CHAPTER FOUR

CAPITALCORPORATE

STRUCTUREFINANCE
AND LEVERAGE

1
Capital Restructuring
 We are going to look at how changes in capital structure affect
the value of the firm, all else equal
 Capital restructuring involves changing the amount of leverage
a firm has without changing the firm’s 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
 Cont’d…
 How should a firm go about choosing its debt–
equity ratio?
 We assume that the guiding principle is to choose
the course of action that maximizes the value of a
share of stock.
 When it comes to capital structure decisions, this is
essentially the same thing as maximizing the value
of the whole firm, and, for convenience, we will
tend to frame our discussion in terms of firm value
 Firm Value and Stock Value: an Example

 The following example illustrates that the capital structure that

maximizes the value of the Firm is the one financial managers
should choose for the shareholders, so there is no conflict in our
goals.
 To begin, suppose the market value of the J.J. Sprint Company is
$1,000.
 The company currently has no debt, and J.J. Sprint’s 100 shares sell
for $10 each.
 Further suppose that J.J. Sprint restructures itself by borrowing
$500 and then paying out the proceeds to shareholders as an extra
dividend of $500/ 100 = $5 per share.
 This restructuring will change the capital structure of the firm with
no direct effect on the firm’s assets.
 The immediate effect will be to increase debt and decrease equity
Choosing a Capital Structure
 What is the primary goal of financial managers?
 Maximize stockholder wealth

 We want to choose the capital structure that will maximize

stockholder wealth
 We can maximize stockholder wealth by maximizing the
value of the firm or minimizing the WACC
 How can capital structure affect
6
value?

∞ FCFt
V = ∑
t=1 (1 + WACC)t

WACC= wd (1-T) rd + wcers

 Capital Structure Effects
7

 The impact of capital structure on value depends

upon the effect of debt on:
 WACC
 FCF
 The Effect of Additional Debt on WACC
8

 Debtholders have a prior claim on cash flows relative to

stockholders.
 Debtholders’ “fixed” claim increases risk of stockholders’
“residual” claim.
 Cost of stock, rs, goes up.
 Debt increases risk of bankruptcy
 Causes pre-tax cost of new debt, rd, to increase
 Adding debt increase percent of firm financed with low-
cost debt (wd) and decreases percent financed with high-
cost equity (wce)
Cont’d…
• Changing the capital structure affects all
the variables in the WA C C equation
• But it’s not easy to say whether those
changes increase the WACC, decrease it, or
balance out exactly and leave the WACC
unchanged
 The Effect of Additional Debt on FCF
10

 Additional debt increases the probability of

bankruptcy.
 Direct costs: Legal fees, “fire” sales, etc.
 Indirect costs: Lost customers, reduction in
productivity of managers and line workers,
reduction in credit (i.e., accounts payable) offered
by suppliers
 Effect of additional debt on Agency costs
11

 Additional debt can affect the behavior of

managers.
 Reductions in agency costs: debt “pre-commits,”
or “bonds,” free cash flow for use in making
interest payments. Thus, managers are less likely
to waste FCF on perquisites or non-value adding
acquisitions.
 Increases in agency costs: debt can make managers
too risk-averse, causing “underinvestment” in risky
but positive NPV projects.
 Asymmetric Information and
12
Signaling
• Managers know the firm’s future prospects better
than investors.
• Managers would not issue additional equity if they
thought the current stock price was less than the true
value of the stock (given their inside information).
• Hence, investors often perceive an additional
issuance of stock as a negative signal, and the stock
price falls.
Business and Financial Risks
• Two dimensions of risk:
(1) business risk – the riskiness of the firm’s
stock if it uses no debt
(2) financial risk – the additional risk
placed on the common stockholders as a
result of the firm’s decision to use debt
 Cont’d…
• The firm has a certain amount of risk inherent
in its operations: this is its business risk
• If a firm uses debt, it partitions its investors
into two groups and concentrates most of its
business risk on one class of investors—the
common stockholders
• However, the common stockholders will demand
compensation for assuming more risk and thus
require a higher rate of return
Cont’d…
• Business risk can be measured by the
standard deviation of its ROIC, σ R O I C
• Business risk depends on a number of factors:
◦ Demand variability
◦ Sales price variability
◦ Input cost variability
◦ Foreign risk exposure
 Cont’d…
• Ability to adjust output prices for changes in input
costs
• Ability to develop new products in a timely, cost-
effective manner
• The extent to which costs are fixed: operating
leverage (high percentage of fixed costs)
• The mixture of fixed and variable costs depends
largely on the type of business
General Income Statement Format and Types of
Leverage
 Operating Risk and Leverage
• The risk that comes from the mix of fixed
and variable costs is referred to as operating
risk
• The greater the fixed operating cost relative to
variable operating costs, the greater the operating risk
• How do operating risk affects cash flow risk, or
how sensitive a firm’s operating cash flows are
to changes in demand?
 Cont’d….
 The degree of operating leverage (DOL)
reflects the elasticity of the operating cash flows
 DOL is the ratio of the % change in operating
cash flows to the % change in units sold.
 A high degree of operating leverage, other
factors held constant, implies that a relatively small
change in sales results in a large change in EBIT.
 The higher a firm’s fixed costs, the greater will be
its operating leverage
 Higher fixed costs are generally associated with more
highly automated, capital intensive firms and industries
Cont’d…
Cont’d…
Question:
• How much do operating cash flows change
when the number of units sold changes.

