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CHAPTER 14
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 operating
income? Probability
Low risk

High risk

0 E(EBIT) EBIT
Note that business risk does not include
financing effects.
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Business risk is affected primarily by:

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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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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Probability Low operating leverage

High operating leverage

EBITL EBITH

Typical situation: Can use operating

leverage to get higher E(EBIT), but
risk increases.
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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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Consider 2 Hypothetical 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
Both firms have same operating
leverage, business risk, and probability
distribution of EBIT. Differ only with
respect to use of debt (capital structure).
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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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Firm U Bad Avg. Good

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

8
Firm L Bad Avg. Good
BEP* 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.5x 3.3x
*BEP same for Firms U and L.
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Expected Values:
U L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) 2.5x

8
Risk Measures:
ROE 2.12% 4.24%
CVROE 0.24 0.39
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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.
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Conclusions

Basic earning power = BEP = EBIT/Total

assets is unaffected by financial
leverage.
L has higher expected ROE because BEP
> k d.
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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If debt increases, TIE falls.

EBIT
TIE =
I

EBIT is constant (unaffected by use

of debt), and since I = kdD, as D
increases, TIE must fall.
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Optimal Capital Structure

That capital structure (mix of debt,
preferred, and common equity) at which P 0
is maximized. Trades off higher E(ROE)
and EPS against higher risk. The tax-
related benefits of leverage are exactly
offset by the debts 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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Describe the sequence of events in a

recapitalization.

Campus Deli announces the

recapitalization.
New debt is issued.
Proceeds are used to repurchase
stock.
Debt issued
Shares bought = .
Price per share
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Cost of debt at different debt levels

after recapitalization

Amount D/A D/E Bond

borrowed ratio ratio rating kd
$ 0 0 0 -- --
250 0.125 0.1429 AA 8%
500 0.250 0.3333 A 9%
750 0.375 0.6000 BBB 11.5%
1,000 0.500 1.0000 BB 14%
 14 - 20
Why does the bond rating and cost of
debt depend upon the amount
borrowed?

As the firm borrows more money, the

firm increases its risk causing the
firms bond rating to decrease, and its
cost of debt to increase.
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What would the earnings per share be
if Campus Deli recapitalized and used
these amounts of debt: $0, $250,000,
$500,000, $750,000? Assume EBIT =
$400,000, T = 40%, and shares can be
repurchased at P0 = $25.
D = 0: (EBIT kdD)(1 T)
EPS0 =
Shares outstanding

($400,000)(0.6)
= 80,000 = $3.00.
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D = $250, kd = 8%.

Shares $250,000
= = 10,000.
repurchased $25

[$400 0.08($250)](0.6)
EPS1 =
80 10
= $3.26.

EBIT $400
TIE = = = 20.
I $20
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D = $500, kd = 9%.

Shares $500
= = 20.
repurchased $25

[$400 0.09($500)](0.6)
EPS2 =
80 20
= $3.55.

EBIT $400
TIE = = = 8.9.
I $45
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D = $750, kd = 11.5%.

Shares $750
= = 30.
repurchased $25

[$400 0.115($750)](0.6)
EPS3 =
80 30
= $3.77.

EBIT $400
TIE = = = 4.6.
I $86.25
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D = $1,000, kd = 14%.

Shares $1,000
= = 40.
repurchased $25

[$400 0.14($1,000)](0.6)
EPS4 =
80 40
= $3.90.

EBIT $400
TIE = = = 2.9.
I $140
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Stock Price (Zero Growth)

D1 EPS DPS
P0 = = = .
ks g ks ks

If payout = 100%, then EPS = DPS and

E(g) = 0.
We just calculated EPS = DPS. To
find the expected stock price (P 0), we
must find the appropriate ks at each of
the debt levels discussed.
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What effect would 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 firms
equity also increases, resulting in a
higher ks.
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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 the business risk of
a firm as if it had no debt.
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The Hamada Equation (contd)

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

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

D = $250 ks = kRF + (kM kRF)bL

bL = bU[1 + (1 T)(D/E)]
bL = 1.0[1 + (1 0.4)($250/$1,750)]
bL = 1.0[1 + (0.6)(0.1429)]
bL = 1.0857.
ks = kRF + (kM kRF)bL
ks = 6.0% + (6.0%)1.0857 = 12.51%.
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Table for Calculating Levered Betas

Amount D/A D/E Levered

borrowed ratio ratio Beta ks
$ 0 0.00% 0.00% 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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Minimizing the WACC

Amount D/A ratio E/A

borrowed ratio ks kd (1 T) WACC
0.00%
$ 0 100.00% 12.00% 0.00% 12.00%
12.50
250 87.50 12.51 4.80 11.55
25.00
500 75.00 13.20 5.40 11.25
37.50
750 62.50 14.16 6.90 11.44
50.00
1,000 50.00 15.60 8.40 12.00
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P0 = DPS/ks
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
*Maximum: Since D = $500,000 and assets
= $2,000,000, optimal D/A = 25%.
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What debt ratio maximizes EPS?

See preceding slide. Maximum EPS =

$3.90 at D = $1,000,000, and D/A = 50%.
Risk is too high at D/A = 50%.
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What is Campus Delis 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).
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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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%

15 ks
WACC
kd(1 T)

0 .25 .50 .75 D/A

$

P0
EPS

D/A
.25 .50
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If is were discovered that the firm had
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 of more debt.
 14 - 39
Other factors to consider when
establishing the firms 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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Long-term Debt Ratios for

Selected Industries

Industry Long-Term Debt Ratio

Pharmaceuticals 20.00%
Computers 25.93
Steel 39.76
Aerospace 43.18
Airlines 56.33
Utilities 56.52
Source: Dow Jones News Retrieval. Data
collected through December 17, 1999.
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Value of Stock
MM result

Actual

No leverage

D/A
0 D1 D2
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The graph shows MMs tax benefit

vs. bankruptcy cost theory.
Logical, but doesnt tell whole
capital structure story. Main
problem--assumes investors have
same information as managers.
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Signaling theory, discussed earlier,

suggests firms should use less debt
than MM suggest.
This unused debt capacity helps
avoid stock sales, which depress P 0
because of signaling effects.
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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 current stockholders.
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Therefore, managers can be expected to:

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

1. Need to make calculations as we

did, but should also recognize
inputs are guesstimates.
2. As a result of imprecise numbers,
capital structure decisions have a
large judgmental content.
3. We end up with capital structures
varying widely among firms, even
similar ones in same industry.