Transcript Ch 17 Financial Leverage and Capital Structure

Ch 16 Financial Leverage and
Capital Structure
1. Capital structure question
• Financial managers want to set up a
capital structure that will maximize the firm
and stock value.
• Changing capital structure influences the
cost of capital. Basing on discounted cash
flow approach, it is clear that the minimum
level of cost of capital would maximize the
value of firm.
• 1) The Effect of Financial Leverage.
• Def of financial leverage: 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.
• Why it is important to firm value or stock
value?
• Ex)
Current
Proposed
Asset
8000000
8000000
Debt
0
4000000
Equity
8000000
4000000
Debt-Equity
0
1
Share Price
20
20
Shares outstanding
400000
200000
Interest rate
10%
10%
Current Capital Structure: No Debt
Recession Expected Expansion
EBIT
500000
1000000
1500000
Interest
0
0
0
Net Income
500000
1000000
1500000
ROE
6.25%
12.50%
18.75%
EPS
1.25
2.5
3.75
Proposed Capital Structure: Debt = $4 million
Recession Expected Expansion
EBIT
500000
1000000
1500000
Interest
400000
400000
400000
Net Income
100000
600000
1100000
ROE
2.50%
15.00%
27.50%
EPS
0.5
3
5.5
• Lessons:
• (1) Variability of EPS and ROE is much larger
under the proposed capital structure with debts,
more risk.
• (2) The effect of financial leverage depends on
the company’s EBIT. When EBIT is relatively
high, leverage is beneficial.
• 2) Homemade leverage: The use of personal
borrowing to change the overall financial
leverage to which the individual is expected.
• Ex) with the previous example, Assume two cases.
Investors A and B have $2000. First one is that investor
A buys 100 shares of a firm with debts. Second one is
that investor B buys 200 shares of a firm without debts
and borrows $2000 at 10%.
Proposed Capital Structure
EPS
Earnings for 100 shares
Net Cost = 100 share * $20 = $2000
Recession
0.5
50
Expected
3
300
Original Capital Structure and Homemade Leverage
EPS
1.25
2.5
Earnings for 200 shares
250
500
Less Interest on $2000 at 10%
200
200
Net Earnings
50
300
Net cost = 200 shares * $20 - Amount Borrowed = 4000-2000=2000
Expansion
5.5
550
3.75
750
200
550
• The investor B could generate the same net earnings as
that of investor A. The capital structure does not matter
to investors.
• 2. Capital Structure and the cost of equity
capital.
• M & M (Miller and Modigliani) proposition I:
• Under certain conditions – (e.g. no taxes,
bankruptcy costs, no brokerage costs, same
information for investors), the firm value has
nothing to do with capital structure – concept of
splitting a pie. The cash flow (EBIT) is
unaffected by the capital structure. Regardless
of debt amounts, the firm value is same.
• VL = VU = SL + D
• M&M proposition II: see what happen to cost of
equity and debt under M&M I – irrelevance.
• Due to cheaper cost of debts, the weight for cost
of debts increases but the cost of debts will be
the same under no tax and no bankruptcy. Due
to increasing risk, the cost of equity would also
increase with debt to equity ratio. But the cost of
equity would increase up to the level generating
the same WACC regardless of debt to equity
ratio.
– WACC is a required return on the firm’s overall assets. Thus
WACC = RA, the cost of the firm’s business risk (the firm’s
assets)
– (RA – RD)(D/E) is the cost of the firm’s financial risk (the
additional return required by stockholders to compensate for the
risk of leverage)
Figure 16-3
Example
• Data
– Required return on assets (RA)= 12%, cost of debt =
8%; percent of debt = 20%
• What is the cost of equity and WACC?
– RE = 12 + (12 - 8)(20/80) = 13%
– WACC=0.8*13%+0.2*0.08=12%
• Suppose instead that the cost of equity is 16%, what is
the debt-to-equity ratio?
– 16 = 12 + (12 - 8)(D/E)
– D/E = 1
• Based on this information, what is the percent of equity
in the firm? And WACC?
– E/V = 1 / 2 = 50%
– WACC=0.5*16%+0.5*0.08=12%
• 3. M&M propositions I and II with
corporate taxes.
• When we consider taxes, key issues are
that an interest paid is tax deductible. And
if the interest is not paid, a firm would go
bankrupt. These would change M&M
propositions.
• Ex) assume two firms, firm U and firm L. Two firms have EBIT of
$1000. Firm L issued $1000 worth of perpetual bonds at 8%. We
also assume no depreciation and no change in NWC.
EBIT
Interest
Taxable Income
Tax (30%)
Net Income
Operating cash flow
EBIT
Taxes
Total
Firm U
1000
0
1000
300
700
Firm L
1000
80
920
276
644
1000
300
700
1000
276
724
• Here, difference is 24 = 724-700. It comes from reduced taxable
income because of interest payment. 24 = (1000*0.08)*0.3
• It is called “interest tax shield.”
