Financial Leverage

Chapter Outline

Financial Leverage Effect of leverage Break-even Analysis Homemade Leverage M&M Propositions (I & II): optimal D/E? No tax Corporate tax Corporate tax & bankruptcy costs Corporate & personal taxes Arbitrage

The Capital-Structure Question and The Pie Model

The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V=E+B If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.

S B

Value of the Firm

The Capital-Structure Question

There are really two important questions: 1. Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. 2. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.

Financial Leverage: An Example

A proposed change in financial leverage

Current Asset Debt Equity D/E Ratio Share Price Shares Out. Interest Rate $8,000,000 $0 Proposed $8,000,000 $4,000,000

$20 n/a

$20 10%

Financial Leverage: An Example

Current capital structure: No debt (unlevered)

Recession Normal $1,000,000 Expansion $1,500,000

EBIT Interest Net Income EPS ROE

$500,000

Financial Leverage: An Example

Proposed capital structure: D/E = 1 (levered)

Recession Normal $1,000,000 Expansion $1,500,000

EBIT Interest Net Income EPS ROE

$500,000

The Effects of Financial Leverage

The effect of financial leverage depends on EBIT When EBIT is high, financial leverage raises EPS and ROE, and vice versa Variability in EPS and ROE is increased under financial leverage

EPS vs EBIT (with and without debt)

EPS

5 4

With Debt

3

No Debt

2

Advantage to debt

1

0 -1 400,000 800,000 1,200,000

EBIT

1,600,000

-2

Disadvantage to debt

-3

Computing Break-Even EBIT & EPS

Ignoring tax: For the unlevered firm, with no debt: For the levered firm, with $4,000,000 debt at 10%: Break-even means EPSU = EPSL, so

Homemade Leverage: Concept

A shareholder can create his desired degree of financial leverage through personal borrowing or lending Assume perfect markets, i.e, no tax, no bankruptcy costs, same borrowing and lending rate Use our previous example to create homemade leverage

Homemade Leverage: Levering

A shareholder owns 100 shares at $20 each. His desired capital structure: D/E = 1 Recession Normal Expansion

EPS of levered firm Portfolio Payoffs Investment cost =

$0.50

$3.00

$5.50

Levering Strategy

However, the firm he owned is a unlevered firm with D/E=0 The shareholder wants to lever his portfolio to generate the same payoffs under his desired capital structure The shareholder has 100 shares, $20 per share Levering Strategy:

Unlevered Firm

Recession

Levered Firm

Normal Expansion

Levering his portfolio from a unlevered firm

EPS of unlevered firm Earnings for 200 shares Less: interest on $2,000 at 10% Net Payoffs Investment cost:

$1.25

$2.50

$3.75

Homemade Leverage: Unlevering

A shareholder owns 100 shares at $20 each. His desired capital structure: D/E = 0 Recession Normal Expansion

EPS of unlevered firm Portfolio Payoffs Investment cost =

$1.25

$2.50

$3.75

Unlevering Strategy

However, the firm is a levered firm with D/E=1 The shareholder wants to unlever his portfolio to generate the same payoffs under his desired capital structure The shareholder has 100 shares, $20 per share Strategy:

Levered Firm

Unlevered Firm

Unlevering his portfolio from a levered firm

Recession Expected Expansion

EPS of levered firm Earnings for 50 shares Add: interest on $1,000 at 10% Net Payoffs Investment cost =

$0.5

$3.00

$5.50

Homemade...