Transcript Financial Leverage and Capital Structure

On Capital Structure
The impact of debt financing on firm and project value
To borrow or not to borrow…?
Objective
To analyze the relationship between capital structure
decision and firm value
Outline
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The effect of financial leverage
Measures of financial leverage
Capital structure and firm value
Empirical evidence on capital structure
The effect of financial leverage
What do borrowing does to firm’s earnings?
Case A: The firm is all equity
The firm has 400,000 shares outstanding, selling at $20/share
Case A: The firm is all equity
The firm has 400,000 shares outstanding, selling at $20/share
EBIT
Recession
Normal
Boom
$500,000
$1,000,000
$1,500,000
Case A: The firm is all equity
The firm has 400,000 shares outstanding, selling at $20/share
Recession
Normal
Boom
EBIT
$500,000
$1,000,000
$1,500,000
Interest
0
0
0
Case A: The firm is all equity
The firm has 400,000 shares outstanding, selling at $20/share
Recession
Normal
Boom
EBIT
$500,000
$1,000,000
$1,500,000
Interest
0
0
0
Net Income
$500,000
$1,000,000
$1,500,000
Case A: The firm is all equity
The firm has 400,000 shares outstanding, selling at $20/share
Recession
Normal
Boom
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%
12.5%
18.75%
Case A: The firm is all equity
The firm has 400,000 shares outstanding, selling at $20/share
Recession
Normal
Boom
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%
12.5%
18.75%
EPS
$1.25
$2.5
$3.75
Case B: The firm has $4 million in long-term debt @10%/year and
200,000 shares selling at $20/share.
EBIT
Recession
Normal
Boom
$500,000
$1,000,000
$1,500,000
Case B: The firm has $4 million in long-term debt @10%/year and
200,000 shares selling at $20/share.
Recession
Normal
Boom
EBIT
$500,000
$1,000,000
$1,500,000
Interest
$400,000
$400,000
$400,000
Case B: The firm has $4 million in long-term debt @10%/year and
200,000 shares selling at $20/share.
Recession
Normal
Boom
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
Case B: The firm has $4 million in long-term debt @10%/year and
200,000 shares selling at $20/share.
Recession
Normal
Boom
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
2.5%
15%
27.5%
Case B: The firm has $4 million in long-term debt @10%/year and
200,000 shares selling at $20/share.
Recession
Normal
Boom
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
2.5%
15%
27.5%
EPS
$0.5
$3
$5.5
Discussion
The standard deviation of ROE and EPS has increased when compared
to the no-debt case.
Conclusion:
With more debt, EPS and ROE become more volatile
Several measures of financial leverage
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The debt-to-equity ratio
The total debt ratio
The dynamic degree of financial leverage
The static degree of financial leverage
Times interest earned
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The cash coverage ratio
The debt-to-equity ratio
D/E is the ratio of debt to equity.
In case A, D/E = 0
In case B, D/E =1
The total debt ratio
Total debt ratio = D/(D+E)
D/(D+E) compares the value of debt to the total firm
value
In case A, D/(D+E) =0
In case B, D/(D+E) = 0.5
The dynamic degree of financial leverage
(DDFL) measures the elasticity of EPS with respect to EBIT.
DDFL= (%Chg. in EPS)/(%Chg. in EBIT)
Consider the change in EBIT and EPS from the normal state to the
booming state of the economy.
In A, DDFL = 1
In B, DDFL = 1.67.
Note:
If you consider the change in EBIT and EPS from the booming state
to the normal state of the economy the calculation yields a different
ratio.
The static degree of financial leverage
SDFL = EBIT/(EBIT - Interest)
In A, SDFL =1 for all three states of the nature.
In B, one has to use expected values
SDFL = 1,000,000/600,000 = 1.67
Attention:
SDFL is not always equal to DDFL. Each ratio captures a different
aspect of the degree of financial leverage
Times interest earned
TIE= EBIT/Interest
TIE compares EBIT to the annual interest payment
In B, TIE =2.5
The cash coverage ratio
Cash coverage = (EBIT + Depreciation)/Interest
Cash coverage compares EBIT plus depreciation to the annual interest
payment.
In B, cash coverage is no less than 2.5 (we don't know the annual amount of
depreciation)
Measuring and evaluating leverage:
A summary
Debt makes cash flows more volatile.
There are several ways to measure leverage.
Each method offers a unique vantage point.
