Chap 10 Leverage and Capital Structure

Leverage and capital structure
Chapter 13
Key concepts and skills
• Understand the effect of financial leverage
on cash flows and cost of equity
• Understand the impact of taxes and
bankruptcy on capital structure choice
• Understand the basic components of
bankruptcy
Copyright © 2011 McGraw-Hill Australia Pty Ltd

PPTs t/a Essentials of Corporate Finance 2e by Ross et al. 13-2
Slides prepared by David E. Allen and Abhay K. Singh
Chapter outline
• The capital structure question
• The effect of financial leverage
• Capital structure and the cost of equity capital
• Corporate taxes and capital structure
• Bankruptcy costs
• Optimal capital structure
• Observed capital structures
• A quick look at the bankruptcy process
Capital structure
• Capital structure—percentage of debt and
equity used to fund the firm’s assets
– ‘Leverage’ = use of debt in capital structure
• Capital restructuring—changing the
amount of leverage without changing the
firm’s assets
– Increase leverage by issuing debt and
repurchasing outstanding shares
– Decrease leverage by issuing new shares and
retiring outstanding debt
Capital structure and
shareholder wealth
• What is the primary goal of financial
managers?
– To maximise shareholder wealth
• We want to choose the capital structure
that will maximise shareholder wealth.
• We can maximise shareholder wealth by
maximising firm value or minimising WACC.

The effect of financial leverage
• How does leverage affect the earnings per share
(EPS) and return on equity (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, we pay our fixed
costs and we have more left over for our
shareholders.
• If we have a really bad year, we still have to pay our
fixed costs and we have less left over for our
shareholders.
• Leverage amplifies the variation in both EPS and
ROE.
Financial leverage, EPS and ROE
example—Table 13.1
• We will ignore the effect of taxes at this stage.
• What happens to EPS and ROE when we issue debt and buy back
shares?
• Eagles Air Services
Table 13.1
Current Proposed
Assets $8,000,000 $8,000,000
Debt $0 $4,000,000
Equity $8,000,000 $4,000,000
Debt/Equity Ratio 0.0 1.0
Share Price $20 $20
Shares Outstanding 400,000 200,000
Interest rate 10% 10%
Eagles Air Services
Capital structure scenarios—Table 13.2
Table 13.2
Current Capital Structure: No Debt
Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 0 0 0
Net Income $500,000 $1,000,000 $1,500,000
ROE 6.25% 12.50% 18.75%
EPS $1.25 $2.50 $3.75
Proposed Capital Structure: Debt = $4 million

Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 400,000 400,000 400,000
Net Income $100,000 $600,000 $1,100,000
ROE 2.50% 15.00% 27.50%
EPS $0.50 $3.00 $5.50

Financial leverage, EPS and ROE—
Example
• Variability in ROE
– Current: ROE ranges from 6.25% to 18.75%
– Proposed: ROE ranges from 2.50% to 27.50%
• Variability in EPS
– Current: EPS ranges from $1.25 to $3.75
– Proposed: EPS ranges from $0.50 to $5.50
• The variability in both ROE and EPS
increases when financial leverage is
increased.
Break-even EBIT
• Find EBIT where EPS is the same under
both the current and proposed capital
structures.
• If we expect EBIT to be greater than the
break-even point, then leverage is
beneficial to our shareholders.
• If we expect EBIT to be less than the break-
even point, then leverage is detrimental to
our shareholders.
Break-even EBIT—Example
EPS = for both capital structures
EBIT EBIT  400,000


400,000 200,000
 400,000 
EBIT   EBIT  400,000 
 200,000 
EBIT 2 EBIT  800,000
EBIT  $800,000
800,000
EPS   $2.00
400,000
Break-even EBIT (cont.)
• 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.
Eagle Air Services—Conclusion
1. The effect of leverage depends on EBIT:
When EBIT is higher, leverage is beneficial.
2. Under the ‘expected’ scenario, leverage
increases ROE and EPS.
3. Shareholders are exposed to more risk with
more leverage.
ROE and EPS more sensitive to changes in EBIT.
4. Capital structure is an important
consideration owing to the impact of
financial leverage.
Homemade leverage and ROE—
Example
• Homemade leverage
– The use of personal borrowing to change the overall amount of financial
leverage to which the individual is exposed.
Conclusion:
• Any stockholder who prefers leverage can create their own
‘homemade’ leverage and replicate the payoffs.
• Eagle Air Services’ capital structure is irrelevant to shareholders.

