1

Chapter 15

Principle 2: There is a Risk-Return Tradeoff

Principle 3: Cash Flows Are the Source of Value

Principle 5: Investors Respond to Incentives

1. Describe a firm's capital structure.2. Explain why firms have different capital

structures and how capital structure influences a firm's weighted average cost of capital.

3. Describe some fundamental differences in industries that drive differences in the way they finance their investments.

4. Use the basic tools of financial analysis to analyze a firm's financing decision.

2

The primary objective of capital structure management is to maximize the total value of the firm's outstanding debt and equity.

The resulting financing mix that maximizes this combined value is called the optimal capital structure.

Capital structure = owner's equity + interest bearing debt

It is also described using a firm's debt ratio.

The Debt to Enterprise Value ratio is also commonly used to describe a firm's capital structure.

Enterprise Value is what you would pay to own 100% of the firm’s assets

Buy all of the equity and pay off all debtExcess cash offsets part of your cost

3

The book value of interest bearing debt includes:◦ Short-term notes payable (e.g., bank loans),◦ Current portion of long-term debt, and◦ Long-term debt.

Blank

Table 15-1 shows that debt ratio is always higher than the debt-to-enterprise value because:◦ Debt ratio is based on book value and book value of

equity is always lower than its market value.◦ Debt to value ratio excludes non-interest bearing

debt in the numerator resulting in a lower value.

4

Debt-to-Enterprise-Value Ratios for Selected Industries

Table 15-1 also reports the Times Interest Earned Ratio, which measures the firm's ability to pay the interest on its debt out of operating earnings.

By borrowing a portion of firm's capital at a fixed rate of interest, firm can “leverage” the rate of return it earns on its total capital into an even higher rate of return on the firm's equity.

For example, if the firm is earning 17% on its investments and paying only 8% on borrowed money, the 9% differential goes to the firm's owners. This is known as favorable financial leverage.

If it earns less than 8%, it will be unfavorable financial leverage.

5

M&M showed that, under ideal conditions, the level of debt in its capital structure does not matter. The theory relies on two basic assumptions:

1. Firm’s cash flows are not affected by financing.2. Financial markets are perfect.

This is important because it tells us capital structure is determined by capital market imperfections◦ Taxes◦ Cost of financial distress/bankruptcy◦ Agency problems Shareholder-Bondholder Manager-Shareholder

Since interest payments are tax deductible (and dividends are not), the after-tax cash flows will be higher if the firm's capital structure includes more debt.

6

Even though debt provides valuable tax savings, a firm cannot keep on increasing debt.

Increasing debt increases the riskiness of equity => higher required return on equityIncreased risk of bankruptcy/financial distress

Thus two factors can have material impact on the role of capital structure in determining firm value and firms must tradeoff the pluses and minuses of both these factors:◦ Interest expense is tax deductible.◦ Debt makes it more likely that firms will experience

financial distress costs.

7

Debt financing can help reduce agency costs. For example, debt financing by creating fixed dollar obligations will reduce the firm's discretionary control over cash and thus reduce wasteful spending.

When firms issue new shares, it is perceived that the firm's stock is overpriced and accordingly share price generally falls.

This provides an added incentive for firms to prefer debt.

Stewart Myers suggested that because of the information issues that arise when firms issue equity, firms tend to adhere to the following pecking order when they raise capital:◦ Internal sources of financing◦ Marketable securities◦ Debt ◦ Hybrid securities◦ Equity

8

1. Higher levels of debt can benefit the firm due to tax savings and potential to reduce agency costs.

2. Higher levels of debt increase the probability of financial distress costs and offset tax and agency cost benefits of debt.

Firms that use more debt financing will experience greater swings in their earnings per share in response to changes in firm revenues and operating earnings. This is referred to as the financial leverage effect.

9

The table below also illustrates the impact of financial leverage on the volatility of earnings per share.

Capital Structure

Worst caseEBIT =$10,000

Best CaseEBIT = $40,000

$ Change in EPS

% Change in EPS

Plan A 2.50 10.00 7.50 300%Plan B 2.00 12.00 10.00 500%Plan C 1.50 14.00 12.50 833%

We observe that when EBIT is high, a more levered firm will realize higher EPS. If EBIT falls, a more levered firm larger drop in earnings per share (EPS).

House of Toast has a new investment project. However, in the weeks since the project was first analyzed, the firm has learned that credit tightening in the financial markets has caused the cost of debt financing for the debt financing plan to increase to 10%.What level of EBIT produces zero EPS for the new borrowing rate?

10

The EBIT-EPS chart analyzes:

◦ Whether the debt plan produces a higher level of EPS for the most likely range of EBIT values.

◦ Possible swings in EPS that might occur under the capital structure alternatives.

11

The current and prospective capital structure alternatives can be described using pro forma balance sheets as given in the next slide.

Current Capital Structure

With New Debt Financing

Long-term debt at 8% $50,000 $50,000

Long-term debt at 10% $50,000

Common Stock $150,000 $150,000

Total Liabilities and Equity

$200,000 $250,000

Common Shares Outstanding

1,500 1,500

A firm's capital structure will affect both the EPS for a given level of operating earnings (EBIT) and the volatility of changes in EPS corresponding to changes in EBIT. We can use pro forma income statements for a range of levels of EBIT that the firm believes is relevant to its future performance.

12

We calculate the EPS over a range of EBITs. 50,000*.08+50,000*.10

EPS =Net income/1500

EBIT/EPS AnalysisEBIT $5,000 $9,000 $20,000 $25,000 $30,000 $35,000

Less: Interest Expense $9,000 $9,000 $9,000 $9,000 $9,000 $9,000

EBT $(4,000) $ 0 $11,000 $16,000 $21,000 $26,000

Less: Taxes $(2,000) $ 0 $5,500 $8,000 $10,500 $13,000

Net Income $(2,000) $ 0 $5,500 $8,000 $10,500 $13,000

EPS $(1.33) $ 0 $3.67 $5.33 $7.00 $8.67Tax rate=50%

-2

0

2

4

6

8

10

0 5 10 15 20 25 30 35 40

EPS

($)

EBIT($, thousands)

EBIT-EPS Chart for House of Toasts, Inc

$9,000

We examine the EPS within the EBIT range of $5,000 to $35,000. The EPS ranges from a low of -$1.33 to a high of $8.67. At EBIT of $9,000, the EPS is equal to zero.

13

The point of intersection of the two capital structure lines found in Figure 15-7 is called the EBIT-EPS indifference point. The point identifies the level at which EPS will be the same regardless of the financing plan chosen by the firm.

At EBIT amounts in excess of the EBIT indifference level, the financing plan with more leverage will generate a higher EPS.

At EBIT amounts below the EBIT indifference level, the financing plan involving less leverage will generate a higher EPS.

14

Assume the tax rate stays the same The indifference point is where

Figure 15.8 reports the survey results of 392 CFOs who were asked about the potential determinants of capital structure choices on a scale of 0 to 4 (0 = not important, 4 = very important).

15