19-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Nineteen

Financial Leverage and Capital

Structure Policy

19-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

19.1 The Capital Structure Question

19.2 The Effect of Financial Leverage

19.3 Capital Structure and the Cost of Equity Capital

19.4 M&M Propositions I & II With Corporate Taxes

19.5 Bankruptcy Costs

19.6 Optimal Capital Structure

19.7 The Pie Again

19.8 Imputation and M&M

19.9 Observed Capital Structures

Summary and Conclusions

Chapter Organisation

19-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Chapter Objectives• Understand the impact of financial leverage on a

firm’s capital structure.• Illustrate the concept of home-made leverage.• Outline both M&M Proposition I and M&M

Proposition II.• Discuss the impact of corporate taxes on M&M

Propositions I and II.• Understand the impact of bankruptcy costs on the

value of a firm.• Identify a firm’s optimal capital structure.

19-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Capital Structure Question• Key issues

– What is the relationship between capital structure and firm value?

– What is the optimal capital structure?

• Capital structure and the cost of capital– The optimal capital structure is chosen if WACC is

minimised.

19-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Effect of Financial Leverage• Financial leverage refers to the extent to which a firm

relies on debt.

• The more debt financing a firm uses in its capital structure, the more financial leverage it employs.

• Financial leverage can dramatically alter the payoffs to shareholders in the firm.

• However, financial leverage may not affect the overall cost of capital.

19-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Computing Break-even EBIT

ABC Company currently has no debt in its capital structure. The company has decided to restructure, raising $2.5 million debt at 10 per cent. ABC currently has 500 000 shares on issue at a price of $10 per share. As a result of the restructure, what is the minimum level of EBIT the company needs to maintain EPS (the break-even EBIT)? Ignore taxes.

19-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Computing Break-even EBIT (continued)• With no debt:

EPS = EBIT/500 000

• With $2.5 million in debt @ 10%:

EPS = (EBIT – $250 0001)/250 0002

1 Interest expense = $2.5 million × 10% = $250 0002 Debt raised will refund 250 000 ($2.5 million/$10) shares, leaving

250 000 shares outstanding

19-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Computing Break-even EBIT (continued)• These are then equal:

EPS = EBIT/500 000 = (EBIT – $250 000)/250 000

• With a little algebra:

EBIT = $500 000

EPSBE = $1.00 per share

19-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Computing Break-even EBIT (continued)

EBIT ($ millions, no taxes)

EPS ($)

0 0.2 0.4 0.6 0.8 1

3

2.5

2

1.5

1

0.5

0

– 0.5

– 1

D/E = 1 (with debt)

D/E = 0 (no debt)

Break-even point

19-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Effect of Financial Leverage• The effect of financial leverage depends on the

company’s EBIT.• The break-even EBIT is where a firm makes a return

just sufficient to pay the interest on debt. • If EBIT is above the break-even point, leverage is

beneficial.• If EBIT is below the break-even point, leverage is not

beneficial.• With financial leverage, shareholders are exposed to

more risk because EPS and ROE are more sensitive to changes in EBIT.

19-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Corporate Borrowing and Home-made Leverage• Despite the effects of financial leverage it does not

necessarily follow that capital structure is an important consideration.

• Why? Because shareholders can adjust the amount

of financial leverage by borrowing and lending on their own.

• Home-made leverage is the use of personal borrowing to alter the degree of financial leverage to which an individual is exposed.

19-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Example—Home-made Leverage and ROE• Original capital structure and home-made leverage

investor uses $500 of their own and borrows $500 to purchase 100 shares.

• Proposed capital structure investor uses $500 of their own, together with $250 in shares and $250 in bonds.

19-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Original Capital Structure and Home-made Leverage

Recession Expected Expansion

EPS of unlevered firm $0.60 $1.30 $1.60 Earnings for 100 shares $60.00 $130.00 $160.00 Less interest on $500 @ 10%

$50.00 $50.00 $50.00

Net earnings $10.00 $80.00 $110.00 ROE 2% 16% 22%

19-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Proposed Capital Structure

Recession Expected Expansion

EPS of levered firm $0.20 $1.60 $2.20 Earnings for 25 shares $5.00 $40.00 $55.00 Plus interest on $250 @ 10%

$25.00 $25.00 $25.00

Net earnings $30.00 $65.00 $80.00 ROE 6% 13% 16%

19-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Capital Structure Theory• Modigliani and Miller (M&M) Theory of Capital

Structure:– Proposition I—firm value– Proposition II—WACC

• The value of the firm is determined by the cash flows to the firm and the risk of the assets.

