Copyright 2004 McGraw-Hill AustraliaPty Ltd20-220.1 The Capital Structure Question20.2 The Effect of Financial Leverage20.3 Capital Structure and the Cost of Equity Capital20.4 M&M Propositions I & II With Corporate Taxes20.5 Bankruptcy Costs20.6 Optimal Capital Structure20.7 The Pie Again20.8 Corporate versus Personal Borrowing20.9 Observed Capital Structures20.10 Summary and ConclusionsChapter Organisation
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-3Chapter Objectives• Understand the impact of financial leverage on a firm’s capitalstructure.• 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 Iand II.• Understand the impact of bankruptcy costs on the value of afirm.• Identify a firm’s optimal capital structure.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-4The Capital Structure Question• Key issues– What is the relationship between capital structure andfirm value?– What is the optimal capital structure?• Cost of capital– A firm’s capital structure is chosen if WACC isminimised.– This is known as the optimal capital structure or targetcapital structure.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-5Example—Computing Break-evenEBITABC Company currently has no debt in its capital structure. Thecompany has decided to restructure, raising $2.5 million debt at10 per cent. ABC currently has 500 000 shares on issue at aprice of $10 per share. As a result of the restructure, what isthe minimum level of EBIT the company needs to maintain EPS(the break-even EBIT)? Ignore taxes.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-6Example—Computing Break-evenEBIT (continued)• With no debt:EPS = EBIT/500 000• With $2.5 million in debt @ 10%:EPS = (EBIT – $250 0001)/250 00021Interest expense = $2.5 million × 10% = $250 0002Debt raised will refund 250 000 ($2.5 million/$10)shares, leaving250 000 shares outstanding
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-7Example—Computing Break-evenEBIT (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
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-9Example—Home-made Leverage andROE• Home-made leverage is the use of personal borrowing toalter the degree of financial leverage. Investors can replicatethe financing decisions of the firm in a costless manner.• ExampleOriginal capital structure and home-made leverage →investor uses $500 of their own and borrows $500 topurchase 100 shares.Proposed capital structure → investor uses $500 of their own,together with $250 in shares and $250 in bonds.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-10Original Capital Structure and Home-made LeverageRecession Expected ExpansionEPS of unlevered firm $0.60 $1.30 $1.60Earnings for 100 shares $60.00 $130.00 $160.00Less interest on $500@ 10%$50.00 $50.00 $50.00Net earnings $10.00 $80.00 $110.00ROE 2% 16% 22%
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-11Proposed Capital StructureRecession Expected ExpansionEPS of levered firm $0.20 $1.60 $2.20Earnings for 25 shares $5.00 $40.00 $55.00Plus interest on $250@ 10%$25.00 $25.00 $25.00Net earnings $30.00 $65.00 $80.00ROE 6% 13% 16%
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-12Capital Structure Theory• Modigliani and Miller Theory of Capital Structure– Proposition I—firm value– Proposition II—WACC• The value of the firm is determined by the cashflows to the firm and the risk of the assets• Changing firm value:– Change the risk of the cash flows– Change the cash flows
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-13M&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
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-14M&M Proposition II• Because of Proposition I, the WACC must be constant, withno taxes:WACC = RA = (E/V) × RE + (D/V) × RDwhere 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)
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-15The Cost of Equity and the WACCDebt-equity ratio, D/ECost of capitalWACC = RARDRE = RA + (RA – RD ) x (D/E)The firm’s overall cost of capital is unaffected by its capital structure.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-16Business and Financial Risk• By M&M Proposition II, the required rate of return on equityarises 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’soperating 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]).
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-17The SML and M&M Proposition II• How do financing decisions affect firm risk in both M&M’sProposition II and the CAPM?• Consider Proposition II: All else equal, a higher debt/equityratio will increase the required return on equity, RE.RE = RA + (RA – RD) × (D/E)
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-18The SML and M&M Proposition II• Substitute RA = Rf + (RM − Rf)βAand by replacement RE = Rf + (RM − Rf)βE• The effect of financing decisions is reflected in the equitybeta, and, by the CAPM, increases the required return onequity.βE = βA(1 + D/E)• Debt increases systematic risk (and moves the firm along theSML).
