Chapter 16: Financial Leverage and Capital Structure Policy.
Indirect bankruptcy costs:
The costs of avoiding a bankruptcy filing incurred by a financially distressed firm.
When is the value of the firm maximized?
-When the WACC is minimized.
How can you increase the debt-equity ratio?
By issuing some bonds and using the proceeds to buy back some stock.
What happens as the debt-equity ratio rises?
The probability that the firm will be unable to pay its bondholders what it promised them also rises. -A firm becomes bankrupt when the value of its assets = the value of its debt. The value of equity is 0. -Because of the expenses associated with bankruptcy, bondholders will not get all that they are owed.
What does M&M Proposition I with taxes state?
Vl = Vu + Tc x D. -The value of the firm increases as total debt increases because of the interest tax shield. -A firm's WACC decreases as the firm relies more heavily on debt financing.
What is the break-even point?
Where the firm earns a return that is just sufficient to pay the interest. -Any point above it, financial leverage will increase EPS.
What is the equation for ROE?
ROE = Net Income / Total Equity.
M&M Proposition II:
Re = Ra + (Ra - Rd) x (D/E). -(Ra - Rd) is the slope. -The y-intercept corresponds to a firm with a debt-equity ratio of 0. -The WACC is the same no matter what the debt-equity ratio is.
M&M Proposition II with corporate taxes...
Re = Ru + (Ru - Rd) x (D/E) x (1 - Tc). -A firm's cost of equity rises as the firm relies more heavily on debt financing.
Key observation:
The change in the value of the firm is the same as the net effect on the stockholders. -The change in the value of the overall firm is the NPV of a re-structuring.
What is M&M Proposition I?
The value of the firm is independent of the firm's capital structure.
What is the interest tax shield?
-Tax savings = to the interest payment multiplied by the corporate tax rate. -PV of the interest tax shield = Tc x D.
Unlevered cost of capital:
-The cost of capital for a firm that has no debt. -Vu = EBIT x (1 - Tc) / Ru.
What is business risk?
-The equity risk that comes from the nature of the firm's operating activities. -Depends on the systematic risk of the firm's assets. -Business risk depends on the firm's assets and operations and is unaffected by capital structure. -Business risk determines Ra.
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 might not affect the overall cost of capital. -Financial leverage acts to magnify gains and losses to shareholders.
Corporate Borrowing and Homemade Leverage:
1. The effect of financial leverage depends on the company's EBIT. WHEN EBIT IS RELATIVELY HIGH, LEVERAGE IS BENEFICIAL. 2. Under the expected scenario, leverage increases 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. -Shareholders can adjust the amount of financial leverage by borrowing and lending on their own. This use of personal borrowing to alter the degree of financial leverage is called HOMEMADE LEVERAGE.
There is nothing special about corporate borrowing because investors can borrow or lend on their own.
As a result, whichever capital structure a firm chooses, THE STOCK PRICE WILL BE THE SAME.
How can you reduce the debt-equity ratio?
By issuing stock and using the money to pay off some debt. -The assets of a firm are not directly affected by a capital restructuring. -A firm can consider capital restructuring decisions in isolation from its investment decisions.
Financial risk:
For an all-equity firm, (Ra - Rd) x D/E would be 0. -As the firm begins to rely on debt financing, the REQUIRED RETURN ON EQUITY RISES. -The extra risk that arises from the use of debt financing is called the financial risk of the firm's equity. -Financial risk id determined by D/E.