1) The document discusses how a company's capital structure and use of debt can impact its value and shareholder returns. It considers how debt can lower the weighted average cost of capital but also increase bankruptcy risk. 2) An example is provided showing how debt can increase earnings per share but also expose shareholders to more risk in economic downturns. The optimal level of debt depends on factors like a company's fixed costs and risk of bankruptcy. 3) Tax benefits of debt are discussed, as interest expenses are tax deductible. However, higher debt also increases financial risk and the required return on equity. The overall impact on the weighted average cost of capital from debt is uncertain and depends on specific company and economic conditions

1. Corporate Financing Decision (MFIN 641)
MBA Vth Term
Kathmandu University School of Management
Rajesh Sharma, PhD

2. Financial Leverage and Capital
Structure Policy

3. Corporate Finance Decision: Overall Flow

4. Leverage and Firm Value
• There are two important questions:
– Why should the stockholders care about maximizing firm value?
Perhaps they should be interested in strategies that maximize shareholder value.
– What is the ratio of debt-to-equity that maximizes the shareholder’s value?
• As it turns out, changes in capital structure only benefit the
stockholders if the value of the firm increases (During Economic
Boom) and vice versa.

5. 5
Value = + + ··· +
FCF1 FCF2 FCF∞
(1 + WACC)1 (1 + WACC)∞
(1 + WACC)2
Free cash flow
(FCF)
Market interest rates
Firm’s business risk
Market risk aversion
Firm’s
debt/equity
mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital
−
=
Determinants of Intrinsic Value: The Capital Structure Choice

6. The Financial View of the Firm
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments

7. Increasing Firm Value
For example: Considering DCF valuation model
• 1st Option: Grow asset side (Investment Decision)
– Positive NPV Projects (Capital Budgeting)
• 2nd Option: Decreasing cost of capital (WACC)
– By lowering WACC, there will be leftover cash that can be used to support growth/
accept projects with positive NPV (How??)

8. Capital Structure Policy
• Change in Capital structure
– A firm’s capital structure is really just a reflection of its borrowing policy e.g. decision like: should
we borrow a lot of money, or just a little?
– What is the best mix of debt and equity that maximize firm value?
• Consequences of such decision:
– Is it straight forward mechanical process?
– Effect of Tax/ Different Economic Scenario/ Firms’ Life Cycle
• At first glance, it probably seems that debt is something to be avoided. After all, the more
debt a firm has, the greater is the risk of bankruptcy (due to fixed payment).
• Debt is really a double-edged sword, and, properly used, debt can be enormously beneficial
to a firm.

9. Capital Structure Policy
• If management so desire, a firm could issue some bonds and use the proceeds to
buy back some stock, thereby increasing the debt–equity ratio. Alternatively, it
could issue stock and use the money to pay off some debt, thereby reducing the
debt–equity ratio. Also, called capital restructurings.
• In general, such restructurings take place whenever the firm substitutes one capital
structure for another while leaving the firm’s assets unchanged.
Because the assets of a firm are not directly affected by a capital restructuring, This means that a
firm can consider capital restructuring decisions in isolation from its investment decisions.
Question to be considered:
• Why should financial managers choose the capital structure that maximizes the
value of the firm?
• What is the relationship between the WACC and the value of the firm?
• What is an optimal capital structure?

10. Effect of Financial Leverage
• To understand the effect of financial leverage:
– Examine the impact of financial leverage on the payoffs to stockholders.
– Financial Leverage refers to the extent to which a firm relies on debt. The more debt
financing a firm uses in its capital structure, the more financial leverage it employs.
• Let's consider an example:
– For now, we ignore the impact of taxes.
– Also, for ease of presentation, we describe the impact of leverage in terms of its
effects on earnings per share, EPS, and return on equity, ROE.
Note that using cash flows instead of these accounting numbers would lead to
precisely the same conclusions, but a little more work would be needed, hence we
reply on these measures.

