Transcript Document 7821868

FINANCE IN A CANADIAN
SETTING
Sixth Canadian Edition
Lusztig, Cleary, Schwab
CHAPTER
SIXTEEN
Capital Structure
Learning Objectives
1. Describe leverage and how it affects
companies.
2. Define indifference analysis, how it is used, and
what it measures.
3. Explain how the value of a company is
established.
4. Name two reasons why the cost of a security
to a company differs from its yield in capital
markets.
5. Describe how debt capacity affects a company.
Introduction

In this chapter we investigate:



the alternative capital structures with
respect to change in the proportions of
debt and equity
the theory that explores how various
degrees of leverage should be valued by
investors
the market imperfections and
considerations when evaluating debt levels
Leverage and Financial Risk


Leverage is encountered whenever fixed costs are
incurred to support operations that generate revenue
 Operating leverage – when a portion of a
company’s operating costs are fixed
 Financial leverage – when a firm finances part of
its business with securities that entail fixed
financing charges such as bond, debentures, or
preferred shares
A firm’s financial results that accrue to equity
investors are magnified through the use of operating
and financial leverage
Leverage and Financial Risk
Operating and Financial Leverage
Leverage and Financial Risk


A firms total leverage is a combination of
operating and financial leverage and measures the
% variation in EPS for a given % change in sales
Increased leverage leads to increased risk
 Business risk – results from general economic
cycles, changing industry conditions, and operating
cost structure of an individual firm

Degree of financial leverage – is the % change on
common equity or EPS divided by the % change in
EBIT that caused the change in equity returns
Leverage and Financial Risk

If only common equity is used changes in
ROE reflect only business risk


If senior securities are used in the capital
structure the variations on ROE are magnified


Financial leverage = 1
Financial leverage > 1
Total value of the firms is expressed by:
Value of firm = value of debt + value of equity
Indifference Analysis

Indifference analysis is a common tool
used in assessing the impact of
leverage and is used to:
determine EPS as a function of
EBIT for various capital structures
 identify the level of EBIT beyond
which reliance on leverage
produces higher EPS

Indifference Analysis

Limitations of indifference analysis include:
1. It ignores cash flow considerations such as
sinking fund provisions for the periodic
retirement of fixed income securities.
2. It does not consider how equity investors may
react to the increased risk imposed by leverage
in the light of uncertain future operating
performance.
Evaluation of
Capital Structures


A capital structure that maximizes share
prices generally will minimize the firm’s
WACC
If a firm can lower its WACC, shareholders
will receive greater returns reflected in
increased share prices

capital structure
 market price per share,  WACC
 market price per share,  WACC
Evaluation of
Capital Structures


Different capital structures results in different levels of
financial risk created through leverage.
Three trade-off possibilities include:
1. Cost equity increases with leverage at a moderate rate
so that when combined with debt

WACC decreases with increased leverage
2. Cost of equity increases at a rate that offsets the
benefits gained through cheaper financing

WACC remains constant
3. Cost of equity increases rapidly with leverage and
increase more than offsets any gains from debt

WACC increases with leverage
Evaluation of
Capital Structures
Consequences of Different Shareholder
Attitudes Toward Risk
Evaluation of
Capital Structures


Leverage is measured as the proportion of
debt in relation to equity in the capital
structure (B/E)
With V = B + E WACC is:
B
E
k  bb
 ke
V
V
Traditional Position

Under the traditional position firms can:



issue reasonable amounts of debt with
little effect on its cost of equity and a low
risk of default
Corporations use debt to take advantage
of the positive aspects of leverage
It is important for companies to find the
optimal level where the WACC is
minimized
Traditional Position
The Traditional Position on Capital
Structure and the Cost of Capital
Theory of Capital Structure

Capital structure without taxes and
bankruptcy costs


denoting keu and keL as the cost of equity
for unlevered and levered firms we have:
E
B
L
ke   bb  keU  cons tan t
V
V
rearranged we get:
k
L
e
k
U
e
 (k
U
e
B
 kb )
E
Theory of Capital Structure
Relationship Between the WACC, Cost of
Equity, and Leverage
Theory of Capital Structure

