value

Capital Structure Theory Under Three

• Case III – Assumptions

Case I – Propositions I and II

Figure 13.3

The CAPM, the SML and Proposition

II

• How does financial leverage affect systematic risk?

• CAPM: RA = Rf + A(RM – Rf)

systematic risk of the firm’s assets

• Proposition II

riskless (RD = Rf)

– RE = Rf + A(1+D/E)(RM – Rf)

Business Risk and Financial Risk

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

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

Case II – Cash Flows

• Interest is tax deductible

• Therefore, when a firm adds debt, it reduces taxes, all else equal

• The reduction in taxes increases the cash flow of the firm

• How should an increase in cash flows affect the

value of the firm?

Interest Tax Shield

• Annual interest tax shield

• Present value of annual interest tax shield

– PV = D(RD)(TC)/RD = DTC = 6250(.30) = 1875

Case II – Proposition I

• The value of the firm increases by the present

value of the annual interest tax shield

of interest tax shield

• Assuming perpetual cash flows

– VU = EBIT(1-T)/RU

– VL = VU + DTC

Case II – Proposition I Cont.

• Data

Cost of debt = 9%; Unlevered cost of capital = 12%

• VU = 25(1-.30) / 12 = $145.83 million

• VL = 145.83 + 75(.30) = $168.33 million

• E = 168.33 – 75 = $93.33 million

Figure 13.4

Case II – Proposition II

• The WACC decreases as D/E increases because

of the government subsidy on interest payments

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?

– 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%

Illustration of Proposition II

Case III

Bankruptcy Costs

• Direct costs

• Financial distress

ultimately end up in bankruptcy

More Bankruptcy Costs

estimate

can at least receive that money

about avoiding bankruptcy instead of running the

business

valuable employees

Figure 13.5

= Value of firm with debt

the firm

– Optimal capital structure is part debt and part equity

is just offset by the increase in expected bankruptcy costs

Figure 13.6

Additional Managerial Recommendations

• Risk of financial distress

– The greater the risk of financial distress, the less debt will

be optimal for the firm

industries and as a manager you need to understand the cost for your industry

• Dividend imputation has a bearing on the use of debt and it will depend if the firm’s shareholders are able to use the franking credits

Observed Capital Structure

• Capital structure does differ by industry

Quick Quiz

• Explain the effect of leverage on EPS and ROE

• What 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

reorganisation?