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Corporate Finance FIN 622

Lesson 20

CAPITAL STRUCTURE AND FINANCIAL LEVERAGE

In this hand out we shall cover the following topics:

When to use WACC?

Pure Play

Capital Structure and Financial Leverage

WHEN TO USE WACC:

As we have covered in our lecture that using WACC as discount rate for discounting the cash flow of

intended project, is only feasible if the proposed project fall within the firms existing activities circle. For

example if a Oil manufacturing concern plans to establish another production facility then the existing

WACC of the firm can be used as discount rate. However, if the same firm is thinking to set up a new

spinning unit, then using existing WACC would be fatal and inappropriate.

WACC of a company reflects the level of risk and WACC is only appropriate discount rate if the intended

investment is replica of company's existing activities having same level of risk.

Using WACC as discount rate when the intended project has different risk level as of company then it will

lead to incorrect rejections and/or incorrect acceptance.

For example, a company having two strategic units and one unit having lower risk than the other, using

WACC to allocate resource will end up putting lower funds to high risk and larger funds to low risk

division.

The other side of this issue emerges from the situation when a firm is having more than one line of

business. For example a firm has two divisions: one of these has relatively low risk and the other has high

risk.

In this case, the firm's overall WACC would be the sum of two different costs of capital, which is one for

each business division. If two of these are contenders for the resources, the riskier division would tend to

have greater returns so it would be having the major chunk. The other one might have huge profit potential

ends up with insufficient resources allocated.

Pure Play

Using WACC blindly can lead to severe problems for a firm. Because we cannot observe the returns of

these investment, there generally is no direct way of coming up with the beta. The approach must be to find

a project or another firm in the industry in which our proposed project falls. We can use the beta of that

firm along with the D/E ration prevalent in that industry.

Once we have the beta and D/E of the firm or industry that resembles to our project we can estimate the

exact beta and D/E of proposed project. For example, if the industry (in which our intended project will

fall) has a beta of 1.7 and D/E ratio of 40:60, and we intend to finance the new project through equity only,

we can calculate the exact beta of intended project which, in turn will be used to calculate the new project

WACC or discount rate to evaluate the project cash flow. This process may involve un-gearing and re-

gearing.

Gbeta x (E / E + D(1-t))

Formula to un-gear equity Beta

Gbeta = Geared beta (1.7 in our example)

= Weight of equity in capital structure

= Weight of debt in capital structure

= Tax rate

In this example we need to un-gear the beta. Why? Note that the beta of the industry in which the proposed

project falls has D/E ratio of 40:60 but the new project shall be all equity financed. We un-gear the beta

that means the financial risk element needs to be removed from the geared beta of 1.7.

If we plug in values in the above equation we get the value of un-geared beta of 1.3296, which is also

WACC as there is no debt. This should be used as discount rate to evaluate future cash flow of proposed

project.

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Corporate Finance FIN 622

Pure play refers to what has been described above. We need to gauge the systematic risk of the new project

in order to calculate the beta and WACC to be used for discounting cash flow.

Capital Structure & Financial Leverage:

FOR the most part, a firm may choose any capital structure. Capital structure refers to the combination of

financing through equity and loans or debt. If management might decided to issue new shares and pay off

bond debt in order to reduce the debt-equity ratio. Activities like this are known as capital restructuring.

This is in fact a change of investment source leaving the firm's assets unchanged.

In the last 4/5 lectures we discussed the concept of WACC. It is simply the firm's overall cost of capital and

comprised of weighted average of the costs of various components of firm's capital structure. Now the

question arises that what happens to cost of capital when we change the relative weights of debt or equity?

The value of firm is maximized when WACC is at its lowest level. As you know that WACC is the discount

rate appropriate to evaluate the cash flow, the lower the discount rate the higher the present value of cash

flow. In other words, present value and discount rate move in opposite direction, lower WACC will ensure

maximizing the cash flow of the firm.

Thus, a firm must choose the capital structure so that the WACC is minimized. A capital structure that

minimizes the WACC would be better than the other one which with higher WACC.

Financial Leverage

The amount of debt in capital structure of a firm is known as financial leverage. In other words, how a firm

utilizes the amount of debt. The more debt in capital structure, there is greater financial leverage.

Financial leverage magnifies the payoffs to shareholders. It means that it increases the profit and loss with

more percentage than a percentage change in sales. It may be possible that financial leverage does not affect

the cost of capital. It is true then firm capital structure becomes irrelevant.

For example, a firm is all equity financed. Total assets are Rs. 6.0 million which are finance by 200,000

shares of Rs. 20 each. It is assumed that EBIT (Earning before Interest & Tax) is Rs. 800,000 in first year

and Rs. 1.20 million in second year. In this case, EPS (Earning per share) will be Rs. 2.67 & Rs.4 per share

respectively in first and second year. The ROE (Return on Equity) is 13.33% and 20% respectively for year

1 & 2.

Now consider that the firm decides to employ debt in it capital structure. The asset side will remain

constant at Rs. 6.0 million. In the proposed restructuring the D/E ratio of 1 is applied. It means that Rs. 3

million will be invested from equity and Rs. 3 million of debt is employed. Interest rate is assumed at 10%.

Assuming the same level of EBIT in both years, the EPS is now Rs. 3.33 and Rs.6 and ROE has jumped to

16.67% and 30% in first and second year respectively.

This magic is played by the financial leverage. It has increased both EPS AND ROE after debt was mixed

up in the capital structure.

DEBT

EPS

NO DEBT

+ FIN LEVERAGE

300000

600,000

EBIT

-2

-IVE FIN LEVERAGE

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Corporate Finance FIN 622

Financial leverage can also increase the losses as well. Looking at the graph above, if the EBIT is not

enough then it magnifies the losses. At EBIT of Rs. 600,000 the EPS is Rs. 2/-. If the EBIT is less than

point BE it represents the negative impact of debt. If the EBIT is falling right to the BE point it increase

the return, the positive financial leverage.