Capital Structure and Leverage

What is 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.

 What determines business risk?
• Uncertainty about demand (sales).
• Uncertainty about output prices.
• Uncertainty about costs.
• Product, other types of liability.
• Operating leverage.
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.
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?
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.
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.
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.
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
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
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.

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
 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
The effect of leverage on profitability
and debt coverage
• For leverage to raise expected ROE, must have BEP
> kd.
• Why? If kd > 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 = kdD).
Conclusions

• Basic earning power (BEP) is unaffected

by financial leverage.
• L has higher expected ROE because BEP >
kd.
• L has much wider ROE (and EPS) swings
because of fixed interest charges. Its
higher expected return is accompanied by
higher risk.
Optimal Capital 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.
Describe the sequence of events in a
recapitalization.

• Campus Deli announces the recapitalization.

• New debt is issued.
• Proceeds are used to repurchase stock.
• The number of shares repurchased is equal to the amount of debt
issued divided by price per share.
Cost of debt at different levels of debt, after
the proposed recapitalization

Amount D/A D/E Bond

borrowed ratio ratio rating kd
$ 0 0 0 -- --
250 0.125 0.1429 AA 8.0%
500 0.250 0.3333 A 9.0%
750 0.375 0.6000 BBB 11.5%
1,000 0.500 1.0000 BB 14.0%
Why do the bond rating and cost of debt
depend upon the amount borrowed?

• As the firm borrows more money, the firm increases its

financial risk causing the firm’s bond rating to decrease, and its
cost of debt to increase.
Analyze the proposed recapitalization at
various levels of debt. Determine the EPS
and TIE at each level of debt.
D = $0
( EBIT - k dD )( 1 - T )
EPS =
Shares outstanding
($400,000)(0.6)
=
80,000
= $3.00
Determining EPS and TIE at different levels of
debt.
(D = $250,000 and kd = 8%)
$250,000
Shares repurchase d = = 10,000
$25
( EBIT - k dD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.08($250,000))(0.6)
=
80,000 - 10,000
= $3.26

EBIT $400,000
TIE = = = 20x
Int Exp $20,000
Determining EPS and TIE at different levels of
debt.
(D = $500,000 and kd = 9%)
$500,000
Shares repurchase d = = 20,000
$25
( EBIT - k dD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.09($500,000))(0.6)
=
80,000 - 20,000
= $3.55

EBIT $400,000
TIE = = = 8.9x
Int Exp $45,000
Determining EPS and TIE at different levels of
debt.
(D = $750,000 and kd = 11.5%)
$750,000
Shares repurchase d = = 30,000
$25
( EBIT - k dD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.115($750,000))(0.6)
=
80,000 - 30,000
= $3.77

EBIT $400,000
TIE = = = 4.6x
Int Exp $86,250
Determining EPS and TIE at different levels of
debt.
(D = $1,000,000 and kd = 14%)
$1,000,000
Shares repurchase d = = 40,000
$25
( EBIT - k dD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.14($1,000,000))(0.6)
=
80,000 - 40,000
= $3.90

EBIT $400,000
TIE = = = 2.9x
Int Exp $140,000
 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 ks.
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.
 Table for calculating WACC and
determining the minimum WACC

Amount E/A
borrowed D/A ratio ratio ks kd (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
Table for determining the stock price
maximizing capital structure
Amount
Borrowed DPS ks 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
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%.
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.
 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
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?
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.