Bahir Dar University

Accounting And Finance Department

Financial Management II

By: Girma N. (MSc)

 Chapter one

Capital Structure Policy and

Financial Leverage
 Objective of the Chapter
At the end of this chapter, the student be able to:
• Define capital structure
• Discus Factors that Influence Capital Structure Decisions
• Differentiate Business and Financial Risk
• Distinguish between Operating & Financial leverage,
• Understand the effect of financial leverage on cash flows and the
cost of equity.
• Differentiate different capital structure theories.
• Understand the impact of taxes and bankruptcy on capital
structure choice.
 Introduction
• Capital refers to FA or resources that businesses & individuals
use to generate wealth, invest, or fund operations.
• Capital is the major part of all kinds of business activities,
which are decided by the size, and nature of the business
concern.
• Debt-equity ratios don’t just drop on firms from the sky, of
course, so now it’s time to wonder where they come from.
• Go back to FM I Chapter 1, and recall that we refer to
decisions about a firm’s debt-equity ratio as capital structure
decisions.
•
 Introduction
• The company issues stock and uses the money to pay off
some debt, thereby reducing the debt-equity ratio.
• Activities such as these, which alter the firm’s existing
capital structure, are called capital restructurings.
• The leading theories of capital structure attempt to
explain the proportions of financial instruments observed
on the right-hand side of corporations’ financial position.
 Introduction
• The main issues that capital structure literature deals with
concern the following questions:
• How do firms finance their operations?
• Which factors influence these choices?
• Is it possible to increase the firm value just by
changing the mix of securities issued?
• Is there an optimal debt-equity combination that
maximizes the value of the firm and if so
• What is it?
• How is it determined?
 Capital Structure Questions
• Capital structure refers to the amount
of debt and/or equity employed by a firm to fund its
operations and finance its assets.
• A firm’s capital structure is typically expressed as a debt-to-
equity or debt-to-capital ratio.
• Capital structure is the permanent financing of the
company represented primarily by long-term debt and
equity.
• How should a firm choose its debt– equity ratio?
Cont’d…
 Cont’d
• the guiding principle is to choose the course of action
that maximizes the value of a share of stock (firm
value).
• Capital restructuring involves changing the amount of
leverage a firm has without changing the firm’s assets
• The firm can increase leverage by issuing debt and
repurchasing outstanding shares.
• The firm can decrease leverage by issuing new shares
and retiring outstanding debt.
 Factors That Influence Capital Structure
Decisions
1. Leverage: It is the basic & important factor, which affect the capital
structure.
✓ It uses fixed-cost financing such as debt, equity & preference share
capital.
✓financial leverage refers to the extent to which a firm relies on debt.
2. Cost of Capital: the major factor in deciding a firm’s capital structure.
• When the cost of capital increases, the firm’s value will also decrease.
Hence the firm must take careful steps to reduce the cost of capital.
✓ Nature of the business:
✓ Size of the company:
✓ Legal requirements:
✓ Requirement of investors:
3. Government policy: Promoter contribution is fixed by the Company
Act.
 Cont’d ….
4. Business risk: This is the risk of the business's operating
income being volatile due to changes in demand,
competition, costs, technology, or other factors.
✓ The higher the business risk, the lower the optimal debt
ratio, as debt increases the financial risk and the
probability of bankruptcy.
[Link] shield: This is the benefit of reducing the taxable
income by deducting the interest payments on debt.
[Link] distress costs: These are the costs of facing
financial difficulties or bankruptcy due to the inability to
meet the debt obligations.
[Link] costs: These are the costs of conflicts of interest
between the different stakeholders of the business, such as
managers, shareholders, and creditors.
 Business and Financial Risk

There are two dimensions of risk:

