FINANCIAL MANAGEMENT • A firm is said to be leveraged if it has fixed costs.

ENDTERM MODULE 6 CAPITAL STRUCTURE • There are two types of leverage:

o Operating leverage – fixed costs associated
Capital Structure with running the firm.
• Target capital structure is the mix of debt, preferred o Financial leverage – fixed costs associated
stock and common equity the firm wants to have. with financing the firm.
• Optimal Capital Structure maximizes a firm’s stock • Degree of leverage - Measure of how much leverage
price. the firm uses.
• Weighing investor-supplied Capital
• Book Value - based on the financial statement Capital Structure
(historical) • The mix of long-term financial sources used to
• Market Value - based on the current available market finance the firm.
values • It usually refers to the specific proportions of debt,
• Target - based on the planned strategy of the firm equity, preferred stock, etc. used to finance the firm.
• Only long-term sources are included.
Trade offs
• Using more debt will raise the risk borne by Breakeven Analysis
stockholders • Finding the level of operations necessary to cover all
• Using more debt generally, increases the expected costs.
return on equity. • Can also be used to analyze the level of profitability
associated with differing levels of sales.
Factors Influencing Capital Structure Decisions • Operating breakeven point:
• Business Risk • The level of sales necessary to cover all operating
• Firm’s Tax Position costs:
• Financial Flexibility • The points where EBIT = $0.
• Managerial Conservatism or Aggressiveness
• Operating Conditions – e.g. when Stock Price ≠ A Stylized Approach
• The algebra:
Intrinsic Value
o PQ-VQ-F=EBIT
o (P-V)Q-F=EBIT
Business Risk vs. Financial Risk
• Solving for Q when EBIT = $0:
• Business Risk – riskiness of the firm’s assets if no
o Q=F/(P-V)
debt is used.
• Practical problem: Most companies don’t sell only
• Financial Risk – additional risk placed on the
one product/service, and therefore quantity is not as
common stockholders as a result of using debt.
reliable as sales volume.
Business Risk Determinants
Graphical Approach to break-even analysis
• Competition
• Demand Variability
• Sales Price Variability
• Input Cost Variability
• Product Obsolescence
• Foreign risk exposure
• Regulatory risk and legal exposures
• The extent to which costs are fixed: operating
leverage

Business risk is the SD of the firms return on invested capital.

ROIC = EBIT (1-T) / Invested Capital

Leverage
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 Using operating leverage

Typical situation: Can use operating leverage to get higher

E(EBIT), but risk also increases.

Operating Leverage Conclusion on Operating Leverage: Holding other factors

• Operating leverage is the extent to which fixed costs constant, the higher the degree of operating leverage, the
are used in a firm’s operations. greater the firm’s business risk.
• If fixed costs are high, other things held constant, the
greater is the business risk. Financial Leverage and Financial Risk
• High degree on operating leverage, other factors • Financial leverage is the use of debt and preferred
held constant, implies that a relatively small change stock.
in sales results in large change in ROE. • Financial risk is the additional risk concentrated on
common stockholders as a result of financial
Degree of Operating Leverage - Measure of how sensitive is leverage.
operating income to changes in units sold.
Degree of Financial Leverage (DFL)
• The percentage change in earnings available to
common stockholders associated with a given
percentage change in EBIT (operating income)

This equation assumes the firm has no preferred stock.

Degree of Total Leverage (DTL)

• The percentage change in EPS that results from a
Effect of Operating Leverage given percentage change in sales.

The higher the fixed cost, the greater is the needed quantity
of goods to be sold to break-even. 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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 Risk and return for leveraged and unleveraged firms

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

ROE Probability

Firm L: Leveraged

Typical situation: Can use operating leverage to get higher

E(ROE), but risk also increases.

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-
Ratio comparison between leveraged and unleveraged firms 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).

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.

Determining Optimal Capital Structure

• Seek to maximize the price of the firm’s stock.
BEP = EBIT / total assets • Changes in use of debt will cause changes in earnings
ROE = NI / equity per share, and, thus, in the stock price.
TIE = EBITDA / interest expense • Cost of debt varies with capital structure.
• Financial leverage increases risk.
• The optimal capital structure always calls for a
debt/assets ratio that is lower than the one that
maximizes expected EPS.

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 Determining EPS and TIE at different levels of debt. (D =
Sequence of events in a recapitalization. $500,000 and rd = 9%)
1. Firm announces the recapitalization.
2. New debt is issued.
3. Proceeds are used to repurchase stock.
4. The number of shares repurchased is equal to the
amount of debt issued divided by price per share.

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 firm’s bond rating to
decrease, and its cost of debt to increase.

Example: Cost of debt at different debt ratios Determining EPS and TIE at different levels of debt. (D =
$750,000 and rd = 11.5%)

Analyze the recapitalization at various debt levels and

determine the EPS and TIE at each level.

