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Lecture FourteenCapital Structure and Leverage

Business vs. financial risk

Operating leverage/financial leverage

Optimal capital structure

Capital structure theory

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Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?

Note that business risk does not include financing effects.

What is business risk?

Probability

EBITE(EBIT)0

Low risk

High risk

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Business risk is affected primarily by:

Uncertainty about demand (sales).

Uncertainty about output prices.

Uncertainty about costs.

Product, other types of liability.

Operating leverage.

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What is operating leverage, and how does it affect a firm’s business risk?

Operating leverage is the use of fixed costs rather than variable costs.

If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

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More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.

What happens if variable costs change?

Sales

$ Rev.TC

FC

QBE Sales

$ Rev.

TC

FC

QBE

} Profit

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Probability

EBITL

Low operating leverage

High operating leverage

Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.

EBITH

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What is financial leverage?Financial risk?

Financial leverage is the use of debt and preferred stock.

Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

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Business Risk vs. Financial Risk

Business risk depends on business factors such as competition, product liability, and operating leverage.

Financial risk depends only on the types of securities issued: More debt, more financial risk. Concentrates business risk on stockholders.

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Firm U Firm L

No debt $10,000 of 12% debt

$20,000 in assets $20,000 in assets

40% tax rate 40% tax rate

Consider 2 Hypothetical Firms

Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt (capital structure).

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Firm U: Unleveraged

Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

Economy

Bad Avg. Good

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Firm L: Leveraged

Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for Firm U.

Economy Bad Avg. Good

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Firm U Bad Avg. GoodBEP* 10.0% 15.0% 20.0%ROE 6.0% 9.0% 12.0%TIE

Firm L Bad Avg. GoodBEP* 10.0% 15.0% 20.0%ROE 4.8% 10.8% 16.8%TIE 1.67x 2.5x 3.3x*BEP same for U and L.

8 8 8

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Expected Values:

E(BEP) 15.0% 15.0%E(ROE) 9.0% 10.8%E(TIE) 2.5x

Risk Measures:ROE 2.12% 4.24%CVROE 0.24% 0.39%

U L

8

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For leverage to raise expected ROE, must have BEP > kd.

Why? If kd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income.

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Conclusions

Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage.

L has higher expected ROE because BEP > kd.

L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

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If debt increases, TIE falls.

TIEEBIT

I

EBIT is constant (unaffected by useof debt), and since I = kdD, as Dincreases, TIE must fall.

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That capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. Trades off higher E(ROE) and EPS against higher risk.

Optimal Capital Structure

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What are “signaling” effects in capital structure?

Managers have better information about a firm’s long-run value than outside investors.

Managers act in the best interests of current stockholders.

Assumptions:

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Therefore, managers can be expected to:

issue stock if they think stock is overvalued.

issue debt if they think stock is undervalued.

As a result, investors view a common stock offering as a negative signal--managers think stock is overvalued.

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Estimated costs of debt and equity for Campus Deli (see p. 1):

Amt. borrowed kd ks

$0 10.0% 15.0%

250 10.0 15.5

500 11.0 16.5

750 13.0 18.0

1,000 16.0 20.0

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Describe the sequence of events in a recapitalization.

Campus Deli announces the recapitalization.

New debt is issued.

Proceeds are used to repurchase stock.

Shares bought =Debt issued

Price per share .

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What would the new stock price be if Campus Deli capitalized and used these amounts of debt: $0, $250,000, $500,000, $750,000? Assume EBIT = $500,000, T =

40%, and shares can be repurchased at P0 = $20.

D = 0:

EPS0

EBIT k D Td 1

000 0 6

100 00000

Shares outstanding

$500, .

,$3. .

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$250,

$20, .

$500 . $250 .

.

$3. .

.

00012 500

0 1 0 6

100 12 5

26

$500

$2520

EBIT

Ix

D = $250, kd = 10%.

Sharesrepurchased

EPS1

TIE

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$500

$20.

$500 . $500 .

$3. .

. .

25

0 11 0 6

100 2556

$500$55

9 1EBIT

Ix

D = $500, kd = 11%.

Sharesrepurchased

EPS2

TIE

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Stock Price (Zero Growth)

PD

k g

EPS

k

DPS

ks s s0

1

If payout = 100%, then EPS = DPS andE(g) = 0.

We just calculated EPS = DPS, and ks was given on Page 1, so we canuse the equation to find P0 as shownon the next slide.

.

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P0 = DPS/ks

Debt DPS ks P0

$0 $3.00 15.0% $20.00

250,000 3.26 15.5

500,000 3.56 16.5

21.03

21.58*

750,000 3.86 18.0 21.44

1,000,000 4.08 20.0 20.40

*Maximum: Since D = $500,000 and assets = $2,000,000, optimal D/A = 25%.

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See preceding slide. Maximum EPS = $4.08 at

D = $1,000,000, and D/A = 50%.

Risk is too high at D/A = 50%.

What debt ratio maximizes EPS?

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What is Campus Deli’s optimal capital structure?

P0 is maximized ($21.58) at D/A = $500,000/$2,000,000 = 25%, so optimal D/A = 25%.

EPS is maximized at 50%, but primary interest is stock price, not E(EPS).

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The example shows that we can push up E(EPS) by using more debt, but the risk resulting from increased leverage more than offsets the benefit of higher E(EPS).

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What’s WACC at D = 0, D = $500, D = $1,000?

WACC w k T w kd d ce s 1

D = 0:

D = 500:

D = 1,000:

WACC = 0 + 1.0(15%) = 15.0%.

WACC = .50(16)(.6) + .50(20.0) = 14.8%.

WACC = .25(11)(.6) + .75(16.5) = 14.0%.

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15

0 .25 .75.50 D/A

ks

WACC

kd(1-T)

$

D/A.25 .50

P0

EPS

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How would these factors affect the Target Capital Structure?

1. Sales stability?

2. High operating leverage?

3. Increase in the corporate tax rate?

4. Increase in the personal tax rate?

5. Increase in bankruptcy costs?

6. Management spending lots of money on lavish perks?

13 - 33Value of Stock

0 D1 D2

D/A

MM result

Actual

No leverage

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The graph shows MM’s tax benefit vs. bankruptcy cost theory.

Logical, but doesn’t tell whole capital structure story. Main problem--assumes investors have same information as managers.

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Signaling theory, discussed earlier, suggests firms should use less debt than MM suggest.

This unused debt capacity helps avoid stock sales, which depress P0 because of signaling effects.

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Conclusions on Capital Structure

1. Need to make calculations as we did, but should also recognize inputs are “guesstimates.”

2. As a result of imprecise numbers, capital structure decisions have a large judgmental content.

3. We end up with capital structures varying widely among firms, even similar ones in same industry.