Chapter 13 1 1

CHAPTER 13:
LEVERAGE AND
CAPITAL STRUCTURE
B a l i n g i t , To p h e
C u n a n a n , A n g e l i e
G a l a n g , A l l a i n e
M a n a s a n , J e r s o n
M e n d o z a , J o h n Pa u l o
N i c o d e m u s , D a e n a
P o n c e , C y l e
R e y e s , J o h n i n
Ta p n i o , P r i n c e s
V e n d e r, J a z e
THE CAPITAL STRUCTURE QUESTION
 How should a firm go about choosing its debt equity ratio? Here, as always,
we assume that the guiding principle is to choose the course action that
maximizes the value of share of stock.
 What happens to the cost of capital when we vary the amount of debt
financing?
 What is the relationship between the WACC and the value of firm
 What is an optimal capital structure?

THE EFFECT OF FINANCIAL LEVERAGE
Financial Leverage - refers to the extent to which a firm relies on
debt. The more debt financing a firm uses in its capital structure, the
more financing leverage it employs. It can also dramatically alter the
payoffs of shareholders in the firm.
• THE IMPACT OF FINANCIAL LEVERAGE
 Financial leverage works in terms of its effects on earnings per share,

EPS, and return on equity, ROE. These accounting numbers is not the
primary concern but using cash flow instead because it would lead to
precisely the same conclusion, but a little more work would be needed.
TABLE 13.1
The Trans Am Corporation
currently has no debt in its
capital structure. The CFO, Ms.
Morris is considering a
restructuring that would
involve issuing debt and using
proceeds to buy back some of
outstanding equity.
TABLE 13.2
To investigate the impact of

the proposed restructuring,
Ms. Morris has prepared Table
13.2, which compares the
firm’s current capital structure
to the proposed capital
structure under three
scenarios
• EPS versus EBIT
EPS – earnings per share
EBIT – earnings before interest and taxes
Break-even point or indifference point
If EBIT is above the break-even or indifference point,

leverage is beneficial
If EBIT is below the break-even or indifference point,

leverage is not beneficial
• Break-Even EBIT
The MPD Corporation has decided in favor of a capital
restructuring. Currently, MPD uses no debt will be $1 million. The
interest rate on the debt will be 9 percent. MPD currently has 200,000
shares outstanding, and the price per share is $20. If the
restructuring is expected to increase EPS, what is the minimum level
for EBIT that MPD's management must be expecting? Ignore taxes in
answering.
To answer, we calculate the break-even EBIT. At any EBIT above
this, the increased financial leverage will increase EPS, so this will tell
us the minimum level for EBIT. Under the old capital structure, EPS is
simply EBIT/200,000. Under the new capital structure, the interest
expense will be $1 million x .09 = $90,000. Furthermore, with the $1
million proceeds, MPD will repurchase $1 million/20 = 50,000 shares
of stock, leaving 150,000 outstanding. EPS is thus (EBIT -
$90,000)/150,000.
Now that we know how to calculate EPS under both
scenarios, we set the two expressions for EPS equal to each
other and solve for the break-even EBIT:
EBIT/200,000 = (EBIT - $90,000)/150,000
EBIT = (4/3) x (EBIT - $90,000)
EBIT = $360,000
Verify that, in either case, EPS is $1.80 when EBIT is

$360,000. Management at MPD is apparently of the opinion
that EPS will exceed $1.80.
• Corporate Borrowing and Homemade Leverage
Conclusions:
1. The effect of financial leverage depends on the company’s
EBIT. When EBIT is relatively high, leverage is beneficial.
2. Under the expected scenario, leverage increases the
returns to shareholders, as measured by both ROE and EPS.
3. Shareholders are exposed to more risk under the proposed
capital structure because the EPS and ROE are much more
sensitive to changes in EBIT in this case.
4. Because of the impact that financial leverage has on both
the expected return to stockholders and the riskiness of the
stock, capital structure is an important consideration.
Shareholders can adjust the amount of financial leverage by
borrowing and lending on their own.
Homemade leverage – the use of personal borrowing to

change the overall amount of financial leverage to which an
individual is exposed
Investors can always increase financial leverage themselves

to create a different pattern of payoffs
• Unlevering the Stock
In our Trans Am example, suppose management adopted

the proposed capital structure. Further, suppose that an
investor who owned 100 shares preferred the original capital
structure. Show how this investor could “unlever” the stock to
recreate the original payoffs.
To create leverage, investors
(insert p 429 example 13.2 here)

