Financial Leverage and Capital Structure Policy: Chapter Organization

T16.
1 Chapter Outline
Chapter 16
Financial Leverage and Capital Structure Policy
Chapter Organization
 16.1 The Capital Structure Question
 16.2 The Effect of Financial Leverage
 16.3 Capital Structure and the Cost of Equity Capital
 16.4 M&M Propositions I and II with Corporate Taxes
 16.5 Bankruptcy Costs
 16.6 Optimal Capital Structure
 16.7 The Pie Again
 16.8 Observed Capital Structures
 16.9 Long-term Financing under Financial Distress and
Bankruptcy
 16.10 Summary and Conclusions CLICK MOUSE OR HIT
SPACEBAR TO ADVANCE
copyright © 2002 McGraw-Hill Ryerson, Ltd.

T16.2 Capital Structure, Cost of Capital, and the Value of the Firm
 Key issues:
 What is the relationship between capital structure and firm value?
Measuring Capital Structure - Leverage and the
Debt/Equity ratio
 What is the optimal capital structure?
 Preliminaries:
 Capital restructurings
 Optimal capital structure: firm value vs. stock value
 Optimal capital structure: firm value vs. WACC
copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 2

T16.3 Example: Computing Break-Even EBIT
 Ignoring taxes:
A. With no debt:
EPS = EBIT/500,000
B. With $2,500,000 in debt at 10%:

EPS = (EBIT - $______)/250,000
C. These are equal when:

EPSBE = EBITBE/______ = (EBITBE - $250,000)/250,000
D. With a little algebra:

EBITBE = $500,000
So EPSBE = $___ /share

T16.3 Example: Computing Break-Even EBIT
 Ignoring taxes:
A. With no debt:
EPS = EBIT/500,000
B. With $2,500,000 in debt at 10%:

EPS = (EBIT - $250,000)/250,000
C. These are equal when:

EPSBE = EBITBE/500,000 = (EBITBE - $250,000)/250,000
D. With a little algebra:

EBITBE = $500,000
So EPSBE = $1.00/share

T16.4 Financial Leverage, EPS and EBIT
EPS ($)
3 D/E = 1
2.5
2
D/E = 0
1.5
0.5
– 0.5
–1 EBIT ($ millions, no
taxes)
0 0.2 0.4 0.6 0.8 1

T16.5 Degree of Financial Leverage
 The Degree of Financial Leverage is measured as
Percentage Change in EPS

Percentage Change in EBIT
 A convenient alternative calculation is
Percentage Change in EPS

Percentage Change in EBIT

T16.6 EPS Versus EBIT (with and without debt)
With Debt
4
3
No Debt
2
Advantage to debt
1
EPS
0
- 400,000 800,000 1,200,000
EBIT 1,600,000
-1
Disadvantage to debt
-2
-3

T16.7 Example: Homemade Leverage and ROE
 Firm does not adopt proposed capital structure

Investor puts up $500 and borrows $500 to buy 100 shares
EPS of
unlevered firm $0.60 $1.30 $1.60
Earnings for
100 shares $60.00 $130.00 $160.00
less interest on
$500 at 10% $50.00 $50.00 $50.00
Net earnings $10.00 $80.00 $110.00

ROE 2% 16% 22%

T16.7 Homemade Leverage: An Example (concluded)
 Firm adopts proposed capital structure

Investor puts up $500, $250 in stock and $250 in bonds
EPS of
levered firm $0.20 $1.60 $2.20
Earnings for
25 shares $5.00 $40.00 $55.00
plus interest on
$250 at 10% $25.00 $25.00 $25.00
Net earnings $30.00 $65.00 $80.00

ROE 6% 13% 16%

T16.8 Milestones in Finance: The M&M Propositions
 Financial leverage and firm value: Proposition I
Since investors can costlessly replicate the financing decisions

of the firm (remember “homemade leverage”?), in the absence
of taxes and other unpleasantries,
the value of the firm is unaffected by its capital structure.
Corollary #1: There is no “magic” in finance - you

can’t get something for nothing.
Corollary #2: Capital restructurings don’t create

value, in and of themselves. (Why is the last part of
the statement so important? Stay tuned.)

