1、Chapter 16Chapter 16Financial Leverage Financial Leverage and Capital Structure and Capital Structure PolicyPolicyMcGraw-Hill/IrwinCopyright 2010 by The McGraw-Hill Companies,Inc.All rights reserved.Key Concepts and Skills Understand the effect of financial leverage on cash flows and the cost of equ
2、ity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process16-2Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with C
3、orporate Taxes Bankruptcy Costs Optimal Capital Structure The Pie Again The Pecking-Order Theory Observed Capital Structures A Quick Look at the Bankruptcy Process16-3Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm,all else equal Capital re
4、structuring involves changing the amount of leverage a firm has without changing the firms assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt16-4Choosing a Capital Structure What
5、 is the primary goal of financial managers?Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC16-5The Effect of Leverage How does leverage affect the EP
6、S and 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,then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year,we still have to pay our fixed costs and we have less left ov
7、er for our stockholders Leverage amplifies the variation in both EPS and ROE16-6Example:Financial Leverage,EPS and ROE Part I We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue debt and buy back shares of stock?16-7Example:Financial Leverage,EPS and ROE Part I
8、I Variability in ROE Current:ROE ranges from 6%to 20%Proposed:ROE ranges from 2%to 30%Variability in EPS Current:EPS ranges from$0.60 to$2.00 Proposed:EPS ranges from$0.20 to$3.00 The variability in both ROE and EPS increases when financial leverage is increased16-8Break-Even EBIT Find EBIT where EP
9、S 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 may be beneficial to our stockholders If we expect EBIT to be less than the break-even point,then leverage is detrimental to our stockholders16-9Example:Break-
10、Even EBIT$1.00500,000500,000EPS$500,000EBIT500,0002EBITEBIT250,000EBIT250,000500,000EBIT250,000250,000EBIT500,000EBIT16-10Example:Homemade Leverage and ROECurrent Capital StructureInvestor borrows$500 and uses$500 of her own to buy 100 shares of stockPayoffs:Recession:100(0.60)-.1(500)=$10 Expected:
11、100(1.30)-.1(500)=$80 Expansion:100(2.00)-.1(500)=$150Mirrors the payoffs from purchasing 50 shares of the firm under the proposed capital structureProposed Capital StructureInvestor buys$250 worth of stock(25 shares)and$250 worth of bonds paying 10%.Payoffs:Recession:25(.20)+.1(250)=$30 Expected:25
12、(1.60)+.1(250)=$65 Expansion:25(3.00)+.1(250)=$100Mirrors the payoffs from purchasing 50 shares under the current capital structure16-11Capital Structure Theory Modigliani and Miller(M&M)Theory of Capital Structure Proposition I firm value Proposition II WACC The value of the firm is determined by t
13、he cash flows to the firm and the risk of the assets Changing firm value Change the risk of the cash flows Change the cash flows16-12Capital Structure Theory Under Three Special Cases Case I Assumptions No corporate or personal taxes No bankruptcy costs Case II Assumptions Corporate taxes,but no per
14、sonal taxes No bankruptcy costs Case III Assumptions Corporate taxes,but no personal taxes Bankruptcy costs16-13Case 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 doesnt change
15、Proposition II The WACC of the firm is NOT affected by capital structure16-14Case I-Equations WACC=RA=(E/V)RE+(D/V)RD RE=RA+(RA RD)(D/E)RA is the“cost”of the firms business risk,i.e.,the risk of the firms assets(RA RD)(D/E)is the“cost”of the firms financial risk,i.e.,the additional return required b
16、y stockholders to compensate for the risk of leverage16-15Figure 16.316-16Case I-Example Data Required return on assets=16%;cost of debt=10%;percent of debt=45%What is the cost of equity?RE=16+(16-10)(.45/.55)=20.91%Suppose instead that the cost of equity is 25%,what is the debt-to-equity ratio?25=1
17、6+(16-10)(D/E)D/E=(25-16)/(16-10)=1.5 Based on this information,what is the percent of equity in the firm?E/V=1/2.5=40%16-17The CAPM,the SML and Proposition II How does financial leverage affect systematic risk?CAPM:RA=Rf+A(RM Rf)Where A is the firms asset beta and measures the systematic risk of th
18、e firms 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)16-18Business 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 stock depends on:Systematic risk of the assets,A,(Busine
19、ss risk)Level of leverage,D/E,(Financial risk)16-19Case II Cash Flow Interest is tax deductible Therefore,when a firm adds debt,it reduces taxes,all else equal The reduction in taxes increases the cash flow of the firm How should an increase in cash flows affect the value of the firm?16-20Case II-Ex
20、ampleUnlevered FirmLevered FirmEBIT5,0005,000Interest0500Taxable Income5,0004,500Taxes(34%)1,7001,530Net Income3,3002,970CFFA3,3003,47016-21Interest Tax Shield Annual interest tax shield Tax rate times interest payment 6,250 in 8%debt=500 in interest expense Annual tax shield=.34(500)=170 Present va
21、lue of annual interest tax shield Assume perpetual debt for simplicity PV=170/.08=2,125 PV=D(RD)(TC)/RD=DTC=6,250(.34)=2,12516-22Case 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 inter
