Leverage Policy

Leverage Policy
References:
Chapter 14 of Brigham, E.F. and Houston, J.F., 2015. 13th
Edition. Fundamentals of financial management. Cengage
Chapter 16 & 17 Ehrhardt, M. C., & Brigham, E. F. (2011).

Financial management: theory and practice. South-Western
Cengage Learning.
Learning Objectives
Identify the trade-offs that firms must consider when they determine the target
01 capital structure
Distinguish between business risk and financial risk and explain the effects that
02 debt financing has on the firm’s expected return and risk.
Discuss the analytical framework used when determining the optimal capital
03 structure.
Discuss capital structure theory and use it to explain why firms in different industries
04 tend to have different capital structures
Introduction
• The capital structure that maximizes a firm’s stock price is
called the Optimal Capital Structure.
• The mix of debt, preferred stock, and common equity the
firm wants to have is called the Target Capital Structure.
Setting the capital structure
• Using more debt will raise
the risk borne by Return
stockholders.
• Using more debt
generally increases the
expected return on equity.
Risk
DETERMINING THE OPTIMAL
CAPITAL STRUCTURE
• Managers should set as the target capital structure the
debt-equity mix that maximizes the firm’s stock price.
• However, it is difficult to estimate how a given change in
the capital structure will affect the stock price.
• As it turns out, the capital structure that maximizes the
stock price also minimizes the WACC;
• An increase in the debt ratio increases the costs of both
debt and equity.
Practice Question
14-2) Jackson Trucking Company is in the process of setting its target capital
structure. The CFO believes that the optimal debt ratio is somewhere between
20% and 50%, and her staff has compiled the following projections for EPS and
the stock price at various debt levels:
Assuming that the firm uses only debt and common equity, what is Jackson’s
optimal capital structure? At what debt ratio is the company’s WACC minimized?
• The riskiness inherent in the firm’s
Business operations if it uses no debt
Risk
• An increase in stockholders’ risk,
Financial over and above the firm’s basic
business risk, resulting from the
Risk use of financial leverage.
Financial Risk
• An increase in stockholders’ risk, over and above the firm’s
basic business risk, resulting from the use of financial
leverage.
• If a firm uses debt (financial leverage), this concentrates
the business risk on common stockholders.
The Hamada Equation
It is harder to quantify leverage’s effects on the cost of
equity, but a theoretical formula can help measure the effect:
Practice Question
14-4) Harley Motors has $10 million in assets, which were financed with
$2 million of debt and $8 million in equity. Harley’s beta is currently 1.2,
and its tax rate is 40%. Use the Hamada equation to find Harley’s
unlevered beta, bU.
= 𝑏𝑙
𝑏𝑢
𝐷
(1+ ( 1− 𝑇 ) ( )
𝐸
)
𝑏𝑢 = 1.2
2
(1 + ( 1 − 0.40 ) ( )
8
)
𝑏𝑢 =1.043
Practice Question
Use the Hamada equation to calculate the unlevered beta for Firm X with
the following data: bL = 1.25, T = 40%, Debt/Assets = 0.42, and
Equity/Assets 0.58. (bU = 0.8714)
Practice Question
What would be the cost of equity for Firm X at Equity/Assets ratios of 1.0
(no debt) and 0.58 if rRF = 5% and RPM = 4%?
=𝑏 (1+ ( 1 − 𝑇 ) 𝐷
𝑏 𝑙 𝑢 )
𝐸
𝑏
𝑙 =0.8714
𝑅𝑖 =𝑟 𝑓 +(𝑟 𝑚 −𝑟 𝑓 ) 𝛽 𝑖
𝑅𝑖= 0.05+ ( 0.04 ) 0.8714 𝑅𝑖= 0.05+ ( 0.04 ) 1.25

𝑅
𝑖=8.49 % 𝑅
𝑖=0.1 𝑜𝑟 10 %
CAPITAL STRUCTURE THEORY
MM (Modigliani and Merton Miller) proved in 1958, under a restrictive set of
assumptions, that a firm’s value should be unaffected by its capital structure.
Here is a partial Listing of their assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s
future investment opportunities.
6. EBIT is not affected by the use of debt.
MM Theory
• Conclusion: that capital structure is irrelevant
• MM provided clues about what is required to make capital
structure relevant and hence to affect a firm’s value
• MM’s work marked the beginning of modern capital
structure research, and subsequent research has focused
on relaxing the MM assumptions to develop a more
robust and realistic theory.
The Effect of Taxes
• MM’s original 1958 paper was criticized harshly, and they
published a follow-up in 1963 that relaxed the assumption
of no corporate taxes.
• They recognized that the Tax Code allows corporations to
deduct interest payments as an expense, but dividend
payments to stockholders are not deductible.
• Conclusion: this differential treatment leads to an optimal
capital structure of 100% debt.
The Effect of Taxes
• MM’s 1963 work was modified several years later by Merton Miller, when
he brought in the effects of personal taxes.
Debt Stock
• bonds pay interest, • Dividends and capital gains So on balance, returns on
• taxed as personal income • Capital gains are taxed at a common stocks are taxed at
at rates going up to 35%, max. rate of 15%, lower effective rates than
• This tax can be deferred returns on debt
until the stock is sold &
realized
The Effect of Taxes
(1) the deductibility of interest favors the use of debt
financing, but
(2) the more favorable tax treatment of income from stocks
favors the use of equity.
• Conclusion: It is difficult to specify the net effect of these
two factors. However, most observers believe that interest
deductibility has a stronger effect and hence that our tax
system favors the corporate use of debt.
The Effect of Potential Bankruptcy
• MM’s irrelevance results also depend on the assumption that that
bankruptcy costs are irrelevant. However, in practice, bankruptcy
exists, and it can be quite costly.
Legal and accounting expenses,
Hard time retaining customers, suppliers, and employees
Liquidate assets
Even the threat of bankruptcy brings about these problems

The Effect of Potential Bankruptcy
• Conclusion: A firm whose earnings are relatively volatile,
faces a greater chance of bankruptcy and thus should use
less debt than a more stable firm.
• This is consistent with our earlier point that firms with high
operating leverage (and thus greater business risk) should
limit their use of financial leverage.
Trade-Off Theory
This theory states tha
t firms trade off the ta
x benefits of debt fina
ncing against proble
ms caused by potenti
al bankruptcy.
The Pecking Order Hypothesis
• The presence of flotation costs and asymmetric information
may cause a firm to raise capital according to a pecking
order.
• In this situation a firm first raises capital internally by
reinvesting its net income and selling off its short-term
marketable securities.
• When that supply of funds has been exhausted, the firm will
issue debt and perhaps preferred stock.
• Only as a last resort will the firm issue common stock .
Signaling Theory
• MM assumed that everyone—investors and managers alike
—has the same information about a firm’s prospects. This is
called symmetric information.
• However, managers often have better information than
outside investors. This is called asymmetric information.
Signaling Theory
• We would expect a firm with very favorable prospects to avoid
selling stock and instead raise any required new capital by using
new debt even if this moved its debt ratio beyond the target level.
• A firm with unfavorable prospects would want to finance with stock,
which would mean bringing in new investors to share the losses.
• Conclusion: the announcement of a stock offering is generally
taken as a signal that the firm’s prospects as seen by its
management are not bright.

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Leverage Policy

Chapter 16 & 17 Ehrhardt, M. C., & Brigham, E. F. (2011).

𝑅𝑖= 0.05+ ( 0.04 ) 0.8714 𝑅𝑖= 0.05+ ( 0.04 ) 1.25

Hard time retaining customers, suppliers, and employees

Even the threat of bankruptcy brings about these problems

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