Corporate taxes



exert an important influence on financing
decisions because the amount of taxes
depends on the capital structure
levered firm’s taxes are reduced by the tax
shield on interest (IT)
VL > Vu

Ignoring bankruptcy, investors would prefer
owning debt and equity of L over equity U
Theory of Capital Structure

Assuming debt outstanding (B) is perpetual
and the tax shield generated by interest
payments becomes a perpetual annuity of IT
then:
IT
 BT
Present value of tax savings =
rb
then
VL  VU  BT
Theory of Capital Structure

The cost of equity keL increases at a slower
rate, which can be seen through the formulas:

B
U
k k 
(1  T )ke  kb
EL
L
e
U
e

EL L B
BT
U
k
ke  kb  ke 1 
V
V
B  EL




Theory of Capital Structure


Individual taxes can influence the value of a
company, therefore they must be considered
for decisions on capital structure
A company wants a capital structure that
minimizes total taxes or maximizes after-tax
distribution
Total after-tax distribution
 I ( I  Tpi )  E (1  Tc )(1  Tpd )
Theory of Capital Structure
Cash Flow with Corporate and Personal
Taxes
Theory of Capital Structure

Bankruptcy Costs


As firms increase financial leverage they
increase the probability of bankruptcy
Regardless of ownership any enterprise that
generates a positive NPV should continue
operating

Bankruptcies often reduce a firm’s economic value
because:
1. the direct costs such as fees for trustees, lawyers,
and court proceedings
2. the loss of profits caused by the loss of trust in the
company
Theory of Capital Structure
Benefit of Tax
Savings, Expected
Bankruptcy Costs,
and Optimal Capital
Structure
Market Imperfections and
Practical Considerations

Agency Problems


when managers fail to act in the best interests of
shareholders
Market Inefficiencies


Imperfections in the markets cause share prices to
fall whenever companies issue equity no matter if
the stock is undervalued, overvalued, or valued
correctly.
Based on the imperfections, companies should issue
bonds when internal equity is not available and only
issue equity as a last resort, which gives rise to the
“pecking order” of corporate finance
Market Imperfections and
Practical Considerations

“Pecking order” of finance holds that
1. Retained earnings or depreciation should
be used first
2. After internal resources are depleted, debt
should be used
3. New common equity should be issued only
when more debt is likely to increase the
chance of bankruptcy

Debt capacity

Debt capacity – the ability of an enterprise
to tolerate higher leverage
Market Imperfections and
Practical Considerations

Considerations determining the debt
capacity of a firm include:



debt capacity can be viewed as a function
of both collateral and stable cash flow
the variability and level of cash flow during
difficult times influences debt capacity
firms with product lines that involve longterm commitments to customers have a
lower debt capacity
Summary
1. A firm that incurs fixed costs while
generating variable revenues is subject to
leverage. Leverage is used to increase the
expected profitability of a firm. Financial risk
is the added variability in returns to
shareholders introduced by financing through
fixed-cost senior securities.
2. Indifference analysis is used to evaluate the
effect of leverage on profitability.
Summary
3. A firm’s capital structure is optimal if it
maximizes shareholder wealth. The
desirability of financial leverage depends on
equity investors’ attitudes toward the implied
trade-offs between risk and expected returns.
The traditional position suggests, optional
moderate leverage.
4. Given corporate taxes, interest on debt
allows the firm to reduce its tax bill and to
increase the amount available for distribution
to security holders.
Summary
5. Firms restrict debt financing in order to limit
the probability of financial distress.
Liquidation decisions entail capital budgeting
analysis that is based on net present values.
Total expected bankruptcy costs increase with
financial leverage and reduce the value of the
firm. The trade-off facing management is
between the tax benefits that accrue through
debt financing and the expected costs of
financial distress that increase with leverage.
Summary
6. Since debt payments represent contractual
obligations, high leverage reduces a firm’s
free cash flow. It thus limits management
flexibility and discretion. A firm’s debt
capacity is mainly a function of the stability of
its cash flow and its collateral’s value and
liquidity.
7. Financial leverage affects a firm’s systematic
risk. Beta, as specified by the Capital Asset
Pricing Model, varies as a function of the debt
proportion that the firm employs.