Ch 13.

Leverage and Capital Structure

© Kelly D. Welch 13-1

Capital Structure: How to fund the firm’s assets: Debt or Equity

• Leverage = use of debt in capital structure
• Capital restructuring = changing leverage without changing the assets

 Manager’s objective: Maximize stockholder wealth

• Capital markets separate operating and financing decisions (Fisher)
• So, financing objective is: Choose capital structure to minimize WACC

 Under MM assumptions:
• Leverage does not impact total firm value or WACC
• While leverage increases cost of equity, it does not affect WACC

 Optimal capital structure:

• Benefits: Corporate taxes subsidize debt
• Costs of financial distress indicate that too much debt destroys value
 Effects of Leverage
© Kelly D. Welch 13-2

• Interest reduces Net Income and Taxable Income, not EBIT

• Debt financing decreases reliance on equity moreso

Homemade Leverage
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 Capital Structure Irrelevance
© Kelly D. Welch 13-4

Ignoring ‘special’ benefits(Taxes) to and costs of debt

 Any stockholder who prefers leverage can create their own
MM Proposition I: Capital structure is irrelevant
 Leverage does not affect:
• Total market value of financial claims V = D + E
• Price per share
• Weighted Average Cost of Capital

MM Proposition II: Leverage

increases the cost of equity

• Compensate equity for firm’s

 Costs and Benefits of Debt
© Kelly D. Welch 13-5

 Benefits to Debt
• Reduces corporate taxes and increases firm value
 PV(Debt Tax Shields) = TC * Debt
 Levered firm value = Unlevered firm value + TC * Debt: VL = VU + TC*D
 Equity gains: E = VL – D
 Cost of equity rises with leverage
 WACC falls due to after tax cost of debt
• (Reduces agency problems, forces control and operational changes)
• (Signals that managers expect to meet obligations)
 Costs of Debt: Bankruptcy costs of financial distress
• Direct bankruptcy costs: Legal and administrative
• Managers worry about financing instead of running the business
• Lost sales and interrupted operations
• Loss of valuable employees and low morale
• Inability to purchase goods on credit
• Fire sales of assets below true value
 Optimal Capital Structure
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 Tradeoff benefits and costs of debt

 Capital Structure in Practice
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 Tax benefit is only important if the firm has a large tax liability
 As the risk of distress grows, optimal leverage falls

 Leverage varies across firms and industries

• Lowest in startup, technology-based industries for firms with intangible
assets and unpredictable earnings
 Computers and drugs: 5-7% debt
• Highest in capital intensive industries for firms with identifiable,
tangible assets and predictable earnings
 Cable television and airlines > 50% debt
• (Extremely high for private equity buyouts)

 Why do so many firms avoid debt?

 Bankruptcy
© Kelly D. Welch 13-8

 Insolvency: unable to meet obligations, negative book equity

 Bankruptcy petition filed in federal court by firm or creditors
 Chapter 7 Liquidation
• Trustee elected by creditors to take over firm’s assets and sell them
• Proceeds are distributed according to absolute priority
 Chapter 11 Reorganization
• Usually, firm continues operation as “debtor-in-possession”
• Firm submits reorganization plan
• If accepted by classes of creditors, then confirmed by court
 The right to file bankruptcy has strategic value
• Immediate “stay” on creditors
• Able to terminate union agreements, layoff workers and reduce wages
 Workouts: Negotiated pre-packaged filings
 Cram-downs: Court-ordered plan acceptance