1. Business risk, or the riskiness of the firm’s stock if it uses
no debt, and
2. Financial risk, which is the additional risk placed on the
common stockholders as a result of the firm’s decision to
use debt.
 Business Risk and operating leverage
✓Leverage is a use of “fixed cost” items in the process of
magnifying earnings.
✓operating leverage ; is the extent to which fixed costs are used in
a firm’s operations.
✓Use of “fixed operating costs” in the process of magnifying
operating income (EBIT)
✓In business terminology, a high degree of operating leverage,
other factors held constant, implies that a relatively small change
in sales results in a large change in ROE.
✓If a high percentage of total costs are fixed, then the firm is said
to have a high degree of operating leverage.
 Cont’d
✓Business risk is equity risk that comes from the nature of
the firm’s operating activities.
✓It depends on the unsystematic risk of the firm’s assets.
✓The greater a firm’s business risk, the greater RA will be,
and, all other things being the same, the greater will be the
firm’s cost of equity.
✓It depends on the firm’s assets and operations and is not
affected by capital structure.
✓Other things held constant, the higher a firm’s operating
leverage, the higher its business risk.
 Cont’d
Business risk depends on a number of factors
✓Variability such as Demand, Sales price and Input cost variability.
✓Ability to adjust output prices for changes in input costs.
✓Ability to develop new products in a timely, cost-effective manner.
✓Foreign risk exposure.
✓The extent to which costs are fixed: operating leverage.
✓If a high percentage of costs are fixed, hence do not decline when
demand falls, then the firm is exposed to a relatively high degree of
business risk and this factor is called operating leverage.
 Financial Risk and financial leverage
✓Financial Risk is an increase in stockholders’ risk, over and
above the firm’s basic business risk, resulting from the use of
financial leverage (debt).
✓is determined by the firm’s financial structure, for an all-equity
firm, this component is zero.
✓As the firm begins to rely on debt financing, the required return
on equity rises. This occurs because the debt financing increases
the risks borne by the stockholders.
✓Financial Leverage is the extent to which fixed-income securities
(debt and preferred stock) are used in a firm’s capital structure.
✓Use of “fixed financial costs” (e.g., debt and preferred stock
financing) in the process of magnifying earnings per share EPS.
 Effect of financial leverage
Effect on Cash Flows
• Financial leverage impacts cash flows in the following ways:
Positive Effects:
• Tax Savings: Interest payments on debt are tax-deductible, reducing taxable
income (known as the tax shield).
• Increased Earnings per Share (EPS): If a firm earns more on its assets
than the cost of debt, shareholders benefit from higher EPS.
Negative Effects:
• Higher Fixed Obligations: Debt increases interest payments, reducing free
cash flows available to shareholders and operations.
• Increased Default Risk: If earnings fluctuate, high debt levels may lead to
liquidity problems or bankruptcy.
Cont’d…
 Distinguish Between
Operating Leverage and Financial Leverage
 Determining the optimal capital structure
• Optimum capital structure is the capital structure
at which the weighted average cost of capital is
minimum and thereby the value of the firm is
maximum.
• Optimum capital structure may be defined as the
capital structure or combination of debt and
equity, that leads to the maximum value of the
firm.
 Determining the optimal capital structure
• What is the primary goal of financial
managers?
• Maximize stockholder wealth/firm value
• We want to choose the capital structure that
will maximize stockholder wealth.
• We can maximize stockholder wealth by
maximizing the value of the firm or
minimizing the WACC.
 Cont’d
• A primary reason for studying the WACC is that the
value of the firm is maximized when the WACC is
minimized.
• To see this, recall that the WACC is the appropriate
discount rate for the firm’s overall cash flows.
• Because values and discount rates move in opposite
directions, minimizing the WACC will maximize the
value of the firm’s cash flows.
 EBIT-EPS ANALYSIS
• EBIT is the metric that makes interest and taxes irrelevant.
• an investor can understand how the company is performing out of
the balance sheet’s composition, making interest and taxes the focal
point of consideration.
• There is no difference if a company has huge debt or no debt at all.
• EPS is the metric that shows a company’s earnings including
interests and taxes.
• It is an important metric because it shows the earnings on a per-
share basis which helps the investors understand how a company
performs on an overall basis.
 CONT’D…
• EBIT-EPS analysis is a method used to study the effects of
leverage on a firm’s earnings per share.
• It involves examining how changes in EBIT impact EPS
under different financing scenarios.
• Essentially, it helps in comparing the potential benefits of
debt financing versus equity financing.
 The Effect of Leverage

• How does leverage affect the EPS and 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, then we pay our fixed cost
and we have more left over for our stockholders.
• If we have a really bad year, we still have to pay our fixed
costs and we have less left over for our stockholders.
• Leverage amplifies the variation in both EPS and ROE.
 Cont’d….
• If a company takes on more leverage, it may increase its
earnings per share (EPS) since debt financing is generally
cheaper than equity.
• Higher EPS can lead to a higher stock price.
• High debt levels increase default risk, which can negatively
affect stock prices if investors perceive the company as
risky.
• Increasing debt can lower WACC up to a certain point.
 BREAK-EVEN EBIT

• If we expect EBIT to be greater than the break-even

point, then leverage may be beneficial to our
stockholders.
EBIT=PQ-VQ-F = 0
• If we expect EBIT to be less than the break-even point,
then leverage is detrimental to our stockholders
 Capital Structure Theory
• Capital Structure Theory refers to the study of how
firms finance their operations through different
sources of funds, such as debt, equity, and hybrid
securities.

