Financial

Leverage and
Capital
Structure
Policy
Dr. Science (Economics), Ph.D.

(Finance), Professor

Iryna Mihus
Key Concepts and Skills

Understand the effect of financial leverage on

cash flows and the cost of equity

Understand the impact of taxes and bankruptcy

on capital structure choice

Understand the basic components of the

bankruptcy process

2
Chapter Outline
The Capital Structure Question
The Effect of Financial Leverage
Capital Structure and the Cost of Equity Capital
M&M Propositions I and II with Corporate Taxes
Bankruptcy Costs
Optimal Capital Structure
The Pie Again
The Pecking-Order Theory
Observed Capital Structures
A Quick Look at the Bankruptcy Process

3
Capital Restructuring
We are going to look at how changes in capital
structure affect the value of the firm, all else equal

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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 What is the primary Maximize
goal of financial stockholder
managers? wealth

Choosing a We want to choose the capital

Capital structure that will maximize
stockholder wealth
Structure
We can maximize stockholder
wealth by maximizing the value of
the firm or minimizing the WACC

5
The Effect of Leverage
How does leverage affect the EPS and ROE of a firm?

When 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

If we have a really bad year, we still have to pay our fixed

costs and we have less left over for our stockholders

Leverage amplifies the variation in both EPS and ROE

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Example: Financial Leverage, EPS and ROE – Part
I

 We will ignore the effect of taxes at this stage

 What happens to EPS and ROE when we issue debt and buy back
shares of stock?

Financial Leverage Example

7
Figure 1
 • Current: ROE ranges from 6% to 20%
Variability in ROE • Proposed: ROE ranges from 2% to 30%
Example:
Financial • Current: EPS ranges from $0.60 to
$2.00
Leverage, Variability in EPS • Proposed: EPS ranges from $0.20 to
$3.00

EPS and ROE The variability in

– Part II both ROE and EPS
increases when
financial leverage
is increased

9
 Find EBIT where EPS is the same
under both the current and proposed
capital structures

If we expect EBIT to be greater than

Break-Even the break-even point, then leverage
EBIT may be 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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Example: Break-Even EBIT
EBIT EBIT  250,000

500,000 250,000
 500,000 
EBIT    EBIT  250,000 
 250,000 
EBIT  2EBIT  500,000
EBIT  $500,000 Break-even Graph

500,000
EPS   $1.00
500,000
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Figure 2
 Example: Homemade Leverage
and ROE

 Current Capital Structure  Proposed Capital Structure

 Investor borrows $500 and  Investor buys $250 worth of
uses $500 of her own to stock (25 shares) and $250
buy 100 shares of stock worth of bonds paying 10%.
 Payoffs:  Payoffs:
 Recession: 100(0.60)  Recession: 25(.20)
- .1(500) = $10 + .1(250) = $30
 Expected: 100(1.30)  Expected: 25(1.60)
- .1(500) = $80 + .1(250) = $65
 Expansion: 100(2.00)  Expansion: 25(3.00)
- .1(500) = $150 + .1(250) = $100
 Mirrors the payoffs from  Mirrors the payoffs from
purchasing 50 shares of the
purchasing 50 shares under
firm under the proposed
the current capital structure
capital structure

13
 Modigliani and Miller Proposition I –
firm value
(M&M)Theory of Proposition II –
Capital Structure WACC

Capital The value of the firm is determined

Structure by the cash flows to the firm and
the risk of the assets
Theory
Change the risk of
the cash flows
Changing firm value Change the cash
flows

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

Case II – Assumptions
Case • Corporate taxes, but no personal taxes
• No bankruptcy costs

Case III – Assumptions

Case • Corporate taxes, but no personal taxes
• Bankruptcy costs

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Case I – Propositions I and II

The value of the firm is NOT

affected by changes in the
capital structure
Proposition I 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

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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 3

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Case I - Example
 Data
 Required return on assets = 16%; cost of debt = 10%;
percent of debt = 45%
 What is the cost of equity?
 RE = 16 + (16 - 10)(.45/.55) = 20.91%
 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
 Based on this information, what is the percent of
equity in the firm?
 E/V = 1 / 2.5 = 40%
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The CAPM, the SML and Proposition II

How does financial leverage affect

systematic risk?

Where A is the firm’s asset

CAPM: RA = Rf + A(RM beta and measures the
– Rf ) systematic risk of the firm’s
assets

Replace RA with the CAPM

and assume that the debt is
Proposition II riskless (RD = Rf)
RE = Rf + A(1+D/E)(RM – Rf)

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Business Risk and
Financial Risk
 RE = Rf + A(1+D/E)(RM – Rf)
 CAPM: RE = Rf + E(RM – Rf)
 E = A(1 + D/E)
 Therefore, the systematic risk of the stock depends on:
 Systematic risk of the assets, A, (Business risk)
 Level of leverage, D/E, (Financial risk)

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 Interest is tax deductible

Therefore, when a firm adds debt, it

reduces taxes, all else equal
Case II – Cash
Flow The reduction in taxes increases the
cash flow of the firm

How should an increase in cash flows

affect the value of the firm?

