Chapter 16: Financing Leverage and Capital Structure Policy

M&M Proposition II

- the WACC of the firm is NOT affected by changes in the capital structure- focus on returns, WACC**assumes corporate tax, but no personal tax. And no bankruptcy costsrE= rA + (rA-rD) * (D/E)^^ rearranged the WACC equation (also got rid of preferred)- this equation tells us that the cost of equity capital depends on 3 things: rA, rD, D/Efirm's required return on assetsfirm's cost of debtfirm's debt-equity ratio

M&M Proposition I

- the value of the firm is NOT affected by changes in the capital structure- focus on firm value the proposition that the value of the firm is independent of the firm's capital structure aka. that it is completely irrelevant how a firm arranges its finances- the size of the pie doesn't depend on how it is sliced (size of pie represents the "value of firm")**assumes no corporate or personal tax and no bankruptcy costs

Corporate tax result

-Leverage effects firm value -Stockholders benefit from tax shield and are better off with more debt -Debt policy matters -Optimum is 100% debt meaningless conclusion

M&M, if financially policy matters it must be because of

-Taxes -Bankruptcy

Corporate borrowing conclusions

-The effect financial leverage depends on companies EBIT. When EBIT is high leverage is beneficial and the opposite is true if the EBIT is low. -Under the expected scenario leverage increases the returns to shareholders as measured by both ROE and EPS -Shareholders are exposed to more risk under the proposed capital structure because,in this case, the EPS & ROE are much more sensitive to changes in EBIT

The total systematic risk of a firm's equity has two parts. What are they?

1. Business risk 2. Financial Risk

Prop II What are the three determinants of a firm's cost of equity?

1. the required rate of return on the firm's assets - Ra 2. the firms cost of debt - Rd 3. the firm's debt-equity ratio - D/E Formula RE = RA + (RA - RD) * (D/E)

interest tax shield

Annual interest tax sheild equals tax rate times interest payment

Case III (Taxes & Bankruptcy Cost)

As the debt to equity ratio increases, the probability of bankruptcy increases - more debt, more bankruptcy risk -This increase probability will increase the expected bankruptcy cost -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

Present value of an interest tax shield

Assume perpetual debt for simplicity The value of the firm, increases by the present value of the annual interest tax shield PV of interest tax shield = Tc x D VL = VU + DTc

Bankruptcy process

Business failure legal bankruptcy technical insolvency accounting insolvency

How do we choose which Capital Structure (debt-equity ratio) is better?

Choose the structure with the lowest WACCAlso, called the optimal capital structure

eminem case 2 conclusions

Corporate taxes but no bankruptcy cost, optimal capital structure is almost 100% debt each dollar of debt increases the cash flows of the front

Eminem case III conclusion

Corporate taxes in bankruptcy cost optimal capital structure is part dectin part equity occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy cost

M & M Prop I

Debt irrelevance Capital Structure decisions have no effect on firm value -leverage has no effect on Vfirm -Investors can obtain own risk through homemade leverage -Stockholders are no better off -Vl = Vu

Cost of Financial Distress

Direct costs: legal and administrative cost Indirect costs: impaired ability to conduct business law sales compromise supply chain

EPS Formula

EPS = net income / shares outstandingNet income = EBIT - Interest

What is the impact of financial leverage on stockholders?

Financial leverage directly will impact on the pay-off of the stockholders. If the firm uses more debt financing in its capital structure, then the firm employs more financial leverage. firms' earnings are good. higher losses for stockholders.

M & M Prop 1 (with taxes)

Firm value increases with leverage, space for perpetual debt formula

M&M theory of capital structure

Firm value is determined by the cash flow to the firm in the risk of the assets, Change in firm value is a result of change in risk of cash flows

Capital structure theory

H one dash no corporate or personal taxes no bankruptcy cost case 2 corporate taxes but no case 3 corporate taxes bankruptcy cost

In an All equity Firm

In an all equity firm,rE = rA because WACC = rA = (E/V)rE + (D/V)rDrA = 1 x rE + 0x0rA is the "cost" of the firm's business risk. (systematic risk)(rA-rD)(D/E) is the financial risk premium to shareholders when a firm levers up (compensating them for the risk)

Capital structure in firm value with taxes

Interest payments are tax deductible but dividend payments or not -So more debt than equity is best -The value of cash flows paid in taxes decreases as leverage is increased by reducing the fraction paid in taxes leverage therefore increases the value of firm

Prop II (No Taxes) Benefit of Debt

Interest tax sheild - can deduct interest payments but not dividends -Less Costly to distribute interest than dividends -Amount deducted: D x T = Vtax savings debt (PV of it)

Under the pecking-order theory, what is the order in which firms will obtain financing?

Internal, Debt, Equity

M&M Case II Prop II

Is WACC decreases as debt to equity ratio increases because of government subsidy on interest payment RA (WACC) = (E/V)RE + (D/V)(RD)(1-Tc) RE = Ru + (Ru - RD)(D/E)(1-Tc)

What does M&M Proposition I state?