Answer:
• It changes by the contribution margin per
unit times the change in units sold
Example
 Suppose the price per unit is $30, the variable
cost per unit is $20, and the total fixed costs are
$5,000. If we go from selling 1,000 units to
selling 1,500 units, an increase of 50% of the units
sold, operating cash flows change from:
Cont’d…
• Operating cash flows doubled when
units sold increased by 50% - for any 1%
change in units sold, the operating cash
flow changes by 2% (in the same direction)
The percentage change in operating
cash flows for a given change in units sold
is:
Cont’d…
 Thus, the sensitivity to change in units sold
from 1,000 units is:

 DOL of 2.0 means that a 1% change in units

sold results in a 1% × 2.0 = 2% change in
operating cash flow
Cont’d…
• DOL is sensitive to the number of units
produced and sold
• it will be different at different no. of units
sold
Operating Break-even

• Operating breakeven occurs when EBIT = 0

• where
◦ P is average sales price per unit of output
◦ Q is units of output
◦ V is variable cost per unit
◦ F is fixed operating costs
Cont’d…
• Break-even quantity obtained as:

where
◦ P = average sales price per unit of output
◦ V = variable cost per unit
◦ F = fixed operating costs (total)
Example
 Suppose a company is evaluating the riskiness of
two alternative plans, and the following data is
available regarding each plan: Which plan is more
riskier (with higher operating leverage)?
Solution
 Financial Risk and Leverage
• Financial risk is the additional risk placed on the
common stockholders as a result of the decision to
finance with debt.
• If a firm uses debt, this concentrates the business
risk on common stockholder.
• The concentration of business risk occurs because debt
holders, who receive fixed interest payments, bear none
of the business risk.
• Financing with debt increases the expected rate of
return for an investment, but debt also increases the
riskiness of the investment to the common
Cont’d…
Financial leverage raises the expected ROE, but it
also increases the risk of the investment as reflected
in the increase in standard deviation and increase in
coefficient of variation.
Using leverage has both good and bad effects: higher
leverage increases expected ROE, but it also
increases risk.
Degree of Financial Leverage

%  in EPS
DFL 
%  in EBIT
EBIT
=
EBIT - I

• Note: If interest expense = 0, DFL = 1.0 (i.e., without

any debt financing, the % change in EPS would be
equal to the % change in EBIT). By incurring interest
expense (debt financing) the firm’s % change in EPS
will be greater than the % change in EBIT.
Question
 Determine the formula for Financial break-even.
 Question
 Maynard, Inc., has no debt outstanding and a total market value of 250,000$. EBIT are
projected to be 28,000$ if economic conditions are normal. If there is strong expansion
in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT
will be 50 percent lower. Maynard is considering a 90,000$ debt issue with a 7 percent
interest rate. The proceeds will be used to repurchase a share of stock. There are
currently 5,000 shares outstanding. Ignore taxes for this problem

A. a) Calculate EPS under each of the three economic scenarios before any debt is
issued. Also calculate the percentage changes in EPS when the economy expands or
enters a recession.

B. B) Repeat part (a) assuming that the economy goes with recapitalization. What do
you observe?
Question
 James Corporation is comparing two different capital structures: an all
equity plan (plan I) and a levered plan (plan II). Under plan I, the
company would have 160,000 shares of stock outstanding. Under plan
II, there would be 80,000 shares of stock outstanding and 2.8$ million
in debt outstanding. The interest rate on the debt is 8 percent and there
are no taxes.

