Capital Structure Decisions 3642

8/8/2019 Capital Structure Decisions 3642

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Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO

CORPORATE FINANCECORPORATE FINANCELaurence BoothLaurence Booth W. Sean ClearyW. Sean Cleary

Chapter 21Chapter 21 ± ± Capital Structure DecisionsCapital Structure Decisions



CHAPTER 21CHAPTER 21Capital Structure DecisionsCapital Structure Decisions



CHAPTER 21 ± Capital Structure Decisions 21 - 3

Lecture AgendaLecture Agenda

Learning ObjectivesLearning Objectives

Important TermsImportant Terms

Financial LeverageFinancial Leverage

Determining Capital StructureDetermining Capital Structure

M&M Irrelevance TheoremM&M Irrelevance Theorem

Impact of TaxesImpact of Taxes

Financial Distress, Bankruptcy and Agency CostsFinancial Distress, Bankruptcy and Agency Costs

Other Factors affecting Capital StructureOther Factors affecting Capital Structure

Capital Structure in PracticeCapital Structure in Practice Summary and ConclusionsSummary and Conclusions

± ± Concept Review QuestionsConcept Review Questions

± ± Appendix 1 Appendix 1 ± ± Thunder Bay IndustriesThunder Bay Industries ± ± Indifference AnalysisIndifference Analysis




Learning ObjectivesLearning Objectives

1.1. How business risk and financial risk affect a firm·s ROE and EPSHow business risk and financial risk affect a firm·s ROE and EPS

2.2. How indifference analysis may be used to compare financingHow indifference analysis may be used to compare financingalternatives based on expected EBIT levelsalternatives based on expected EBIT levels

3.3. Modigliani and Miller·s irrelevance, argument, as well as the keyModigliani and Miller·s irrelevance, argument, as well as the keyassumptions upon which it is basedassumptions upon which it is based

4.4. How the introduction of corporate taxes affects M&M·s irrelevanceHow the introduction of corporate taxes affects M&M·s irrelevanceargument argument

5.5. How financial distress and bankruptcy costs lead to the static tradeHow financial distress and bankruptcy costs lead to the static trade--off off theory of capital structuretheory of capital structure

6.6. How information asymmetry problems and agency problems may leadHow information asymmetry problems and agency problems may lead firms to follow a pecking order approach to financing firms to follow a pecking order approach to financing

7.7. How other factors such as firm size, profitability and growth, asset How other factors such as firm size, profitability and growth, asset tangibility, and market conditions can affect a firm·s capital structure.tangibility, and market conditions can affect a firm·s capital structure.




Important Chapter TermsImportant Chapter Terms

Agency costsAgency costs BankruptcyBankruptcy Business riskBusiness risk Cash flowCash flow--toto--debt ratiodebt ratio Corporate debt tax shieldCorporate debt tax shield Direct costs of bankruptcyDirect costs of bankruptcy EPS indifference point EPS indifference point Financial breakFinancial break--even pointseven points Financial distressFinancial distress

Financial leverageFinancial leverage Financial leverage riskFinancial leverage risk

premiumpremium

Financial riskFinancial risk Fixed burden coverage ratioFixed burden coverage ratio Homemade leverageHomemade leverage Indifference point Indifference point

Indirect costs of bankruptcyIndirect costs of bankruptcy Invested capitalInvested capital M&M equity cost equationM&M equity cost equation Modigliani and MillerModigliani and Miller Pecking orderPecking order Profit planning chartsProfit planning charts

Return on equity (ROE)Return on equity (ROE) Return on invested capitalReturn on invested capital Risk value of moneyRisk value of money Static tradeoff Static tradeoff



Intr oduction to LeverageIntr oduction to Leverage





The Focus of this Chapter The Focus of this Chapter

You know:You know: ± ± It is the responsibility of the financial manager to maximizeIt is the responsibility of the financial manager to maximize

shareholder wealth.shareholder wealth.

± ± The after The after--tax cost of debt is significantly lower than the cost of tax cost of debt is significantly lower than the cost of equity primarily because of the taxequity primarily because of the tax--deductibility of interestdeductibility of interestexpense«theref ore, using debt has a cost advantage over expense«theref ore, using debt has a cost advantage over equity.equity.

± ± The lower the cost of capital, the greater the value of the firm.The lower the cost of capital, the greater the value of the firm.

± ± This chapter addresses the question:This chapter addresses the question:

Does the relative mix of financing used by a firm affect its value?If so, how and why and are what are the other impacts that capital structure can have on the firm?




In this Chapter You Will LearnIn this Chapter You Will Learn

1.1. The optimal (target) capital structure is the one that The optimal (target) capital structure is the one that maximizes the value of the firm and minimizes the cost maximizes the value of the firm and minimizes the cost of capital.of capital.

2.2. How lenders seek to protect themselves from excessiveHow lenders seek to protect themselves from excessiveuse of corporate leverage through the use of protectiveuse of corporate leverage through the use of protectivecovenants.covenants.

3.3. The tax advantage to debt is offset at higher levels of The tax advantage to debt is offset at higher levels of financial leverage by costs associated with financial financial leverage by costs associated with financial

distress and bankruptcy.distress and bankruptcy.4.4. Firms depart from the target capital structure inFirms depart from the target capital structure in

practice because of financing preferences and capitalpractice because of financing preferences and capitalmarket conditions.market conditions.



Leverage: What is It?Leverage: What is It?

Capital Structure DecisionsCapital Structure Decisions




LeverageLeverage

The increased volatility in operating incomeThe increased volatility in operating incomeover time, created by the use of fixed costs inover time, created by the use of fixed costs inlieu of variable costs.lieu of variable costs.