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-19Corporate Taxes• The interest tax shield is the tax saving attained bya firm from interest expense.• Assumptions:– perpetual cash flows– no depreciation– no fixed asset or NWC spending.• For example, a firm is considering going from $0debt to $400 debt at 10 per cent.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-20Corporate TaxesTax saving = $16 = 0.40 x $40 = TC × RD × D
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-21Corporate Taxes• What is the link between debt and firm value?Since interest creates a tax deduction, borrowing creates atax shield. The value added to the firm is the present value ofthe annual interest tax shield in perpetuity.• M&M Proposition I (with taxes):• Key result VL = VU + TCD( )( )DT/RDRT.PVCDDC=××=== 160$10016$savingtax
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-22Total debt (D)Value ofthe firm(VL)VUVL = VU + TC x D= TCVUTC x DVL= VU + $160VU$400M&M Proposition I with Taxes
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-23Taxes, the 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. Whathappens to equity value, E?VU = $100 × (1 – 0.30)/0.125 = $560VL = $560 + (0.30 × $100) = $590∴ E = $490
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-24Taxes, the WACC and Proposition IIWACC and the cost of equity (M&M Proposition II with taxes):RE = RU + (RU – RD) × (D/E) × (1 – TC)( ) ( ) ( )( ) ( ) ( )%86113001100590$100$12860590$490$WACC%86123001490$100$10012501250.........RE=−××+×==−××−+=
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-25Taxes, the WACC andPropositions I and II—Conclusions• The WACC decreases as more debt financing is used.• Optimal capital structure is all debt.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-26Debt-equity ratio, D/ECost of capital (%)RURD × (1 – TC)REWACCRERUWACCRD × (1 – TC)Taxes, the WACC and Proposition II
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-27Bankruptcy Costs• Borrowing money is a good news/bad newsproposition.– The good news: interest payments are deductible andcreate a debt tax shield (TCD).– The bad news: all else equal, borrowing more moneyincreases the probability (and therefore the expectedvalue) of direct and indirect bankruptcy costs.• Key issue: The impact of financial distress on firmvalue.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-28Direct versus Indirect BankruptcyCosts• Direct costsThose costs directly associated with bankruptcy,(e.g. legal and administrative expenses).• Indirect costsThose costs associated with spending resources toavoid bankruptcy.• Financial distress:– significant problems in meeting debt obligations– most firms that experience financial distress do recover.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-29Direct versus Indirect BankruptcyCosts• The static theory of capital structure:A firm borrows up to the point where the tax benefitfrom an extra dollar in debt is exactly equal to thecost that comes from the increased probability offinancial distress. This is the point at which WACCis minimised and the value of the firm ismaximised.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-30Value ofthe firm(VL )Debt-equity ratio, D/EOptimal amount of debtD/EPresent value of taxshield on debtFinancialdistress costsActual firm valueVU = Value of firmwith no debtVL = VU + TC × DMaximumfirm value VL*VUThe Optimal Capital Structure and theValue of the Firm
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-31Cost ofcapital(%)Debt/equity ratio(D/E)D*/E*The optimal debt/equity ratioRUWACCRD × (1 – TC)RERUWACC*Minimumcost of capitalThe Optimal Capital Structure and theCost of Capital
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-32Value ofthe firm( VL )Totaldebt (D)D*PV of bankruptcy costsCase IIIStatic TheoryCase IM&M (no taxes)VL*VUCase IIM&M (with taxes)Net gain from leverageThe Capital Structure Question
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-33Managerial Recommendations• The tax benefit is only important if the firm has alarge tax liability.• Risk of financial distress:– The greater the risk of financial distress, the less debt willbe optimal for the firm.– The cost of financial distress varies across firms andindustries.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-34Lower financial leverageBondholderclaimBankruptcyclaimTaxclaimShareholderclaimHigher financial leverageBondholderclaimBankruptcyclaimTaxclaimShareholderclaimThe Extended Pie Model
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-35The Value of the Firm• Value of the firm = marketed claims + non-marketed claims:– Marketed claims are the claims of shareholders andbondholders.– Non-marketed claims are the claims of the governmentand other potential stakeholders.• The overall value of the firm is unaffected bychanges in the capital structure.• The division of value between marketed claims andnon-marketed claims may be impacted by capitalstructure decisions.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-36Corporate Borrowing and PersonalBorrowing• Without tax, corporate and personal borrowing areinterchangeable.• With corporate and personal tax, there is anadvantage to corporate borrowing because of theinterest tax shield.• With corporate and personal tax, and dividendimputation, shareholders are again indifferentbetween corporate and personal borrowing.
Copyright 2004 McGraw-Hill AustraliaPty Ltd20-37Dynamic 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 ofthe firm.• Agency costs of debt– These occur when equity holders act in their own bestinterests rather than the interests of the firm.