My report on BA 107 in our MBA class.

1. FINANCIAL LEVERAGE

2. What is it?

3. Financial Leverage
» The use of an amount of debt to finance
firm’s assets in order increase expected
earnings per share.

4. Consider This…
Susan Smith is the financial officer of High-Tech
Manufacturing Corporation (HTMC). The corporation
currently has no debt.
Shares of common stock - $200,000
Shares trade - $50/each age
Total market capitalization = $10,000,000
Profits per year = $1,000,000
Required return on assets (ROA)= 10%
ROA=ROE (since HTMC has no debt)

5. Consider This…
* Shareholder suggests that HTMC should issue
$5,000,000 in long term-debt at an interest rate 6%.
Proceeds of debts can repurchase half the company’s
common stock (100,000 shares of stock)
-If economy continues to grow at normal rate-----Earnings
before interest and tax (EBIT) = $1,000,000
-If economy falls into recession: EBIT = $500,000
-If economy booms---: EBIT = $1,500,000
*Ms. Smith believes that the probability of each outcome
is 1/3, so expected value of EBIT = $1,000,000.
Expected (EBIT)=(1/3) $1,500,000 + (1/3) $1,000,000 +(1/3)
$500,000 = $1,000,000

6. HTMC
The Current and Proposed Capital Structures for High-Tech
Manufacturing Corporation

7. HTMC
Cash Flows to Stockholders and Bondholders Under the Current
and Proposed Capital Structure for HTMC
Assume EBIT=$1,000,000

8. HTMC
Expected EPS (no debt)= (1/3) $7.50 + (1/3) $5 + (1/3) $ 2.50= $5
Expected EPS (with debt)= (1/3) $12 + (1/3) $7 + (1/3) $2 =$7
Expected ROE (no debt)= (1/3) 15% +(1/3) 10% + (1/3) 5%= 10%
Expected ROE (with debt)=(1/3) 24% + (1/3) 14% + (1/3) 4%= 14%

9. The Fundamental Principle Financial Leverage
Financial Leverage
- employing long-term debt financing
- wherein debt financing is used to magnify the impact
of change in EBIT on earnings per share.

10. The Fundamental Principle Financial Leverage
» Substituting long-term debt for equity in a company’s capital
structure increases both the level of expected returns to
shareholders(measured by ROE) and the risk of those expected
returns.
Leverage Increases Expected Return---But Does it Increase
Value?
Recall that if HTMC recapitalized, its expected EPS increases from $5 to
$7, likewise , expected ROE increases from 10%-14%
* stock price will remain $50
P=$7/.14= $50

11. The Fundamental Principle Financial Leverage
• There is no unique, optimal capital structure for the
company to maximize firm’s value.
• Substituting debt for equity will increase the expected
EPS, but only at the cost of higher variability with higher
EPS volatility, shareholders will expect higher
return, meaning that they will discount earnings at a higher
rate.
• These two effects essentially cancel each other out, so
shareholders are just as happy with a capital structure that
includes no debt as they are with that consists of equal
propositions of debt and equity.

12. The Modigliano and Miller Capital Structure
Irrelevance Propositions
No Taxes
No
In a world with “perfect markets”, capital Bankruptcy
Costs
structure cannot influence firm value and is
thus irrelevant.
No Cost of
Enforcing
Debt
Made an important distinction between a firm’s business Contracts
risk and its financial risk

13. Business Risk vs. Financial Risk
Business Risk Financial Risk
how a firm chooses
to distribute that risk
Variability of a between
firms cash stockholders and
flows bondholders

14. HTMC’s Business Risk
• HTMC’s business risk is determined by how its
earnings, before interest and taxes fluctuates
with the state of the economy.
• M&M pointed out that leverage changes neither
the total cash flows generated by a firm, nor the
variability of those cash flows.
Therefore, changing leverage cannot change the
overall value of a firm. Leverage simply
determines how firms divide their cash flows and
risk between stockholders and bondholders.

15. Proposition I: The Capital Structure Irrelevance
Proposition
The value of the firm is independent of the capital
structure and is given by capitalizing its expected net
operating income (EBIT) at the rate r.

16. Proposition I: The Capital Structure Irrelevance
Proposition
V = (E + D) = EBIT / r
V = total market value of the firm
E = market value of equity
D = market value of debt
EBIT = earnings before interest and taxes
r = required return on firm’s assets

17. HTMC’s Market Value
V= $1,000,000/ 10%
V=$10,000,000
Firm value is thus determined by the level of
HTMC’s operating profits and by the firm’s
degree of business risk.

18. Proposition II: How Increasing Leverage
Affects the Cost of Equity
The cost of equity capital for a levered firm =
The constant overall cost of capital + a risk premium.

