Unit 11

ASSESSING LONG-TERM
DEBT, EQUITY, AND CAPITAL
STRUCTURE

- CHAPTER 16
Cornett, Adair & Nofsinger (2017).
“Finance: Applications and Theory”, 4th
Edition. McGraw Hill Education.
16-1
Introduction
• Capital structure
• The mixture of debt and equity that are used to
finance the firm’s operations
• Funding decision factors
• Debt interest payments are tax deductible
• Risks posed by increased debt e.g. too much
debt may cause the firm to bankrupt

16-2
Capital Structure & Shareholders’ Wealth
• The primary goal of financial management:
• Maximize stockholders’ wealth

• Maximizing shareholders’ wealth =

• Maximizing firm value
• Minimizing WACC

• Objective: Choose the optimal capital

structure that will minimize WACC and
maximize firm value i.e. stockholders’ wealth

16-3
Active vs. Passive Capital Structure Changes
Active management
• Selling one type of capital to fund the retirement of other
kinds of capital e.g. issue equities to repay callable
bonds before maturity in order to reduce the percentage
of using debt capital
Passive management
• Gradually adjust financing mix (debt or equity) over time

• Waiting for additional capital requirement

• Funding new projects disproportionately with the type of
capital you want to increase

16-4
Active vs. Passive
• Choice depends on three factors
• The need for changes to the firm’s capital
structure
• How quickly the firm is growing
• The flotation costs under the active
management approach

16-5
The Effect of Financial Leverage
• Use of debt in capital structure is referred to
as “financial leverage”
• Financial leverage amplifies the variation in
both EPS and ROE (two important indicators
of firm value) i.e. Debt magnifies potential risk
and return
• However, inappropriate use of financial
leverage may cause financial distress to a firm
• Financial distress is the condition in which a
firm is near bankruptcy Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-6
Trans Am Corporation Example

Table 13.1
Current Proposed
Assets $8,000,000 $8,000,000
Debt $0  $4,000,000
Equity $8,000,000 $4,000,000
Debt/Equity Ratio 0.0
  1.0
Share Price $20 $20
Shares Outstanding 400,000
  200,000
Interest rate 10% 10%

Adapted from Ross, Westerfield, Jordan, Wong and Wong

(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-7
 Trans Am Corporation
With and Without Debt
Table 13.2
Current Capital Structure: No  Debt
Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 0  0 0
Net Income $500,000 $1,000,000 $1,500,000
ROE 6.25% 12.50% 18.75%
     
EPS $1.25 $2.50 $3.75

Proposed Capital Structure: Debt

  = $4 million
Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000
Interest 400,000  400,000 400,000
Net Income $100,000 $600,000 $1,100,000
ROE 2.50% 15.00% 27.50%
     
EPS $0.50 $3.00 $5.50

Adapted from Ross, Westerfield, Jordan, Wong and Wong

(2015) “Essentials of Corporate Finance: Asia Global Edition”
Financial Leverage Effect
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 (i.e. the risk) in both ROE

and EPS increases when financial leverage
is increased
Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-9
Break-Even EBIT
• The level of EBIT at which EPS will be equal for
two different capital structures
• Solving for EPS equation so that investor
indifference between two capital structures
• Express EPS as function of EBIT for each capital
structure
• Set them equal to each other
• Solve for the break-even EBIT

• e.g. EPSall-equity
  = EPS50%-debt
  (Earnings = Net Profits after interest and tax)

=> EBIT(1-Tc) / sharesall-equity

  = (EBIT-interest)(1-Tc) / shares50%-debt
 
Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-10
Example: Break-Even EBIT when EPSs are equal for both
Capital Structures

EPSall-equity = EPS50%-debt
EBIT EBIT - $400,000
=
400,000 200,000
é 400,000 ù
EBIT = ê ú(EBIT -$400,000)
ë 200,000 û
EBIT = 2 ´ EBIT - $800,000
EBIT = $800,000
$800,000
EPS = = $2.00
400,000
Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-11
Break-Even EBIT for Trans Am Corp

• If we expect EBIT to be greater than the break-even point, then

financial leverage is beneficial to our stockholders
• If we expect EBIT to be less than the break-even point, then
financial leverage is detrimental to our stockholders
16-12
”
Adapted from Ross, Westerfield, Jordan, Wong and Wong (2015) “Essentials of Corporate Finance: Asia Global Edition
Trans Am Corp Conclusions
1. The effect of financial leverage depends on the
size of EBIT
• When EBIT is higher than the break-even level, financial
leverage is beneficial to the firm

2. Shareholders are exposed to more risk with

more financial leverage
• ROE and EPS are more volatile and sensitive to changes in
EBIT

3. Under the “Expected” scenario, financial

leverage increases ROE and EPS, but the
“Recession” scenario decreases ROE and
EPS performance Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-13
Capital Structure Theory:
Modigliani and Miller Theory
The Modigliani and Miller (M&M) Theory is a tool for
examining the effects of various variables on the
choice of optimal capital structure for firms
• It has two propositions
• M&M Proposition I – Firm Value or it called “The Pie
Model”
• M&M Proposition II – WACC

16-14
Capital Structure Theory:
Modigliani and Miller Theory

• Case I (M&M 1958 model) – Assumptions

• No corporate or personal taxes
• No bankruptcy costs
• Case II (M&M 1961 model) – Assumptions
• Corporate taxes, but no personal taxes
• No bankruptcy costs
• Case III (Static Theory) – Assumptions
• Corporate taxes, but no personal taxes
• Bankruptcy costs Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-15
Modigliani and Miller’s Perfect World (Case I)

