Chapter 14

LEVERAGE

Alex Tajirian
Leverage 14-2

1 OBJECTIVE
! Does amount of a company's debt matter? If it does, is there an
optimal proportion of debt to total assets? ( optimal ] (Debt/Asset)
level that maximizes value of firm)

! What happens to EPS, Cost of Capital, and Price of stock when debt
is substituted for equity?

! Are companies, in reality, at their optimal (Debt/Asset) or do they

have a target capital structure?

! Practical considerations and Leverage.

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Alex Tajirian
Leverage 14-3

2 MOTIVATION

2.1 WHAT IS CAPITAL STRUCTURE ANALYSIS?

Finding firm's lowest cost of capital, other things (dividends,
projects, total assets) constant. ] Choose (Debt/Asset) that
maximizes value of firm

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Alex Tajirian
Leverage 14-4

3 THEORIES EXPLAINING CAPITAL STRUCTURE

# Simplification: Assume only two alternatives; debt and equity

# What are a firm's optimal proportions of Debt (D) and Equity (E)? ]
What is a firm's optimal Debt/Asset ratio?

# Need a theory to tell us factors influencing optimal (Debt/Asset)

ratio.

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Alex Tajirian
Leverage 14-5

3.1 M&M I (Modigliani & Miller I)

Assumptions:
No taxes, no floatation costs, no bankruptcy associated costs,
unlimited lending and borrowing capacity

Analysis:
Given assumptions, both investor and firm have same
opportunities. If a firm _ Debt, it is equivalent to investor
borrowing and investing proceeds in firm. Thus, firm provides
no added value.

Result:
Capital structure is irrelevant

Value of Firm with no debt

=
value of the firm with debt, i.e. changing the mix of debt and equity
does not change the value of the firm.

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Alex Tajirian
Leverage 14-6

3.1.1 M&M With Taxes

Assumptions:
As above, save firms (not individuals) can deduct interest from
tax bill.

Analysis:
Here, unlike in M&MI, firm has advantage over individual.
Thus, firm can provide benefit from leverage through interest
deductions.

Result:
Value of firm increases as debt increases. Thus, 100% debt is
optimal.

Valuewith debt ' Valueno debt % tax shield

As the proportion of debt increases, the tax shield

increases, Thus, the value of the firm increases.

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Alex Tajirian
Leverage 14-7

3.2 BANKRUPTCY CONSIDERATIONS

Assumptions:
As above, save now we include in analysis cost of financial
distress associated with higher debt. These include:
! ` in sales due to unknown life of product/firm

! Suppliers less willing to replenish inventory or provide

new products

! legal fees
! cost of correct-sizing

Analysis:
As (Debt/Asset)_, there are two factors working in opposite
directions; interest savings (+), and financial distress (-).
ˆ if (+) > (-) Y value _.

Result:
As debt is increased, price of company increases, then starts to
fall. Thus, optimal capital structure is between 0 and 100%
debt.

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Alex Tajirian
Leverage 14-8

3.3 CAPITAL STRUCTURE CONCLUSION

There are two factors influencing the optimal amount of debt: taxes
and cost of financial distress.

Capital Structure theory tells us that there exists an optimal capital

structure and that all future projects ought to be financed using this
optimal (Debt/Asset).

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Alex Tajirian
Leverage 14-9

As debt increases
Benefit Cost
Value of firm value of firm = =
= + +
with leverage with no leverage PV PV
(interest savings) (distress)
_ 6 + > -
maximized 6 + = -
` 6 + < -

Thus, given our simplification, the optimal capital structure is a combination of Debt and Equity.

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Alex Tajirian
Leverage 14-10

4 Debt/Asset, EPS, WACC, & VALUE OF FIRM

Question: What happens to EPS, WACC, and price of stock, as debt is

increased, holding every thing else (total assets, dividends,
projects) constant?

4.1 EXPERIMENT:
Objective:
Change (Debt/Asset), holding everything else constant, then observe
what happens to P, EPS, WACC. Choose (Debt/Asset) that
maximizes value of firm.

Procedure:
Manager, while riding BART to work, using his/her laptop financial
models spreadsheet, tries different financing combinations of D and
E, then observes what happens to the price of stock, EPS, and
WACC.

