Leverage and Capital Structure

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1. What is the rela- If WACC is minimized, the firm's value is maximized.

tionship between
Weighted Aver-
age Cost of Cap-
ital (WACC) and
the value of the
firm?

2. Weighted Aver- It is the appropriate discount rate to use for cash flows with
age Cost of Cap- risk that is similar to that of the overall firm.
ital (WACC)
Ignoring taxes,
WACC = (E/V) * Re + (D/V) *Rd

Where V = E + D

3. What is an opti- It is a mix of (debt - equity) ratio at which the WACC is

mal capital struc- minimized (the lowest possible value).
ture?
It is sometimes called the firm's target capital structure,
consisting of a mix of debt, preferred stock and common
equity with which the firm intends to raise the capital.

4. EPS v/s EBIT x - axis: EBIT

y - axis: EPS

2 lines are present in the graph:

a) No debt: Represents the case of no financial leverage.

As EBIT increases for a certain amount of money, EPS
increases by 1 unit.

b) Proposed capital structure (With debt): EPS is negative

if EBIT = 0.

EPS is more sensitive to changes in EBIT because of the

financial leverage employed.

Break - even point: EPS is = for both capital structures.

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5. The effect of financial leverage depends on the company's

EBIT. When EBIT is relatively high, leverage is beneficial.

6. What is the im- Financial leverage directly will impact the pay - off of the
pact of finan- stockholders. If the firm uses more debt financing in its
cial leverage on capital structure, then, the firm employs more financial
stockholders? leverage.

a) More financial leverage can lead to higher returns for

stockholders, when the firms' earnings are good.

b) However, when the firms' earnings are low, more finan-

cial leverage results in higher losses for stockholders.

7. Homemade The use of personal burrowing to change the overall

leverage/What is amount of financial leverage to which an individual is
homemade exposed. This means that shareholders can adjust the
leverage? amount of financial leverage by burrowing and lending on
their own.

8. Why is a com- Because the investors can always increase the financial
pany's capital leverage by themselves in order to create a different pat-
structure irrele- tern of pay offs.
vant?
Thus, there is nothing special about corporate burrowing
because investors can burrow or lend on their own (home-
made leverage).

9. M&M Proposition Proposed by Franco Modigliani and Merton Miller.

I
States that the value of a firm is independent of its capital
structure. This means that a firm's overall cost of capital is
not affected by its capital structure.
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This implies that the value of the firm is independent of the

percentage of debt or equity in its capital structure. Thus,
the choice of capital structure is irrelevant for maximizing
the value of the firm.

Capital structure is irrelevant because shareholders can

create their own leverage or unlever the stock to create
the payoff they desire, regardless of the capital structure
the firm actually chooses.

Assumptions:
a) Capital markets are perfect. eg: CAPM
b) Investors can burrow and lend at the risk - free rate:
COS and investors have equivalent burrowing costs.
c) No one has superior market information: Companies
and investors have same information.
d) All information is incorporated in stock price.
e) Taxes don't vary by the source of financing: No taxes.
f) No bankruptcy costs.
g) Firm has fixed projects underway.

10. M&M Proposition Ignoring taxes,

II WACC = (E/V) * Re + (D/V) *Rd

Where V = E + D

Ra = (E/V) * Re + (D/V) *Rd

Where Ra = WACC

Thus,
Re = Ra + (Ra - Rd) * (D/E)

States that a firm's cost of equity capital is a +ve linear

function of its capital structure.

This implies that the cost of equity capital is increasing

in the percentage of debt in the capital structure. Thus,
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greater the % of debt in the capital structure, the greater
the rate of return required by equity holders.

It means that the cost of equity (Re) depends on:

a) Required Rate of Return on the firm's assets, Ra =

WACC.

b) The firm's cost of debt, Rd.

c) The firm's debt-equity ratio, (D/E).

Note: The change in the capital structure weights, such as,

E/V and D/V, is exactly offset by the change in the cost
of equity (Re), so the WACC remains the same => M&M
Proposition I is confirmed.

