Capital restructuring
Capital restructuring involves changing the amount of leverage a firm has without changing
the firm’s assets. The firm can increase leverage by issuing debt and repurchasing
outstanding shares. The firm can decrease leverage by issuing new shares and retiring
outstanding debt (increase equity)
The capital structure (weight of equity/debt etc) will affect WACC (which is the discount rate used to
calculate NPV of project). Smaller WACC, higher present value, higher value the firm. Bigger
WACC, smaller value of the firm.
Choosing a capital structure
What is the primary goal of financial managers? Maximize stockholder wealth
We want to choose the capital structure that will maximize stockholder wealth. We can
maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC
The WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the value of
the firm by discounting the firm’s expected future cash flows at the discount rate – the process is the
same as finding the value of anything else.
Since value and discount rate move in opposite directions, firm value will be maximized when
WACC is minimized. A firm is just a portfolio of projects, some with positive NPVs and some with
negative NPVs when evaluated at the WACC. The value of the firm is the sum of the NPVs of its
component projects. We already know that lower discount rates increase NPVs; consequently,
decreasing the WACC will increase firm value .
The Effect of Leverage
How does leverage affect the EPS (earning per share) and ROE (return on equity) of a firm?
When we increase the amount of debt financing, we increase the fixed interest expense
If we have a really good year, then we pay our fixed cost and we have more left over for our
stockholders. If we have a really bad year, we still have to pay our fixed costs and we have
less left over for our stockholders
Leverage increases the differences in both EPS and ROE
if we increase the amount of debt in a restructuring, we are implicitly decreasing the amount of
outstanding shares. Financial Leverage refers to the extent to which a firm relies on debt.
Example: Financial Leverage, EPS and ROE – Part I
What happens to EPS and ROE when we issue debt and buy back shares of stock? We will
ignore the effect of taxes at this stage.
Variability in ROE
Current: ROE ranges from 6% to 20%
Proposed: ROE ranges from 2% to 30%
, Variability in EPS
Current: EPS ranges from $0.60 to $2.00
Proposed: EPS ranges from $0.20 to $3.00
The variability in both ROE and EPS increases when financial leverage is increased
Break Even EBIT
Find EBIT where EPS is the same under both the current and proposed capital structures
If we expect EBIT to be greater than the break-even point, then leverage may be beneficial to
our stockholders. If we expect EBIT to be less than the break-even point, then leverage is
negative to our stockholders
Many students feel that if a company expects to achieve the break-even EBIT, it should automatically
issue debt. You should emphasize that this is a break-even point relative to EBIT and EPS. Beyond
this point, EPS will be larger under the debt alternative, but with additional debt, the firm will have
additional financial risk that would increase the required return on its common stock. A higher
required return might offset the increase in EPS, resulting in a lower firm value despite the higher
EPS. The M&M models, described in upcoming sections, will offer key points to make about this
relationship.
EPS = Earnings available to common shareholders/ no. of shares outstanding
Capital structure
Can a firm’s capital structure affect its market value? Is there an optimal level of debt
Market value of the firm = PV all the projects taken by the firm
PV = CF1/(1+i)n + CF2/(1+i)n….
Two views:
1) Traditional
2) Modigliani & Miller
Capital restructuring involves changing the amount of leverage a firm has without changing
the firm’s assets. The firm can increase leverage by issuing debt and repurchasing
outstanding shares. The firm can decrease leverage by issuing new shares and retiring
outstanding debt (increase equity)
The capital structure (weight of equity/debt etc) will affect WACC (which is the discount rate used to
calculate NPV of project). Smaller WACC, higher present value, higher value the firm. Bigger
WACC, smaller value of the firm.
Choosing a capital structure
What is the primary goal of financial managers? Maximize stockholder wealth
We want to choose the capital structure that will maximize stockholder wealth. We can
maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC
The WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the value of
the firm by discounting the firm’s expected future cash flows at the discount rate – the process is the
same as finding the value of anything else.
Since value and discount rate move in opposite directions, firm value will be maximized when
WACC is minimized. A firm is just a portfolio of projects, some with positive NPVs and some with
negative NPVs when evaluated at the WACC. The value of the firm is the sum of the NPVs of its
component projects. We already know that lower discount rates increase NPVs; consequently,
decreasing the WACC will increase firm value .
The Effect of Leverage
How does leverage affect the EPS (earning per share) and ROE (return on equity) of a firm?
When we increase the amount of debt financing, we increase the fixed interest expense
If we have a really good year, then we pay our fixed cost and we have more left over for our
stockholders. If we have a really bad year, we still have to pay our fixed costs and we have
less left over for our stockholders
Leverage increases the differences in both EPS and ROE
if we increase the amount of debt in a restructuring, we are implicitly decreasing the amount of
outstanding shares. Financial Leverage refers to the extent to which a firm relies on debt.
Example: Financial Leverage, EPS and ROE – Part I
What happens to EPS and ROE when we issue debt and buy back shares of stock? We will
ignore the effect of taxes at this stage.
Variability in ROE
Current: ROE ranges from 6% to 20%
Proposed: ROE ranges from 2% to 30%
, Variability in EPS
Current: EPS ranges from $0.60 to $2.00
Proposed: EPS ranges from $0.20 to $3.00
The variability in both ROE and EPS increases when financial leverage is increased
Break Even EBIT
Find EBIT where EPS is the same under both the current and proposed capital structures
If we expect EBIT to be greater than the break-even point, then leverage may be beneficial to
our stockholders. If we expect EBIT to be less than the break-even point, then leverage is
negative to our stockholders
Many students feel that if a company expects to achieve the break-even EBIT, it should automatically
issue debt. You should emphasize that this is a break-even point relative to EBIT and EPS. Beyond
this point, EPS will be larger under the debt alternative, but with additional debt, the firm will have
additional financial risk that would increase the required return on its common stock. A higher
required return might offset the increase in EPS, resulting in a lower firm value despite the higher
EPS. The M&M models, described in upcoming sections, will offer key points to make about this
relationship.
EPS = Earnings available to common shareholders/ no. of shares outstanding
Capital structure
Can a firm’s capital structure affect its market value? Is there an optimal level of debt
Market value of the firm = PV all the projects taken by the firm
PV = CF1/(1+i)n + CF2/(1+i)n….
Two views:
1) Traditional
2) Modigliani & Miller