11. Current
Assets Rs.20,000
Debt Rs.0
Equity Rs.20,000
Debt/Equity ratio 0.00
Interest rate n/a
Shares outstanding 400
Share price Rs.50
Effect of Financial Leverage: Example
Proposed
Rs.20,000
Rs.8,000
Rs.12,000
2/3
8%
240
Rs.50
Consider an all-equity firm that is contemplating going into debt. (Maybe
some of the original shareholders want to cash out.)

12. Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest 0 0 0
Net income Rs.1,000 Rs.2,000 Rs.3,000
EPS Rs.2.50 Rs.5.00 Rs.7.50
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
EPS and ROE Under Current Structure

13. Recession Expected Expansion
EBIT Rs.1,000 Rs.2,000 Rs.3,000
Interest Rs. 640 Rs. 640 Rs. 640
Net income Rs.360 Rs.1,360 Rs.2,360
EPS Rs.1.50 Rs.5.67 Rs.9.83
ROE 3.0% 11.3% 19.7%
Proposed Shares Outstanding = 240 shares
EPS and ROE Under Proposed Structure

14. Financial Leverage and EPS
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
1,000 2,000 3,000
EPS
Debt
No Debt
Break-even
point
EBIT in dollars, no taxes
Advantage to
debt
Disadvantage to
debt
Effects of
Financial
Leverage
depends
upon EBI
Slope of
debt is
higher
than slope
of solid
line

15. How can capital structure affect value?
V =
∑
∞
t=1
FCF t
(1 + WACC)t
WACC= wd (1-T) rd + were
The impact of capital structure on value depends upon the effect of debt on:
1) Free Cash Flow (FCF)
2) WACC

16. How can capital structure affect value?
EXAMPLE:
• WACC= wd (1-T) rd + were
• Cost of debt < Cost of Equity (why not infuse additional debt)
Current
• WACC= 0.19*(1-0.25) * 4.2% + 0.81 * 5.5% = 5 %
Projected
• WACC= 0.4*(1-0.25) * 4.2% + 0.60 * 5.5% = 4.5%
Is this correct ?

17. How can capital structure affect value?
• Higher leverage exposes firm to higher systematic risk: Higher beta
Firm Response to address such risks
• Tax is controlled by Government Policy
• Cost of debt (rd) and Cost of Equity (re ) are controlled by demand and supply
• One of the way company can respond: By altering capital structure

18. Effect of Additional Debt on FCF
• Additional debt increases the probability of bankruptcy.
– Direct costs: Legal fees, “fire” sales, etc.
– Indirect costs: reduction in productivity of managers, reduction in credit (i.e., accounts
payable) offered by suppliers
• Additional debt can affect the behavior of managers.
– Increases in agency costs: debt can make managers too risk-averse, causing
“underinvestment” in risky but positive NPV projects.

19. Effect of Additional Debt
• If a firm has high % of fixed costs (incurred during economic boom): It does not
decline when demand falls (incurred during downturn). Exposed to higher degree
of business risk.
• The higher the proportion of fixed costs within a firm’s overall cost structure, the
greater the operating leverage.
• Debt-holders received fixed income as an interest or coupon but do not bear
business risk.
• Additional risk placed to common shareholders as result of debt.
• Result: Higher debt will result higher expected return for common shareholders

20. Effect of Additional Debt on WACC
• Cost of debt < Cost of Equity (atleast in the earlier phase) : Adding debt increase
percent of firm financed with low-cost debt (wd) and decreases percent financed
with high-cost equity (we)
• Debtholders have a prior claim on cash flows relative to stockholders.
– Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.
– Cost of stock, re, goes up.
• Firm’s can deduct interest expenses.
– Reduces the taxes paid
– Frees up more cash for payments to investors
• Debt increases risk of bankruptcy
– Causes pre-tax cost of debt, rd, to increase
• Net effect on WACC = Uncertain (Depend upon different scenario).

21. Effect of Additional Debts on WACC
Net effect on WACC = Uncertain (Depend upon different scenario).
• If a firm has high % of fixed costs (i.e. cost of debt): It does not decline during
downturn.
• Additional risk placed to common shareholders as result of debt (i.e. bankruptcy
risk).
• Result: Higher debt will result higher expected return for common shareholders

22. Important consideration: Effect of TAX