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Alex Tajirian
Leverage 14-11

Step 1: Value of Assets = value of debt + value of equity

value of debt = PV of all outstanding debt
value of equity = (pstock) x (# of shares outstanding)

Step 2: Assume company has Debt = 0 ] value of assets = value

of equity

Step 3: Increase proportion of debt by, say 10%

Total Assets _ (from Step 1)

Step 4: Change the mix of debt and equity ] Substitute debt for
company equity ] To hold total assets constant, firm has
to reduce total value of equity Y firm has to re-purchase
enough of its own shares to maintain value of total assets
constant.

Step 5: Repeat step 3.

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Alex Tajirian
Leverage 14-12

4.2 Experiment Starting Information

EBIT $6 million
shares outstanding 1 million
Debt 0
price of stock $20
tax rate 40%

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Alex Tajirian
Leverage 14-13

Notes for tables below:

! kd obtained from rate of similar bonds
! interest = interest paid to bond (debt) holders = kd x (amount of
debt)

! earnings before taxes = (EBIT - interest )

! Tax = (Earnings before taxes) x ( tax rate)
! NI = net income = earnings before taxes - Tax
! # of Shares repurchased = (amount of debt)/ (price of stock)
! Amount of shares after re-purchase = [(original # of shares) - (#
of shares repurchased)] = [10,000 - (# of shares re-purchased)]

! Debt = (Debt/Asset)(Assets)
! = + (km - kRF)$s; as debt increased, beta was adjusted based on
ks RF
estimates from “similar” companies rather than the Hamada
equation

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Alex Tajirian
 Leverage 14-14

Dividend EPS
p0 ' ' ; assume all earnings paid as dividends
ks ks

Net Income
EPS '
# of shares outstanding
WACC ' wd(1& T)k d % wsk s

Debt
wd '
Asset
Debt
$leverage ' $no debt(1 % )(1 & T)
Equity
price price price
P/E ' ' '
earnings per share NI per share NI
# of shares

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Alex Tajirian
Leverage 14-15

4.3 EXPERIMENT RESULTS

Amount kd ks S A Price D/A WACC EPS Shares

of Debt Outstanding
($ million) (millions)
0 7.5% 12.0% 30.0 30.0 20.00 0.00 12.00% 2.4 1.00
2 7.9% 12.4% 28.3 30.3 30.27 0.07 11.89% 3.8 0.93
4 8.2% 12.9% 26.4 30.4 30.38 0.13 11.85% 3.9 0.87
6 9.0% 13.2% 24.8 30.8 30.82 0.19 11.68% 4.1 0.81
8 10.0% 14.0% 22.3 30.3 30.29 0.26 11.89% 4.2 0.74
10 12.0% 15.2% 18.9 28.9 28.95 0.35 12.44% 4.4 0.65
12 15.0% 16.8% 15.1 27.1 27.13 0.44 13.27% 4.6 0.56
14 19.0% 20.0% 10.2 24.2 24.23 0.58 14.86% 4.8 0.42

(EBIT & Amount of Debt)(1 & tax rate)

S ' ; assumes a perpetuuity for simplicity
ks

D = Amount of Debt
A = Total Assets = D + S

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Alex Tajirian
 Leverage 14-16

D/A & Cost of Capital

20.00%

18.00%

16.00%

14.00%

12.00%
cost of capital

10.00%

8.00%

6.00%

4.00%

2.00%
kd
0.00% ks
0.00 0.10 0.20 0.30 0.40 0.50 0.60 WACC
D/A

kd : cost of debt _ as default risk _

ks:: cost of equity _ as company's exposure (sensitivity) to
interest rates _ Y $ _

L At (Debt/Asset) = 0%, WACC = ks , since wd = 0

At (Debt/Asset) = 100%, WACC = kd (1 - T), since ws = 0

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Alex Tajirian
 Leverage 14-17

D/A & Price Of Stock

35.00

$27.13
30.00

$30.82 $30.29
$30.27 $30.38
$28.95
25.00

$24.23
20.00 $20.00
Pirce

15.00

10.00

5.00

0.00
0.00 0.10 0.20 0.30 0.40 0.50 0.60

D/A

optimal capital structure = (Debt/Asset)* = 19%

# level of (Debt/Asset) at minimum cost of capital = that of

maximum price

ˆ theoretically, you should finance all future projects using

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Alex Tajirian
Leverage 14-18

(Debt/Asset) = 19%.
# The level of (Debt/Asset) that maximizes EPS is not same level as
maximum price Y maximizing EPS does not maximize value of
firm.

# To the right of the optimal level we have too much debt Y if

company reduces the level of debt, then the price of the stock
should go up. The opposite would be happen if debt is increased.

