FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

FINANCE IN A FINANCE IN A CANADIAN SETTINGCANADIAN SETTING

Sixth Canadian EditionSixth Canadian Edition

Lusztig, Cleary, Lusztig, Cleary, SchwabSchwab

CHAPTER CHAPTER

SIXTEENSIXTEEN

Capital StructureCapital Structure

Learning ObjectivesLearning Objectives

1. Describe leverage and how it affects 1. Describe leverage and how it affects companies.companies.

2. Define indifference analysis, how it is used, and 2. Define indifference analysis, how it is used, and what it measures.what it measures.

3. Explain how the value of a company is 3. Explain how the value of a company is established.established.

4. Name two reasons why the cost of a security to 4. Name two reasons why the cost of a security to a company differs from its yield in capital a company differs from its yield in capital markets.markets.

5. Describe how debt capacity affects a company.5. Describe how debt capacity affects a company.

IntroductionIntroduction

In this chapter we investigate:In this chapter we investigate: the alternative capital structures with the alternative capital structures with

respect to change in the proportions of respect to change in the proportions of debt and equitydebt and equity

the theory that explores how various the theory that explores how various degrees of leverage should be valued by degrees of leverage should be valued by investorsinvestors

the market imperfections and the market imperfections and considerations when evaluating debt considerations when evaluating debt levelslevels

Leverage and Financial Leverage and Financial RiskRisk

Leverage is encountered whenever fixed costs are Leverage is encountered whenever fixed costs are incurred to support operations that generate revenueincurred to support operations that generate revenue Operating leverageOperating leverage – when a portion of a company’s – when a portion of a company’s

operating costs are fixedoperating costs are fixed Financial leverageFinancial leverage – when a firm finances part of its – when a firm finances part of its

business with securities that entail fixed financing business with securities that entail fixed financing charges such as bond, debentures, or preferred charges such as bond, debentures, or preferred sharesshares

A firm’s financial results that accrue to equity investors A firm’s financial results that accrue to equity investors are magnified through the use of operating and are magnified through the use of operating and financial leveragefinancial leverage


Operating and Financial LeverageOperating and Financial Leverage


A firms total leverage is a combination of A firms total leverage is a combination of operating and financial leverage and measures the operating and financial leverage and measures the % variation in EPS for a given % change in sales% variation in EPS for a given % change in sales

Increased leverage leads to increased riskIncreased leverage leads to increased risk Business riskBusiness risk –– results from general economic results from general economic

cycles, changing industry conditions, and operating cycles, changing industry conditions, and operating cost structure of an individual firmcost structure of an individual firm

Degree of financial leverageDegree of financial leverage –– is the % change on is the % change on common equity or EPS divided by the % change in common equity or EPS divided by the % change in EBIT that caused the change in equity returnsEBIT that caused the change in equity returns


If only common equity is used changes in If only common equity is used changes in ROE reflect only business riskROE reflect only business risk Financial leverage = 1Financial leverage = 1

If senior securities are used in the capital If senior securities are used in the capital structure the variations on ROE are structure the variations on ROE are magnifiedmagnified Financial leverage > 1Financial leverage > 1

Total value of the firms is expressed by:Total value of the firms is expressed by:

Value of firm = value of debt + value of equityValue of firm = value of debt + value of equity

Indifference AnalysisIndifference Analysis

Indifference analysis is a common Indifference analysis is a common tool used in assessing the impact of tool used in assessing the impact of leverage and is used to:leverage and is used to:

determine EPS as a function of determine EPS as a function of EBIT for various capital EBIT for various capital structuresstructures

identify the level of EBIT identify the level of EBIT beyond which reliance on beyond which reliance on leverage produces higher EPSleverage produces higher EPS

Indifference AnalysisIndifference Analysis

Limitations of indifference analysis Limitations of indifference analysis include:include:1. It ignores cash flow considerations such 1. It ignores cash flow considerations such

as sinking fund provisions for the periodic as sinking fund provisions for the periodic retirement of fixed income securities.retirement of fixed income securities.

2. It does not consider how equity investors 2. It does not consider how equity investors may react to the increased risk imposed may react to the increased risk imposed by leverage in the light of uncertain future by leverage in the light of uncertain future operating performance.operating performance.

Evaluation of Evaluation of Capital StructuresCapital Structures

A capital structure that maximizes share A capital structure that maximizes share prices generally will minimize the firm’s prices generally will minimize the firm’s WACCWACC

If a firm can lower its WACC, If a firm can lower its WACC, shareholders will receive greater returns shareholders will receive greater returns reflected in increased share pricesreflected in increased share prices capital structurecapital structure

market price per share, market price per share, WACC WACC

market price per share, market price per share, WACC WACC


Different capital structures results in different levels of Different capital structures results in different levels of financial risk created through leverage.financial risk created through leverage.

