In this chapter you will understand the effect of financial leverage on cash flows and cost of equity, understand the impact of taxes and bankruptcy on capital structure choice, understand the basic components of bankruptcy.
Leverage and capital structure Chapter 13 Key concepts and skills • Understand the effect of financial leverage on cash flows and cost of equity • Understand the impact of taxes and bankruptcy on capital structure choice • Understand the basic components of bankruptcy Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-2 Chapter outline • The capital structure question • The effect of financial leverage • Capital structure and the cost of equity capital • Corporate taxes and capital structure • Bankruptcy costs • Optimal capital structure • Observed capital structures • A quick look at the bankruptcy process Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-3 Capital structure • Capital structure—percentage of debt and equity used to fund the firm’s assets – ‘Leverage’ = use of debt in capital structure • Capital restructuring—changing the amount of leverage without changing the firm’s assets – Increase leverage by issuing debt and repurchasing outstanding shares – Decrease leverage by issuing new shares Copyright © 2011 McGraw-Hill outstanding Australia Pty Ltd and retiring debt PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-4 Capital structure and shareholder wealth • What is the primary goal of financial managers? – To maximise shareholder wealth • We want to choose the capital structure that will maximise shareholder wealth • We can maximise shareholder wealth by maximising firm value or minimising WACC Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-5 The effect of financial leverage • How does leverage affect the earnings per share (EPS) and return on equity (ROE) of a firm? • When we increase the amount of debt financing, we increase the fixed interest expense • If we have a really good year, we pay our fixed costs and we have more left over for our shareholders • If we have a really bad year, we still have to pay our fixed costs and we have less left over for our shareholders • Leverage amplifies the variation in both EPS Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a ROE Essentials of Corporate Finance 2e by Ross et al 13-6 and Slides prepared by David E Allen and Abhay K Singh Financial leverage, EPS and ROE example—Table 13.1 • • • We will ignore the effect of taxes at this stage What happens to EPS and ROE when we issue debt and buy back shares? Eagles Air Services Table 13.1 Assets Debt Equity Debt/Equity Ratio Share Price Shares Outstanding Interest rate Current $8,000,000 $0 $8,000,000 0.0 $20 400,000 10% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh Proposed $8,000,000 $4,000,000 $4,000,000 1.0 $20 200,000 10% 13-7 Eagles Air Services Capital structure scenarios—Table 13.2 Table 13.2 EBIT Interest Net Income ROE EPS Current Capital Structure: No Debt Recession Expected Expansion $500,000 $1,000,000 $1,500,000 0 $500,000 $1,000,000 $1,500,000 6.25% 12.50% 18.75% $1.25 $2.50 $3.75 Proposed Capital Structure: Debt = $4 million Recession Expected Expansion EBIT $500,000 $1,000,000 $1,500,000 Interest 400,000 400,000 400,000 Net Income $100,000 $600,000 $1,100,000 ROE 2.50% 15.00% 27.50% EPS $0.50 $3.00 $5.50 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-8 Financial leverage, EPS and ROE—Example • Variability in ROE – Current: ROE ranges from 6.25% to 18.75% – Proposed: ROE ranges from 2.50% to 27.50% • Variability in EPS – Current: EPS ranges from $1.25 to $3.75 – Proposed: EPS ranges from $0.50 to $5.50 • The variability in both ROE and EPS increases when financial leverage is Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-9 Break-even EBIT • Find EBIT where EPS is the same under both the current and proposed capital structures • If we expect EBIT to be greater than the break-even point, then leverage is beneficial to our shareholders • If we expect EBIT to be less than the break-even point, then leverage is detrimental to our shareholders Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-10 M&M summary Table 13.4 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-32 M&M summary Table 13.4 (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-33 Bankruptcy costs • Direct costs – Legal and administrative costs • Enron = $1 billion; WorldCom = $600 million – Bondholders incur additional losses – Disincentive to debt financing • Financial distress – Significant problems meeting debt obligations – Most firms that experience financial distress not ultimately file for Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTsbankruptcy t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-34 Indirect bankruptcy costs • Indirect bankruptcy costs – Larger than direct costs, but more difficult to measure and estimate – Stockholders wish to avoid a formal bankruptcy – Bondholders want to keep existing assets intact so