Chapter 13

Leverage and
Capital Structure

1
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 1-213-2

Chapter Outline
• The Capital Structure Question
• The Effect of Financial Leverage
• Capital Structure Theory: Case I, II &III
• Corporate Taxes and Capital Structure
• Bankruptcy Costs
• Optimal Capital Structure

2
 1-313-3

Capital Structure
• Decision on how to raise the funds?
– Issue Equity Securities
– Issue Debt Securities
• What is the primary goal of financial managers?
– Maximize stockholders’ wealth
• We want to choose the capital structure that will
maximize stockholder wealth by either:
– maximizing firm value or
– minimizing WACC

3
 1-413-4

Capital Restructuring
• We are going to look at how changes in capital
structure affect the value of the firm, all else
equal
• Capital restructuring involves changing the
amount of leverage a firm has without changing
the firm’s assets
• Increase leverage by issuing debt and
repurchasing outstanding shares
• Decrease leverage by issuing new shares and
retiring outstanding debt

4
 1-513-5

The Effect of Leverage

• How does leverage affect the EPS 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 over for our
stockholders

5
 1-613-6

Financial Leverage, EPS and ROE

• What happens to EPS and ROE when we

issue debt and buy back shares of stock?
• We will ignore the effect of taxes at this
stage
• Example: Refer to Table 13.1, 13.2 (pg
406)

6
 1-713-7
Financial Leverage, ROE and EPS
Current Proposed
Assets $8 mil $8 mil
Debt 0 $4 mil (at 10% interest)
Equity $8 mil $4 mil
Debt equity ratio 0 1
Share price $20 $20
Shares outstanding 400k 200k

Current capital structure (No debt) Proposed capital (D=$4mil)

Equity=$8mil, o/shares=400k Equity=$4mil, o/shares=200k
Bad Normal Good Bad Normal Good

EBIT 500k 1mil 1.5mil 500k 1mil 1.5mil

7
 1-813-8
Example: Financial Leverage, EPS
and ROE
• Variability in ROE
– Current: ROE ranges from 6.25% to 18.75%
– Proposed: ROE ranges from 2.50% to 27.50%
• Variability in EPS
– Current: EPS ranges from $1.25 to $3.75
– Proposed: EPS ranges from $0.50 to $5.50
• The variability in both ROE and EPS increases
when financial leverage is increased. IOW,
Leverage amplifies the variation in both EPS and
ROE
8
 1-913-9

Break-Even EBIT
• Find EBIT where EPS 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 is
beneficial to our stockholders
• If we expect EBIT to be less than the
break-even point, then leverage is
detrimental to our stockholders
9
 13-10
1-10

Example: Break-Even EBIT

EPS (Current) = EPS (Proposed)
EBIT EBIT −interest
=
shares outstanding shares outstanding

10
 13-11
1-11

Homemade Leverage
Homemade leverage: use of personal borrowing to change
the overall amount of financial leverage to which the
individual is exposed ==>capital structure is irrelevant

• Company: Current capital structure (all equity)

• Investor prefers the payoff under proposed capital struc.
===> levered (buy more shares by borrowed funds and
pay interest)

• Company: Proposed capital structure (equity + debt)

• Investor prefers the payoff under current capital struc.
===> unlevered (sell shares and lend out the proceeds to
earn interest)

11
 13-12
1-12

Homemade Leverage-Example
Example: company is under current capital structure. An
investor is owning 100 shares but prefers the payoffs
under proposed capital structure

• Current Capital Structure==> Proposed Capital

Structure (levered)

12
 13-13
1-13

Example: Homemade Leverage

Example: company use proposed capital structure. An
investor is owning 100 share but prefers the payoffs
under current capital structure

• Proposed Capital Structure==> Current Capital

Structure (unlevered)