A. If EBIT is 350,000$, which plan will result in the higher EPS?

B. If EBIT is 500,000$, which plan will result in the higher EPS?

C. What is the break-even EBIT?

 Capital Structure Theory
• There are different theories regarding capital structure
decisions
• Modern capital structure theory began in 1958, when Professors
Franco Modigliani and Merton Miller (hereafter MM) published
what has been called the most influential finance article ever
written, ‘The Cost of Capital, Corporation Finance, and the
Theory of Investment.”
• MM (1958) reasoned that if the following conditions hold, the
value of the firm is not affected by its capital structure:
1). There are no brokerage costs
2). There are no taxes (hence no tax advantage associated with debt
financing relative to equity financing … this isolates the effect of
financial leverage)
Cont’d…
3). There are no bankruptcy costs.
4). Investors can borrow at the same rate as
corporations
Therefore, if individuals are seeking a given level of
risk, they can either
a). borrow or lend on their own, or
b). invest in a business that borrows or lends
Cont’d…
• In other words, if an individual wants to increase
the risk of his/her investment, he/she could:
• invest in a company that uses debt to finance its
assets or
• invest in a firm with no financial leverage and take
out a personal loan—increasing his/her own
financial leverage (home made leverage)
Cont’d…
5). All investors have the same information as
management about the firm’s future investment
opportunities.
6). EBIT is not affected by the use of debt
If these assumptions hold true, MM proved that a
firm’s value is unaffected by its capital structure
Therefore, the following condition will take place.
Analysis of the MM Theory
• MM developed the basic framework
for the analysis of capital structure and
the effect of taxes.
 Proposition I – firm value
 Proposition II – WACC
• The value of the firm is determined by
the cash flows to the firm and the risk of
the assets
Cont’d…
• At the end, the following scenario will taka place

where:
 VL is the value of a levered firm, which is equal to VU

(the value of an identical but unlevered firm)

 SL is the value of the levered firm’s stock, and

 D is the value of its debt.

MM Theory under three Special Cases

 Case I – Assumptions
 No corporate or personal taxes

 No bankruptcy costs

 Case II – Assumptions
 Corporate taxes, but no personal taxes

 No bankruptcy costs

 Case III – Assumptions

 Corporate taxes, but no personal taxes

 Bankruptcy costs
Cont’d…
 The proposition that the value of the firm is
independent of the firm’s capital structure.
THE PIE MODEL
 One way to illustrate M&M Proposition I is to

imagine two firms that are identical on the left side

of the balance sheet.
 Their assets and operations are exactly the same.

The right sides are different because the two firms

finance their operations differently.
Cont’d…
 we can view the capital structure question in terms
of a “pie” model.
Cont’d…
 gives two possible ways of cutting up the pie
between the equity slice, E , and the debt slice, D :
40%–60% and 60%–40%.
 However, the size of the pie in Figure is the same
for both firms because the value of the assets is the
same.
 This is precisely what M&M Proposition I states:
The size of the pie doesn’t depend on how it is
sliced.
Case I – Propositions I and II
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

doesn’t change
Proposition II
• The WACC of the firm is NOT affected by capital structure

• The main point with case I is that it doesn’t matter how we

divide our cash flows between our stockholders and

bondholders, the cash flow of the firm doesn’t change. Since
the cash flows don’t change; and we haven’t changed the risk
of existing cash flows, the value of the firm won’t change.
Cont’d…
• When there are no taxes, the cost of equity to a
levered firm, ReL, is equal to:
(1) the cost of equity to an unlevered firm in the

same risk class, ReU, plus. Since RA= ReU,

(2) a risk premium whose size depends on both the

difference between an unlevered firm’s costs of

debt and equity and the amount of debt used.
(RA – RD)(D/E)
Case I - Equations
WACC = RA = (E/V)RE + (D/V)RD

RE = RA + (RA – RD)(D/E)

• RA is the “cost” of the firm’s business risk, i.e., the

risk of the firm’s assets
• (RA – RD)(D/E) is the “cost” of the firm’s financial
risk, i.e., the additional return required by
stockholders to compensate for the risk of leverage
 Figure 4.2
49
 Case I - Example
50
 Data
 Required Rate of return on assets = 16%, cost of debt =
10%; percent of debt = 45%
 What is the cost of equity?
 RE = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91%