Three trade-off possibilities include:Three trade-off possibilities include:1. Cost equity increases with leverage at a moderate rate so that 1. Cost equity increases with leverage at a moderate rate so that

when combined with debtwhen combined with debt WACC decreases with increased leverageWACC decreases with increased leverage

2. Cost of equity increases at a rate that offsets the benefits 2. Cost of equity increases at a rate that offsets the benefits gained through cheaper financinggained through cheaper financing

WACC remains constantWACC remains constant

3. Cost of equity increases rapidly with leverage and increase 3. Cost of equity increases rapidly with leverage and increase more than offsets any gains from debtmore than offsets any gains from debt

WACC increases with leverageWACC increases with leverage


Consequences of Different Consequences of Different Shareholder Attitudes Toward RiskShareholder Attitudes Toward Risk

Evaluation ofEvaluation of Capital Structures Capital Structures

Leverage is measured as the Leverage is measured as the proportion of debt in relation to proportion of debt in relation to equity in the capital structure (B/E)equity in the capital structure (B/E)

With V = B + E WACC is:With V = B + E WACC is:

V

Ek

V

Bbk eb

Traditional PositionTraditional Position

Under the traditional position firms can:Under the traditional position firms can: issue reasonable amounts of debt with issue reasonable amounts of debt with

little effect on its cost of equity and a low little effect on its cost of equity and a low risk of default risk of default

Corporations use debt to take advantage Corporations use debt to take advantage of the positive aspects of leverageof the positive aspects of leverage

It is important for companies to find the It is important for companies to find the optimal level where the WACC is optimal level where the WACC is minimizedminimized

Traditional PositionTraditional Position

The Traditional Position on Capital The Traditional Position on Capital Structure and the Cost of CapitalStructure and the Cost of Capital

Theory of Capital Theory of Capital StructureStructure

Capital structure without taxes and Capital structure without taxes and bankruptcy costsbankruptcy costs denoting kdenoting kee

u u and kand keeLL as the cost of as the cost of

equity for unlevered and levered equity for unlevered and levered firms we have:firms we have:

rearranged we get:rearranged we get:

tconskV

Bb

V

Ek U

ebLe tan

E

Bkkkk b

Ue

Ue

Le )(


Relationship Between the WACC, Relationship Between the WACC, Cost of Equity, and LeverageCost of Equity, and Leverage


Corporate taxesCorporate taxes exert an important influence on financing exert an important influence on financing

decisions because the amount of taxes decisions because the amount of taxes depends on the capital structuredepends on the capital structure

levered firm’s taxes are reduced by the tax levered firm’s taxes are reduced by the tax shield on interest (IT)shield on interest (IT)

VVL L > V> Vuu

Ignoring bankruptcy, investors would prefer Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity Uowning debt and equity of L over equity U


Assuming debt outstanding (B) is Assuming debt outstanding (B) is perpetual and the tax shield generated perpetual and the tax shield generated by interest payments becomes a by interest payments becomes a perpetual annuity of IT then:perpetual annuity of IT then:

Present value of tax savings =Present value of tax savings =

thenthen

BTr

IT

b

BT V VU L


The cost of equity kThe cost of equity keeLL increases at a increases at a

slower rate, which can be seen through slower rate, which can be seen through the formulas:the formulas:

bUe

L

Ue

Le kkT

E

Bkk )1(

L

Ueb

Le

L

EB

BTkk

V

Bk

V

Ek 1


Individual taxes can influence the value Individual taxes can influence the value of a company, therefore they must be of a company, therefore they must be considered for decisions on capital considered for decisions on capital structure structure

A company wants a capital structure A company wants a capital structure that minimizes total taxes or maximizes that minimizes total taxes or maximizes after-tax distributionafter-tax distribution

Total after-tax distributionTotal after-tax distribution)1)(1()( pdcpi TTETII


Cash Flow with Corporate and Cash Flow with Corporate and Personal TaxesPersonal Taxes

Theory of Capital Theory of Capital StructureStructure Bankruptcy CostsBankruptcy Costs

As firms increase financial leverage they increase As firms increase financial leverage they increase the probability of bankruptcythe probability of bankruptcy

Regardless of ownership any enterprise that Regardless of ownership any enterprise that generates a positive NPV should continue operatinggenerates a positive NPV should continue operating

Bankruptcies often reduce a firm’s economic value Bankruptcies often reduce a firm’s economic value because:because:

1. the direct costs such as fees for trustees, lawyers, and 1. the direct costs such as fees for trustees, lawyers, and court proceedingscourt proceedings

2. the loss of profits caused by the loss of trust in the 2. the loss of profits caused by the loss of trust in the companycompany


Benefit of Tax Benefit of Tax Savings, Savings, Expected Expected Bankruptcy Costs, Bankruptcy Costs, and Optimal and Optimal Capital StructureCapital Structure

Market Imperfections and Market Imperfections and Practical ConsiderationsPractical Considerations

Agency ProblemsAgency Problems when managers fail to act in the best interests of when managers fail to act in the best interests of

shareholdersshareholders Market InefficienciesMarket Inefficiencies

Imperfections in the markets cause share prices to fall Imperfections in the markets cause share prices to fall whenever companies issue equity no matter if the whenever companies issue equity no matter if the stock is undervalued, overvalued, or valued correctly.stock is undervalued, overvalued, or valued correctly.

