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FIN 720 Topic 3 Lecture 2

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18 views23 pages

FIN 720 Topic 3 Lecture 2

Uploaded by

Mayibongwe Madisa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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FIN 720: TOPIC 3 Lecture 2

Leverage and Capital Structure


The Journey
 General Introduction & Definitions
 Importance & Impact of Capital Structure & Financial Leverage
 Measures of Leverage
 Capital Structure Theories
 Modigliani & Miller (M&M)
 With & Without taxes
 Optimal Capital Structure
 Summary
Re-call-Value of the firm
WACC (i) = 10%

Period Profit Power (1+i)^ PV


(P0) 20000 0 1 20000
(p1) 20400 1 1.1 18545.45
(p2) 20808 2 1.21 17196.69
(p3) 21224 3 1.331 15945.91
(p4) 21648 4 1.4641 14785.88
86473.93
Re-call-Value of the firm
WACC (i) = 12%

Period Profit Power (1+i)^ PV


(P0) 20000 0 1 20000
(p1) 20400 1 1.12 18214.29
(p2) 20808 2 1.2544 16588.01
(p3) 21224 3 1.404928 15106.82
(p4) 21648 4 1.573519 13757.7
83666.82
Homemade Leverage
 Back to Basics
 In a “taxless” environment, leverage is important for the firm
 Does it also mean that firm’s leverage is important for individual investors?
 Not really! Says Modigliani & Miller
 Investors can use personal borrowings to create their preferred leverage on
their investment portfolio.
 i.e., can borrow money & invest it in further equity.
 Borrowing hence creates leverage
Homemade Leverage

Option A Option B
Assets 500000 500000
Debt 0 200000
Equity 500000 300000
Share Price P20 P20
No. of Shares 25000 15000
Interest Rate 15% 15%
Profit before Interest 175000 175000
Homemade Leverage
 Assume that the Company is presently
structured as in option A & is considering re-
structuring to option B.
 If the Company ultimately moves to option B we
have already seen that EPS will increase from
P7.00 to P9.67
 If however, the company decides to stay at
option A, investors would lose the chance to
have a pay off equivalent to an EPS of P9.67.
 An investor can still achieve an equivalent pay
off through homemade leverage & replication
of option B
Homemade leverage
 Replicating option B
 The Debt/equity ratio in Option B = 200000: 300000 = 2:3
 The Investor must then borrow on her own at an interest of 15%.
 E.g. ? An investor wishing to buy P10000 worth of shares can buy .6 x 10000
outright and .4 x 10000 using borrowed funds.
 P6000 shares paid for in cash and P4000 shares paid for with a 15% loan.
 Total shares purchased= P10000/20 = 500
Homemade Leverage
 Pay off From Option A (unlevered) = EPS x No.of shares: 7 x 300 = P2100
 Pay off from Option B (levered) = 9.67 x 300 = P2900
 Investor in Firm A (unlevered) can use home leverage to earn a pay off of
P2900 by acquiring additional 200 shares using borrowings;
 (7 x 500) – (.15 x 4000) = P2900
Homemade leverage
 Assumes Individuals can borrow at same rate with Companies.
 Therefore value can not be created through leveraging the firm
 Individuals borrow to increase shareholding hence value
 Increased shareholding creates value through leverage
If individuals borrow at higher rate,
 Value can be created through leverage
Enter Modigliani & Miller
 Homemade leverage concept therefore demonstrates
that for shareholders, no capital structure is superior
or inferior in the absence of taxes.

 Thisis the Modigliani and Miller Proposition I (no


taxes)

 Also follows that the value of a levered firm is the


same as the value of an unlevered firm provided
individuals & firms borrow at the same rate & there
are no taxes.
MM I

Explicit MM I assumptions.
 At any given level of risk, Individuals and Companies can
borrow at the same level
 Individuals and Companies pose the same level of risk to
lenders.
 There are no transaction costs, bankruptcy costs or
information costs
 There is no tax
Modigliani & Miller II (no tax)
 A firm’s capital structure has an impact on the firm’s cost of equity capital.
 Re-call that the firm’s cost of capital is a weighted average of cost of equity
(RE) and cost of debt (RD)
 WACC = (E/V)RE + (D/V)RD
 Where;
 Required rate of return by shareholders RE
 Value, V = E + D

 MMII says: RE = WACC + (WACC – RD)D/E


MM II (no Taxes
 WACC represents expected return required
from business risk of the firm’s assets.
 Re-call that an Investment’s required rate of
return is determined by its systematic or un-
diversifiable.
 Business risk; risk associated with operating
cash flows & affects both equity and debt
capital providers.
 Business risk is systematic & therefore un-
diversifiable
 Therefore WACC is not affected by leverage
MM II no taxes
 Changing leverage can not affect the firm’s operating cash flows.
 leverage only affects distribution of cash flows between equity providers
(dividends) & debt capital providers (interest)
 Therefore value of firm not affected by leverage!
 Leverage reduces amount available for distribution to equity holders?
MM II

 Financial risk arises from leverage & affects only equity


capital providers.
 Therefore RE = compensation for business and finance
risk
 RE = WACC + (WACC – RD)D/E
 So RE for levered firm higher than for unlevered firm
MM

 MM conclusion
 Capital structure not relevant for shareholder wealth.
 A company’s overall return (WACC) is determined by its
business risk.
 Companies with same levels of business risk but different
capital structures should have same expected returns.
 Arbitrage will close any inconsistencies?
MM: Capital Structure with taxes
 Taxes have an impact on the distribution of cash flows.
 Assume a classic tax system as opposed to imputed tax system
 Leverage results in tax saving (tax rate x interest payable) aka ‘interest tax
shield’
 Cash flow from levered firm is greater by the interest tax shield.
 Value of levered firm (VL) > (VU) by PV of interest tax shield (TC x D)
 Where; TC = tax rate and D = debt capital
MM with Taxes

 MM I with taxes:VL = VU + (TC x D)

 Increase in (TC x D) will increase value of


firm, so optimal capital structure = 100%
debt?
 WACC decrease as debt increases.
 Capital structure in a world with taxes
matters
 MM II with taxes: RE = RU + (RU – RD)D/E x
(1- TC)
 Where RU = cost of capital of unlevered firm
MM & the ‘Real’ World
 Why then don’t we find Highly Levered Companies around town?
1. Tax Exhaustion
 Insufficient tax liability to give rise to interest tax shield

2. Debt Capacity
 Most debt issued is secured, therefore how much debt a firm can raise depends on
the availability of assets that can be used as security
 E.g. Assets with a poor second hand market & high depreciation rates will attract
very little debt
MM & the ‘Real’ World
3. Agency Costs
 Restrictions imposed by providers of debt finance
 E.g. Restrictions on taking on additional debt, restrictions on dividend pay outs,
restrictions on disposal of assets, etc

4. Insolvency costs
 Insolvency: when cash flows can not support repayments of debt.
 Probability increases with leverage
 Value of firm decreases with increased liquidation probability.
MM & ‘Reality’
 Value of the firm with Bankruptcy
 VL = VU + (TC x D) – EBANKRUPTCY

 Where = EBANKRUPTCY cost of bankruptcy x probability of bankruptcy.


 Bankruptcy Costs
 Direct: e.g. liquidation administration, legal costs, loss on sale of assets
 Indirect: e.g. losses associated with impending liquidation, loss of opportunities,
credit lines being frozen, good staff leaving, low morale, etc
Optimal Capital Structure Exists?

Read & prepare for a Discussion on


1. Static Theory of Capital Structure
2. The Pie Model of Capital Structure (extended version)
3. The Pecking-Order Theory

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