Financial Leverage and Capital Structure Policy C H A P T E R 16

Financial Leverage and Capital Structure Policy C H A P T E R 16

Capital Restructuring What is meant by capital restructuring What is the primary goal of financial managers? Can leverage help in achieving such goals?

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 The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt

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 the value of the firm or minimizing the WACC

Financial Leverage The extent to which a firm relies on debt The more debt financing a firm uses in its capital structure, the more financial leverage it employs

Financial leverage, EPS, and ROE: an example Review the example in word file CH16

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

Ex 1 Page 569 (SOLUTION IN WORD CH16) Maynard, Inc., has no debt outstanding and a total market value of 250,000 . EBIT are projected to be 28,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 50 percent lower. Maynard is considering a 90,000 debt issue with a 7 percent interest rate. The proceeds will be used to repurchase a share of stock. There are currently 5,000 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 the economy goes with recapitalization. What do you observe?

Ex 4 Page 542 James Corporation is comparing two different capital structures: an all equity plan (plan I) and a levered plan (plan II). Under plan I, the company would have 160,000 shares of stock outstanding. Under plan II, there would be 80,000 shares of stock outstanding and 2.8 million in debt outstanding. The interest rate on the debt is 8 percent and there are no taxes. A. If EBIT is 350,000 , which plan will result in the higher EPS? B. If EBIT is 500,000 , which plan will result in the higher EPS? C. What is the break-even EBIT?

Corporate borrowing & home made leverage 1. The effect of leverage depends on the company’s EBIT. When EBIT is relatively high, leverage is beneficial 2. Under the expected scenarios, leverage increase the returns to shareholders, as measured by both ROE and EPS 3. 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 4. Because of the impact that financial leverage has on both the expected return to stockholder and the riskiness of the stock, capital structure is an important consideration

Corporate borrowing & home made leverage Homemade leverage: the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed. REVIEW THE WORD CH16 EXAMPLE ON HOMEMADE LEVERAGE.

Corporate borrowing & home made leverage Proposed capital structure expansion expected recession 5.5 3 0.5 EPS 550 300 50 Earnings for 100 shares Original capital structure and homemade leverage 3.75 2.5 1.25 EPS 750 500 250 Earnings for 200 shares 200 200 200 Less: interest on 2,000 at 10% 550 300 50 Net earnings

Ex 9 Page 543 ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with 600,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth 300,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be 80,000 A. Rico owns 30,000 worth of XYZ’s stock. What rate of return is he expecting? B. Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage?

Capital Structure Theory Modigliani and Miller (M&M)Theory of Capital Structure Proposition I (no taxes): the value of the firm is independent of the firm’s capital structure The value of the firm is NOT affected by changes in the capital structure. Which means the value of a levered firm (VL) is equal to the unlevered firm VU (VL VU) The cash flows of the firm do not change; therefore, value doesn’t change (THE PIE MODEL) A firm’s WACC is the same no matter what mixture of debt and equity is used to finance the firm.

Capital Structure Theory We want to see what happens when we the debt equity ratio in a firm is changed (ignoring taxes). Since WACC required rate of return on firms assets WACC RA . And when we put RE in one side we will have: RE RA (RA – RD)(D/E) We know as a fact that the cost of debt is lower than the cost of equity. However, this change is offset by the increase in the cost of equity from borrowing.

Proposition II (no tax) RE RA (RA – RD)(D/E) The firm’s cost of equity capital is a positive linear function of the firm’s capital structure The cost of equity depends on three things: WACC or RA, cost of debt, and D/E debt equity ratio. Implications II The cost of equity rises as the firm increases its use of debt .financing :The risk of equity depends on two things A. the riskiness of the firm’s operations(Business risk)and this .risk determines RA .B. financial risk and it is determined by D/E

Capital Structure Theory

Example Required return on assets 16%(same as WACC 16%) cost of debt 10%; debt 45% (tax is ignored) What is the cost of equity? RE RA (RA – RD)(D/E) )45/55()0.16-0.10( 0.16 Re 20.9% Suppose instead that the cost of equity is 22%, what is the debt-to-equity ratio? RE RA (RA – RD)(D/E) )D/E( 0.06 0.16 0.22 )D/E( 0.06 0.16- 0.22 )D/E( 0.06 0.06 D/E 1 Based on this information, what is the percent of equity in the firm? 50%

M & M proposition I and II with corporate taxes Example page 547 Firm L Firm U 1,000 1,000 EBIT 80 0 I 920 1,000 Taxable income 276 300 Taxes (30%) 644 700 NI

M & M proposition I and II with corporate taxes Firm L Firm U CFFA ooo,1 ooo,1 EBIT 276 300 Taxes 724 700 total We see from the result that capital structure has some effect because the cash flow from U and L is not the same, even thought the two firms have identical assets. Firm L Firm U Cash flow 644 700 To stock holder 80 0 To bond holder 724 700 total The fact that interest is deductible for tax purposes has generated a tax saving interest payment ( 80) * tax rate (0.30) 24 interest tax shield

M & M proposition I and II with corporate taxes 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?

