2201AFE Corporate Finance

Week 11: Financial Leverage and Capital Structure Policy Readings: Chapter 19

Agenda
Last Week Financial Leverage and Capital Structure Policy
Key Concepts and Skills

Real World Application

CDO101 A primer on collateralised debt obligations!

Next Week
Approved list of deferred exam sitting is published on Learning@GU > Assessment

Last Lecture
Cost of Equity Cost of Preferred Stock Cost of Debt Proportion or weight of each form of financing Cost of Capital = WACC
Unadjusted/Adjusted When should we use WACC? Other approaches: pure play and subjective

Flotation Costs

Financial Leverage and Capital Structure Policy

Chapter 19

1. Introduction & Financial Statements

7. Mid-semester Exam 8. Some Lessons from Capital Market History

2. Time Value of Money 9. Return, Risk & the Security Market Line

3. Valuing Shares & Bonds

4. Net Present Value & Other Investment Criteria

10. Cost of Capital

5. Making Capital Investment Decisions & Project Analysis

11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy

6. Revision for Mid-sem Exam

13. Options & Revision

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Key Concepts and Skills

The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure

Choosing a Capital Structure

What is the primary goal of financial managers?
Maximize stockholder wealth
Choose the optimal capital structure Maximize the value of the firm

Minimize the WACC

Capital Restructuring
Financial leverage = the extent to which a firm relies on debt financing. Capital restructuring involves changing the amount of leverage a firm has without changing the firms assets.

The firm can increase leverage by issuing debt and repurchasing outstanding shares. The firm can decrease leverage by issuing new shares and retiring outstanding debt.

The Effect of Leverage

How does leverage affect the EPS and ROE of a firm? More debt financing, means more fixed interest expense. In expansion, we have more income after we pay interest, have more left over for stockholders. In recession, we still have to pay our costs therefore we have less left over for stockholders.

Leverage amplifies the variation in both EPS and ROE.

Example: Financial Leverage, EPS and ROE

Current Capital Structure: No Debt
Recession EBIT $300,000 0 $300,000 Interest Net Income Expected 0 Expansion 0 $650,000 $1,000,000 $650,000 $1,000,000

Current
Assets Debt Equity Debt/Equity Ratio Share Price Shares Outstanding $5,000,000 $0 $5,000,000 0 $10 500,000

Proposed
$5,000,000 $2,500,000 $2,500,000 1 $10 250,000

ROE
EPS

6.00%
$0.60

13.00%
$1.30

20.00%
$2.00

Proposed Capital Structure: Debt = $2.5 million

Recession
EBIT Interest Net Income $300,000 $250,000 $50,000

Interest Rate

N/A

10%

Expected
$250,000 $400,000

Expansion
$250,000 $750,000

$650,000 $1,000,000

ROE
EPS

2.00%
$0.20

16.00%
$1.60

30.00%
$3.00
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Break-Even EBIT
Break-Even EBIT where: EPS debt = EPS no debt If expected EBIT > break-even EBIT, then leverage is beneficial to our stockholders. If expected EBIT < break-even EBIT, then leverage is detrimental to our stockholders.

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Example: Break-Even EBIT

EPS no debt debt earnings earnings interest = shares shares EBIT EBIT 250 = 500 250 250EBIT = 500(EBIT 250) 250EBIT = 500EBIT 125,000 250EBIT = 125,000 $125,000 EBIT = = $500 250 = EPS

Note: Numbers in thousands

Outcomes: EPS with No Debt = $500/500 = $1 EPS with Debt = ($500-$250)/250 = $1

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Break Even EBIT

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Capital Structure Theory

Modigliani and Miller Theory of Capital Structure.
Proposition I firm value Proposition II cost of equity & WACC

The value of the firm is determined by the cash flows to the firm and the risk of the assets. Changing firm value.
Change the risk of the cash flows. Change the cash flows.

