THE DEBT-EQUITY CHOICE

The Effect of Financial Leverage

How does financial leverage affect the EPS and ROE of a firm? Leverage amplifies the variation in both EPS and ROE
More debt leads to more interest expense If we have a really good year, then we pay fixed interest and we have more left over for stockholders If we have a really bad year, we still have to pay fixed interest and we have less left over for stockholders

Leverage vs. EPS and ROE

An all-equity firm:
V = $20 million 1 million shares outstanding Current share price: $20

Change capital structure:

Raise $10 million in debt (RD = 7.5%) Repurchase 500,000 shares

New capital structure: 50% debt, 50% equity Ignore taxes for simplicity

EPS for the Unlevered Firm

Unlevered (all equity) capital structure:
Bad times Good times $2,750,000 Expected $2,000,000

EBIT
Net income

$1,250,000

$1,250,000
$1.25 6.25%

$2,750,000
$2.75 13.75%

$2,000,000
$2.00 10.00%

EPS
ROE

EPS for the Levered Firm

New levered capital structure (50% equity, 50% debt):
Bad times EBIT $1,250,000 Good times $2,750,000 Expected $2,000,000

Interest
Net income EPS ROE

750,000
$500,000 $1.00

750,000
$2,000,000 $4.00

750,000
$1,250,000 $2.5

5.00%

20.00%

12.50%

Comparison
Unlevered
Bad times EPS ROE $1.25 6.25% Expected $2.00 10.00% Good times $2.75 13.75%

Levered with 50% debt

EPS ROE $1.00 $2.5 $4.00

5.00%

12.50%

20.00%

Leverage magnifies shareholders gains and losses makes equity riskier expected return higher!
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$3.0 EPS $2.5

EPS v.s. EBIT Unlevered Firm - - Levered Firm ......

$2.0

$1.5

$1.0 1M 1.5M 2M 2.5M 3M EBIT

Break-Even EBIT
Find EBIT where EPS is the same under both the current and proposed capital structures If expected EBIT > break-even point, then leverage is beneficial to stockholders If expected EBIT < break-even point, then leverage is detrimental to stockholders

Finding Break-Even EBIT

EPS without Debt EPS with Debt EBIT EBIT Interest expense # of shares # of shares after capital restructur e EBIT EBIT $750,000 1,000,000 500,000 Solve for EBIT : $1,500,000

$1,500,000 EPS $1.5 1,000,000

Capital Structure
Managers ultimate goal: maximize firm value Firm value = PV of cash flows to the firm WACC is the appropriate discount rate for the firms asset WACC weights determined by capital structure Choose combination of debt and equity that maximizes firm value or equivalently, choose Debt-Equity mix that minimizes WACC!

Capital Structure Theory Under Three Special Cases Modigliani and Miller Theory of Capital Structure
Proposition I firm value Proposition II WACC

Case I Assumptions
No corporate taxes No bankruptcy costs or agency costs

Case II Assumptions
Corporate taxes, but No bankruptcy costs or agency costs

Case III
Consider corporate taxes, bankruptcy costs and agency costs

Case I: M&M Proposition I (1958)

In the absence of taxes, the value of the firm is independent of its financial leverage Capital structure is irrelevant.
Firm Value

D/E

Case I: M&M Proposition II (1958)

If there are no taxes:

E D WACC RA RE RD (1 Tc) V V
Solve for RE:

D RE RA ( RA RD ) E

The greater the leverage the greater RE becomes but WACC stays the same!

M&M Proposition II (1958)

RE = RA + (RA RD ) (D/E)
Cost of capital

WACC = RA RD D/E

A World without Taxes

Widget Manufacturing is currently an all-equity financed firm worth $5 million. WM plans to issue $2,000,000 in debt and to use proceeds to repurchase stock. The cost of debt is 10%. The cost of unlevered equity equals 14%. Assume no taxes.

a. What is the value of the firm after the repurchase? b. What is the firms cost of capital after repurchase? c. What is its cost of levered equity?

