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14-1Copyright 2001 by Harcourt,Inc.All rights reserved.CHAPTER 14Capital Structure and LeveragenBusiness vs.financial risknOptimal capital structurenOperating leveragenCapital structure theory14-2Copyright 2001 by Harcourt,Inc.All rights reserved.nUncertainty about future operating income(EBIT),i.e.,how well can we predict operating income?nNote that business risk does not include financing effects.What is business risk?ProbabilityEBITE(EBIT)0Low riskHigh risk14-3Copyright 2001 by Harcourt,Inc.All rights reserved.Business risk is affected primarily by:nUncertainty about demand(sales).nUncertainty about output prices.nUncertainty about costs.nProduct,other types of liability.nOperating leverage.14-4Copyright 2001 by Harcourt,Inc.All rights reserved.What is operating leverage,and how does it affect a firms business risk?nOperating leverage is the use of fixed costs rather than variable costs.nIf most costs are fixed,hence do not decline when demand falls,then the firm has high operating leverage.14-5Copyright 2001 by Harcourt,Inc.All rights reserved.nMore operating leverage leads to more business risk,for then a small sales decline causes a big profit decline.nWhat happens if variable costs change?Sales$Rev.TCFCQBESales$Rev.TCFCQBEProfit14-6Copyright 2001 by Harcourt,Inc.All rights reserved.ProbabilityEBITLLow operating leverageHigh operating leverageTypical situation:Can use operating leverage to get higher E(EBIT),but risk increases.EBITH14-7Copyright 2001 by Harcourt,Inc.All rights reserved.What is financial leverage?Financial risk?nFinancial leverage is the use of debt and preferred stock.nFinancial risk is the additional risk concentrated on common stockholders as a result of financial leverage.14-8Copyright 2001 by Harcourt,Inc.All rights reserved.Business Risk vs.Financial RisknBusiness risk depends on business factors such as competition,product liability,and operating leverage.nFinancial risk depends only on the types of securities issued:More debt,more financial risk.Concentrates business risk on stockholders.14-9Copyright 2001 by Harcourt,Inc.All rights reserved.Firm UFirm LNo debt$10,000 of 12%debt$20,000 in assets$20,000 in assets40%tax rate40%tax rateConsider 2 Hypothetical FirmsBoth firms have same operating leverage,business risk,and probability distribution of EBIT.Differ only with respect to use of debt(capital structure).14-10Copyright 2001 by Harcourt,Inc.All rights reserved.Firm U:UnleveragedProb.0.250.500.25EBIT$2,000$3,000$4,000Interest 0 0 0EBT$2,000$3,000$4,000Taxes(40%)800 1,200 1,600NI$1,200$1,800$2,400 Economy Bad Avg.Good 14-11Copyright 2001 by Harcourt,Inc.All rights reserved.Firm L:LeveragedProb.*0.250.500.25EBIT*$2,000$3,000$4,000Interest 1,200 1,200 1,200EBT$800$1,800$2,800Taxes(40%)320 720 1,120NI$480$1,080$1,680*Same as for Firm U.Economy Bad Avg.Good 14-12Copyright 2001 by Harcourt,Inc.All rights reserved.Firm UBadAvg.GoodBEP*10.0%15.0%20.0%ROE6.0%9.0%12.0%TIEFirm LBadAvg.GoodBEP*10.0%15.0%20.0%ROE4.8%10.8%16.8%TIE1.67x2.5x3.3x*BEP same for Firms U and L.88814-13Copyright 2001 by Harcourt,Inc.All rights reserved.Expected Values:E(BEP)15.0%15.0%E(ROE)9.0%10.8%E(TIE)2.5xRisk Measures:s sROE2.12%4.24%CVROE0.24 0.39 U L 814-14Copyright 2001 by Harcourt,Inc.All rights reserved.nFor leverage to raise expected ROE,must have BEP kd.nWhy?If kd BEP,then the interest expense will be higher than the operating income produced by debt-financed assets,so leverage will depress income.14-15Copyright 2001 by Harcourt,Inc.All rights reserved.ConclusionsnBasic earning