• Changing firm value:– Change the risk of the cash flows– Change the cash flows

19-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

M&M Proposition I

• The size of the pie does not depend on how it is sliced.

• The value of the firm is independent of its capital structure.

Value of firm Value of firm

19-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

M&M Proposition II• Because of Proposition I, the WACC must be

constant, with no taxes:

WACC = RA = (E/V) × RE + (D/V) × RD

where RA is the required return on the firm’s assets

• Solve for RE to get M&M Proposition II:

RE = RA + (RA – RD) × (D/E)

19-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Cost of Equity and the WACC

Debt-equity ratio, D/E

Cost of capital

WACC = RA

RD

RE = RA + (RA – RD ) x (D/E)

• The firm’s overall cost of capital is unaffected by its capital structure.

19-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Business and Financial Risk• By M&M Proposition II, the required rate of return on

equity arises from sources of firm risk. Proposition II is:

RE = RA + [RA – RD] × [D/E]

• Business risk—equity risk arising from the nature of the firm’s operating activities (measured by RA).

• Financial risk—equity risk that comes from the financial policy (i.e. capital structure) of the firm (measured by [RA – RD] × [D/E]).

19-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The SML and M&M Proposition II• How do financing decisions affect firm risk in both

M&M’s Proposition II and the CAPM?

• Consider Proposition II: All else equal, a higher debt/equity ratio will increase the required return on equity, RE.

RE = RA + (RA – RD) × (D/E)

19-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The SML and M&M Proposition II (continued)

• Substitute RA = Rf + (RM Rf)βA

and by replacement RE = Rf + (RM Rf)βE

• The effect of financing decisions is reflected in the equity beta, and, by the CAPM, increases the required return on equity.

βE = βA(1 + D/E)

• Debt increases systematic risk (and moves the firm along the SML).

19-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Corporate Taxes• The interest tax shield is the tax saving attained by a

firm from interest expense.

• Assumptions:– perpetual cash flows– no depreciation– no fixed asset or NWC spending.

• For example, a firm is considering going from $0 debt to $400 debt at 10 per cent.

19-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Corporate Taxes (continued)

Tax saving = $16 = 0.40 x $40 = TC × RD × D

19-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Corporate Taxes (continued)• What is the link between debt and firm value?

– Since interest creates a tax deduction, borrowing creates a tax shield. The value added to the firm is the present value of the annual interest tax shield in perpetuity.

• M&M Proposition I (with taxes):

• Key result:VL = VU + TCD

DT

/RD R T

. PV

C

DDC

160$10016$savingtax

19-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Total debt (D)

Value of the firm

(VL)

VU

VL = VU + TC x D

= TC

VU

TC x DVL= VU + $160

VU

$400

M&M Proposition I with Taxes

19-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Taxes, WACC and Proposition II• Taxes and firm value: an example

– EBIT = $100

– TC = 30%

– RU = 12.5%

• Suppose debt goes from $0 to $100 at 10 per cent. What happens to equity value, E?

VU = $100 × (1 – 0.30)/0.125 = $560

VL = $560 + (0.30 × $100) = $590

E = $490

19-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Taxes, WACC and Proposition II• WACC and the cost of equity (M&M Proposition II

with taxes):

RE = RU + (RU – RD) × (D/E) × (1 – TC)

%8611

3001100590$100$12860590$

490$WACC

%8612

3001490$100$10012501250

.

. . .

.

. . . . RE

19-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Debt-equity ratio, D/E

Cost of capital (%)

RU

RD (1 – TC)

RE

WACC

RE

RU

WACC

RD (1 –

TC)

Taxes, WACC and Proposition II

19-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Taxes, WACC andPropositions I and II—Conclusions• The no-tax case:

– Implications of proposition I: A firm’s capital structure is irrelevant A firm’s WACC is the same no matter what the mixture of debt

and equity is used to finance the firm.

