Chapter 16 Financial Leverage Capital Structure Policy The Capital Structure Question the change in the value of a firm is the same as the net effect on the stockholders the NPV rule applies to capital structure decisions and the change in the value of the overall firm is the NPV of a restructuring the value of a firm is maximized when the WACC is minimized because values and discount rates move in opposite directions minimizing WACC will maximize the value of the firm s cash flows one capital structure is better than another if it results in a lower weighted average cost of capital The Effect of Financial Leverage financial leverage refers to the extent to which a firm relies on debt the more debt financing a firm uses in its capital structure the more financial leverage it employs homemade leverage use of personal borrowing to change the overall amount of financial leverage to which the individual is exposed o o any stockholder who prefers the proposed structure can simply create it using homemade leverage investors can always increase financial leverage themselves to create a different pattern of payoffs Capital Structure and the Cost of Equity Capital M M Proposition I the value of a firm is independent of its capital structure It is completely irrelevant how a firm chooses to arrange its finances o o The size of the pie doesn t depend on how its sliced M M Proposition II firm s cost of equity capital is a positive linear function of its capital structure o The cost of equity depends on 3 things required return RA cost of debt RD debt equity ratio D E o RE RA RA RD x D E o WACC E V x RE D V x RD o The change in capital structure weights is exactly offset by the change in the cost of equity so WACC stays the same Cost of equity can be broken down into 2 components required return on assets RA and cost of equity D E x RA RD Business risk equity risk that comes from the nature of the firm s operating activities Financial risk equity risk that comes from the financial policy 9capital structure M M Propositions I and II with Corporate Taxes interest paid on debt is tax deductable failure to meet debt obligations can result in bankruptcy interest tax shield tax saving attained by a firm from interest expense the fact that interest is tax deductable for tax purposes has generated a tax saving equal to the interest payment multiplied by the corporate tax rate because the debt it perpetual the same tax shield is generated every year PV of interest tax shield cost of debt x tax rate TC x D Unlevered cost of capital cost of capital for a firm that has no debt a firm becomes bankrupt when the value of its assets equals the value of its debt direct bankruptcy costs costs that are directly associated with bankruptcy legal administrative indirect bankruptcy costs costs of avoiding bankruptcy financial distress costs direct indirect costs associated with going bankrupt or experiencing financial distress o VU EBIT x 1 T RU o VU value of unlevered firm RU discount rate RE RU RU RD x D E x 1 TC Bankruptcy Costs Optimal Capital Structure Case I no taxes or bankruptcy costs o No optimal capital structure Case II taxes but no bankruptcy costs o Optimal capital structure is almost 100 debt o Each addt l dollar of debt increases cash flow Case III taxes bankruptcy costs o Optimal capital structure is part debt and part equity o Occurs where the benefit of each addt l dollar of debt is offset by the increase in expected bankruptcy costs The Hamada Equation because the increased use of debt causes both the costs of debt and equity to increase we need to estimate the new cost of equity the Hamada Equation attempts to quantify the increased cost of equity due to financial leverage BL BU 1 1 T D E The Value of the Firm Value of the firm marketed claims nonmarketed claims o Marketed claims claims of bondholders stockholders o Nonmarketed claims claims of government Pecking Order Theory firm s prefer to issue debt rather than equity if internal financing is insufficient o o o internal financing firm issue debt next issue equity last