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Alex Tajirian
Leverage 14-19

4.4 EXPERIMENT CONCLUSION

! (Debt/Asset) at Minimum WACC = level of maximum price
! (Debt/Asset) for maximum price not equal to maximum EPS
! WACC is U-shaped
! If no financial distress cost, then 100% debt is optimal

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Alex Tajirian
Leverage 14-20

5 CHECKLIST FOR CAPITAL STRUCTURE DECISIONS

! Sales Stability/predictability

! Asset Structure:
The more a firm's ability to use its assets as collateral, the
higher the debt. (real-estate v. R&D companies)

! Operating Leverage

! Earnings/expansion Growth Rate:

High growth rate companies need heavy external financing.
Also, flotations costs of debt < that of equity. Thus, they tend
to issue more debt.

! Profitability Rate:
Highly profitable companies issue less debt, since they tend
to rely more on retained earnings. (Apple, Microsoft, Coca
Cola)

! Tax: higher tax rates, more debt

! Rating Agencies: Some firms like to maintain a certain level

of rating.

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Alex Tajirian
Leverage 14-21

6 TARGET CAPITAL STRUCTURE

# Firms never issue both Debt & Equity simultaneously

! Current stock price vs. Expected (by firm) price

! Current kd vs. expected (by firm)

# There is evidence that firms have a target capital structure in

mind!

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Alex Tajirian
Leverage 14-22

7 SUMMARY

T The optimal capital structure is a trade-off between a tax shield, due to interest expense
being tax deductible, & bankruptcy, due to excess burden of having to meet interest
payments.

T Capital structure analyzes the effect of debt (leverage) on the price of the firm, holding
every thing else (total assets, dividends, projects) constant.

T If you include taxes and bankruptcy costs in analysis, then the value of the firm initially
increases then decreases as debt is increased.

T Debt level that maximizes EPS is not same as that of maximum price.

T A number of factors determine optimal debt in practice.

T Firms generally do not issue both debt and equity at the same time

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Alex Tajirian
Leverage 14-23

8. QUESTIONS

I. Agree/Disagree-Explain
1 Project cash flows should be discounted at the rate of the source of financing. Thus, if it is
100% equity financed, then the discount rate is the company's required rate of return.

2 Since debt is tax-deductible, then it makes no sense for a firm to issue equity.

3 As you increase debt in the capital structure from a level of zero, WACC first decreases then
increases.

4 The optimal capital structure is given by the level of debt that maximizes EPS.

5 If there are no bankruptcy costs, then the optimal capital structure is 100% debt.

6 The level of debt that maximizes the value of the firm is the same as the one that minimizes
the WACC.

7 A firm will maximize value if it operates at a level of minimum cost.

8 Capital structure involves the analysis of a firm's optimal amount of debt.

9 Every time you want to finance a new project, you need to re-estimate the optimal capital
structure.

10 Increasing the amount of debt has no impact on cost of debt.

11 Increasing the amount of debt, the firm's cost of equity does not change.

12 The higher the firm's profitability, the lower the debt, other things equal.

13 Preferred stocks have a higher required return than common equity, other things constant.

14 Increasing the (Debt/Asset) ratio has no impact on a company's required return.

15 Financial distress refers to a firm's inability to meet its debt obligation.

16 The higher the sales stability, other things equal, the higher is a firm's (Debt/Asset).

17 The higher the operating leverage, other things equal, the higher a firm's (Debt/Asset).

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Alex Tajirian
Leverage 14-24

18 Company XYZ Inc. needs financing and management believes that its stock price is
overvalued. Other things equal, the firm would be better off issuing debt now.

19 Company XYZ Inc. needs financing and management believes that interest rates are heading
down. Thus, XYZ Inc. is more likely to issue debt than equity now.

20 A firm, with zero debt, is planning to issue new equity to finance an expansion project. If
NPV of project > 0 using ks, then the manager might be accepting a bad project.

II. Numerical.
1 Uno Inc. has one product that is selling at $10 per unit. Suppose that it sold 20,000 units the
last year. The firm's operating costs were $100,000 and its NWC was $45,000. The
company has 10,000 shares outstanding, $30,000 debt with 8% coupon, its required return
= 15%, and subject to a 40% tax rate.
(a) What is its EPS?
(b) Assume that Uno Inc. is retaining only 10% of its earnings. What would be a fair
price for its stock?
(c) What is its P/E?

