197.capital structure lecture gdansk 2006 lecture 2
TRANSCRIPT
EBIT/EPS Analysis The tax benefit of debt
Trade-off theory Practical considerations in the
determination of capital structure
CAPITAL STRUCTURELecture 2
Kevin Campbell, University of Stirling, October 2006 22
Capital structure
Issues:
EBIT-EPS analysis The tax shield benefit of debt The trade-off theory of capital structure Practical considerations that affect the
capital structure decision
Kevin Campbell, University of Stirling, October 2006 33
Business Risk vs Financial Risk
Business risk is the variability of a firm’s Earnings Before Interest and Taxes (EBIT)
Financial risk arises from the use of debt, which imposes a fixed cost in the form of interest payments = financial leverage.
Kevin Campbell, University of Stirling, October 2006 44
EBIT/EPS analysis
Examines how different capital structures affect earnings available to shareholders (EPS) and risk
Question: for different levels of EBIT, how does financial leverage affect EPS?
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Risk and the Income Statement
SalesBusiness – Variable costsRisk – Fixed costs
EBIT – Interest expense
Financial Earnings before taxesRisk – Taxes
Net Income
EPS = Net Income / no. of shares
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Current and Proposed Capital Structures
CURRENT PROPOSED
Total assets $100 million $100 millionDebt 0 million 50 millionEquity 100 million 50 millionShare price $25 $25No. of shares 4,000,000 2,000,000Interest rate 10% 10%
Note: for the purpose of simplicity we ignore taxes in this example
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CURRENT CAPITAL STRUCTURE No Debt, 4 Million Shares (millions omitted)
EBIT 50%EBIT 50% EBIT 50%EBIT 50%
BELOWBELOW ABOVE ABOVE EXPECTEDEXPECTED EXPECTEDEXPECTED
EXPECTEDEXPECTED
EBIT $6.00 $12.00 $18.00– Int 0.00 0.00 0.00NI $6.00 $12.00 $18.00EPS $ 1.50 $ 3.00 $ 4.50
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EBIT 50%EBIT 50% EBIT 50%EBIT 50%
BELOWBELOW ABOVE ABOVE EXPECTEDEXPECTED EXPECTEDEXPECTED
EXPECTEDEXPECTED
EBIT $6.00 $12.00 $18.00– Int 5.00 5.00 5.00NI $1.00 $ 7.00 $13.00EPS $ 0.50 $ 3.50 $ 6.50
PROPOSED CAPITAL STRUCTURE 50% Debt (10% Coupon), 2 million Shares (millions omitted)
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EBIT/EPS analysisCurrent versus Proposed
Current (no debt)
Proposed (with debt)
EPS8
6
4
2
0
-2
-43 6 9 10 12 15 18
EBIT
For EBIT up to £10m, equity financing is best
For EBIT greater than £10m, debt financing is best
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The impact of financial leverage
If EBIT is > 10, the levered capital structure is preferable, ie EPS is higher
If EBIT is < 10, the unlevered capital structure is preferable
Conclusion: whether or not debt is beneficial is dependent upon the capacity of firms to generate EBIT
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Indifference Level
The break-even EBIT occurs where the lines cross
At that level of EBIT both capital structures have the same EPS
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Set the two EPS values equal to each other and solve for EBIT:
Current (unlevered) Proposed (levered)
(EBIT-Int)(1-T) = (EBIT-Int)(1-T) S S
Since we assume T=0
(EBIT-Int) = (EBIT-Int) S S
Breakeven Point
Kevin Campbell, University of Stirling, October 2006 1313
Break-even EBIT (millions omitted)
10$
20$2
)5($4422
)1.50($
4
EBIT
EBIT
EBITEBIT
EBITEBIT
EPSEPS LU
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EPSU 1.5 3.0 4.5
EPSL 0.5 3.5 6.5
SpreadU 3.0
SpreadL 6.0 … that’s RISK
The impact of financial leverage
EBIT 50%EBIT 50% EBIT 50%EBIT 50%
BELOWBELOW ABOVE ABOVE EXPECTEDEXPECTED EXPECTEDEXPECTED EXPECTEDEXPECTED
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The impact of financial leverage
Leverage increases EPS if EBIT is high enough.
At very low levels of EBIT, EPS can be negative – as interest on debt has priority over payments to shareholders.
Financial leverage produces a broader spread of EPS values, ie shareholders’ returns are less predictable. This represents added RISK.
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Summary: EBIT/EPS analysis
Indicates EBIT values when one capital structure may be preferred over another
Analysis of expected EBIT can focus on the likelihood of actual EBIT exceeding the indifference point
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Because interest on debt is deducted from EBIT before the amount of tax paid is calculated, there is a benefit to debt … in the form of lower corporate taxes
Consider an example …
The tax benefit of debt
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Firm Unlevered Firm Levered
No debt $10,000 of 12% Debt$20,000 Equity $10,000 in Equity40% tax rate 40% tax rate
The tax benefit of debt
Both firms have same business risk and EBIT of $3,000.
They differ only with respect to use of debt.