± ± Leverage magnifies pr ofits and losses.Leverage magnifies pr ofits and losses. There are two types:There are two types: ± ± Operating leverageOperating leverage

± ± Financial leverageFinancial leverage

Both types of leverage have the same effect onBoth types of leverage have the same effect onshareholders but are accomplished in veryshareholders but are accomplished in verydifferent ways, for very different purposesdifferent ways, for very different purposesstrategically.strategically.




Leverage Effects on Operating IncomeLeverage Effects on Operating Income

Years

When a firm increases the

use of fixed costs it

increases the volatility of

operating income.

Normal volatility of operating income

Operating

Income

+

0

-



Financial versus Operating LeverageFinancial versus Operating Leverage





Operating LeverageOperating LeverageWhat is it? How is it Increased?What is it? How is it Increased?

Operating leverage is:Operating leverage is:

± ± The increased volatility in operating income caused by fixedThe increased volatility in operating income caused by fixedoperating costs.operating costs.

You should understand that managers do makeYou should understand that managers do makedecisions affecting the cost structure of the firm.decisions affecting the cost structure of the firm.

Managers can, and do, decide to invest in assets that Managers can, and do, decide to invest in assets that give rise to additional fixed costs and the intent is togive rise to additional fixed costs and the intent is toreduce variable costs.reduce variable costs.

± ± This is commonly accomplished by a firm choosing to becomeThis is commonly accomplished by a firm choosing to becomemore capital intensive and less labour intensive, therebymore capital intensive and less labour intensive, therebyincreasing operating leverage.increasing operating leverage.




Operating LeverageOperating Leverage Advantages and Disadvantages Advantages and Disadvantages

Advantages:Advantages: ± ± Magnification of pr ofits to the shareholders if the firm isMagnification of pr ofits to the shareholders if the firm is

pr ofitable.pr ofitable.

± ± Operating efficiencies (faster pr oduction, fewer err ors, higher Operating efficiencies (faster pr oduction, fewer err ors, higher quality) usually result increasing pr oductivity, reducingquality) usually result increasing pr oductivity, reducingµdowntime¶ etc.µdowntime¶ etc.

Disadvantages:Disadvantages: ± ± Magnification of losses to the shareholders if the firm does notMagnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.earn enough revenue to cover its costs.

± ± Higher break even pointHigher break even point ± ± High capital cost of equipment and the illiquidity of such anHigh capital cost of equipment and the illiquidity of such an

investment make it:investment make it: Expensive (more difficult to finance)Expensive (more difficult to finance)

Potentially exposed to technological obsolescence, etc.Potentially exposed to technological obsolescence, etc.




Financial LeverageFinancial LeverageWhat is it? How is it Increased?What is it? How is it Increased?

Your textbook defines financial leverage as:Your textbook defines financial leverage as: ± ± The increased volatility in operating income causedThe increased volatility in operating income caused

by the corporate use of sources of capital that carryby the corporate use of sources of capital that carry

fixed financial costs.fixed financial costs. Financial leverage can be increased in the firmFinancial leverage can be increased in the firm

by:by: ± ± Selling bonds or preferred stock (taking on financialSelling bonds or preferred stock (taking on financial

obligations with fixed annual claims on cash flow)obligations with fixed annual claims on cash flow) ± ± Using the pr oceeds fr om the debt to retire equity (if Using the pr oceeds fr om the debt to retire equity (if the lenders don¶t pr ohibit this thr ough the bondthe lenders don¶t pr ohibit this thr ough the bondindenture or loan agreement)indenture or loan agreement)




Financial LeverageFinancial Leverage Advantages and Disadvantages Advantages and Disadvantages

Advantages:Advantages: ± ± Magnification of pr ofits to the shareholders if the firm isMagnification of pr ofits to the shareholders if the firm is

pr ofitable.pr ofitable.

± ± Lower cost of capital at low to moderate levels of financialLower cost of capital at low to moderate levels of financial

leverage because interest expense is taxleverage because interest expense is tax--deductible.deductible.Disadvantages:Disadvantages:

± ± Magnification of losses to the shareholders if the firm does notMagnification of losses to the shareholders if the firm does notearn enough revenue to cover its costs.earn enough revenue to cover its costs.

± ± Higher break even point.Higher break even point.

± ± At higher levels of financial leverage, the low after At higher levels of financial leverage, the low after--tax cost of tax cost of debt is offset by other effects such as:debt is offset by other effects such as: Present value of the rising pr obability of bankruptcy costsPresent value of the rising pr obability of bankruptcy costs

Agency costs Agency costs

Lower operating income (EBIT), etc.Lower operating income (EBIT), etc.




Effects of Operating and Financial LeverageEffects of Operating and Financial LeverageSummarySummary

Equity holders bear the added risks associated with the useEquity holders bear the added risks associated with the useof leverage.of leverage.

The higher the use of leverage (either operating or financial)The higher the use of leverage (either operating or financial)the higher the risk to the shareholder.the higher the risk to the shareholder.

Leverage therefore can and does affect shareholdersLeverage therefore can and does affect shareholdersrequired rate of return, and in turn this influences the cost of required rate of return, and in turn this influences the cost of capital.capital.

HIGHER LEVERAGE = HIGHER COST OF CAPITALHIGHER LEVERAGE = HIGHER COST OF CAPITAL








Business RiskBusiness Risk

All firms experience variability in sales and operatingAll firms experience variability in sales and operating(fixed and variable) operating costs over time.(fixed and variable) operating costs over time.

± ± Some firms operate in a highly volatile industry (f or example oilSome firms operate in a highly volatile industry (f or example oil

and gas) and we would say the firm has a high degree of and gas) and we would say the firm has a high degree of business risk.business risk.