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 Case II - Example

Unlevered Firm Levered Firm

EBIT 5,000 5,000

Interest 0 500
Taxable 5,000 4,500
Income
Taxes (34%) 1,700 1,530
Net Income 3,300 2,970
CFFA 3,300 3,470

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Interest Tax Shield

Tax rate times interest payment

Annual interest tax 6,250 in 8% debt = 500 in
interest expense
shield Annual tax shield = .34(500) =
170

Present value of Assume perpetual debt for

simplicity

annual interest tax PV = 170 / .08 = 2,125

PV = D(RD)(TC) / RD = DTC =
shield 6,250(.34) = 2,125

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Case II – Proposition I

The value of the firm Value of a levered firm =

value of an unlevered firm +
increases by the present PV of interest tax shield
value of the annual interest Value of equity = Value of the
tax shield firm – Value of debt

Assuming perpetual cash VU = EBIT(1-T) / RU

flows VL = VU + DTC

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Example: Case II – Proposition I

 Data
 EBIT = 25 million; Tax rate = 35%; Debt = $75 million; Cost of debt = 9%; Unlevered
cost of capital = 12%
 VU = 25(1-.35) / .12 = $135.42 million
 VL = 135.42 + 75(.35) = $161.67 million
 E = 161.67 – 75 = $86.67 million

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Figure 4

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Case II – Proposition II

The WACC decreases

as D/E increases RA = (E/V)RE + (D/V)(RD)(1-TC)
because of the
government subsidy RE = RU + (RU – RD)(D/E)(1-TC)
on interest payments

RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
Example 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
Suppose that the firm changes its capital structure so that the debt-to-equity ratio
becomes 1.

What will happen to the cost of equity under the new capital structure?
RE = 12 + (12 - 9)(1)(1-.35) = 13.95%

What will happen to the weighted average cost of capital?

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

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Figure 5

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Case III
Now we add bankruptcy costs

As the D/E ratio increases, the probability of bankruptcy

increases

This increased probability will increase the expected

bankruptcy costs

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

will be offset by the increase in expected bankruptcy cost

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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Bankruptcy Costs

Legal and administrative costs

Ultimately cause bondholders
Direct costs to incur additional losses
Disincentive to debt financing

Significant problems in meeting

debt obligations
Financial distress Firms that experience financial
distress do not necessarily file
for bankruptcy

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More Bankruptcy Costs
 Indirect bankruptcy costs
 Larger than direct costs, but more difficult to measure
and estimate
 Stockholders want to avoid a formal bankruptcy filing
 Bondholders want to keep existing assets intact so they
can at least receive that money
 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

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Figure 6

34
Figure 7

35
Conclusions
Case Case Case

Case I – no taxes Case II – Case III –

or bankruptcy corporate taxes corporate taxes
costs but no and bankruptcy
• No optimal capital bankruptcy costs costs
structure • Optimal capital • Optimal capital
structure is almost structure is part
100% debt debt and part
• Each additional equity
dollar of debt • Occurs where the
increases the cash benefit from an
flow of the firm additional dollar of
debt is just offset
by the increase in
expected
bankruptcy costs

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Figure 8

37
Managerial Recommendations

The tax benefit is only important if the firm has

a large tax liability

The greater the risk of financial distress, the less

debt will be optimal for the firm
Risk of financial distress 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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Figure 9

39
The Value of the Firm

 Value of the firm = marketed claims + nonmarketed claims

 Marketed claims are the claims of stockholders and bondholders
 Nonmarketed claims are the claims of the government and other
potential stakeholders
 The overall value of the firm is unaffected by changes in
capital structure
 The division of value between marketed claims and
nonmarketed claims may be impacted by capital structure
decisions

40
The Pecking-Order Theory

Theory stating that • Rule 1

firms prefer to issue • Use internal financing first
debt rather than equity • Rule 2
if internal financing is • Issue debt next, new equity last
insufficient.

The pecking-order • There is no target D/E ratio

theory is at odds with • Profitable firms use less debt
the tradeoff theory: • Companies like financial slack

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Observed Capital Structure

 Capital structure does differ by industry

 Differences according to Cost of Capital 2008 Yearbook by Ibbotson
Associates, Inc.
 Lowest levels of debt
 Computers with 5.61% debt
 Drugs with 7.25% debt
 Highest levels of debt
 Cable television with 162.03% debt
 Airlines with 129.40% debt

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Work the Web Example

 You can find information about a company’s capital structure relative to its
industry, sector and the S&P 500 at Reuters
 Click on the web surfer to go to the site
 Choose a company and get a quote
 Choose Ratio Comparisons

43
Bankruptcy Process – Part I

Business failure – business has terminated with a loss to creditors

Legal bankruptcy – petition federal court for bankruptcy

Technical insolvency – firm is unable to meet debt obligations

Accounting insolvency – book value of equity is negative

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Bankruptcy Process – Part II

• Chapter 7 of the Federal Bankruptcy Reform Act of

1978
Liquidation • Trustee takes over assets, sells them and distributes
the proceeds according to the absolute priority rule

• Chapter 11 of the Federal Bankruptcy Reform Act of

1978
Reorganization • Restructure the corporation with a provision to
repay creditors

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Quick Quiz
What is the break-even
Explain the effect of
EBIT, and how do we
leverage on EPS and ROE
compute it?

What is the optimal

How do we determine the capital structure in the
optimal capital structure? three cases that were
discussed in this chapter?

What is the difference

between liquidation and
reorganization?

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  Suppose managers of a firm know that the company is
approaching financial distress.

Ethics Issues
 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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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%?

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