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Chapter 13
Leverage and Capital
Structure # IRTEBE

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Key Concepts and Skills
, REEnt
After studying this chapter, you should be able to:AGSE
RE
• Discuss the effect of financial leverage. Debt Ratio (Ett)
• Analyze the impact of taxes and bankruptcy on capital
structure choice. Dcorporate tax &YE B&
=> FR

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• Identify the essentials of the bankruptcy process.
*
/
EF'n Et Xt
↑
ME ERK/N

© McGraw Hill, LLC 3

 Chapter Outline
13.1 The Capital Structure Question.
13.2 The Effect of Financial Leverage.
13.3 Capital Structure and the Cost of Equity Capital.
13.4 Corporate Taxes and Capital Structure.
13.5 Bankruptcy Costs.
13.6 Optimal Capital Structure.
13.7 Observed Capital Structures.
13.8 A Quick Look at the Bankruptcy Process.

© McGraw Hill, LLC 4

 ****
&
Capital Structure
E Stock holders

Capital structure = Percent of debt and equity used to fund

the firm’s assets.
• “Leverage” = Use of debt in capital structure."IE
Capital restructuring = Changing the amount of leverage
Loading…
without changing the firm’s assets. E 221 ELEY
• Increase leverage by issuing debt and repurchasing
,
.

outstanding shares. F . UXAT5tA

• Decrease leverage by issuing new shares and retiring

outstanding debt. Deleverage F EEEEE YJHAS
, .

&
(* ]

3 F
A
© McGraw Hill, LLC 5
 Capital Structure & Shareholder Wealth
The primary goal of financial managers:
• Maximize stockholder wealth.
Maximizing shareholder wealth =
D• Maximizing firm value.
• Minimizing WACC.
& tipil - DORFE

Objective: Choose the capital structure that will minimize

WA CC and maximize stockholder wealth.
C

© McGraw Hill, LLC 6

 The Effect of Financial Leverage
RAFET . BRA
“Financial leverage” = Use of debt.
E GREE ASE FREEBisH
G Leverage amplifies the variation in both EPS and ROE.
&

We will ignore the effect of taxes at this stage.* F

What happens to EPS and ROE when we issue debt and
buy back shares of stock?

© McGraw Hill, LLC 7

 Trans Am Corporation Example
Table 13.1 Current and Proposed Capital Structures for the Trans Am
Corporation.
Debt ratio 0 % Debt ratio 50 %

Current Proposed
Assets $8,000,000 $8,000,000
Debt $ 0
& $4,000,000
Equity $8,000,000 $4,000,000
Debt-equity ratio D/E 0 * 1=

Share price $20 $20

Shares outstanding 400,000 200,000
Interest rate 10% 10%

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 Deleverage
>
-
Trans Am Corporation With and Without Debt
=> Hu Fer Y

Table 13.2 Capital Structure Scenarios for the Trans Am Corporation.

Current Capital Structure: No Debt
Recession Expected Expansion
EBIT * $500,000 · TERA $1,000,000 F $1,500,000

· Interest
Net income
0
$500,000 $1,000,000
0
$1,500,000
0

ROE
EPS ⑮ 6.25% A 12.50%
$2 50
18.75%
5) 3 75

li
, .

EPS $1.25 $2.50

Proposed Capital Structure: Debt = $4 million $3.75

( &
Recession Expected Expansion
EBIT $500,000 $1,000,000 $1,500,000 US

i
VS
Interest 400,000 400,000 400,000
Net income $100,000 $ 600,000 47 $1,100,000
47
ROE
© McGraw Hill, LLC
- X2.50% 15.00% 27.50%
$ 51 5 - 9
 Leverage Effects
Variability in ROE.
• Current: ROE ranges from 6.25% to 18.75%.
• Proposed: ROE ranges from 2.50% to 27.50%. E .Risk
range
Variability in EPS.
• Current: EPS ranges from $1.25 to $3.75.
• Proposed: EPS ranges from $.50 to $5.50.
The variability in both ROE and EPS increases when
financial leverage is increased.

Return to Quick Quiz

© McGraw Hill, LLC 10

 Example: Break-Even EBIT EPS = for both
Capital Structures EN50
OGER
% RE

O EBIT
$400,000
=
EBIT − $400,000
200,000 - IEL LETE
⎡ $ 400,000 ⎤
EBIT = ⎢ ⎥ (EBIT − $400,000 )
⎣ 200, 000 ⎦
Loading…
EBIT = 2 × EBIT − 800,000
E EBIT $800
000
EBIT = $800,000
= ,

↑ 05 RE 50 % YPTE FARC
or

$ 800,000 ROE . EPS

EPS = = $2.00
$ 400,000
* 35800 REALAF
LISEE)
,
000 >
-

↓S : 800 , 000
- DIS

© McGraw Hill, LLC 11

 Break-Even EBIT
Figure 13.1 Financial leverage: EPS and EBIT for the Trans Am Corporation

EPS
*** *
------

with debt7
--------
↑
I
↓ with debt P

EBIT
-

# .E
If we expect EBIT to be greater than the break-even point, then leverage is
beneficial to our stockholders.
If we expect EBIT to be less than the break-even point, then leverage is
detrimental to our stockholders.
Access the text alternative for slide images.