11. The no - tax case a) M&M Proposition I:

The value of the leveraged firm, Vl (uses debt financing)

is = to the value of the unleveraged firm, Vu (doesn't use
debt financing):
Vl = Vu

Implications:
i) A firm's capital structure is irrelevant.
ii) A firm's WACC is the same no matter what mixture of
debt and equity is used to finance the firm.

b) M&M Proposition II:

Re = Ra + (Ra - Rd) * (D/E)

Implications:
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i) The cost of equity rises as the firm increases its use of
debt financing.
ii) The risk of the equity depends on: business risk and
financial risk.

12. If a firm uses only No, it doesn't follow. While, it is true that the cost of equity
debt and equi- and debt are rising, it is important to note that debt cost
ty financing, and is still less than the cost of equity. Since we are using
given that the more and more debt, WACC doesn't necessarily rise, so
risk of both is the value of the firm doesn't necessarily fall.
increased by in-
creased burrow-
ing, does it not
follow that in-
creasing debt in-
creases the over-
all risk of the firm
and therefore, de-
creases the value
of the firm?

13. Total systematic a) Business Risk: Depends on the firm's assets and oper-
risk of the firm's ations and is not affected by capital structure.
equity
b) Financial Risk: It is completely determined by financial
policy.

14. Business Risk The equity risk that comes from the nature of the firm's
operating activities, such as, competition, product liability
and so on.

The greater a firm's business risk, the greater Ra will be,

and, all other things being the same, the greater will be
the firm's cost of equity, Re.

It determines Ra.

15. Financial Risk The equity risk that comes from the financial policy (i.e.,
capital structure) of the firm.

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It's the extra risk that arises from the use of debt financing.

It depends only on the types of securities issued. eg: More

debt = more financial risk.

It is determined by (D/E).

16. Suppose Firm A No, because business risk doesn't involve financial poli-
has greater busi- cies affecting the cost of equity.
ness risk than
Firm B. Is it true
that Firm A also
has a higher cost
of equity capital?
Explain.

17. Is there an eas- Because many relevant factors such as bankruptcy costs,
ily identifiable tax asymmetries, and agency costs cannot easily be iden-
debt-equity ratio tified or quantified, it's practically impossible to determine
that will maxi- the precise debt-equity ratio that maximizes the value of
mize the value of a firm. However, if the firm's cost of new debt suddenly
a firm? Why or becomes much more expensive, it's probably true that the
why not? firm is too highly leveraged.

18. Why is the use of It is called leverage because it magnifies gains or losses.
debt financing re-
ferred to as using FYI: Financial leverage refers to the amount of debt that
financial "lever- a firm uses to buy assets. Most companies use debt fi-
age"? nancing because by using debt a company can increase
its leverage as it can invest in business operations without
increasing its equity.

19. Interest Tax The tax saving attained by a firm from the tax deductibility
Shield of interest expense. Since bonds are perpetual, we can
discount tax savings back to present:

Present Value = Tc * D

Where Tc = Corporate Tax Rate

D = Amount of debt
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The higher the tax rate, the greater the incentive to burrow.

20. What is the rela- M&M Proposition I:

tionship between
the value of an The value of the leveraged firm (Vl) is = to the value of the
unlevered firm unleveraged firm (Vu) + Present Value of the interest tax
and the value of a shield:
levered firm once Vl = Vu + (Tc * D)
we consider the
effects of corpo- Thus, the value of a levered firm increases as total debt
rate taxes? increases because of the interest tax shield.

Implications:
i) Debt financing is highly advantageous, and, in the ex-
treme, a firm's optimal capital structure is 100% debt.

ii) A firm's WACC decreases as the firm relies more heavily

on debt financing.

21. If we only con- The value of a levered firm is more than the value of the
sider the effects unlevered firm by the amount of interest tax shield once
of taxes, what is corporate tax is considered.
the optimum cap-
ital structure? This means that the value of the levered firm keeps in-
creasing with the level of debt if we only consider cor-
porate tax and forget about the financial distress. In this
case, the optimum capital structure will be the one that
has 100% debt.

22. Bankruptcy A condition under which a person or corporation is de-

clared unable to pay debts.

