Capital Structure and

Leverage

 Business vs. financial risk

 Optimal capital structure
 Operating leverage
 Capital structure theory
 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.
 Financial risk is the additional
risk concentrated on equity
shareholders 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 equity
shareholders.
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).
Optimal Capital Structure
 That capital structure (mix of debt
and 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 and 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 - kdD )( 1 - T )
EPS 
Sharesoutstandin g
($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
Sharesrepurchase
d 10,000
$25
( EBIT - kdD )( 1 - T )
EPS 
Sharesoutstandin g
($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
Sharesrepurchase
d 20,000
$25
( EBIT - kdD )( 1 - T )
EPS 
Sharesoutstandin g
($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
Sharesrepurchase
d 30,000
$25
( EBIT - kdD )( 1 - T )
EPS 
Sharesoutstandin g
($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
Sharesrepurchase
d 40,000
$25
( EBIT - kdD )( 1 - T )
EPS 
Sharesoutstandin g
($400,000- 0.14($1,00 0,000))(0.
6)

80,000- 40,000
$3.90

EBIT $400,000
TIE   2.9x
Int Exp $140,000
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.
Stock Price, with zero
growth
D1 EPS DPS
P0   
ks - g ks ks

 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.
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.
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.
The Hamada Equation

βL = βU[ 1 + (1 - T) (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.
Calculating levered betas and
costs of equity
If D = $250,

βL = 1.0 [ 1 + (0.6)($250/$1,750) ]
βL = 1.0857

ks = kRF + (kM – kRF) βL

ks = 6.0% + (6.0%) 1.0857
ks = 12.51%
 Table for calculating levered
betas and costs of equity
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
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 D/A E/A

borrowed 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 is Campus Deli’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).
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 bankruptcy costs?
5. Management spending lots of
money on lavish perks?
 Modigliani-Miller Irrelevance
Theory
Value of Stock MM result

Actual

No leverage

D/A
0 D1 D2
Modigliani-Miller Irrelevance
Theory
 The graph shows MM’s tax benefit
vs. bankruptcy cost theory.
 Logical, but doesn’t tell whole
capital structure story. Main
problem--assumes investors have
same information as managers.
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?
 Assume:
 Managers have better information
about a firm’s long-run value than
outside investors.
 Managers act in the best interests of
current stockholders.
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.
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.