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
DE DE
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)