± ± Other firms operate in a very stable industry where revenues andOther firms operate in a very stable industry where revenues andexpenses don¶t change much fr om year to year thr oughout theexpenses don¶t change much fr om year to year thr oughout thebusiness cycle; these firms have low business risk.business cycle; these firms have low business risk.

Business risk is the variability of a firm·s operatingBusiness risk is the variability of a firm·s operatingincome caused by operational risk.income caused by operational risk.

± ± Business risk is measured by the standard deviation of EBIT.Business risk is measured by the standard deviation of EBIT.




Financial LeverageFinancial LeverageRisk and LeverageRisk and Leverage

Lenders to the firm insulate themselves from riskLenders to the firm insulate themselves from riskthrough financial contracting:through financial contracting:

Lending money thr ough a f ormal, legallyLending money thr ough a f ormal, legally--binding contract.binding contract.

Demanding a fixed rate of return on the money they lend to theDemanding a fixed rate of return on the money they lend to thefirm, infirm, in--keeping with their required return on monies borr owed.keeping with their required return on monies borr owed.

Demanding other pr omises that will pr otect the lender¶s interestsDemanding other pr omises that will pr otect the lender¶s interestsover the life of the loan/investment.over the life of the loan/investment.

Demanding a high priority in the priority of claims list in the eventDemanding a high priority in the priority of claims list in the eventof corporate dissolution/bankruptcy.of corporate dissolution/bankruptcy.

Shareholders bear the risk associated with businessShareholders bear the risk associated with businessrisk, and the added risks associated with the use of risk, and the added risks associated with the use of leverage because they are residual claimants of theleverage because they are residual claimants of the

firm. firm.




Return on Investment (ROI)Return on Investment (ROI)Financial LeverageFinancial Leverage

Return on Investment (ROI)Return on Investment (ROI) ± ± is the return on all the capital pr ovided by investors; EBIT is the return on all the capital pr ovided by investors; EBIT

minus taxes divided by invested capital.minus taxes divided by invested capital.

± ± Invested Capital (IC) is a firm¶s capital structure consisting of Invested Capital (IC) is a firm¶s capital structure consisting of shareholders¶ equity and shortshareholders¶ equity and short-- and longand long--term debt.term debt.

)1(

BSE

T EBIT

ROI

![ 21-2]

But we know the claims

on the numerator

(operating income after

taxes) are very

different, and so too arethe risks each provider

of capital is exposed.




Return on Equity (ROE)Return on Equity (ROE)Financial LeverageFinancial Leverage

ROEROE ² ² is the return earned by equity holders onis the return earned by equity holders ontheir investment in the companytheir investment in the company

± ± ROE = net income divided by shareholders¶ equity.ROE = net income divided by shareholders¶ equity.

)1)((

S

I D ![ 21-1]




ROI versus ROEROI versus ROEFinancial LeverageFinancial Leverage

If the firm is completely financed by equity:If the firm is completely financed by equity:ROE = ROI.ROE = ROI.

Let us examine the effects of sales volatility onLet us examine the effects of sales volatility onROI and ROE given different levels of financialROI and ROE given different levels of financialleverage.leverage.





Using this base income statement:Using this base income statement:

The following three slides show three different financing strategiesThe following three slides show three different financing strategiesand the impacts on ROE, ROI, EPS for breakand the impacts on ROE, ROI, EPS for break--even, normal, and higheven, normal, and highsales levels:sales levels:

Sales $1,000Variable costs 300

Fixed costs 158

EBIT $542

Interest 42

Taxable Income $500

Tax (40%) 200

Net Income $300

Table 21-1 Example Income Statement




Financial LeverageFinancial LeverageIncome StatementIncome Statement ± ± No Financial LeverageNo Financial Leverage

77.5% 100.0% 140.0%

Sales 5 $1,000 $1,400

Variable costs 6 00 420

Fixed costs 158 158 158EBIT $1 $542 $822

Interest 0 0 0

Taxable Income $1 $542 $822

Tax (40%) 0 217 329

Net Income $0 $325 $493

Invested capital $1,700 100.0%

Debtholder s' investment $0 0.0%Shareholder s' Equit $1,700 100.0%

R I 0.0% 19.1% 29.0%

R E 0.0% 19.1% 29.0%

EPS (1,700 shares) $0.00 $0.19 $0.29

Table 21-1 Exa ple Inco e State ent

This assu es a 0.0

debt/equity ratio

ROE = ROI because no use

of debt financing.




Financial LeverageFinancial LeverageIncome StatementIncome Statement ± ± Base CaseBase Case

-

Sales

aria le costs 6

Fi e costsBI

Interest

a a le Income -

a ( )

et Income - 6

Investe ca ital

e thol ers' investment

Sharehol ers' it

I

- 66

S ( shares)

Ta le 21-1 E ample Income Statement

This assumes a 0.70

de t/equity ratio

ROE is levered compared to

ROI ecause of the moderateuse of de t financing.




Financial LeverageFinancial LeverageIncome Statement with High Financial LeverageIncome Statement with High Financial Leverage

.4% .0% 40.0%

Sale 46 $1,000 $1,400

Varia le costs 104 300 420

Fi e costs 158 158 158EBI $84 $542 $822

Interest 84 $84 $84

a a le Income $0 $458 $738

a 40% 0.08 183.2 295.2

Net Income $0 $275 $443

Investe ca ital = $1,700 100.0%

e thol er s' investment = $1,400 82.4%Sharehol er s' Equit = $300 17.6%

I = 3.0% 19.1% 29.0%

E = 0.0% 91.6% 147.6%

EPS 300 shares) = $0.00 $0.92 $1.48

Ta le 21-1 E a ple nco e State ent

ROE is ore volatile than

RO ecause of the high useof financial leverage.







