FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition

• Lusztig, Cleary, Schwab

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• CHAPTER
• SIXTEEN
• Capital Structure

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Learning Objectives

• 1. Describe leverage and how it affects
  companies.
• 2. Define indifference analysis, how it is used,
  and what it measures.
• 3. Explain how the value of a company is
  established.
• 4. Name two reasons why the cost of a security to
  a company differs from its yield in capital
  markets.
• 5. Describe how debt capacity affects a company.

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Introduction

• In this chapter we investigate
• the alternative capital structures with respect
  to change in the proportions of debt and equity
• the theory that explores how various degrees of
  leverage should be valued by investors
• the market imperfections and considerations when
  evaluating debt levels

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Leverage and Financial Risk

• Leverage is encountered whenever fixed costs are
  incurred to support operations that generate
  revenue
• Operating leverage when a portion of a
  companys operating costs are fixed
• Financial leverage when a firm finances part of
  its business with securities that entail fixed
  financing charges such as bond, debentures, or
  preferred shares
• A firms financial results that accrue to equity
  investors are magnified through the use of
  operating and financial leverage

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Leverage and Financial Risk

• Operating and Financial Leverage

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Leverage and Financial Risk

• A firms total leverage is a combination of
  operating and financial leverage and measures the
  variation in EPS for a given change in sales
• Increased leverage leads to increased risk
• Business risk results from general economic
  cycles, changing industry conditions, and
  operating cost structure of an individual firm
• Degree of financial leverage is the change on
  common equity or EPS divided by the change in
  EBIT that caused the change in equity returns

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Leverage and Financial Risk

• If only common equity is used changes in ROE
  reflect only business risk
• Financial leverage 1
• If senior securities are used in the capital
  structure the variations on ROE are magnified
• Financial leverage gt 1
• Total value of the firms is expressed by
• Value of firm value of debt value of equity

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Indifference Analysis

• Indifference analysis is a common tool used in
  assessing the impact of leverage and is used to
• determine EPS as a function of EBIT for various
  capital structures
• identify the level of EBIT beyond which reliance
  on leverage produces higher EPS

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Indifference Analysis

• Limitations of indifference analysis include
• 1. It ignores cash flow considerations such as
  sinking fund provisions for the periodic
  retirement of fixed income securities.
• 2. It does not consider how equity investors may
  react to the increased risk imposed by leverage
  in the light of uncertain future operating
  performance.

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Evaluation of Capital Structures

• A capital structure that maximizes share prices
  generally will minimize the firms WACC
• If a firm can lower its WACC, shareholders will
  receive greater returns reflected in increased
  share prices
• capital structure
• ? market price per share, ? WACC
• ? market price per share, ? WACC

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Evaluation of Capital Structures

• Different capital structures results in different
  levels of financial risk created through
  leverage.
• Three trade-off possibilities include
• 1. Cost equity increases with leverage at a
  moderate rate so that when combined with debt
• WACC decreases with increased leverage
• 2. Cost of equity increases at a rate that
  offsets the benefits gained through cheaper
  financing
• WACC remains constant
• 3. Cost of equity increases rapidly with leverage
  and increase more than offsets any gains from
  debt
• WACC increases with leverage

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Evaluation of Capital Structures

• Consequences of Different Shareholder Attitudes
  Toward Risk

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Evaluation of Capital Structures

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

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Traditional Position

• Under the traditional position firms can
• issue reasonable amounts of debt with little
  effect on its cost of equity and a low risk of
  default
• Corporations use debt to take advantage of the
  positive aspects of leverage
• It is important for companies to find the optimal
  level where the WACC is minimized

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Traditional Position

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

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Theory of Capital Structure

• Capital structure without taxes and bankruptcy
  costs
• denoting keu and keL as the cost of equity for
  unlevered and levered firms we have
• rearranged we get

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Theory of Capital Structure

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

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Theory of Capital Structure

• Corporate taxes
• exert an important influence on financing
  decisions because the amount of taxes depends on
  the capital structure
• levered firms taxes are reduced by the tax
  shield on interest (IT)
• VL gt Vu
• Ignoring bankruptcy, investors would prefer
  owning debt and equity of L over equity U

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Theory of Capital Structure

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

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Theory of Capital Structure

• The cost of equity keL increases at a slower
  rate, which can be seen through the formulas

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Theory of Capital Structure

• Individual taxes can influence the value of a
  company, therefore they must be considered for
  decisions on capital structure
• A company wants a capital structure that
  minimizes total taxes or maximizes after-tax
  distribution
• Total after-tax distribution

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Theory of Capital Structure

• Cash Flow with Corporate and Personal Taxes

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Theory of Capital Structure

• Bankruptcy Costs
• As firms increase financial leverage they
  increase the probability of bankruptcy
• Regardless of ownership any enterprise that
  generates a positive NPV should continue
  operating
• Bankruptcies often reduce a firms economic value
  because
• 1. the direct costs such as fees for trustees,
  lawyers, and court proceedings
• 2. the loss of profits caused by the loss of
  trust in the company

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Theory of Capital Structure

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

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Market Imperfections and Practical Considerations

• Agency Problems
• when managers fail to act in the best interests
  of shareholders
• Market Inefficiencies
• Imperfections in the markets cause share prices
  to fall whenever companies issue equity no matter
  if the stock is undervalued, overvalued, or
  valued correctly.
• Based on the imperfections, companies should
  issue bonds when internal equity is not available
  and only issue equity as a last resort, which
  gives rise to the pecking order of corporate
  finance

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Market Imperfections and Practical Considerations

• Pecking order of finance holds that
• 1. Retained earnings or depreciation should be
  used first
• 2. After internal resources are depleted, debt
  should be used
• 3. New common equity should be issued only when
  more debt is likely to increase the chance of
  bankruptcy
• Debt capacity
• Debt capacity the ability of an enterprise to
  tolerate higher leverage

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Market Imperfections and Practical Considerations

• Considerations determining the debt capacity of a
  firm include
• debt capacity can be viewed as a function of both
  collateral and stable cash flow
• the variability and level of cash flow during
  difficult times influences debt capacity
• firms with product lines that involve long-term
  commitments to customers have a lower debt
  capacity

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Summary

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

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Summary

• 3. A firms capital structure is optimal if it
  maximizes shareholder wealth. The desirability of
  financial leverage depends on equity investors
  attitudes toward the implied trade-offs between
  risk and expected returns. The traditional
  position suggests, optional moderate leverage.
• 4. Given corporate taxes, interest on debt allows
  the firm to reduce its tax bill and to increase
  the amount available for distribution to security
  holders.

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Summary

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

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Summary

• 6. Since debt payments represent contractual
  obligations, high leverage reduces a firms free
  cash flow. It thus limits management flexibility
  and discretion. A firms debt capacity is mainly
  a function of the stability of its cash flow and
  its collaterals value and liquidity.
• 7. Financial leverage affects a firms systematic
  risk. Beta, as specified by the Capital Asset
  Pricing Model, varies as a function of the debt
  proportion that the firm employs.