• If the same amount of tax shield happens
forever, we can write:
PV of tax shield  (TC  D  RD ) / RD
 TC  D
VL  VU  TC  D
• Thus M&M proposition I with corporate tax says
that as debts increase, the firm value increases.
It means that the capital structure does matter in
the firm value. It is not the same as the original
proposition.
• M&M a little bit expanded the previous
model with corporate tax (Tc), considering
personal taxes on income from stocks (Ts)
and on income from debt (Td). They
pointed out the deductibility of interests
favors the use of debt but the more
favorable tax treatment of income from
stocks favors the use of equity financing.
• VL = VU + [1-(1-Tc)(1-Ts)/(1-Td)] D
• M&M proposition II with corporate taxes: Cost of
equity would increase with debts. Due to tax
sheltering, After tax cost of debts will be lower
and WACC will go down.
WACC  ( E / V )  RE  ( D / V )  RD  (1  TC )
RE  Ru  ( Ru  RD )  ( D / E )  (1  TC )
• Ru is an unlevered cost of capital
• WACC and RE change with debts associated
with tax shelter. The firm value would improve
with corporate taxes. Figure 16.5
Figure 16-5
Example
• Format Co has only debts and equity. Its
debts are $500. Its EBIT (perpetuity) is
$151.52. Tax rate is 34%. Ru is 20%.
Cost of capital is 10%. No depreciation
and additional investments are assumed.
• 1) what is the value of Format’s equity?
• Vu= OFC/ Ru
• = (EBIT+Depreciation –Tax)/Ru
• =EBIT*(1-Tax rate)/Ru=100/0.2=500.
• VL =Vu+T*D =500+0.34*500 =670.
• E=VL-D=670-500 =170.
• 2) What is cost of equity
• RE=Ru+(Ru-RD)*(D/E)*(1-tax rate)
• =0.2+(0.2-0.1)*(500/170)*(1-0.34)=39.4
• 3) What is WACC
• (170/670)*39.4%+(500/670)*10%*(10.34)=14.92%
• WACC is lower than cost of capital without
debts (Ru=20%). Thus debt financing
improves value of the firm.
• 4. Bankruptcy costs
• 1) direct bankruptcy costs: costs that are directly
associated with bankruptcy, such as legal and
administrative expenses.
• Ex) Enron spent more than $1 billion on laywers,
accountants, consultants… Lehman supposedly spent
almost $2 billion
• 2) Indirect bankruptcy costs: the costs of avoiding a
bankruptcy filing incurred by a firm.
• 3) Financial distress: both direct and indirect bankruptcy
costs such as losing market shares, inability to purchase
goods on credit.
• These costs would increase cost of debt when debt
increases.
• 5. Optimal Capital Structure
• 1) Static (or Trade-off) theory of capital
structure:
• firms borrow up to the point where the tax
benefit from an extra in debt is equal to the
cost that comes from the increased
probability of financial distress. Thus firm
value would hit the optimal level of debt to
equity ratio and then decrease as debt
increases.
• At the optimal level of debt to equity ratio,
WACC would be minimum.
• 6. Revisit to pie
• Total value of firm would be determined by cash
flow (CF).
• CF = payments to stockholders + payments to
bond holders + payment to the government +
payment to bankruptcy courts and lawyers +
payment to other claims.
• Marketed claims = payment to stockholders and
payment to bondholders.
• When we say the value of firm, it typically refers
to marketed claims. Optimal capital structure
relates to the marketed claims.
• 7. Signaling theory: the level of information
(symmetric or asymmetric) about valuation
will affect the capital structure.
• A firm with very positive prospects would
avoid to issue share not to share potential
future profits. A firm with a negative
prospects would prefer to issue equity to
share risk. Thus the announcement of
stock or debt financing signal to the
market the firm’s prospects seen by its
own management.
• 8. Pecking order theory.
• In reality, many firms carry less debt
despite of the advantages of having debts
inside.
• Theory : due to floatation costs or
information asymmetry, the firm will use
internal financing first. Then they will
issue debt if necessary. As a last resort,
equity would be sold.
• Potential explanation: signaling effect of
selling overvalued equity to the market.
• 9. Reserve Borrowing Capacity
• A firm wants to maintain a reserve
borrowing capacity. Thus in normal time,
he or she use more equity and less debt.
• 10. Using debt financing to constrain
management.
• Due to agency problem associated with
extra free cash in the firm, owners want to
increase debts to reduce extra free cash
or relevant agency problem.
