Chapter 14

1. Chapter 14 Establishing a Target Capital Structure Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

2. Learning Objectives • Describe the effects of financial leverage on equity risks and return. • Use EBIT-EPS indifference analysis to evaluate financing alternatives. • Explain why capital structure doesn’t matter in a world without taxes, transactions costs, or other market imperfections. • Explain the existence of an optimal capital structure in terms of the trade-offs between the tax advantages of debt and the expected costs of financial distress. • Identify those elements of business risk which influence the probability of financial distress.

3. Learning Objectives (Cont.) • Discuss how the possibility of financial distress may affect management behavior. • Explain how agency costs can affect a firm’s financing strategy. • Explain how leveraged recapitalizations such as leveraged buyouts can mitigate the agency costs of equity. • Discuss how financing flexibility and the needs for financial reserves can influence the capital structure choice.

4. Financial Leverage and Financial Risk • Financial Leverage - The substitution of fixed cost financing for common stock. • Business Risk - The inherent variability of a firm’s operating earnings. • Financial Risk - The risk shareholders bear for the firm’s use of financial leverage.

5. Effects of Financial Leverage on ROE Where: rA = return on assets before financing costs i = after-tax cost of debt D = amount of debt in the capital structure E = amount of equity in the capital structure

6. Consequences of Leverage - An Example Hi-Tech Running Shoes needs $5 million in assets to support sales. Option A: Issue 500,000 shares @ $10/share Option B: Issue 250,000 shares @ $10/share; $2.5 million in debt @ 10% Expected EBIT = $1,000,000; EBIT (Low Estimate) = $200,000; EBIT (High Estimate) $2,000,000

7. Consequences of Leverage - An Example Effect of leverage on Hi-Tech’s Earnings Per Share States of the World Bad Mediocre Normal Good No Leverage 500,000 shares @ $ 10/share EBIT $200,000 $500,000 $1,000,000 $2,000,000 Less: Interest@ 10% 0 0 00 Equity Income $200,000 $500,000 $1,000,000 $2,000,000 Less: Tax @ 50% 100,000 250,000 500,0001,000,000 Equity income after tax $100,000 $250,000 500,000 $1,000,000 EPS $.20 $.50 $1.00 $2.00 ROE (%) 2 5 10 20

8. Consequences of Leverage - An Example Effect of leverage on Hi-Tech’s Earnings Per Share States of the World Bad Mediocre Normal Good 50 percent debt 250,000 shares @ $ 10/share; $2.5 million in debt @10% interest EBIT $200,000 $500,000 $1,000,000 $2,000,000 Less: Interest@ 10% 250,000 250,000250,000250,000 Equity Income ($50,000) $250,000 $750,000 $1,750,000 Less: Tax @ 50% ($25,000) 125,000 375,000875,000 Equity income after tax ($25,000) $125,000 $375,000 $875,000 EPS ($.10) $.50 $1.50 $3.50 ROE (%) -1 5 15 35

9. EBIT - EPS Indifference Point Where: EBIT* = EBIT-EPS indifference point IA,IB = interest expense under plan A and B PA,PB = preferred stock dividends under plan A and B tc = corporate tax rate NA,NB = number of shares outstanding under plan A and B

10. Hi-Tech’s EBIT - EPS Indifference Point

11. Effects of Financial Leverage on Risk and Return • When ROA exceeds the after-tax interest cost of debt, financial leverage increase both EPS and ROE. • Financial leverage increase the variability of EPS and ROE. • Financial leverage increases the expected level of EPS and ROE.

12. Traditional Approach to Capital Structure According to the traditional approach to capital structure, the prudent use of debt can lower the firm’s overall cost of capital and thereby increase its market value.

13. Traditional Approach to Capital Structure - A Graphical View ke = Cost of equity capital k0 = Weighted Average Cost of Capital Required return kd = Cost of debt capital L* Debt/Total Equity

14. Modigliani and Miller’s Proposition I In the absence of taxes, transaction costs and other market imperfections, the value of firm is independent of its capital structure.

15. Modigliani and Miller’s Proposition I - An Example Suppose two firms are identical in all respects except for capital structure. Firm U is unlevered, and Firm L has $1 million in 10 percent debt. Both firms have an expected EBIT of $500,000.

