Topic 11 - Financial Leverage And Capital Structure

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This article is a topic within the subject Business Finance.

Contents

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 399-428.

To maximise firm value, we need to minimise the WACC (choosing the optimal capital structure).

Financial Leverage

[1] Financial Leverage is the extent to which a company is committed to fixed charges related to interest payments. Capital Structure is the mix of debt & equity that makes up a company’s total market value.

The Effect of Financial Leverage – Example

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We conclude that the effect of financial leverage depends on EBIT;

  • When EBIT is High, financial leverage raises ROE & EPS (Earnings Per Share)
  • When EBIT is Low, financial leverage lowers ROE & EPS

Thus, a higher leveraged firm as higher highs & lower lows than a low leverage firms, & the variability of ROE & EPS increases with financial leverage. Overall, financial leverage amplifies the effect of changes in EBIT (more sensitive) on ROE & EPS. Using more debt makes ROE/EPS more risky. However, capital structure may not be a vital decision due to homemade leverage.

Corporate Borrowing And Homemade Leverage

Homemade Leverage is the use of personal borrowing/lending to change the overall amount of financial leverage to which the individual is exposed.

Suppose the firms didn’t leverage is capital structure. An investor can still replicate the returns from the leveraged structure. If an investor wants to invest $100 and prefers the leveraged structure, he would buy 5 shares with his own money & 5 shares with borrowed money at 10%.

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If investors can borrow/lend at the same rate as the corporation (perfect capital markets), than homemade leverage can be used to alter capital structure to attain the same CF’s that the firm would with any capital structure. Therefore, investors are indifferent to changes in the firm’s capital structure & its share price should be the same regardless of capital structure.

Modigliani & Miller (M&M) Proposition 1

[2]

Assumptions

  1. No Taxes
  2. Perfect Capital Markets (No Capital Market Imperfections)
  3. Firm’s Cash Flows are Independent of Financing (Capital Structure)

Proposition

The size of the pie (assets/value) does not depend on how it is sliced (debt/equity).

FINS1613113.jpgThe value of the firm is independent of its capital structure (WACC is constant).

Understanding

Consider 2 firms with the same operating income of $X each year. Firm L is levered & Firm U is unlevered.

FINS1613114.jpg

Leverage increases both the risk & expected return on equity. However, it does not affect the risk of the firm’s cash flows.

Modigliani & Miller (M&M) Proposition 2

[3]

Unlevered Firm

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Levered Firm

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Intuition

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Because leverage does not affect the riskiness of a firms cash flows, so the firm’s business risk is unaffected by leverage

M&M 2 – Assumptions

  1. No Corporate Taxes
  2. 0 Probability of Bankruptcy

FINS1613118.jpg

Proposition

A firms cost of equity capital is a positive linear function of its capital structure. As the Debt/Equity ratio increases:

FINS1613119.jpg

The cost of equity for a firm & Beta reflects:

  • Business Risk – cost structure or operating leverage (systematic risk of the firm’s assets)
  • Financial Risk – financial leverage

Note on Riskless Debt

FINS16131110.jpg

Understanding M&M Proposition 1 & 2

M&M 1 (Value of Unlevered Firm (Vu) = Value of Levered Firm (VL)) is reflected in the fact that WACC is independent of the D/E ratio. Capital structure is irrelevant.

Intuition

Given that the cash flows do not depend on D/E, the market value is independent of D/E only if the cost of capital (WACC) used to discount those cash flows is also independent of the D/E ratio.

M&M 2 is reflected in the positive linear slope of R_E (business+financial risk) in relation to the D/E ratio. WACC is unchanged as the lower weight given to equity offsets increases in R_E

FINS16131115.jpg

Conclusion

M&M Propositions suggest capital structure does not matter in perfect capital markets with no taxes or bankruptcy costs.

M&M Propositions – Introducing Taxes

[4] Interest expenses are tax deductible against income. So debt increases cash flows available to the firm’s stakeholders.

FINS16131111.jpg

Conclusion 2

According to M&M 1 & 2 with taxes & without bankruptcy, debt increases firm value as it decreases WACC.

FINS16131112.jpg

M&M Propositions – Introducing Bankruptcy Costs

[5] As the D/E ratio rises, the probability of being unable to repay debt obligations increases

  • Direct Bankruptcy Costs – directly associated with bankruptcy e.g. legal & admin expenses
  • Indirect Bankruptcy Costs – difficulties of running a firm in distress e.g. damaged reputation, employees leave

Trade-Off Theory

As D/E increases, probability & cost of financial distress increases. Hence the optimal capital structure is the D/E level where an incremental increase in the PV of the tax shield from borrowing an additional dollar is just offset by the incremental increase in the PV of financial distress costs. This minimises WACC to maximise value.

FINS16131113.jpg

Firms with other tax shields e.g. depreciation will benefit less from the tax shield & a firm will greater risk of financial distress should borrow less.

Empirical data suggests firms are generally underleveraged. This could be because some firms are not as profitable and don’t benefit from an interest tax shield, other tax shields are available (e.g. depreciation), and the dividend imputation system weakens the benefit of debt over equity

Summary

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End

This is the end of this topic. Click Business Finance to go back to the main subject page for Business Finance

References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.

  1. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 400-403
  2. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 405-407
  3. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 405-407
  4. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 408-411
  5. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 412-417
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