4 Capital Structure (Chapter 16: financial Leverage and Capital Structure Policy)

Contents
4 Capital Structure (Chapter 16: financial Leverage and Capital Structure Policy) ........................... 1
4.1 Introduction ............................................................................................................................ 1
4.2 Capital Structure effect on EPS and ROE ................................................................................ 1
4.2.1 Break Even EBIT............................................................................................................... 2
4.3 Capital Structure Theory: - Modigliani and Miller (M&M)...................................................... 4
4.3.1 Introduction .................................................................................................................... 4
4.3.2 M&M Proposition I.......................................................................................................... 5
4.3.3 M&M Proposition II......................................................................................................... 5
4.3.4 M&M Propositions I and II with corporate taxes ............................................................ 6
4.4 Optimal Capital Structure: Static theory of Capital Structure ................................................ 8
4.5 The Pecking Order Theory..................................................................................................... 10

4.1 Introduction

• 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 i.e. increasing or decreasing % of debt to capital in order to maximize value
of a company.

• 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

• We can maximize stockholder wealth by maximizing the value of the firm or minimizing the
WACC by altering the debt portion.

4.2 Capital Structure effect on EPS and ROE

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 • 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

4.2.1 Break Even EBIT (Degree of financial leverage ,DFL)

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

• Depend on Break even EBIT:-

• 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

Example (see table 16.3 and table 16.4 page 511)

The Trans Am Corporation currently has no debt in its capital structure. The CFO, Ms Morris is
considering a restructuring that would involve issuing debt and using the proceeds to buy back some
of the outstanding equity. Below are the details.

Current condition Proposed

Assets $8m $8m
Debt 0 $4 m
Equity $8m $4m
Debt Equity 0 1
Share Price $20 $20
Shares Outstanding 400 k 200k
Interest rate 10% 10%
Interest 0 $400k = $4m x 10%

Other info : - assume no change on stock price, no taxes.

: - EBIT is forecast to be $1m and expected to increase by $500 k during boom and
reduce by $500K if recession.

Therefore Scenario analysis under both regimes is as follows:-

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 Current condition = no debt
Recession Expected Expansion
EBIT $500k $1 m $1.5m
Interest 0 0 0
Net Income $500k $1 m $1.5m
ROE 6.25% = ($500k /$8m) 12.50% ($1m/$8m) 18.75% ($1.5m /$8m)
EPS $1.25 = ($500k/ 400k) $2.50 ($1m/400k) $3.75 ($1.5m/ 400k)

ROE = Net Income / Equity

EPS = Net Income / number of shares

proposed condition = $4m

Recession Expected Expansion
EBIT $500K $1m $1.5m
Interest $400k $400k $400k
Net Income $100k $600k $1.1m
ROE 2.5% ($100k/$4m) 15% ($600 k /$4m) 27.5 ($1.1m/$4m)
EPS $0.5 ($100k/200k) $3 ($600k/200k) $5.50 ($1.1m/200k)

Break even EBIT=

EPS before = EPS proposed

𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇 − 𝐼𝑁𝑇𝐸𝑅𝐸𝑆𝑇

=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠

𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇 − $400 𝑘

=
400 000 200 000

EBIT = 2EBIT - $800 K

EBIT = $800 k

Therefore when EBIT is $800 k, EPS is $2 under both capital structures. If EBIT beyond than $800k ,
leverage is beneficial.

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 $3.50
Financial Leverage: EPS and EBIT for the Trans Am Corporation
$3.00

$2.50

Break-even Point:
EPS = $1; EBIT =
$2.00
$500,000

$1.50
Current
EPS

$1.00

$0.50

$0.00
$300,000 $650,000 $1,000,000

EBIT

4.3 Capital Structure Theory: - Modigliani and Miller (M&M)

4.3.1 Introduction
 The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the
basis for modern thinking on capital structure. The basic theorem states that, under a
certain market price process (the classical random walk), in the absence of taxes,
bankruptcy costs, agency costs, and asymmetric information, and in an efficient
market, the value of a firm is unaffected by how that firm is financed.[1] It does not
matter if the firm's capital is raised by issuing stock or selling debt. It does not matter
what the firm's dividend policy is. Therefore, the Modigliani–Miller theorem is also
often called the capital structure irrelevance principle. (Wikipedia)

 Have two propositions

o M&M proposition I: - The capital structure i.e. combination between equity
and debt will not affect value of a company.

o M&M proposition II: - states that the value of the firm depends on three
things:

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 1) Required rate of return on the firm's assets (Ra)
2) Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)

o The discussion of the theory is based on the Unlevered vs. levered company.
Unlevered referring to the company 100% equity base. While Levered representing
the company with debt.

4.3.2 M&M Proposition I

o The nature of the capital structure will not influence the value of a company as it not
involves any cash flow changes. If cash flow of the said company change, only then
the values of the company also change.

4.3.3 M&M Proposition II

o The required rate of return on equity (Re) increases as the firm’s debt-equity ratio
increases.
o Even though the Re increases but the Cost of capital (WACC) remain the same.

