chapter 12 capital structure and leverage © 2000 south-western college publishing

Chapter 12Chapter 12

CAPITAL STRUCTURE CAPITAL STRUCTURE AND LEVERAGEAND LEVERAGE

© 2000 South-Western College Publishing

CAPITAL STRUCTURECAPITAL STRUCTURE

The mix of debt and equity within a firm's capital

(Consider preferred stock a form of debt)

The use of debt is Financial LeverageFinancial Leverage

THE CENTRAL ISSUETHE CENTRAL ISSUECan the use of leverage affect the value of a firm's equity or its stock

price?

RISK IN THE CONTEXT OF LEVERAGERISK IN THE CONTEXT OF LEVERAGE

Define risk as variation in recorded financial performance

measured at ROE and EPS

TM 12-1 Slide 1 of 2

PERFORMANCE MEASURESPERFORMANCE MEASURES


ROE =EAT

Equity and EPS =

EAT

# shares

Variation in Recorded Financial Performance Variation in Recorded Financial Performance Arises from Two SourcesArises from Two Sources

Variation in Business Operations

The Use of Debt in the Capital Structure (Leverage)

BUSINESS RISKBUSINESS RISK Variation in operating performance measured at EBIT

FINANCIAL RISKFINANCIAL RISKThe additional variation in ROE and EPS (over that in EBIT)

caused by the use of Financial Leverage


Sources of Variation Performance Variations as Risk

Variation in Business BusinessOperations Operations

CreateVariation

EBIT in EBIT Business Risk

PlusAdditionalVariation from Financial Risk

Financing the Effects of debt Financing

Leads to

OverallPerformance Variation in Risk inMeasured by ROE and EPS FinancialROE and EPS Performance

Figure 12-1 Business and Financial Risk


THE GOOD NEWSTHE GOOD NEWS

CONSIDER THE EFFECT

OF INCREASING

LEVERAGE

WHEN BUSINESS IS GOODGOOD


Leverage AnalysisArizona Hot Air Balloon Corporation

($000)Leverage Scenarios

#1 #2 #3 0% Debt 50% Debt 80% Debt

Capital Debt - $ 500 $ 800 Equity $ 1,000 500 200

Total $ 1,000 $ 1,000 $ 1,000

Shares @ $10 100,000 50,000 20,000

Rev $ 1,000 $ 1,000 $ 1,000Cost/Exp 800 800 800EBIT $ 200 $ 200 $ 200Interest (10%) - 50 80EBT $ 200 $ 150 $ 120Tax (40%) 80 60 48EAT $ 120 $ 90 $ 72

ROE 12% 18% 36%

EPS $1.20 $1.80 $3.60


WHEN DOES LEVERAGE HELP?WHEN DOES LEVERAGE HELP?

The Return on Capital vs. the Cost of Debt

LEVERAGE HELPS IF:

ROCE > After Tax Cost of Debt

TM 12-4

ROCE =EBIT(1 - T)

Debt Equity

But Leverage Works Both Ways

THE BAD NEWSTHE BAD NEWS

CONSIDER THE EFFECT OF INCREASING LEVERAGE WHEN BUSINESS IS POORPOOR

TM 12-5

Leverage AnalysisArizona Hot Air Balloon Corporation

($000)Leverage Scenarios

#1 #2 #3 0% Debt 50% Debt 80% Debt

Capital Debt - $ 500 $ 800 Equity $ 1,000 500 200

Total $ 1,000 $ 1,000 $ 1,000

Shares @ $10 100,000 50,000 20,000

Rev $ 800 $ 800 $ 800Cost/Exp 720 720 720EBIT $ 80 $ 80 $ 80Interest (10%) - 50 80EBT $ 80 $ 30 $ -Tax (40%) 32 12 - EAT $ 48 $ 18 $ -