– Implications of proposition II: The cost of equity rises as the firm increases its use of debt

financing The risk of the equity depends on two things: the riskiness of

the firm’s operations (business risk) and the degree of financial leverage (financial risk).

19-30Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Taxes, WACC, and Propositions I and II—Conclusions• With taxes:

– Implications of proposition I: Debt financing is highly advantageous, and, in the extreme, a

firm’s optimal capital structure is 100 per cent debt. A firm’s WACC decreases as the firm relies on debt financing.

– Implications of proposition II: Unlike proposition I, the general implications of proposition II

are the same whether there are taxes or not.

19-31Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Bankruptcy Costs• Borrowing money is a good news/bad news

proposition:– The good news: interest payments are deductible and create

a debt tax shield (TCD).

– The bad news: all else equal, borrowing more money increases the probability (and therefore the expected value) of direct and indirect bankruptcy costs.

• Key issue: The impact of financial distress on firm value.

19-32Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Direct versus Indirect Bankruptcy Costs• Direct bankruptcy costs are costs directly associated

with bankruptcy such as legal and administrative expenses.

• Indirect bankruptcy costs are costs associated with spending resources to avoid bankruptcy.

• Financial distress:– significant problems in meeting debt obligations– most firms that experience financial distress do recover.

19-33Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Optimal Capital Structure

• The static theory of capital structure:– A firm borrows up to the point where the tax benefit from an

extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. This is the point at which WACC is minimised and the value of the firm is maximised.

– It is called the static theory because it assumes that the firm is fixed in terms of its assets and operations and it only considers possible changes in the debt/equity ratio.

19-34Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Value ofthe firm

(VL )

Debt-equity ratio, D/EOptimal amount of debtD/E

Present value of taxshield on debt

Financial distress costs

Actual firm value

VU = Value of firm with no debt

VL = VU + TC D

Maximumfirm value VL*

VU

The Optimal Capital Structure and the Value of the Firm

19-35Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Cost ofcapital

(%)

Debt/equity ratio (D/E)D*/E*

The optimal debt/equity ratio

RU

WACC

RD (1 – TC)

RE

RU

WACC*Minimum cost of capital

The Optimal Capital Structure and the Cost of Capital

19-36Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Value ofthe firm

( VL )

Total debt (D)D*

PV of bankruptcy costs

Case III Static TheoryCase IM&M (no taxes)

VL*

VU

Case IIM&M (with taxes)

Net gain from leverage

The Capital Structure Question

19-37Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Managerial Recommendations• Taxes

– The tax benefit is only important if to firms in a tax-paying position.

– The higher the tax payable, the greater the incentive to borrow.

• Financial distress:– The greater the risk of financial distress, the less debt will be

optimal for the firm.– All other things equal, the greater the volatility in EBIT, the

less a firm should borrow.– The costs of financial distress depend primarily on the firm’s

assets and how easily ownership to those assets can be transferred.

19-38Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

The Extended Pie Model

19-39Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Corporate Borrowing and Personal Borrowing• Without tax, corporate and personal borrowing are

interchangeable.

• With corporate and personal tax, there is an advantage to corporate borrowing because of the interest tax shield.

• With corporate and personal tax, and dividend imputation, shareholders are again indifferent between corporate and personal borrowing.

19-40Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Dynamic Capital Structure Theories• Pecking order theory:

– Investment is financed first with internal funds, then debt, and finally with equity.

• Information asymmetry cost:– Management has superior information on the prospects of

the firm.

• Agency costs of debt:– These occur when equity holders act in their own best

interests rather than the interests of the firm.

19-41Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Debt-to-Equity Ratios for Selected Australian Industries, 2006

Industry Debt/Equity %

Banks 129

Coal 10

Engineering 31

Gas 141

Gold 15

Medical 11

Oil 8

Property trusts 69

Real Estate 40

Retail 28

Telecommunications 17

19-42Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan

Summary and Conclusions• The optimal capital structure for a firm is one that

maximises the value of the firm and minimises the overall cost of capital.

• If taxes, financial distress costs, and any other imperfections are ignored, the firm’s capital structure is simply irrelevant.

• If company taxes are considered, capital structure matters a great deal.

• Bankruptcy or financial distress costs reduce the attractiveness of debt financing.

• Australian firms typically do not use great amounts of debt (but pay substantial taxes) and firms in similar industries tend to have similar capital structures.