• It aims to determine the optimal mix of financing

that minimizes the firm's cost of capital while
maximizing shareholder value.
 Cont’d….
1. Modigliani and Miller (M&M)Theory of Capital
Structure
• Proposition I – firm value
• Proposition II – WACC
• The value of the firm is determined by the cash
flows to the firm and the risk of the assets
• Changing firm value
• Change the risk of the cash flows
• Change the cash flows
MM Capital Structure Theory Under Three Special
Cases
• Case I – Assumptions
• No corporate or personal taxes
• No bankruptcy costs
• Case II – Assumptions
• Corporate taxes, but no personal taxes
• No bankruptcy costs
• Case III – Assumptions
• Corporate taxes, but no personal taxes
• Bankruptcy costs
 CASE I – PROPOSITIONS I AND II
Proposition I
✓The value of the firm is NOT affected by changes in the capital structure
✓The cash flows of the firm do not change; therefore, value doesn’t change
Proposition II
✓ The WACC of the firm is NOT affected by capital structure
Case I – Equations
✓WACC = RA = (E/V)RE + (D/V)RD
✓RE = RA + (RA – RD)(D/E)
✓RA is the “cost” of the firm's business risk, i.e., the risk of the firm's assets
(RA -RD)(D/E) is the “cost” of the firm's financial risk, i.e., the additional
return required by stockholders to compensate for the risk of leverage.
Cont’d
 CASE I - EXAMPLE
• Data
• Required return on assets = 16%; cost of debt = 10%; percent of
debt = 45%
• What is the cost of equity?
• RE = 16 + (16 - 10)(.45/.55) = 20.91%
• Suppose instead that the cost of equity is 25%, what is the debt-to-
equity ratio?
• 25 = 16 + (16 - 10)(D/E)
• D/E = (25 - 16) / (16 - 10) = 1.5
• Based on this information, what is the percent of equity in the
firm?
• E/V = 1 / 2.5 = 40%
 THE CAPM, THE SML And Proposition II
• How does financial leverage affect systematic risk?
• CAPM: RA = Rf + A(RM – Rf)
• Where A is the firm’s asset beta and measures the
systematic risk of the firm’s assets

• Proposition II
• Replace RA with the CAPM and assume that the debt is
riskless (RD = Rf)
• RE = Rf + A(1+D/E)(RM – Rf)
 CASE II – CASH FLOW

• Interest is tax deductible

• Therefore, when a firm adds debt, it reduces
taxes, all else equal
• The reduction in taxes increases the cash flow of
the firm
• How should an increase in cash flows affect the
value of the firm?
CASE II - EXAMPLE

Unlevered Firm Levered Firm

EBIT 5,000 5,000

Interest 0 500
Taxable 5,000 4,500
Income
Taxes (34%) 1,700 1,530
Net Income 3,300 2,970
CFFA 3,300 3,470
 Interest Tax Shield
• Annual interest tax shield
• Tax rate times interest payment
• 6,250 in 8% debt = 500 in interest expense
• Annual tax shield = .34(500) = 170

• Present value of annual interest tax shield

• Assume perpetual debt for simplicity
• PV = 170 / .08 = 2,125
• PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125
 CASE II – PROPOSITION I
• The value of the firm increases by the present value of
the annual interest tax shield
• Value of a levered firm = value of an unlevered firm + PV of
interest tax shield
• Value of equity = Value of the firm – Value of debt

• Assuming perpetual cash flows

• VU = EBIT(1-T) / RU
• VL = VU + DTC
 EXAMPLE: CASE II – PROPOSITION I

• Data
• EBIT = 25 million; Tax rate = 35%; Debt = $75 million;
Cost of debt = 9%; Unlevered cost of capital = 12%