M & M proposition I with taxes

M & M proposition I and II with corporate taxes Debt has two features that we haven’t talked about in M&M Proposition I& II (with tax ignored): 1. interest paid on debt is tax deductible.(good for a firm) 2. failure to meet debt obligations can result in bankruptcy. (not good for a firm). Interest tax shield: the tax saving attained by a firm from interest expense Proposition I with taxes: Value of a levered firm value of an unlevered firm PV of interest tax shield VL VU DTC (page 548) Implications of proposition I: .Debt financing is highly advantageous .1 A firm WACC decreases as the firm realize more heavily on debt financing .2

Example EBIT 25 million; Tax rate 35%; Debt 75 million; Cost of debt 9%; Unlevered cost of capital 12% Calculate the PV of VU, VL? VU EBIT * (1- Tc)/ RU 25,000,000*(1-0.35)/ 0.12 135,416,666.7 The value of levered firm VL VU Tc*D 135,416,666.7 (0.35*75,000,000) 161,666,666.7

M&M proposition II with tax :Proposition II with tax RE RU (RU-RD) (D/E) (1-Tc) RU unlevered cost of capital or cost of capital of .firm with no debt :Implications of proposition II (with tax) cost of equity rises as the firm increases its use of debt .financing :The risk of equity depends on two things A. the riskiness of the firm’s operations(Business risk)and this .risk determines RA .B. financial risk and it is determined by D/E

Proposition II with taxes

Ex 10 Page 571 Wood Crop. Uses no debt. The WACC is 9 percent. If the current market value of the equity is 23 million and there are no taxes, what is EBIT? With no taxes, the cost of capital of unlevered firm is the cost of equity which can be used as a discount rate for the firm’s value. VU EBIT/WACC 23,000,000 EBIT/0.09 EBIT 0.09 ( 23,000,000) EBIT 2,070,000

Ex 11 Page 543 In the previous question suppose that corporate tax rate is 35 percent. What is EBIT? What is the If there are corporate taxes, the WACC? Explain?firm is: value of unlevered VU EBIT (1-tc)/ RU EBIT: 23,000,000 EBIT (1-.35)/0.09 EBIT 3,184,615.38 WACC still the same 9%

Ex 14 Page 543 Frederick & Co. expects its EBIT to be 92,000 every year for ever. The firm can borrow at 9 percent. Frederick currently has no debt, and its cost of equity is 15 percent. If the tax rate is 35 percent, what is the value of the firm? What will the value be if the company borrows 60,000 and uses the proceeds to repurchase shares? :The value of the unlevered firm is VU EBIT(1 – tC)/RU VU 92,000(1 – .35)/.15 VU 398,666.67 :The value of the levered firm is VL VU tCD VL 398,666.67 .35( 60,000) VL 419,666.67 .b

Ex 15 Page 544 In problem 14, what is the cost of equity after recapitalization? What is the WACC? What are the implications for the firm’s capital structure decision? We can find the cost of equity using M&M Proposition II with taxes. Doing so, we find: RE RU (RU – RD)(D/E)(1 – t) RE .15 (.15 – .09)( 60,000/ 398,667)(1 – .35) RE .1565 or 15.65% Using this cost of equity, the WACC for the firm after recapitalization WACC (E/V)RE (D/V)RD(1 – tC)is: WACC .1565( 398,667/ 419,667) .09(1 – .35)( 60,000/ 419,667) WACC .1425 or 14.25%

Bankruptcy Costs Direct costs Legal and administrative costs Ultimately cause bondholders to incur additional losses Disincentive to debt financing Financial distress Significant problems in meeting debt obligations Firms that experience financial distress do not necessarily file for bankruptcy

Bankruptcy Costs Indirect bankruptcy costs Indirect cost are more difficult to measure and estimate Stockholders want 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 The firm may also lose sales, experience interrupted operations and lose valuable employees

Optimal Capital Structure Static theory of capital structure This theory says that firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased .probability of financial distress Illustration to the next figure of the value of the firm First line (yellow), represent M&M proposition I with No tax (straight line) Next line (blue), represent M&M proposition I with tax. (Upward slopping straight line) Third line (red), represent the static theory of capital structure or the optimal capital structure(the value of the firm rises to a maximum and then decline beyond .that point At the maximum value of the firm VL* is reached at D* which means the optimal .amount of borrowing The difference between the value of the firm in static theory and M&M value of the firm with tax is the loss in value from the possibility of financial distress

Optimal Capital Structure The static theory of capital structure:

Optimal Capital Structure We know that the capital structure that maximizes the value of the firm is the one that minimize the .cost of capital Next figure represent the WACC line which .correspond to the static theory Decline at first because the after tax cost of debt is o .cheaper than cost of equity However, at some point the cost of debt begins to rise, o and the fact that debt is cheaper than equity is offset by .the financial distress cost o .*Minimum WACC occurs at D/E

Optimal Capital Structure and the cost of capital

Conclusions Case I – no taxes or bankruptcy costs No optimal capital structure The value of the firm and its WACC are not affected by capital structure. Case II – corporate taxes but no bankruptcy costs Optimal capital structure is almost 100% debt Each additional dollar of debt increases the cash flow of the firm WACC decreases as much as the amount of debt goes up. 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

Managerial recommendations Taxes o The tax benefit from leverage is important only to firm that are in a tax paying position. o Firm with accumulated losses will get little value from the interest tax shield. o The higher the tax rate, the greater the incentive to borrow. Financial distress o the greater the volatility in EBIT, the less a firm should borrow. In other words, firms with greater risk of experiencing financial distress, will borrow less than other firms.