Corporate Governance and

Corporate Finance

Topic 2
Corporate Governance and Corporate Finance

Prepared by: Dr. Hassan M. Hafez

Financial Advisor, FRA, CMA-KSA
Associate Professor of Finance
Faculty of Business Administration and International Trade - MIU
Optimal Capital Structure

o The identification of the optimum capital structure

should take into account the analysis of financing
policy determinants: the opportunity cost of
capital, the tax policy, the agency costs etc.

o The financing decision can be defined as the way

of choosing a company’s financing resources, in
order to reach the maximization of shareholders’
wealth. (Finance Mix; Debt and Equity)

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Optimal Capital Structure

o The changes in capital structure affect the value of the

firm, Capital restructuring involves changing the amount
of leverage a firm has without changing the firm’s assets.

o The firm can increase leverage by issuing debt and

repurchasing outstanding shares. The firm can decrease
leverage by issuing new shares and retiring outstanding
debt.

o We want to choose the capital structure that will maximize

stockholder wealth by maximizing the value of the firm or
minimizing the WACC
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The Effect of Leverage
How does leverage affect the EPS and ROE of a firm?

oWhen 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

oIf we have a really bad year, we still have to pay our fixed costs and we
have less left over for our stockholders

oLeverage amplifies the variation in both EPS and ROE

Financial Leverage Example

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Financial Leverage and EPS and ROE
o Variability in ROE
 Current: ROE ranges from 6% to 20%
 Proposed: ROE ranges from 2% to 30%

o Variability in EPS
 Current: EPS ranges from $0.60 to $2.00
 Proposed: EPS ranges from $0.20 to $3.00

The variability in both ROE and EPS increases when

financial leverage is increased
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Capital Structure Theory
o Modigliani and Miller (M&M)Theory of Capital
Structure
 Proposition I – firm value
 Proposition II – WACC

o The value of the firm is determined by the cash

flows to the firm and the risk of the assets

o Changing firm value

 Change the risk of the cash flows ( Unceratinty)
 Change the cash flows

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Capital Structure Theory Under Three
Special Cases
o Case I – Assumptions
 No corporate or personal taxes
 No bankruptcy costs

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 – Propositions I and II
o Proposition I
 The value of the firm is NOT affected by changes in
the capital structure
The main point with case I is that it doesn’t matter how we divide our
cash flows between our stockholders and bondholders, the cash flow of
the firm doesn’t change. Since the cash flows don’t change; and we
haven’t changed the risk of existing cash flows, the value of the firm
won’t change.

 The cash flows of the firm do not change; therefore,

value doesn’t change
Proposition II
 The WACC of the firm is NOT affected by capital

structure 16-8
Case I - Equations
WACC = RA = (E/V)RE + (D/V)RD

RE = RA + (RA – RD)(D/E)

 RA is the “cost” of the firm’s business risk, i.e., the

risk of the firm’s assets

 (RA – RD)(D/E) is the “cost” of the firm’s financial risk,

i.e., the additional return required by stockholders to
compensate for the risk of leverage

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Figure 16.3

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Case I - Example
o Data
 Required return on assets = 16%; cost of debt = 10%;
percent of debt = 45%
o What is the cost of equity?
 RE = 16 + (16 - 10)(.45/.55) = 20.91%
o Suppose instead that the cost of equity is 25%, what is
the debt-to-equity ratio?
 25 = 16 + (16 - 10)(D/E)
 D/E = (25 - 16) / (16 - 10) = 1.5
o Based on this information, what is the percent of equity
in the firm?
 E/V = 1 / 2.5 = 40%
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Case I - Example
o D+E = V.

o We are looking at ratios. All that matters is the relationship between them.
So, let E = 1. Then D/1 = 1.5; Solve for D; D = 1.5. Then V = 1 + 1.5 =
2.5 and the percent equity is 1 / 2.5 = 40%.

o the choice of E = 1 is for simplicity. You are confused about the process,
then show them that it doesn’t matter what you set E equal to, as long as
you keep the relationships intact. So, let E = 5; then D/5 = 1.5 and D =
5(1.5) = 7.5; V = 5 + 7.5 = 12.5 and E/V = 5 / 12.5 = 40%.

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Case II – Cash Flow
o Interest is tax deductible

o Therefore, when a firm adds debt, it reduces taxes, all

else equal

o The reduction in taxes increases the cash flow of the

firm

o How should an increase in cash flows affect the value

of the firm?

