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02/03/2013

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Chapter 13

Leverage and Capital Structure

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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter Outline
• • • • • • The Capital Structure Question The Effect of Financial Leverage Capital Structure Theory: Case I, II &III Corporate Taxes and Capital Structure Bankruptcy Costs Optimal Capital Structure

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Capital Structure
• Decision on how to raise the funds? – Issue Equity Securities – Issue Debt Securities • What is the primary goal of financial managers? – Maximize stockholders’ wealth • We want to choose the capital structure that will maximize stockholder wealth by either: – maximizing firm value or – minimizing WACC
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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 • Increase leverage by issuing debt and repurchasing outstanding shares • Decrease leverage by issuing new shares and retiring outstanding debt
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The Effect of Leverage
• 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
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Financial Leverage, EPS and ROE
• What happens to EPS and ROE when we issue debt and buy back shares of stock? • We will ignore the effect of taxes at this stage • Example: Refer to Table 13.1, 13.2 (pg 406)

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Financial Leverage, ROE and EPS
Current Assets $8 mil Debt 0 Equity $8 mil Debt equity ratio 0 Share price $20 Shares outstanding 400k Proposed $8 mil $4 mil (at 10% interest) $4 mil 1 $20 200k

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Current capital structure (No debt) Proposed capital (D=$4mil) Equity=$8mil, o/shares=400k Equity=$4mil, o/shares=200k Bad Normal Good Bad Normal Good EBIT 500k 1mil 1.5mil 500k 1mil 1.5mil

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Example: Financial Leverage, EPS and ROE
• Variability in ROE – Current: ROE ranges from 6.25% to 18.75% – Proposed: ROE ranges from 2.50% to 27.50% • Variability in EPS – Current: EPS ranges from $1.25 to $3.75 – Proposed: EPS ranges from $0.50 to $5.50 • The variability in both ROE and EPS increases when financial leverage is increased. IOW, Leverage amplifies the variation in both EPS and ROE
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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
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Example: Break-Even EBIT
EPS (Current) = EPS (Proposed)

EBIT EBIT −interest = shares outstanding shares outstanding

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Homemade Leverage

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Homemade leverage: use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed ==>capital structure is irrelevant • Company: Current capital structure (all equity) • Investor prefers the payoff under proposed capital struc. ===> levered (buy more shares by borrowed funds and pay interest) • Company: Proposed capital structure (equity + debt) • Investor prefers the payoff under current capital struc. ===> unlevered (sell shares and lend out the proceeds to earn interest)
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Homemade Leverage-Example

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Example: company is under current capital structure. An investor is owning 100 shares but prefers the payoffs under proposed capital structure • Current Capital Structure==> Proposed Capital Structure (levered)

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Example: Homemade Leverage
Example: company use proposed capital structure. An investor is owning 100 share but prefers the payoffs under current capital structure • Proposed Capital Structure==> Current Capital Structure (unlevered)

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Capital Structure Theory
• Modigliani and Miller (1958) 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
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Capital Structure Theory Under Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes – No bankruptcy costs

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• Case II – Assumptions
– Corporate taxes, but no personal taxes – No bankruptcy costs

• Case III – Assumptions
– Corporate taxes, but no personal taxes – Bankruptcy costs
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Case I – No Taxes & No Bankruptcy costs
• Proposition I (firm value = V)
– The value of the firm is NOT affected by changes in the capital structure... due to the cash flows of the firm do not change.

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• Proposition II (cost of capital = WACC)
– The WACC of the firm is NOT affected by capital structure

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Case I - Equations
• Prop I: Vu = EBIT/Ru VL = Vu • Prop II: RE = Ru + (Ru – RD)(D/E) RE = RA + (RA – RD)(D/E) WACC = RA = (E/V)RE + (D/V)RD = Ru RA = cost of business risk (RA – RD)(D/E) = cost of financial leverage
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Case I - Example
Cost of assets (unlevered) = Ru = 16%, Cost of debt = RD = 10%; D/V= 45% • What is the cost of equity for levered firm?

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• What is the cost of assets/WACC for levered?

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Case II – With Corporate Tax & No Bankruptcy Costs

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• 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

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Case II - Example
Unlevered Firm EBIT Interest (6250
*8%)

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Levered Firm 5000 500 4500 1530 2970
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5000 0 5000 1700 3300

Taxable Income Taxes (34%) Net Income OCF

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Interest Tax Shield
• Annual interest tax shield – Tax rate times interest payment – $6250 debt @ 8% = $500 in interest expense – Annual tax shield = 0.34(500) = $170 • Present value of annual interest tax shield – Assume perpetual debt for simplicity – PV = 170 /0.08 = $2125 – PV = Annual tax Shield / cost of debt = Corp tax rate * Interest payment/cost of debt = Corp tax rate(Debt*cost of debt)/cost of debt = DTC = 6250(0.34) = $2125
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Case II – Proposition I
• The value of the firm increases by the present value of the annual interest tax shield
– Value of a levered firm = value of an unlevered firm + PV(i tax shield) – VU = EBIT(1-T) / RU – VL = VU + DTC
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Example: Case II – Proposition I
• EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12% = Ru

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Case II – Proposition II
• The WACC decreases as debt increases because of the government subsidies on interest payments – RE = RU + (RU – RD)(D/E)(1-TC) – WACC = RA = (E/V)RE + (D/V)(RD)(1-TC) • Example – EBIT=25m, Tc=35%, D=75m, Rd=9%, Ru=12%, V=161.67m, E=86.67m

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Case III-With Corp Tax and With Bankruptcy costs
• Financial distress – Significant problems in meeting debt obligations – Most firms that experience financial distress do not ultimately file for bankruptcy • Direct costs – Costs directly related to bankruptcy ,eg: legal and administrative costs • Indirect bankruptcy costs – Costs of avoiding a formal bankruptcy filing

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Case III-With Corp Tax and With Bankruptcy costs

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• 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 expected bankruptcy cost-Trade-off Theory • After this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added VL = VU + DTC –PV(BC)
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Figure 13.5

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Conclusions
• Case I – no taxes or bankruptcy costs – No optimal capital structure • Case II – corporate taxes but no BC – Optimal capital structure is 100% debt – Each additional dollar of debt increases the cash flow of the firm • Case III – corporate taxes and BC – 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
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Additional Managerial Recommendations

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• The tax benefit is only important if the firm has a large tax liability • 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
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Tutorial
• Problem 4, 9, 11 and 14 from page 430

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