Equation 21 Equation 21 ² ² 2 is the definition of ROI:2 is the definition of ROI:

If we reIf we re--express EBIT (1express EBIT (1--T) in the ROE equation,T) in the ROE equation,we get:we get:

)1(

BSE

T EBIT ROI

![ 21-2]





This is the financial leverage equation:This is the financial leverage equation:

ROI measures the return that the firm earnsROI measures the return that the firm earns from operations, but DOES NOT explicitly from operations, but DOES NOT explicitlyconsidered how the firm is financed.considered how the firm is financed.

)1((SE

BT R ROI ROI ROE ![ 21-3]





If we rearrange Equation 21 If we rearrange Equation 21 ² ² 3, grouping like terms3, grouping like termsinvolving ROI we get:involving ROI we get:

The second term is fixed.The second term is fixed.

The first term depends on the firm·s uncertain ROI.The first term depends on the firm·s uncertain ROI. This means we can graph ROE against ROI as a straight This means we can graph ROE against ROI as a straight line.line.

See Figure 21 See Figure 21 --1 on the following slide.1 on the following slide.

)1()1(SE BT R

SE B ROI ROE ![ 21-4]





21 - 1 F GURE

ROE

80

60

40

20

ROI

-20

-40

-60

All Equity

D/E =0.70

-16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40

Slope of the

all equity

line is = 1.0.

n this case

RO = ROE.

D/E = 0.70.

Slope of the

line > 1.0.

A ove the

intercept

with the

horizontal

axis, ROE

>RO .

Financial Break-even

points where ROE = 0

ndifference point where

ROEs for different financing

strategies are equal.





Financial BreakFinancial Break--even point:even point:

± ± Points at which a firm¶s ROE is zer o.Points at which a firm¶s ROE is zer o.

Indifference Point:Indifference Point:

± ± Points at which two financing strategies pr ovide thePoints at which two financing strategies pr ovide thesame ROE. same ROE.




Financial LeverageFinancial LeverageThe Rules of Financial LeverageThe Rules of Financial Leverage

For valueFor value--maximizing firms, the use of debt maximizing firms, the use of debt increases the expected ROE so shareholdersincreases the expected ROE so shareholdersexpect to be better off by using debt financing,expect to be better off by using debt financing,

rather than equity financing.rather than equity financing. Financing with debt increases the variability of theFinancing with debt increases the variability of the

firm·s ROE, which usually increases the risk to the firm·s ROE, which usually increases the risk to thecommon shareholders.common shareholders.

Financing with debt increases the likelihood of theFinancing with debt increases the likelihood of the firm running into financial distress and possibly firm running into financial distress and possiblyeven bankruptcy.even bankruptcy.





% D E Ratio 1 % E uit

R %

Range

Ta le 21-2 ar in R alues

R E %

R reflects the usiness risk of the firm.

R E =R in the all e uit firm.

R E increases as the firm finances with more de t.





% D E Ratio 1 % E uit

R %

6

Range

Ta le 21-3 i er ariation R alues

R E %

i er variation in R means magnifie R E over a still

wi er range than R .




Financial LeverageFinancial LeverageInvesting Using LeverageInvesting Using Leverage

Figure 21 Figure 21 ² ² 2 illustrates the monthly returns2 illustrates the monthly returns from investing in the S&P/TSX Composite Index from investing in the S&P/TSX Composite Indexusing two different financing strategies:using two different financing strategies:

1.1. Investing in the index (all equity)Investing in the index (all equity)

2.2. Investing in the index with 80 borr owed on margin.Investing in the index with 80 borr owed on margin.

The added volatility of gains and losses overThe added volatility of gains and losses overtime is clearly evident .time is clearly evident .

These principles of leverage apply toThese principles of leverage apply tocorporations as well as householdscorporations as well as households

(See Figure 21 (See Figure 21 ² ² 2 on the following slide)2 on the following slide)




Financial LeverageFinancial LeverageInvesting Using LeverageInvesting Using Leverage

21 - 2 F GURE



Indifference AnalysisIndifference Analysis





Financial LeverageFinancial LeverageIndifference AnalysisIndifference Analysis

Is a profit planning technique used to forecast Is a profit planning technique used to forecast the EPSthe EPS--EBIT relationships under different EBIT relationships under different financing scenarios. financing scenarios.

The indifference point is where:The indifference point is where:

EPSEPS(Financing strategy 1)(Financing strategy 1)=EPS=EPS(Financing strategy 2)(Financing strategy 2)





The formula for EPS, given EBIT, interest on debt (RThe formula for EPS, given EBIT, interest on debt (RDDB), theB), thecorporate tax rate (T), and the number of common sharescorporate tax rate (T), and the number of common sharesoutstanding (#):outstanding (#):

We can rearrange the definition of EPS and show how it varies withWe can rearrange the definition of EPS and show how it varies withEBIT:EBIT:

#

)1)(( T B R EBIT EPS

![ 21-5]





EPS is a simple linear function of EBIT:EPS is a simple linear function of EBIT:

This is illustrated in the EPSThis is illustrated in the EPS--EBIT graph inEBIT graph inFigure 21 Figure 21 ² ² 3 found on the following slide:3 found on the following slide:

#

)1(#

)1( T EBIT T B R EPS ![ 21-6]




Financial LeverageFinancial LeverageEPSEPS--EBIT (Pr ofit Planning) ChartsEBIT (Pr ofit Planning) Charts

21 - 3 F GURE

0.8

0.6

0.4

0.2

0

-0.2

-0.4

-0.6 EPS 0 D/E EPS 70 D/E

-567-397-312-227 -142 57 28 113 198 283 368 453 538 623 708 793 878 963 10481133

ndifference

point.