In this case, the firm's assets = to the value of its debts,

then, the resulting equity has no value.
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It occurs when a firm borrows "too much" and cash flows

are insufficient to cover interest payments. Technically, in
this situation, the debt holders get control of the company.

23. Financial Dis- When a firm is having significant problems in meeting its
tress debt obligations.

24. Direct Bankrupt- The costs that are directly associated with bankruptcy,
cy Costs such as:
a) Legal costs
b) Administrative expenses
c) Time and effort from going to court costs.
d) Delays in implementation of decisions.

These costs are relatively minute.

25. Indirect Bank- The costs of avoiding a bankruptcy filing incurred by a

ruptcy Costs financially distressed firm. Egs:

a) Others less wiling to do business with you.

b) Pay higher costs to suppliers, managers, potential
debt-holders and employees.
c) Price may have to be discounted to attract customers
(after sales service).

These costs are relatively larger and more likely, to put the
company into financial distress.

26. Financial Dis- The direct and indirect costs associated with going bank-
tress Costs rupt or experiencing financial distress.

These costs are determined by how easily ownership of

the firm's assets can be transferred.

The greater the debt, the greater the chance of financial

distress.

The problems that comes up in financial distress are

particularly severe, and the financial distress costs, are,
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thus, larger, when the stockholders and bondholders are
different groups.

27. Stockholders Until a firm is legally bankrupt, the stockholders control

(Shareholders) it. Because they will be largely negatively impacted with
bankruptcy, they have a strong incentive to avoid a bank-
ruptcy filing.

FYI: Stockholders (Shareholders) own one or more shares

of a corporation's capital stock. A stockholder is consid-
ered to be separate from the corporation and as a result
will have limited liability as far the corporation's obligations.

28. Bondholders Primarily concerned with protecting the value of the firm's
assets and will try to take control away from the stock-
holders. They have a strong incentive to seek bankruptcy
to protect their interests and keep the stockholders from
further dissipating the assets of the firm.

FYI: A bondholder is the owner of a government, municipal

or corporate bond.

Bondholders are entitled to a return of principal when the

bond matures and, with the exception of those who own
zero-coupon bonds, periodic interest in the form of coupon
payments. Being a bondholder is generally perceived as
low risk because bonds guarantee consistent interest pay-
ments and the return of principal at maturity.

Bonds are typically considered safer investments than

stock because bondholders have a higher claim on the
issuing company's assets in the event of bankruptcy. This
means if the company must liquidate everything to pay its
debts, bondholders receive payment before shareholders.
Of course, neither are paid before the company settles
debts with banks, mortgage holders and other creditors.

29. Static Theory of A firm borrows up to the point where the tax benefit from
Capital Struc- an extra dollar in debt is exactly = to the cost that comes

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ture/Can you de- from the increased probability of financial distress:
scribe the trade
- off that defines Vl = Vu + (Tc * D) - Cb(D)
the static theory Where Cb = Bankruptcy cost (function of debt)
of capital struc-
ture? Based on the works of Modigliani and Miller.

As a firm starts to add debt, the tax shield provides wealth

to the owners of the company (cutting into the govern-
ment's share) and the WACC is falling across this range. At
some point, the costs of financial distress begin to enter as
more debt is added. Eventually, the additional $1 benefit
of the tax shield is exactly offset by the additional cost of
financial distress. At that point, WACC is lowest and we
have the optimal (debt - equity) ratio for the firm.

Assumption: Firm is fixed in terms of number of its assets

and operations, and it only considers changes in the (debt
- equity) ratio.

