Leverage And Capital Structure

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25/09/2010

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 FINS1613 Business Finance
Week 10

Chapter 13
Capital Structure:
Theory and Evidence

1

4

Revision Week 9

Chapter 13 Outline

„ Chapter 12
¾ We learnt how to determine RE, RD, RP using various methods

„ The Capital Structure Question

¾ We learnt how to calculate weights for RE, RD, RP for WACC

„ The Effect of Financial Leverage

¾ We learnt how to calculate tax with classical and imputation tax systems „ Capital Structure and the Cost of Equity

¾ W
We learnt l t when h tto calculate l l t WACC with ith classical l i l and d iimputation t ti tax systems four different ways following Officer (1994)

Capital
„ Corporate Taxes and Capital Structure
„ Bankruptcy Costs
„ Optimal Capital Structure
„ Observed Capital Structures

„ Chapter 15
¾ We learnt about the various ways firms issue (raise) capital
¾ Equity – IPOs, Secondary equity offerings; Debt – long-term bonds

¾ We learnt how to calculate underpricing of IPOs
¾ IPO spread, direct costs, indirect costs

2

CONTENTS

5

WHAT IS THE CAPITAL STRUCTURE
„ Definition: Capital structure mode of financing used to finance investments
¾ It is the proportion of Debt, Equity, Hybrids (etc.) that comprise the overall value of the firm

1. Understand capital structure
2. What is the impact of leverage on the firm’s risk (i.e., understand financial risk)
3. Understand the ‘capital structure irrelevance’ theory of
Modigliani and Miller (MM).
(MM)
4. Explain the impact of taxes and other factors on capital structure decisions.
5. Consider the empirical evidence on capital structure.
6. Outline the main factors that financial managers should consider when determining a firm’s financing strategy.

¾ [Recall that Value = Debt + Equity + Hybrids +...]
„ Optimal capital structure:

¾ The structure that maximizes Shareholder wealth by minimizing WACC
„ Target capital structure:

¾ The structure that management deems ideal
¾ This need not equal the optimal capital structure
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6

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25/09/2010

ISSUES IN DETERMINING THE CAPITAL STRUCTURE?

Choosing a Capital Structure

„ Overall issue: How should the firm finance

„ What is the primary goal of financial

managers?
– Maximise shareholder wealth

investments?
„ Steps:
1 Determine the financing choices
1.
2. Analyze the impact of these choices on the firm’s market value
3. Determine the optimal structure

„ We want ant to choose the capital str structure ct re that

will maximise shareholder wealth
„ We can maximise shareholder wealth by

maximising firm value or minimising WACC

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10

WHAT ARE THE CHOICES

The Effect of Leverage

„ Should the firm use retained earnings or seek external

„ How does leverage affect the EPS and ROE of a

financing?
¾ How much capital must be raised externally versus internally? „ When we increase the amount of debt financing,

firm? we increase the fixed interest expense
„ If we have a really yg good yyear, then we p pay y our

„ If external financing, g, fixed cost 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 and
ROE

¾ How much should it borrow
¾ How much should it raise through issuing shares
„ Financier:

¾ Should the firm use an intermediary (i.e., a bank or institution) or should the firm go directly to investors

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Capital Restructuring

The Effect of Leverage (continued)

„ We are going to look at how changes in capital

„ The extent to which debt is used in the capital

structure affect the value of the firm, all else equal
„ Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets
„ Increase
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