Ch. 16: Financial Leverage and Capital Structure Policy
Case III assumptions
-Corporate taxes, but no personal taxes -Bankruptcy costs
Bankruptcy direct costs
-Legal and administrative costs -Ultimately cause bondholders to incur additional losses -Disincentive to debt financing
•What is the primary goal of financial managers?
-Maximize stockholder wealth
Bankruptcy financial distress
-Significant problems in meeting debt obligations -Firms that experience financial distress do not necessarily file for bankruptcy
Case II - Proposition II -- Ra =
= (E/V)Re + (D/V)(Rd)(1-Tc)
CFFA =
EBIT - taxes
Financial risk
The equity risk that comes from the financial policy (the capital structure) of the firm Risk from the use of debt financing Debt holders have less risky position than equity holder because they get paid first if the co. goes bankrupt
value of equity =
Value of the firm - Value of debt
The tax benefit is only important if the firm has
a large tax liability
If we expect EBIT to be less than the break-even point, then leverage is
detrimental to our stockholders
The value of the firm is maximized when the WACC
is minimized Minimizing WACC will maximize the value of the firm's cash flows Capital structure is better if it results in a lower weighted cost of capital
At high debt levels, the possibility of financial distress is a chronic problem for the firm, so the benefits of debt financing may be
offset by the distress costs
RA
the "cost" of the firm's business risk, i.e., the risk of the firm's assets
Value of a levered firm =
value of an unlevered firm + PV of interest tax shield VL = VU + DTC
•How does financial leverage affect systematic risk? (Prop II)
•CAPM: RA = Rf + bA(RM - Rf) -Where bA is the firm's asset beta and measures the systematic risk of the firm's assets •Proposition II -Replace RA with the CAPM and assume that the debt is riskless (RD = Rf) -RE = Rf + bA(1+D/E)(RM - Rf)
Case II - Cash Flow
•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?
•Assuming perpetual cash flows in Case II - Proposition I, what is the value of the equity for a firm with EBIT = $50 million, Tax rate = 40%, Debt = $100 million, cost of debt = 9%, and unlevered cost of capital = 12%?
VU = $50M (1 - .4) / .12 = $250M VL = $250M + $100M (.4) = $290M Value = E + Debt E = VL - Debt = $290M - $100M = $190M
value of an unlevered firm =
VU = EBIT(1-T) / RU
A firm will borrow because the interest tax shield
is valuable
Valuation peaks where weighted average cost of capital reaches
its minimum
•If we expect EBIT to be greater than the break-even point, then leverage
may be beneficial to our stockholders
At relatively low debt levels, the benefit from debt...
outweighs the costs
Financial leverage
refers to the extent to which a firm relies on debt The more debt financing a firm uses in it capital structure, the more financial leverage it employs Financial leverage acts to magnify gains and losses to shareholders Financial leverage is more volatile
Business risk
riskiness of assets. What assets do I need to own to be in the business I'm in? Is the consumption of those assets volatile? Riskiness in assets based on business Depends on the systematic risk of the firm's assets Equity risk that comes from the nature of the firm's operating activities Unaffected by capital structure Whatever the riskiness of the assets is reflected in the business risk of the stock (ex. High risk if auto manufacturer/airline, etc.)