ROE 4.8% 1.8% 0%

EPS $0.48 $0.18 $0.00

TM 12-5

FINANCIAL LEVERAGE AND FINANCIAL LEVERAGE AND FINANCIAL RISKFINANCIAL RISK

Financial leverage

Multiplies goodgood results into great results

Multiplies bad bad results into terrible results

ROE and EPS make wider swings with more leverage

The incremental variation is financial risk


ROE

Column #1 Column #3

No Debt 80% Debt

Good TimesGood Times (Table 12-1) 12.0% 36.0%

Bad TimesBad Times (Table 12-2) 4.8% 0.0%

Difference 7.2% 36.0%

Incremental Difference

in ROE Due to

Financial Leverage = 36.0% - 7.2% = 28.8%

Change in ROE due to Business Risk = 7.2%

Change in ROE due to Financial Risk = 28.8%

36.0%

Table 12-3 Financial Leverage and Risk


PUTTING THE IDEAS TOGETHER - PUTTING THE IDEAS TOGETHER - THE EFFECT ON STOCK PRICETHE EFFECT ON STOCK PRICE

1. During periods of reasonably good performance, leverage enhances results in terms of ROE and EPS which drives stock price up.

2. Leverage adds variability to financial performance when operating results change. This means performance is riskier with more leverage

which drives stock price down.

Both become more pronounced as leverage increases.

The effects drive stock prices in opposite directions

At low levels of leverage the positive effect dominates, while

at high levels the negative effect is stronger


Stock

Price

% Debt

0% Optimal 100%

C/S

Figure 12-2 The Effect of Leverage on Stock Price


Finding The Optimum Is A Practical ProblemFinding The Optimum Is A Practical Problem

Generally Accepted Wisdom

1. A firm with good profit prospects and little or no debt is probably missing an opportunity by not using borrowed money if interest rates are reasonable.

2. For most businesses the optimal capital structure lies somewhere between 30% and 50% debt.

3. Debt levels above 60% create excessive risk, and should be avoided.


MEASURING LEVERAGEMEASURING LEVERAGE

Example 12-2Moberly Moped Manufacturing Company ($000)

Revenue $5,580 Capital

Cost/Expense 4,200 Debt $1,000

EBIT $1,380 Equity 7,000

Total $8,000Stock: 700,000 shares, selling at book value of $10

Interest: 15% Tax rate: 40%

Moberly is interested in boosting stock price by restructuring capital to 50% debt. However, the economic outlook is shaky, and EBIT may decline. Estimate the effect of restructuring on EPS. Use the DFL to assess the risk impact.

TM 12-8

DFLEPS

EBIT

EBIT

EBIT I

%

%

Solution: Calculate the current and proposed capital structures:

Current Proposed

Capital

Debt $1,000 $4,000

Equity $7,000 $4,000

Total $8,000 $8,000

Shares outstdg 700,000 400,000

Calculate projected EAT and EPS at the current level of business

for both capital structures:

Current Proposed

EBIT $1,380 $1,380

Interest (15%) 150 600

EBT $1,230 $ 780

Tax (@ 40%) 492 312

EAT $ 738 $ 468

EPS $1.054 $1.170


Calculate the DFL under

each structure:

EPS will be more volatile under proposed structure. Illustrate with 30% decline in EBIT.

Current structure:

Proposed structure:

Apply to projected EPSs: Current: $1.054(1 - .336) = $.70

Proposed: $1.170(1 - .531) = $.55

Implication: EPS may be lower under proposal in bad times. Gives management a sense

of the trade-off with respect to risk


DFLcurEBIT

EBIT I$1380

$1380 $1501.12

% (% )

. .

EPS DFL EBITcur cur 1 12 30% 33 6%

% (% )

. .

EPS DFL EBITprop prop

1 77 30% 53 1%

DFLEBIT

EBIT Iprop

$1380

$1380 $600.1 77

USING LEVERAGE CONCEPTS TO MANAGE USING LEVERAGE CONCEPTS TO MANAGE CAPITAL STRUCTURE EBIT-EPS ANALYSISCAPITAL STRUCTURE EBIT-EPS ANALYSIS

EPS

$4.00

50% Debt

$3.00

No

Advantage

$1.00

EBIT

$100 $200 $300 $400

Advantage

to Equity

EBIT-EPS Analysis

Figure 12-3 Arizona Hot Air Balloon Corporation, From Table 12-1, Columns 1 and 2

TM 12-10

to debtLeverage

$2.00

OPERATING LEVERAGEOPERATING LEVERAGE

The mix of fixed and variable cost in a firm's Cost StructureBest understood through BREAKEVEN ANALYSISBREAKEVEN ANALYSIS