30. Optimal Capital a) M & M graph: No tax + No bankruptcy + No other real -

Structure and the world imperfections
Cost of Capital
x - axis: Total Debt (D)
y - axis: Value of the firm (Vl)

The total value of the firm is not affected by its debt policy,
so, Vl is constant (horizontal line).

x - axis: Debt - Equity Ratio (D/E)

y - axis: Weighted Average Cost of Capital (WACC)

The overall cost of capital is not affected by the debt policy,

so, WACC is constant (horizontal line).
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Conclusion: The value of a firm and it's WACC are not

affected by the capital structures.

b) M & M graph: Corporate taxes + No bankruptcy costs

x - axis: Total Debt (D)

y - axis: Value of the firm (Vl)

The firm's value critically depends on its debt policy. The

more the firm borrows, the more it is worth because the
interest payments are tax deductible, and the gain in the
firm value is = PV of the interest tax shield.

x - axis: Debt - Equity Ratio (D/E)

y - axis: Weighted Average Cost of Capital (WACC)

As the firm increases its financial leverage, the cost of

equity does increase, but this increase is more than offset
by the tax break associated with debt financing. Thus, the
firm's overall cost of capital declines as WACC declines as
the firm uses more and more debt financing.

Conclusion: The value of the firm increases, and the

WACC decreases as the amount of debt goes up.

c) Static Theory: Corporate taxes + Bankruptcy costs (Fi-

nancial Distress Costs)

x - axis: Total Debt (D)

y - axis: Value of the firm (Vl)

The firm borrows up to the point where the tax benefit from
an extra dollar in debt is exactly = to the cost that comes
from the increased probability of financial distress. Thus,
the value of the firm grows to the point at which the tax
saving from an additional dollar in debt financing is exactly
balanced by the increased bankruptcy costs associated
with additional burrowing.
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x - axis: Debt - Equity Ratio (D/E)

y - axis: Weighted Average Cost of Capital (WACC)

The lowest possible WACC occurs at the optimal debt -

equity ratio (optimal debt financing).

Conclusion: Vl reaches a maximum, optimal amount of

burrowing. At the same time, the WACC is minimized at
the optimal debt - equity ratio.

31. What are the a) Business Risk

important factors b) Financial Risk
in making capi- c) Tax Exposure
tal structure deci- d) Financial Flexibility
sions? e) Management Style
f) Growth Stage
g) Market Conditions

32. Tax benefit is rel-

evant only if firm
pays taxes. Why?

33. Firms with tax

benefits from
other sources
(such as depre-
ciation) will get
less benefit from
leverage. Why?

34. Firms with Firms with greater risk of experiencing financial distress
greater risk of ex- will borrow less than firms with lower risk. Greater the
periencing finan- volatility in EBIT, the less a firm should borrow. Cost of
cial distress will financial distress depends primarily on the firms assets,
burrow less than costs will be determined by how easily ownership of those
firms with lower assets can be transferred.
risk of financial
distress. Why?
Firm with mostly tangible assets that can be sold without a
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loss will have incentive to borrow more. For firms that rely
heavily on intangibles, such as employee talent or growth
opportunities, debt will be less attractive because these
assets effectively cannot be sold.

35. Firms have differ-

ent tax rates, af-
fecting incentive
to borrow. Why?

36. Financial dis- The costs of financial distress depend primarily on the
tress more cost- firm's assets. In particular, financial distress costs will be
ly for some firm determined by how easily ownership of those assets can
than for others. be transferred.
Why?
For example, a firm with mostly tangible assets that can
be sold without great loss in value will have an incentive
to borrow more. For firms that rely heavily on intangibles,
such as employee talent or growth opportunities, debt will
be less attractive because these assets effectively cannot
be sold.

37. Do U.S. corpora- No. In fact, they rely more heavily on equity financing.
tions rely heavi- Also, the level of debt financing is different associated with
ly in debt financ- different industries.
ing?

38. What regularities a) U.S. firms don't rely heavily on debts. In fact, they pay
do we observe a large amount in taxes. This reflects that there is some
in capital struc- restriction in using debt financing (through which interest
tures? tax shield can be enjoyed).

b) The use of debt financing is varied across different

industries. Firms' assets and operations in one industry
is different from other industry and accordingly, the use of
debt financing is different.

39. How can using a) Business failure: A business has been terminated with
debt lead to fi- a loss to creditors (or even an all-equity firm can fail).
nancial distress?
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b) Legal bankruptcy: Bankruptcy is a legal proceeding for
liquidating or reorganizing a business.

c) Technical insolvency: Occurs when a firm is unable to

meet its financial obligations.

d) Accounting insolvency: Firms with -ve net worth are

insolvent on the books. This happens when the total book
liabilities exceed the book value of the total assets.

