Leverage and Capital Structure

and the balance sheet Leverage and Capital Structure Week 8 2 3 Capital budgeting Capital restructuring Effect of leverage on EPS and CFFA per share Changing the amount of leverage a firm has without changing the firm s assets Increase leverage by issuing new debt and repurchasing outstanding shares Decrease leverage by issuing new shares and paying off outstanding debt Goal: Choose the capital structure that will maximize firm value Firm value V = PV of free cash flows V = CFFA 1 /(1+r WACC ) + CFFA 2 /(1+r WACC ) 2 + Maximizing firm value = minimizing WACC Increasing debt lets firm reduce the number of shares, but also increases interest expenses In a really good year, we pay the fixed cost and we have more ler over per share In a really bad year, we ssll have to pay our fixed costs and we have less ler over per share Leverage amplifies the variason in EPS and CFFA per share 4 5 Example: Unlevered?irm (E = $6,000) Example: Levered?irm (D = $3,000, E = $3,000) (in $1,000) Bust Base Boom (in $1,000) Bust Base Boom EBIT -1,000 500 1,000 Interest (10%) 0 0 0 Taxable Income -1,000 500 1,000 Taxes (34%) +340-170 -340 Net Income -660 330 660 EPS (in $) -$6.60 $3.30 $6.60 CFFA -560 430 760 CFFA per share (in $) -$5.60 $4.30 $7.60 EBIT -1,000 500 1,000 Interest (10%) -300-300 -300 Taxable Income -1,300 200 700 Taxes (34%) +442-68 -238 Net Income -858 132 462 EPS (in $) -$17.16 $2.64 $9.24 CFFA -458 532 862 CFFA per share (in $) -$9.16 $10.64 $17.24 6 DepreciaSon = 100 MV of equity = $6,000; # of shares outstanding = 100,000 7 DepreciaSon = 100 MV of equity = $3,000; # of shares outstanding = 50,000 1-1

CFFA per share in unlevered and levered?irm $15.00 $20.00 $10.00 $15.00 $5.00 $10.00 $0.00 Bust Base Boom ($5.00) EPS unlevered EPS levered ($10.00) ($15.00) ($20.00) CF unlevered CF levered $0.00 Bust Base ($5.00) ($10.00) 9 Break- even EBIT 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 Example: Break- even EBIT Example (no taxes) Financial Leverage: EBIT and EPS No debt 30.0 E = $6 million 100,000 shares 25.0 Debt D = $3 million at 10% E = $3 million 50,000 shares EPSno debt = EPS debt EBIT/100,000 = (EBIT- 300,000)/50,000 EBIT = 600,000 EPS = $6.00 No debt With debt 20.0 EBIT where EPS is the same under both the current and proposed capital structures 15.0 10.0 5.0 Break-even point: EBIT = $600,000; EPS = $3.00 0.0 500,000 10 1,500,000 Case I (no taxes) M&M ProposiSon I Case I Cash flows of the firm do not change by changes in the capital structure Therefore, value of the firm is not affected No corporate or personal taxes No bankruptcy costs Corporate taxes, but no personal taxes No bankruptcy costs Case III Corporate taxes, but no personal taxes Bankruptcy costs Case II 1,000,000 EBIT ($) 11 Modigliani and Miller s theory of capital structure 14 Boom ($15.00) 8 $5.00 EPS ($) EPS in unlevered and levered?irm M&M ProposiSon II WACC of the firm is not affected by capital structure Firm s cost of equity capital is a posisve linear funcson of its debt/equity raso 15 1-2

Case I (no taxes) Proposition II Case I (no taxes) - Example WACC = R A = E/V R E + D/V R D (without taxes) ó R E = [R A R D D/V] * (E+D)/E ó R E = R A + (R A R D ) D/E R A = required return on assets (= WACC) Cost of the firm s business risk, i.e., the risk of the firm s assets Constant in D/E (financial leverage) (R A R D ) D/E Cost of the firm s financial risk, i.e., the addisonal return required by stockholders to compensate for the risk of leverage Increases in D/E (financial leverage) Unlevered firm R A = WACC = 16% R E = R A = 16% Levered firm R D = 10% D/V = 60% R E =.16 + (.16 -.10) (60/40) = 25% R A = WACC =.4 * 25% +.6 * 10% = 16% 16 17 Case I: D/E ratio and WACC Case II: Corporate taxes, no bankruptcy Interest is tax deducsble When a firm adds debt, it reduces taxes, all else equal ReducSon in taxes increases the free cash flow of the firm Annual interest tax shield Tax rate * interest payment 21 22 Example Example continued (in $1,000) Unlevered Firm Levered Firm (debt of $3,000) EBIT 1,000 1,000 Interest (10%) 0-300 Taxable Income 1,000 700 Taxes (34%) -340-238 Net Income 660 462 CFFA 760 862 Annual interest tax shield Interest = DR D = 3,000 * 10% = 300 Interest tax shield = DR D T C = 300 (.34) = 102 PV of annual interest tax shield Assume perpetual debt for simplicity PV = DR D T C / R D = DT C = 3,000(.34) = 1,020 PV = 102 / 10% = 1,020 Difference = 102 23 DepreciaSon = 100 24 1-3

