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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,14 -,47,Copyright 2001 by Harcourt, Inc.All rights reserved.,CHAPTER 14,Capital Structure and Leverage,Business vs. financial risk,Optimal capital structure,Operating leverage,Capital structure theory,Uncertainty about future,operating income,(EBIT), i.e., how well can we predict operating income?,Note that business risk does,not,include financing effects.,What is business risk?,Probability,EBIT,E(EBIT),0,Low risk,High risk,Business risk is affected primarily by:,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 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,.,More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.,What happens if variable costs change?,Sales,$,Rev.,TC,FC,Q,BE,Sales,$,Rev.,TC,FC,Q,BE,Profit,Probability,EBIT,L,Low operating leverage,High operating leverage,Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.,EBIT,H,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.,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.,Firm U,Firm L,No debt$10,000 of 12% debt,$20,000 in assets$20,000 in assets,40% tax rate40% tax rate,Consider 2 Hypothetical Firms,Both firms have same operating leverage, business risk, and probability distribution of EBIT.,Differ only with respect to use of debt (capital structure),.,Firm U: Unleveraged,Prob.0.250.500.25,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,Economy,Bad Avg. Good,Firm L: Leveraged,Prob.*0.250.500.25,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$1,680,*Same as for Firm U.,Economy,Bad Avg. Good,Firm U,BadAvg.Good,BEP*10.0%15.0%20.0%,ROE,6.0%,9.0%,12.0%,TIE,Firm L,BadAvg.Good,BEP*10.0%15.0%20.0%,ROE,4.8%,10.8%,16.8%,TIE1.67x2.5x3.3x,*BEP same for Firms U and L.,8,8,8,Expected Values:,E(BEP)15.0%15.0%,E(ROE)9.0%10.8%,E(TIE)2.5x,Risk Measures:,s,ROE,2.12%4.24%,CV,ROE,0.24 0.39,U,L,8,For leverage to raise expected ROE, must have,BEP k,d,.,Why?,If k,d, BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income.,Conclusions,Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage.,L has higher expected ROE because BEP k,d,.,L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.,If debt increases, TIE falls.,EBIT is constant (unaffected by use,of debt), and since I = k,d,D, as D,increases, TIE must fall.,TIE =,EBIT,I,Optimal Capital Structure,That capital structure (mix of debt, preferred, and common equity) at which P,0,is maximized. Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debts risk-related costs.,The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.,Describe the sequence of events in a recapitalization.,Campus Deli,announces,the recapitalization.,New debt is,issued,.,Proceeds are used to,repurchase,stock.,Debt issued,Price per share,Shares bought = .,Amount D/A D/E Bond,borrowed ratio ratio rating k,d,Cost of debt at different debt levels after recapitalization,$ 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%,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.,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 P,0,= $25.,D = 0:,EPS,0,=,= = $3.00.,(EBIT k,d,D)(1 T),Shares outstanding,($400,000)(0.6),80,000,D = $250, k,d,= 8%.,= = 10,000.,Sharesrepurchased,$250,000,$25,TIE = = = 20.,$400,$20,EBIT,I,EPS,1,=,= $3.26.,$400 0.08($250)(0.6),80 10,D = $500, k,d,= 9%.,= = 20.,Sharesrepurchased,$500,$25,TIE = = = 8.9.,$400,$45,EBIT,I,EPS,2,=,= $3.55.,$400 0.09($500)(0.6),80 20,D = $750, k,d,= 11.5%.,= = 30.,Sharesrepurchased,$750,$25,TIE = = = 4.6.,$400,$86.25,EBIT,I,EPS,3,=,= $3.77.,$400 0.115($750)(0.6),80 30,D = $1,000, k,d,= 14%.,= = 40.,Sharesrepurchased,$1,000,$25,TIE = = = 2.9.,$400,$140,EBIT,I,EPS,4,=,= $3.90.,$400 0.14($1,000)(0.6),80 40,Stock Price (Zero Growth),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 k,s,at each of the debt levels discussed.,P,0,= = = .,D,1,k,s, g,EPSk,s,DPSk,s,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 k,s.,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 (contd),b,L,= b,U,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.,Calculating Levered Betas,D = $250,b,L,= b,U,1 + (1 T)(D/E),b,L,= 1.01 + (1 0.4)($250/$1,750),b,L,= 1.01 + (0.6)(0.1429),b,L,= 1.0857.,k,s,= k,RF,+ (k,M, k,RF,)b,L,k,s,= 6.0%,+ (6.0%)1.0857 = 12.51%.,k,s,= k,RF,+ (k,M, k,RF,)b,L,Table for Calculating Levered Betas,Amount borrowed,$ 0,250,500,750,1,000,D/A ratio,0.00%,12.50,25.00,37.50,50.00,Levered Beta,1.00,1.09,1.20,1.36,1.60,D/E ratio,0.00%,14.29,33.33,60.00,100.00,k,s,12.00%,12.51,13.20,14.16,15.60,Minimizing the WACC,Amount borrowed,$ 0,250,500,750,1,000,D/A ratio,0.00%,12.50,25.00,37.50,50.00,WACC,12.00%,11.55,11.25,11.44,12.00,E/A ratio,100.00%,87.50,75.00,62.50,50.00,k,s,12.00%,12.51,13.20,14.16,15.60,k,d,(1 T),0.00%,4.80,5.40,6.90,8.40,P,0,= DPS/k,s,Amount,Borrowed,DPS,k,s,P,0,$ 0,$3.00,12.00%,$25.00,250,000,3.26,12.51,500,000,3.55,13.20,26.03,26.89*,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%.,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?,What is Campus Delis optimal capital structure?,P,0,is maximized ($26.89) at D/A = $500,000/$2,000,000 = 25%, so optimal D/A = 25%.,EPS is maximized at 50%, but primary interest is stock price, not E(EPS).,The example shows that we can push up E(EPS) by using more debt, but the risk resulting from,increased leverage more than offsets the benefit of higher E(EPS).,%,15,0,.25,.75,.50,D/A,k,s,WACC,k,d,(1 T),$,D/A,.25,.50,P,0,EPS,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.,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,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?,Long-term Debt Ratios for Selected Industries,Industry,Long-Term Debt Ratio,Pharmaceuticals20.00%,Computers25.93,Steel39.76,Aerospace43.18,Airlines56.33,Utilities56.52,Source:,Dow Jones News Retrieval,. Data collected through December 17, 1999.,Value of Stock,0,D,1,D,2,D/A,MM result,Actual,No leverage,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.,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.,What are “signaling” effects in capital structure?,Managers have better information about a firms long-run value than outside investors.,Managers act in the best interests of current stockholders.,Assumptions:,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.,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.,
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