19. Proposition II: How Increasing Leverage
Affects the Cost of Equity
re =+ ra +( ra- rd)D/E
re = required rate of return for equity.
rd = required rate of return for debt.
ra = required rate of return of a company with
100% equity (the same as the asset required rate of
return)

20. HTMC’s re
• For no debt outstanding:
• re =10%
• rd =6%
re=.10+(.10-.06)$0/$10,000,000=.10=10%
• For 50%debt 50% Equity capital:
re =10%
re =.10+ (.10-.06)x$5,000,000/$5,000,000=.14=14%

21. The M&M Model with Corporate Taxes
Decide whether to retain the firm’s existing all-equity
capital structure or adopt a proposed 50% debt 50%
equity capitalization.

22. Cash Flows to Stockholders and Bondholders Under the Current and Proposed
Capital Structure for HTMC-with Corporate taxation
Assume:
EBIT= $1,000,000 next year
r = 10%
Tc (corporate tax rate on earnings) =35%

23. Unlevered and Levered Versions of HTMC
Vu = [EBIT(1-Tc)]/r
= NI/r=$650,000/.10 = $6,500,000
The introduction of 35% corporate profit tax causes an immediate $3,500,000
reduction (from $10,000,000 to $6,500,000) in the market value of the current
all-equity version of HTMC.

24. Determining the Present Value of Debt Tax Shields
PV Interest Tax Shields = Tc x D
= .35 ($5,000,000)
= $1,750,000
The introduction of 35% corporate profit tax causes an
immediate $3,500,000 reduction (from $10,000,000 to
$6,500,000) in the market value of the current all-equity version
of HTMC.
Vl = Vu+PVtax shield
= Vu+TcD= $6,500,000 + $ 1,750,000
= $8,250,000

25. THE M&M Model
with Corporate and Personal Taxes
GL= [1-[(1- tc) (1- tPS)/1- tPB] DL
GL = Gain to leverage
tc = corporate tax rate
tPS = personal tax rate on stock capital gains Corporations have to
tPB = personal tax rate on interest income pay higher interest
DL = Debt of leveraged firm on debt
because individuals
have a tax-
disadvantage
relative to capital
gains.

26. THE M&M Model with Corporate and Personal Taxes
• If no tax world ----- (Tc=Tps =Tpd=0)
• In a world with only corporate taxes (Tc=.35;
Tps=Tpd=.40)
GL= [1-(1-.35)(1-0)/(1-.40)/(1-.40)/$ 5,000,000=
-.0833

27. Agency Cost/ Tax Shield Trade-Off Model of
Corporate Leverage
Agency costs arise because of core problems such as
conflicts of interest between shareholders and
management. Shareholders wish for management to
run the company in a way that increases shareholder
value.

28. Other factors influencing debts: Bankruptcy Costs
Direct Cost of Indirect Cost of
Bankruptcy Bankruptcy
out of pocket economic losses that
expenses directly result from
related to bankruptcy but not
bankruptcy filing and cash outlays spent
administration on the process itself

29. Agency Cost/ Tax Shield Trade-Off Model of
Corporate Leverage
VL = Vu + PV tax shield – PV
bankruptcy costs

30. The Asset Substitution Problem
• A problem that arises when a company exchanges its low-risk
assets for high-risk investments.
• The transfer of assets places more risk on the debt holders without
providing them with additional compensation. High-risk projects
can yield higher profits, however more risk is incurred by the firm.
The added profit may only benefit the shareholders, as the
bondholders require only a fixed return. The increase level of risk
does affect the bondhold.

31. The Underinvestment Problem
• An agency problem where a company refuses to invest in low-risk
assets, in order to maximize their wealth at the cost of the debt
holders. Low-risk projects provide more security for the firm's debt
holders, since a steady stream of cash can be generated to pay off
the lenders. The safe cash flow does not generate an excess return
for the shareholders. As a result, the project is rejected.
• Shareholders under invest capital by refusing to participate in low-
risk projects. This is similar to the asset substitution problem, where
shareholders exchange low-risk assets for high-risk ones. Both
instances will increase shareholder value at the expense of the debt
holders. Since high-risk projects have large profits, the shareholders
benefit from increased income, as the debt holders require only a
fixed portion of cash flow. The problem occurs because the debt
holders are not compensated for the additional risk.

32. How much debt is right for your company?
Taxes Risk
Factors
to
Consider Costs of
Financial
Slack / Financial
Asset Type Distress

33. Considerations for Taxes
• Debt is Tax Deductible: Increase in Debt
reduces the income tax paid IF the company is
in a tax-paying position.
• However, the company has to MAKE money.

34. Considerations for Risk
• FINANCIAL RISK: Directly controlled by
managers. This can be noted in the
formula for unleveraging and levering Betas.
• OPERATING OR ASSET RISK: Can be controlled
by managers through their choice of scale or
size of fixed assets.

35. Financial Slack
• the amount of funds a firm has available to
invest without visiting the external financial
markets after paying interest and before
paying dividends + Depreciation.

36. Conclusions
• The effect of financial leverage depends upon
EBIT.
• When EBIT are high, financial leverage raises
EPS and ROE.
• The variability of EPS and ROE is increased
with financial leverage.