Ch 16 Financial Leverage and Capital Structure

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Ch 16 Financial Leverage and Capital Structure
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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.

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• 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)

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• 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 companys 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.

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• 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.
• The investor B could generate the same net
  earnings as that of investor A. The capital
  structure does not matter to investors.

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• 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

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• MM proposition II see what happen to cost of
  equity and debt under MM 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.

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• WACC is a required return on the firms overall
  assets. Thus WACC RA, the cost of the firms
  business risk (the firms assets)
• (RA RD)(D/E) is the cost of the firms
  financial risk (the additional return required by
  stockholders to compensate for the risk of
  leverage)

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Figure 16-3
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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
• WACC0.8130.20.0812
• 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
• WACC0.5160.50.0812

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• 3. MM 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 MM propositions.

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• 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.
• Here, difference is 24 724-700. It comes from
  reduced taxable income because of interest
  payment. 24 (10000.08)0.3
• It is called interest tax shield.

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• If the same amount of tax shield happens forever,
  we can write
• Thus MM 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.

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• MM 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

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• MM 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.
• 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

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Figure 16-5
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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 Formats equity?
• Vu OFC/ Ru
• (EBITDepreciation Tax)/Ru

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• EBIT(1-Tax rate)/Ru100/0.2500.
• VL VuTD 5000.34500 670.
• EVL-D670-500 170.
• 2) What is cost of equity
• RERu(Ru-RD)(D/E)(1-tax rate)
• 0.2(0.2-0.1)(500/170)(1-0.34)39.4

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• 3) What is WACC
• (170/670)39.4(500/670)10(1-0.34)14.92
• WACC is lower than cost of capital without debts
  (Ru20). Thus debt financing improves value of
  the firm.

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• 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.

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• 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.

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• 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.

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• 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 firms prospects seen by its own
  management.

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• 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.

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• 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.

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• 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.

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• 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.

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• 2) Chapter 7 Liquidation termination of the
  firm as a going concern.
• (1) Procedure petition -gt bankruptcy trustee -gt
  liquidation
• (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

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• 3) Chapter 11 Reorganization plan financial
  restructuring of a failing firm to attempt to
  continue operations as a going concern.
• Order petition -gt approval/denial -gt
  reorganization plan -gt accepted by creditors and
  court -gt payment to creditors or stockholders
• Prepacked deal.

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• 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.

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• 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.

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• Major findings (1) As debt amounts change, WACC
  also changes. (2) value of operation (Vop)
  increases, (3) stock price increases.

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• 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.

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• 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)