Leverage and optimal capital structure
The static view
Miller & Modigliani’s view
Leverage and optimal capital structure:The static
view
There is an optimal capital structure:
That debt-to-equity ratio that maximizes total firm value.
The two opposite effects of leverage
Risk increase (as discussed above)
Discount rate becomes higher -> Total firm value goes down
Tax savings
Cash flows to stakeholders increase
-> Total firm value goes up
Remember:
Assets are financed by shareholders and creditors
The cash flow from assets go back to shareholders and creditors
The present value of cash flows from assets is the total market value of the
firm, V:
PV CF from assets = V
At the same time,
V = market value of equity + market value of debt
Hence,
PV CF from assets = market value of equity + market value of debt
Tax savings: Exemplification
Project A: Levered
Project A: Unlevered
EBIT
$100
$100
Interest
$50
-
EBT
$50
$100
Tax (40%)
$20
$40
NI
$30
$60
Tax savings: Exemplification
Project A: Levered
Project A: Unlevered
EBIT
$100
$100
Interest
$50
-
EBT
$50
$100
Tax (40%)
$20
$40
NI
$30
$60
Tax savings: Exemplification
Project A: Levered
Project A: Unlevered
EBIT
$100
$100
Interest
$50
-
EBT
$50
$100
Tax (40%)
$20
$40
NI
$30
$60
Tax savings: Exemplification
Project A: Levered
Project A: Unlevered
EBIT
$100
$100
Interest
$50
-
EBT
$50
$100
Tax (40%)
$20
$40
NI
$30
$60
Tax savings: Exemplification
Project A: Levered
Project A: Unlevered
EBIT
$100
$100
Interest
$50
-
EBT
$50
$100
Tax (40%)
$20
$40
NI
$30
$60
Tax savings: Exemplification
Project A: Levered
Project A: Unlevered
EBIT
$100
$100
Interest
$50
-
EBT
$50
$100
Tax (40%)
$20
$40
NI
$30
$60
Cash flow from assets:
Levered case = $50 + $30 =$80
Unlevered case = $60
By leveraging the project, we increase its total cash flows
Optimal capital structure:The static view
A little debt will generates tax savings without adding too much risk
A lot of debt will dramatically increase risk more than offsetting tax
savings
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E
V
Static view: Leverage and firm value
VU
D/E*
D/E
The static view: A summary
The optimal capital structure is simply a matter of balancing
corporate debt tax shields against the risk of financial distress
(bankruptcy costs)
The cost of bankruptcy
The overall cost of bankruptcy is also called the cost of financial
distress:
direct (legal and administrative expenses)
indirect (opportunity costs caused by the increasing difficulties of
running a business on the brink of bankruptcy)
The theory of optimal capital structure (Merton
Miller and Franco Modigliani)
This theory is known as the irrelevance theory because
M&M argue that capital structure doesn’t really matter
M&M 1958
I. The overall market value of the firm and the WACC
are completely independent of firm's capital structure.
II. The cost of equity is a linear function of firm's
leverage
Proposition I
(assume perpetual CF)
Proof:
VL = (CF to s/h + CF to b/h)/(wacc)
VL = [(EBIT - rD) +rD]/(wacc) = VU
Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow aD
receive the payoff
a(EBIT - rD)
a(EBIT - rD)
Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow aD
receive the payoff
a(EBIT - rD)
a(EBIT - rD)
Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow aD
receive the payoff
a(EBIT - rD)
a(EBIT - rD)
Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow aD
receive the payoff
a(EBIT - rD)
a(EBIT - rD)
Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow aD
receive the payoff
a(EBIT - rD)
a(EBIT - rD)
Since the payoffs are equal:
a(VL - D) = aVU - aD
VL = VU.
Proposition II
II. The cost of equity is a linear function of firm's leverage, that is a
function of its debt/equity ratio
ke = wacc + (wacc - r)(D/E)
beta equity = business risk + financial risk
beta equity = beta assets + (D/E) beta assets
M&M 1963
I. The overall market value of the firm is an
increasing function of leverage
II. The cost of equity is a function of capital
structure and corporate taxes.
