filefin205 ch 14 slidess

8/12/2019 FileFIN205 Ch 14 Slidess

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Capital Structure andLeverage

Chapter 14


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Capital Structure and Leverage

Business vs. Financial Risk

Optimal Capital Structure

Operating Leverage Capital Structure Theory


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What is business risk?

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

Note that business risk does not include financingeffects.

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Probability

EBITE(EBIT)0

Low risk

High risk


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What determines business risk?

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 firms 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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Effect of Operating Leverage

More operating leverage leads to more businessrisk, for then a small sales decline causes a bigprofit decline.

What happens if variable costs change?

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Sales

$Rev.

TC

FC

QBE Sales

$

Rev.

TC

FC

QBE

} Profit


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Operating Breakeven

Operating Breakeven

The output quantity (QBE)at which EBIT = 0.


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Calculate QBE


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Illustration of Operating

Leverage


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Using Operating Leverage

Typical situation: Can use operating leverage

to get higher E(EBIT), but risk also increases.

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Probability

EBITL

Low operating leverage

High operating leverage

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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An Example:

Illustrating Effects of Financial Leverage

Two firms with the same operating leverage,

business risk, and probability distribution of

EBIT.

Only differ with respect to their use of debt

(capital structure).

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Firm U Firm L

No debt $10,000 of 12% debt$20,000 in assets $20,000 in assets40% tax rate 40% tax rate


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Firm U: Unleveraged

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Economy

Bad Average Good

Probability 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000

Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400


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Firm L: Leveraged

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Economy

Bad Average Good

Probability* 0.25 0.50 0.25

EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800

Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for Firm U.


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Ratio Comparison Between

Leveraged & Unleveraged Firms

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Firm U Bad Average Good

BEP 10.0% 15.0% 20.0%

ROE 6.0 9.0 12.0TIE

Firm L Bad Average Good

BEP 10.0% 15.0% 20.0%ROE 4.8 10.8 16.8TIE 1.67 2.50x 3.30x


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Risk and Return for Leveraged

and Unleveraged Firms

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Expected values:Firm U Firm L

E(BEP) 15.0% 15.0%

E(ROE) 9.0% 10.8%E(TIE) 2.5

Risk measures:Firm U Firm L

ROE 2.12% 4.24%CVROE 0.24 0.39


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ROE Probability Distributions

with and without Leverage


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The Effect of Leverage on

Profitability and Debt Coverage

For leverage to raise expected ROE, must haveBEP > rd.

Why? If rd> BEP, then the interest expense

will be higher than the operating incomeproduced by debt-financed assets, so leveragewill depress income.

As debt increases, TIE decreases because EBITis unaffected by debt, but interest expenseincreases (Int Exp = rdD).

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Conclusions

Basic earning power (BEP) is unaffected by

financial leverage.

L has higher expected ROE because BEP > rd.

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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Optimal Capital Structure

The capital structure (mix of debt, preferred,and common equity) at which P0is maximized.

Trades off higher E(ROE) and EPS against

higher risk. The tax-related benefits ofleverage are exactly offset by the debts risk-related costs.

The target capital structure is the mix of debt,preferred stock, and common equity withwhich the firm intends to raise capital.

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Sequence of Events in a

Recapitalization

Firm announcesthe recapitalization.

New debt is issued.

Proceeds are used to repurchasestock. The number of shares repurchased is equal to the

amount of debt issued divided by price per share.

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Why do the bond rating and cost of debt

depend upon the amount of debt

borrowed?

As the firm borrows more money, the firm

increases its financial risk causing the firms

bond rating to decrease, and its cost of debt

to increase.

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Analyze the recapitalization at various debt

levels and determine the EPS and TIE at each

level.

$3.00

80,000

(0.6)($400,000)

goutstandinSharesT)D)(1r(EBITEPS

$0D

d

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Determining EPS and TIE at Different Levels

of Debt (D = $250,000 and rd= 8%)

20x$20,000

$400,000

ExpInt

EBITTIE

$3.26

10,00080,000

000))(0.6)0.08($250,($400,000

goutstandinShares

T)D)(1r(EBITEPS

10,000$25

$250,000drepurchaseShares

d

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of Debt (D = $500,000 and rd= 9%)

8.9x$45,000

$400,000

ExpInt

EBITTIE

$3.55

20,00080,000

000))(0.6)0.09($500,($400,000

goutstandinShares

T)D)(1r(EBITEPS

20,000$25


d

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of Debt (D = $750,000 and rd= 11.5%)

4.6x$86,250

$400,000

ExpInt

EBITTIE

$3.77

30,00080,000

),000))(0.60.115($750($400,000

goutstandinShares

T)D)(1r(EBITEPS

30,000$25


d

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of Debt (D = $1,000,000 and rd= 14%)

2.9x$140,000

$400,000

ExpInt

EBITTIE

$3.90

40,00080,000

6)0,000))(0.0.14($1,00($400,000

goutstandinShares

T)D)(1r(EBITEPS

40,000$25

$1,000,000drepurchaseShares

d

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Stock Price with Zero Growth

sss

10

rDPS

rEPS

grDP

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If all earnings are paid out as dividends, E(g) =0.