power=BEP=EBIT/Total assets is unaffected by financial leverage.nL has higher expected ROE because BEP kd.nL has much wider ROE(and EPS)swings because of fixed interest charges.Its higher expected return is accompanied by higher risk.14-16Copyright 2001 by Harcourt,Inc.All rights reserved.If debt increases,TIE falls.EBIT is constant(unaffected by useof debt),and since I=kdD,as Dincreases,TIE must fall.TIE=EBITI14-17Copyright 2001 by Harcourt,Inc.All rights reserved.Optimal Capital StructurenThat 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 debts risk-related costs.nThe target capital structure is the mix of debt,preferred stock,and common equity with which the firm intends to raise capital.14-18Copyright 2001 by Harcourt,Inc.All rights reserved.Describe the sequence of events in a recapitalization.nCampus Deli announces the recapitalization.nNew debt is issued.nProceeds are used to repurchase stock.Debt issued Price per shareShares bought=.14-19Copyright 2001 by Harcourt,Inc.All rights reserved.Amount D/A D/E Bondborrowed ratio ratio rating kdCost of debt at different debt levels after recapitalization$0 0 0 -2500.1250.1429 AA 8%5000.2500.3333 A 9%7500.3750.6000 BBB 11.5%1,0000.5001.0000 BB 14%14-20Copyright 2001 by Harcourt,Inc.All rights reserved.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.14-21Copyright 2001 by Harcourt,Inc.All rights reserved.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:EPS0=$3.00.(EBIT kdD)(1 T)Shares outstanding($400,000)(0.6)80,00014-22Copyright 2001 by Harcourt,Inc.All rights reserved.D=$250,kd=8%.=10,000.Sharesrepurchased$250,000$25TIE=20.$400$20EBITIEPS1=$3.26.$400 0.08($250)(0.6)80 1014-23Copyright 2001 by Harcourt,Inc.All rights reserved.D=$500,kd=9%.=20.Sharesrepurchased$500$25TIE=8.9.$400$45EBITIEPS2=$3.55.$400 0.09($500)(0.6)80 2014-24Copyright 2001 by Harcourt,Inc.All rights reserved.D=$750,kd=11.5%.=30.Sharesrepurchased$750$25TIE=4.6.$400$86.25EBITIEPS3=$3.77.$400 0.115($750)(0.6)80 3014-25Copyright 2001 by Harcourt,Inc.All rights reserved.D=$1,000,kd=14%.=40.Sharesrepurchased$1,000$25TIE=2.9.$400$140EBITIEPS4=$3.90.$400 0.14($1,000)(0.6)80 4014-26Copyright 2001 by Harcourt,Inc.All rights reserved.Stock Price(Zero Growth)If payout=100%,then EPS=DPS andE(g)=0.We just calculated EPS=DPS.To find the expected stock price(P0),we must find the appropriate ks at each of the debt levels discussed.P0=.D1ks gEPSksDPSks14-27Copyright 2001 by Harcourt,Inc.All rights reserved.What effect would increasing debt have on the cost of equity for the firm?nIf the level of debt increases,the riskiness of the firm increases.nWe have already observed the increase in the cost of debt.nHowever,the riskiness of the firms equity also increases,resulting in a higher ks.14-28Copyright 2001 by Harcourt,Inc.All rights reserved.The Hamada EquationnBecause the increased use of debt causes both the costs of debt and equity to increase,we need to estimate the new cost of equity.nThe Hamada equation attempts to quantify the increased cost of equity due to financial leverage.nUses the unlevered beta of a firm,which represents the business risk of a firm as if it had no debt.14-29Copyright 2001 by Harcourt,Inc.All rights reserved.