Financial Leverage and Capital Structure Policy

Learning Objectives

• Connect the value of the firm to stockholder wealth

• Understand the effect of financial leverage

• Apply Modigliani & Miller’s Propositions I and II with and without taxes

• Explain costs of financial distress

• Describe the static (trade-off) theory of capital structure

• Differentiate between marketed and non-marketed claims on a firm’s cash flows (CFs)

• Explain the pecking order theory of capital structure

• Summarize findings on capital structures among U.S. corporations

• Describe the bankruptcy process and the hierarchy of claims

Capital Structure Decision

• Debt-Equity Ratio: Considered essential for optimizing the firm's capital structure to maximize firm value.

  • Capital restructuring involves adjusting the firm’s debt-equity ratio.

  • Optimal capital structure maximizes the value to shareholders.

  • Debt as a fixed cost effects on the firm’s NPV.

Weighted Average Cost of Capital (WACC)

• WACC Definition: The firm's overall cost of capital, a weighted average of costs of various components.

  • WACC minimizes at the point where firm value is maximized.

  • Decision-making: selecting capital structure to minimize WACC leads to optimal .

Financial Leverage Basics

• Financial Leverage: Extent a firm uses debt over equity.

  • Higher leverage magnifies gains/losses for shareholders.

• Example: Firm evaluates the impact of debt vs. equity on its Earnings Before Interest and Taxes (EBIT) results.

EPS vs. EBIT Impact

• Financial leverage magnifies shareholders’ gains and losses, increasing EPS sensitivity compared to EBIT changes.

• Example: Increase in EBIT from $400,000 raises EPS by $2 due to financial leverage.

Break-Even EBIT Calculation

• Example: MPD Corporation restructures with $1M debt at a 9% interest rate; need to identify the minimum EBIT for increased EPS.

• Calculation using:

  • Old structure: EPS = EBIT/200,000

  • New structure: EPS = (EBIT - $90,000)/150,000

  • Solving gives a break-even EBIT of $360,000.

  • $3,950 as EBIT leads to a consistent EPS across structures.

Financial Leverage Considerations

• The effectiveness of leverage depends considerably on the firm's EBIT level.

• Higher leverage can offer greater returns in favorable conditions but increases risks of insolvency in poor performance.

Modigliani & Miller (M&M) Propositions

• M&M Proposition I: Firm value is unchanged regardless of capital structure; WACC remains constant if firm states identical assets.

• M&M Proposition II: Cost of equity increases with leverage; indicated as a linear function of the debt-equity ratio.

Risk Components

• Business Risk (RA): Risk based on the firm's operational nature, not affected by capital structure.

• Financial Risk: Increased due to heightened financial leverage as seen in changes to cost of equity.

The Impact of Corporate Taxes on Capital Structure

• Interest Tax Shield: Deductibility of interest reduces taxable income, increasing firm value.

• Levered firm example: Analysis of EBIT and calculations illustrate how the tax shield works.

WACC under Tax Conditions

• With corporate taxes, WACC functions as:
  WACC = \frac{E}{V} \times RE + \frac{D}{V} \times RD \times (1 - TC)

• Observing how debt can increase firm value due to tax costs.

Bankruptcy Process Overview

• Bankruptcy: Legal process for dealing with insolvency; includes liquidation and reorganization.

  • Liquidation: Termination with asset sales to pay creditors.

  • Reorganization: Attempting to restructure financial obligations while continuing operations.

• Priority of Claims in a liquidation:

  1. Administrative costs

  2. Other expenses

  3. Wages and salaries

  4. Benefits

  5. Tax claims

  6. Unsecured creditors

Indirect Bankruptcy Costs

• Damage from financial distress involves costs to maintain business operations and avoid bankruptcy.

  • Disrupt normal operations and decrease value, potentially even if a firm does not file for bankruptcy.

Static Theory of Capital Structure

• This model evaluates the point where the marginal benefit of the tax shield equals the marginal cost of financial distress.

