Financial Leverage» The use of an amount of debt to finance firm’s assets in order increase expected earnings per share.
Consider This…Susan Smith is the financial officer of High-TechManufacturing Corporation (HTMC). The corporationcurrently has no debt. Shares of common stock - $200,000 Shares trade - $50/each age Total market capitalization = $10,000,000 Profits per year = $1,000,000 Required return on assets (ROA)= 10% ROA=ROE (since HTMC has no debt)
Consider This…* Shareholder suggests that HTMC should issue$5,000,000 in long term-debt at an interest rate 6%.Proceeds of debts can repurchase half the company’scommon stock (100,000 shares of stock)-If economy continues to grow at normal rate-----Earningsbefore interest and tax (EBIT) = $1,000,000-If economy falls into recession: EBIT = $500,000-If economy booms---: EBIT = $1,500,000 *Ms. Smith believes that the probability of each outcomeis 1/3, so expected value of EBIT = $1,000,000. Expected (EBIT)=(1/3) $1,500,000 + (1/3) $1,000,000 +(1/3) $500,000 = $1,000,000
HTMC The Current and Proposed Capital Structures for High-Tech Manufacturing Corporation
HTMCCash Flows to Stockholders and Bondholders Under the Currentand Proposed Capital Structure for HTMCAssume EBIT=$1,000,000
The Fundamental Principle Financial LeverageFinancial Leverage- employing long-term debt financing- wherein debt financing is used to magnify the impactof change in EBIT on earnings per share.
The Fundamental Principle Financial Leverage» Substituting long-term debt for equity in a company’s capital structure increases both the level of expected returns to shareholders(measured by ROE) and the risk of those expected returns. Leverage Increases Expected Return---But Does it Increase Value? Recall that if HTMC recapitalized, its expected EPS increases from $5 to $7, likewise , expected ROE increases from 10%-14% * stock price will remain $50 P=$7/.14= $50
The Fundamental Principle Financial Leverage • There is no unique, optimal capital structure for the company to maximize firm’s value. • Substituting debt for equity will increase the expected EPS, but only at the cost of higher variability with higher EPS volatility, shareholders will expect higher return, meaning that they will discount earnings at a higher rate. • These two effects essentially cancel each other out, so shareholders are just as happy with a capital structure that includes no debt as they are with that consists of equal propositions of debt and equity.
The Modigliano and Miller Capital Structure Irrelevance Propositions No Taxes NoIn a world with “perfect markets”, capital Bankruptcy Costsstructure cannot influence firm value and isthus irrelevant. No Cost of Enforcing DebtMade an important distinction between a firm’s business Contractsrisk and its financial risk
Business Risk vs. Financial Risk Business Risk Financial Risk how a firm chooses to distribute that risk Variability of a between firms cash stockholders and flows bondholders
HTMC’s Business Risk• HTMC’s business risk is determined by how its earnings, before interest and taxes fluctuates with the state of the economy.• M&M pointed out that leverage changes neither the total cash flows generated by a firm, nor the variability of those cash flows. Therefore, changing leverage cannot change the overall value of a firm. Leverage simply determines how firms divide their cash flows and risk between stockholders and bondholders.
Proposition I: The Capital Structure Irrelevance PropositionThe value of the firm is independent of the capitalstructure and is given by capitalizing its expected netoperating income (EBIT) at the rate r.
Proposition I: The Capital Structure Irrelevance Proposition V = (E + D) = EBIT / rV = total market value of the firmE = market value of equityD = market value of debtEBIT = earnings before interest and taxesr = required return on firm’s assets
HTMC’s Market ValueV= $1,000,000/ 10%V=$10,000,000Firm value is thus determined by the level ofHTMC’s operating profits and by the firm’sdegree of business risk.
Proposition II: How Increasing Leverage Affects the Cost of EquityThe cost of equity capital for a levered firm =The constant overall cost of capital + a risk premium.
Proposition II: How Increasing Leverage Affects the Cost of Equity re =+ ra +( ra- rd)D/Ere = required rate of return for equity.rd = required rate of return for debt.ra = required rate of return of a company with100% equity (the same as the asset required rate ofreturn)
HTMC’s re• For no debt outstanding:• re =10%• rd =6% re=.10+(.10-.06)$0/$10,000,000=.10=10%• For 50%debt 50% Equity capital: re =10% re =.10+ (.10-.06)x$5,000,000/$5,000,000=.14=14%
The M&M Model with Corporate TaxesDecide whether to retain the firm’s existing all-equitycapital structure or adopt a proposed 50% debt 50%equity capitalization.