(RA - RD)(D/E)
the "cost" of the firm's financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage
unlevered cost of capital
the cost of capital for a firm that has no debt Cost of equity in an unlevered firm
Homemade leverage:
the use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed. Investors can always increase financial leverage themselves to create a different pattern of payoffs (it does not matter if the company chooses a different capital structure) To create leverage, investors borrow on their own. To undo leverage, investors must lend money. The company's structure is irrelevant
Capital Restructuring
•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 A firm can increase leverage by issuing debt and buying back outstanding shares A firm can use its cash flow from profitable operations to buy back the company's stock or retire debts to reduce leverage Capital restructurings alter the firm's existing capital structure while leaving the firm's assets unchanged
Summary of the Cases
•Case I - no taxes or bankruptcy costs -No optimal 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 •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
Break-Even EBIT
•Find EBIT where EPS is the same under both the current and proposed capital structures There is a breakeven point where above that we would be better off having a leveraged capital structure (equity) and below we do not want leverage The effect of financial leverage depends on the company's EBIT. When EBIT is relatively high, leverage is beneficial
Capital Structure Theory
•Modigliani and Miller (M&M)Theory of Capital Structure -Proposition I - firm value -Proposition II - WACC •The value of the firm is determined by the cash flows to the firm and the risk of the assets •Changing firm value -Change the risk of the cash flows -Change the cash flows
Case III
•Now we add bankruptcy costs •As the D/E ratio increases, the probability of bankruptcy increases •This increased probability will increase the expected bankruptcy costs •At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost •At this point, the value of the firm will start to decrease, and the WACC will start to increase as more debt is added Bankruptcy increases the cost of trying to attract people, legal and administrative feeds, bondholders are worried they won't get paid Its okay in theory to add debt without limit... but at some point bankruptcy costs cause this curve to bend because financial distress costs eat up all the advantage of interest deductibility of debt
Business Risk and Financial Risk
•RE = Rf + bA(1+D/E)(RM - Rf) •CAPM: RE = Rf + bE(RM - Rf) -bE = bA(1 + D/E)
Case II - Proposition II
•The WACC decreases as D/E increases because of the government subsidy on interest payments The best capital structure is 100% debt
Case II - Proposition I
•The value of the firm increases by the present value of the annual interest tax shield Under case 2, you want to increase your debt as much as possible The value of the firm increases without limit as we add more debt to the capital structure The weighted average cost of capital decreases as the debt-equity ratio increases
The Pecking-Order Theory
•Theory stating that firms prefer to issue debt rather than equity if internal financing is insufficient. Rule 1 : Use internal financing first Rule 2 : Issue debt next, new equity last Answer to why many highly profitable, large firms use little debt (this is the opposite of what we would expect because there is little risk of bankruptcy) Firms prefer to use internal financing whenever possible because selling securities can be expensive If a firm is very profitable, it might never need external financing, so it would end up with little or no debt If you try to raise money by selling equity, you run the risk of signaling to investors that the price of stocks is too high, so equity is a last resort
Case I equations
•WACC = Ra = (E/V)Re + (D/V)Rd •Re = Ra + (Ra - Rd)(D/E) We can hold half the investment in equity and half in debt (bonds) to reduce the volatility of equity (if the company made the equity riskier)
Choosing a Capital Structure
•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 The change in the value of the firm is the same as the net effect on the stockholders
•How does leverage affect the EPS and 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, then we pay our fixed cost and we have more left over for our stockholders •If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders •Leverage amplifies the variation in both EPS and ROE If we increase the leverage, it makes EPS more volatile and makes the ROE go up during good times (because we have less equity) and makes the ROE go down during hard times (because we have less net income)
Business failure
•business has terminated with a loss to creditors
technical insolvency
•firm is unable to meet debt obligations For example if a company can't pay rent right now but the landlord will let them pay it later
Value of the firm =
•marketed claims + nonmarketed claims •The overall value of the firm is unaffected by changes in capital structure •The division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions Marketed claims can be bought and sold in financial markets and the nonmarketed claims cannot be sold in financial markets The total value of all the claims to the firm's cash flows is unaltered by capital structure The optimal capital structure is one that maximizes the value of the marketed claims or, equivalently, minimizes the value of nonmarketed claims like taxes and bankruptcy costs
Reorganization
-Chapter 11 of the Federal Bankruptcy Reform Act of 1978 -Restructure the corporation with a provision to repay creditors the option of keeping the firm a going concern; it often involves issuing new securities to replace old securities. Firm restructuring of a failing firm to attempt to continue operations as a going concern. The corporation has worked out a deal with the creditors; the creditors will come to bankruptcy court and will say their new plan (creditors get to decide; firm continues to be in business). Creditors decide it is better to keep the company running than to shut it down
•Liquidation
-Chapter 7 of the Federal Bankruptcy Reform Act of 1978 (Refers to the chapter in the bankruptcy code) -Trustee takes over assets, sells them and distributes the proceeds according to the absolute priority rule -termination of the firm as a going concern. Involves selling off the assets of the firm. The proceeds are distributed to creditors in order of priority. Trustee sells your stuff
•Present value of annual interest tax shield
-Assume perpetual debt for simplicity -PV = 170 / .08 = 2,125 -PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125 2 ways to calculate PV: 1. You can take cash flow per year divided by required return 2. You can take the amount of debt times the tax rate
Case II assumptions
-Corporate taxes, but no personal taxes -No bankruptcy costs
Required return on assets = 16%; cost of debt = 10%; percent of debt = 45%, cost of equity=25% •Based on this information, what is the percent of equity in the firm?