40. Bankruptcy Liq- Termination of the firm as a going concern, and it involves
uidation selling off the assets of the firm.

The resulting proceeds, net of selling costs, are distributed

to creditors in order of established priority (in accordance
with APR):

a) Administrative expenses associated with bankruptcy

b) Other expenses arising after the filing of an involuntary
bankruptcy petition but before the appointment of a trustee
c) Wages, salaries and commissions
d) Contributions to the employee benefit plans
e) Consumer claims
f) Government tax claims
g) Payment to unsecured creditors
h) Payment to preferred stockholders
i) Payment to common stockholders

If any proceeds remain, after expenses and payments to

the creditors, they are distributed to the shareholders.

41. How does bank- a) Federal court petition

ruptcy liquida- b) Trustee named - creditors select
tion takes place? c) Sell assets
d) Stop operating - no longer a "going concern"
e) Payoff creditors
f) Remainder to shareholders

42.

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Absolute Priority Establishes the priority of claims under liquidation.
Rule (APR)
The higher a claim is on this list, the more likely it it to be
paid.

Due to negotiations between the firm and its creditors,

APR is not strictly followed.

43. Bankruptcy Re- Financial restructuring of a failing firm to attempt to contin-

organization ue operations as a going concern. Mostly involves issuing
new securities to replace old securities.

Corporate reorganization takes place under Chapter 11

Federal Bankruptcy Reform Act of 1978.

44. How does bank- Worth more "alive" than "dead"

ruptcy reorga-
nization takes a) Voluntary or involuntary
place? b) Federal judge approves
c) Classes established
d) "Debtor in possession" runs business
e) Reorganization plans submitted
f) Creditors accept and court affirms
g) Payments made / capital structure revised
h) Business operates under plan
i) Cram down possible

45. Some firms have Actual or likely litigation - related losses are usually results
filed for bank- of suspicious transactions and fraud transactions. When
ruptcy because a company fails to initiate or make any special effort for
of actual or like- identifying suspicious transactions will occur.
ly litigation - re-
lated losses. Is Some firms deliberately use these losses as a device to
this a proper use file bankruptcy, but bankruptcy is not a tool to avoid pay-
of the bankrupt- ments to creditors. Appropriate measures have to be taken
cy process? to control and minimize litigation - related losses filing as
bankruptcy. Hence, it is not a proper use of bankruptcy
process.

46.
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Firms sometimes It could be argued that using bankruptcy laws as a sword
use the threat of may simply be the best use of the asset. Creditors are
bankruptcy filing aware at the time a loan is made of the possibility of
to force credi- bankruptcy, and the interest charged incorporates it.
tors to renego-
tiate terms. Crit-
ics argue that
in such cases,
the firm is us-
ing bankruptcy
laws "as a sword
rather than a
shield." Is this an
ethical tactic?

47. What is the ba- As with any management decision, the goal is to maximize
sic goal of finan- the value of shareholder equity by maximizing the firm
cial management value and minimizing the cost of capital.
with regard to
its capital struc-
ture?

48. Earnings Per A measure of the net income earned on each share of
Share (EPS) common stock; computed as net income minus preferred
dividends divided by the average number of common
shares outstanding during the year.

= (Net Income - Dividends paid on preferred Stock)/Num-

ber of shares outstanding

49. Net Income (NI) A company's total earnings, also called net profit or the
"bottom line." Net income is calculated by subtracting total
expenses from total revenues.

50.
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Price Per Share = Debt/Number of repurchased shares
(PPS)
= Debt/(Outstanding shares before debt - Outstanding
shares after debt)

51. Value of a firm The price for which the firm can be sold, which equals the
present value of future profits.

= (Number of outstanding shares) *(PPS)

52. Cash flow of a = (EPS) * (Number of shares individually held)

firm/shareholder
= (EBIT/Number of outstanding shares) * (Number of
shares individually held)

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