13
 13-14
1-14

Capital Structure Theory

• Modigliani and Miller (1958) Theory of
Capital Structure
– Proposition I – firm value
– Proposition II –WACC
• The value of the firm is determined by the
cash flows to the firm and the risk of the
assets
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows
14
 13-15
1-15
Capital Structure Theory Under
Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs
15
 13-16
1-16
Case I – No Taxes & No
Bankruptcy costs
• Proposition I (firm value = V)
– The value of the firm is NOT affected by
changes in the capital structure... due to the
cash flows of the firm do not change.
• Proposition II (cost of capital = WACC)
– The WACC of the firm is NOT affected by
capital structure

16
 13-17
1-17

Case I - Equations
• Prop I: Vu = EBIT/Ru
VL = Vu

• Prop II: RE = Ru + (Ru – RD)(D/E)

RE = RA + (RA – RD)(D/E)

WACC = RA = (E/V)RE + (D/V)RD = Ru

RA = cost of business risk
(RA – RD)(D/E) = cost of financial leverage
17
 13-18
1-18
Case I - Example
Cost of assets (unlevered) = Ru = 16%,
Cost of debt = RD = 10%;
D/V= 45%
• What is the cost of equity for levered firm?

• What is the cost of assets/WACC for levered?

18
 13-19
1-19

Case II – With Corporate Tax &

No Bankruptcy Costs
• 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

19
 13-20
1-20

Case II - Example
Unlevered Firm Levered Firm

EBIT 5000 5000

Interest (6250 0 500

*8%)
Taxable 5000 4500
Income
Taxes (34%) 1700 1530
Net Income 3300 2970
OCF
20
 13-21
1-21

Interest Tax Shield

• Annual interest tax shield
– Tax rate times interest payment
– $6250 debt @ 8% = $500 in interest expense
– Annual tax shield = 0.34(500) = $170
• Present value of annual interest tax shield
– Assume perpetual debt for simplicity
– PV = 170 /0.08 = $2125
– PV = Annual tax Shield / cost of debt
= Corp tax rate * Interest payment/cost of debt
= Corp tax rate(Debt*cost of debt)/cost of debt
= DTC = 6250(0.34) = $2125
21
 13-22
1-22

Case 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(i tax shield)

– VU = EBIT(1-T) / RU
– VL = VU + DTC

22
 13-23
1-23

Example: Case II – Proposition I

• EBIT = 25 million; Tax rate = 35%; Debt =
$75 million; Cost of debt = 9%; Unlevered
cost of capital = 12% = Ru

23
 13-24
1-24

Case II – Proposition II
• The WACC decreases as debt increases because
of the government subsidies on interest payments
– RE = RU + (RU – RD)(D/E)(1-TC)
– WACC = RA = (E/V)RE + (D/V)(RD)(1-TC)
• Example
– EBIT=25m, Tc=35%, D=75m, Rd=9%, Ru=12%,
V=161.67m, E=86.67m

24
 13-25
1-25
Case III-With Corp Tax and
With Bankruptcy costs
• Financial distress
– Significant problems in meeting debt obligations
– Most firms that experience financial distress do not
ultimately file for bankruptcy

• Direct costs
– Costs directly related to bankruptcy ,eg: legal and
administrative costs
• Indirect bankruptcy costs
– Costs of avoiding a formal bankruptcy filing

25
 13-26
1-26
Case III-With Corp Tax and With
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 shield will be offset by the expected
bankruptcy cost-Trade-off Theory
• After this point, the value of the firm will start to
decrease and the WACC will start to increase as
more debt is added VL = VU + DTC –PV(BC)

26
 13-27
1-27

Figure 13.5

27
 13-28
1-28

Conclusions
• Case I – no taxes or bankruptcy costs
– No optimal capital structure
• Case II – corporate taxes but no BC
– Optimal capital structure is 100% debt
– Each additional dollar of debt increases the
cash flow of the firm
• Case III – corporate taxes and BC
– 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 costs
28
 13-29
1-29

Additional Managerial
Recommendations
• The tax benefit is 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 industry

29
 13-30
1-30

Tutorial

• Problem 4, 9, 11 and 14 from page 430

30