• 11. investment opportunity set
• If a firm has more investment opportunity,
he or she use low amount of debts and
maintain reserves. Otherwise, he or she
will use more debts.
• 12. Market timing theory.
• When stock market prices are high, a firm
will issue equity. When interest rate is low,
he or she will issue debts.
• Observed Capital Structure: Table 16.7
• 13. Bankruptcy Process
• 1) Terminologies
• Business failure: a business is terminated with
losses to creditors.
• Bankruptcy: Legal proceeding in order to
liquidate or reorganize the firm.
• Technical insolvency: a firm is unable to meet its
financial obligations.
• Accounting insolvency: book value of liabilities
exceeds book value of total asset.
2) Chapter 7: Liquidation – termination of the firm as a
going concern.
• (1) Procedure: petition -> bankruptcy trustee ->
liquidation
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(2) Order:
Administrative and relevant legal costs.
Wages, salaries and commissions.
Employee benefit plans
Consumer claims
Government tax claims
Unsecured creditors
Preferred stockholders
Common stockholders
• (3) Absolute Priority Rule establishing priority of claims in
liquidation
3) Chapter 11: Reorganization plan –
financial restructuring of a failing firm to
attempt to continue operations as a
going concern.
(1) Order: petition -> approval/denial ->
reorganization plan -> accepted by
creditors and court -> payment to
creditors or stockholders
(2) Prepacked deal.
• 14. Estimating the optimal capital structure
• Cost of debt: investment bankers decide
lending rates, basing on their analysis of a
firm and relevant industry. E.g) credit
rating, accounting ratios, etc.
• Cost of equity: Hamada equation
• b = bu [1+(1-t)(Wd/Ws)]. Here Ws =We.
• Recapitalization means issuing more
debts to optimize its capital structure, and
use the debt proceeds to repurchase
stock.
E.g) one example (Financial Management
14th edition by Brigham and Ehrhardt).
Here a firm currently has 20% of debts. It is
considering optimal capital structure through
recap.
Wd
Ws
rd
b
rs
rd(1-t)
WACC
Vop
Debt
Equity
# of shares
Stock price
Net income
EPS
0%
100%
7.70%
1.09
12.82%
4.62%
12.82%
234.01
0.00
234.01
12.72
18.40
30.00
2.36
10%
90.0%
7.80%
1.16
13.26%
4.68%
12.40%
241.90
24.19
217.71
11.35
19.19
28.87
2.54
20%
80.0%
8%
1.25
13.80%
4.80%
12.00%
250.00
50.00
200.00
10
20.00
27.60
2.76
30%
70.0%
8.50%
1.37
14.50%
5.10%
11.68%
256.85
77.05
179.79
8.69
20.68
26.07
3.00
40%
60.0%
9.90%
1.52
15.43%
5.94%
11.63%
257.86
103.15
154.72
7.44
20.79
23.87
3.21
50%
50.0%
12%
1.74
16.73%
7.20%
11.97%
250.73
125.37
125.37
6.25
20.07
20.97
3.36
60%
40.0%
16%
2.07
18.69%
9.60%
13.24%
226.65
135.99
90.66
5.13
17.67
16.94
3.30
Risk free rate is 6.3% and a market risk premium is 6%. tax rate is 40%
Value of operation, Vop = [FCF(1+g)]/(WACC-g), where FCF= $30 million and growth rate is 0%.
# of shares after recap = # of share before recap *(VopNew - new debt)/(VopNew - old debt)
# of shares after recap = # of share before recap - (new debt -old debt)/price of share before repurchase
EBIT is assumed to be $50 million
• Major findings: (1) As debt amounts
change, WACC also changes. (2) value of
operation (Vop) increases, (3) stock price
increases.
More about recapitalization (repurchase):
• New debt will be recorded as short term
investment.
• # of outstanding shares remaining after
the repurchase = # of outstanding shares
before the repurchase – (new debt – old
debt)/ stock price before the repurchase.
• Repurchase did not affect shareholder
wealth or the price per share.
Before issung additional debt After debt issue, but prior to repurchase Post repurchase
Wd
20%
40%
40%
Value of operation
250
257.86
257.86
+ value of st investment
0
53.14
0
Total Intrinsic value
250
311.004
257.86
- Debt
50
103.14
103.14
Intrinsic value of equity
200
207.86
154.72
/ number of shares
10
10
7.44
price per share
20.00
20.79
20.79
Value of stock
200
207.86
154.716
+ cahs distributed in repurchase
0
0
53.14
wealth of shareholders
200
207.86
207.86
• Basing on no change in stock price in the
previous slide, we can calculate the
number of shares remaining after the
repurchase.
• (Vop new – new debt)/Npost =(Vop new –
old debt)/Nprior
• Npost = Nprior *(Vop new-new debt)/(Vop
new-old debt)