It is completely irrelevant how a firm chooses to arrange its financesAssets of two identical companies will be valued the same no matter what the debt to equity ratio the size of the pie doesn't depend on how it is sliced

M&M Prop 2 (Case 1 no taxes)

Leverage increases the risk and return to stock holders formula RE = RA + [ (RA-RD) x D/E] RE (Return on unlevered equity [cost of equity]) RA:

M & M prop 1 (with taxes)

Market value of debt + market value of equity must equal the value of the cash flows produced by the firms assets. -The capital structure decisions a firm makes will have no effect on the value of the firm, same pie -Under proper conditions debt should be irrelevent -Vu = Vl -Vfirm = V assets = V debt + V equity -We can create a levered or unlevered position by adjusting the trading in our own account this homemade leverage suggested capital structure is irrelevant in determining the value of the firm

What is the relationship between the value of an unlevered firm and the value of a levered firm once we consider the effect of corporate taxes?

Modigliani-Miller Proposition I states that, in the absence of taxes, the value of a levered firm equals the value of an otherwise identical unlevered firm. Since Levered is identical to Unlevered in every way except its capital structure and neither firm pays taxes, the value of the two firms should be equal.

Chapter 11 Bankruptcy (Reorganization)

Most common restructure the corporation with a provision to repay creditors

ROE

Net income/ total equity

M&M Case I Conclusions:

No taxes or bankruptcy costs no optimal capital struck

more debt means more risk to shareholders because...

PS and ROE are much more sensitive to changes in EBIT in this case

Present Value of an Interest Tax Sheild

Present value of the interest tax shield==(TC × D × RD)/RDTC × D

M&M Prop I and II (with taxes)

Prop 1 -Firm value increases with leverage (Debt is good) Prop 2 -Rise in equity risk/return offset by tax sheild

Solve for cost of equity capital

RE = RA + (RA − RD) × (D/E)

Chapter 7 Bankruptcy (Liquidation)

Rusty is appointed to take over assets sell them and distribute the process to the absolute priority rule

M & M Prop II (with taxes)

Some of the increase in equity risk in return is offset by the interest tax shield formula

A levered firm pays less --- than an all equity firm

Taxes

Factors in target debt to equity ratio

Taxes since interest is tax deductible highly profitable firm should use more day types of asset the cost of financial distress depends on the types of assets a firm has uncertainty of operating income even without debt firms with uncertain operating income have a high probability of experiencing financial distress pecking order in financial slack theory that firfer to issue debt rather than equity of internal financing is insufficient

Business Failure

Terminated with loss to creditors

Risk of financial distress

The greater the risk of financial distress the less debt will be optimal for the first the cost of financial distress varies across firms and industries in as a manager you need to understand the cost for your into

What is the relationship between the WACC and the value of the firm?

The relationship between the WACC and the value of the firm is, if the WACC is minimized then the firm value will be maximized. The weighted average cost of capital is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.

managerial recommendations

The tax benefit is only important if the firm has a large tax liability

What is homemade leverage?

The use of personal borrowing to alter the degree of financial leverageshareholders can adjust the amount of financial leverage by borrowing and lending on their own

The value of the firm

The value of the firm equals marketed claims versus non marketed claims marketing claims in the claims of stockholders and bondholders non marketed claims are the claims of the government in other potential steakhouse the overall value of the firm is unaffected by changes in capital structure in between marketed claims in non marketing claims may be impacted by capital structure decision

Why should financial managers choose the capital structure that maximizes the value of the firm?

The value of the firm is maximized when the WACC is minimized

Packing order theory

Theory that firms prefer to issue debt rather than acquittee if internal financing is sufficient insufficient will one use financing first roll 2 issue debt next new equity lossed the pecking order theory is at odds with the tradeoff theory there is no target deck to equity ratio do you lestat companies like financial slack

Tax affects and financial distress

There is a trade off between the tax advantage of debt & the cost of financial distress It is difficult to express this with the precise rigorous formula

Value of Levered Company

VL = VU + TC * D

Value with prop I

Value of Levered firm, VL, exceeds the value of unlevered firm by the present value of the interest tax shield (Tc *D)

Cost of Financial Distress on Value of levered firm

Vl = Vu + PV tax sheild - financial distress

WACC formula

WACC = (E/V) × RE + (D/V) × RD

Default

Where Fern feels to make the required interest and principle payments on debt or violates a debt covenant after the firm defaults debt holders are given certain rights the assets of the firm and they even take legal ownership of the firm's assets through bankrupt

accounting insolvency

book value of equity is negative (-net worth)

Technical Insolvency

firm is unable to meet debt obligations

Proposition II with taxes....

implies that a firm's cost of capital (rE) increases as the firm relies more heavily on debt financing- because of financial risk

What is WACC?

is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted.All sources of capital, including common stock, preferred stock, bonds and any other long-term debt

Chapter 11

reorganization, must be voted on

Interest Tax Shield

tax saving attained by a firm from interest expense

What is an optimal capital structure?

the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

Financial distress

when a firm has difficulty meeting its debt obligations

A primary reason for studying the WACC is that the value of the firm is maximized

when the WACC is minimized.

What is the impact of financial leverage on stockholders?

A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share. Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure.

Relationship between EBIT and financial leverage

The effect of financial leverage depends on the company's EBIT.When EBIT is relatively high, leverage is beneficial.