2 XYZ Inc. is considering issuing new equity. The firm's stock is currently trading at $12, with
$.25 dividends per share which are expected to grow annually at 5%. The company is
considering issuing 100,000 new shares at the current market price. Their investment banker
would charge them $2 per share to issue and sell the new shares.
(a) What is the cost of new equity to the firm?
(b) How much new capital would XYZ Inc. raise if it were to go ahead with the deal?

3 0D Inc. currently has no debt and is considering increasing its (Debt/Equity) to 40%. Its
current Beta = 2 and is subject to 40% tax rate. If kRF= 4%, kM= 10% , what would its new
cost of retained earnings be? (Assume for simplicity T=0)

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Alex Tajirian
Leverage 14-25

9.0 ANSWERS TO QUESTIONS

I. Agree/Disagree-Explain

1 Disagree. Discounted by the project's WACC/hurdle-rate, which reflects both the project's
risk and firm's capital structure.

2 Disagree. Excessive debt increases the cost of financial distress, thus, lowers the value of the
firm.

3 Agree. You are substituting low cost (debt) for expensive (equity) in the calculation of the
average cost (WACC).

4 Disagree. EPS is maximized at a level different than the level of optimal debt.

5 Agree, since debt interest is tax deductible and there are no offsetting disadvantages.

6 Agree. See Graph " Debt/Asset, WACC & PRICE" p. 18.

7 Disagree. At minimum WACC not at minimum cost, since at minimum cost (cost = 0) the
firm would not exist.

8 Disagree. Optimal proportion of debt to total assets.

9 Disagree. Theoretically, the optimal capital structure gives you the best combinations.

10 Disagree. Increasing a firm's debt, increases default risk, which increases DRP. Thus, kd
increases.

11 Disagree. Increasing debt, increases the firms exposure (sensitivity) to market interest rates.
Since interest rates are part of the systematic risk (see chapter 4), the firm's beta increases.
Thus, ks increases.

12 Agree. With high profitability, the firm is able to finance projects using retained earnings.
Thus, the firm does not need to raise new debt or equity.

13 Disagree. Preferred stock have a "desirable" feature in them from the point of view of an
investor. The "good" feature is that holders get paid dividends before the common
stockholders. Hence, investors would require a lower compensation. Thus, required return
would be less.
14 Disagree. As (Debt/Asset) _ , the firm's exposure to interest rates _. Since interest rate is a
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Alex Tajirian
Leverage 14-26

systematic factor, it would increase the firm's beta.

15 Disagree. A company might still be making its debt obligation. For a discussion on financial
distress, see p. 7.

16 Agree. With sales being stable, the firm is more likely, other things equal, to take the
additional CF burden of debt.

17 Disagree. High operating leverage means that the firm has a high commitment, in the short-
run, to paying for fixed costs. This CF commitment makes the firm less likely to take
additional debt CF commitments.

18 Disagree. Since the stock is overvalued, then the firm would rather issue equity now at the
higher prices to reduce effect of dilution.

19 Disagree. The firm would be better off issuing debt in the future as the cost of debt would
be less then, assuming they are correct in their guess regarding the direction of interest rate
change.

20 Agree. The cost of the new project should be ke not ks. Since the former is >, then the project
might end up with NPV < 0 using the correct cost of capital.

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Alex Tajirian
Leverage 14-27

II. Numerical.
1. (a)
NI
EPS '
# of shares outstanding
NI ' EBIT & interest & Tax Bill
' (R& C) & interest & [(R& C) & interest]T
' [(R& C) & (amount of debt × kd)](1 & T)

' [(10×20,000) & 100,000) & (30,000×.08)](1 & .4)

' (97,600)(.6) ' $58,560
$58,560
EPS ' ' $5.856
10,000

b)
Dividend Dividend EPS(1 & retention ratio)
p0 ' ' '
k ks ks

($5.856)(1 & .1) 5.27

' ' ' $35.136
.15 .15

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Alex Tajirian
Leverage 14-28

c)
price
P/E '
earnings per share
35.136
' ' 6
5.856

2. (a)
Since F is measured in terms of $ per share and not % of price,
D0(1% g)
ks ' % g
P0 & F

.25(1% .05)
' % .05 ' .026 % .05 ' 7.6%
12 & 2

(b) New equity = 100,000($12 -F) = 100,000 ($10) = $1 million

3.

Debt
$leverage ' $no leverage × 1 % (1 & T)
Equity
' 2(1 % .4) ' 2.8
ˆ from CAPM
knew ' 4 % (10 & 4)(2.8) ' 20.8%

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Alex Tajirian