13.0,Leverage and Capital Structure,Chapter 13,13.1,Key Concepts and Skills,Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process,13.2,Chapter Outline,The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital Corporate Taxes and Capital Structure Bankruptcy Costs Optimal Capital Structure Observed Capital Structures A Quick Look at the Bankruptcy Process,13.3,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 firms assets Increase leverage by issuing debt and repurchasing outstanding shares Decrease leverage by issuing new shares and retiring outstanding debt,13.4,Choosing a Capital Structure,What 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 firm value or minimizing WACC,13.5,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 Leverage amplifies the variation in both EPS and ROE,13.6,Example: Financial Leverage, EPS and ROE,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?,13.7,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,13.8,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,13.9,Example: Break-Even EBIT,13.10,Example: Homemade Leverage and ROE,Current Capital Structure Investor borrows $2000 and uses $2000 of their own to buy 200 shares of stock Payoffs: Recession: 200(1.25) - .1(2000) = $50 Expected: 200(2.50) - .1(2000) = $300 Expansion: 200(3.75) - .1(2000) = $550 Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structure,Proposed Capital Structure Investor buys $1000 worth of stock (50 shares) and $1000 worth of Trans Am bonds paying 10%. Payoffs: Recession: 50(.50) + .1(1000) = $125 Expected: 50(3.00) + .1(1000) = $250 Expansion: 50(5.50) + .1(1000) = $375 Mirrors the payoffs from purchasing 100 shares under the current capital structure,13.11,Capital Structure Theory,Modigliani and Miller 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,13.12,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,13.13,Case 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 Proposition II The WACC of the firm is NOT affected by capital structure,13.14,Case 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 by stockholders to compensate for the risk of leverage,13.15,Case 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) = .2091 = 20.91% Suppose instead that the cost of equity is 25%, what is the debt-to-equity ratio? .25 = .16 + (.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%,13.16,Figure 13.3,13.17,The 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 the firms assets Proposition