A World without Taxes

(a) $5 million in the absence of taxes (and other distorting factors) debt has no impact on firm value. (b) WACC = RE = 14% To verify: WACC = 16.67% 3/5 + 10% 2/5 = 14% The firms cost of capital has not changed! (c) V = $5M, D = $2M => D/E = 2/3
R E R A (R A - R D ) (D/E) 14% (14% - 10%) (2/3) 16.67%

With debt, the equity is riskierrequired return increases

Case II: Proposition I with Taxes (1963)

Tax shield is generated by interest payments PV of interest tax shields:

RD D TC D TC RD
The Value of levered firms (VL) is equal to the value of unlevered firms (VU) plus the PV of the interest tax shield.

VL VU D TC

Value of equity = VL Value of debt Implication: Debt financing is advantageous if we ignore bankruptcy costs and agency costs.

M&M Proposition I (1963)

Value of Levered Firm = Value of Unlevered Firm + PV of Interest Tax Shields VL=VU+D TC

Firm Value

DTC

VU
VU
D

Case II: Proposition II with Taxes

The levered cost of equity is
R EL D R EU (R EU R D ) (1 TC ) E

REL : levered cost of equity REU : unlevered cost of equity capital

M&M Proposition II (1963)

REL Cost of capital

REU
WACC RD (1 TC) D/E

A World with Taxes

An all-equity financed firm has after-tax cash perpetual flows of $300,000 and the cost of (unlevered) equity is 15%. The firm could borrow $1,000,000 at 8% to repurchase part of its equity. Tax rate is 40%. Assume that the agency and bankruptcy costs of debt are zero.

a. What is the value of the all-equity firm? b. What would be the value of the firm if it decided to go ahead and borrow $1,000,000? c. Calculate the WACC for the levered firm.

A World with Taxes

(a) The value is the PV of future after-tax cash flows:
VU = $0.3M/0.15 = $2M

(b) VL = VU + DTC = $2M + $1M 0.4 = $2.4 M (c) E = VL D = $2.4M $1M = $1.4M
R EL R EU D (R EU R D ) (1 TC ) E

REL=15% + (15% 8%)(1 0.4)1/1.4=18% WACC=18%1.4/2.4+8%(1 0.4) 1/2.4= 12.5% < 15%

Case III: Capital Structure with FC and AC

The tradeoff between the benefits and costs of using debt leads to a basic capital structure theory. Benefits: tax shield on interest Costs: Interest payments Financial distress costs (FC) Agency costs (AC)
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Cost of Leverage: Financial Distress

Debt increases the probability of default and bankruptcy! Direct costs
Legal and administrative costs (lawyers) Example: http://query.nytimes.com/gst/fullpage.html?res=940DE1D81530F93BA35754C0A96E948260

Indirect costs
Losses due to fire sale liquidations Business opportunities lost due to financial distress
Customers lose faith Suppliers may deny credit Employees may flee
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Cost of Leverage: Agency Costs

Debt changes managers incentives May lead to changes in investment policies Asset substitution: Firm may invest in negative NPV gambles when it is in financial distress Under-investment: Forego positive NPV projects when close to bankruptcy Milking the property

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Balance Sheet for a Company in Distress

Assets Cash Fixed Asset Total BV MV $200 $200 $400 $0 $600 $200 Liabilities LT bonds Equity Total BV MV $300 $200 $300 $0 $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

Agency Cost: Asset Substitution

The Gamble Win Big Lose Big Probability 10% 90% Payoff $1,000 $0

Cost of investment is $200 (all the firms cash) Required return is 50% Expected CF from the Gamble = $1000 0.10 + $0 = $100 NPV = -$200 + $100/1.1 = -$133

Agency Cost: Asset Substitution

Expected CF from the Gamble To Bondholders = $300 0.10 + $0 = $30 To Stockholders = ($1000 - $300) 0.10 + $0 = $70

PV of Bonds Without the Gamble = $200 PV of Stocks Without the Gamble = $0

PV of Bonds With the Gamble = $30 / 1.5 = $20 PV of Stocks With the Gamble = $70 / 1.5 = $47

Agency Cost: Underinvestment

Consider a government-sponsored project that guarantees $350 in one period Cost of investment is $300 (the firm only has $200 now) so the stockholders will have to supply an additional $100 to finance the project Required return is 10%

$350 NPV $300 $18.18 1.10

Should we accept the project?

