CHAPTER 13

Capital Structure and Leverage

Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory
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Target Capital Structure

Preferred, Optimal mix of D, E and P/S to: a) Max value of firm and b) Raise capital and finance expansion Tradeoffs: More debt increases risk, which lowers stock P; but more debt leads to higher expected return on equity (ROE), which raises stock P. Optimal capital structure: Max stock P.
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4 Factors That Influence Capital Structure

1. Business Risk Risk w/no debt, 100% E 2. Firms tax position Does it need more tax shelter from debt or not? 3. Financial flexibility Ability to raise capital, on reasonable terms, under adverse conditions 4. Managers: Conservative or aggressive?
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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

E(EBIT)

EBIT

Note that business risk does not include financing effects, of debt and interest expense for example.
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What determines business risk? (Variability of EBIT)

TR (Sales Revenue) = P x Q Uncertainty about demand (Sales): Q Uncertainty about output prices: P Uncertainty about costs (Input P) Elasticity of Demand Price sensitivity Currency Risk Exposure Foreign sales? Product and other types of legal liability Operating leverage (FC vs. VC)
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Firms can control business risk:

Negotiate long-term contracts for labor, supplies, inputs, leases, etc. Marketing strategies to stabilize units sales and prices Hedging with commodity and financial futures to stabilize revenues and costs General Rule: The greater the business risk, the lower the optimal debt ratio.
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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, and therefore do not decline when demand falls, then the firm has high operating leverage. Examples: Nuclear plant, UM-Flint, GM and Ford, Automated Equipment vs. Low-Tech Equipment General Rule: Higher the operating leverage, the greater the business risk, lower optimal debt
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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. $ TC Rev.

} Profit TC
FC

FC QBE

Sales

QBE

Sales
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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.
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Illustration of Operating Leverage

See Example Fig 13-2 in Book, p. 428 and graph p. 430 Breakeven Formula: QBE = FC / (P VC) $20,000 / ($2 1.50) = 40,000 units $60,000 / ($2 1.00) = 60,000 units
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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 (Debt). Remember: Business Risk is the risk with no debt.
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Business risk vs. Financial risk

Example: Income from sales commissions

and Adjustable-rate Mortgage (ARM) 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 see p. 431. 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 difference is with respect to their use of debt (capital structure).
Firm U No debt $20,000 in assets 40% tax rate E = $20,000 Firm L $10,000 of 12% debt $20,000 in assets 40% tax rate E = $10,000
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Firm U: Unleveraged, E = $20,000

Prob. EBIT Interest EBT Taxes (40%) NIAT Bad 0.25 $2,000 0 $2,000 800 $1,200

Economy Avg. 0.50 $3,000 0 $3,000 1,200 $1,800

Good 0.25 $4,000 0 $4,000 1,600 $2,400

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Firm L: Leveraged, E = $10,000

Prob.* EBIT* Interest EBT Taxes (40%) NIAT
*Same as for Firm U.
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Bad 0.25 $2,000 1,200 $ 800 320 $ 480

Economy Avg. 0.50 $3,000 1,200 $1,800 720 $1,080

Good 0.25 $4,000 1,200 $2,800 1,120 $1,680

Ratio comparison between leveraged and unleveraged firms

FIRM U Bad Avg
15.0% 9.0%

Good
20.0% 12.0%

BEP (EBIT/TA) 10.0% ROE (NIAT/E) 6.0% TIE (EBIT/INT)

FIRM L
BEP ROE TIE

Bad
10.0% 4.8% 1.67x

Avg
15.0% 10.8% 2.50x

Good
20.0% 16.8% 3.30x
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Risk and return for leveraged and unleveraged firms

Expected Values: E(BEP) E(ROE) E(TIE) Risk Measures:

Firm U 15.0% 9.0%

Firm L 15.0% 10.8% 2.5x

ROE CVROE

Firm U 2.12% 0.24

Firm L 4.24% 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: L vs. U

Basic earning power (EBIT/TA) is unaffected by financial leverage. L has higher expected ROE (10.8 v. 9%) because BEP > rd. L has more risk: greater ROE (and EPS) variability because of fixed interest charges. Higher expected return (10.8%) is accompanied by higher risk ( = 4.24%) . See Example in Book: Table 13-2, p. 432.
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Optimal Capital Structure

The capital structure (mix of debt, preferred, and common equity) at which share price (P0) is maximized. Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debts riskrelated 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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Sequence of events in a recapitalization.

Firm 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.