T16.8 Milestones in Finance: The M&M Propositions (concluded)
The cost of equity and financial leverage: Proposition II

 A. Because of Prop. I, the WACC must be constant. With no
taxes,
WACC = RA = (E/V)  RE + (D/V)  RD
where RA is the required return on the firm’s assets
 B. Solve for RE to get MM Prop. II
RE = RA + (RA - RD)  (D/E)

( ) Cost of equity has two parts:
1. RA and “business” risk
2. D/E and “financial” risk

T16.9 The Cost of Equity and the WACC (See Figure 16.3)
Cost of capital
RE = RA + (RA – RD ) x (D/E)
WACC = RA
RD
Debt-equity ratio, D/E

T16.10 The CAPM, the SML, and Proposition II
The effect of financing decisions on firm risk is reflected in both M&M’s

Proposition II and in the CAPM.
Consider Proposition II: All else equal, a higher debt-equity ratio will
increase the required return on equity, RE.
M&M Proposition II: RE = RA + (RA - RD)  (D/E)
The effect of financing decisions is reflected in the equity beta, and, by

the CAPM, increases the required return on equity.
CAPM: RE = RF + (RM - RF)  E
In other words, debt increases systematic risk (and moves the firm
along the SML).

T16.11 Business Risk and Financial Risk
 By M&M Proposition II, the required return on equity

arises from two sources of firm risk. Proposition II is:
RE = RA + (RA - RD)  (D/E)
 Business risk - equity risk that comes from the nature of

the firm’s operating activities (measured by RA in the
equation above); and
 Financial risk - equity risk that comes from the financial

policy (i.e., capital structure) of the firm. Financial risk is
measured by (RA - RD)  (D/E) in the equation above.

T16.12 Debt, Taxes, Bankruptcy, and Firm Value
 The interest tax shield and firm value
For simplicity: (1) perpetual cash flows
(2) no depreciation
(3) no fixed asset or NWC spending
A firm is considering going from zero debt to $400 at 10%:
Firm U Firm L
(unlevered) (levered)
EBIT $200 $200
Interest 0 $40
Tax (40%) $80 $64
Net income $120 $96
Cash flow
from assets $120 $____
Tax saving = $16 = ____  $40 = TC  RD  D

T16.12 Debt, Taxes, Bankruptcy, and Firm Value
 The interest tax shield and firm value
For simplicity: (1) perpetual cash flows
(2) no depreciation
(3) no fixed asset or NWC spending
A firm is considering going from zero debt to $400 at 10%:
Firm U Firm L
(unlevered) (levered)
EBIT $200 $200
Interest 0 $40
Tax (40%) $80 $64
Net income $120 $96
Cash flow
from assets $120 $136
Tax saving = $16 = .40  $40 = TC  RD  D

T16.12 Debt, Taxes, Bankruptcy, and Firm Value (concluded)
 What’s the link between debt and firm value?
Since interest creates a tax deduction, borrowing

creates a tax shield. Its value is added to the value of
the firm.
 MM Proposition I (with taxes)
PV(tax saving) = $16/____ = $____

= (TC  RD  D)/RD = TC D

T16.12 Debt, Taxes, Bankruptcy, and Firm Value (concluded)
 What’s the link between debt and firm value?
Since interest creates a tax deduction, borrowing

creates a tax shield. Its value is added to the value of
the firm.
 MM Proposition I (with taxes)
PV(tax saving) = $16/.10 = $160

= (TC  RD  D)/RD = TC D
 Key result: VL = V U + T C D

T16.13 M&M Proposition I with Taxes (Figure 16.4)
VL=VU+TCXD
=TC
TD X D

T16.14 Example: Debt, Taxes, and the WACC
 Taxes and firm value: an example

 EBIT = $100
 TC = 30%
 RU = 12.5%
Q. Suppose debt goes from $0 to $100 at 10%, what

happens to equity value, E?
VU = $100  (______)/.125 = $560
VL = $560 + .30  $_____ = $590, so E = $_____ .