Case II Proposition I Case II: Total debt and?irm value 25 Value of the firm increases by the PV of the annual interest tax shield Value of a levered firm V L = value of an unlevered firm V U + PV of interest tax shield Value of equity E = Value of the firm V L value of debt D Assuming perpetual cash flows V U = EBIT(1- T C ) / R U R U is cost of capital for unlevered firm Always constant = R A, unlevered = R E, unlevered V L = V U + DT C E L = V L - D 26 27 Example: Case II Proposition I EBIT = 1 million, constant Tax rate T C = 34% Unlevered cost of capital R U = 11% N U = 0.2 (shares outstanding) Levered firm Debt D = 3 Cost of debt R D = 10% Value of the firm V U = 1 (1-.34) /.11 = 6 V L = 6 + 3 (.34) = 7.02 Value of equity E U = 6 E L = 7.02 3 = 4.02 Stock P U = 6/0.2 = $30.00 P L = 7.02 /0.2 = $35.10 P L = E L /(200,000-3 million/p L ) = $35.10 N L = 0.2 3/35.1 = 0.11 V U = EBIT(1- T C ) / R U V L = V U + DT C E U = V U E L = V L D P U = V U /N U P L = V L /N U P L = E L /N L N L = N U D/P L In million, except per share figures 28 Case II Proposition II: WACC and capital structure WACC = R A = E/V R E + D/V R D (1- T C ) Required return on the firm s overall assets R E =R f +β E (R M - R f ) (CAPM, to get current R E ) WACC (R A ) decreases as D/E increases due to government subsidy on interest payments, as shown by V L = V U + DT C (ProposiSon I) For an unlevered firm (D=0): R A = R U = R E = k (from CAPM) For a levered firm without taxes: R D < R A = R U = constant (for any D/E) < R E For a levered firm with taxes: R D < R A < R U < R E R E increases as D/E increases In a world without taxes (T C =0) R E = [R A D/V R D (1- T C )] V/E WACC solved for R E = R A +[R A R D (1- T C )] D/E R A is constant, R E is linear in D/E In a world with taxes V U + t c D = D + E Market value balance sheet (solve for V U ) V U R U + t c DR D = DR D + ER E Sources of cash=uses of cash (solve for R E ) R E = R U + (R U R D ) (1- T C ) D/E R E is linear in D/E Case II: D/E ratio and WACC Example: Case II Proposition II Unlevered firm E = $6 million R A = R U = R E = 11% Levered firm D = E = $3 million R D = 10% R E = R U + (R U R D )(D/E)(1- T C ) =.11 + (.11-.10)(3/3)(1-.34) = 11.66% R A = (3/6) 11.66% + (3/6) 10% (1-.34) = 9.13% 29 30 1-4

Suppose that the firm changes its capital structure so that the debt- to- equity raso becomes 2 Cost of equity RE =.11 + (.11 -.10) (2) (1-.34) = 12.32% increased WACC RA =.333(.1232) +.667(.10)(1-.34) = 8.5% decreased 31 Costs of?inancial distress Example: Case II Proposition II 32 Expected bankruptcy costs = probability of bankruptcy * costs of bankruptcy As the D/E raso increases, probability of bankruptcy increases expected bankruptcy costs increase At some point, addisonal value of interest tax shield is offset by expected bankruptcy cost Value of firm starts to decrease and WACC starts to increase as more debt is added 33 Case III: Total debt and?irm value Case III: With bankruptcy costs 34 Case I: No taxes or bankruptcy costs is irrelevant Case II: Corporate taxes, no bankruptcy costs OpSmal capital structure is 100% debt Case III: Corporate taxes, bankruptcy costs Opt. capital structure: part debt, part equity Occurs where the benefit from an addisonal dollar of debt is just offset by the increase in expected bankruptcy costs Optimal capital structure and WACC Conclusions 35 Direct bankruptcy costs Legal and administrasve costs Can cause addisonal losses to bondholders DisincenSve to debt financing Indirect bankruptcy costs Costs of avoiding a bankruptcy Larger than direct costs, but more difficult to measure and essmate 36 1-5

Factors affecting the optimal capital structure Optimal capital structure and?irm value 37 38 Volatility of cash?lows affects optimal capital structure should be weighted towards equity Less of a cash obligason for debt payments Greater flexibility for cash flow fluctuaSons Allows for long- term invessng without worrying about short term liabilises 39 Business terminated with a loss to creditors Legal bankruptcy 41 Pre- packaged filings Cram- downs Technical insolvency Firm is unable to meet debt obligasons AccounSng insolvency Book value of equity is negasve Bankruptcy process The right to file bankruptcy has strategic value Special cases PeSSon federal court for bankruptcy 40 Bankruptcy Immediate stay on creditors Ability to terminate labor agreements Ability to lay off large numbers of workers Ability to reduce wages Cost of capital, 2010 Yearbook (Morningstar, 2010) Business failure Strong and certain cash flows should be weighted towards debt Cash flow to make debt payments Tax benefit from the interest payments Ownership is not diluted by issuing addisonal shares Debt has a fixed Sme horizon Fewer tangible assets More volasle cash flows Forms of?inancial distress Variable or uncertain cash flows Tax benefit maters only if the firm has a large tax liability The greater the risk of financial distress, the less debt is opsmal Liquida7on (Chap. 7) Reorganiza7on (Chap. 11) PeSSon filed in federal court Trustee elected by creditors to take over firm s assets Trustee atempts to sell assets Proceeds distributed according to APR PeSSon filed by firm or creditors Firm runs operason as debtor- in- possession Firm submits reorg- anizason plan, incl. how to repay creditors If accepted, firm operates under plan for a fixed Sme 42 1-6

Absolute priority rule (APR) 1. AdministraSve expenses associated with the bankruptcy 2. Other expenses arising arer the filing of an involuntary bankruptcy pesson 3. Wages, salaries and commissions 4. ContribuSons to employee benefit plans 5. Consumer claims 6. Tax claims 7. Payment to unsecured creditors (banks, bond holders) 8. Payment to preferred stockholders 9. Payment to common stockholders 43 1-7