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CHAPTER 16

Capital Structure and Leverage

Business vs. Financial Risk


Operating & Financial Leverage
Optimal Capital Structure
Capital Structure theory
Capital Structure Example
16-1

Preview of Capital Structure

WACC = wd(rd)(1-T) + ws(rs)


Debt Increases Equity Cost (rs)
Debt Reduces Taxes
Debt Increases Risk of Bankruptcy
Increased Bankruptcy Reduces FCFs
Increased Bankruptcy Increases Agency
Costs
Issuing Equity is Negative Market Signal
16-2

Business Risk

Business Risk is Uncertainty about future


Operating Income (EBIT)
Low risk

Probability

High risk

E(EBIT)

EBIT

Note: Business Risk DOES NOT include financing


risks
16-3

Major Determinants of
Business Risk

Demand Variability (Unit Sales)


Sales Price Variability
Input Cost variability
Ability to adjust output prices
Ability to develop new products
Foreign Risk Exposure
Operating Leverage (% Fixed Ops
Costs)
16-4

Operating Leverage &


Business Risk

Operating Leverage is relationship


between Fixed Operating costs & Variable
Operating costs

If most costs Fixed, Operating Leverage


High & Business Risk Higher

Breakeven Analysis

EBIT = PQ VQ F = 0
QBE = F/(P V)
16-5

Effect of Operating Leverage

More Operating Leverage leads to more


Business Risk: Small Sales decline causes a
Big Profit decline (and vice versa)
Rev.

Rev.
$
TC

} Profit
TC
FC

FC
QBE

Sales

QBE

Sales
16-6

Using Operating Leverage


Low operating leverage
Probability
High operating leverage

EBITL

EBITH

Can use Operating Leverage to get


higher EBIT, but risk also increases
16-7

Financial Leverage &


Financial Risk

Financial Leverage is the use of debt


and preferred stock (fixed financial
costs)

Financial Risk is the additional risk


concentrated on common
stockholders as a result of Financial
Leverage
16-8

Business Risk vs.


Financial Risk

Business Risk depends on business


factors: Economy, Competitiveness &
Operating Leverage

Financial Risk depends on Debt vs


Equity decisions

More Debt, more financial risk


Increases risk to Common Stockholders
16-9

Financial Leverage Example

Two firms with same Operating Leverage,


Business Risk, and probability distribution of
EBIT
Only differ in use of debt (capital structure)
Firm U
No debt
$20,000 in assets
40% tax rate

Firm L
$10,000 of 12% debt (50%)
$20,000 in assets
40% tax rate
16-10

Financial Leverage Example


Unleveraged
Prob.
EBIT
Interest
EBT
Taxes (40%)
NI
Leveraged
Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI

Bad
0.25
$2,000
0
$2,000
800
$1,200

Bad
0.25
$2,000
1,200
$ 800
320
$ 480

Economy
Avg.
0.50
$3,000
0
$3,000
1,200
$1,800
Economy
Avg.
0.50
$3,000
1,200
$1,800
720
$1,080

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

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

16-11

Ratio Comparison between


Leveraged & Unleveraged firms
FIRM U
BEP
ROE
TIE

FIRM L
BEP
ROE
TIE

Bad

Avg

Good

10.0%
6.0%

15.0%
9.0%

20.0%
12.0%

Bad

Avg

Good

10.0%
4.8%
1.67x

15.0%
10.8%
2.50x

20.0%
16.8%
3.30x
16-12

Risk & Return between


Leveraged & Unleveraged firms
Expected Values:
E(BEP)
E(ROE)
E(TIE)
Risk Measures:

ROE
CVROE

Firm U
15.0%
9.0%

Firm L
15.0%
10.8%
2.5x

Firm U
2.12%
0.24

Firm L
4.24%
0.39
16-13

Financial Leverage
Conclusions

Basic Earning Power (BEP) is unaffected by


Financial Leverage

For leverage to increase ROE: BEP > rd

Leveraged firm has higher expected ROE


because BEP > rd & higher risk (ROE & CV)
Higher Expected Return is accompanied by
Higher Risk
16-14

Optimal Capital Structure

Mix of debt, preferred, & common


equity at which Ps (Value) is
maximized & WACC is minimized
Target (Optimal) Capital Structure