they can at least receive that money – Assets lose value as management spends time worrying about avoiding bankruptcy instead of running the business – Lost sales, interrupted operations, loss of valuable employees, low morale, inability to purchase goods on credit Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-35 Case III With bankruptcy costs • D/E ratio → probability of bankruptcy • probability → expected bankruptcy costs • At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy costs • At this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-36 Optimal capital structure Figure 13.5 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-37 Conclusions • Case I—no taxes or bankruptcy costs – No optimal capital structure • Case II—corporate taxes but no bankruptcy costs – Optimal capital structure = 100% debt – Each additional dollar of debt increases the cash flow of the firm • Case III—corporate taxes and bankruptcy costs – Optimal capital structure is part debt and part equity – Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-38 The capital structure question Figure 13.6 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-39 Observed capital structures • Capital structure differs by industry • Example: – Differences in Australian industries according to Table 13.5 • Media classification—Brisbane Broncos—0% debt • Utilities classification—Envestra—398.9% debt Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-40 Example: Work the Web • You can find information about a company’s capital structure relative to its industry and sector using industry centre or sector analysis through Yahoo! Finance • Click on the information icon to go to the site – Choose a company and get a quote – Perform sector and industry comparisons Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-41 Bankruptcy process • Business failure—business has terminated with a loss to creditors • Legal bankruptcy—petition federal court for bankruptcy • Technical insolvency—firm is unable to meet debt obligations • Accounting insolvency—book value of equity is negative Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-42 Liquidation and reorganisation • Companies Act 1993 and the Liquidation Regulations 1994 • Process – A petition is filed in a federal court A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation by several of its creditors – An administrator is appointed by the court or the creditors to take over the assets of the debtor The administrator will attempt to liquidate the assets – When the assets are liquidated, after payment of the bankruptcy administration costs, the proceeds are distributed among the creditors – If any proceeds remain, after expenses and payments to creditors, they are distributed to the shareholders Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-43 Liquidation and reorganisation (cont.) • The distribution of liquidation proceeds is made according to section 556 of the Australian Government Corporations Law • Brief priority list (absolute priority rule) – – – – – – – – – Administrative expenses associated with the bankruptcy Other expenses arising after the filing of a bankruptcy petition, but before the appointment of an administrator Wages, salaries and superannuation contributions for employees owed before the company goes into liquidation Amounts due in respect of injury compensation owed before the company goes into liquidation Amounts due to employees for leave of absence owed before the company goes into liquidation Retrenchment payments payable to employees of the company In New Zealand the preferential payment under 3, 4, and is limited to $15 000 per employee Payment to unsecured creditors Payment to preference shareholders Payment to ordinary shareholders Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 13-44 Quick quiz • Explain the effect of leverage on EPS and ROE • What is break-even EBIT? • How we determine optimal capital structure? • What is the optimal capital structure in the three cases that were discussed in this chapter? • What is the difference between liquidation and reorganisation? • What are the direct and indirect costs of Copyright © 2011 McGraw-Hill Australia Pty Ltd bankruptcy? PPTs t/a Essentials of Corporate Finance 2e by Ross et al 13-45 Slides prepared by David E Allen and Abhay K Singh Chapter 13 END 13-46 ... capital structure question • The effect of financial leverage • Capital structure and the cost of equity capital • Corporate taxes and capital structure • Bankruptcy costs • Optimal capital structure. .. David E Allen and Abhay K Singh 13-3 Capital structure • Capital structure? ??percentage of debt and equity used to fund the firm’s assets – ? ?Leverage? ?? = use of debt in capital structure • Capital restructuring—changing... concepts and skills • Understand the effect of financial leverage on cash flows and cost of equity • Understand the impact of taxes and bankruptcy on capital structure choice • Understand the