© McGraw Hill, LLC 12

 Trans Am Corporation Conclusions
1. The effect of leverage depends on EBIT.
• When EBIT is higher, leverage is beneficial.

1. Under the “Expected” scenario, leverage increases ROE

and EPS.
2. Shareholders are exposed to more risk with more
leverage.
• ROE and EPS are more sensitive to changes in EBIT.

© McGraw Hill, LLC 13

 Example: Homemade Leverage & ROE
TABLE 13.3 Proposed Capital Structure versus Original Capital Structure with Homemade
Leverage
Proposed Capital Structure
Recession Expected Expansion
EPS $ .50 $ 3.00 $ 5.50
Earnings for 100 shares 50.00 300.00 550.00
Net cost = 100 shares at $20 = $2,000
Original Capital Structure and Homemade Leverage
Recession Expected Expansion
EPS $ 1.25 $ 2.50 $ 3.75
Earnings for 200 shares 250.00 500.00 750.00
Less: Interest on $2,000 at 10% 200.00 200.00 200.00
Net
Netcost = 200 shares at $20 − Amount borrowed $= 50.00
earnings $4,000 − 2,000$ =300.00
$2,000 $ 550.00
Conclusion:
• Any stockholder who prefers leverage can create their own “homemade” leverage and
replicate the payoffs.
• Trans Am’s capital structure is irrelevant to shareholders.
© McGraw Hill, LLC 14
 Capital Structure Theory
M& MEE
Modigliani and Miller. 3) ME LEXtIn Jybk.

• M&M Proposition I – The Pie Model.

• M&M Proposition II – WACC.
The value of the firm is determined by the cash flows to the
firm and the risk of the firm’s assets.
• Changing firm value.
• Change the risk of the cash flows.
• Change the cash flows.

© McGraw Hill, LLC 15

 Capital Structure Theory Three Special
Cases P32 n
Case I – Assumptions.
• No corporate or personal taxes. &
Th99
• No bankruptcy costs. AEXTE
Case II – Assumptions.
Case I ,

• Corporate taxes, but no personal taxes. = EN RAFFEDE

*A corporate
• No bankruptcy costs. 100 % LE
TRY 3XE
Case III – Assumptions.
57
• Corporate taxes, but no personal taxes. * to corporate
• Bankruptcy costs. => JE53 TnIYIXE
Return to Quick Quiz

© McGraw Hill, LLC 16

#Case I – Propositions I and II
①
Proposition I. "nt ·
cash flows PI ? JEF3k
• 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. WALL R*% M

• The WACC of the firm is NOT affected by capital structure.

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 Case I – Equations

WACC = RA = (E / V )× RE + (D / V )× RD

RE = RA + (RA − RD )× (D / E )
RA = “Cost” of the firm’s business risk (that is, the risk of the
firm’s assets).
(RA − RD)(D/E) = “Cost” of the firm’s financial risk (that is,
the additional return required by stockholders to compensate
for the risk of leverage).

© McGraw Hill, LLC 18

 M&M Propositions I & II Figure 13.3
Figure 13.3 The cost of equity and the WACC: M&M Propositions I and II
with no taxes

The change in the capital structure weights (E/V and D/V) is exactly
(RE ), so the WACC stays the same.
offset by the change in the cost of equity
Fach Access the text alternative for slide images.

© McGraw Hill, LLC 19

 Business and Financial Risk

RE = RA + (RA − RD )× (D / E )

Business Risk Financial Risk

Proposition II: the systematic risk of the stock depends on:

• Systematic risk of the assets, RA, (business risk).
• Level of leverage, D/E, (financial risk).

© McGraw Hill, LLC 20

 Case II – Corporate Taxes
Interest on debt is tax Tint
deductible.
When a firm adds debt, it reduces taxes, all else equal.
The reduction in taxes increases the cash flow of the firm.
The reduction in taxes reduces net income.