• It states that in an efficient market without

taxes and bankruptcy costs, the value of a
firm does not depend upon the firm’s
capital structure
• Assumptions:
• No taxes
• No cost or chance of bankruptcy
• Perfectly efficient markets
• Symmetric information sets for all participants
16-16
M&M Theory’s Case I Propositions
• Proposition I
• The value of a levered firm is equal to the value
of unlevered firm (all-equity financed)
• The value of the firm is NOT affected by
changes in the capital structure
• The cash flows of the firm do not change;
therefore, firm value doesn’t change

16-17
M&M Theory’s Case I Propositions

• Proposition II
• The cost of equity increases with the use of
debt in a capital structure
• However, the WACC of the firm is NOT affected
by capital structure because debt is less
expensive than equity Financial Risk
Business Risk

   

16-18
Cost of Equity (iE or RE) = Required Return on Business Risk (iE,0 or
RU, all equity) + Financial Risk (iD or RD, financial leverage)

RE = RU + (D/E) x (RU – RD)

Business Risk Financial Risk

(Market Risk / Systematic Risk)

• Proposition II: the cost of equity of the stock

depends on:
• Required return of unlevered firm assets, RU (i.e.
business risk only)
• Level of financial leverage, D/E, (i.e. financial risk)
Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-19
M&M Propositions I & II (Case I)

The change in the capital structure weights (E/V and D/V) is exactly offset by
the change in the cost of equity (RE), so the WACC stays the same.
Adapted from Ross, Westerfield, Jordan, Wong and Wong (2015) “Essentials of Corporate Finance: Asia Global Edition”
16-20
M&M with Corporate Taxes (Case II)
• Proposition I
• Assumes debt is perpetual and interest is tax-
deductible
• The reduction in taxes increases the cash flows
of the firm
• Thus, tax savings or tax shield increases the
value of the firm
Tax Savings

16-21
M&M Proposition I with Corporate Taxes (Case II)
Tax Savings

Adapted from Ross, Westerfield, Jordan, Wong and Wong

(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-22
M&M with Corporate Taxes (Case II)
• Proposition II
• Assume interest on debt is tax-deductible, the
cost of debt after tax further decreases the cost
of capital of the firm
After Tax

OR, RE = RU + D/E x (RU – RD) x (1 – TC)

Proposition IIa (with corporate taxes): After Tax

WACC = E/(E+D) x RE + D/(E+D) x RD x (1 –  TC)

16-23
Case II – Graph of Proposition II

After Tax

16-24
”
Adapted from Ross, Westerfield, Jordan, Wong and Wong (2015) “Essentials of Corporate Finance: Asia Global Edition
M&M Theory Summary

Adapted from Ross, Westerfield, Jordan, Wong and Wong (2015) “Essentials of Corporate Finance: Asia Global 16-25
”
Edition
Case III – Static Theory with Corporate
Taxes and Bankruptcy Costs
•  D/E ratio → probability of bankruptcy
•  probability → expected bankruptcy costs
• At some point, the additional value of tax savings or
shield will be offset by the expected bankruptcy costs
• Bondholders will bear some of the firm risk
• Thus, bondholders will demand higher compensation
in return for risk of financial distress
• At this point, the value of the firm will start to decrease
and the WACC will start to increase as more debt is
added
Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-26
Costs of Financial Distress
• May face tighter credit requirements and
higher interest rates
• Declining investment partnership
opportunities with other firms
• Loss of consumers and suppliers
confidence
• Potential loss of best employees

16-27
Case III - Optimal Capital Structure
Tax Savings

VL = VU + DTC –
Bankruptcy Costs

Adapted from Ross, Westerfield, Jordan, Wong and Wong

(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-28
 The Three Cases of Capital Structure

Proposition I
- Firm Value

Proposition II
- WACC

16-29
Adapted from Ross, Westerfield, Jordan, Wong and Wong (2015) “Essentials of Corporate Finance: Asia Global Edition”
 Conclusions
• Case I – no taxes or bankruptcy costs
• No optimal capital structure
• Case II – corporate taxes but no bankruptcy costs
• Optimal capital structure = 100% debt
• Each additional dollar of debt increases the cash flows
of the firm
• Case III – corporate taxes and bankruptcy costs
• Optimal capital structure is partly debt and partly equity
• Occurs where the benefit from an additional dollar of
debt is just offset by the increase in expected
bankruptcy costs Adapted from Ross, Westerfield, Jordan, Wong and Wong
(2015) “Essentials of Corporate Finance: Asia Global Edition”
16-30
Capital Structure Theory vs. Reality
Managerial recommendation:
• Factors to be considered for optimal capital
structure of a firm:
• Effect of Financial Leverage - firms with stable, predictable
income streams (above breakeven EBIT) should use more
debt capital
• Tax Savings - firms that subject to high tax rates should use
more debt capital
• Bankruptcy Costs - the greater the risk of financial distress,
the lesser the use of debt capital to finance the firm’s
business operations
16-31
Observed Capital Structures in Market

• Economic sectors with highest D/E ratios,

i.e. firms with high debt level or high
financial leverage, tend to have high and
stable income streams
• Economic sectors with lowest D/E ratios,
i.e. firms with low debt level or low financial
leverage, tend to have low and variable
(unstable) income streams

16-32
References
Cornett, Adair & Nofsinger (2017). “Finance:
Applications and Theory”. 4th Edition.
McGraw Hill Education.

Ross, Westerfield, Jordan, Wong and Wong

(2015) “Essentials of Corporate Finance:
Asia Global Edition”. 1st Edition. McGraw
Hill Education.

16-33
End of Lecture 12

16-34