Financial leverage

1
Chapter 16

• Financial leverage
• Ross, Westerfield, Jordan, Roberts

2
Capital structure (corporate)

• How are the assets of the firm finance
• Fixed obligations (debt)
• Coupon bonds
• Discount bonds
• Mortgage bonds
• Preferred Stock
• Dividend payment
• Some flexibility in payment
• Residual obligation (equity)
• Retained earnings
• Newly issued equity

3
Capital structure (personal)

• Fixed obligations (debt)
• Credit card debt
• Line of credit
• Car loan
• House mortgage
• Residual obligation (equity)
• Equity on car and house
• Household assets
• Financial assets
• RRSPs, RESPs, Savings, etc
• Pensions, mutual funds, financial portfolios

4
Personal Balance sheet
Liquid Assets Checking accts Financial
portfolios Pensions, etc Fixed Assets
Clothing Household goods Car House
Human Capital
Current Liabilities Line of credit Credit
Card debt Long-term Liabilities Student
Loans Car Loans Equity Out-of-pocket
equity Sweat Equity
5
Students Balance sheet
Liquid Assets Checking accts 200
Financial portfolios 0 Pensions, etc 0
Fixed Assets Clothing 1,500 Household
4,000 Car 1,500 Total Assets 7,200
??? Human Capital 60,000
Current Liabilities Credit Card debt
300 Long-term Liabilities Student Loans
20,000 Equity (13,100) 46,900
Out of Pocket ??? Sweat Equity ???
6
Professional (10 yrs Out)
Liquid Assets Checking accts 1,500
Portfolios 60,000 Pensions 40,000 Fixed
Assets Clothing 5,000 Household
20,000 Car 20,000 House 150,000
Total Assets 296,500 Human Capital
300,000
Current Liabilities Line of credit 3,500
Credit Card debt 800 Long-term Liabilities
Car Loans 12,000 Mortgage
120,000 Equity 170,200 470,200
Out of Pocket ??? Sweat equity ???
DR 46
7
25 yrs Out
Current Liabilities Line of credit 5,000
Credit Card debt 5,000 Long-term Liabilities
Car Loans 10,000 Mortgage
0.00 Equity 1,375,000 Out-of-pocket
equity Sweat equity
Liquid Assets Checking accts 5,000
Portfolios 600,000 Pensions 400,000
Fixed Assets Clothing 10,000 Household
100,000 Car 30,000 House
250,000 Total Assets 1,395,000 Human
Capital 1,000,000
DR 1.5
8
Value of the firm

• Approximating
• EBIT are the cash flows to the investors in the
  firm
• Bondholders
• Equity holders
• rA is the return on assets

9
Change in value (no taxes)

• If a firm is fully equity financed, i.e.,
• Return on assets (ROA) equals return on equity
  (ROE) equals wacc

10
Changes in value (no taxes)

• If firm finances with a mix of debt and equity
• Value of firm remains constant
• ROA wacc remains constant
• ROE increases due to new default risk

11
Example

• ROA 10,
• EBIT 1,000,000
• Firm increases leverage to 50 _at_ 6
• Value of the firm remains constant

12
Miller Modigliani I(no taxes)

• Proposition One
• Proposition Two

13
MMI graphically
V
VL VU
10
RE
R
0.14
0.10
wacc
leverage
0.06
RD
leverage
0.50
14
Business Financial Risk

• Return on assets
• Return on equity
• Beta of equity including financial risk

15
Taxes change everything

• Tax law
• Interest payments are deductible before taxes
• Results it tax subsidy to debt
• Dividend payments are not deductible
• Value of the firm may increase
• If tax subsidy (tax shield) reduces wacc, then

16
Equity-financed firm with taxes

• ROA 10, Tax rate 40
• EBIT 1,000,000
• E 6,000,000

17
Equity/debt-financed firm with taxes

• leverage 50 _at_ 6 (buys back stock)

18
Miller Modigliani II(taxes)

• Proposition One
• Proposition Two

19
MMII graphically
V
VL VU TC
9
RE
R
0.10
wacc
leverage
0.06
RD
leverage
20
Bankruptcy costs

• Direct costs (legal)
• Indirect costs
• Loss of business
• Cost of managers dealing with financial distress
  rather than running the firm
• Agency costs
• Monitoring costs

21
MMII with financial distress
V
VL VU TC
RE
R
wacc
0.10
RD
leverage
0.06
leverage
22
Canadian Imperial

• Canadian imperial is very risky
• Leverage will be low
• Bankers unwilling to lend

CA FA Limited Mineral rights
CL D 5 Equity 95
23
ACAN

• ACAN has good cash flows
• Leverage will be low to medium
• Bankers are willing to lend to a point
• Cyclicality of construction will limit leverage

CA (20) FA (80)
CL D (35) Equity (65)
24
Newfoundland Power

• NF is a regulated monopoly
• Cash flows very consistent
• Leverage will be medium to high
• Bankers to lend for projects
• Also able to float bonds

CA (10) FA (90)
CL D (65) Equity (35)
25
CIBC

• CIBC has good cash flows
• Deposits are insured
• Leverage will be high

DD (35) SD (35) GICs (30) Equity (5)
CA (20) FA (80)
26
Operating Leverage

• Asset side of the balance sheet
• Fixed versus Variable costs
• Fixed
• Invariable relative to output
• Lease payments, Marketing costs, Administrative
  costs
• Variable
• Variable relative to output
• Labor, Inputs, energy
• Total costs Fixed Variable

27
Accounting Break-even

• Revenues Price Quantity
• Fixed costs depreciation constant
• Variable costs v quantity
• Break-even when revenue equals cost
• Solve for the break-even Quantity

28
High Operating leverageMonopoly

v
P
FC
Q
29
Low Operating leverageCompetition

P
v
FC
Q
30
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