Chapter 21 - Capital Structure Decisions

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth W. Sean Cleary Chapter 21 Capital Structure Decisions
Prepared by Ken Hartviksen
CHAPTER 21 Capital Structure Decisions
Lecture Agenda
Learning Objectives Important Terms Financial Leverage Determining Capital Structure M&M Irrelevance Theorem Impact of Taxes Financial Distress, Bankruptcy and Agency Costs Other Factors affecting Capital Structure Capital Structure in Practice Summary and Conclusions
Concept Review Questions Appendix 1 Thunder Bay Industries Indifference Analysis
CHAPTER 21 Capital Structure Decisions 21 - 3
Learning Objectives
1. 2. 3. 4. 5. 6. 7. How business risk and financial risk affect a firms ROE and EPS How indifference analysis may be used to compare financing alternatives based on expected EBIT levels Modigliani and Millers irrelevance, argument, as well as the key assumptions upon which it is based How the introduction of corporate taxes affects M&Ms irrelevance argument How financial distress and bankruptcy costs lead to the static trade-off theory of capital structure How information asymmetry problems and agency problems may lead firms to follow a pecking order approach to financing How other factors such as firm size, profitability and growth, asset tangibility, and market conditions can affect a firms capital structure.
21 - 4
Important Chapter Terms

Agency costs Bankruptcy Business risk Cash flow-to-debt ratio Corporate debt tax shield Direct costs of bankruptcy EPS indifference point Financial break-even points Financial distress Financial leverage Financial leverage risk premium
Financial risk Fixed burden coverage ratio Homemade leverage Indifference point Indirect costs of bankruptcy Invested capital M&M equity cost equation Modigliani and Miller Pecking order Profit planning charts Return on equity (ROE) Return on invested capital Risk value of money Static tradeoff
21 - 5
Introduction to Leverage
Financial Leverage
The Focus of this Chapter

You know:
It is the responsibility of the financial manager to maximize shareholder wealth. The after-tax cost of debt is significantly lower than the cost of equity primarily because of the tax-deductibility of interest expensetherefore, using debt has a cost advantage over equity. The lower the cost of capital, the greater the value of the firm. This chapter addresses the question: Does the relative mix of financing used by a firm affect its value? If so, how and why and are what are the other impacts that capital structure can have on the firm?
In this Chapter You Will Learn

1. The optimal (target) capital structure is the one that maximizes the value of the firm and minimizes the cost of capital. 2. How lenders seek to protect themselves from excessive use of corporate leverage through the use of protective covenants. 3. The tax advantage to debt is offset at higher levels of financial leverage by costs associated with financial distress and bankruptcy. 4. Firms depart from the target capital structure in practice because of financing preferences and capital market conditions.
Leverage: What is It?

Capital Structure Decisions
Leverage
The increased volatility in operating income over time, created by the use of fixed costs in lieu of variable costs.
Leverage magnifies profits and losses.
There are two types:

Operating leverage Financial leverage
Both types of leverage have the same effect on shareholders but are accomplished in very different ways, for very different purposes strategically.
21 - 10
Leverage Effects on Operating Income

When a firm increases the Normal volatility of use of fixed costs it operating income of increases the volatility operating income.
Operating Income
0 CHAPTER 21 Capital Structure Decisions
Years
21 - 11
Financial versus Operating Leverage

Operating Leverage
What is it? How is it Increased?
Operating leverage is:

The increased volatility in operating income caused by fixed operating costs.
You should understand that managers do make decisions affecting the cost structure of the firm. Managers can, and do, decide to invest in assets that give rise to additional fixed costs and the intent is to reduce variable costs.
This is commonly accomplished by a firm choosing to become more capital intensive and less labour intensive, thereby increasing operating leverage.
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Operating Leverage
Advantages and Disadvantages
Advantages:
Magnification of profits to the shareholders if the firm is profitable. Operating efficiencies (faster production, fewer errors, higher quality) usually result increasing productivity, reducing downtime etc.
Disadvantages:
Magnification of losses to the shareholders if the firm does not earn enough revenue to cover its costs. Higher break even point High capital cost of equipment and the illiquidity of such an investment make it:
Expensive (more difficult to finance) Potentially exposed to technological obsolescence, etc.
Financial Leverage
What is it? How is it Increased?
Your textbook defines financial leverage as:

The increased volatility in operating income caused by the corporate use of sources of capital that carry fixed financial costs.
Financial leverage can be increased in the firm by:

Selling bonds or preferred stock (taking on financial obligations with fixed annual claims on cash flow) Using the proceeds from the debt to retire equity (if the lenders dont prohibit this through the bond indenture or loan agreement)
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Financial Leverage
Advantages and Disadvantages
Advantages:
Magnification of profits to the shareholders if the firm is profitable. Lower cost of capital at low to moderate levels of financial leverage because interest expense is tax-deductible.
Disadvantages:
Magnification of losses to the shareholders if the firm does not earn enough revenue to cover its costs. Higher break even point. At higher levels of financial leverage, the low after-tax cost of debt is offset by other effects such as:
Present value of the rising probability of bankruptcy costs Agency costs Lower operating income (EBIT), etc.
Effects of Operating and Financial Leverage

Summary
Equity holders bear the added risks associated with the use of leverage.
The higher the use of leverage (either operating or financial) the higher the risk to the shareholder.
Leverage therefore can and does affect shareholders required rate of return, and in turn this influences the cost of capital.
HIGHER LEVERAGE = HIGHER COST OF CAPITAL
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Financial Leverage
Business Risk
All firms experience variability in sales and operating (fixed and variable) operating costs over time.
Some firms operate in a highly volatile industry (for example oil and gas) and we would say the firm has a high degree of business risk. Other firms operate in a very stable industry where revenues and expenses dont change much from year to year throughout the business cycle; these firms have low business risk.
Business risk is the variability of a firms operating income caused by operational risk.
Business risk is measured by the standard deviation of EBIT.
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Financial Leverage
Risk and Leverage
Lenders to the firm insulate themselves from risk through financial contracting:
Lending money through a formal, legally-binding contract. Demanding a fixed rate of return on the money they lend to the firm, in-keeping with their required return on monies borrowed. Demanding other promises that will protect the lenders interests over the life of the loan/investment. Demanding a high priority in the priority of claims list in the event of corporate dissolution/bankruptcy.
Shareholders bear the risk associated with business risk, and the added risks associated with the use of leverage because they are residual claimants of the firm.
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Return on Investment (ROI)

Financial Leverage
Return on Investment (ROI)
is the return on all the capital provided by investors; EBIT minus taxes divided by invested capital. Invested Capital (IC) is a firms capital structure consisting of shareholders equity and short- and long-term debt.
But we know the claims on the numerator (operating income after taxes) are very different, and so too are the risks each provider of capital is exposed.
[ 21-2]
EBIT(1 T ) ROI SE B
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Return on Equity (ROE)

Financial Leverage
ROE is the return earned by equity holders on their investment in the company
ROE = net income divided by shareholders equity.
[ 21-1]
( EBIT RD B)(1 T ) ROE SE
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ROI versus ROE

Financial Leverage
If the firm is completely financed by equity: ROE = ROI. Let us examine the effects of sales volatility on ROI and ROE given different levels of financial leverage.
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Financial Leverage
Risk and Leverage
Using this base income statement:
Table 21-1 Example Income Statement

Sales Variable costs Fixed costs EBIT Interest Taxable Income Tax (40%) Net Income $1,000 300 158 $542 42 $500 200 $300
The following three slides show three different financing strategies and the impacts on ROE, ROI, EPS for break-even, normal, and high sales levels:
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Financial Leverage
Income Statement No Financial Leverage
-77.5% Sales Variable costs Fixed costs EBIT Interest Taxable Income Tax (40%) Net Income Invested capital = Debtholders' investment = Shareholders' Equity = ROI = ROE = EPS (1,700 shares) = $225 68 158 -$1 0 -$1 0 -$0 $1,700 $0 $1,700 0.0% 0.0% $0.00 100.0% $1,000 300 158 $542 0 $542 217 $325 140.0% $1,400 420 158 $822 0 $822 329 $493
This assumes a 0.0 ROE 100.0% = ROI because no use debt/equity ratio 0.0%of debt financing. 100.0%
19.1% 19.1% $0.19 29.0% 29.0% $0.29
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Financial Leverage
Income Statement Base Case
-71.5% Sales Variable costs Fixed costs EBIT Interest Taxable Income Tax (40%) Net Income Invested capital = Debtholders' investment = Shareholders' Equity = ROI = ROE = EPS (1000 shares) = $285 86 158 $42 42 -$0 0 -$0 $1,700 $700 $1,000 1.5% -0.1% $0.00 100.0% $1,000 300 158 $542 42 $500 200 $300 140.0% $1,400 420 158 $822 42 $780 312 $468
ROE is levered a 0.70 This assumes compared to 100.0% ROI because ofratiomoderate debt/equity the 41.2% use of debt financing. 58.8%
19.1% 42.9% $0.30 29.0% 66.9% $0.47
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Financial Leverage
Income Statement with High Financial Leverage
-65.4% Sales Variable costs Fixed costs EBIT Interest Taxable Income Tax (40%) Net Income Invested capital = Debtholders' investment = Shareholders' Equity = ROI = ROE = EPS (300 shares) = $346 104 158 $84 84 $0 0.08 $0 $1,700 $1,400 $300 3.0% 0.0% $0.00 100.0% $1,000 300 158 $542 $84 $458 183.2 $275 140.0% $1,400 420 158 $822 $84 $738 295.2 $443
ROE 100.0% is more volatile than ROI because of the high use 82.4% of 17.6% financial leverage.
19.1% 91.6% $0.92 29.0% 147.6% $1.48
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Financial Leverage
Risk and Leverage
Consider the equation for ROE:

EBT times (1 T) = Net Income EBIT Interest expense = EBT
[ 21-1]
( EBIT RD B)(1 T ) ROE SE
The equation reduce to net income divided by BV of shareholders equity.
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Financial Leverage
Risk and Leverage
Equation 21 2 is the definition of ROI:
[ 21-2]
EBIT(1 T ) ROI SE B
If we re-express EBIT (1-T) in the ROE equation, we get:

Financial Leverage
Risk and Leverage
This is the financial leverage equation:
[ 21-3]
B ROE ROI ( ROI RD (1 T ) SE
ROI measures the return that the firm earns from operations, but DOES NOT explicitly considered how the firm is financed.
Financial Leverage
Risk and Leverage
If we rearrange Equation 21 3, grouping like terms involving ROI we get:
[ 21-4]
ROE ROI (1
B B ) RD (1 T ) SE SE
The second term is fixed. The first term depends on the firms uncertain ROI. This means we can graph ROE against ROI as a straight line.
See Figure 21 -1 on the following slide.
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Financial Leverage
Risk and Leverage
21 - 1 FIGURE
ROE 80 60 All Equity 40 20 D/E =0.70 Slope of the D/E = 0.70. all equity Slope of 1.0. line is = the line > 1.0. In this case ROI = ROE. Above the intercept with the horizontal axis, ROE >ROI.
ROI
-16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40
-20 -40 -60
Indifference point where Financial Break-even ROEs where ROE financing pointsfor different = 0 strategies are equal.
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Financial Leverage
Risk and Leverage
Financial Break-even point:

Points at which a firms ROE is zero.
Indifference Point:
Points at which two financing strategies provide the same ROE.
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Financial Leverage
The Rules of Financial Leverage
For value-maximizing firms, the use of debt increases the expected ROE so shareholders expect to be better off by using debt financing, rather than equity financing.
Financing with debt increases the variability of the firms ROE, which usually increases the risk to the common shareholders. Financing with debt increases the likelihood of the firm running into financial distress and possibly even bankruptcy.
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Financial Leverage
Table 21-2 Varying ROI Values

70% D/E Ratio 100% Equity ROE (%)
14.48 48.48 34 10 30 20
ROI (%)
10 30 Range
ROI reflects the business risk of the firm.

ROE =ROI in the all equity firm. ROE increases as the firm finances with more debt.
Financial Leverage
Table 21-3 Wider Variation ROI Values

70% D/E Ratio 100% Equity ROE (%)
-19.52 65.48 85 -10 40 50
ROI (%)
-10 40 Range
Wider variation in ROI means magnified ROE over a still wider range than ROI.
Financial Leverage
Investing Using Leverage
Figure 21 2 illustrates the monthly returns from investing in the S&P/TSX Composite Index using two different financing strategies:
1. Investing in the index (all equity) 2. Investing in the index with 80% borrowed on margin.
The added volatility of gains and losses over time is clearly evident. These principles of leverage apply to corporations as well as households
(See Figure 21 2 on the following slide)
Financial Leverage
Investing Using Leverage
21 - 2 FIGURE
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Indifference Analysis
Financial Leverage
Is a profit planning technique used to forecast the EPS-EBIT relationships under different financing scenarios. The indifference point is where:
EPS(Financing strategy 1)=EPS(Financing strategy 2)
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Financial Leverage
The formula for EPS, given EBIT, interest on debt (RDB), the corporate tax rate (T), and the number of common shares outstanding (#):
[ 21-5]
( EBIT RD B)(1 T ) EPS #
We can rearrange the definition of EPS and show how it varies with EBIT:
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Financial Leverage
EPS is a simple linear function of EBIT:
[ 21-6]
RD B(1 T ) EBIT(1 T ) EPS # #
This is illustrated in the EPS-EBIT graph in Figure 21 3 found on the following slide:
Financial Leverage
EPS-EBIT (Profit Planning) Charts
21 - 3 FIGURE
0.8 0.6 0.4 0.2 0

