Professional Documents
Culture Documents
Advantages of Debt
Interest is tax deductible (lowers the
effective cost of debt)
Debt-holders are limited to a fixed return
so stockholders do not have to share
profits if the business does exceptionally
well
Debt holders do not have voting rights
Disadvantages of Debt
Higher debt ratios lead to greater risk and
higher required interest rates (to
compensate for the additional risk)
Business Risk
Standard measure is beta (controlling for
financial risk)
Factors:
Demand variability
Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)
Financial Risk
The additional risk placed on the common
stockholders as a result of the decision to
finance with debt
Financial Risk
Leverage increases shareholder risk
Leverage also increases the return on
equity (to compensate for the higher risk)
Question?
Is the increase in expected return due to
financial leverage sufficient to compensate
stockholders for the increase in risk?
Topics To Be Covered
Leverage in a Tax Free Environment
How Leverage Affects Returns
The Traditional Position
Capital Structure
When a firm issues debt and equity
securities it splits cash flows into two
streams:
Safe stream to bondholders
Risky stream to stockholders
Capital Structure
Modigliani and Miller (1958) show that
financing decisions dont matter in perfect
capital markets
M&M Proposition 1:
Firms cannot change the total value of their
securities by splitting cash flows into two
different streams
Firm value is determined by real assets
Capital structure is irrelevant
Effects of Leverage
What happens if WPS levers up again by
borrowing an additional $10,000 and at the
same time paying out a special dividend of $10
per share, thereby substituting debt for equity?
This should have no impact on WPS assets or
total cash flows:
V is unchanged
D= $35,000
E= $75,000 - $35,000 = $40,000
Effects of Leverage
What if instead of assuming V is
unchanged we allow V it rise to $80,000
as a result of the change in capital
structure?
Then E = $80,000 - $35,000 = $45,000
Any increase or decrease in V as a result
of the change in capital structure accrues
to the shareholders
Effects of Leverage
What if the new borrowing increases the
risk of bankruptcy?
This would suggest that the risk of the old
debt is higher (and the value of the old
debt is lower)
If this is the case, then shareholders would
gain from the increase in leverage at the
expense of the original bondholders.
.01VU
.01 Profits
Strategy 2
Buy 1% of Firm Ls Equity and Debt
Dollar investment=
Dollar Return=
From owning .01 DL
From owning .01 EL
Total
.01EL= .01(VL-DL)
.01 (Profits interest)
Strategy 4
Buy 1% of Firm Us Equity and borrow on your own
account .01DL (home-made leverage)
Dollar investment=
Dollar Return=
From borrowing .01DL
From owning .01 EU
Total
.01(Vu DL)
-.01 interest
.01 (Profits)
.01 (Profits interest)
D
E
rA
rD
rE
DE
DE
M&M Proposition II
rE
rA
rD
Risk free debt
Risky debt
D
E
M&M Proposition 2
Bonds are almost risk-free at low debt levels
rD is independent of leverage
rE increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk
BA
BD
BE
DE
DE
D
BE BA BA BD
E
WACC
D
E
WACC rA rD rE
V
V
WACC
Expected
Return
.20=rE
Equity
.15=rA
All
assets
.10=rD
Debt
Risk
BD
BA
BE
WACC
Example - A firm has $2 mil of debt and
100,000 of outstanding shares at $30
each. If they can borrow at 8% and the
stockholders require 15% return what is
the firms WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at
8% and the stockholders require 15% return what is the
firms WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
D
E
WACC rD rE
V
V
2
3
.08 .15
5
5
.122 or 12.2%
rE
rA =WACC
rD
D
V
An intermediate position
A moderate degree of financial leverage may
increase the return on equity (but less than
predicted by M&M proposition 2)
A high degree of financial leverage increases
the return on equity (but by more than predicted
by M&M proposition 2)
WACC then declines at first, then rises with
increasing leverage (U-shape)
Its minimum point is the point of optimal capital
structure.
WACC
rD
D
E
rD
D
E
1/2 Debt
1,000
1,000
100
Pretax Income
1,000
900
Taxes @ 40%
400
360
$600
$540
EBIT
Interest Pmt
Capital Structure
D x rD x Tc
PV of Tax Shield =
(assume perpetuity)
= D x Tc
rD
Example:
Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
rE
WACC
rD
D
E
Financial Distress
Market Value of The Firm
Costs of
financial distress
PV of interest
tax shields
Value of levered firm
Value of
unlevered
firm
Optimal amount
of debt
Debt/Total Assets
Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.