Cash Flows to Stockholders and Bondholders Under the Current and ProposedCapital Structure for HTMC-with Corporate taxationAssume:EBIT= $1,000,000 next yearr = 10%Tc (corporate tax rate on earnings) =35%
Unlevered and Levered Versions of HTMCVu = [EBIT(1-Tc)]/r = NI/r=$650,000/.10 = $6,500,000 The introduction of 35% corporate profit tax causes an immediate $3,500,000 reduction (from $10,000,000 to $6,500,000) in the market value of the current all-equity version of HTMC.
Determining the Present Value of Debt Tax ShieldsPV Interest Tax Shields = Tc x D = .35 ($5,000,000) = $1,750,000The introduction of 35% corporate profit tax causes animmediate $3,500,000 reduction (from $10,000,000 to$6,500,000) in the market value of the current all-equity versionof HTMC.Vl = Vu+PVtax shield = Vu+TcD= $6,500,000 + $ 1,750,000 = $8,250,000
THE M&M Model with Corporate and Personal Taxes GL= [1-[(1- tc) (1- tPS)/1- tPB] DLGL = Gain to leveragetc = corporate tax ratetPS = personal tax rate on stock capital gains Corporations have totPB = personal tax rate on interest income pay higher interestDL = Debt of leveraged firm on debt because individuals have a tax- disadvantage relative to capital gains.
THE M&M Model with Corporate and Personal Taxes• If no tax world ----- (Tc=Tps =Tpd=0)• In a world with only corporate taxes (Tc=.35; Tps=Tpd=.40) GL= [1-(1-.35)(1-0)/(1-.40)/(1-.40)/$ 5,000,000= -.0833
Agency Cost/ Tax Shield Trade-Off Model of Corporate LeverageAgency costs arise because of core problems such asconflicts of interest between shareholders andmanagement. Shareholders wish for management torun the company in a way that increases shareholdervalue.
Other factors influencing debts: Bankruptcy Costs Direct Cost of Indirect Cost of Bankruptcy Bankruptcy out of pocket economic losses that expenses directly result from related to bankruptcy but not bankruptcy filing and cash outlays spent administration on the process itself
Agency Cost/ Tax Shield Trade-Off Model of Corporate LeverageVL = Vu + PV tax shield – PVbankruptcy costs
The Asset Substitution Problem• A problem that arises when a company exchanges its low-risk assets for high-risk investments.• The transfer of assets places more risk on the debt holders without providing them with additional compensation. High-risk projects can yield higher profits, however more risk is incurred by the firm. The added profit may only benefit the shareholders, as the bondholders require only a fixed return. The increase level of risk does affect the bondhold.
The Underinvestment Problem• An agency problem where a company refuses to invest in low-risk assets, in order to maximize their wealth at the cost of the debt holders. Low-risk projects provide more security for the firms debt holders, since a steady stream of cash can be generated to pay off the lenders. The safe cash flow does not generate an excess return for the shareholders. As a result, the project is rejected.• Shareholders under invest capital by refusing to participate in low- risk projects. This is similar to the asset substitution problem, where shareholders exchange low-risk assets for high-risk ones. Both instances will increase shareholder value at the expense of the debt holders. Since high-risk projects have large profits, the shareholders benefit from increased income, as the debt holders require only a fixed portion of cash flow. The problem occurs because the debt holders are not compensated for the additional risk.
How much debt is right for your company? Taxes Risk Factors to Consider Costs of Financial Slack / Financial Asset Type Distress
Considerations for Taxes• Debt is Tax Deductible: Increase in Debt reduces the income tax paid IF the company is in a tax-paying position.• However, the company has to MAKE money.
Considerations for Risk• FINANCIAL RISK: Directly controlled by managers. This can be noted in the formula for unleveraging and levering Betas.• OPERATING OR ASSET RISK: Can be controlled by managers through their choice of scale or size of fixed assets.
Financial Slack• the amount of funds a firm has available to invest without visiting the external financial markets after paying interest and before paying dividends + Depreciation.
Conclusions• The effect of financial leverage depends upon EBIT. • When EBIT are high, financial leverage raises EPS and ROE. • The variability of EPS and ROE is increased with financial leverage.