Tài chính doanh nghiệp - Chapter 13: Leverage and capital structure

Leverage and Capital StructureChapter 130Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerKey Concepts and SkillsUnderstand the effect of financial leverage on cash flows and cost of equityUnderstand the impact of taxes and bankruptcy on capital structure choiceUnderstand the basic components of bankruptcy1Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerChapter OutlineThe Capital Structure QuestionThe Effect of Financial LeverageCapital Structure and the Cost of Equity CapitalCorporate Taxes and Capital StructureBankruptcy CostsOptimal Capital StructureObserved Capital Structures2Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCapital RestructuringWe are going to look at how changes in capital structure affect the value of the firm, all else equalCapital restructuring involves changing the amount of leverage a firm has without changing the firm’s assetsIncrease leverage by issuing debt and repurchasing outstanding sharesDecrease leverage by issuing new shares and retiring outstanding debt3Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerChoosing a Capital StructureWhat is the primary goal of financial managers?Maximise shareholder wealthWe want to choose the capital structure that will maximise shareholder wealthWe can maximise shareholder wealth by maximising firm value or minimising WACC4Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe Effect of LeverageHow does leverage affect the EPS and ROE of a firm?When we increase the amount of debt financing, we increase the fixed interest expenseIf we have a really good year, then we pay our fixed cost and we have more left over for our shareholdersIf we have a really bad year, we still have to pay our fixed costs and we have less left over for our shareholdersLeverage amplifies the variation in both EPS and ROE5Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Financial Leverage, EPS and ROEWe will ignore the effect of taxes at this stageWhat happens to EPS and ROE when we issue debt and buy back shares?6Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Financial Leverage, EPS and ROEVariability in ROECurrent: ROE ranges from 6.25% to 18.75%Proposed: ROE ranges from 2.50% to 27.50%Variability in EPSCurrent: EPS ranges from $1.25 to $3.75Proposed: EPS ranges from $0.50 to $5.50The variability in both ROE and EPS increases when financial leverage is increased7Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBreak-Even EBITFind EBIT where EPS is the same under both the current and proposed capital structuresIf we expect EBIT to be greater than the break-even point, then leverage is beneficial to our shareholdersIf we expect EBIT to be less than the break-even point, then leverage is detrimental to our shareholders8Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Break-Even EBIT9Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerExample: Homemade Leverage and ROECurrent Capital StructureInvestor borrows $2000 and uses $2000 of their own to buy 200 sharesPayoffs:Recession: 200(1.25) - .1(2000) = $50Expected: 200(2.50) - .1(2000) = $300Expansion: 200(3.75) - .1(2000) = $550Mirrors the payoffs from purchasing 100 shares from the firm under the proposed capital structureProposed Capital StructureInvestor buys $1000 worth of shares (50 shares) and $1000 worth of Trans Am bonds paying 10%.Payoffs:Recession: 50(.50) + .1(1000) = $125Expected: 50(3.00) + .1(1000) = $250Expansion: 50(5.50) + .1(1000) = $375Mirrors the payoffs from purchasing 100 shares under the current capital structure10Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCapital Structure TheoryModigliani and Miller Theory of Capital StructureProposition I – firm valueProposition II – WACCThe value of the firm is determined by the cash flows to the firm and the risk of the assetsChanging firm valueChange the risk of the cash flowsChange the cash flows11Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCapital Structure Theory Under Three Special CasesCase I – AssumptionsNo corporate or personal taxesNo bankruptcy costsCase II – AssumptionsCorporate taxes, but no personal taxesNo bankruptcy costsCase III – AssumptionsCorporate taxes, but no personal taxesBankruptcy costs12Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase I – Propositions I and IIProposition IThe value of the firm is NOT affected by changes in the capital structureThe cash flows of the firm do not change, therefore value doesn’t changeProposition IIThe WACC of the firm is NOT affected by capital structure13Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase I – EquationsWACC = RA = (E/V)RE + (D/V)RDRE = 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 leverage14Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase I – ExampleDataRequired 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?.25 = .16 + (.16 - .10)(D/E)D/E = (.25 - .16) / (.16 - .10) = 1.5Based on this information, what is the percent of equity in the firm?E/V = 1 / 2.5 = 40%15Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 13.316Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerThe CAPM, the SML and Proposition IIHow does financial leverage affect systematic risk?CAPM: RA = Rf + A(RM – Rf)Where A is the firm’s asset beta and measures the systematic risk of the firm’s assetsProposition IIReplace RA with the CAPM and assume that the debt is riskless (RD = Rf)RE = Rf + A(1+D/E)(RM – Rf)17Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBusiness Risk and Financial RiskRE = Rf + A(1+D/E)(RM – Rf)CAPM: RE = Rf + E(RM – Rf)E = A(1 + D/E)Therefore, the systematic risk of the share depends on:Systematic risk of the assets, A (Business risk)Level of leverage, D/E (Financial risk)18Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase II – Cash FlowsInterest is tax deductibleTherefore, when a firm adds debt, it reduces taxes, all else equalThe reduction in taxes increases the cash flow of the firmHow should an increase in cash flows affect the value of the firm?19Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase II – ExampleUnlevered FirmLevered FirmEBIT50005000Interest0500Taxable Income50004500Taxes (30%)15001350Net Income35003150CFFA3500365020Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerInterest Tax ShieldAnnual interest tax shieldTax rate times interest payment6250 in 8% debt = 500 in interest expenseAnnual tax shield = .30(500) = 150Present value of annual interest tax shieldAssume perpetual debt for simplicityPV = 150 / .08 = 1875PV = D(RD)(TC)/RD = DTC = 6250(.30) = 187521Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase II – Proposition IThe value of the firm increases by the present value of the annual interest tax shieldValue of a levered firm = value of an unlevered firm + PV of interest tax shieldValue of equity = Value of the firm – Value of debtAssuming perpetual cash flowsVU = EBIT(1-T)/RUVL = VU + DTC22Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase II – Proposition I Cont.DataEBIT = $25 million; Tax rate = 30%; Debt = $75 million; Cost of debt = 9%; Unlevered cost of capital = 12%VU = 25(1-.30) / .12 = $145.83 millionVL = 145.83 + 75(.30) = $168.33 millionE = 168.33 – 75 = $93.33 million23Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 13.424Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase II – Proposition IIThe WACC decreases as D/E increases because of the government subsidy on interest paymentsRA = (E/V)RE + (D/V)(RD)(1-TC)RE = RU + (RU – RD)(D/E)(1-TC)ExampleRE = .12 + (.12-.09)(75/86.67)(1-.35) = 13.69%RA = (86.67/161.67)(.1369) + (75/161.67)(.09)(1-.35)RA = 10.05%25Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase II – Proposition II Cont.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 - .09)(1)(1-.35) = 13.95%What will happen to the weighted average cost of capital?RA = .5(.1395) + .5(.09)(1-.35) = 9.9%26Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerIllustration of Proposition II27Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerCase IIINow we add bankruptcy costsAs the D/E ratio increases, the probability of bankruptcy increasesThis increased probability will increase the expected bankruptcy costsAt some point, the additional value of the interest tax shield will be offset by the expected bankruptcy costAt this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added28Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBankruptcy CostsDirect costsLegal and administrative costsUltimately cause debtholders to incur additional lossesDisincentive to debt financingFinancial distressSignificant problems in meeting debt obligationsMost firms that experience financial distress do not ultimately end up in bankruptcy29Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerMore Bankruptcy CostsIndirect bankruptcy costsLarger than direct costs, but more difficult to measure and estimateShareholders wish to avoid a formal bankruptcy filingDebtholders want to keep existing assets intact so they can at least receive that moneyAssets lose value as management spends time worrying about avoiding bankruptcy instead of running the businessAlso have lost sales, interrupted operations and loss of valuable employees30Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 13.5= Value of firm with debt31Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerConclusionsCase I – no taxes or bankruptcy costsNo optimal capital structureCase II – corporate taxes but no bankruptcy costsOptimal capital structure is 100% debtEach additional dollar of debt increases the cash flow of the firmCase III – corporate taxes and bankruptcy costsOptimal capital structure is part debt and part equityOccurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs32Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerFigure 13.633Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerAdditional Managerial RecommendationsRisk of financial distressThe greater the risk of financial distress, the less debt will be optimal for the firmThe cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industryDividend imputation has a bearing on the use of debt and it will depend if the firm’s shareholders are able to use the franking credits34Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerObserved Capital StructureCapital structure does differ by industry35Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerBankruptcy ProcessBusiness failure – business has terminated with a loss to creditorsLegal bankruptcy – petition federal court for bankruptcyTechnical insolvency – firm is unable to meet debt obligationsAccounting insolvency – book value of equity is negative36Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan TraylerQuick QuizExplain the effect of leverage on EPS and ROEWhat is the break-even EBIT?How do we determine the optimal capital structure?What is the optimal capital structure in the three cases that were discussed in this chapter?What is the difference between liquidation and reorganisation?37Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance by Ross, Trayler, Bird, Westerfield & JordanSlides prepared by Rowan Trayler