© McGraw Hill, LLC 21

 Case II – Example
It . F
Unlevered Levered
U L
EBIT $1,000 $1,000
Interest $0 D
$80
Taxable Income $1,000 $920
Taxes (21%) $210 $193.20 ↓ A Ho
Net Income $790 $726.80
CFFA -RE $790 $806.80

CFFA =
Net Income a Interest
Interest Tax Shield = $16.80 per year

© McGraw Hill, LLC 22

 Interest Tax Shield
Annual interest tax shield.
• Tax rate times interest payment.
• $1,000 in 8 percent debt = $80 in interest expense.
• Annual tax shield = .21($80) = $16.80.
Present value of annual interest tax shield.
• Assume perpetual debt.

• PV = $16.80/.08 = $210.

• PV = D (RD )(TC ) / RD = D × TC = $1, 000 (.21) = $210.

© McGraw Hill, LLC 23

 M&M Proposition I with Taxes Figure
13.4
Figure 13.4 M&M Proposition I with taxes

&

Access the text alternative for slide images.

© McGraw Hill, LLC 24

 M&M Summary Table 13.4 1

Table 13.4 Modigliani and Miller summary.

I. The no-tax case case] .

No corporate & personal taxes
A. Proposition I: The value of the leveraged firm (VL) is equal to the
value of the unleveraged firm (VU):
VL = VU
B. Implications of Proposition I:
1. A firm’s capital structure is irrelevant.
2. A firm’s weighted average cost of capital, WACC, is the same no
matter what mixture of debt and equity is used to finance the firm.
C. Proposition II: The cost of equity, RE, is:
RE = RA + (RA − RD )× D
& D/E RA = Wall = lEv] (RE) ( Pr ) (Rp]
+

b
where RA is the WACC, RD ↓ is the cost of debt, and D/E is the debt-
equity ratio. Business Risk Financial Risk
© McGraw Hill, LLC 25
 M&M Summary Table 13.4 2

D. Implications of Proposition II:

1. The cost of equity rises as the firm increases its use of debt
financing.
2. The risk of the equity depends on two things: the riskiness of the
firm’s operations (business risk) and the degree of financial leverage
(financial risk). Business risk determines RA; financial risk is
determined by D/E.
II. The tax case No personal taxes
Case 2 Have corporate
: .

A. Proposition I with taxes: The value of the leveraged firm (VL) is

equal to the value of the unleveraged firm (VU) plus the present
value of the interest tax shield:
VL = VU + TC × D EF
where TC is the corporate tax rate and D is the amount of debt.

© McGraw Hill, LLC 26

 M&M Summary Table 13.4 3

B. Implications of Proposition I with taxes:

1. Debt financing is highly advantageous, and, in the extreme, a firm’s
optimal capital structure is 100 percent debt.
2. A firm’s weighted average cost of capital, WACC, decreases as the
firm relies more heavily on debt financing.

© McGraw Hill, LLC 27

 Bankruptcy Costs TREE F
E STINYEPHE
Direct costs. EFE
Legal and administrative costs.
• Enron = $1 billion; WorldCom = $600 million.
/
Bondholders incur additional losses. #A AERA ,

Disincentive to &
debt financing. CREXFE , Y.
/ *or ** E
Financial distress. REG M
• Significant problems meeting &
debt obligations.
1
• Most firms that experience financial distress do not
ultimately file for bankruptcy.
& F ** ] FITIE
Return to Quick Quiz
GFIXE
© McGraw Hill, LLC 28
 Indirect Bankruptcy Costs Delisting Fin
Indirect bankruptcy costs.
• Larger than direct costs, but more difficult to measure and
convertible
estimate. Bonds
1 Exchangeable Bonds)
(TEAREE) - ELE
• Stockholders wish to avoid a formal bankruptcy.
• Bondholders want to keep existing assets intact so they can at
Loading…
least receive that money.
Vd
• Assets lose value as management spends time worrying about
avoiding bankruptcy instead of running the business. F
• Lost sales, interrupted operations, loss of valuable employees,
low morale, and inability to purchase goods on credit.

Return to Quick Quiz

FRE
© McGraw Hill, LLC 29
 Case III With Bankruptcy Costs
* X TREENE X
↑ D/E ratio →↑ probability of bankruptcy.
↑ probability →↑ expected bankruptcy costs.
St EFIA
.

At some point, the additional value of the interest tax shield

will be offset by the expected bankruptcy costs.
FLIG
At this point, the value of the firm will start to decrease and
the WACC will start to increase as more debt is added.
company value
WACL

© McGraw Hill, LLC 30

 Optimal Capital Structure Figure 13.5
Figure 13.5 The static theory of capital structure: The optimal capital structure
and the value of the firm

IEEE ,
E*) firm valued

Access the text alternative for slide images.