-567-397-312-227 -142 57 28 113 198 283 368 453 538 623 708 793 878 963 1048 1133
Indifference point.
-0.2
-0.4
-0.6
The horizontal intercept of the 70% D/E line is greater by the added interest expense that must be covered before producing earnings available for common shareholders. EPS 0% D/E EPS 70% D/E
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Financial Leverage
EPS-EBIT (Profit Planning) Charts
The slope of the lines are a function of the number of common shares outstanding (dilution of EPS).
The all equity line will have a lower slope because every dollar of net income is divided by more common shares.
The horizontal intercept is greater for the debt financing line because the firm must cover its interest expense before earnings begin to accrue to the benefit of shareholders.
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Determining Capital Structure


Table 21 4 demonstrates the 1990 results of a Conference Board survey of 119 U.S. companies to determine their capital structure. External sources of information include:
(#2) checking with their advisors, and (#5) examining other firms in the industry.
The three primary sources of information are:

(#4) impact on profits (#3) risk (#1) analysis of cash flows
Table 21-4 Determinants of Capital Structure

1. 2. 3. 4. 5. 6. Analysis of cash flows Consultations Risk considerations Impact on profits Industry comparisons Other 23.0% 18.3% 16.5% 14.0% 12.0% 3.4%
Source: Data from Conference Board, 1990
Primary sources include: Analysis of cash flows Risk consideration Impact on profits

Useful Ratios
Stock ratios (balance sheet ratios) that are helpful include:

Total debt to total assets Debt to equity ratio
Flow ratios make use of information taken from the income statement and when combined with balance sheet data help to determine the ability of the firm to service its debt.
21 - 48

Fixed Burden Coverage Ratio:
[ 21-7]
EBITDA Fixed Burden Coverage I (Pref.Div. SF ) /(1 T )
An expanded interest coverage ratio that looks at a broader measure of both income and the expenditures associated with debt.

Cash-flow-to-debt ratio (CFTD)
[ 21-8]
CFTD
EBITDA Debt
A direct measure of the cash flow over a period that is available to cover a firms stock of outstanding debt.

Table 21-5 Moody's Average Credit Ratios IG
Coverage Leverage (%) Cash flow-to-debt (%) Liquidity (%) Profit margin (%) Return on assets (%) Sales stability Total assets ($ billion) Altman Z score 4.01 46.2 18.3 3.66 6.26 8.41 7.14 6.31 2.17
Investment grade (IG) companies have at least a BBB bond rating.
Non-IG
1.45 67.4 8.10 4.45 1.39 6.92 5.60 1.19 1.62
So urce: Data fro m M o o dy's Investo r Services, "The Distributio n o f Co mmo n Financial Ratio s by Rating and Industry fo r No rth A merican No n-Financial Co rpo ratio ns," December 2004.
Altman Z score is a weighted average of several key ratios and is a useful predictor of a firms probability of bankruptcy.
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Altman Z Score
Altmans prediction of bankruptcy equation:
[ 21-9]
Z 1.2 X 1 1.4 X 2 3.3 X 3 0.6 X 4 0.999 X 5
Where:
X1 = working capital divided by total assets X2 = retained earnings divided by total assets X3 = EBIT divided by total assets X4 = market values of total equity divided by non-equity book liabilities X5 = sales divided by total assets
The Modigliani and Miller Irrelevance Theorem

The Modigliani and Miller (M&M) Irrelevance Theorem

M&M and Firm Value
The theorem that concludes (under some simplifying assumptions) that the value of the firm should not be affected by the manner in which it is financed.
How the firm is financed is irrelevant.
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(M&M) Irrelevance Theorem

Assumptions
Assumptions about the Real World:

Markets are perfect in the sense that there are no transactions costs or asymmetric information problems No taxes There is no risk of costly bankruptcy or associated financial distress
Modeling Assumptions:
There exist two firms in the same risk class with different levels of debt The earnings of both firms are perpetuities
21 - 55

Arbitrage Argument
Arbitrage is a powerful economic force in capital markets. Where two identical assets trade at different prices, market traders will spot the opportunity to earn riskless profits.
Traders will sell the overvalued asset and buy the undervalued asset. This activity will cause the price of the overvalued asset to fall, and the price of the undervalued asset to rise until the two are priced the same. The traders will earn abnormal profits from these trades until the prices of the two securities move into equilibrium.
Table 21 6 illustrates the two different positions and the equal payoffs

Arbitrage Argument
Market participants who find levered investments trading for a greater value, can undo the leverage and earn abnormal profits. Arbitrage will force assets with equal payoffs to trade for the same price.
Table 21 6 illustrates the two different positions and the equal payoffs
21 - 57

M&M and Firm Value
Table 21-6 M&M Arbitrage Table I Portfolios (Actions)
Portfolio A: Buy of unlevered firm Portfolio B: Buy of levered firm's equity Buy of levered firm's debt Total portfolio SL D (SL + D) (EBIT KD D ) KD D EBIT
Cost
VU
Payoff
EBIT
Net payoffs are equal
Portfolio A and B must be priced equally despite their different financial structures because the payoffs are equal.