CAPITAL STRUCTURE AND THE COST
OF EQUITY CAPITAL
M&M Proposition I – it is completely irrelevant how a firm
chooses to arrange its finances
- the value of a firm is independent of its capital structure
• M&M Proposition I: The Pie Model
Imagine two firms that are identical on left-hand side of the

balance sheet
Their assets and operations are exactly the same
The right-hand sides are different because the two firms

finance their operations differently
In this case, we can view the capital structure questions in

terms of a “pie” model
The size of the pie doesn’t depend on how it is sliced

• The Cost of Equity and Financial Leverage: M&M
Proposition II
M&M Proposition II tells us that the firm’s cost of equity is
composed of two components:
1. required return on the firm’s overall assets
2. firm’s financial structure
The total systematic risk of the firm’s equity has two parts:
1. Business Risk- the equity risk that comes from the nature of the
firm’s operating activities
2. Financial Risk- the equity risk that comes from the financial policy
of the firm
CORPORATE TAXES AND CAPITAL
STRUCTURE
Two distinguishing features of a debt:
1. Interest paid on debt is tax deductible
2. Failure to meet debt obligations can result in bankruptcy
• Interest Tax Shield- the tax saving attained by a firm from
the tax deductibility of interest expense
We will assume that depreciation is zero; capital spending is zero; no

additions to NWC
Total cash flow to L is $24 more

TAXES AND M&M PROPOSITION I
• The value of the leveraged firm (VL) is equal to the value of the
unleveraged firm (VU) plus the present value of the interest tax shield:
VL = VU + TC x D
Present Value of the interest tax shield:
= (TC × D × RD)/ RD
= TC × D
Tc = corporate tax rate
D = amount of debt
RD = cost of debt of the firm
Implications of Proposition I with Taxes:
• Debt financing is highly advantageous, and, in the extreme, a

firm’s optimal capital structures is 100 percent debt.
• A firm’s weighted average cost of capital, WACC, decreases as

the firm relies more heavily on debt financing.
BANKRUPTCY COSTS
Is the limit to the amount of where the firm uses debt.
Bankruptcy is the time where debts is equal to the amount of

assets.
DIRECT BANKRUPTCY COSTS

The cost that are directly associated with bankruptcy, such
as legal and administrative expenses.
This is also the formal process of turning over the

ownership to the bondholders.
FINANCIAL DISTRESS
Financial distress is a term in corporate finance used
to indicate a condition when promises to creditors of
a company are broken or honored with difficulty.
The direct and indirect costs associated with going

bankrupt or experiencing financial distress.
If financial distress cannot be relieved, it can lead

to bankruptcy.
INDIRECT BANKRUPTCY COSTS
The cost of avoiding a bankruptcy filling incurred by a
financially distressed firm.
This is where a firm becomes financially distressed and it's

nearing bankruptcy.
Some of their ways is they would focus on trying to survive

instead of operating the business.
By doing this, sales are lost and they will not able to pay the
employees.
OPTIMAL CAPITAL STRUCTURE
Is the best mix of debt, preferred stock and common stock that
maximizes a company’s stock price by minimizing its cost of
capital.
In theory, debt financing offers the lowest cost of capital due to
its tax deductibility.
However, too much debt increases the financial risk to

shareholders and the return on equity that they require.
A QUICK LOOK AT THE BANKRUPTCY
PROCESS
Business failure
Legal Bankruptcy
Technical Insolvency
Accounting Insolvency

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CHAPTER 13:

 What is an optimal capital structure?

• THE IMPACT OF FINANCIAL LEVERAGE

 Financial leverage works in terms of its effects on earnings per share,

To investigate the impact of

EPS – earnings per share

EBIT – earnings before interest and taxes

Break-even point or indifference point

If EBIT is above the break-even or indifference point,

If EBIT is below the break-even or indifference point,

EBIT/200,000 = (EBIT - $90,000)/150,000

EBIT = (4/3) x (EBIT - $90,000)

Verify that, in either case, EPS is $1.80 when EBIT is

Homemade leverage – the use of personal borrowing to

Investors can always increase financial leverage themselves

In our Trans Am example, suppose management adopted

To create leverage, investors

(insert p 429 example 13.2 here)

Imagine two firms that are identical on left-hand side of the

Their assets and operations are exactly the same

The right-hand sides are different because the two firms

In this case, we can view the capital structure questions in

The size of the pie doesn’t depend on how it is sliced

1. required return on the firm’s overall assets

2. firm’s financial structure

We will assume that depreciation is zero; capital spending is zero; no

Total cash flow to L is $24 more

Present Value of the interest tax shield:

• Debt financing is highly advantageous, and, in the extreme, a

• A firm’s weighted average cost of capital, WACC, decreases as

Bankruptcy is the time where debts is equal to the amount of

DIRECT BANKRUPTCY COSTS

This is also the formal process of turning over the

The direct and indirect costs associated with going

If financial distress cannot be relieved, it can lead

This is where a firm becomes financially distressed and it's

Some of their ways is they would focus on trying to survive

However, too much debt increases the financial risk to

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