M&M 1963: Proposition I
VL= [PVCF to s/h + PVCF to b/h] = EBIT(1-T)/ke + rTD/r
VL = VU + tax shield
M&M 1963: Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow (1-T)aD
receive the payoff
a(1-T)(EBIT - rD)
a(1-T)(EBIT - rD)
M&M 1963: Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow (1-T)aD
receive the payoff
a(1-T)(EBIT - rD)
a(1-T)(EBIT - rD)
M&M 1963: Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow (1-T)aD
receive the payoff
a(1-T)(EBIT - rD)
a(1-T)(EBIT - rD)
M&M 1963: Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow (1-T)aD
receive the payoff
a(1-T)(EBIT - rD)
a(1-T)(EBIT - rD)
M&M 1963: Proposition I
Alternative proof
Assume two firms:
L is levered VL = SL + D
U is unlevered VU = SU
portfolio A
portfolio B
invest today
buy aSL = a(VL - D)
buy aSU = a VU
borrow (1-T)aD
receive the payoff
a(1-T)(EBIT - rD)
a(1-T)(EBIT - rD)
Since the payoffs are equal,
a(VL - D) = aVU - a(1-T)D
That is VL = VU + (D)(T)
(D)(T) = tax shield
Exemplification: NoDebt Inc. and MoreDebt S.A. have identical EBIT of $69,230.77 in perpetuity.
NoDebt has 15,000 shares outstanding selling at $30 each and no debt. MoreDebt has 20,000 shares
outstanding and $200,000 in perpetual debt. The corporate tax rate is 35%, and the interest on debt is 5%.
Mr. R buys 800 shares in MoreDebt SA, while Mr. P borrows $5,200 (at 5%) and uses his own savings to buy 600
shares in NoDebt. Who will have a higher cash flow at the end of the year?
CF (Mr. R) = (0.04)[$69,230.77 – (0.05)(200,000)](0.65) = $1,540
CF (Mr. P) = (0.04)($69,230.77)(0.65) – (0.05)(5,200) = $1,540
What is the price per share for More Debt Inc.?
Since the payoff for the two portfolios is equal, 600 shares in NoDebt should have the same market value as 800 shares in
MoreDebt and a 5,200 loan.
$18,000 = (X)800 + 5,200; x = $16/share
Total MV (NoDebt) = (30)(15,000) = $450,000
Total MV (MoreDebt) = (16)(20,000) + 200,000 = $520,000
Notice that $520,000 = $450,000 + (0.35)(200,000)
What is the cost of equity and the WACC for each of the two firms?
WACC(NoDebt) = Ke(NoDebt) = (69,230.77)(0.65)/450,000 = 0.1
Ke(More Debt) = (69,230.77- 10,000)(0.65)/320,000 = 0.1203
Notice that 0.1203 = 0.1 + (0.1 – 0.05)(0.65)(0.625)
WACC(MoreDebt) = (0.1203)(0.6154) + (0.05)(0.65)(0.3846) = 8.65%
M&M 1963: Proposition II
II. The cost of equity is a function of capital
structure and corporate taxes.
ke = wacc + (wacc - r)(1-T)(D/E)
Capital structure with corporate and
personal taxes (Miller 1976)
Stockholders receive: (EBIT- rD)(1-Tc)(1-Ts)
Tc = corporate tax
Ts = personal tax on equity income
Bondholders receive: rD(1-Td)
Td = personal tax on ordinary income
Capital structure with corporate and
personal taxes (Miller 1976)
VL = PV of (EBIT- rD)(1-Tc)(1-Ts) + rD(1-Td)
VL = VU + [1 - (1-Tc)(1-Ts)/(1-Td)]D
VL = VU + tax shield
Capital structure with corporate and personal taxes
(Miller 1976)
The tax shield can be negative, positive or zero, depending on
the differences between personal and corporate tax rates.
Summary
VL = VU + Debt tax shield - Cost of bankruptcy - Agency costs
Discussion
Debt clearly makes residual cash flow more volatile.
Debt generates tax shields.
The net effect is unclear
Since wacc is calculated as an average of a relatively high cost
of equity and relatively low cost of debt, it is not clear what
happens to the overall market value of the firm.
Discussion (con’t)
In an ideal world, capital structure should have no impact on
total firm value (M&M 1958)
In the real world, however, capital structure appears to have
some influence on total market value.
Discussion (con’t)
The real question:
How much impact has debt financing?
If impact is small, then we’re back to M&M
Discussion (con’t)
Choosing the right investment projects is the main determinant of
firm value
Financing the projects is only a matter of fine tuning
Conclusion
The range of optimal capital structure is a matter of
managerial opinion
NPV implications
Even though the impact of debt financing might be small, one
has to account for it when calculating NPV