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
TM 12-1 Slide 2 of 2
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
TM 12-2 Slide 1 of 2
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
TM 12-2 Slide 2 of 2
THE GOOD NEWSTHE GOOD NEWS
CONSIDER THE EFFECT
OF INCREASING
LEVERAGE
WHEN BUSINESS IS GOODGOOD
TM 12-3 Slide 1 of 2
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
TM 12-3 Slide 2 of 2
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
TM 12-6 Slide 1 of 2
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
TM 12-6 Slide 2 of 2
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
TM 12-7 Slide 1 of 3
Stock
Price
% Debt
0% Optimal 100%
C/S
Figure 12-2 The Effect of Leverage on Stock Price
TM 12-7 Slide 2 of 3
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.
TM 12-7 Slide 3 of 3
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
TM 12-9 Slide 1 of 2
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
TM 12-9 Slide 2 of 2
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
TM 12-11 Slide 1 of 3
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
TM 12-11 Slide 2 of 3
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
TM 12-11 Slide 3 of 3
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
TM 12-12 Slide 1 of 2
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
TM 12-12 Slide 2 of 2
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
TM 12-13 Slide 1 of 2
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
TM 12-13 Slide 2 of 2
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)
TM 12-15 Slide 1 of 2
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
TM 12-15 Slide 2 of 2
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"
TM 12-17 Slide 1 of 2
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
TM 12-17 Slide 2 of 2
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.
TM 12-20 Slide 1 of 2
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
TM 12-21 Slide 1 of 2
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
TM 12-21 Slide 2 of 2
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