FINANCIAL MANAGEMENT, SPRING 2022

TOPIC 9 – Capital Structure and

Leverage
9.1 Business risk
9.2 Financial Risk - Capital structure theories
9.3 Optimal capital structure and target structure
9.4 Financial leverage vs. operating leverage
9.1 Business risk
¨ Uncertainty about future operating income (EBIT), i.e., how
well can we predict operating income?

Probability Low risk

High risk

0 E(EBIT) EBIT

¨ Note that business risk does not include financing effects.

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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.
¨ Others: page 445.

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What is operating leverage, and how does it
affect a firm’s 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 business
risk, for then a small sales decline causes a big
profit decline.

$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales
¨ What happens if variable costs change?
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Using operating leverage

Low operating leverage

Probability
High operating leverage

EBITL EBITH

¨ Typical situation: Can use operating leverage to

get higher E(EBIT), but risk also increases.
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9.2 Financial Risk - Capital structure
theories
¨ Capital Structure (or 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).

Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate

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Firm U: Unleveraged

Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400

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Firm L: Leveraged

Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680

*Same as for Firm U.

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Ratio comparison between leveraged and
unleveraged firms

FIRM U Bad Avg Good

BEP 10.0% 15.0% 20.0%
ROE 6.0% 9.0% 12.0%
TIE ∞ ∞ ∞

FIRM L Bad Avg Good

BEP 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.50x 3.30x
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Risk and return for leveraged and
unleveraged firms
Expected Values:
Firm U Firm L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) ∞ 2.5x

Risk Measures:
Firm U Firm L
σROE 2.12% 4.24%
CVROE 0.24 0.39

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The effect of leverage on profitability and
debt coverage
¨ For leverage to raise expected ROE, must have
BEP > rd.
¨ Why? If rd > BEP, then the interest expense will be
higher than the operating income produced by
debt-financed assets, so leverage will depress
income.
¨ As debt increases, TIE decreases because EBIT is
unaffected by debt, and interest expense increases
(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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9.3 Optimal capital structure and
target structure
¨ That capital structure (mix of debt, preferred,
and common equity) at which P0 is maximized.
Trades off higher E(ROE) and EPS against higher
risk. The tax-related benefits of leverage are
exactly offset by the debt’s risk-related costs.
¨ The target capital structure is the mix of debt,
preferred stock, and common equity with which
the firm intends to raise capital.

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Stock Price, with zero growth

D1 EPS DPS
P0 = = =
rs - g rs rs

¨ If all earnings are paid out as dividends, E(g)

= 0.
¨ EPS = DPS
¨ To find the expected stock price (P0), we must
find the appropriate ks at each of the debt
levels discussed.
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What effect does increasing debt have on
the cost of equity for the firm?
¨ If the level of debt increases, the riskiness of the
firm increases.
¨ We have already observed the increase in the cost
of debt.
¨ However, the riskiness of the firm’s equity also
increases, resulting in a higher rs.

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Finding Optimal Capital Structure

¨ The firm’s optimal capital structure can be

determined two ways:
¤ Minimizes WACC.
¤ Maximizes stock price.

¨ Both methods yield the same results.

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WACC

WACC or weighted average cost of capital

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Table for calculating WACC and
determining the minimum WACC

Amount E/A
borrowed D/A ratio ratio rs rd (1 – T) WACC
$ 0 0.00% 100.00% 12.00% 0.00% 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
* Amount borrowed expressed in terms of thousands of dollars
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Table for determining the stock price
maximizing capital structure

Amount
Borrowed DPS rs P0

$ 0 $3.00 12.00% $25.00

250,000 3.26 12.51 26.03
500,000 3.55 13.20 26.89
750,000 3.77 14.16 26.59
1,000,000 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 if there were more/less business risk than
originally estimated, how would the analysis 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 less
debt. On the other hand, lower business risk
would lead to an optimal capital structure with
more debt.

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Other factors to consider when establishing the
firm’s target capital structure

1. Industry average debt ratio

2. TIE ratios under different scenarios
3. Lender/rating agency attitudes
4. Reserve borrowing capacity
5. Effects of financing on control
6. Asset structure
7. Expected tax rate

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How would these factors affect the target
capital structure?
1. Sales stability?
2. High operating leverage?
3. Increase in the corporate tax rate?
4. Increase in the personal tax rate?
5. Increase in bankruptcy costs?
6. Management spending lots of money on lavish
perks?

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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 common stock offering
as a negative signal--managers think stock is
overvalued.

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Conclusions on Capital Structure

¨ Need to make calculations as we did, but should also

recognize inputs are “guesstimates.”
¨ As a result of imprecise numbers, capital structure
decisions have a large judgmental content.
¨ We end up with capital structures varying widely
among firms, even similar ones in same industry.

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