T16.14 Example: Debt, Taxes, and the WACC
 Taxes and firm value: an example

 EBIT = $100
 TC = 30%
 RU = 12.5%
Q. Suppose debt goes from $0 to $100 at 10%, what

happens to equity value, E?
VU = $100  (1 - .30)/.125 = $560
VL = $560 + .30  $100 = $590, so E = $490 .

T16.14 Example: Debt, Taxes, and the WACC (concluded)
 WACC and the cost of equity (MM Proposition II with taxes)
With taxes:
RE = RU + (RU - RD)  (D/E)  (1 - TC )
RE = _____+ (_____- .10)  ($____/____)  (1 - .30)

= 12.86%
WACC = ($____/____)  .1286 + (100/590)  .10  (1 - .30)

= 11.86%

T16.14 Example: Debt, Taxes, and the WACC (concluded)
 WACC and the cost of equity (MM Proposition II with taxes)
With taxes:
RE = RU + (RU - RD)  (D/E)  (1 - TC )
RE = .125 + (.125 - .10)  ($100/490)  (1 - .30)

= 12.86%
WACC = ($490/590)  .1286 + (100/590)  .10  (1 - .30)

= 11.86%
Notice: The WACC decreases as more debt financing is used.

Optimal capital structure is all debt!
T16.15 Taxes, the WACC, and Proposition II
Cost of capital (%)
RE
RU
WACC
RD  (1 – TC)
Debt-equity ratio, D/E

T16.15 The Cost of Equity and the WACC: M&M Proposition II with Taxes
(Figure 16.5)
Rdx(1-TC) Rdx(1-TC)
=8%x(1-.30)
=5.6%
M&M Proposition I with taxes implies that a firm’s WACC

decreases as the firm relies more heavily on debt financing.
M&M Proposition II with taxes implies that the firm’s cost of

equity rises as the firm relies more heavily on debt financing.

T16.16 Modigliani and Miller Summary (Table 16.6)
 I. The No-Tax Case
A. Proposition I: The value of the firm levered equals the value of the firm unlevered:
VL = VU
Implications of Proposition I:
1. A firm’s capital structure is irrelevant.
2. A firm’s WACC is the same no matter what mix of debt and equity is used.
B. Proposition II: The cost of equity, R E, is
RE = RA + (RA - RD) D/E
where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity ratio.
C. Implications of Proposition II
1. The cost of equity rises as the firm increases its use of debt financing.
2. The risk of equity depends on the risk of firm operations and on the degree of
financial leverage.

T16.16 Modigliani and Miller Summary (Table 16.6) (concluded)
 II. The Tax Case
A. Proposition I with Taxes:

The value of the firm levered equals the value of the firm unlevered plus
the present value of the interest tax shield:
VL = VU + TcD
where Tc is the corporate tax rate and D is the amount of debt.
B. Implications of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s
optimal capital structure is 100 percent debt.
2. A firm’s WACC decreases as the firm relies more heavily on debt
financing.

T16.17 The Optimal Capital Structure and the Value of the Firm
 Borrowing money is a good news/bad news proposition.
The good news: interest payments are deductible and create a “debt tax
shield” (i.e., TCD).
The bad news: all else equal, borrowing more money increases the
probability (and, therefore, the expected value) of direct and indirect
bankruptcy costs.
 Key issue: The Impact of Financial Distress on Firm Value
 The Static Theory of Capital Structure
The theory that a firm borrows up to the point where the tax benefit from
an extra dollar of debt is exactly equal to the cost that comes from the
increased probability of financial distress.

