Financial Leverage and

Capital Structure Policy

Learning Unit Five
Chapter 16
Financial Structure and Capital Structure

 A firm’s choice of how much debt it should have relative to

equity is known as a capital structure decision
 A firm’s capital structure is a reflection of its borrowing policy
 debt is really a double-edged sword
 Striking the right balance of debt and equity is what the capital
structure
 Capital restructurings: firm substitutes one capital structure for
another while leaving the firm’s assets unchanged.
Stockholder Interests

There are two important questions:

1.Why should the stockholders care about maximizing firm value?
Perhaps they should be interested in strategies that maximize shareholder value.

2.What is the ratio of debt-to-equity that maximizes the shareholder’s value?

As it turns out, changes in capital structure only benefit the stockholders if the value of
the firm increases.
Optimal Capital Structure

 Firm’s target capital structure

 Maximizing the value of the whole firm
 Value of the firm is maximized when the WACC is minimized
Finance Leverage and EPS
MM Proposition I: The Pie Model
 Franco Modigliani and Merton Miller =MM
 The value of a firm is defined to be the sum of the value of the firm’s debt and the
firm’s equity.
V = Debt + Equity
 If the goal of the firm’s management is to make the firm as valuable as possible,
then the firm should pick the debt-equity ratio that makes the pie as big as possible
 Value of the firm
Assumptions of the M&M Model
 Homogeneous Expectations
 Homogeneous Business Risk Classes
 Perpetual Cash Flows
 Perfect Capital Markets:
 Perfect competition
 Firms and investors can borrow/lend at the same rate
 Equal access to all relevant information
 No transaction costs
 No taxes
M&M (Debt Policy Doesn’t Matter)

 When there are no taxes and capital markets function well, it makes no
difference whether the firm borrows or individual shareholders borrow.

 Therefore, the market value of a company does not depend on its capital
structure.
MM Proposition I (No Taxes)

 We can create a levered or unlevered position by adjusting

the trading in our own account.
 This homemade leverage suggests that capital structure is
irrelevant in determining the value of the firm:
 Value of the levered firm is the same as the value of the
unlevered firm
VL = VU
 Because FCF and values of firms L and U are equal, their
WACCs are equal.
 Therefore, capital structure is irrelevant.
 MM Proposition II: The Cost of Equity and
Financial leverage
 Required return to Equity holders rises with leverage
 Expected return is positively related to leverage

D E
RWACC   RD   RE
DE DE
 Proposition II
 Leverage increases the risk and return to stockholders
RE = RWACC + (D / E) (RWACC - RD)
 Cost of equity depends on
 Required rate of return on assets (WACC)
 Firm’s cost of debt (Rd)
 Firm’s debt equity ration (D/E)
MM II
MM Propositions I and II with Corporate Taxes

 Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered
firms.

 Therefore, more CF goes to investors (debt +equity) and less to taxes when leverage is
used.

 In other words, the debt “shields” some of the firm’s CF from taxes.
MM I with tax
MM II with tax
Total Cash Flow to Investors

 All-equity firm / Unlevered firm Levered firm

S G S G

B
 The levered firm pays less in taxes than does the all-equity firm.
 Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of
the unlevered firm.
 This is how cutting the pie differently can make the pie “larger.” -the government takes a
smaller slice of the pie!
 Costs of Financial Distress
 Bankruptcy risk versus bankruptcy cost
 Debt has benefits but also increases obligation

 Obligation are not met: results into financial distress

 Ultimate distress is bankruptcy: Ownership of the firms’ assets is legally transferred from
the stockholders to the bondholders
 The possibility of bankruptcy has a negative effect on the value of the firm.

 Leverage increases the likelihood of bankruptcy

 However, it is not the risk of bankruptcy itself that lowers value.

 Rather, it is the costs associated with bankruptcy.

 It is the stockholders who bear these costs.
Direct Costs

 Legal and administrative costs

 Court, experts, administrative
 Enron and WorldCom was 1$Billion and $600 million, Lehman
Brothers $ 2B
 Kingfisher Airlines, Satyam Computers, ITI, Maria Chemicals
are some of the examples of bankruptcy cases in India
 It is estimated that direct costs are around 3 percent of total
market value of the firm.
Indirect Costs

 Impaired ability to conduct business (e.g., lost sales)

 75% of American would not purchase an automobile from a
bankrupt company because they might not honor the warranty
 Volkswagen case
 Case of Chrysler (Insolvency)
 Bank run in Nepal
 Atlantis Casino case
Optimum Capital Structure

 Static theory of capital structure .

 firms borrow up to the point where the tax benefit from an extra dollar in debt is exactly equal to
the cost that comes from the increased probability of financial distress
Trade-off Theory
 MM theory ignores bankruptcy (financial distress) costs, which increase as more
leverage is used.
 At low leverage levels, tax benefits outweigh bankruptcy costs.
 At high levels, bankruptcy costs outweigh tax benefits.
 An optimal capital structure exists that balances these costs and benefits
 Excessively levered firms may pass up some valuable investment projects.
 To minimize the expected costs of future underinvestment, firms with valuable
growth opportunities must have relatively low target debt ratios.
Pecking Order Theory of Capital Structure

 selling securities to raise cash can be expensive

 Profitable firm might never need external financing
 If undervalued stock – use debt finance
 If overvalued stock – use equity finance but price will go down (signaling effect)
 Pecking order:
 First internal financing
 Issue debt if necessary
 Equity will be sold as a last resort
IMPLICATIONS OF THE PECKING
ORDER
 No target capital structure
 Profitable firms use less debt
 Companies will want financial slack
Problem

 1 to 7
 8 and 9
 10 to 15 (HW)