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Cost of debt at different debt ratios

Amount borrowed $0 250 500 750 1,000 D/A ratio 0 0.125 0.250 0.375 0.500 D/E ratio 0 0.143 0.333 0.600 1.000 Bond rating -AA A BBB BB rd -8.0% 9.0% 11.5% 14.0%
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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 firms bond rating to decrease, and its cost of debt to increase see p. 440.

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Analyze the recapitalization at various debt levels and determine the EPS and TIE at each level.
EBIT = $400,000 Shares = 80,000

D $0 ( EBIT - rdD )( 1 - T ) EPS Shares outstanding ($400,000) (0.6) 80,000 $3.00

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Determining EPS and TIE at different levels of debt. (D = $250,000 and rd = 8%)
Shares repurchased $250,000 10,000 $25 ( EBIT - rdD )( 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

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Determining EPS and TIE at different levels of debt. (D = $500,000 and rd = 9%)
Shares repurchased $500,000 20,000 $25 ( EBIT - rdD )( 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

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Determining EPS and TIE at different levels of debt. (D = $750,000 and rd = 11.5%)
$750,000 Shares repurchased 30,000 $25 ( EBIT - rdD )( 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
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Determining EPS and TIE at different levels of debt. (D = $1,000,000 and rd = 14%)
Shares repurchased $1,000,000 40,000 $25 ( EBIT - rdD )( 1 - T ) EPS Shares outstanding ($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
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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 rs at each of the debt levels discussed.
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What effect does more debt have on a firms cost of equity?

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 rs.
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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

bL = bU[ 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.
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Calculating levered betas and costs of equity

If D = $250, bL = 1.0 [ 1 + (0.6)($250/$1,750) ] bL = 1.0857 rs = rRF + (rM rRF) bL rs = 6.0% + (6.0%) 1.0857 rs = 12.51%
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Table for calculating levered betas and costs of equity

Amount borrowed $0 250 500 750 1,000 D/A ratio 0% 12.50 25.00 37.50 50.00 D/E ratio 0% 14.29 33.33 60.00 100.00 Levered beta 1.00 1.09 1.20 1.36 1.60 rs 12.00% 12.51 13.20 14.16 15.60
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Finding Optimal Capital Structure

The firms optimal capital structure can be determined two ways:

Minimizes WACC. Maximizes stock price.

Both methods yield the same results.

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Table for calculating levered betas and costs of equity

Amount borrowed $0 250
500

D/A ratio 0% 12.50

25.00

E/A ratio
100%

rs
12.00%

rd(1-T)
--

WACC
12.00%

87.50
75.00

12.51
13.20

4.80%
5.40%

11.55
11.25

750
1,000

37.50
50.00

62.50
50.00

14.16
15.60

6.90%
8.40%

11.44
12.00
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Determining the stock price maximizing capital structure

Amount borrowed $0 250
500

DPS
$3.00

rs

P0

12.00% $25.00

3.26
3.55

12.51
13.20

26.03
26.89

750
1,000

3.77
3.90

14.16
15.60

26.59
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 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). 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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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. However, lower business risk would lead to an optimal capital structure with more debt.
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Other factors to consider when establishing the firms target capital structure
1. 2. 3.

4.
5. 6. 7.

Industry average debt ratio TIE ratios under different scenarios Lender/rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rate
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How would these factors affect the target capital structure?

1. 2. 3.

4.
5. 6.

Increase in sales stability? D High operating leverage? D Increase in the corporate tax rate? D Increase in the personal tax rate? D Increase in bankruptcy costs? D Management spending lots of money on lavish perks? D
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Modigliani-Miller Irrelevance Theory

Value of Stock

MM result: No Bankruptcy Costs

Value Added by Debt Tax Benefits

Actual
Value Reduced by Bankruptcy Costs

No leverage
D/A

D1

D2

Optimal Capital Structure: Marginal Tax Benefits = Marginal Bankruptcy Costs

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Modigliani-Miller Irrelevance Theory

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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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.
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What are signaling effects in capital structure?

Assumptions:

Managers have better information about a firms longrun value and firms prospects than outside investors. Managers act in the best interests of current stockholders. Issue stock if they think stock is overvalued. Issue debt if they think stock is undervalued. As a result, investors view a stock offering negatively-managers think stock is overvalued.
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What can managers be expected to do?

Favorable v. Unfavorable Prospects for a Firm

Favorable prospects, profitable new product, Issue Debt or Equity? Why? Unfavorable prospect, pending losses, Issue Debt or Equity? Why? Conclusions: 1. Issuing stock is negative signal, depresses price 2. Firm should maintain reserve borrowing capacity, use more E, less D than suggested by trade-off theory

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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. See Table 13-4, p. 452.
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