T16.17 The Optimal Capital Structure and the Value of the Firm (continued) (Figure
16.6)
VL=VU+TCXD

T16.18 The Optimal Capital Structure and the Cost of Capital (Figure 16.7)
Rdx(1-TC)

T16.19 The Capital Structure Question (Figure 16.8)

T16.20 The Pie(Figure 16.8)

Non-financial Industries D/E ratio Ratio
Real estate developers, builders, operators 4.938
Accommodation, food and beverage, educational, and recreational services 2.091
Beverages and tobacco 1.669
Printing, publishing, and broadcasting 1.504
T16.21 D/E ratios from table 16.7
Other fules and electricity 1.392

Tranportation services 1.332
Telecommunications carriers and postal and courier services 1.283
Machinery and equipment 1.246
Consumer goods and services 1.195
Building materials and construction 1.101
Motor vehicles, parts and accessories, and tires 1.091
Food, including food retailing 1.091
Petroleum and natural gas 1.087
Wood and paper 0.962
Household appliances and electrical products 0.756
Chemicals, chemical products and textiles 0.721
Fabricated metal products 0.704
Iron, steel and related products 0.599
Non-ferrous metals and primary metal products 0.411
Electronic equipment and computer services 0.380
T16.22 Long-term financing under financial distress
 Definitions of financial distress

 Business failure
 Legal bankruptcy
 Technical insolvency
 Accounting insolvency
 What happens
 Varies depending on the severity of the distress and the recourse
that debt-holders have negotiated
 Liquidation versus Reorganization of assets
 Relaxing covenant restrictions when the firm is in financial distress.

T16.23 Chapter 16 Quick Quiz
1. Why does the firm’s cost of equity increase with leverage?

All else equal, as the D/E ratio increases, the riskiness of the remaining
equity increases.
2. What are direct bankruptcy costs?
Direct bankruptcy costs are generally observable and, therefore,
measurable. Examples: legal fees, accounting fees, administrative
expenses.
3. What kinds of firms would be most likely to suffer indirect bankruptcy
costs?
Firms most likely to lose customers and/or sales as the likelihood of
distress increases.
4. Name three types of financial distress.
Business failure; legal bankruptcy; technical insolvency
T16.24 Solution to Problem 16.1
 Probit, Inc. has no debt outstanding and a total market value of $80,000.
Earnings before interest and taxes (EBIT) are projected to be $4,000 if
economic conditions are normal. If there is strong expansion in the economy,
then EBIT will be 30% higher. If there is a recession, then EBIT will be 60%
lower.
Probit is considering a $35,000 debt issue with a 5% interest rate. The

proceeds will be used to repurchase shares of stock. There are currently 2,000
shares outstanding. Ignore taxes for this problem.
a. Calculate earnings per share, EPS, under each of the three economic
scenarios before any debt is issued. Also calculate the percentage changes in
EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Probit goes through with the
recapitalization. What do you observe?

T16.24 Solution to Problem 16.1 (continued)
a. EBIT: $1,600 $4,000 $_____
Interest: 0 0 0
Taxes: 0 0 0
NI: $_____ $4,000 $_____
EPS: $ .80 $2.00 $____
EPS: -60% --- +30%

T16.24 Solution to Problem 16.1 (continued)
a. EBIT: $1,600 $4,000 $5,200
Interest: 0 0 0
Taxes: 0 0 0
NI: $1,600 $4,000 $5,200
EPS: $ .80 $2.00 $2.60
EPS: -60% --- +30%

T16.24 Solution to Problem 16.1 (concluded)
b. $80,000/2,000 shares = $40 per share

$35,000/$40 = 875 shares bought back
2,000 - 875 = 1,125 shares left outstanding
EBIT: $1,600$4,000$5,200
Interest: 1,750 1,750 1,750
Taxes: 00 0
NI: -$150$2,250$3,450
EPS: -$0.13$2.00 $3.07
 EPS: -106.50%--- +53.50%

 Drednaught Corp. uses no debt. The weighted average cost of

capital (WACC) is 12 percent. If the current market value of the
equity is $25 million, and the corporate tax rate is 34 percent,
what is the EBIT? What is the WACC? Explain.
According to M&M, V = VU + TCD.