The horizontal intercept of the 70 D/E line isgreater y the added interest expense that must e

covered efore producing earnings availa le for

common shareholders.




Financial LeverageFinancial LeverageEPSEPS--EBIT (Pr ofit Planning) ChartsEBIT (Pr ofit Planning) Charts

The slope of the lines are a function of theThe slope of the lines are a function of thenumber of common shares outstanding (dilutionnumber of common shares outstanding (dilutionof EPS).of EPS).

± ± The all equity line will have a lower slope becauseThe all equity line will have a lower slope becauseevery dollar of net income is divided by more commonevery dollar of net income is divided by more commonshares.shares.

The horizontal intercept is greater for the debt The horizontal intercept is greater for the debt

financing line because the firm must cover its financing line because the firm must cover itsinterest expense before earnings begin tointerest expense before earnings begin toaccrue to the benefit of shareholders.accrue to the benefit of shareholders.









Table 21 Table 21 ² ² 4 demonstrates the 1990 results of a4 demonstrates the 1990 results of aConference Board survey of 119 U.S. Conference Board survey of 119 U.S. companies to determine their capital structure.companies to determine their capital structure.

External sources of information include:External sources of information include: ± ± (#2) checking with their advisors, and(#2) checking with their advisors, and

± ± (#5) examining other firms in the industry.(#5) examining other firms in the industry.

The three primary sources of information are:The three primary sources of information are:

± ± (#4) impact on pr ofits(#4) impact on pr ofits ± ± (#3) risk(#3) risk

± ± (#1) analysis of cash flows(#1) analysis of cash flows





1. Anal i of ca flow 23.0%

2. Con ultation 18.3%3. Ri con i eration 16.5%

4. Impact on profit 14.0%

5. In u tr compari on 12.0%

6. Ot er 3.4%

Source: Data from Conference Boar , 1990

Ta le 21-4 Deter inants o Capital Structure

Pri ary sources include:

Analysis o cash lows

Risk consideration

pact on pro its




Determining Capital StructureDetermining Capital StructureUseful RatiosUseful Ratios

Stock ratios (balance sheet ratios) that areStock ratios (balance sheet ratios) that arehelpful include:helpful include:

± ± Total debt to total assetsTotal debt to total assets

± ± Debt to equity ratioDebt to equity ratio

Flow ratios make use of information taken fromFlow ratios make use of information taken fromthe income statement and when combined withthe income statement and when combined with

balance sheet data help to determine the abilitybalance sheet data help to determine the abilityof the firm to service its debt .of the firm to service its debt .





Fixed Burden Coverage Ratio:Fixed Burden Coverage Ratio:

± ± An expanded interest coverage ratio that looks at a An expanded interest coverage ratio that looks at abr oader measure of both income and thebr oader measure of both income and theexpenditures associated with debt.expenditures associated with debt.

)1/()Pref. iv.( T SF I

EBIT ACoverage Burden Fixed

![ 21-7]





CashCash--flow flow--toto--debt ratio (CFTD)debt ratio (CFTD)

± ± A direct measure of the cash flow over a period that is A direct measure of the cash flow over a period that isavailable to cover a firm¶s stock of outstanding debt.available to cover a firm¶s stock of outstanding debt.

Debt

I D D ![ 21-8]






Determining Capital StructureDetermining Capital Structure Altman Score Altman Score

Altman·s prediction of bankruptcy equation:Altman·s prediction of bankruptcy equation:

Where:Where:XX11 = working capital divided by total assets= working capital divided by total assets

XX22 = retained earnings divided by total assets= retained earnings divided by total assetsXX33 = EBIT divided by total assets= EBIT divided by total assets

XX44 = market values of total equity divided by non= market values of total equity divided by non--equity book liabilitiesequity book liabilities

XX55 = sales divided by total assets= sales divided by total assets

99906033412154321

X . X . X . X . X . Z ![ 21-9]



The Modigliani and Miller IrrelevanceThe Modigliani and Miller Irrelevance

TheoremTheorem





The Modigliani and Miller (M&M)The Modigliani and Miller (M&M)Irrelevance TheoremIrrelevance Theorem

M&M and Firm ValueM&M and Firm Value

The theorem that concludes (under someThe theorem that concludes (under somesimplifying assumptions) that the value of thesimplifying assumptions) that the value of the

firm should not be affected by the manner in firm should not be affected by the manner inwhich it is financed.which it is financed.

± ± How the firm is financed is irrelevant.How the firm is financed is irrelevant.




(M&M) Irrelevance Theorem(M&M) Irrelevance Theorem Assumptions Assumptions

Assumptions about the Real World: Assumptions about the Real World: Markets are perfect in the sense that there are no Markets are perfect in the sense that there are no

transactions costs or asymmetric inf ormation pr oblemstransactions costs or asymmetric inf ormation pr oblems

No taxesNo taxes

There is no risk of costly bankruptcy or associated financialThere is no risk of costly bankruptcy or associated financialdistressdistress

Modeling Assumptions:Modeling Assumptions:

There exist two firms in the same ³risk class´ with differentThere exist two firms in the same ³risk class´ with differentlevels of debtlevels of debt

The earnings of both firms are perpetuitiesThe earnings of both firms are perpetuities




(M&M) Irrelevance Theorem(M&M) Irrelevance Theorem Arbitrage Argument Arbitrage Argument

Arbitrage is a powerful economic f orce in capital Arbitrage is a powerful economic f orce in capitalmarkets.markets.