© McGraw Hill, LLC 31

 Conclusions M & METE

Case I – no taxes or bankruptcy costs.

• 2No optimal capital structure.
&
Case II – corporate taxes but no bankruptcy costs.
• Optimal capital structure =&100 percent debt.
S
• Each additional dollar of debt increases the cash flow of
the firm.
Case III – corporate taxes and bankruptcy costs.
• Optimal capital structureIis part debt and part equity.S
• Occurs where the benefit from an additional dollar of debt
is just offset by the increase in expected bankruptcy costs.

© McGraw Hill, LLC 32

 The Capital Structure Question Figure
13.6
Figure 13.6 The capital structure question

ME
I WALL F ,max

B ,B 112 at
&
>
- AARQEMG WACC .

Access the text alternative for slide images.

© McGraw Hill, LLC 33

 Additional Managerial Recommendations
Taxes.
• The tax benefit is only important if the firm has a large tax
liability.
• Higher tax rate → greater incentive to use debt.
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.

© McGraw Hill, LLC 34

 Observed Capital Structures
Table 13.5 Capital structures for U.S. industries
Ratio of Debt to Ratio of Debt to Number of Representative
Industry Total Capital (%)* Equity (%) Companies SIC Code Companies
Electric utilities 45.9% 85.4% 33 491 American Electric Power,
Southern Co.

Computer equipment 13.7 12.0 14 357 Apple. HP

Paper 45.7 84.2 14 26 Avery Dennison. International

Paper

Petroleum refining 411 69.8 10 291 Chevron. ExxonMobil

Airlines 55.5 124.9 9 451 Delta. Southwest

Telephone 37.5 59.9 9 4S4 AT&T. T-Mobile

communications

Motor vehicle 34.7 53.2 23 371 Allison Transmission.

equipment SORL Auto Parts

Fabric apparel 42.0 56.5 10 23 Hanesbrands. Under Armour

General 23.5 30.7 11 53 Costco. Dollar General

* merchandise
Debt is the book value of preferred stock and long-term debt, including amounts due in one year. Equity is
the market value of outstanding shares. Total capital is the sum of debt and equity. Median values are
stores
shown.
Source: Costofcapital.duffandphelps.com,
Restaurants 51.9 July 7, 2020. 107.9 22 5812 McDonald's. Papa John's

Drugs
© McGraw Hill, LLC 10.5 11.7 49 283 Merck. Pfizer 35
 Example: Work the Web
You can find information about a company’s capital structure
relative to its industry and sector using the industry center or
sector analysis through www.reuters.com.
Click on this link to go to the site.
• Choose a company and get a quote.
• Perform sector and industry comparisons.

© McGraw Hill, LLC 36

 Financial Distress Defined
D Business failure – business terminated with a loss to
creditors.

e
Legal bankruptcy – petition filed in federal court for
bankruptcy.
Technical insolvency – firm unable to meet debt obligations.
Accounting insolvency – book value of equity is negative.

© McGraw Hill, LLC 37

 The Bankruptcy Process Liquidation
Chapter 7 of the Federal Bankruptcy Reform Act of 1978.
Process.
• Petition filed in federal court.
• Trustee elected by creditors to take over firm’s assets.
• Trustee attempts to sell assets.
• Proceeds distributed according to the absolute priority rule
(APR).

Return to Quick Quiz

© McGraw Hill, LLC 38

 The Bankruptcy Process Reorganization
Chapter 11 of the Federal Bankruptcy Reform Act of 1978.
Process:
• Petition filed by firm or creditors.
• Usually, firm continues operation as “debtor-in-possession.”
• Firm submits reorganization plan.
• If accepted by classes of creditors, then confirmed by court.
• Firm makes payments to creditors and operates under plan
for some fixed time.

Return to Quick Quiz

© McGraw Hill, LLC 39

 Financial Management & Bankruptcy
Bankruptcy can be expensive and slow.
• Prepacks: prepackaged filings.
• Cram-downs: court-ordered plan acceptance.
• Section 363: auction-like bankruptcy.
• Workouts: negotiated extensions or payments.
The right to file bankruptcy has strategic value.
• Immediate “stay” on creditors.
• Ability to terminate labor agreements.
• Ability to lay off large numbers of workers.
• Ability to reduce wages.

© McGraw Hill, LLC 40

 Quick Quiz
1. How does financial leverage affect ROE and EPS?
(Slide 13.9).
2. What are the three capital structure cases? (Slide
13.15).
3. What are the direct and indirect costs of bankruptcy?
(Slides 13.27 and 13.28).
4. What are the two chapters of bankruptcy and how do
they differ? (Slides 13.37 & 13.38).

© McGraw Hill, LLC 41

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