Week 10

Topic:FinancialLeverageandCapitalStructure
Agenda:
CapitalStructureinaNutshell
FinancialLeverageandItsImpactonEquityRisk
HomemadeLeverage:ReplicatingtheFinancialLeverageofaFirm
ModiglianiandMillers(M&M)PropositionsinanIdealWorld
ModiglianiandMillers(M&M)PropositionsinaTaxableWorld
ModiglianiandMillers(M&M)PropositionsinaWorldwithTaxes
andBankruptcy
KyungHwanShim,FINS1613S2Yr2016
CapitalStructureinaNutshell
TheCapitalStructureQuestion
Recallthatthe
formulation
1
takesthecapitalstructure(themixofdebtandequity)ofthefirm
asgiven.
Notethatthe
firmsassets,i.e.
cashflow.
istheappropriatediscountratetovaluea
, where denotesthefirmsperpetual
Capitalstructurequestion: Whatistheoptimaldebtchoice
maximizesfirmvalue ?
Answer:Itmustbethedebtchoicethatminimizes
that
.
3
FinancialLeverageandItsImpacton
EquityRisk
WhatisFinancialLeverage?
CapitalStructure:Themixofdebtandequitywhichmakesupthe
totalmarketvalue ofacompany.
FinancialLeverage: theextenttowhichacompanyiscommittedto
fixedchargesrelatedtointerestpayments.Measuredby:
thedebttovalueratio:
,or
thedebttoequityratio:
Marketleverageusesmarketvaluesofdebtandequity.
Bookleverageusesbookvaluesfromtherightsideofthebalance
sheet.
TheEffectsofFinancialLeverage
Currentlythecompanyhasnodebt.Theproposalistoissuedebtanduse
theproceedstobuybackshares,i.e.,undergoacapitalrestructuring.
Fromtheexample:
whenEBITishigh,financialleverageraisesROEandEPSeven
higher
whenEBITislow,financialleveragelowersROEandEPSeven
lower
FinancialleverageamplifiesthevolatilityofROEandEPScausedby
changesinEBIT.
Conclusion:Financialleveragemakesequityriskier!
FinancialLeverageandBreakEvenEBIT
BreakevenEBITisthelevelofEBITwhichmakesearningsper
sharethesamebetweendebtandnodebtalternatives:
Fromthepreviousexamplewehave,