Homemade Leverage
• Financial leverage : Magnifies gains/losses
to shareholders
• Homemade leverage: Personal borrowing
or lending to increase or decrease leverage
respectively
• Stock (unlevered) + Personal borrowing =
Levered cash flow (Increase leverage)
• Stock (levered) + Personal lending =
unlevered cash flow (Decrease leverage)
Copyright ©2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al 13-15
Slides prepared by David E Allen and Abhay K Singh
Example Homemade Leverage
• You own 150 shares of a company that is all
equity financed with 9000 shares
outstanding and each share sells for $42.
The EBIT is $40,000. The company is
debating of converting into a 40% debt
capital structure with 8% interest. Ignore
taxes

Current (All equity) Proposed (40% debt)
Assets Debt Assets Debt
$378,000 $0 $378,000 $151,200
Equity Equity
9000 * $42 = $226,800 (5,400
$378,000 (9000 shares)
shares)
How many shares in proposed balance sheet?

•Repurchase share = 151,200/$42 = 3,600 shares

What is the cash flow to you as a shareholder
under both capital structure? (150 shares)
• Make income statement

• Current income statement
EBIT = $40,000
Interest = $0
Taxes = $0
• Net income = $40,000
• EPS = Net income/# of shares =
$40,000/9,000 = $4.40
• Cash flow = $4.40 * 150 = $666
• Proposed income statement
EBIT = $40,000
Interest = 8% * $151,200 = $12,096
Taxes = 0 (Ignoring taxes)
• Net income = $27,904
• EPS = $27,904/5,400 shares = $5.17
• Cash flow= $5.17/150 shares = $775
Capital structure theory
• Modigliani and Miller
– M&M Proposition I—The pie model
– M&M Proposition II—WACC
• The value of the firm is determined by the
cash flows to the firm and the risk of the
firm’s assets.
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows
Capital structure theory
Three special cases
• Case I—Assumptions
– No corporate or personal taxes
– No bankruptcy costs
• Case II—Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III—Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs
Case I Proposition I-Example
• An all equity firm has a market value of $300,000 and 50,000 shares
outstanding. It is thinking of changing its capital structure by borrowing
$120,000 in debt and repurchasing shares. Ignore taxes
• Share price before leverage = $300,000/50,000 shares = $6
• Number of shares repurchase = $120,000/$6 = 20,000
• # shares remaining = 50,000-20,000 = 30,000 shares
• Vu = VL
• Equity after leverage = $300,000-$120,000 = $180,000 (30,000 shares)

• Share price = $180,000/30,000 = $6
• Share price is constant, WACC is constant

M and M Proposition I (No Tax)
• Vu = VL
• Implication: Share Price is Constant
• Value of anything = PV of future cash flow
• Value of any firm =

• Firm value = Constant

M and M Proposition II (No Tax)
• Return/cost of equity (Re) increases with
more leverage (Share price constant)
• RE = RA + (RA – RD)(D/E)

M&M Proposition II
• Cost of equity depends on three things
- The required rate of return on the firm’s
assets (RA)
- RD; The firm’s cost of debt
-Firm’s debt-equity ratio (D/E)

Case I—Propositions I and II
• Proposition I
– The value of the firm is NOT affected by
changes in the capital structure.
– The cash flows of the firm do not change;
therefore value doesn’t change.
• Proposition II
– The WACC of the firm is NOT affected by
capital structure.

Case I—Equations
• WACC = RA = (E/V)RE + (D/V)RD
• RE = RA + (RA – RD)(D/E)
– RA is the ‘cost’ of the firm’s business risk, i.e.

the risk of the firm’s assets.
– (RA – RD)(D/E) is the ‘cost’ of the firm’s financial
risk, i.e. the additional return required by
stockholders to compensate for the risk of
leverage.
Case I—Example
• Data
– Required return on assets = 16%, cost of debt = 10%,
percentage of debt = 45%
• What is the cost of equity?
– R = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91%
E
• Suppose instead that the cost of equity is 25%, what is the
debt-to-equity ratio?
– .25 = .16 + (.16 - .10)(D/E)
– D/E = (.25 - .16) / (.16 - .10) = 1.5
• Based on this information, what is the percentage of equity in
the firm?
– E/V = 1 / 2.5 = 40%

M&M Propositions I and II
Figure 13.3
• 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.