22、est tax shield Value of equity=Value of the firm Value of debt Assuming perpetual cash flows VU=EBIT(1-T)/RU VL=VU+DTC16-23Example:Case II Proposition I Data EBIT=25 million;Tax rate=35%;Debt=$75 million;Cost of debt=9%;Unlevered cost of capital=12%VU=25(1-.35)/.12=$135.42 million VL=135.42+75(.35)=
23、$161.67 million E=161.67 75=$86.67 million16-24Figure 16.416-25Case 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+(12-9)(75/86.67)(1-.35)=13.69%RA=(86.67/161.67)(13.69)+(75/
24、161.67)(9)(1-.35)RA=10.05%16-26Example:Case II Proposition II 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+(12-9)(1)(1-.35)=13.95%What will happen to the weighted average co
25、st of capital?RA=.5(13.95)+.5(9)(1-.35)=9.9%16-27Figure 16.516-28Case III Now we add bankruptcy costs As the D/E ratio increases,the probability of bankruptcy increases This increased probability will increase the expected bankruptcy costs At some point,the additional value of the interest tax shiel
26、d will be offset by the increase in expected bankruptcy cost At this point,the value of the firm will start to decrease,and the WACC will start to increase as more debt is added16-29Bankruptcy Costs Direct costs Legal and administrative costs Ultimately cause bondholders to incur additional losses D
27、isincentive to debt financing Financial distress Significant problems in meeting debt obligations Firms that experience financial distress do not necessarily file for bankruptcy16-30More Bankruptcy Costs Indirect bankruptcy costs Larger than direct costs,but more difficult to measure and estimate St
28、ockholders want to avoid a formal bankruptcy filing 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 The firm may also lose sales,experience interrupt
29、ed operations and lose valuable employees16-31Figure 16.616-32Figure 16.716-33Conclusions Case I no taxes or bankruptcy costs No optimal capital structure Case II corporate taxes but no bankruptcy costs Optimal capital structure is almost 100%debt Each additional dollar of debt increases the cash fl
30、ow 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 costs16-34Figure 17.816-35Managerial Recommendations The tax benefit is
31、 only important if the firm has a large tax liability Risk of financial distress The greater the risk of financial distress,the less debt will be optimal for the firm The cost of financial distress varies across firms and industries,and as a manager you need to understand the cost for your industry1
32、6-36Figure 16.916-37The Value of the Firm Value of the firm=marketed claims+nonmarketed claims Marketed claims are the claims of stockholders and bondholders Nonmarketed claims are the claims of the government and other potential stakeholders The overall value of the firm is unaffected by changes in
33、 capital structure The division of value between marketed claims and nonmarketed claims may be impacted by capital structure decisions16-38The Pecking-Order TheoryTheory stating that firms prefer to issue debt rather than equity if internal financing is insufficient.Rule 1Use internal financing firs
34、tRule 2Issue debt next,new equity lastThe pecking-order theory is at odds with the tradeoff theory:There is no target D/E ratioProfitable firms use less debtCompanies like financial slack16-39Observed Capital Structure Capital structure does differ by industry Differences according to Cost of Capita
35、l 2008 Yearbook by Ibbotson Associates,Inc.Lowest levels of debt Computers with 5.61%debt Drugs with 7.25%debt Highest levels of debt Cable television with 162.03%debt Airlines with 129.40%debt16-40Work the Web Example You can find information about a companys capital structure relative to its indus
36、try,sector and the S&P 500 at Reuters Click on the web surfer to go to the site Choose a company and get a quote Choose Ratio Comparisons16-41Bankruptcy Process Part I Business failure business has terminated with a loss to creditors Legal bankruptcy petition federal court for bankruptcy Technical i
37、nsolvency firm is unable to meet debt obligations Accounting insolvency book value of equity is negative16-42Bankruptcy Process Part II Liquidation Chapter 7 of the Federal Bankruptcy Reform Act of 1978 Trustee takes over assets,sells them and distributes the proceeds according to the absolute prior
38、ity rule Reorganization Chapter 11 of the Federal Bankruptcy Reform Act of 1978 Restructure the corporation with a provision to repay creditors16-43Quick Quiz Explain the effect of leverage on EPS and ROE What is the break-even EBIT,and how do we compute it?How do we determine the optimal capital st
39、ructure?What is the optimal capital structure in the three cases that were discussed in this chapter?What is the difference between liquidation and reorganization?16-44Ethics Issues Suppose managers of a firm know that the company is approaching financial distress.Should the managers borrow from cre
40、ditors and issue a large one-time dividend to shareholders?How might creditors control this potential transfer of wealth?16-45Comprehensive Problem Assuming perpetual cash flows in Case II-Proposition I,what is the value of the equity for a firm with EBIT=$50 million,Tax rate=40%,Debt=$100 million,cost of debt=9%,and unlevered cost of capital=12%?16-46End of Chapter16-47