M&M and Firm Value
Where payoffs are identical for two different assets, both should be priced the same.
[ 21-10]
VU S L D VL
The value of the levered firm (VL) is equal to the value of its debt plus the value of its equity (SL + D) and this must equal the value of the unlevered firm (VU). Debt cannot destroy value.

Personal Leverage and Corporate Leverage
Table 21-7 M&M Arbitrage Table II Portfolios (Actions)

Portfolio C: Buy of unlevered firm Portfolio D: Buy of levered firm's equity Buy of levered firm's debt Total portfolio VU D (VU - D) EBIT - K D D (EBIT - KD D )
Cost
SL
Payoff
(EBIT - KD D )
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Homemade Leverage
Homemade leverage is the creation of the same effect of a firms financial leverage through the use of personal leverage. This means that individuals can:
Buy an unlevered firm, and through the use of personal debt, replicate corporate leverage, or Buy a levered firm, and undo its effects.
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M&M and The Cost of Capital
M&M made a modeling assumption (to simplify the calculations and focus analysis on the leverage issue) that the firms earnings represent a perpetuity:
[ 21-11]
(EBIT-KD D) SL Ke
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The cost of equity capital is simply the earnings yield and is estimated as follows:
[ 21-12]
Ke
(EBIT-KD D) SL
21 - 63

M&M and The Cost of Capital Since the value of the firm is unchanged by leverage, we can define the unlevered value (VU) by discounting the firms expected EBIT by it unlevered equity cost (KU):
[ 21-13]
EBIT VU S L D VL VU
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M&M Equity Cost Equation To determine who equity cost varies with the debt-equity ratio, we solve for EBIT, and substitute it for EBIT in the leveraged equity cost equation:
[ 21-14]
K e K u ( KU K D ) D / S L
If the firm has no debt, the equity investor requires KU (cost of unlevered equity). KU depends on business risk of the firm. As the firm uses debt, the equity cost increases due to the financial leverage risk premium.

M&M and The Cost of Capital In a world without taxes, the WACC (KU) is simply the weighted average of the cost of debt and the cost of equity:
[ 21-15]
S D KU K E K D V V
Figure 21 4 illustrates M&M without corporate taxes (the irrelevance model) where the cost of equity (KE) rises in a prescribed manner to offset the lower cost of debt (KD) producing WACC that remains unchanged by the use of financial leverage.
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20 - 4 FIGURE
Equity Cost KE
WACC
Debt Cost KD
Debt-Equity Ratio
21 - 67

If WACC remains the same regardless of the financial strategy used by the firm:
VL = VU Financial strategy is irrelevant
As the use of debt financing is increased, the cost of equity will riseso even if EPS is increased through the use of debt financing, that benefit is offset by a higher discount rate. From a shareholder wealth perspective, under the M&M assumptions, financing strategy is irrelevant.
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The Impact of Corporate Taxes on The Irrelevance Theorem

The Impact of Taxes

Introducing Corporate Taxes The value of firms drop in the presence of corporate taxes. The higher the tax rate, the lower the value of the firm.
[ 21-16]
EBIT(1 T ) VU KU
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The Impact of Taxes

Corporate Tax Effect on Levered Equity
Table 21-8 M&M with Taxes Portfolios (Actions)

Portfolio E: Buy of unlevered firm Portfolio D: Buy of levered firm's equity Buy of levered firm's debt Total portfolio VU D(1-T) (VU - D)(1-T) EBIT(1-T) - K D D (EBIT - KD D )(1-T)
Cost
SL
Payoff
(EBIT - KD D )(1-T)
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The Impact of Taxes

Introducing Corporate Taxes
To avoid arbitrage the value of the firm must equal: VU D(1-t) = SL VL = SL + D, therefore:
Corporate Debt Tax Shield
[ 21-17]
VL VU DT
The value of the firm with leverage is the value without leverage plus the corporate debt tax shield from debt financing.
The Impact of Taxes