400,000

400,000
200,000

$800,000
400,000

400,000
200,000

400,000
$800,000
$2.00
FinancialLeverageandBreakEvenEBIT
IfweexpectEBITtobegreater
thanthebreakevenpoint,
thenleverageisbeneficialto
theshareholders
otherwise,leverageis
detrimentaltothe
stockholders.
IfEBITisvariableovertime,
financialleverageamplifiesthe
variabilitytoequityreturns,
i.e.equitybecomesriskier
withmoreleverage.
10
HomemadeLeverage:Replicating
theFinancialLeverageofaFirm
11
CorporateBorrowingvsHomemadeLeverage
Homemadeleverage: theuseofpersonalborrowing/lendingtochangean
investorsexposuretofinancialleverage
12
HomemadeLeverage:MainConceptualPoints
Stockholderswhoprefermore financialleveragecanreplicatea
greaterfinancialleverageexposurebyborrowing andinvesting the
proceedsinstocks.
Stockholderswhoprefersless financialleveragecanreplicatealower
financialleverageexposurebyselling stocksandlending the
proceeds.
Conclusion: Withhomemadeleverageitmakesnodifference
whetherafirmchoosesahigheroralowerfinancialleverage.
Thevalueofafirmshouldbeindependentofcapitalstructure.
13
ModiglianiandMillersPropositions
inanIdealWorld
14
ModiglianiandMiller
ThehomemadeleverageargumentisbasedontheworkofFranco
ModiglianiandMertonMiller(M&M).
Muchofwhatweknowaboutmodernfinancetheoryisbasedon
theworkofM&M.
M&Marguedthatunderidealcircumstances,thevalueofafirmis
determinedonlybythefirmsoperations.
Nothingelseshouldaffectfirmvalue.
15
ModiglianiandMiller
M&Mproposethatthefirmvaluechangesonlyifthereisachangein:
(i)theriskofthefirmscashflows,and/or
(ii)thelevelofthefirmscashflows
Thetotalvalueofthefirmisnotaffectedbythemixofdebtand
equity.I.e.,
Debt
40%
Equity
60%
Equity
40%
=
Debt
60%
Debt
0%
Equity
100%
16
ModiglianiandMillersPropositionI
Considertwoidenticalfirmswiththesameamountofoperatingcash
flows
everyyear;exceptfirm isleveredandfirm isnot
levered(unlevered).
Note:thevalueofthefirmsareidenticalirrespectiveofthe
differenceincapitalstructure.
M&MPropositionI: Thevalueoffirmisindependentofthecapital
structure.
Since
arethesame,the
isalsothesamebetweenthe
twofirms.
17
ModiglianiandMillersPropositionII
sOverallCostofCapital:
sOverallCostofCapital:
sEquityCostofCapital(M&MProp.II):
M&MPropositionII: Afirmscostofequityisincreasinginfinancial
leverage
18
ModiglianiandMillersPropositionII
19
ModiglianiandMillersPropositionIIandBetas
BasedonM&MPropositionII:
.
SubstitutingintheCAPMequationgivesthefollowing:
Ifthereisnofearofbankruptcythendebtisriskless,i.e.
D
0,
andequitybetabecomes
E
20
ModiglianiandMillersPropositionsIandII:Example
NodebtInc.isanallequityfirm.Itsequitybetais.80.TheTbill
rateis5%andthemarketriskpremiumisexpectedtobe10%.
AssumethatNodebtistaxexempt.
a)WhatisNodebtsassetbeta?
b)WhatisNodebtsWACC?
21
ModiglianiandMillersPropositionsIandII
SupposethatNoDebtissuesasmalldebt sosmallthatinvestors
perceivethebondstoberiskfree.Aftertheissue,thedebt
comprises10%ofthefirmscapitalstructure.
a)Whatisthebetaandtherequiredrateofreturnonthedebt?
b)Whatisthenewbetaandtherequiredrateofreturn
onthefirmsequity?
c)WhatistheWACCofNoDebtunderthenewfinancing
mix.HastheWACCchanged?Interprettheresult.
d)CalculatethebetaoftheassetsofNoDebtgiventhenew
financingmix.Hasthebetachanged?
22
ModiglianiandMillersPropositionsIandIIwithNoTaxes
a )S in c e t h e d e b t is r is k le s s , D 0 a n d R D 5 % .
. 8 1 1 . 8 9
E
9
R R ( R R ) D
E
1 3 % (1 3 % 5 % ) 1 1 3 . 8 9 %
9
b ) E
1 D
A
c ) W A C C 0 . 9 1 3 . 8 9 % 0 . 1 5 % 1 3 % (n o c h a n g e )
R E h a s in c r e a s e d d u e t o f in a n c ia lle v e r a g e ,b u t t h e n e w
m ix o f d e b t a n d e q u it y h a s s h if t e d t h e w e ig h t t o d e b t ,
w h ic h h a s a lo w e r c o s t .T h e n e t e f f e c t is t h e s a m e W A C C .
d )
D E
E . 1 0 . 9 . 8 9 . 8 (n o c h a n g e ).
23
inaTaxableWorld
24
CorporateTaxes
Intherealworld,
(i)firmsmustpaytaxes;and
(ii)borrowingrisksexposinginvestorstobankruptcy.
Weconsiderthetaximplicationsfirst.
Interestexpenseistaxdeductible. Thisgivesrisetotaxshields.
InterestTaxShield: Thetaxsavingrelatedtoborrowing.
Financingwithdebtincreasestheamountofprofitswhichis
distributabletoallinvestors.
Therefore,debtcanincreasefirmvalue.
25
CorporateTaxesandAfterTaxCashFlows
D=6250 with
UnleveredFirm
LeveredFirm
5000
5000
500
TaxableIncome
5000
4500
Taxes(30%)
1500
1350
NetIncome
3500
3150
Cash Flow
3500
3650
EBIT
Interest
26
InterestTaxShieldandFirmValue
Annualinteresttaxshield:
6250indebt@8%=500ininterestexpense
Annualtaxshield=
6250
8%
0.3
150
PVofInterestTaxShieldsintheM&MWorld:
Assumingperpetualdebtandthattaxshieldshavethesamerisk
asthedebt,
150
1875

0.08
Theexistenceofcorporatetaxesmakesdebtfinancingappealing.
27
M&MPropositionIwithCorporateTaxes
Considerleveredfirm andunleveredfirm again.
Whatis and sfirmvalueifprofitsaretaxable?
A ftertaxcash flo w for U is EB IT (1 T )