Suppose instead that the cost of equity is 25%, what is

the debt-to-equity ratio?
Cont’d…
Solution
.25 = .16 + (.16 - .10)(D/E)
D/E = (.25 - .16) / (.16 - .10) = 1.5
 Based on this information, what is the
percent of equity in the firm?
E/V = 1 / 2.5 = 40%
 Cont’d…
• Remember, that if the firm is financed with 45% debt, then it is financed
with 55% equity.
• The way to compute the D/E ratio is % debt / (1-%debt)
• Assuming that Required Return on Asset (RA) does not change when the
capital structure changes, how to get the % of equity from the D/E ratio?
• Remember that D+E = V. We are looking at ratios, so the actual $ amount
of D and E is not important.
• So, let E = 1. Then D/1 = 1.5; Solve for D; D = 1.5.
• Then V = 1 + 1.5 = 2.5 and the percent equity is 1 / 2.5 = 40%.
• The choice of E = 1 is for simplicity.
it doesn’t matter what you set E equal to, as long as you keep the
relationships in tact.
So, let E = 5; then D/5 = 1.5 and D = 5(1.5) = 7.5; V = 5 + 7.5 = 12.5 and
E/V = 5 / 12.5 = 40%.
Case II – Cash Flow
 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?
Case II - Example
Interest Tax Shield
 Annual interest tax shield
 Tax rate times interest payment.
 6,250 in 8% debt = 500 in interest expense
 Annual tax shield = .34(500) = 170
 Present value of annual interest tax shield
 Assume perpetual debt for simplicity
 PV = 170 / .08 = 2,125
 PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125
Other Example
 Cont’d…

We see from the result that capital structure has some effect because the cash
flow from U and L is not the same, even thought the two firms have identical
assets.

The fact that interest is deductible for tax purposes has generated a tax saving = interest
payment ($80) * tax rate (0.30) = $24 = interest tax shield
Case II – 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
 Value of equity = Value of the firm – Value of debt
 Assuming perpetual cash flows
 VU = EBIT(1-T) / RU
 VL = VU + DTC
Example: Case II – Proposition I
 Data
EBIT = 25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%
VU = EBIT(1-T) / RU
 VU = 25(1-.35) / .12 = $135.42 million

VL = VU + DTC
 VL = 135.42 + 75(.35) = $161.67 million
 E = 161.67 – 75 = $86.67 million
 Figure 4.3
60
Case II – Proposition II
 The WACC decreases as D/E increases because of
the government subsidy on interest payments
 Wacc = RA = (E/V)RE + (D/V)(RD)(1-TC)
 RE = RU + (RU – RD)(D/E)(1-TC)
 Example
 RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
 RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35)
RA = 10.05%
Example: Case II – Proposition II
 Suppose that the firm changes its capital structure so
that the debt-to-equity ratio becomes 1.
 What will happen to the cost of equity under the new
capital structure?
 RE = 12 + (12 - 9)(1)(1-.35) = 13.95%
 What will happen to the weighted average cost of
capital?
 RA = .5(13.95) + .5(9)(1-.35) = 9.9%
 Figure 4.4
63
Case III
 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
Bankruptcy Costs
 Direct costs
 Legal and administrative costs
 Ultimately cause bondholders to incur additional
losses
 Disincentive to debt financing
 Financial distress
 Significant problems in meeting debt obligations
 Firms that experience financial distress do not
necessarily file for bankruptcy
More Bankruptcy Costs
 Indirect bankruptcy costs
 Larger than direct costs, but more difficult to measure and
estimate
 Stockholders want to avoid a formal bankruptcy filing
 Bondholders want to keep existing assets intact so they can
at least receive that money
 Assets lose value as management spends time worrying
about avoiding bankruptcy instead of running the business
 The firm may also lose sales, experience interrupted
operations and lose valuable employees
 Figure 4.5.
67
 Figure 4.6.
68
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
is just offset by the increase in expected bankruptcy costs
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
 Figure 4.7
71
 Bankruptcy Process – Part I
72

 Business failure – business has terminated with a

loss to creditors
 Legal bankruptcy – petition federal court for
bankruptcy
 Technical insolvency – firm is unable to meet debt
obligations
 Accounting insolvency – book value of equity is
negative
 Bankruptcy Process – Part II
73

 Liquidation
 Trustee takes over assets, sells them and distributes the
proceeds according to the absolute priority rule
 Reorganization
 Restructure the corporation with a provision to repay
creditors
End of Chapter

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