Financial Leverage and Bankruptcy: Impact on Firm Value and Capital Structure, Slides of Finance

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Capital Structure Decisions

Lecture Agenda

1. Financial Leverage

2. Determining Capital Structure

3. M&M Irrelevance Theorum

4. The Impact of Taxes

5. Financial Distress, Bankruptcy & Agency Costs

6. Other Factors Affecting Capital Structure

Introduction to Leverage

Financial Leverage

The Focus of this Chapter

• You know:
  • It is the responsibility of the financial manager to maximize

shareholder wealth.

• The after-tax cost of debt is significantly lower than the cost of

equity primarily because of the tax-deductibility of interest

expense…therefore, using debt has a cost advantage over equity.

• The lower the cost of capital, the greater the value of the firm.
• This chapter addresses the question:

Does the relative mix of financing used by a firm affect its value? If

so, how and why and are what are the other impacts that capital

structure can have on the firm?

Leverage Determining CS (^) M&M Irrelevance Taxes Distress/Bankruptcy (^) Other

Leverage: What is It?

Capital Structure Decisions

Leverage

• The increased volatility in operating income over

time, created by the use of fixed costs in lieu of

variable costs.

– Leverage magnifies profits and losses.

• There are two types:

– Operating leverage

– Financial leverage

• Both types of leverage have the same effect on

shareholders but are accomplished in very

different ways, for very different purposes

strategically.

Leverage Determining CS (^) M&M Irrelevance Taxes Distress/Bankruptcy (^) Other

Financial versus Operating

Leverage

Capital Structure Decisions

Operating Leverage

What is it? How is it Increased?

• Operating leverage is:
  • The increased volatility in operating income caused by fixed

operating costs.

• You should understand that managers do make decisions

affecting the cost structure of the firm.

• Managers can, and do, decide to invest in assets that give rise to

additional fixed costs and the intent is to reduce variable costs.

• This is commonly accomplished by a firm choosing to become more

capital intensive and less labour intensive, thereby increasing

operating leverage.

Leverage Determining CS (^) M&M Irrelevance Taxes Distress/Bankruptcy (^) Other

Financial Leverage

What is it? How is it Increased?

• Your textbook defines financial leverage as:

– The increased volatility in operating income

caused by the corporate use of sources of

capital that carry fixed financial costs.

• Financial leverage can be increased in the

firm by:

– Selling bonds or preferred stock (taking on

financial obligations with fixed annual claims

on cash flow)

– Using the proceeds from the debt to retire

equity (if the lenders don’t prohibit this

through the bond indenture or loan

agreement)

Leverage Determining CS (^) M&M Irrelevance Taxes Distress/Bankruptcy (^) Other

Financial Leverage

Advantages and Disadvantages

Advantages:

• Magnification of profits to the shareholders if the firm is

profitable.

• Lower cost of capital at low to moderate levels of financial

leverage because interest expense is tax-deductible.

Disadvantages:

• Magnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.

• Higher break even point.
• At higher levels of financial leverage, the low after-tax cost of debt

is offset by other effects such as:

• Present value of the rising probability of bankruptcy costs
• Agency costs
• Lower operating income (EBIT), etc.

Leverage Determining CS (^) M&M Irrelevance Taxes Distress/Bankruptcy (^) Other

Financial Leverage

Capital Structure Decisions

Business Risk

• All firms experience variability in sales and operating (fixed and

variable) operating costs over time.

• Some firms operate in a highly volatile industry (for example oil and

gas) and we would say the firm has a high degree of business risk.

• Other firms operate in a very stable industry where revenues and

expenses don’t change much from year to year throughout the

business cycle; these firms have low business risk.

• Business risk is the variability of a firm’s operating income

caused by operational risk.

• Business risk is measured by the standard deviation of EBIT.

Leverage Determining CS (^) M&M Irrelevance Taxes Distress/Bankruptcy (^) Other

Return on Investment (ROI)

Financial Leverage

Return on Investment (ROI)

• is the return on all the capital provided by investors; EBIT minus

taxes divided by invested capital.

• Invested Capital (IC) is a firm’s capital structure consisting of

shareholders’ equity and short- and long-term debt.

SE B

EBIT T

ROI

[ 21-2]

But we know the claims

on the numerator

(operating income after

taxes) are very different, and so too are

the risks each provider

of capital is exposed.

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Return on Equity (ROE)

Financial Leverage

ROE – is the return earned by equity

holders on their investment in the

company

– ROE = net income divided by

shareholders’ equity.

SE

EBIT R B T

ROE

D

[ 21-1] =

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