• VU = 25(1-.35) / .12 = $135.42 million

• VL = 135.42 + 75(.35) = $161.67 million
• E = 161.67 – 75 = $86.67 million
CONT’D
 CASE II – PROPOSITION II
• The WACC decreases as D/E increases because of the
government subsidy on interest payments
• RA = (E/V)RE + (D/V)(RD)(1-TC)
• RE = RU + (RU – RD)(D/E)(1-TC)

• Example
• See the above examples data
• RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
• RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-.35)
RA = 10.05%
EXAMPLE: CASE II – PROPOSITION II
• Suppose that the firm changes its capital structure so
that the debt-to-equity ratio becomes 1.
• What will happen to the cost of equity under the new
capital structure?
• RE = 12 + (12 - 9)(1)(1-.35) = 13.95%

• What will happen to the weighted average cost of

capital?
• RA = .5(13.95) + .5(9)(1-.35) = 9.9%
Cont’d
 CASE III
• Now we add bankruptcy costs
• As the D/E ratio increases, the probability of
bankruptcy increases
• This increased probability will increase the expected
bankruptcy costs.
• At some point, the additional value of the interest tax
shield will be offset by the increase in expected
bankruptcy cost.
• At this point, the value of the firm will start to
decrease, and the WACC will start to increase as more
debt is added.
 Bankruptcy Costs
• Direct costs
• Legal and administrative costs
• Ultimately cause bondholders to incur additional losses
• Disincentive to debt financing

• Financial distress
• Significant problems in meeting debt obligations
• Firms that experience financial distress do not necessarily file
for bankruptcy
 More Bankruptcy Costs
• Indirect bankruptcy costs
• Larger than direct costs, but more difficult to measure and
estimate
• Stockholders want to avoid a formal bankruptcy filing
• 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
• The firm may also lose sales, experience interrupted
operations and lose valuable employees
 The Static Theory of Capital Structure
• The theory of capital structure that we have outlined
is called the static theory of capital structure.
• It says that firms borrow up to the point where the
tax benefit from an extra dollar in debt is exactly
equal to the cost that comes from the increased
probability of financial distress.
• We call this the static theory because it assumes that
the firm is fixed in terms of its assets and operations
and it considers only possible changes in the debt–
equity ratio.
 Static Trade-off Theory
• A theory that explains a company’s optimal capital
structure.
• The static trade-off theory recognises the benefits of
increased tax shield when debt increases, but also
acknowledges the increased in cost of financial
distress.
• Managers following this approach will seek to balance
the benefits of debt with the costs of financial distress,
and identify an optimal capital structure.
Cont’d
Cont’d
CONT’D
 Conclusions
• Case I – no taxes or bankruptcy costs
• No optimal capital structure
• Case II – corporate taxes but no bankruptcy costs
• Optimal capital structure is almost 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
 Managerial Recommendations
• The tax benefit is only important if the firm has a large
tax liability
• Risk of financial distress
• The greater the risk of financial distress, the less debt will be
optimal for the firm
• The cost of financial distress varies across firms and
industries, and as a manager you need to understand the
cost for your industry
 Pecking-order Theory
• MM’s assumption about firms and individuals having the
same (symmetric) information is relaxed.
• Owners/managers of firms know more about their firms’
prospects, risks, and values than outside investors do.
• This asymmetric information generates adverse selection
problems when firms turn to external financing.
• Implications:
• Securities issued by firms are mispriced (adverse selection cost)
• Some firms do not undertake positive NPV investment projects
• Low-quality firms (in terms of risk and profitability of their
investment projects) are more likely than high-quality firms to get
funded.
• Financing choices can eliminate or mitigate adverse
selection costs. Hence capital structure matters under
asymmetric information.
 The Pecking-order Theory
• Theory stating that firms prefer to issue debt rather
than equity if internal financing is insufficient.
• Rule 1
• Use internal financing first (retained earnings)
• Rule 2
• Issue debt next, new equity last.
• The pecking-order theory is at odds with the tradeoff
theory:
• There is no target D/E ratio
• Profitable firms use less debt
• Companies like financial slack
Cont’d
 Using Debt Financing To Constrain Managers
Debt financing can be used to constrain managers in two
ways:
• By funneling some of the capital back to shareholders
through higher dividends or stock repurchases.
• By shifting the capital structure toward more debt in the
hope that higher debt service requirements will force
managers to be more disciplined.
• High-ability managers are compelled to use debt financing
not only to lessen information asymmetry but also to
guarantee that the market finds their superior ability.
End Of the Chapter
Thank You!!!