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Capital Structure Theory Under Three Special Cases

Case I Assumptions:
No taxes No bankruptcy costs
Taxes Bankruptcy costs

Case II Assumptions:
With taxes No bankruptcy costs

Case I Case II Case III

Case III Assumptions:

With taxes With bankruptcy costs

Proposition I firm value Proposition II cost of equity & WACC

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Case I No Taxes
Proposition I:
The value of the firm is NOT affected by changes in the capital structure. The cash flows of the firm do not change; therefore, value doesnt change.

Proposition II:
Cost of Equity increases as Debt increases. The WACC of the firm is NOT affected by capital structure.

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Case I No Taxes Equations

Proposition I (firm value): V = EBIT/RA if no debt, RA= RE

Proposition II (RE & WACC): WACC = RA = (E/V)RE + (D/V)RD RE = RA + (RA RD)(D/E)

Where:

RA is the cost of the firms business risk, i.e., the risk of the firms assets. (RA RD)(D/E) is the cost of the firms financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage (D/E).
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Case I No Taxes Example

Data
Required return on assets = WACC = RA = 0.16 Cost of debt = RD = 0.10 Percent of debt = D = 0.45
E = 1 0.45 = 0.55 or 55% D/E = 0.45/0.55 = 0.82

What is the cost of equity?

RE = RA + (RA RD)(D/E) RE = 0.16 + (0.16 0.10)(0.45/0.55) = 0.2091

Proof for WACC:

WACC = RA = (E/V)RE + (D/V)RD WACC = RA = 0.55 0.2091 + 0.45 0.10 = 0.16 or 16%
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Case I No Taxes Example

What happens if the firm increases leverage so that D/E = 1.5? (before D/E = 0.82 when D = 45%, E = 55%) What is the cost of equity?
RE = RA + (RA RD)(D/E) RE = 0.16 + (0.16 0.10)(1.5) = 0.25 or 25%

Proof for WACC:

WACC = RA = (E/V)RE + (D/V)RD From D/E = 1.5, D = 60%, E = 40%
WACC = 0.4 25% + 0.6 10% = 16%

E 1 V 1 D/E

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The CAPM, Business Risk, Financial Risk and Proposition II

How does financial leverage affect systematic risk?

CAPM: RE = Rf + E(RM Rf) for equity CAPM: RA = Rf + A(RM Rf) for assets Where A is the firms asset beta and measures the systematic risk of the firms assets, also called unlevered beta the risk of the assets if the firm would have no debt ( in essence E = A if no debt)
RE = RA + (RA RD)(D/E) RE = RA + (RA Rf)(D/E) assume RD = Rf
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The CAPM, Business Risk, Financial Risk and Proposition II Proposition II As we introduce debt in the firm: RE = Rf + A(1+D/E)(RM Rf) E = A(1 + D/E)
Therefore, the systematic risk of the stock depends on: Systematic risk of the assets, A, (Business risk) Level of leverage, D/E, (Financial risk)

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Its all about pizza

Yogi Berra* was once asked whether he wanted his pizza sliced into four pieces as usual He replied, No, slice it into eight pieces Im hungry tonight. Hmm?
Lawrence Peter "Yogi" Berra (born May 12, 1925 in St. Louis, Missouri) is a former Major League Baseball player and manager. He played almost his entire career for the New York Yankees and was elected to the baseball Hall of Fame in 1972. http://en.wikipedia.org/wiki/Yogi_Berra
*

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Pizza and Capital Structure Theory

Assuming perfect capital markets, Modigliani and Miller found, without taxes, the total value of a firm is unaffected by its capital structure.
Whether or not an investment makes sense does not depend on how we are going to raise the money to pay for it.

Why is this true?

A firm's cash flow is like a pizza: to change the firm's capital structure is to change the size of individual pizza slices. This does not change the overall size of the pizza, nor does it change the overall value of the firm.
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Pizza and Capital Structure Theory

Pizza We might have an unsliced pizza, but want slices we can then always cut it up ourselves. Or, we have a bunch slices, but want a whole pizza: we can always stick them back together. Learning We should be willing to pay the same price for one whole pizza or an equivalent bunch of slices.