Where two identical assets trade at different prices,Where two identical assets trade at different prices,market traders will spot the opportunity to earnmarket traders will spot the opportunity to earn

riskless pr ofits.riskless pr ofits. Traders will sell the overvalued asset and buy theTraders will sell the overvalued asset and buy the

undervalued asset.undervalued asset.

This activity will cause the price of the overvalued asset to This activity will cause the price of the overvalued asset to fall, and the price of the undervalued asset to rise until thefall, and the price of the undervalued asset to rise until the

two are priced the same.two are priced the same. The traders will earn abnormal pr ofits fr om these trades untilThe traders will earn abnormal pr ofits fr om these trades untilthe prices of the two securities move into equilibrium.the prices of the two securities move into equilibrium.

T able 21T able 21 ± ± 6 illustrates the two different positions and the equal payoffs6 illustrates the two different positions and the equal payoffs




(M&M) Irrelevance Theorem(M&M) Irrelevance Theorem Arbitrage Argument Arbitrage Argument

Market participants who find levered investmentsMarket participants who find levered investmentstrading f or a greater value, cantrading f or a greater value, can undo the leverageundo the leverage andandearn abnormal pr ofits.earn abnormal pr ofits.

Arbitrage will f orce assets with equal payoffs to trade f or Arbitrage will f orce assets with equal payoffs to trade f or the same price.the same price.

T able 21T able 21 ± ± 6 illustrates the two different positions and the equal payoffs6 illustrates the two different positions and the equal payoffs




(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and Firm ValueM&M and Firm Value

Portfolios (Actions) Cost Pa off

Portfolio A VU IT

u of unlevered f irm

Portfolio

u of levered f irm ' e ui S¡

( IT ¢

)

u of levered f irm ' de ¢

Total or tfolio (S¡

) IT

Table 21- & Arbitra e Table

Net pa offs

are equal

Portfolio A and must be priced equall despite their different financial

structures because the pa offs are equal.




(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and Firm ValueM&M and Firm Value

Where payoffs are identical for two different assets, bothshould be priced the same.

The value of the levered firm (VL) is equal to the value of its debt plusthe value of its equity (S

L+ D) and this must equal the value of the

unlevered firm (VU).

D ebt cannot destroy value.

L LU V DS V !![ 21-10]




(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremPersonal Leverage and Corporate LeveragePersonal Leverage and Corporate Leverage

Portfolios (Actions) Cost Pa off

Portfolio C L (EBIT -£

)B y of nlevered f rm

Portfolio D

B y of levered f rm s e ty VU EBIT

B y of levered f rm s de t D - KD D

Total portf ol o (VU - D) (EBIT - KD D )

Ta le 21- & Ar itra e Ta le




(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremHomemade LeverageHomemade Leverage

Homemade leverage is the creation of the sameHomemade leverage is the creation of the sameeffect of a firm·s financial leverage through theeffect of a firm·s financial leverage through theuse of personal leverage.use of personal leverage.

This means that individuals can:This means that individuals can:

± ± Buy an unlevered firm, and thr ough the use of Buy an unlevered firm, and thr ough the use of personal debt, replicate corporate leverage, or personal debt, replicate corporate leverage, or

± ± Buy a levered firm, and undo its effects.Buy a levered firm, and undo its effects.




(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and The Cost of CapitalM&M and The Cost of Capital

M&M made a modeling assumption (to simplify theM&M made a modeling assumption (to simplify thecalculations and focus analysis on the leverage issue) that thecalculations and focus analysis on the leverage issue) that the firm·s earnings represent a firm·s earnings represent a perpetuityperpetuity::

K

D)( EBIT- K S

e

D L ![ 21-11]





The cost of equity capital is simply the earnings yield and isThe cost of equity capital is simply the earnings yield and isestimated as follows:estimated as follows:

S

D )(EB I -K K

L

De !

[ 21-12]





Since the value of the firm is unchanged by leverage, we canSince the value of the firm is unchanged by leverage, we candefine the unlevered value (define the unlevered value (VVUU) by discounting the firm·s) by discounting the firm·sexpected EBIT by it unlevered equity cost (expected EBIT by it unlevered equity cost (K K UU):):

V DS V

EBIT V L L

U

U !!![ 21-13]







In a world without taxes, the WACC (K In a world without taxes, the WACC (K UU) is simply the weighted) is simply the weightedaverage of the cost of debt and the cost of equity:average of the cost of debt and the cost of equity:

Figure 21 Figure 21 ² ² 4 illustrates M&M without corporate taxes (the4 illustrates M&M without corporate taxes (theirrelevance model) where the cost of equity (irrelevance model) where the cost of equity (K K EE) rises in a) rises in aprescribed manner to offset the lower cost of debt (prescribed manner to offset the lower cost of debt (K K D D ))producing WACC that remains unchanged by the use of producing WACC that remains unchanged by the use of financial leverage. financial leverage.

V D K

V S K K D E U ![ 21-15]





20 - 4 F GURE

Debt-Equity Ratio

Debt Cost KD

Equity Cost KE

WACC

%





If WACC remains the same regardless of the financialIf WACC remains the same regardless of the financialstrategy used by the firm:strategy used by the firm:

± ± VVLL = V= VUU

± ± Financial strategy is irrelevantFinancial strategy is irrelevant As the use of debt financing is increased, the cost of As the use of debt financing is increased, the cost of

equity will rise«so even if EPS is increased through theequity will rise«so even if EPS is increased through theuse of debt financing, that benefit is offset by a higheruse of debt financing, that benefit is offset by a higherdiscount rate.discount rate.