Cost REV Total Cost

Profit Loss Fixed

Cost

Q QB/E

Figure 12-5 The Breakeven Diagram


THE ALGEBRA OF BREAKEVENTHE ALGEBRA OF BREAKEVEN

Contribution (to profit and fixed cost)

Ct = P - V

where Ct is the contribution,

P is price, and

V is variable cost per unit

Contribution margin


CP V

PM

Breakeven Sales LevelBreakeven Sales LevelEBIT = PQ - VQ - FC

Where P = Price per unit

V = Variable cost per unit

Q = Quantity sold, and

FC = Total fixed cost

At Breakeven:: 0 = PQ - VQ - FC

Q(P - V) -FC = 0


Q =F

P - VB / EC

S =P(F )

P - V=

F

CB / EC C

M

THE EFFECT OF OPERATING LEVERAGEWith More Operating Leverage

Profits (at EBIT) Improve Faster as Output Increases Above the Breakeven Level

BUTLosses (at EBIT) Increase Faster as Output Falls Below the Breakeven

Level

THEREFORE

Operating Leverage can enhance performance

BUT

Always Increases Business Risk


Profit EBIT

Cost Cost

FC

Loss (EBIT)

FC

Q Q

A B A B

Low Operating Leverage High Operating Leverage

(a) (b)

Figure 12-6 Breakeven Diagrams at High and Low Operating Leverage

THE DEGREE OF OPERATING LEVERAGE (DOL) - A MEASUREMENTTHE DEGREE OF OPERATING LEVERAGE (DOL) - A MEASUREMENT


DOLEBIT

Q

%

%

DOLQ P V

Q P V FC

( )

( )

CONCEPT SUMMARYCONCEPT SUMMARY

Improved

Operating Performance

Sales EBITLeverage Amplified

Changes

Improved

Financial Performance

EBIT ROE and EPSLeverage Amplified

Changes

Figure 12-7 The Similar Functions of Operating and Financial Leverage


Operating Financial

Leverage Leverage

Creates

Risk Amplifies Existing and Amplifies

Relationship Business Risk Financial Risk

Cash Substitutes fixed Substitutes fixed

Outflows cost for variable return debt for

cost in cost variable return

structure equity in capital structure

Figure 12-8 Risk and Cost Relationships Between Operating and Financial Leverage


THE COMPOUNDING EFFECT OF THE COMPOUNDING EFFECT OF OPERATING AND FINANCIAL LEVERAGEOPERATING AND FINANCIAL LEVERAGE

DTL = DOL DFL

Variation Operating Variation Financial Variation

in in in

Sales Leverage EBIT Leverage ROE and EPS

Figure 12-9 The Compounding Effect of Operating and Financial Leverage

TM 12-14

CAPITAL STRUCTURE THEORYCAPITAL STRUCTURE THEORYNOTATION

Vd = Market Value of the firm's debt

Ve = Market Value of the firm's stock (equity)

Vf = Market Value of the firm in total

Hence,

Vf = Vd + Ve

Investors' returns on the firm's securities will be:

kd = return on an investment in debt (bonds)

ke = return on an investment in equity (stock)

ka = average cost of capital

(Initially we ignore taxes and transactions costs)


VALUE COMES FROM OPERATING VALUE COMES FROM OPERATING INCOME (OI = EBIT)INCOME (OI = EBIT)

OI = I + Dwhere

I = Total annual interest payment to bondholders, and

D = Total annual dividend payment to stockholders

Debt is assumed to be perpetual and there is no growthand

THINK OF RETURNS AS DRIVING VALUE


VI

kd

d

VD

ke

e

VI

k

D

kf

d e

VOI

kf

a

GRAPHIC PORTRAYALSVf , Ps

% Debt

ka

% Debt

Figure 12-10 Variation in Value and Average Return with Capital Structure

TM 12-16

THE EARLY THEORY BY MODIGLIANITHE EARLY THEORY BY MODIGLIANI AND MILLER AND MILLER

Restrictive Assumptions

1. There are no income taxes.

2. Securities trade in perfectly efficient capital markets

in which there are no transaction costs.