Agency Cost: Underinvestment (Continued) Expected CF from the government sponsored project: To Bondholder = $300 To Stockholder = ($350 - $300) = $50 PV of Bonds Without the Project = $200 PV of Stocks Without the Project = $0

PV of Bonds With the Project = $300 / 1.1 = $272.73

PV of Stocks With the project = $50 / 1.1 - $100 = -$54.55

Agency Cost: Milking the Property

Liquidating dividends
Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. Such tactics often violate bond indentures.

Increase perquisites to shareholders and/or management

Optimal Capital Structure (w/ FC, AC)

The use of debt initially causes the firms WACC to decline. (Reason: RD <RE since debt has seniority over
equity and RD is tax-deductible.)

As debt increases, RD and RE both increase due to higher risk associated with financial distress and agency costs. At some point, WACC will increase. The mix of debt and equity financing at the point where the WACC is minimized and firm value is maximized is called the optimal capital structure.

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Case III: Firm Value

Bankruptcy costs Agency costs

VL VU DTC A( D) BC ( D)
Tax shield

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Cost of Capital and Leverage

REL Cost of capital

REU WACC (w/ BC and AC) WACC (M&M II & Taxes) RD (1 TC) Optimal Leverage D/E ratio
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Firm Value and Debt

PV of Agency and Bankruptcy Costs Firm Value

VL= VU+D TC

VL= VU+D TC
BC(D) A(D) VU

Optimal Debt

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Optimal Capital Structure

Optimal debt level will:
Increase with expected cash flows Decrease with past profitability (pecking order: profitable firm does not need to issue debt) Decrease with risk of cash flows Decrease with level of R&D spending

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The Real World: Debt Policy

Most CFOs do not seem to care about:
Bankruptcy costs Comparable firms

Most important factors that determine CFOs capital structure decisions:

Funding needs Financial flexibility and risk Cost of financing

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Survey evidence on whether firms have optimal or target debt-equity ratios. The survey is based on the responses of 392 CFOs. Source: Graham and Harvey Journal of Financial Economics 60 (2001) 187-243

Debt Policy Factors

Financial flexibility Credit rating Earnings and cash flow volatility Insufficient internal funds Level of interest rates Interest tax savings Transactions costs and fees Equity undervaluation/overvaluation Comparable firm debt levels Bankruptcy/distress costs Customer/supplier comfort

0%

10%

20%

30%

40%

50%

60%

Percent of CFO's identifying factor as important or very important

Survey evidence on some of the factors that affect the decision to issue debt. The survey is based on the responses of 392 CFOs. Source: Graham and Harvey Journal of Financial Economics 60 (2001) 187-243

The Real World: Equity Issuance

Capital structure is more often changed by changes in the total market value of equity rather than the amount of debt Firms issue stock when
Share price overvalued Reached debt capacity

Firms repurchase stock

Share price undervalued Avoid dilution due to stock option compensation

Common Stock Factors

Earnings per share dilution Magnitude of equity undervaluation/overvaluation If recent stock price increase, selling price "high" Providing shares to employee bonus/option plans Maintaining target debt/equity ratio Diluting holdings of certain shareholders Stock is our "least risky" source of funds Sufficiecny of recent profits to fund activities Similar amount of equity as same-industry firms Favorable investor impression vs. issuing debt

0%

10%

20%

30%

40%

50%

60%

70%

Percent of CFO's identifying factor as important or very important

Survey evidence on some of the factors that affect the decision to issue common stock. The survey is based on the responses of 392 CFOs.