The total claims of corporate taxes, debt holders, and equity holders are borne by the pre-tax cash flow produced by the firm. If the firm uses more debt, and interest on that debt is tax-deductible, this produces a greater tax shield, reducing the government share of the value of the private enterprise, the WACC must go down.
Here we assume a zero-sum game (that value is not destroyed through the use of financial leverage)
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The Impact of Taxes

Firm Value with Corporate Taxes
21 - 5 FIGURE
Debt
Equity
Taxes
21 - 74
The Impact of Taxes

The tax corrected value of Equation 21-14 is:
[ 21-18]
K e KU ( KU K D )(1 T ) D / S L
Both the interest cost and the financial leverage risk-premium on the equity cost are reduced by (1- T) As the use of debt increases, WACC decreases, and therefore the value of the firm in a world with corporate taxes should increase
(See Figure 21 6 on the following slide)
21 - 75
The Impact of Taxes

M&M with Corporate Taxes
21 - 6 FIGURE
Equity Cost KE
WACC Debt Cost KD(1-T) Debt-Equity Ratio
21 - 76
The Impact of Taxes

WACC with Corporate Taxes WACC declines continuously with the use of debt financing. WACC equation corrected for the tax-deductibility of interest expense is:
[ 21-19]
S D WACC K e K D (1 T ) V V
21 - 77
The Impact of Taxes

Tax-Extended M&M Equity Cost Equation
The beta version of Equation 21 18 allows us to adjust for the systematic risk of the firm:
[ 21-20]
K e RF MRP U (1 (1 T ) D / S L )
Equity cost without any debt is the risk-free rate plus the market risk premium (MRP) times the unlevered beta coefficient. This equation allows us to unlever betas to get the unlevered equity cost. There is one important flaw in this equation it is assumed that 100% debt financing is optimal. To address that issue, we must relax M&Ms assumptions regarding risk of financial distress or bankruptcy.
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Incorporating Financial Distress, Bankruptcy and Agency Costs

Bankruptcy
Introduction
Bankruptcy is a state of insolvency that occurs when a firm commits an act of bankruptcy, such as nonpayment of interest, and creditors enforce their legal rights to recoup money, or when a firm voluntarily declares bankruptcy in an effort to be protected while reorganizing to become solvent again.
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Reorganization
Firms can be reorganized under:
Companies Creditors Arrangements Act (CCAA)
Used by larger more complex firms with debt > $5m Flexible allowing the firm to pursue agreements with creditors/employees, to raise new financing Trustee is appointed by the court and there is a stay-ofproceedings
Bankruptcy Insolvency Act (BIA)

Limited scope to prevent creditors from seizing assets No DIP financing No provision to impose a settlement on all creditors
Costs of Bankruptcy
Direct Costs
Direct Costs:
Costs incurred as a direct result of bankruptcy including:
Liquidation of assets Loss of tax losses (potential tax shield benefits) Legal and accounting costs
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Costs of Bankruptcy
Indirect Costs
Indirect Costs:
Financial distress costs are losses to a firm prior to declaration of bankruptcy including:
Agency costs Increasing costs of doing business:
Creditors tightening trade credit terms Lending increasing risk premiums and increasing monitoring surveillance loss of key staff and increases in recruitment and retention costs Distracted management focused on financing and not on management of business operations.
Reduced sales revenue:

Management is distracted by financial issues Customers may become wary and look for other suppliers
(Figure 21 8 illustrates the rising value of distress costs with increasing debt)
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Static Tradeoff
Firm Value and Financial Distress Costs
21 - 8 FIGURE
VU + DT
Value
Distress Costs
Debt Ratio
21 - 84
Costs of Bankruptcy
Agency Costs Agency Costs:
It is possible for shareholders (and Board of Directors) to act in their own best interests at the expense of debt holders. When under financial stress sometimes:
Preferential treatment of creditors. Assets may be dissipated to related but solvent companies. Moral hazard (where management may take extraordinary risks that will be ultimately borne by the debt holders, not the equity holders) (asymmetric payoff of an option)
Being aware of these risks, lenders take action to protect their interests including:
Moratorium on further debt. Increases in rates on adjustable-rate debt. Demands for additional surveillance of financial performance. Take the firm to court to enforce rights.
(Figure 21 7 illustrates the shareholders one year call option value on the underlying firm) CHAPTER 21 Capital Structure Decisions 21 - 85
Financial Distress, Bankruptcy, and Agency Costs