From a shareholder wealth perspective, under the M&MFrom a shareholder wealth perspective, under the M&Massumptions, financing strategy is irrelevant .assumptions, financing strategy is irrelevant .



The Impact of Corporate Taxes on TheThe Impact of Corporate Taxes on The

Irrelevance TheoremIrrelevance Theorem





The Impact of TaxesThe Impact of TaxesIntr oducing Corporate TaxesIntr oducing Corporate Taxes

The value of firms drop in the presence of corporate taxes.The value of firms drop in the presence of corporate taxes.

The higher the tax rate, the lower the value of the firm.The higher the tax rate, the lower the value of the firm.

)1(

K

T EBIT V

U

U

![ 21-16]







To avoid arbitrage the value of the firm must equal:To avoid arbitrage the value of the firm must equal:

VVUU ² ² D(1D(1--t) = St) = SLL

VVLL = S= SLL + D, therefore:+ D, therefore:

The value of the firm with leverage is the value without leverage plusThe value of the firm with leverage is the value without leverage plusthe corporate debt tax shield from debt financing.the corporate debt tax shield from debt financing.

DT V V U L ![ 21-17]

Corporate De t

Tax Shield





The total claims of corporate taxes, debt The total claims of corporate taxes, debt holders, and equity holders are borne by theholders, and equity holders are borne by theprepre--tax cash flow produced by the firm.tax cash flow produced by the firm.

If the firm uses more debt, and interest on that If the firm uses more debt, and interest on that debt is taxdebt is tax--deductible, this produces a greaterdeductible, this produces a greatertax shield, reducing the government share of tax shield, reducing the government share of the value of the private enterprise, the WACCthe value of the private enterprise, the WACC

must go down.must go down. ± ± Here we assume a zer oHere we assume a zer o--sum game (that value is notsum game (that value is not

destr oyed thr ough the use of financial leverage)destr oyed thr ough the use of financial leverage)




The Impact of TaxesThe Impact of TaxesFirm Value with Corporate TaxesFirm Value with Corporate Taxes

Taxes

uite t

21 - 5 F GURE





The taxThe tax ² ²corrected value of Equation 21corrected value of Equation 21--14 is:14 is:

Both the interest cost and the financial leverage riskBoth the interest cost and the financial leverage risk--premium on thepremium on theequity cost are reduced by (1equity cost are reduced by (1-- T)T)

As the use of debt increases, WACC decreases, and therefore theAs the use of debt increases, WACC decreases, and therefore thevalue of the firm in a world with corporate taxes should increasevalue of the firm in a world with corporate taxes should increase

(See Figure 21 (See Figure 21 ² ² 6 on the following slide)6 on the following slide)

/)1)((

S DT K K K K

L DU U e ![ 21-18]




The Impact of TaxesThe Impact of TaxesM&M with Corporate TaxesM&M with Corporate Taxes

21 - 6 F GURE

Debt-Equity Ratio

Debt Cost KD(1-T)

Equity Cost KE

WACC

%




The Impact of TaxesThe Impact of TaxesWACC with Corporate TaxesWACC with Corporate Taxes

WACC declines continuously with the use of debt financing.WACC declines continuously with the use of debt financing.

WACC equation corrected for the taxWACC equation corrected for the tax--deductibility of interest deductibility of interest expense is:expense is:

)1( T K V

D K

V

S WACC De ![ 21-19]




The Impact of TaxesThe Impact of TaxesTaxTax--Extended M&M Equity Cost EquationExtended M&M Equity Cost Equation

The ¶beta· version of Equation 21 The ¶beta· version of Equation 21 ² ² 18 allows us to adjust for the18 allows us to adjust for thesystematic risk of the firm:systematic risk of the firm:

Equity cost without any debt is the riskEquity cost without any debt is the risk--free rate plus the market risk free rate plus the market riskpremium (MRP) times the unlevered beta coefficient .premium (MRP) times the unlevered beta coefficient .

This equation allows us to unlever betas to get the unlevered equityThis equation allows us to unlever betas to get the unlevered equity

cost .cost . There is one important flaw in this equationThere is one important flaw in this equation ² ² it is assumed that 100% it is assumed that 100% debt financing is optimal.debt financing is optimal.

To address that issue, we must relax M&M·s assumptions regardingTo address that issue, we must relax M&M·s assumptions regardingrisk of financial distress or bankruptcy.risk of financial distress or bankruptcy.

)/)1(1( S DT MRP RF K LU e v! F[ 21-20]



Incorporating Financial Distress,Incorporating Financial Distress,

Bankruptcy and Agency CostsBankruptcy and Agency Costs





BankruptcyBankruptcyIntr oductionIntr oduction

Bankruptcy is a state of insolvency that occursBankruptcy is a state of insolvency that occurswhen a firm commits an act of bankruptcy, suchwhen a firm commits an act of bankruptcy, suchas nonas non--payment of interest, and creditorspayment of interest, and creditors

enforce their legal rights to recoup money, orenforce their legal rights to recoup money, orwhen a firm voluntarily declares bankruptcy inwhen a firm voluntarily declares bankruptcy inan effort to be protected while reorganizing toan effort to be protected while reorganizing tobecome solvent again.become solvent again.




