RW7eCh16 (2).doc

CHAPTER16 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY Learning Objectives LO1 The effect of financial leverage on firm value and cost of capital. LO2 The impact of taxes and bankruptcy on capital structure choice. LO3 The essentials of the bankruptcy process. Answers to Concepts Review and Critical Thinking Questions 1. (LO1) Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely to the firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases, so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher cost of equity if it uses greater leverage. 2. (LO1) No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to remember is that the cost of debt is still less than the cost of equity. Since we are using more and more debt, the WACC does not necessarily rise. 3. (LO1) Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot easily be identified or quantified, it’s practically impossible to determine the precise debt/equity ratio that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes much more expensive, it’s probably true that the firm is too highly leveraged. 4. (LO1) The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs, tend to use less financial leverage. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter. 5. (LO1) It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses. 6. (LO1) Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate level. 7. (LO3) One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders’ best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable use of the process. 8. (LO3) As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates it. 9. (LO1, 2) The basic goal is to minimize the value of non-marketed claims. 10. (LO3) The two most basic options are liquidation or reorganization, though creative alternatives may exist. S16-1 11. (LO3) g, f, d, b, c, a, e. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. (LO1) a. A table outlining the income statement for the three possible states of the economy is shown below. The EPS is the net income divided by the 5,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. Recession Normal Expansion EBIT $14,000 $28,000 $36,400 Interest 0 0 0 NI $14,000 $28,000 $36,400 EPS $ 2.80 $ 5.60 $ 7.28 %ΔEPS –50 ––– +30 b. If the company undergoes the proposed recapitalization, it will repurchase: Share price = Equity / Shares outstanding Share price = $250,000/5,000 Share price = $50 Shares repurchased = Debt issued / Share price Shares repurchased =$90,000/$50 Shares repurchased = 1,800 The interest payment each year under all three scenarios will be: Interest payment = $90,000(.07) = $6,300 The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy under the proposed recapitalization. Recession Normal Expansion EBIT $14,000 $28,000 $36,400 Interest 6,300 6,300 6,300 NI $7,700 $21,700 $30,100 EPS $2.41 $ 6.78 $9.41 %ΔEPS –64.52 ––– +38.71 S16-2 2. (LO2) a. A table outlining the income statement with taxes for the three possible states of the economy is shown below. The share price is still $50, and there are still 5,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. Recession Normal Expansion EBIT $14,000 $28,000 $36,400 Interest 0 0 0 Taxes 4,900 9,800 12,740 NI $9,100 $18,200 $23,660 EPS $1.82 $3.64 $4.73 %ΔEPS –50 ––– +30 b. A table outlining the income statement with taxes for the three possible states of the economy and assuming the company undertakes the proposed capitalization is shown below. The interest payment and shares repurchased are the same as in part b of Problem 1. Recession Normal Expansion EBIT $14,000 $28,000 $36,400 Interest 6,300 6,300 6,300 Taxes 2,695 7,595 10,535 NI $5,005 $14,105 $19,565 EPS $1.56 $4.41 $6.11 %ΔEPS –64.52 ––– +38.71 Notice that the percentage change in EPS is the same both with and without taxes. 3. (LO1, 2) a. Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE: ROE = NI/$250,000 The ROE for each state of the economy under the current capital structure and no taxes is: Recession Normal Expansion ROE .0560 .1120 .1456 %ΔRO –50 ––– +30 E The second row shows the percentage change in ROE from the normal economy. b. If the company undertakes the proposed recapitalization, the new equity value will be: Equity = $250,000 – 90,000 Equity = $160,000 So, the ROE for each state of the economy is: ROE = NI/$160,000 Recession Normal Expansion ROE .0481 .1356 .1881 S16-3 %ΔRO –64.52 ––– +38.71 E c. If there are corporate taxes and the company maintains its current capital structure, the ROE is: ROE .0364 .0728 .0946 %ΔRO –50 ––– +30 E If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each state of the economy is: ROE .0313 .0882 .1223 %ΔRO –64.52 ––– +38.71 E Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage change in ROE is also the same with or without taxes. 