Corporate Financing Decision (FIN 502)

MBA
Kathmandu University School of Management

Rajesh Sharma, PhD

 Financial Leverage and Capital
Structure Policy

*Note: Leverage: We will deal only with Fin. leverage not Opt. leverage
(Chapter 16: Fundamental of Corporate Finance by Ross, Westerfield and Jordan)
 Leverage and Firm Value

• There are two important questions:

– Why should the stockholders care about maximizing firm value?

Perhaps they should be interested in strategies that maximize shareholder value.
– What is the ratio of debt-to-equity that maximizes the shareholder’s value?

• As it turns out, changes in capital structure only benefit the

stockholders if the value of the firm increases.
Determinants of Intrinsic Value: The Capital Structure Choice

Net operating Required investments

−
profit after taxes in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average Firm’s

cost of capital debt/equity
(WACC) mix

Market interest rates Cost of debt

Cost of equity
Market risk aversion Firm’s business risk
4
 Increasing Firm Value

For example: Considering DCF valuation model

• 1st Option: Grow asset side (Investment Decision)

– Positive NPV Projects (Capital Budgeting)

• 2nd Option: Decreasing cost of capital (WACC)

– By lowering WACC, there will be leftover cash that can be used to support growth/
accept projects with positive NPV (How??)
 Capital Structure Policy

• Change in Capital structure

– A firm’s capital structure is really just a reflection of its borrowing policy e.g. decision like:
should we borrow a lot of money, or just a little?
– What is the best mix of debt and equity that maximize firm value?

• Consequences of such decision:

– Is it straight forward mechanical process?
– Effect of Tax/ Different Economic Scenario/ Firms’ Life Cycle

• At first glance, it probably seems that debt is something to be avoided. After all, the more
debt a firm has, the greater is the risk of bankruptcy (due to fixed payment).

• Debt is really a double-edged sword, and, properly used, debt can be enormously beneficial
to a firm.
 Capital Structure Policy
• If management so desire, a firm could issue some bonds and use the proceeds to
buy back some stock, thereby increasing the debt–equity ratio. Alternatively, it
could issue stock and use the money to pay off some debt, thereby reducing the
debt–equity ratio. Also, called capital restructurings.

• In general, such restructurings take place whenever the firm substitutes one capital
structure for another while leaving the firm’s assets unchanged.

Because the assets of a firm are not directly affected by a capital restructuring, This means that a
firm can consider capital restructuring decisions in isolation from its investment decisions.

Question to be considered:
• Why should financial managers choose the capital structure that maximizes the
value of the firm?
• What is the relationship between the WACC and the value of the firm?
• What is an optimal capital structure?
 Effect of Financial Leverage

• Financial Leverage refers to 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.

• To understand the effect of financial leverage:

– Examine the impact of financial leverage on the payoffs to stockholders.

• Let's consider an example:

– For now, we ignore the impact of taxes.
– Also, for ease of presentation, we describe the impact of leverage in terms of its
effects on earnings per share (EPS) and return on equity (ROE).

Note that using cash flows instead of these accounting numbers would lead to precisely
the same conclusions, but a little more work would be needed, hence we reply on these
measures.
Effect of Financial Leverage: Example

Consider an all-equity firm that is contemplating going into debt (Maybe

some of the original shareholders want to cash out).

Current Proposed
Assets Rs.20,000 Rs.20,000
Debt Rs.0 Rs.8,000
Equity Rs.20,000 Rs.12,000
Debt/Equity ratio 0.00 2/3
Interest rate n/a 8%
Shares outstanding 400 240
Share price Rs.50 Rs.50
EPS and ROE Under Current Structure

Recession Expected Expansion

EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0
Net income Rs.1,000 Rs.2,000 Rs.3,000
EPS Rs.2.50 Rs.5.00 Rs.7.50
ROE 5% 10% 15%

Current Shares Outstanding = 400 shares

EPS and ROE Under Proposed Structure

Recession Expected Expansion

EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest Rs. 640 Rs. 640 Rs. 640
Net income Rs.360 Rs.1,360 Rs.2,360
EPS Rs.1.50 Rs.5.67 Rs.9.83
ROE 3.0% 11.3% 19.7%

Proposed Shares Outstanding = 240 shares

Financial Leverage and EPS
Effects of
12.00 Financial
Leverage
10.00 Debt
depends upon
EBIT: Zero
8.00 No Debt
Advantage to
6.00 Break-even
Slope of debt
debt
EPS

is higher than
point slope of solid
4.00
line: Higher
effect
2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage to
debt
EBIT in dollars, no taxes
How can capital structure affect value?
∞
∑ FCF t
V = t=1
(1 + WACC)t
WACC= wd (1-T) rd + were
The impact of capital structure on value depends upon the effect of debt on:
1) Free Cash Flow (FCF) and Growth (Alternative use of funds:
Available due to lower cost of capital)
2) Cost of Equity
3) WACC

Let's evaluate
How can capital structure affect value?
EXAMPLE:
• WACC= wd (1-T) rd + were
• Cost of debt < Cost of Equity (why not infuse additional debt)
Current
• WACC= 0.19*(1-0.25) * 4.2% + 0.81 * 5.5% = 5 %
Projected
• WACC= 0.4*(1-0.25) * 4.2% + 0.60 * 5.5% = 4.5%

Is this correct ?
 How can capital structure affect value?
• Higher leverage exposes firm to higher systematic risk: Higher beta

Firm Response to address such risks

• Tax is controlled by Government Policy

• Cost of debt (rd) and Cost of Equity (re ) are controlled by demand and supply

• One of the way company can respond: By altering capital structure

 Effect of Additional Debt on FCF

• Additional debt increases the probability of bankruptcy.

– Direct costs: Legal fees, “fire” sales, etc.
– Indirect costs: reduction in productivity of managers, reduction in credit (i.e., accounts
payable) offered by suppliers

• Additional debt can affect the behavior of managers.

– Increases in agency costs: debt can make managers too risk-averse, causing
“underinvestment” in risky but positive NPV projects.
 Effect of Additional Debt on cost of equity
• If a firm has high % of fixed costs (incurred during economic boom): It does not
decline when demand falls (incurred during downturn). Exposed to higher degree
of business risk.

• The higher the proportion of fixed costs within a firm’s overall cost structure, the
greater the operating leverage (Refers to proportion of total cost that are
fixed).

• Debt-holders received fixed income as an interest or coupon but do not bear

business risk.

• Additional risk placed to common shareholders as result of debt.

• Result: Higher debt will result higher expected return for common shareholders
 Effect of Additional Debt on WACC
• Cost of debt < Cost of equity : Adding debt increase percent of firm financed
with low-cost debt (wd) and decreases percent financed with high-cost equity (we).

• Debtholders have a prior claim on cash flows relative to stockholders.

– Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.
– Cost of stock, re, goes up.

• Firm can deduct interest expenses.

– Reduces the taxes paid
– Frees up more cash for payments to investors

• Debt increases risk of bankruptcy

– Causes pre-tax cost of debt, rd, to increase (new)

• Net effect on WACC = Uncertain (Depend upon different scenario).

 Effect of Additional Debts on WACC

Net effect on WACC = Uncertain (Depend upon different scenario).

• If a firm has high % of fixed interest payment: It does not decline during
economic downturn.

• Additional risk placed to common shareholders as result of debt (i.e., erosion in

value due to bankruptcy risk and its’ proceed).

• Result: Higher debt will result higher expected return for common shareholders that increases
overall WACC.

What about firm’s life cycle, existing leverage?

 Important consideration while deciding on
capital structure (i.e., leverage): Effect of TAX