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$2,000,000.14-30Copyright 2001 by Harcourt,Inc.All rights reserved.Calculating Levered BetasD=$250bL=bU1+(1 T)(D/E)bL=1.01+(1 0.4)($250/$1,750)bL=1.01+(0.6)(0.1429)bL=1.0857.ks=kRF+(kM kRF)bLks=6.0%+(6.0%)1.0857=12.51%.ks=kRF+(kM kRF)bL14-31Copyright 2001 by Harcourt,Inc.All rights reserved.Table for Calculating Levered BetasAmount borrowed$0 250 500 750 1,000D/A ratio 0.00%12.5025.0037.5050.00Levered Beta1.001.091.201.361.60D/E ratio 0.00%14.29 33.33 60.00100.00ks 12.00%12.51 13.20 14.16 15.6014-32Copyright 2001 by Harcourt,Inc.All rights reserved.Minimizing the WACCAmount borrowed$0 250 500 750 1,000D/A ratio 0.00%12.50 25.00 37.50 50.00WACC 12.00%11.55 11.25 11.44 12.00E/A ratio100.00%87.50 75.00 62.50 50.00ks 12.00%12.51 13.20 14.16 15.60kd(1 T)0.00%4.80 5.40 6.90 8.4014-33Copyright 2001 by Harcourt,Inc.All rights reserved.P0=DPS/ksAmountBorrowedDPSksP0$0$3.0012.00%$25.00250,0003.2612.51500,0003.5513.2026.0326.89*750,0003.7714.1626.591,000,0003.9015.6025.00*Maximum:Since D=$500,000 and assets=$2,000,000,optimal D/A=25%.14-34Copyright 2001 by Harcourt,Inc.All rights reserved.See preceding slide.Maximum EPS=$3.90 at D=$1,000,000,and D/A=50%.Risk is too high at D/A=50%.What debt ratio maximizes EPS?14-35Copyright 2001 by Harcourt,Inc.All rights reserved.What is Campus Delis optimal capital structure?P0 is maximized($26.89)at D/A=$500,000/$2,000,000=25%,so optimal D/A=25%.EPS is maximized at 50%,but primary interest is stock price,not E(EPS).14-36Copyright 2001 by Harcourt,Inc.All rights reserved.The example shows that we can push up E(EPS)by using more debt,but the risk resulting from increased leverage more than offsets the benefit of higher E(EPS).14-37Copyright 2001 by Harcourt,Inc.All rights reserved.%150.25.75.50D/AksWACCkd(1 T)$D/A.25.50P0EPS14-38Copyright 2001 by Harcourt,Inc.All rights reserved.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.14-39Copyright 2001 by Harcourt,Inc.All rights reserved.Other factors to consider when establishing the firms target capital structure?1.Industry average debt ratio2.TIE ratios under different scenarios3.Lender/rating agency attitudes4.Reserve borrowing capacity5.Effects of financing on control6.Asset structure7.Expected tax rate14-40Copyright 2001 by Harcourt,Inc.All rights reserved.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?14-41Copyright 2001 by Harcourt,Inc.All rights reserved.Long-term Debt Ratios for Selected IndustriesIndustry Long-Term Debt RatioPharmaceuticals20.00%Computers25.93Steel39.76Aerospace43.18Airlines56.33Utilities56.52Source:Dow Jones News Retrieval.Data collected through December 17,1999.14-42Copyright 2001 by Harcourt,Inc.All rights reserved.Value of Stock0D1D2D/AMM resultActualNo leverage14-43Copyright 2001 by Harcourt,Inc.All rights reserved.nThe graph shows MMs tax benefit vs.bankruptcy cost theory.nLogical,but doesnt tell whole capital structure story.Main problem-assumes investors have same information as managers.14-44Copyright 2001 by Harcourt,Inc.All rights reserved.Signaling theory,discussed earlier,suggests firms should use less debt than MM suggest.This unused debt capacity helps avoid stock sales,which depress P0 because of signaling effects.14-45Copyright 2001 by Harcourt,Inc.All rights reserved.What are“signaling”effects in capital structure?nManagers have better information about a firms long-run value than outside investors.nManagers act in the best interests of current stockholders.Assumptions:14-46Copyright 2001 by Harcourt,Inc.All rights reserved.Therefore,managers can be expected to:nissue stock if they think stock is overvalued.nissue 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.14-47Copyright 2001 by Harcourt,Inc.All rights reserved.Conclusions on Capital Structure1.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.14-48Copyright 2001 by Harcourt,Inc.All rights reserved.演讲完毕，谢谢观看！
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