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REQUIRED TEXT: (A) Ross, Westerfield and Jordan. Fundamentals of Corporate Finance. (email is needed) McGraw-Hill/ Irwin. Tenth edition, alternate version

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(C) Hewlett Packard 10B calculator or any other Financial Calculator

During the week of January 28th 2015 – February 4th 2015 (with one interruption due to snow / weather) the following was discussed:

FINANCIAL LEVERAGE AND
CAPITAL STRUCTURE POLICY

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 of action that maximizes the value of a
share of stock. As we discuss next, however, when it comes to capital structure decisions,
this is essentially the same thing as maximizing the value of the whole firm, and, for convenience, we will tend to frame our discussion in terms of firm value.

CAPITAL STRUCTURE AND THE COST OF CAPITAL
In Chapter 14 , we discussed the concept of the fi rm’s weighted average cost of capital,
or WACC. You may recall that the WACC tells us that the fi rm’s overall cost of capital is
a weighted average of the costs of the various components of the fi rm’s capital structure.
When we described the WACC, we took the firm’s capital structure as given. Thus, one
important issue that we will want to explore in this chapter is what happens to the cost of
capital when we vary the amount of debt fi nancing, or the debt–equity ratio.
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 fi rm’s overall cash fl ows. Because values and discount rates move in opposite
directions, minimizing the WACC will maximize the value of the fi rm’s cash fl ows.
Thus, we will want to choose the fi rm’s capital structure so that the WACC is minimized.
For this reason, we will say that one capital structure is better than another if it results in a
lower weighted average cost of capital. Further, we say that a particular debt–equity ratio
represents the optimal capital structure if it results in the lowest possible WACC. This
optimal capital structure is sometimes called the fi rm’s target capital structure as well.

THE BASICS OF FINANCIAL LEVERAGE
We start by illustrating how financial leverage works. For now, we ignore the impact of
taxes. Also, for ease of presentation, we describe the impact of leverage in terms of its effects on earnings per share, EPS, and return on equity, ROE. These are, of course, accounting numbers and, as such, are not our primary concern. Using cash fl ows instead of these accounting numbers would lead to precisely the same conclusions, but a little more work would be needed. We discuss the impact on market values in a subsequent section.
Financial Leverage, EPS, and ROE:

An Example 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 the proceeds to buy back some of the outstanding equity.

Table 16.3 presents both the current and proposed capital structures;  the firm’s assets have a market value of $8 million, and there are 400,000 shares outstanding.

Because Trans Am is an all-equity firm, the price per share is $20.
The proposed debt issue would raise $4 million; the interest rate would be 10 percent.
Because the stock sells for $20 per share, the $4 million in new debt would be used to
purchase $4 million/20 = 200,000 shares, leaving 200,000. After the restructuring, Trans
Am would have a capital structure that was 50 percent debt, so the debt–equity ratio would be 1. Notice that, for now, we assume that the stock price will remain at $20.

To investigate the impact of the proposed restructuring, Ms. Morris has prepared
Table 16.4 , which compares the firm’s current capital structure to the proposed capital
structure under three scenarios. The scenarios reflect different assumptions about the firm’s EBIT. Under the expected scenario, the EBIT is $1 million. In the recession scenario, EBIT falls to $500,000. In the expansion scenario, it rises to $1.5 million.
To illustrate some of the calculations behind the figures in Table 16.4 , consider the expansion case. EBIT is $1.5 million. With no debt (the current capital structure) and no taxes, net income is also $1.5 million. In this case, there are 400,000 shares worth $8 million total.

EPS is therefore $1.5 million/400,000 = $3.75. Also, because accounting return on equity, ROE, is net income divided by total equity, ROE is $1.5 million/8 million = 18.75%.

With $4 million in debt (the proposed capital structure), things are somewhat different. Because the interest rate is 10 percent, the interest bill is $400,000. With EBIT of $1.5 million, interest of $400,000, and no taxes, net income is $1.1 million. Now there are only 200,000 shares worth $4 million total. EPS is therefore $1.1 million/200,000 = $5.50, versus the $3.75 that we calculated in the previous scenario. Furthermore, ROE is $1.1 million/4 million = 27.5%. This is well above the 18.75 percent we calculated for the current capital structure.

16.3
Current                            Proposed
Assets                                                  $8,000,000                     $8,000,000
Debt                                                     $ 0                                     $4,000,000
Equity                                                  $8,000,000                     $4,000,000
Debt–equity ratio:                             0                                        1
Share price                                        $ 20                                   $ 20
Shares outstanding                       400,000                            200,000
Interest rate                                       10%                                  10%

Current Capital Structure:                     No Debt
Recession                       Expected                       Expansion
EBIT                    $500,000                         $1,000,000                    $1,500,000
Interest              0                                         0                                        0
Net income      $500,000                         $1,000,000                    $1,500,000
ROE                      6.25%                               12.50%                           18.75%
EPS                      $ 1.25                                $ 2.50                             $ 3.75
Proposed Capital Structure: Debt = $4 million
EBIT                   $500,000                           $1,000,000                    $1,500,000
Interest             400,000                              400,000                          400,000
Net income     $100,000                           $600,000                        $1,100,000
ROE                    2.50%                                 15.00%                          27.50%
EPS                     $ .50                                    $ 3.00                             $ 5.50

Break-Even EBIT

The MPD Corporation has decided in favor of a capital restructuring. Currently, MPD uses
no debt financing. Following the restructuring, however, 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 will thus be (EBIT – $90,000)/ 150,000. Now that we know how to calculate EPS under both scenarios, we set them 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)

= $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.

Unlevering the Stock
In our Trans Am example, suppose management adopts 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 re-create the original payoffs.
To create leverage, investors borrow on their own. To undo leverage, investors must
lend money. In the case of Trans Am, the corporation borrowed an amount equal to half
its value. The investor can unlever the stock by simply lending money in the same proportion.
In this case, the investor sells 50 shares for $1,000 total and then lends the $1,000 at
10 percent. The payoffs are calculated in the following table:
Recession Expected Expansion
EPS (proposed structure) $ .50 $ 3.00 $ 5.50
Earnings for 50 shares 25.00 150.00 275.00
Plus: Interest on $1,000 100.00 100.00 100.00
Total payoff $125.00 $250.00 $375.00
These are precisely the payoffs the investor would have experienced under the original
capital structure.