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 Case II - Example
Unlevered Levered Firm
Firm
EBIT 5,000 5,000
Interest (6250x0.08) 0 500
Taxable Income 5,000 4,500

Taxes (34%) 1,700 1,530

Net Income 3,300 2,970
CFFA 3,300 3,470

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Interest Tax Shield
o Annual interest tax shield
 Tax rate times interest payment
 6,250 in 8% debt = 500 in interest expense
 Annual tax shield = .34(500) = 170

Present value of annual interest tax shield

 Assume perpetual debt for simplicity
 PV = 170 / .08 = 2,125
 PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125

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 Case II – Proposition I
o The value of the firm increases by the present
value of the annual interest tax shield
o Value of a levered firm = value of an unlevered firm +
PV of interest tax shield
o Value of equity = Value of the firm – Value of debt

o Assuming perpetual cash flows

o VU = EBIT(1-T) / RU
o VL = VU + DTC
o RU = cost of capital for an unlevered firm
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Example: Case II – Proposition I
o Data
o EBIT = 25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%
o VU = 25(1-.35) / .12 = $135.42 million

o VL = 135.42 + 75(.35) = $161.67 million

o E = 161.67 – 75 = $86.67 million

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Figure 16.4

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Case II – Proposition II
o The WACC decreases as D/E increases because
of the government subsidy on interest payments
o RA = (E/V)RE + (D/V)(RD)(1-TC)
o RE = RU + (RU – RD)(D/E)(1-TC)

Example
 RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
 RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35)
RA = 10.05%

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Example: Case II –
Proposition II
o Suppose that the firm changes its capital structure so
that the debt-to-equity ratio becomes 1.

o What will happen to the cost of equity under the new

capital structure?
o RE = 12 + (12 - 9)(1)(1-.35) = 13.95%

What will happen to the weighted average cost of

capital?
o RA = .5(13.95) + .5(9)(1-.35) = 9.9%

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Figure 16.5

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Case III
o Now we add bankruptcy costs; As the D/E ratio increases,
the probability of bankruptcy increases

o This increased probability will increase the expected

bankruptcy costs

o At some point, the additional value of the interest tax

shield will be offset by the increase in expected
bankruptcy cost

o At this point, the value of the firm will start to decrease,

and the WACC will start to increase as more debt is added

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Figure 16.6

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Figure 16.7

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Conclusions
Case I – no taxes or bankruptcy costs
 No optimal capital structure
Case II – corporate taxes but no bankruptcy costs
 Optimal capital structure is almost 100% debt
 Each additional dollar of debt increases the cash flow
of the firm
Case III – corporate taxes and bankruptcy costs
 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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16-26
Managerial Recommendations
o The tax benefit is only important if the firm has
a large tax liability

o Risk of financial distress

o The greater the risk of financial distress, the less debt
will be optimal for the firm

o 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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The Pecking-Order Theory
o Theory stating that firms prefer to issue debt rather than
equity if internal financing is insufficient.
 Rule 1

 Use internal financing first

 Rule 2

 Issue debt next, new equity last

o The pecking-order theory is at odds with the tradeoff theory:
 There is no target D/E ratio

 Profitable firms use less debt

 Companies like financial slack‫ا لركود ا لما لى‬

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Comprehensive Problem
Assuming perpetual cash flows in Case II - Proposition
I, what is the value of the equity for a firm with EBIT =
$50 million, Tax rate = 40%, Debt = $100 million, cost
of debt = 9%, and unlevered cost of capital = 12%?

oVU = $50 million (1 - .4) / .12 = $250 million

oVL = $250 million + $100 million (.4) = $290 million
oE = VL – Debt = $290 million - $100 million = $190
million

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The Agency Theory

o The Jensen-Meckling model illustrates that the agency

costs can be reduced through leverage. Those costs borne
to motivate the entrusted managers to maximize the
shareholders’ wealth instead of acting in their own benefit.

o The conflict between the owners and the managers of the

company have an impact on corporate value and
performance. (Proved first lecture)

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Corporate Governance and Corporate Finance

o The influence on corporate performance and value, as well

as the impact of leverage on the reduction of agency
costs, both support the idea that the financing method is
correlated to the organization of the business, with
specific relations between the different persons implicated
in the business, i.e. concerning the corporate governance.

o suppliers of corporate capital make sure that their

investments bring them benefit.

o The evidence that debt can serve as an instrument to

discipline managers to avoid the inefficient consumption of
a company’ resources is vital 15-31
Corporate Governance and Corporate Finance

o Managers choose, the debt instruments to limit their own plans

and financial constructions, thus trying to prevent changes in
corporate control.

o Both leverage and well-designed corporate governance

structures represent solutions for reducing agency problems , we
would expect the companies in which the corporate governance
mechanism functions properly to have a lower debt ratio.

o Corporate governance limit the role of debt as a disciplinary

mechanism. (the analyzed companies have significantly
diminished their leverage)

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Conclusion

o Taking into account the role of debt in disciplining managers,

corporate governance mechanisms are correlated to the
selection of a firm’s financing resources.

o The functioning of corporate governance mechanisms
is linked to the financing decision in the sense that it ensures
 a framework of relationships (between stakeholders)
favorable for the attraction of financial capital.

o The financing decision will influence performance and will

contribute to solving conflicts of interest. There is, therefore,
a univocal relation between the financing decision of an
enterprise and the corporate governance mechanism.
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Quiz
o Explain the effect of leverage on EPS and ROE
o What is the break-even EBIT, and how do we compute it?
o How do we determine the optimal capital structure?
o What is the optimal capital structure in the three cases that
were discussed in this chapter?
o What is the difference between liquidation and reorganization?

o Suppose managers of a firm know that the company is

approaching financial distress.
 Should the managers borrow from creditors and issue a large
one-time dividend to shareholders?
 How might creditors control this potential transfer of wealth?

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