The CAPM, the SML and
Proposition II
• How does financial leverage affect systematic
risk?
• CAPM: RA = Rf + A(RM – Rf)
– Where A is the firm’s asset beta and measures
the systematic risk of the firm’s assets.
• Proposition II
– Replace RA with the CAPM and assume that the
debt is riskless (RD = Rf).
– RE = Rf + A(1+D/E)(RM – Rf)
Business risk and financial risk
• RE = Rf + A(1+D/E)(RM – Rf)
• CAPM: RE = Rf + E(RM – Rf)
– E = A(1 + D/E)
• Therefore, the systematic risk of the share
depends on:
– Systematic risk of the assets, A (business risk)
– Level of leverage, D/E (financial risk)

Case II—Corporate taxes
• Interest on debt is tax deductible.
• When a firm adds debt, it reduces taxes, all
else being equal.
• The reduction in taxes increases the cash
flow of the firm.
• The reduction in taxes reduces net income.

Case II—Example
Unlevered firm Levered firm
EBIT 5000 5000
Interest 0 500
Taxable Income 5000 4500
Taxes (30%) 1500 1350
Net Income 3500 3150
CFFA 3500 3650

Interest tax shield
• Annual interest tax shield
– Tax rate times interest payment
– 6250 in 8% debt = 500 in interest expense
– Annual tax shield = .30(500) = 150
• Present value of annual interest tax shield
– Assume perpetual debt for sake of simplicity
– PV = 150 / .08 = 1875
– PV = D(RD)(TC)/RD = DTC = 6250(.30) = 1875
Case II—Proposition I
• The value of the firm increases by the present
value of the annual interest tax shield.
– Value of a levered firm = value of an unlevered
firm + PV of interest tax shield.
– Value of equity = Value of the firm – Value of debt
• Assuming perpetual cash flows
– VU = EBIT(1-T)/RU
– VL = VU + DTC

Case II—Proposition I (cont.)
• Data
– EBIT = $25 million; tax rate = 30%; debt = $75
million; cost of debt = 9%; unlevered cost of
capital = 12%
• VU = 25(1-.30) / .12 = $145.83 million
• VL = 145.83 + 75(.30) = $168.33 million
• E = 168.33 – 75 = $93.33 million

M&M Proposition I with taxes
Figure 13.4

Case II—Proposition II
• The WACC decreases as D/E increases because
of the government subsidy on interest
payments.
– RA = (E/V)RE + (D/V)(RD)(1-TC)
– RE = RU + (RU – RD)(D/E)(1-TC)
• Example:
– RE = .12 + (.12-.09)(75/86.67)(1-.35) = 13.69%
– RA = (86.67/161.67)(.1369) + (75/161.67)(.09)
(1-.35)
– RA = 10.05%
Case II—Proposition II (cont.)
• Suppose that the firm changes its capital
structure so that the debt-to-equity ratio
becomes 1.
• What will happen to the cost of equity
under the new capital structure?
– RE = .12 + (.12 - .09)(1)(1-.35) = 13.95%
• What will happen to the weighted average
cost of capital?
– RA = .5(.1395) + .5(.09)(1-.35) = 9.9%
Illustration of Proposition II

M&M summary
Table 13.4

M&M summary
Table 13.4 (cont.)

Bankruptcy costs
• Direct costs
– Legal and administrative costs
• Enron = $1 billion; WorldCom = $600 million
– Bondholders incur additional losses
– Disincentive to debt financing
• Financial distress
– Significant problems meeting debt obligations
– Most firms that experience financial distress
do not ultimately file for bankruptcy
Indirect bankruptcy costs
• Indirect bankruptcy costs
– Larger than direct costs, but more difficult to measure
and estimate
– Stockholders wish to avoid a formal bankruptcy
– Bondholders want to keep existing assets intact so
they can at least receive that money
– Assets lose value as management spends time
worrying about avoiding bankruptcy instead of
running the business
– Lost sales, interrupted operations, loss of valuable
employees, low morale, inability to purchase goods on
credit