In this case, V = $25M, WACC = 12%, and D = 0. So,
V = $25M = EBIT(1 - .34)/.12 + 0
EBIT = $4.545M

 Fordebtful Industries has a debt/equity ratio of 2.5. Its WACC is 12

percent, and its cost of debt is 12 percent. The corporate tax rate is
35 percent.
a. What is Fordebtful’s cost of equity capital?
b. What is Fordebtful’s unlevered cost of equity capital?
c. What would the cost of equity be in part (a) if the debt/equity
ratio were 1.5? What if it were 1.0? What if it were zero?

T16.26 Solution to Problem 16.12 (concluded)
a. Since WACC = (E/V)(RE ) + (D/V)(RD)(1 - TC),

WACC = .12 = (.2857)RE + (.7143)(.12)(.65),
Solving, RE = .2250
b. .2250 = RU + (RU - .12)(2.5)(.65) Solving, RU

= .16
c. .12 = (.40)RE + (.60)(.12)(.65)

Solving, RE = .1830
.12 = (.50)RE + (.50)(.12)(.65)

Solving, RE = .1620
.12 = (1.0)RE + (0)(.12)(.65)

Solving, RE = RU = WACC = .12

Financial Leverage and Capital Structure Policy: Chapter Organization

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T16.

copyright © 2002 McGraw-Hill Ryerson, Ltd.

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 2

B. With $2,500,000 in debt at 10%:

C. These are equal when:

D. With a little algebra:

So EPSBE = $___ /share

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 3

B. With $2,500,000 in debt at 10%:

C. These are equal when:

D. With a little algebra:

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 4

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 5

 The Degree of Financial Leverage is measured as

Percentage Change in EPS

 A convenient alternative calculation is

Percentage Change in EPS

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 6

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 7

 Firm does not adopt proposed capital structure

Net earnings $10.00 $80.00 $110.00

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 8

 Firm adopts proposed capital structure

Net earnings $30.00 $65.00 $80.00

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 9

 Financial leverage and firm value: Proposition I

Since investors can costlessly replicate the financing decisions

Corollary #1: There is no “magic” in finance - you

Corollary #2: Capital restructurings don’t create

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 10

The cost of equity and financial leverage: Proposition II

 B. Solve for RE to get MM Prop. II

RE = RA + (RA - RD)  (D/E)

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 11

Debt-equity ratio, D/E

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 12

The effect of financing decisions on firm risk is reflected in both M&M’s

M&M Proposition II: RE = RA + (RA - RD)  (D/E)

The effect of financing decisions is reflected in the equity beta, and, by

CAPM: RE = RF + (RM - RF)  E

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 13

 By M&M Proposition II, the required return on equity

RE = RA + (RA - RD)  (D/E)

 Business risk - equity risk that comes from the nature of

 Financial risk - equity risk that comes from the financial

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 14

Tax saving = $16 = ____  $40 = TC  RD  D

Tax saving = $16 = .40  $40 = TC  RD  D

 What’s the link between debt and firm value?

Since interest creates a tax deduction, borrowing

PV(tax saving) = $16/____ = $____

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 17

 What’s the link between debt and firm value?

Since interest creates a tax deduction, borrowing

PV(tax saving) = $16/.10 = $160

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 18

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 19

 Taxes and firm value: an example

Q. Suppose debt goes from $0 to $100 at 10%, what

VL = $560 + .30  $_____ = $590, so E = $_____ .

copyright © 2002 McGraw-Hill Ryerson, Ltd Slide 20

 Taxes and firm value: an example

Q. Suppose debt goes from $0 to $100 at 10%, what

PV(tax saving) = $16/ = $

VL = $560 + .30  $_ = $590, so E = $_ .

RE = ___+ (_- .10)  ($/__)  (1 - .30)

WACC = ($/)  .1286 + (100/590)  .10  (1 - .30)

NI: $_ $4,000 $_