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Quick Quiz
Under Case I, what are the values of the firm with debt (levered) and without debt (unlevered)?

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Case II Introducing Taxes

What happens to the firms cash flows?
Interest is tax deductible. Therefore, when a firm adds debt, it reduces taxes, all else equal. The reduction in taxes increases the cash flow of the firm.

How should an increase in cash flows affect the value of the firm?

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Case II with Taxes Example

Unlevered Firm (No Debt) EBIT Interest Taxable Income Taxes (34%) Net Income CFFA=EBIT-Tax 5,000 0 5,000 1,700 3,330 3,300 Levered Firm (With Debt) 5,000 500
(6,250 @ 8%)

4,500 1,530 2,970 3,470

Tax saving = $170 = 0.34 x $500 = TC RD D

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Interest Tax Shield

Annual interest tax shield
Tax rate times interest payment $6,250 in 8% debt = 500 in interest expense Annual tax shield = 0.34(500) = 170

Present value of annual interest tax shield

Assume perpetual debt for simplicity PV = 170 / 0.08 = 2,125
6250 0.08 0.34 6250 0.34 2125 0.08 D R D TC PV D TC RD PV
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Case II with Taxes Proposition I

The value of the firm increases by the present value of the annual interest tax shield
Value of a levered firm = Value of an unlevered firm + PV of interest tax shield
Assuming perpetual cash flows

VU = EBIT(1-T) / RU
with no debt RU = RA= RE and VU = E

VL = VU + DTC E = VL - D
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Case II with Taxes Proposition I Example

Data Inc. has earnings of $25 million per year every year. The firm has no debt and the cost of capital is 12%. If tax is 35% what is the value of the firm?
EBIT = 25 million; Tax rate = TC= 35%; Unlevered cost of capital = RU = 12% = RA = RE VU = ?

VU = EBIT(1-T) / RU VU = 25(1-0.35) / 0.12 = $135.42 million VU = E

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Case II with Taxes Proposition I Example

Data Inc. decides to issue bonds that have a market value of $75 million at a cost of 9%. What is the value of the firm? What will be the value of equity? D = $75 million, RD= 9%, VL = ?, E = ? VU = 135.42 (calculated on previous slide) VL = VU + tax shield VL = VU + DTC VL = 135.42 + 75(0.35) = 135.42+26.25 = $161.67 m E = VL - D E = 161.67 75 = $86.67 million
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Case II with Taxes Proposition II

Recap: In case I Proposition II - no taxes:
RE increases as Debt increases WACC is unchanged

When taxes are introduced in Case II:

RE increases as Debt increases

RE = RU + (RU RD)(D/E)(1-TC)
WACC decreases as D/E increases

RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)

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Case II with Taxes Proposition II Example

Data Inc. info from Case II proposition I:
EBIT = 25 million; TC= 35%; D = $75 million; RD= 9%; Unlevered cost of capital = RU= 12% E = $86.67m; VL = $161.67m (slide 32) D/E = 75/86.67 = 0.87, E/V = 86.67/161.67 = 0.54, D/V = 75/161.67 = 0.46

RE = RU + (RU RD)(D/E)(1-TC)
RE = 0.12 + (0.12-0.09)(0.87)(1-0.35) = 13.69%

RL = WACC = (E/V)RE + (D/V)(RD)(1-TC)

RL = WACC = (0.54)(0.1369) + (0.46)(0.09)(1-0.35) = 10.05%
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Case II with Taxes Proposition II Example

Suppose Data Inc. changes its capital structure so that the debt-to-equity ratio becomes 1.
Before: D/E = 0.87 Now: D/E = 1 E = 54%, D = 46% E = 50%, D = 50%

What will happen to the cost of equity under the new capital structure? (previously 13.69%) RE = 0.12 + (0.12 0.09)(1)(1-0.35) = 13.95% What will happen to the weighted average cost of capital?
(previously 10.05%)

WACC = 0.5(0.1395) + 0.5(0.09)(1-0.35) = 9.9% What if D/E = 1.25? RE = ? WACC = ?