-E/V = 1 / 2.5 = 40%
nonmarketed claims
-are the claims of the government and other potential stakeholders
Required return on assets = 16%; cost of debt = 10%; percent of debt = 45% •What is the cost of equity?
RE = 16 + (16 - 10)(.45/.55) = 20.91%
Tax claims
Squeezing down tax claim but made bankruptcy claim bigger because you issue more debt Depending upon how we arrange out capital structure bankruptcy claims and tax claims can be shrunk and expanded The more bonds you issue, the less taxes you pay to the government because your interest deduction is higher
accounting insolvency
book value of equity is negative Total book liabilities exceed the book value of total assets
legal bankruptcy
•petition federal court for bankruptcy
Indirect bankruptcy costs
-Larger than direct costs, but 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 the costs of avoiding a bankruptcy filing incurred by a financially distressed firm ex. loss of employees, loss of sales, etc.
Case I assumptions
-No corporate or personal taxes -No bankruptcy costs
•Therefore, the systematic risk of the stock depends on:
-Systematic risk of the assets, bA, (Business risk) -Level of leverage, D/E, (Financial risk)
•Annual interest tax shield
-Tax rate times interest payment -6,250 in 8% debt = 500 in interest expense -Annual tax shield = .34(500) = 170 Interest paid on debt is tax deductible (benefit of debt financing) Interest tax shield: the tax savings attained by a firm from interest expense The value of the firm increases as total debt increases because of the interest tax shield because your permanently getting more cash flow
Case I - Proposition II
-The WACC of the firm is NOT affected by capital structure The proposition that a firm's cost of equity capital is a positive linear function of the firm's capital structure. As the firm raises its debt-equity ratio, the increase in leverage raises the risk of the equity and therefore the required return or cost of equity. The cost of equity depends on: -The required rate of return on the firm's assets (Ra) -The firm's cost of debt (Rd) -The firm's debt-equity ratio (D/E)
•Risk of financial distress
-The greater the risk of financial distress, the less debt will be optimal for the firm -The cost of financial distress varies across firms and industries, and as a manager you need to understand the cost for your industry
Case I - 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 the proposition that the value of the firm is independent of the firm's capital structure. (The size of the pie doesn't depend on how its sliced--percentage of debt vs equity). The firm's overall cost of capital is unaffected by its capital structure.
•The pecking-order theory is at odds with the tradeoff theory:
-There is no target D/E ratio -Profitable firms use less debt -Companies like financial slack
marketed claims
-the claims of stockholders and bondholders
Required return on assets = 16%; cost of debt = 10%; percent of debt = 45% •Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio?
25 = 16 + (16 - 10)(D/E) D/E = (25 - 16) / (16 - 10) = 1.5
Case II - Proposition II -- Re =
=Ru + (Ru - Rd)(D/E)(1-Tc)
Bankruptcy
Bankruptcy costs is one limiting factor affecting the amount of debt a firm might use As the debt-equity ratio rises, so does the probability that the firm will be unable to pay its bondholders what was promised to them When bankruptcy happens, ownership of the firm's assets is transferred from the stockholders to the bondholders A firm becomes bankrupt when the value of assets equals the value of debt (equity is 0)