• Illustrates the balance between taking on debt for tax benefits and the risks of bankruptcy costs.

Optimal Capital Structure

• The goal is to maximize the interest tax shield and minimize bankruptcy/distress costs; reflects dynamic financial strategies.

Pecking Order Theory

• Firms prefer using internal financing over debt or equity; this approach helps reduce costs associated with issuing securities.

• Implies firms have no set target capital structure but adjust financing according to immediate funding needs.

Observed Capital Structures in U.S. Firms

• Most U.S. corporations have lower debt-equity ratios reflective of their operational environments and risks.

• Industry-specific trends in capital structure types illustrate that firms tend to follow sector norms.

Summary of M&M with and without Taxes

1. M&M I (without taxes) = Capital structure irrelevant; WACC unchanged.

2. M&M II (with taxes): Value of levered firm increases with more debt, suggesting optimal may lean to 100% debt, effectively altering WACC.

Managerial Recommendations on Capital Structure

• Consider tax benefits against financial distress risks while contemplating optimal debt levels.

• Factor in specific firm characteristics like asset liquidity and industry norms as critical components in the capital structure decision process.

Connect the value of the firm to stockholder wealth:

1. The capital structure that maximizes the value of the firm also maximizes the stockholder value.

2. The optimal capital structure is defined as the Debt-to-Equity ratio that minimizes WACC.

3. The value of the firm is maximized when the WACC is minimized because a lower WACC indicates that the firm can finance its operations more cheaply, thus increasing overall firm value.

Understand the effect of financial leverage:

1. Financial leverage is the extent to which the firm relies on debt.

2. Financial leverage magnifies gains and losses to shareholders by increasing earnings per share (EPS), return on equity (ROE), and influencing Earnings Before Interest and Taxes (EBIT).

Recall and apply Modigliani & Miller’s Propositions I and II with no taxes:

1. Proposition I (without taxes): The value of the levered firm equals the value of the unlevered firm because as the firm adds debt, the increase in the cost of equity offsets the proportion financed with lower-cost debt, keeping firm value unchanged.

2. Proposition II (without taxes): As leverage increases, the risk and required return of equity rises due to business risk (operational) and financial risk (debt related).

Recall and apply Modigliani & Miller’s Propositions I and II with taxes:

1. The value of the levered firm equals the value of the unlevered firm plus the present value of the interest tax shield.

2. With taxes, the required return on equity rises with leverage, but slightly decreases due to the existence of the tax shield.

Explain the costs of financial distress:

1. Direct bankruptcy costs refer to the financial outlays, such as legal fees during bankruptcy proceedings.

2. Indirect bankruptcy costs can include loss of customers, damage to reputation, and operational disruptions, which can persist even if bankruptcy is avoided.

Explain the static (trade-off) theory of capital structure:

1. This theory evaluates the balance where the marginal benefit of the tax shield equals the marginal cost of financial distress, considering WACC, total debt, and the debt-to-equity ratio.

2. Various factors such as state income taxes and likelihood of financial distress influence capital structure decisions.

Explain the difference between marketed and unmarketed claims on a firm’s cash flows:

1. Marketed claims are those that can be traded in financial markets, while unmarketed claims, like certain employee benefits, cannot.

2. Claims included in the firm’s value consist of marketed claims, which can impact overall firm value and optimal capital structure depending on the presence of unmarketed claims.

Explain the pecking order theory of capital structure:

1. Managers prefer using internal financing over external financing, followed by debt and then equity.

2. Key implications include the absence of a target capital structure, less debt used by profitable firms, and a desire for financial slack to maintain operational flexibility.

Summarize findings on capital structures among U.S. corporations, which show variations reflecting industry standards and operational risks.
Describe the bankruptcy process and the priority of claims:

1. Types of financial distress include liquidity issues and insolvency.

2. The Chapter 7 liquidation process involves asset sales to satisfy creditors.

3. The Chapter 11 reorganization process aims to restructure debts while continuing operations.