EB IT (1 T )
VU PVo f EB IT (1 T )
RU
28
A ftertaxcash flow fo r L is
(EB IT R D D ) (1 T ) R D D EB IT (1 T ) T D R D

cash flo w to
equityhold ers
cash flow to
d eb th o ld ers
VL PVof EB IT (1 T ) PVof T D R D
M&MPropositionIwithCorporateTaxes:
VL VU PVo fTaxSh ield From D eb t

T D RD
VL VU
VU T D
RD
29
30
M&MPropositionIIwithCorporateTaxes
Withcorporatetaxes,thevalueofthefirmisincreasinginfinancial
leverage.
Since
isconstant,ahigherfirmvaluemeansthatthe
thefirmisdecreasinginfinancialleverage.
of
ifprofitsaretaxable:
D
W A C C R D (1 T )
V
E
RE
V
31
DefineRUtheunleveragedcostofcapitalforthefirm,i.e.the
ofthefirmif
0.Then,
M&MProposition IIwithCorporateTaxes:
RE RU
D

( R U R D ) (1 T )
E
Implicationsforcostofequityaresimilartothecasewithouttaxes.
Equityriskincreaseswithfinancialleverage,butlessrapidly.
32
33
M&MPropositionswithCorporateTaxes
Q)WhatisNoDebtsfirmvaluebeforeandaftertheleverage
changeifithasperpetualoperatingcashflowsof$5Kandthe
corporatetaxrateis30%?
A) With
0,
1
With
1 .3
.13
$26.9
,
26.9

.3

$27.7
26.9
10
.3
34
M&MPropositionswithCorporateTaxes
Alternatively,
1
.13
.1362
1
9
.13
.05
.3
9/10
.05
.3
1 .3
.1262
.1362
1/10
.1262
$27.7
35
inaWorldwithTaxesand
Bankruptcy
36
BankruptcyCosts
Directbankruptcycosts: Costsdirectlyassociatedwithbankruptcy;
theoutofpocketexpensesrelatedtobankruptcy,suchaslegal
fees,courtfeesandadministrativecosts.
Indirectbankruptcycosts: Costsrelatedtodifficultiesrunninga
distressedbusiness.Examples:
disruptionsinoperationsandlossofcustomers
tightercreditconstraintsfromsuppliersandbanks
lossofemployeesandcustomers
damagetofirmsreputation
Foregone+NPVinvestmentopportunities
Etc.
Bankruptcyhasanegativeeffectonfirmvalue.
37
M&MPropositionswithTaxandBankruptcyCosts
Whiledebt
(i) generatestaxshields;
(ii) debtalsocreatescostsoffinancialdistress
Theoptimalamountofdebtfinancing isacompromise
betweentaxsavings andfinancialdistress costs.
M&MPropositionIwithTaxesandBankruptcy:

ThePVofTaxShieldsdominatesthePVofDistressCostsif
whilethelatterdominatestheformerif
38
M&MPropositionwithTaxandBankruptcyCosts
39
M&MPropositionwithTaxandBankruptcyCosts
Thetradeoffbetweenhighertaxsavingsandhighercostof
financialdistress determinestheoptimalamountofDebt.
Theoptimalamountofdebt iswherethePVoftaxshield
gainedisexactlyoffsetbytheriseinthePVofdistresscost
resultingfromanincrementalincreasein ,i.e.
Tax Shield
isalsowherethefirmvalueismaximized.
40
M&MPropositionwithTaxandBankruptcyCosts:Example
Assume ABC operates in a Modigliani and Miller's world with
corporate taxes and bankruptcy. Your research shows certain levels
of debt are associated with an incremental PV of financial distress
costs as shown in the table below. Based on this research, what is the
amount of debt that is closest to the optimal amount of debt for ABC?
ABC has a tax rate of 35%.
a)
b)
c)
d)
e)
Debt
IncrementalPVof
FinancialDistressCosts
83.3M
70.2M
60.7M
51.4M
43.6M
0.50
0.42
0.34
0.30
0.23
41
Conclusion
Financialleverageincreasesequityrisk,equitybeta,andthecostof
equitycapital.
Inanenvironmentwithtaxesandbankruptcycosts,theidealmixof
debtandequityisonethat:
(i)maximizesfirmvalueor
(ii)minimizesthefirms
Problems:
CriticalThinkingandConceptsReview:13.113.6
QuestionsandProblems:18,1117
42

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Topic:FinancialLeverageandCapitalStructure

A ftertaxcash flo w for U is EB IT (1 T )

VL VU PVo fTaxSh ield From D eb t

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