4. (LO1) a. Under Plan I, the unlevered company, net income is the same as EBIT with no corporate tax. The EPS under this capitalization will be: EPS = $350,000/160,000 shares EPS = $2.19 Under Plan II, the levered company, EBIT will be reduced by the interest payment. The interest payment is the amount of debt times the interest rate, so: NI = $350,000 – .08($2,800,000) NI = $126,000 And the EPS will be: EPS = $126,000/80,000 shares EPS = $1.58 Plan I has the higher EPS when EBIT is $350,000. b. Under Plan I, the net income is $500,000 and the EPS is: EPS = $500,000/160,000 shares EPS = $3.13 Under Plan II, the net income is: NI = $500,000 – .08($2,800,000) NI = $276,000 And the EPS is: EPS = $276,000/80,000 shares S16-4 EPS = $3.45 Plan II has the higher EPS when EBIT is $500,000. c. To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is: EBIT/160,000 = [EBIT – .08($2,800,000)]/80,000 EBIT = $448,000 5. (LO1) We can find the price per share by dividing the amount of debt used to repurchase shares by the number of shares repurchased. Doing so, we find the share price is: Share price = $2,800,000/(160,000 – 80,000) Share price = $35.00 per share The value of the company under the all-equity plan is: V = $35.00(160,000 shares) = $5,600,000 And the value of the company under the levered plan is: V = $35.00(80,000 shares) + $2,800,000 debt = $5,600,000 6. (LO1, 2) a. The income statement for each capitalization plan is: I II All-equity EBIT $39,000 $39,000 $39,000 Interest 16,000 24,000 0 NI $23,000 $15,000 $39,000 EPS $ 3.29 $ 3.00 $ 3.55 The all-equity plan; Plan II has the lowest EPS. b. The breakeven level of EBIT occurs when the capitalization plans result in the same EPS. The EPS is calculated as: EPS = (EBIT – R DD/Shares outstanding This equation calculates the interest payment (D D) and subtracts it from the EBIT, which results in the net income. Dividing by the shares outstanding gives us the EPS. For the all-equity capital structure, the interest term is zero. To find the breakeven EBIT for two different capital structures, we simply set the equations equal to each other and solve for EBIT. The breakeven EBIT between the all-equity capital structure and Plan I is: EBIT/11,000 = [EBIT – .10($160,000)]/7,000 EBIT = $44,000 And the breakeven EBIT between the all-equity capital structure and Plan II is: EBIT/11,000 = [EBIT – .10($240,000)]/5,000 EBIT = $44,000 The break-even levels of EBIT are the same because of M&M Proposition I. S16-5 c. Setting the equations for EPS from Plan I and Plan II equal to each other and solving for EBIT, we get: [EBIT – .10($160,000)]/7,000 = [EBIT – .10($240,000)]/5,000 EBIT = $44,000 This break-even level of EBIT is the same as in part b again because of M&M Proposition I. d. The income statement for each capitalization plan with corporate income taxes is: II All-equity I EBIT $39,000 $39,000 $39,000 Interest 16,000 24,000 0 Taxes 9,200 6,000 15,600 NI $ 13,800 $ 9,000 $ 23,400 EPS $ 1.97 $ 1.80 $ 2.13 The all-equity plan still has the highest EPS; Plan II still has the lowest EPS. We can calculate the EPS as: EPS = [(EBIT – R DD(1 – t C]/Shares outstanding This is similar to the equation we used before, except now we need to account for taxes. Again, the interest expense term is zero in the all-equity capital structure. So, the breakeven EBIT between the all- equity plan and Plan I is: EBIT(1 – .40)/11,000 = [EBIT – .10($160,000)](1 – .40)/7,000 EBIT = $44,000 The breakeven EBIT between the all-equity plan and Plan II is: EBIT(1 – .40)/11,000 = [EBIT – .10($240,000)](1 – .40)/5,000 EBIT = $44,000 And the breakeven between Plan I and Plan II is: [EBIT – .10($160,000)](1 – .40)/7,000 = [EBIT – .10($240,000)](1 – .40)/5,000 EBIT = $44,000 The break-even levels of EBIT do not change because the addition of taxes reduces the income of all three plans by the same percentage; therefore, they do not change relative to one another. 7. (LO1) To find the value per share of the stock under each capitalization plan, we can calculate the price as the value of shares repurchased divided by the number of shares repurchased. So, under Plan I, the value per share is: P = $160,000/(11,000 – 7,000 shares) P = $40 per share And under Plan II, the value per share is: P = $240,000/(11,000 – 5,000 shares) S16-6 P = $40 per share This shows that when there are no corporate taxes, the stockholder does not care about the capital structure decision of the firm. This is M&M Proposition I without taxes. 8. (LO1) a. The earnings per share are: EPS = $32,000/8,000 shares EPS = $4.00 So, the cash flow from the company is: Cash flow = $4.00(100 shares) Cash flow = $400 b. To determine the cash flow to the shareholder, we need to determine the EPS of the firm under the proposed capital structure. The market value of the firm is: V = $55(8,000) V = $440,000 Under the proposed capital structure, the firm will raise new debt in the amount of: D = 0.35($440,000) D = $154,000 in debt. This means the number of shares repurchased will be: Shares repurchased = $154,000/$55 Shares repurchased = 2,800 Under the new capital structure, the company will have to make an interest payment on the new debt. The net income with the interest payment will be: NI = $32,000 – .08($154,000) NI = $19,680 This means the EPS under the new capital structure will be: EPS = $19,680/(8,000 – 2,800) shares EPS = $3.7846 Since all earnings are paid as dividends, the shareholder will receive: Shareholder cash flow = $3.7846(100 shares) Shareholder cash flow = $378.46 c. To replicate the proposed capital structure, the shareholder should sell 35 percent of their shares, or 35 shares, and lend the proceeds at 8 percent. The shareholder will have an interest cash flow of: S16-7 Interest cash flow = 35($55)(.08) Interest cash flow = $154 The shareholder will receive dividend payments on the remaining 65 shares, so the dividend