The Firm Value as a Call Option for Shareholders
21 - 7 FIGURE
No limited liability
Equity Payoff
0
$50 million debt
Underlying Firm Value
21 - 86
Costs of Bankruptcy
Summary
Costs of Bankruptcy are very high. Probability of Bankruptcy and Financial Distress costs rise exponentially as the use of debt increases. These costs rob value from both shareholders and potentially debt holders.
21 - 87
Costs of Bankruptcy
Static Tradeoff Model
Figure 21 9 illustrates the impact of bankruptcy and financial distress costs on M&M with corporate taxes.
Cost of equity rises throughout as more debt is added. The cost of debt rises at higher levels of debt. WACC falls initially because the benefits of the tax-deductibility of interest expense out-weigh the marginal increases in component costs, however, at higher levels of debt, the taxadvantage of debt is offset and the value of the firm falls when WACC starts to rise.
21 - 88
Static Tradeoff Model

21 - 9 FIGURE
Cost (%) Ke
WACC
KD
Debt-to-equity D/E* Firm Value
21 - 89
Other Factors Affecting Capital Structure Decisions

Other Factors Affecting Capital Structure

Pecking Order
Static Trade off model ignores two issues:

1. Information asymmetry problems 2. Agency problems
These factors are likely responsible for what Myers and Donaldson call the pecking order. The pecking order is the order in which firms prefer to raise financing
1. starting with internal cash flow, 2. debt and 3. finally issuing common equity.
Capital Structure in Practice

Capital Structure in Practice

Factors favouring corporate ability and willingness to issue debt:
Profitability (so the firm can use the tax shield benefit of interest-deductibility). Unencumbered tangible assets to be used as collateral for secured debt. Stable business operations over time. Corporate size. Growth rate of the firm. Capital market conditions
Summary and Conclusions

In this chapter you have learned:
The three effects of leverage: expected ROE tends to increase, the variability of the ROE increases, and the risk of financial distress increases. The major determinants of the firms capital structure decision are its impact on profits, risk and cash flows. Impacts can be assessed by profit planning charts, financial break-even analysis and use of standard ratios Debt creates value because interest on debt is tax-deductible The tax incentive to use debt is offset by the resulting financial distress and bankruptcy costs In a dynamic world, firms depart from the static trade-off optimal debt ratio over time, then refinance to bring it back in line with the target debt ratio. Actual capital structures are constantly changing as firms take advantage of market conditions.
Concept Review Questions

Concept Review Question 1

Business and Financial Risk
Define business risk and financial risk.
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Appendix 1 Thunder Bay Industries

Exercise in Indifference Analysis
Thunder Bay Industries

The Problem
Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years. The company is now operating at 100% of capacity and must expand in order to meet the demand for its new line of video games. The current financial statements for Thunder Bay Industries are as follows:
Thunder Bay Industries Balance Sheet as at December 31, 20xx ($ '000s Cdn.) Assets: Cash Accounts receivable Inventories Net Fixed Assets Liabilities and Owner's Equity: Accounts payable Accruals Other current liabilities 8% bonds maturing in 10 years Common stock (100,000 outstanding) Retained earnings Total Liabilities and Owner's Equity
1,000 2,100 2,766 16,244 _______ $22,110
Total Assets
550 249 1 5,000 1,000 15,310 $22,110
The most recent income statement is found on the following slide:
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The Problem
Thunder Bay Industries Income Statement for the year ended December 31, 20xx ($ '000s Cdn) Sales Cost of Goods Sold Gross Margin on Sales Administrative and Selling Expenses Earnings before Interest Expense and Taxes Interest expense Earnings before tax Taxes Net Income $25,002 18,252 $ 6,750 4,000 2,750 400 $ 2,350 1,011 $1,339
If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company undertakes the planned expansion management has identified a probability distribution for possible EBIT levels:
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The Problem
If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company undertakes the planned expansion management has identified a probability distribution for possible EBIT levels: Possible EBIT $2,200 $2,700 $3,200 $3.700 Probability .1 .4 .4 .1
The planned expansion will require Thunder Bay Industries to raise $10,000,000 in new capital. If raised in the form of bonds, the bonds would carry a 6.5% coupon rate. New common stock could be sold for $250.00 per share.
Find the EBIT/EPS indifference point. What is the probability that EBIT will be greater than the indifference point? Which method of financing is most likely to maximize earnings per share? What method of financing do you recommend? Why? Discuss the limitations of indifference analysis. Prepare a properly labeled diagram of the EBIT/EPS analysis.
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The Solution
You can first determine the expected EBIT for next year and using that, determine the standard deviation of that EBIT. These calculations will be useful later when we try to determine the probability that EBIT will be less than, or greater than the indifference point.
Possible EBIT $2,200,000 2,700,000 3,200,000 3,700,000 Probability 10.0% 40.0% 40.0% 10.0% Expected EBIT = Wtd EBIT $220,000 1,080,000 1,280,000 370,000 $2,950,000
EBIT .1(7502 ) .4(2502 ) .4(2502 ) .1(7502 )