U has $20K in Equity & L has $10K in Equity
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EBIT $3,000 $3,000Interest 0 1,200EBT $3,000 $1,800Taxes (40%) 1 ,200 720NI $1,800 $1,080ROE 9.0% 10.8%
Firm U Firm L
U; 1.8/20K = 9% L; 1.08 / 10K = 10.8%
The tax benefit of debt
Kevin Campbell, University of Stirling, October 2006 2020
Why does financial leverage increase the overall return to investors? Investors include both:
Debtholders (banks & bondholders) Shareholders
Total return to investors: U: NI = $1,800. L: NI + Interest = $1,080 + $1,200 = $2,280.
Taxes paid: U: $1,200 L: $720 Difference = $480
More EBIT goes to investors in Firm L
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Because the Government subsidizes debt, and the tax savings go to the investors.
The tax savings are called the “tax shield” and grows proportionally with the increase of debt.
Why does financial leverage increase the overall return to investors?
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Debt versus Equity
Basic point. A firm’s cost of debt is always less than its cost of equity. Why? debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible.
It may appear a firm should use as much debt and as little equity as possible due to the cost difference … but this ignores the potential problems associated with debt.
A Basic Capital Structure Theory
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A Basic Capital Structure Theory
There is a trade-off between the benefits of using debt and the costs of using debt.
The use of debt creates a tax shield benefit from the interest on debt.
The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.
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The costs of financial distress associated with debt
Bankruptcy costs including legal and accounting fees and a likely decline in the value of the firm’s assets
Financial distress may also cause customers, suppliers, and management to take actions harmful to firm value.
A Basic Capital Structure Theory
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Agency costs arise from conflicts between shareholders and bondholders
When you lend money to a business, you are allowing the shareholders to use that money in the course of running that business.
Shareholders interests are different from your interests, because
You (as lender) are interested in getting your money back
Shareholders are interested in maximizing their wealth
A Basic Capital Structure Theory
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Agency costs associated with debt:
Restrictive covenants meant to protect creditors can reduce firm efficiency.
Monitoring costs may be expended to insure the firm abides by the restrictive covenants.
As the level of debt financing increases, the contractual and monitoring costs are expected to increase.
A Basic Capital Structure Theory
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Capital structure: practical considerations
In addition to the variables described by the trade-off theory of capital structure, a variety of practical considerations also affect a firm’s capital structure decisions:
Industry standards Creditor and rating agency requirements Maintaining excess borrowing capacity Profitability and the need for funds Managerial risk aversion Corporate control
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Industry standards
It is natural to compare a firm’s capital structure to other firms in the same industry.
Business risk is a significant factor impacting a firm’s capital structure and is heavily influenced by a firm’s industry.
Evidence indicate firms’ capital structures tend toward an industry average.
Practical considerations
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Creditor and Rating Agency Requirements
Firms need to abide by restrictive covenants, which may include restrictions on the amount of future debt.
Firms typically desire to appear financially strong to potential creditors in order to maintain borrowing capacity and low interest rates.
Using less debt in capital structure helps to maintain this appearance.
Practical considerations
Kevin Campbell, University of Stirling, October 2006 3030
Maintaining Excess Borrowing Capacity
Successful firms typically maintain excess borrowing capacity.
This provides financial flexibility to react to investment opportunities.
The maintenance of excess borrowing capacity causes firms to use less debt in their capital structure than otherwise.
Practical considerations
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Profitability and the Need for Funds
Profits can be paid out as dividends to shareholders or reinvested in the firm.
If a firm generates high profits and reinvests a large proportion back into the firm, then it has a continuous source of internal funding.
This will reduce the use of debt in the firm’s capital structure.
Practical considerations
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Practical considerations Managerial Risk Aversion
Well-diversified shareholders are likely to welcome the use of financial leverage.
Management wealth is typically much more dependent upon the success of the company acting as their employer.
To the extent management can act on their own desires, the firm is likely to have less debt in its capital structure than is desired by shareholders.
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Practical considerations Corporate Control
Controlling owners may desire to issue debt instead of ordinary shares since debt does not grant ownership rights.
Firms with little financial leverage are often considered excellent takeover targets.
Issuing more debt may help to avoid a corporate takeover.
Kevin Campbell, University of Stirling, October 2006 3434
Summary
EBIT/EPS analysis may be used to help determine whether it would be better to finance a project with debt or equity.
Firms must trade-off the tax advantage to debt financing against the effect of debt on firm risk.
Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure.
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KONIEC
DZIĘKUJĘ ZA UWAGĘ
Kevin Campbell, University of Stirling, October 2006 3636
Homework…EBIT/EPS Analysis
A company is considering the following two capital structures:
Plan A: sell 1,200,000 shares at £10 per share (£12 million total)
Plan B: issue £3.5 million in debt (9% coupon) and sell 850,000 shares at £10 per share (£12 million total)
Assume a corporate tax rate of 50%
REQUIRED:
(a) What is the break-even value of EBIT?(b) At this break-even value, what is the income statement for each
capital structure plan and the EPS?(c) Draw a diagram to illustrate the trade-off between EBIT and EPS