Case III
With bankruptcy costs
•  D/E ratio → probability of bankruptcy
•  probability → expected bankruptcy
costs
• At some point, the additional value of the
interest tax shield will be offset by the
expected bankruptcy costs.
• At this point, the value of the firm will start
to decrease and the WACC will start to
increase as more debt is added.
Optimal capital structure
Figure 13.5

Conclusions
• Case I—no taxes or bankruptcy costs
– No optimal capital structure
• Case II—corporate taxes but no bankruptcy costs
– Optimal capital structure = 100% debt
– Each additional dollar of debt increases the cash flow
of the firm
• Case III—corporate taxes and bankruptcy costs
– Optimal capital structure is part debt and part equity
– Occurs where the benefit from an additional dollar of
debt is just offset by the increase in expected
bankruptcy costs
The capital structure question
Figure 13.6

Observed capital structures
• Capital structure differs by industry
• Example:
– Differences in Australian industries according
to Table 13.5
• Media classification—Brisbane Broncos—0% debt
• Utilities classification—Envestra—398.9% debt

Bankruptcy process
• Business failure—business has terminated
with a loss to creditors
• Legal bankruptcy—petition federal court
for bankruptcy
• Technical insolvency—firm is unable to
meet debt obligations
• Accounting insolvency—book value of
equity is negative
Liquidation and reorganisation
• Companies Act 1993 and the Liquidation
Regulations 1994.
• Process
– A petition is filed in a federal court. A corporation may file
a voluntary petition, or involuntary petitions may be filed
against the corporation by several of its creditors.
– An administrator is appointed by the court or the creditors
to take over the assets of the debtor. The administrator will
attempt to liquidate the assets.
– When the assets are liquidated, after payment of the
bankruptcy administration costs, the proceeds are
distributed among the creditors.
– If any proceeds remain, after expenses and payments to
creditors, they are distributed to the shareholders.
Liquidation and reorganisation
(cont.)
• The distribution of liquidation proceeds is made according to
section 556 of the Australian Government Corporations Law.
• Brief priority list (absolute priority rule)
– 1. Administrative expenses associated with the bankruptcy.
– 2. Other expenses arising after the filing of a bankruptcy petition, but before the
appointment of an administrator.
– 3. Wages, salaries and superannuation contributions for employees owed before the
company goes into liquidation.
– 4. Amounts due in respect of injury compensation owed before the company goes into
liquidation.
– 5. Amounts due to employees for leave of absence owed before the company goes into
liquidation.
– 6. Retrenchment payments payable to employees of the company. In New Zealand the
preferential payment under 3, 4, 5 and 6 is limited to $15 000 per employee.
– 7. Payment to unsecured creditors.
– 8. Payment to preference shareholders.
– 9. Payment to ordinary shareholders.

Quick quiz
Kyle Corp. is comparing two different capital structures, an all-
equity plan (Plan I) and a levered plan (Plan II). Under Plan I, Kyle
would have 400,000 shares of stock outstanding. Under Plan II,
there would be 260,000 shares of stock outstanding and
$6,020,000 in debt outstanding. The interest rate on the debt is
10%, and there are no taxes
•If EBIT is $1,3 million, which plan will result in the higher EPS?
•If EBIT is $2,1 million, which plan will result in higher EPS?
•Use M&M proposition I to find the price per share of equity
under each of the two proposed plans. What is the value of the
firm?


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Leverage and capital structure

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Proposed Capital Structure: Debt = $4 million

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EBIT EBIT  400,000

• If we expect EBIT to be greater than the break-even point, then

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How many shares in proposed balance sheet?

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• Make income statement

• Equity after leverage = $300,000-$120,000 = $180,000 (30,000 shares)

• Share price is constant, WACC is constant

• Value of any firm =

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– RA is the ‘cost’ of the firm’s business risk, i.e.

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• The change in the capital structure weights (E/V and D/V) is

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EBIT 5000 5000

Taxable Income 5000 4500

Taxes (30%) 1500 1350

Net Income 3500 3150

CFFA 3500 3650

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Copyright © 2011 McGraw-Hill Australia Pty Ltd

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Copyright © 2011 McGraw-Hill Australia Pty Ltd

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Copyright © 2011 McGraw-Hill Australia Pty Ltd

Copyright © 2011 McGraw-Hill Australia Pty Ltd

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