3. Investors and companies can borrow as much as they want

at the same rate. That is,

a. Rates don't go up as one borrows more money, and

b. The rate is the same for investors and companies

Subtlety No Costs Associated With Bankruptcy

THE RESULT: INDEPENDENCE HYPOTHESISINDEPENDENCE HYPOTHESIS

Value Is Independent Of Structure

Supported The "Operating Income View"


Value

Firm's

Value

% Debt(a) Firm's Value Constant with Leverage

The Independence Hypothesis

Capital

Costs ke

ka

kd

% Debt

(b) Capital Component Costs and LeverageThe Independence Hypothesis

Figure 12-11


THE ARBITRAGE CONCEPTTHE ARBITRAGE CONCEPTArbitrage: making a profit by buying and selling the same thing

at the same time in two different markets.

If the value of a firm were to go up due to adding leverage, shareholders could get a better return by 1. selling those shares,

2. borrowing some money on their own, and

3. investing in a similar but unleveraged company.

The arbitrage is between the leveraged and unleveraged companies. The sell-off drives the price of the leveraged firm down. The buying drives the price of the unleveraged firm up. Holding the two together keeps the value of any firm constant as leverage increases.

The theory provided behavioral support for the operating income argument.

INTERPRETING THE RESULTINTERPRETING THE RESULTLeverage affects value due to market imperfections (taxes, transaction costs)

not because of the basic interaction of investors and companies.

TM 12-18

FINANCING AND THE U.S. TAX SYSTEMFINANCING AND THE U.S. TAX SYSTEM All 50% Debt

Equity 50% Equity

EBIT $ 100 $ 100

Interest (10% of debt) 50

EBT $ 100 $ 50

Tax (40% of EBT) 40 20

Net Income (EAT) $ 60 $ 30

Dividend 60 30

Net Retained $ 0 $ 0

Capital Debt $ 500 Equity $ 1,000 500Total Capital $ 1,000 $ 1,000

Payments to Investors

Interest 0 $ 50

Dividends $ 60 30

Total $ 60 $ 80 TM 12-19

INCLUDING CORPORATE TAXES INCLUDING CORPORATE TAXES IN THE MM THEORYIN THE MM THEORY

If T = tax rate, and I = Interest

TI is the tax shield associated with debt financing

PV of tax shield =

Then if B = Debt, I = B kd, and

PV of tax shield =

TB accrues entirely to stockholders since the value of bonds is fixed

by contract terms and interest rates.


TI

kd

TI

k

TBk

kTB

d

d

d the Benefit of Debt

Market Value

Value with Leverage

Value without

Leverage

% Debt (a) Value of the Firm as a Function of Leverage MM Theory with Taxes

Capital Costs ke

ka

kd(1-T)

% Debt (b) Cost of Capital as a Function of Leverage MM Theory with Taxes

Figure 12-12 TM 12-20 Slide 2 of 2

Bankruptcy costs increase investors' concerns that they will incur losses as risk increases with leverage, which depresses price as leverage increases.

Market Value with

Value Taxes

{{ Value Including Bankruptcy Costs

Value without Leverage

% Debt Optimal

Capital

Structure

(a) Value of the Firm as a Function of Leverage MM Theory with Taxes and Bankruptcy Costs


INCLUDING BANKRUPTCY COSTS IN THE MM THEORY

Capital

Costs

ke

ka

kd(1-T)

% Debt, Leverage

Optimal

Capital

Structure (b) Cost of Capital as a Function of Leverage MM Theory with Taxes

and Bankruptcy Costs

Figure 12-13


CONCLUSIONCONCLUSIONIn the MM model with taxes and bankruptcy costs, additional leverage increases the value of

a firm when total leverage is relatively low. However,

after a maximum, further increases reduce value.

The theory does not locate the maximum.

The same result was developed intuitively for different reasons:

• MM attribute the benefit of leverage solely to taxes

• The intuitive approach recognizes the impact of improved

performance on investors' perceptions

• Both attribute leverage's negative effects to risk

AN INSIGHT INTO MERGERS AND ACQUISITIONS

The increase in value associated with initially adding leverage may justifypaying a high price to acquire an unleveraged firm with debt.

TM 12-22

chapter 12 capital structure and leverage © 2000 south-western college publishing

Documents

use of leverage

leverage scenarios

financial risk tm

leverage works

tofinancial leverage

context of leverage

leverage help

financial performance