EPS = DPS.

To find the expected stock price ( ),we must find the appropriate rsat each of thedebt levels discussed.

P0


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What effect does more debt

have on a firms cost of equity?

If the level of debt increases, the firms risk

increases.

We have already observed the increase in the

cost of debt.

However, the risk of the firms equity also

increases, resulting in a higher rs.

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The Hamada Equation

Because the increased use of debt causes boththe costs of debt and equity to increase, weneed to estimate the new cost of equity.

The Hamada equation attempts to quantifythe increased cost of equity due to financialleverage.

Uses the firms unlevered beta, whichrepresents the firms business risk as if it hadno debt.

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The Hamada Equation

bL= bU[1 + (1T)(D/E)]

Suppose, the risk-free rate is 6%, as is the

market risk premium. The unlevered beta of

the firm is 1.0. We were previously told that

total assets were $2,000,000.

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Calculating Levered Betas and

Costs of Equity

If D = $250,

bL = 1.0[1 + (0.6)($250/$1,750)]

= 1.0857

rs = rRF+ (rMrRF)bL

= 6.0% + (6.0%)1.0857

= 12.51%

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Table for Calculating Levered

Betas and Costs of Equity

AmountBorrowed

D/ARatio

D/ERatio

LeveredBeta rs

$ 0 0% 0% 1.00 12.00%

250 12.50 14.29 1.09 12.51

500 25.00 33.33 1.20 13.20

750 37.50 60.00 1.36 14.16

1,000 50.00 100.00 1.60 15.60

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Finding Optimal Capital

Structure

The firms optimal capital structure can be

determined two ways:

Minimizes WACC.

Maximizes stock price.

Both methods yield the same results.

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Table for Calculating Levered

Betas and Costs of Equity

AmountBorrowed

D/ARatio

E/ARatio rs rd(1 T) WACC

$ 0 0% 100% 12.00% -- 12.00%

250 12.50 87.50 12.51 4.80% 11.55

500 25.00 75.00 13.20 5.40% 11.25

750 37.50 62.50 14.16 6.90% 11.44

1,000 50.00 50.00 15.60 8.40% 12.00

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Determining the Stock Price

Maximizing Capital Structure

AmountBorrowed DPS rs P0

$ 0 $3.00 12.00% $25.00

250 3.26 12.51 26.03

500 3.55 13.20 26.89

750 3.77 14.16 26.59

1,000 3.90 15.60 25.00

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What debt ratio maximizes EPS?

Maximum EPS = $3.90 at D = $1,000,000, and

D/A = 50%. (Remember DPS = EPS because

payout = 100%.)

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

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What is the optimal capital

structure?

P0is maximized ($26.89) at D/A =$500,000/$2,000,000 = 25%, so optimal D/A =25%.

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

The example shows that we can push upE(EPS) by using more debt, but the riskresulting from increased leverage more thanoffsets the benefit of higher E(EPS).

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h f h /l b k


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What if there were more/less business riskthan originally estimated, how would theanalysis be affected?

If there were higher business risk, then the

probability of financial distress would be

greater at any debt level, and the optimal

capital structure would be one that had lessdebt.

However, lower business risk would lead to an

optimal capital structure with more debt.

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Modigliani-Miller Irrelevance

Theory

A firms value should be unaffected by its

capital structure.

In other words, it does not matter how a firm

finances its operationshence, that capital

structure is irrelevant.


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Modigliani-Miller Assumptions

There are no brokerage costs.

There are no taxes.

There are no bankruptcy costs.

Investors can borrow at the same rate ascorporations.

All investors have the same information asmanagement about the firms future investmentopportunities.

EBIT is not affected by the use of debt.


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Trade-Off Theory

Trade-Off Theory:

The capital structure theory that states that firms

trade off the tax benefits of debt financing against

problems caused by potential bankruptcy.


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Trade-Off Theory


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Signaling Theory

Symmetric Information The situation where investors and managers have

identical information about firms prospects.

Asymmetric Information The situation where managers have different (better)

information about firms prospects than do investors.

Signal

An action taken by a firms management that providesclues to investors about how management views thefirms prospects.


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Incorporating Signaling Effects

Signaling theory suggests firms should use less

debt than MM suggest.

This unused debt capacityhelps avoid stock

sales, which depress stock price because of

signaling effects.

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Wh i li ff i


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What are signaling effects in

capital structure?

Assumptions: Managers have better information about a firms long-

run value than outside investors.

Managers act in the best interests of currentstockholders.

What can managers be expected to do?

Issue stock if they think stock is overvalued.

Issue debt if they think stock is undervalued. As a result, investors view a stock offering

negativelymanagers think stock is overvalued.

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Wh b d


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What can managers be expected

to do?

Issue stockif they think stock is overvalued.

Issue debtif they think stock is undervalued.

As a result, investors view a common stock

offering as a negative signalmanagers think

stock is overvalued.

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Conclusions on Capital Structure

Need to make calculations as we did, butshould also recognize inputs areguesstimates.

As a result of imprecise numbers, capitalstructure decisions have a large judgmentalcontent.

We end up with capital structures varyingwidely among firms, even similar ones in sameindustry.

filefin205 ch 14 slidess

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