16. Modigliani and Miller’s Proposition I - An Example Suppose the two firms have the following valuations: Firm UFirm L EBIT $500,000 $500,000 Interest 0 100,000 Dividends $500,000 $400,000 Cost of Equity 0.15 0.16 Market Value of Equity $3,333,333 $2,500,000 Market Value of Debt 01,000,000 Market Value of Firm $3,333,333 $3,500,000

17. Modigliani and Miller’s Proposition I - An Example Suppose you owned 10 percent of L’s stock with a market value of $250,000. According to MM, you should 1. Sell off your shares in L for $250,000 2. Borrow an amount equal to 10 percent of L’s debt ($100,000) at an interest rate of 10 percent 3. Buy 10 percent of the shares of U for $333,333 With these transactions you would receive $350,000 in cash for the sale of your stock in L, plus your borrowing, whereas you would be spending only $333,000 to buy U’s stock. You would earn $16,667 from this transaction in uncommitted funds.

18. Modigliani and Miller’s Proposition I - An Example The effects of these financial transactions on your income will be Old income From New Income From Investment in LInvestment in U 10% Firm’s Equity Income $500,000 $500,000 Interest Expense on Borrowing 0 100,000 Net Income $500,000 $400,000 Investment income from the common stock is the same in both cases, but now you have $16,668 to spend as you please.

19. Modigliani and Miller’s Proposition II The cost of equity capital for a levered firm equals the overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt.

20. The MM’s Proposition II - A Graphical Representation (ke ) Required return (k0 ) (kd ) Debt / Equity

21. MM with Corporate Taxes Consider two firms are identical in all respects except for capital structure. Firm U is unlevered, and Firm L has $1 million in 10 percent debt. Both firms have an expected EBIT of $500,000 and marginal tax rates of 40 percent.

22. MM with Corporate Taxes Income Statement Firm UFirm L Earning Before Interest and Taxes $500,000 $500,000 Interest Paid to Bondholders 0 100,000 Pre-tax Profits $500,000 $400,000 Taxes @ 40% 200,000 160,000 Income to Stockholders $300,000 $240,000 Income to Stockholders and Bondholders $300,000 $340,000 Interest Tax Shield (Interestx0.40) 0 $40,000 Present Value of Tax Shield 0 400,000

23. MM with Corporate Taxes In a world where the only market imperfection is corporate taxes, the value of a levered firm (VL) equal the value of an unlevered firm (VU) plus the present value of the debt tax shields:

24. Financial Leverage and Financial Distress • Financial Distress - A situation where a firm has difficulty meeting its contractual obligations. • Bankruptcy - An extreme form of financial distress where a firm defaults on its obligations and is placed under the protection of the court until a place is devised to pay creditors.

25. Financial Leverage and Financial Distress - A Graphical View PV costs of financial distress PV of interest tax shield Value of firm with debt financing Market value of the firm Value of firm if all-equity financed L* = optimal debt ratio Debt Ratio

26. Probability of Financial Distress For any given level of debt, the higher the business risk, the greater will be the likelihood of financial distress. Determinants of business risk are: • The Firm’s Cost Structure • Demand Stability • Competition • Price Fluctuations • Firm Size and Diversification • Stage in the Industry Life Cycle

27. Costs of Financial Distress - Adverse Selection • Selection of High-Risk Projects • Foregoing Low-Risk Positive NPV Projects • Myopic Decision Making

28. Cost of Financial Distress - Industry Characteristics Industry-specific characteristics that argue for low debt ratios include the following: • Products that require repairs • Good/Services where quality is an important attribute, but where it is difficult to access in advance • Products for which there are switching costs • Products whose value to the customer depends on services and/or complementary products supplied by other firms

29. Cost of Financial Distress - Industry Characteristics Firm-specific characteristics that argue for low debt ratios include the following: • High growth opportunities • Substantial Organizational assets • Large excess tax deductions

30. Agency Costs and Capital Structure • Stockholder-Manager Conflicts • Excessive Perk Consumption • Shrinking Responsibility • Stockholder-Bondholder Conflicts • Shareholder incentive to take on high-risk projects • Shareholder incentive to pass up certain positive NPV projects

31. Agency Cost of Debt • Costs of monitoring to insure that they are not exploited by shareholders. • Control costs in the form of restrictive covenants.

32. Agency Costs of Equity • Management’s interest in the firm decreases as “outside” equity increases. • Incentives to expand the size of the firm • Reduce dividend payments • Invest in substandard projects

33. Reducing Agency Costs of Equity - Expanding Leverage One answer to the agency costs of equity is through a leveraged recapitalization that restricts management’s discretion over free cash flows by boosting debt and shrinking equity. Two ways of doing this are: • Leveraged Cash-Out • Leveraged Buyout

34. Strategic Factors Influencing Capital Structure • Financial Flexibility and Corporate Strategy • Value of Financial Reserves • Less valuable for well-established, publicly traded firms • Most valuable for privately held firms, small companies, or firms that the market has difficulty in valuing