• WACC (RA) = (E/V)RE + (D/V)RD

Rearrange the formula we will get:-

RE = RA + (RA – RD) (D/E)

Based on the formula above we can plot Re against D/E, therefore RA – RD is the
gradient of the RE

The graph shows that as the firm increase level of debt, the RE is increase but the WACC still remain.
In other words, the change in the capital structure weights (E/V and D/V) is exactly offset by the
change in the cost of equity (RE), so the WACC stays the same.

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 o The model: - RE = RA + (RA – RD) (D/E) also indicate the compensation required by
the equity holder for the business risk (RA) and financial risk [(RA – RD) (D/E)] that
the company face.

4.3.4 M&M Propositions I and II with corporate taxes

4.3.4.1 Introduction

The existence of the tax shield may influence WACC? Is M&M propositions I and II hold? (The
discussion is based on example page 519-526)

Let two firm U and L, which is quite identical except that Firm L was financed by bond which pays
interest of $80 (Bond amount = $1000 x 8% coupon) . Therefore the Net Income will be:-

Firm U (unlevered) Firm L (Levered)

EBIT $1000 $1000
Interest 0 $80
Taxable income $1000 $920
Taxes (30%) $300 $276
Net Income $700 $644

The cash flow effect of the interest payment will be:-

Cash flow Firm U Firm L

EBIT $1000 $1000
taxes $300 $276
Total CF $700 $724

Therefore the cash able to distribute to the bondholder and shareholder will be:-

Cash flow Firm U Firm L

To s/h $700 $644
To b/h 0 $80
Total $700 $724

The difference of $24 is the tax shield ($80 x 0.3)

4.3.4.2 M&M Proposition I and taxes

M&M proposition I stated that Vu= VL, if no cash effect.

However, the tax effects has affected cash flow effect, the value of levered firm could be said more
than the value of the unlevered firm. It can be measure by the following formula:-

𝐸𝐵𝐼𝑇 𝑥 (1 − 𝑇𝑐)
𝑉𝑢 =
𝑅𝑢

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 𝑅𝑢 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑓𝑖𝑟𝑚

𝑉𝑙 = 𝑉𝑢 + 𝑇𝑐 𝑥𝐷

Based on our example, let the cost of capital of unlevered firm is 10% (𝑅𝑢) , Vu and VL will be:

1000 𝑥 (1 − 0.3)
𝑉𝑢 = = $7000
0.10

𝑉𝑙 = $7000 + (0.3 𝑥 1000) = $7300

Figure 16.4 page 521

Based on the result it shows that company are better off using debts than equity and the best is by
using 100% debt. However, this is far than true especially when risk of bankruptcy need to take into
consideration.

4.3.4.3 M&M proposition II and taxes

• M&M II stated that WACC (RA) = (E/V) RE + (D/V)RD and by rearrange it we can
get RE = RA + (RA – RD) (D/E) where WACC will not change whatever the
composition between equity and debt. But the more you support your capital with
debt, the riskier it will be to the s/h (RE)

• But with the inclusion of tax effect, this proposition will not be hold and the formula
needs to modify :-

WACC with tax effect: = WACC (RA) = (E/V) RE + (D/V) (RD) (1-Tc)

To find WACC need to find new RE which can use the formula below:-

RE = Ru + (Ru – RD) (D/E) (1-Tc)

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 Continue from our previous example,

Ru = 10%, 𝑉𝑙 = $7300, RD =8%

The RE will be:-

RE = 0.10 + (0.10 – 0.08) (1000/6300) (1-0.3) = 10.22%

Equity = Total MKT value – Total Debt Value = $7300 - $1000 = $6300

Therefore, WACC will be:-

WACC = ($6300/$7300) 10.22% + ($1000/$7300) (8%) (1-0.3)= 9.6%

Based on the result we can say that the company is better off with debt as Vu = 10% greater than 𝑉𝑙
=9.6%

Figure 16.5 page 522

4.4 Optimal Capital Structure: Static theory of Capital Structure

 M&M I and II clearly shows that the tax effect has great impact on capital structure
and to certain extend imply that company are better to fully finance their activities via
debt. However, both propositions do not take into consideration of bankruptcy issue.
Therefore this was resolve by static theory of capital structure.

 Static theory of capital structure: - Theory that the firm's capital structure is
determined by a trade-off of the value of tax shields against the costs of bankruptcy.
(bizterms.net)

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 Figure 16.6 page 527

Figure 16.7 page 528

Figure 17.8

17-34

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Figure 16.8 page 529

The graphs above show the optimum combination between debt and equity where at that point the
combination will bring the maximum value of the firm by fully utilizing the tax shield benefits and at
the same time face acceptable level risk of bankruptcy. At that point the WACC is the lowest.

4.5 The Pecking Order Theory

 Previous theory (M&M and Static) prefer to use debt instead of equity to reap the tax
shield benefits but commensurate with financial distress risks. However this Quite
contradict with the Pecking Order Theory

 Pecking Order Theory: - The theory stated that a company should fully utilize their
internal financing until exhausted and followed by debt and the equity is the last
choice of financing method.

 Implications of the theory :-

o No target capital structure i.e. no optimum combination between debt and
equity
o Profitable companies use less debt
o Companies will want financial slack (internally generated cash flow) :-
Financial slack will help company to finance projects as they appear.

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