56250 25,000 25,000 56250 162,500 403.11 $403,110

The Solution
Next set up equations for EPS for each alternative source of financing, equate them, substitute in known values and solve for the common EBIT.
EPScommon EPSdebt ( EBIT RD B1 )(1 T ) n1 n2
( EBIT RD B1 RD B2 )(1 T ) n1
EPScommon EPSdebt ( EBIT RD B1 )(1 T ) ( EBIT RD B1 RD B2 )(1 T ) n1 n2 n1 ( EBIT 400,000)(1 .43) ( EBIT 400,000 650,000)(1 .43) 100,000 40,000 100,000 EBIT $2,675,000
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The Solution Our prediction for EPS at EBIT=$2,675,000 for the common share financing alternative is:
EPScommonshare EPSDebt ($2,675,000 $400,000)(1 .43) $9.26 140,000 ($2,675,000 $1,050,000)(1 .43) $9.26 100,000
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The Solution The probability than EBIT will favour common stock financing (ie. be less than the indifference point) is:
z
Where:
2,675,000 2,950,000 z 403,110 0.6822
z = the number of standard deviations away from the mean X = the point of interest = the standard deviation of the probability distribution = the mean of the probability distribution
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The Solution
2,675,000 2,950,000 403,110 0.6822
The negative sign indicates that the point of interest (X) or (indifference point) lies on the left-hand side of the mean. It lies .6822 of 1 standard deviation away from the mean. Going to the table for Values of the Standard Normal Distribution Function we find the area under the curve between the point of interest and the mean of the distribution to be: .2517 or 25.27% Therefore, the probability that EBIT will exceed the indifference point (favouring debt financing) is 75.17% The probability that EBIT will be below the indifference point (favouring equity financing is (1- .7517) 24.83%.
(These normal distribution is plotted on the following chart.)
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The Solution
2,675,000 2,950,000 403,110 0.6822
Area = .2517
Area = .5
=$2,950,000 X=$2,675,000
(These relationships are now plotted on the following indifference chart.)


The Solution
EPS
Debt Financing $9.26 Area = .2517 Area = .5 Equity Financing
$400,000
$1,050,000
=$2,950,000 X=$2,675,000
(This chart illustrates that debt financing is forecast to produce higher EPS than the equity alternative.)
Copyright
Copyright 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein.
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Chapter 21 - Capital Structure Decisions

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Chapter 21 - Capital Structure Decisions

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INTRODUCTION TO

Prepared by Ken Hartviksen

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

Important Chapter Terms

CHAPTER 21 Capital Structure Decisions

The Focus of this Chapter

In this Chapter You Will Learn

Leverage: What is It?

There are two types:

CHAPTER 21 Capital Structure Decisions

Leverage Effects on Operating Income

0 CHAPTER 21 Capital Structure Decisions

Financial versus Operating Leverage

Operating leverage is:

Your textbook defines financial leverage as:

Financial leverage can be increased in the firm by:

CHAPTER 21 Capital Structure Decisions

Effects of Operating and Financial Leverage

HIGHER LEVERAGE = HIGHER COST OF CAPITAL

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

Return on Investment (ROI)

Return on Investment (ROI)

CHAPTER 21 Capital Structure Decisions

Return on Equity (ROE)

( EBIT RD B)(1 T ) ROE SE

CHAPTER 21 Capital Structure Decisions

ROI versus ROE

CHAPTER 21 Capital Structure Decisions

Table 21-1 Example Income Statement

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

Consider the equation for ROE:

( EBIT RD B)(1 T ) ROE SE

The equation reduce to net income divided by BV of shareholders equity.

CHAPTER 21 Capital Structure Decisions

Equation 21 2 is the definition of ROI:

If we re-express EBIT (1-T) in the ROE equation, we get:

This is the financial leverage equation:

B ROE ROI ( ROI RD (1 T ) SE

If we rearrange Equation 21 3, grouping like terms involving ROI we get:

CHAPTER 21 Capital Structure Decisions

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CHAPTER 21 Capital Structure Decisions

Financial Break-even point:

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

Table 21-2 Varying ROI Values

ROI reflects the business risk of the firm.

Table 21-3 Wider Variation ROI Values

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions

( EBIT RD B)(1 T ) EPS #

CHAPTER 21 Capital Structure Decisions

EPS is a simple linear function of EBIT:

RD B(1 T ) EBIT(1 T ) EPS # #

0.8 0.6 0.4 0.2 0

CHAPTER 21 Capital Structure Decisions

CHAPTER 21 Capital Structure Decisions