Financial Leverage: the extent to which a company is committed to fixed charges related to interest payments. Measured by:

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Wk 11 FINS1613 Notes 13.1 Discuss the effect of Financial Leverage Financial Leverage: the extent to which a company is committed to fixed charges related to interest payments.

The debt to value ratio D/V: D/V= D/(D+E) From this example, we observe that: Debt financing makes the equity of the firm more risky.

1 Wk 11 FINS1613 Notes 13.1 Discuss the effect of Financial Leverage Financial Leverage: the extent to which a company is committed to fixed charges related to interest payments. Measured by: The debt to equity ratio D/E: market value of outstanding debt divided by the market value of equity. The debt to value ratio D/V: D/V= D/(D+E) From this example, we observe that: Debt financing makes the equity of the firm more risky. When Sales are high, financial leverage raises ROE and EPS When Sales are low, financial leverage lowers ROE and EPS That is, the sensitivity of ROE and EPS to changes in EBIT is increasing with financial leverage. Conclusion: Financial leverage enhances the risks equity holders are exposed to and amplifies the effect of changes in sales on ROE and EPS. Break-Even EBIT EPS on Break-Even EBIT

2 If we expect EBIT to be greater than the breakeven point, then leverage is beneficial to our shareholders. If we expect EBIT to be less than the break even point, then leverage is detrimental to our stockholders. With Debt has a Greater Slop and Greater Elasticity as EPS is more sensitive to changes in EBIT with debt financing If EBIT is variable overtime, financial leverage amplifies equity risk. Corporate Borrowing and Homemade Leverage Homemade Leverage: the use of personal borrowing/lending to change the overall amount of financial leverage to which an investor is exposed to through his equity holding. NUMBERS FROM THE PREVIOUS TABLE The investor invests in 100 shares then borrows his own funds (Debt Financing) to create leverage and invest in 200 shares Any stockholder who prefers financial leverage can create his/her own homemade leverage and replicate the payoffs of the firm with financial leverage. Because investors can engage in homemade leverage, investors should be indifferent to changes in a firm s capital structure. Capital Structure is irrelevant to shareholders. Capital Structure Theory Modigliani and Miller argued that the value of a firm is determined by the cash flows to the firm and the risk of the firm s assets. This implies the firm value will only change if: - There is a change in the risk of cash flows - There is a change in the value of the cash flows The total firm value is not affected by the ratio to debt to equity financing.

3 M&M Proposition 1: Consider two identical companies with the same operating cash flows every period, except firm L is levered and firm U is not levered (unlevered). The value of the firm is unaffected by changes in capital structure. Similarly, the WACC is unaffected by changes in capital structure. M&M Proposition 2: A firm s cost of equity capital is a positive linear function of its capital structure. A firm s cost of equity capital is increasing with financial leverage as represented by the positive linear function. R A = Return on Asset R A R D = Positive Compensation for Financial Risk D/E = Leverage Ratio Meant to be Β D

of bankruptcy. We consider tax implications first. Interest charges from borrowing are tax deductible.

4 Proposition 1 & 2 Example without Taxes: If the firm raises a capital of $1 the firm has to raise a compensation of 13% on the investment 13.2 Analyse the impact of taxes and bankruptcy on capital structure choice In the real world, firms must contend with taxes and the risk of bankruptcy. We consider tax implications first. Interest charges from borrowing are tax deductible. So debt increases the amount of cash flows available to the firm s investors. Increasing debt should increase firm value. Interest tax shield: The tax savings from borrowing.

M&M Proposition 1 with Corporate Taxes- SUPER IMPORTANT For every dollar of debt increased the firm value increases by 30c M&M Proposition 2 with Corporate Taxes: The firm value is increasing in

5 M&M Proposition 1 with Corporate Taxes- SUPER IMPORTANT For every dollar of debt increased the firm value increases by 30c M&M Proposition 2 with Corporate Taxes: The firm value is increasing in financial leverage due to greater tax shields. This means that the WACC decreases with financial leverage. That is RA changes with financial leverage. Define RU the unleveraged cost of capital (WACC when D/E = 0)

13.3 Identify the essentials if the bankruptcy process Direct bankruptcy costs: The costs that are directly associated with bankruptcy, such as legal and administrative expenses Indirect bankruptcy

Examples: Disruptions in operation Loss of employees Damage to firm s reputation Foregone investment opportunities.

6 13.3 Identify the essentials if the bankruptcy process Direct bankruptcy costs: The costs that are directly associated with bankruptcy, such as legal and administrative expenses Indirect bankruptcy costs: The difficulties of running a business that is experiencing financial distress. Examples: Disruptions in operation Loss of employees Damage to firm s reputation Foregone investment opportunities. M&M Propositions with Taxes and Bankruptcy: Tax saving increases with financial leverage But the cost of financial distress increases with financial leverage There is a trade off between tax savings and increased cost of financial distress. The optimal capital structure is the D/E level at which the incremental increase in the PV of the tax shield from borrowing an additional dollar is exactly offset by the incremental increase in the PV of financial distress costs. It s also where the firm value is maximized. M&M Propositions with Bankruptcy: Remember R D x D = Interest Cost

Optimal Capital Structure

Capital Structure Optimal Capital Structure What is capital structure? How should a firm choose a debt-toequity ratio? The goal: Which is done by: Which is done by: Financial Leverage Scenario A B C Market