Determining EPS and TIE at different levels of debt. (D =

$1,000,000 and rd = 14%)

Determining EPS and TIE at different levels of debt. (D =

$250,000 and rd = 8%)

Stock Price, with zero growth

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

• EPS = DPS

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 • To find the expected stock price (P0), we must find Finding Optimal Capital Structure
the appropriate rs at each of the debt levels
discussed. • The firm’s optimal capital structure can be
determined two ways:
What effect does more debt have on a firm’s cost of equity? o Minimizes WACC.
• If the level of debt increases, the riskiness of the firm o Maximizes stock price.
increases. • Both methods yield the same results.
• We have already observed the increase in the cost of
debt. Table for calculating levered betas and costs of equity
• However, the riskiness of the firm’s equity also
increases, resulting in a higher rs.

The Hamada Equation

• Because the increased use of debt causes both the
costs of debt and equity to increase, we need to
estimate the new cost of equity.
• The Hamada equation attempts to quantify the
increased cost of equity due to financial leverage.
• Uses the unlevered beta of a firm, which represents Determining the stock price maximizing capital structure
the business risk of a firm as if it had no debt.

bL = bU[ 1 + (1 – T) (D/E)]

Calculating levered betas and costs of equity, example:

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.

What debt ratio maximizes EPS?

• Maximum EPS = $3.90 at D = $1,000,000, and D/A =
50%. (Remember DPS = EPS because payout =
Table for calculating levered betas and costs of equity
100%.)
• Risk is too high at D/A = 50%.

What is the firm’s optimal capital structure?

• P0 is maximized ($26.89) at D/A =
$500,000/$2,000,000 = 25%, so optimal D/A = 25%.
• EPS is maximized at 50%, but primary interest is
stock price, not E(EPS).
• The example shows that we can push up E(EPS) by
using more debt, but the risk resulting from
increased leverage more than offsets the benefit of
higher E(EPS).

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Graphical Illustration: Plotting figures in Graphs

Relationship Between Capital Structure and EPS Capital Structure Theory

• The Effect of Taxes
• The Effect of Potential Bankruptcy
• Trade-off Theory
• Signaling Theory

Trade-Off Theory (Modigliani and Miller)

1. Theory:
• Interest is tax-deductible expense, therefore less
expensive than common or preferred stock.
• So, 100% debt is the preferred capital structure.
2. Theory:
• Interest rates rise as debt/asset ratio increases
• Tax rates fall at high debt levels (lowers debt tax
shield)
Relationship Between Capital Structure and Cost of Capital
• Probability of bankruptcy increases as debt/assets
ratio increases.
3. Two levels of debt:
a) Threshold debt level (D/A1) = where bankruptcy
costs become material
b) Optimal debt level (D/A2) = where marginal tax
shelter benefits = marginal bankruptcy–related costs
• Between these two debt levels, the firm’s stock price
rises, but at a decreasing rate
• So, the optimal debt level = optimal capital structure
4. Theory and empirical evidence support these ideas, but
Relationship Between Capital Structure and Stock Price the points cannot be identified precisely.
5. Many large, successful firms use much less debt than the
theory suggests—leading to development of signaling
theory.

Modigliani-Miller Irrelevance Theory

Degree of Total Leverage (DTL)

• The percentage change in EPS that results from a
given percentage change in sales.

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Signaling Theory
• Symmetric Information
o Investors and managers have identical
information about the firm’s prospects.
• Asymmetric Information
o Managers have better information about
their firm’s prospects than do outside
investors.
• Signal
o An action taken by a firm’s management
that provides clues to investors about how
management views the firm’s prospects
• Result: Reserve Borrowing Capacity
o Ability to borrow money at a reasonable
cost when good investment opportunities
arise
o Firms often use less debt than “optimal” to
ensure that they can obtain debt capital
later if needed.

Incorporating signaling effects

• Signaling theory suggests firms should use less debt
than MM suggest.
• This unused debt capacity helps avoid stock sales,
which depress stock price because of signaling
effects.

What are “signaling” effects in capital structure?

• Assumptions:
o Managers have better information about a firm’s
long-run value than outside investors.
o Managers act in the best interests of current
stockholders.
• What can managers be expected to do?
o Issue stock if they think stock is overvalued.
o Issue debt if they think stock is undervalued.
o As a result, investors view a stock offering
negatively--managers think stock is overvalued.
• Using Debt Financing to Constrain Managers
o Conflicts of interest among managers especially
if there is excess cash
o Leveraged Buyout

Variations in Capital Structures among Firms

• Wide variations in use of financial leverage among

industries and firms within an industry
• TIE (times interest earned ratio) measures how safe
the debt is:
o percentage of debt
o interest rate on debt
o company’s profitability

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