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Chapter 16

FINANCIAL LEVERAGE
AND
CAPITAL STRUCTURE POLICY
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Recap
• The weighted average cost of capital is

• The value of the firm is maximized when the WACC is minimized

• Too much debt can enhance the probability of bankruptcy

• So how to find the optimal capital structure?

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Cost and Benefits of Debt

Benefits
•Lower cost of financing

•Tax advantage

Costs
•Bankruptcy and possible financial distress

•Borrowing saves a firm money on its corporate taxes, but

the more a firm borrows, the more likely it is that the firm
will become bankrupt
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Bankruptcy Costs
• Direct costs
• Legal and administrative costs (Enron paid over $1
billion)
• United Airlines paid $335 million on lawyers,
accountants, consultants and examiners
• Financial distress
• Significant problems in meeting debt obligations
• Most firms that experience financial distress do not
ultimately file for bankruptcy
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More Costs
• Indirect bankruptcy costs
• Assets lose value as management spends time worrying about
avoiding bankruptcy instead of running the business

• The firm may also lose sales, experience interrupted operations

and lose valuable employees

• Potentially fruitful programs are dropped to preserve cash

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Capital Restructuring
• We are going to look at how 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

• 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
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The Effect of Leverage

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The Effect of Leverage

• So financial leverage can magnify gains and losses to shareholders

• If EBIT is high, financial leverage can be beneficial for shareholders

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Break-Even EBIT
• The effect of financial leverage
depends on the company’s EBIT

• In Break-Even EBIT, EPS is the same

under both the current and proposed
capital structures

• If we expect EBIT to be greater than

the break-even point, then leverage is
beneficial to our stockholders

• If we expect EBIT to be less than the

break-even point, then leverage is
detrimental to our stockholders
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Break-Even EBIT
• The MPD Corporation is evaluating a potential capital
restructuring decision.

• Currently, MPD uses no debt financing. Following the

restructuring, however, debt will be $1 million. MPD will
use the fund to repurchase shares

• The interest rate on the debt will be 9 percent. MPD

currently has 200,000 shares outstanding, and the price
per share is $20.
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Break-Even EBIT
• Under the old capital structure, EPS is simply
EBIT/200,000.

• Under the new capital structure, the interest expense will

be $1 million *.09 =$90,000.
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Break-Even EBIT
• Furthermore, with the $1 million proceeds, MPD will
repurchase $1 million/20 =50,000 shares of stock, leaving
150,000 outstanding.

• EPS will thus be (EBIT -$90,000)/150,000

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Optimal Capital Structure

• At relatively low debt levels, the probability of bankruptcy
and financial distress is low, and the benefit from debt
outweighs the cost

• At very high debt levels, the possibility of financial distress

is also high, so the benefit from debt financing may be more
than offset by the financial distress costs

• Optimal capital structure exists somewhere in between

these extremes
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CAPITAL STRUCTURE: SOME

MANAGERIAL RECOMMENDATIONS
• Taxes: Some firms do not need to pay any tax (tax holiday
in EPZ and Infrastructure project)

• The higher the tax rate, the greater the incentive to borrow

• Financial Distress: Firms with a greater risk of experiencing

financial distress will borrow less (R & D based firms,
airlines, tourism)

• The greater the volatility in EBIT, the less a firm should

borrow