Based on the imperfections, companies should issue Based on the imperfections, companies should issue bonds when internal equity is not available and only bonds when internal equity is not available and only issue equity as a last resort, which gives rise to the issue equity as a last resort, which gives rise to the “pecking order” of corporate finance“pecking order” of corporate finance

Market Imperfections and Market Imperfections and Practical ConsiderationsPractical Considerations ““Pecking order” of finance holds thatPecking order” of finance holds that

1. Retained earnings or depreciation should be 1. Retained earnings or depreciation should be used firstused first

2. After internal resources are depleted, debt 2. After internal resources are depleted, debt should be usedshould be used

3. New common equity should be issued only 3. New common equity should be issued only when more debt is likely to increase the chance when more debt is likely to increase the chance of bankruptcyof bankruptcy

Debt capacityDebt capacity Debt capacityDebt capacity – the ability of an enterprise to – the ability of an enterprise to

tolerate higher leverage tolerate higher leverage

Market Imperfections and Market Imperfections and Practical ConsiderationsPractical Considerations

Considerations determining the debt Considerations determining the debt capacity of a firm include:capacity of a firm include: debt capacity can be viewed as a function debt capacity can be viewed as a function

of both collateral and stable cash flowof both collateral and stable cash flow the variability and level of cash flow during the variability and level of cash flow during

difficult times influences debt capacitydifficult times influences debt capacity firms with product lines that involve long-firms with product lines that involve long-

term commitments to customers have a term commitments to customers have a lower debt capacitylower debt capacity

SummarySummary

1. A firm that incurs fixed costs while 1. A firm that incurs fixed costs while generating variable revenues is subject to generating variable revenues is subject to leverage. Leverage is used to increase the leverage. Leverage is used to increase the expected profitability of a firm. Financial expected profitability of a firm. Financial risk is the added variability in returns to risk is the added variability in returns to shareholders introduced by financing shareholders introduced by financing through fixed-cost senior securities.through fixed-cost senior securities.

2. Indifference analysis is used to evaluate 2. Indifference analysis is used to evaluate the effect of leverage on profitability.the effect of leverage on profitability.

SummarySummary

3. A firm’s capital structure is optimal if it 3. A firm’s capital structure is optimal if it maximizes shareholder wealth. The desirability maximizes shareholder wealth. The desirability of financial leverage depends on equity of financial leverage depends on equity investors’ attitudes toward the implied trade-investors’ attitudes toward the implied trade-offs between risk and expected returns. The offs between risk and expected returns. The traditional position suggests, optional traditional position suggests, optional moderate leverage.moderate leverage.

4. Given corporate taxes, interest on debt allows 4. Given corporate taxes, interest on debt allows the firm to reduce its tax bill and to increase the firm to reduce its tax bill and to increase the amount available for distribution to the amount available for distribution to security holders.security holders.

SummarySummary

5. Firms restrict debt financing in order to limit 5. Firms restrict debt financing in order to limit the probability of financial distress. the probability of financial distress. Liquidation decisions entail capital budgeting Liquidation decisions entail capital budgeting analysis that is based on net present values. analysis that is based on net present values. Total expected bankruptcy costs increase Total expected bankruptcy costs increase with financial leverage and reduce the value with financial leverage and reduce the value of the firm. The trade-off facing management of the firm. The trade-off facing management is between the tax benefits that accrue is between the tax benefits that accrue through debt financing and the expected through debt financing and the expected costs of financial distress that increase with costs of financial distress that increase with leverage.leverage.

SummarySummary

6. Since debt payments represent contractual 6. Since debt payments represent contractual obligations, high leverage reduces a firm’s free obligations, high leverage reduces a firm’s free cash flow. It thus limits management flexibility cash flow. It thus limits management flexibility and discretion. A firm’s debt capacity is mainly and discretion. A firm’s debt capacity is mainly a function of the stability of its cash flow and a function of the stability of its cash flow and its collateral’s value and liquidity. its collateral’s value and liquidity.

7. Financial leverage affects a firm’s systematic 7. Financial leverage affects a firm’s systematic risk. Beta, as specified by the Capital Asset risk. Beta, as specified by the Capital Asset Pricing Model, varies as a function of the debt Pricing Model, varies as a function of the debt proportion that the firm employs.proportion that the firm employs.

FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

Documents

Transcript of FINANCE IN A CANADIAN SETTING Sixth Canadian Edition