Mix of debt, preferred stock, & common


equity at which firm should raise capital

Use of Debt reduces Taxes


16-15

MM vs. Trade-off Theory

MM theory ignores Bankruptcy (financial


distress) Costs, which increase as more
Debt is used

Trade-off Theory includes Bankruptcy

VL = VU + TD
VL = VU + TD (PV of Bankruptcy Costs)

An Optimal capital structure exists that


balances costs and tax benefits
16-16

Trade-off Theory vs MM
Value of Stock

MM with no bankruptcy risk

Value added by
Debt tax benefits

Value reduced by
potential bankruptcy
Actual Value

No leverage

D/A

D1

D2

16-17

Signaling effects in
Capital Structure

Managers (Insiders) have better information

Firms keep Reserve Borrowing Capacity

Will sell new stock if stock is overvalued


Will sell bonds/buyback stock if stock is
undervalued
New stock sales are negative signals & vice versa
Avoid new stock issues
Able to borrow for opportunities & emergencies

Signaling theory suggests firms should use less


Debt than MM suggest
16-18

Other Capital Structure Issues

Use of Debt to Constrain Managers


Investment Opportunity Set (IOS)

Higher Business Risk

High IOS: Lower Debt Levels


Low IOS: Higher Debt Levels
Increases probability of Bankruptcy
Optimal capital structure has less debt

See Checklist at end of Chapter

16-19

Capital Structure Example

Example Sequence of Events

Firm decides to 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
current price per share (P0)
16-20

Initial Assumptions

Total Assets = $2,000,000


Debt = None (all Equity)
EBIT = $400,000
Price per Share (P0) = $25.00
rrf = 6%, rmkt = 6%
RPmkt = 6%
Beta (no debt) = 1.0
Payout = 100%
Growth (g) = 0%
Shares Outstanding = 80,000
16-21

Cost of debt at different debt levels


(Investment Banker Estimates)
Amount
borrowed
$
0

D/A
ratio
0

D/E
ratio
0

Bond
rating
--

250

0.125

0.1429

AA

8.0%

500

0.250

0.3333

9.0%

750

0.375

0.6000

BBB

11.5%

1,000

0.500

1.0000

BB

14.0%

rd
--

16-22

Determine the EPS and TIE at each


level of debt
D $0
( EBIT - rd D )( 1 - T )
EPS
Shares outstanding
($400,000)(0.6)
80,000
$3.00

16-23

Determining EPS and TIE


(D = $250,000 and rd = 8%)
$250,000
10,000
$25
( EBIT - rd D )( 1 - T )
EPS
Shares outstanding
($400,000- 0.08($250,000))(0.6)
80,000 - 10,000
$3.26

Shares repurchased

EBIT
TIE
Int Exp

$400,000
20x
$20,000

16-24

Summary of EPS & TIE Ratios


Amount
Borrowed
0

EPS

TIE Ratio

$3.00

250

3.26

20x

500

3.55

8.89x

750

3.77

4.64x

1000

3.90

2.85
16-25

Stock Price, with zero growth


P0

D1
rs - g

EPS
rs

DPS
rs

If all earnings are paid out as dividends,


g = 0. Therefore: EPS = DPS
To find the expected stock price (P0), we
must find the appropriate Beta & rs at
each of the debt levels discussed
16-26

Calculating Beta & rs from


Hamada Equation & CAPM
Hamada Equation: L = U[ 1 + (1 - T) (D/E)]
L = 1.0 [ 1 + (0.6)($250/$1,750) ]
L = 1.09
CAPM:

rs = rRF + (rM rRF) L

rs = 6.0% + (6.0%) 1.0857


rs = 12.51%
16-27

Summary of Betas & rs at


different levels of Debt
Amount
borrowed
$

D/A
ratio

D/E Levered
ratio
Beta

0.00%

0.00% 1.00

rs
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
16-28

Summary of WACC at different


levels of Debt
Amount D/A (Wd)
borrowed ratio

E/A (Ws)

ratio

rs

rd (1 T) WACC
12.00%

250

0.00% 100.00% 12.00% 0.00%


12.50
87.50
12.51
4.80

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

11.55

* Amount borrowed expressed in terms of thousands of dollars


16-29

Summary of Stock Price at


different levels of Debt
Amount
Borrowed

EPS/DPS

rs

P0

$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

16-30

Optimal Capital Structure

The Optimal Capital structure


Minimizes WACC (NOT EPS!)
The Optimal Capital structure
Maximizes Stock Price. (NOT EPS!)

Both methods yield the same results


16-31