Lecture 23. Tuesday Apr 27 th Financial Leverage
Balance Sheet Assets Land*! & Buildings*! Equipment*!! Machinery*!! Inventories*!!! Accounts Receivable*!!! Cash*!!! Liabilities Debt Secured* Unsecured Equity Ordinary Preference Tuesday Apr 27th Financial Leverage 2
Profit and Loss Revenues minus Variable Costs gives Contribution Contribution minus Overhead gives Earnings Before Interest & Taxes EBIT minus Interest gives Earnings Before Tax EBT minus Tax gives Earnings After Tax (EAT) Tuesday Apr 27th Financial Leverage 3
Summary for Gearing Discussion Balance Sheet Profit & Loss Assets Liabilities EBIT Secured Debt Less Interest Current Unsecured Debt EBT Total Debt LessTax Non-Current EAT Equity Less Dividends Total Assets Total Liabilities Retained Tuesday Apr 27th Financial Leverage 4
A Look at Dell Balance Sheet Profit & Loss Assets Liabilities EBIT 3754 Secured Debt - Less Interest -30 Current 10,633 Unsecured Debt 13,031 EBT 3724 Total Debt 13,031 LessTax -1079 Non-Current 8,678 EAT 2645 Equity 6,280 Less Dividends - Total Assets 19,311 Total Liabilities 19,311 Retained 2645 Tuesday Apr 27th Financial Leverage 5
Leverage Factor Is defined as the Ratio between the firm s assets and the firm s equity. Tuesday Apr 27th Financial Leverage 6
Leverage Factor Exchange $3Bn of Dell equity for Debt Tuesday Apr 27th Financial Leverage 7
Exchange Debt for Equity The Value of Dell remains the same! The Risk in Dell remains the same! Risk in Dell is redistributed between Creditors and Stockholders Tuesday Apr 27th Financial Leverage 8
Class Application #1 (Page 66) What Is The NPV Of A New Bond Issue? Is the amount received today from the bondholders 1. equal to, 2. less than, or 3. greater than the present value of the cash flows that must be paid to satisfy the bond s promises? Tuesday Apr 27th Financial Leverage 9
Perfect Markets - Assumptions Zero Tax Rates No Transaction Costs Full Information instantly available to all market participants No Regulations Tuesday Apr 27th Financial Leverage 10
Class Application #1 (Page 66) Under Perfect Markets Assumptions The Bond will be priced in the market taking all relevant information into account So the firm value will be unaffected by issuing Bonds in place of Equity Tuesday Apr 27th Financial Leverage 11
Results if Markets are Perfect How Company is financed (Debt/Equity) is not important so don t spend management energy on this subject. Tuesday Apr 27th Financial Leverage 12
Class Application #2 (Page 67) The Effect Of Financial Leverage On The Risk Of The Firm Consider Boring and Exciting, identical firms with $10,000 of assets. Boring equity only:- 1,000 shares. Exciting with $5,000 debt and $5,000 equity:- 500 shares. Note that the price per share of both firms is $10. Show how effects of leverage on the EPS of Exciting by assuming some levels of EBIT and a Coupon Rate of 10%. Tuesday Apr 27th Financial Leverage 13
Class Application #2 (Page 67) Assume 3 levels of EBIT:- 500, 1,000 and 1,500 Boring, Inc. (1,000 shares) Exciting, Inc. (500 shares) EBIT 500 1,000 1,500 500 1,000 1,500 Interest - - - (500) (500) (500) EAI EPS Tuesday Apr 27th Financial Leverage 14
Class Application #2 (Page 67) 2.0 Leverage Exciting Boring 1.5 1.0 EPS 0.5 0.0-0.5-1.0 0 500 1000 1500 EBIT Tuesday Apr 27th Financial Leverage 15
Results if Markets are Perfect Payment or Not of a Dividend is not an important decision. Shareholders who want cash can sell some shares if no dividend paid. Company can issue Bonds to replace capital lost when a dividend is paid. Tuesday Apr 27th Financial Leverage 16
Nothing is Certain but Death and Taxes Benjamin Franklin US Corporate Federal Tax Rate is 35%. States, on average, add 5%. See National Center for Policy Analysis document on News page Tuesday Apr 27th Financial Leverage 17
Class Application #3 (Page 67) Financial Leverage, Taxes, and Value Return to Boring and Exciting Get more realistic: add a federal tax rate of 34% to our analysis. Redo the income statement from before with the addition of taxes. Has the conclusion changed? Tuesday Apr 27th Financial Leverage 18
Class Application #3 (Page 67) Boring, Inc. (1,000 shares) Exciting, Inc. (500 shares) EBIT 500 1,000 1,500 500 1,000 1,500 Interest - - - (500) (500) (500) EBT 500 1,000 1,500-500 1,000 Taxes EAT 500 1,000 1,500-500 1,000 EPS 0.50 1.00 1.50-1.00 2.00 Tuesday Apr 27th Financial Leverage 19
Class Application #3 (Page 67) 2.0 Leverage Exciting Boring EPS after Taxes 1.5 1.0 0.5 0.0-0.5-1.0 0 500 1000 1500 EBIT Tuesday Apr 27th Financial Leverage 20
Less Tax is Paid By Exciting 0 Taxes Paid Exciting Boring -100-200 -300-400 -500-600 500 1,000 1,500 EBIT Tuesday Apr 27th Financial Leverage 21
Value of the Firm If less Tax is Paid by Exciting than by Boring, then The cashflow from the Project Exciting is greater than the Cashflow from the Project Boring, and NPV of Exciting > NPV of Boring Tuesday Apr 27th Financial Leverage 22
Miller and Modigliani (M&M) If debt is permanent V V T D L U C where : V V T D L U C = + ( * ) ( 12.1) is the value of a levered firm is the value of an unlevered firm is the corporate income tax rate, and is the value of permanent debt Tuesday Apr 27th Financial Leverage 23
The Total Risk of the Firm Is not changed by issuing bonds The Risk Measured by the firm s Beta is the weighted sum of the Stock s Beta and the Bond s Beta β = w * β + w * β F S S B B Tuesday Apr 27th Financial Leverage 24
When to stop borrowing? Company, Stock and Bond Betas CompanyBeta StockBeta BondBeta 2 1.6 Beta 1.2 0.8 0.4 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Percentage Debt Tuesday Apr 27th Financial Leverage 25
Agency Costs Issuing Bonds costs money Issuing Bonds costs management effort Bond Agreements can place restrictions on the actions of the Firm (see Lucent s 10K) Tuesday Apr 27th Financial Leverage 26
Other Conflicts Bondholders can put the firm into Bankruptcy Liquidation Chapter 7 of the Bankruptcy Act of 1978 or Chapter 11 Often involves renegotiation of employment contracts supply contracts Tuesday Apr 27th Financial Leverage 27
Prepare Your Answers to 1. Problem 7 on Page 359 of the Textbook And 2. Problem 6 on Page 386 of the Textbook.. For Thursday Tuesday Apr 27th Financial Leverage 28