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Quick Quiz
Under Case II, it is beneficial and should firms take on more debt?

What sort of industries typically have high D/E ratio?

What is the capital structure of Apple Inc (APPL)?

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Case III with Bankruptcy Costs

Now we add bankruptcy costs. As the D/E ratio increases, the probability of bankruptcy increases. This increased probability will increase the expected bankruptcy costs. At some point, the additional value of the interest tax shield will be offset by the increase in expected bankruptcy cost. At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added.

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Bankruptcy Costs
Direct costs
Legal and administrative costs.

Indirect costs
Larger than direct costs & more difficult to measure and estimate.

Financial distress costs

All costs associated with going bankrupt and/or avoiding bankruptcy.

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Conclusions
Case I no taxes or bankruptcy costs.
No optimal capital structure.

Case II corporate taxes but no bankruptcy costs.

Optimal capital structure is almost 100% debt. Each additional dollar of debt increases the cash flow of the firm.

Case III corporate taxes and bankruptcy costs.

Optimal capital structure is part debt and part equity. Occurs where the benefit from an additional dollar of debt just offsets the increase in expected bankruptcy costs.
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Managerial Recommendations
The tax benefit is only important if the firm has a large tax liability. Risk of financial distress:
The greater the risk of financial distress, the less debt will be optimal for the firm. The cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industry.

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Real World Application CDO101: A primer on collateralised debt obligations!

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CDO101
What is a CDO? An arbitrage cash flow Collateralised Debt Obligation (or CDO) is a structured pool of below investment grade corporate loan and bond assets The Fund, which is a special purpose entity (SPV), issues various tranches of debt and equity to fund its purchase of corporate loans and bonds This pool of loans and bonds acts as collateral for the Funds liabilities Because the majority of these liabilities are rated investment grade, the Fund equity benefits from the difference between the income generated by the collateral pool and the Funds liability costs CDO funds issued today are generally $300-500 million in size. The underlying collateral typically represents 100-200 obligors in 20-30 industries. Below is a typical CDO structure:

The Funds indenture governs the order in which cash generated by the Fund is paid to the various tranches

Generally, the higher the tranches rating, the higher its position in the Funds cash flow waterfall
Residual cash generated by the collateral assets after paying the Funds required principal and interest payment to the liabilities and the management fee is distributed to the holders of the Fund equity

Source: http://www.octagoncredit.com/cdo-basics.htm

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Who Buys CDO debt?

The liabilities of CDO funds are typically purchased by banks, hedge funds, insurance companies and pension funds The equity tranche of CDOs are generally purchased by banks, insurance companies, high net worth individuals, hedge funds, and the manager of the CDO

How do CDOs work?

Initially, all the cash flows from a CDO's collection of assets are pooled together This pool of payments is separated into rated tranches Each tranche also has a perceived (or stated) debt rating to it. The highest end of the credit spectrum is usually the 'AAA' rated senior tranche The middle tranches are generally referred to as mezzanine tranches and generally carry 'AA' to 'BB' ratings and the lowest junk or unrated tranches are called the equity tranches Each specific rating determines how much principal and interest each tranche receives

Sub-prime CDO example

The 'AAA'-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments As such, it has the most predictable cash flow and is usually deemed to carry the lowest risk On the other hand, the lowest rated tranches usually only receive principal and interest payments after all other tranches are paid Furthermore they are also first in line to absorb defaults and late payments Depending on how spread out the entire CDO structure is and depending on what the loan composition is, the equity tranche can generally become the "toxic waste" portion of the issue

Source: http://www.octagoncredit.com/cdo-basics.htm and http://www.investopedia.com/articles/07/cdomortgages.asp

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Next Week
Next week we look at the role of dividends and how firms set dividend policy.

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