ReorganizationReorganization

Firms can be reorganized under:Firms can be reorganized under:

± ± Companies Creditors Arrangements Act (CC AA)Companies Creditors Arrangements Act (CC AA) Used by larger more complex firms with debt > $5mUsed by larger more complex firms with debt > $5m

FlexibleFlexible ± ± allowing the firm to pursue agreements with allowing the firm to pursue agreements with creditors/employees, to raise new financingcreditors/employees, to raise new financing

Trustee is appointed by the court and there is a stayTrustee is appointed by the court and there is a stay--of of--pr oceedingspr oceedings

± ± Bankruptcy Insolvency Act (BIA)Bankruptcy Insolvency Act (BIA)

Limited scope to prevent creditors fr om seizing assetsLimited scope to prevent creditors fr om seizing assets No DIP financingNo DIP financing

No pr ovision to impose a settlement on all creditorsNo pr ovision to impose a settlement on all creditors




Costs of BankruptcyCosts of BankruptcyDirect CostsDirect Costs

Direct Costs:Direct Costs:

± ± Costs incurred as a direct result of bankruptcyCosts incurred as a direct result of bankruptcyincluding:including:

Liquidation of assetsLiquidation of assets Loss of tax losses (potential tax shield benefits)Loss of tax losses (potential tax shield benefits)

Legal and accounting costsLegal and accounting costs




Costs of BankruptcyCosts of BankruptcyIndirect CostsIndirect Costs

Indirect Costs:Indirect Costs: ± ± Financial distress costs are losses to a firm prior to declaration of Financial distress costs are losses to a firm prior to declaration of

bankruptcy including:bankruptcy including: Agency costs Agency costs Increasing costs of doing business:Increasing costs of doing business:

± ± Creditors tightening trade credit termsCreditors tightening trade credit terms ± ± Lending increasing risk premiums and increasing monitoringLending increasing risk premiums and increasing monitoring

surveillancesurveillance ± ± loss of key staff and increases in recruitment and retention costsloss of key staff and increases in recruitment and retention costs ± ± Distracted management f ocused on financing and not on managementDistracted management f ocused on financing and not on management

of business operations.of business operations.

Reduced sales revenue:Reduced sales revenue: ± ± Management is distracted by financial issuesManagement is distracted by financial issues

± ± Customers may become wary and look f or other suppliersCustomers may become wary and look f or other suppliers

(F igure 21(F igure 21 ± ± 8 illustrates the rising value of distress costs with increasing debt)8 illustrates the rising value of distress costs with increasing debt)




Static Tradeoff Static Tradeoff Firm Value and Financial Distress CostsFirm Value and Financial Distress Costs

21 - 8 F GURE

Distress Costs

VU + DT

Debt Ratio

Value








Costs of BankruptcyCosts of BankruptcySummarySummary

Costs of Bankruptcy are very high.Costs of Bankruptcy are very high.

Probability of Bankruptcy and Financial DistressProbability of Bankruptcy and Financial Distress

costs rise exponentially as the use of debt costs rise exponentially as the use of debt increases.increases.

These costs rob value from both shareholdersThese costs rob value from both shareholdersand potentially debt holders.and potentially debt holders.




Costs of BankruptcyCosts of BankruptcyStatic Tradeoff ModelStatic Tradeoff Model

Figure 21 Figure 21 ² ² 9 illustrates the impact of bankruptcy and9 illustrates the impact of bankruptcy and financial distress costs on M&M with corporate taxes. financial distress costs on M&M with corporate taxes.

± ± Cost of equity rises thr oughout as more debt is added.Cost of equity rises thr oughout as more debt is added.

± ± The cost of debt rises at higher levels of debt.The cost of debt rises at higher levels of debt.

± ± WACC falls initially because the benefits of the taxWACC falls initially because the benefits of the tax--deductibilitydeductibilityof interest expense outof interest expense out--weigh the marginal increases inweigh the marginal increases incomponent costs, however, at higher levels of debt, the taxcomponent costs, however, at higher levels of debt, the tax--advantage of debt is offset and the value of the firm falls whenadvantage of debt is offset and the value of the firm falls when

WACC starts to rise. WACC starts to rise.

St ti T d ff M d lSt ti T d ff M d l




Static Tradeoff ModelStatic Tradeoff Model21 - 9 F GURE

WACC

Ke

D/E*

Cost (%)

KD

Debt-to-equity

FirmValue



O h F Aff i C i l SO h F Aff i C i l S




Other Factors Affecting Capital StructureOther Factors Affecting Capital StructurePecking Order Pecking Order

Static Trade off model ignores two issues:Static Trade off model ignores two issues:

1.1. Inf ormation asymmetry pr oblemsInf ormation asymmetry pr oblems

2.2. Agency pr oblems Agency pr oblems

These factors are likely responsible for what These factors are likely responsible for what Myers and Donaldson call theMyers and Donaldson call the pecking orderpecking order..

The pecking order is the order in which firmsThe pecking order is the order in which firmsprefer to raise financingprefer to raise financing

1.1. starting with internal cash flow,starting with internal cash flow,

2.2. debt anddebt and

3.3. finally issuing common equity.finally issuing common equity.



Capital Structure in PracticeCapital Structure in Practice





Capital Structure in PracticeCapital Structure in Practice

Factors favouring corporate ability andFactors favouring corporate ability andwillingness to issue debt:willingness to issue debt:

± ± Pr ofitability (so the firm can use the tax shield benefitPr ofitability (so the firm can use the tax shield benefitof interestof interest--deductibility).deductibility).

± ± Unencumbered tangible assets to be used asUnencumbered tangible assets to be used ascollateral f or secured debt.collateral f or secured debt.

± ± Stable business operations over time.Stable business operations over time.

± ± Corporate size.Corporate size.

± ± Gr owth rate of the firm.Gr owth rate of the firm.

± ± Capital market conditionsCapital market conditions




Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned: ± ± The three effects of leverage: expected ROE tends to increase,The three effects of leverage: expected ROE tends to increase,

the variability of the ROE increases, and the risk of financialthe variability of the ROE increases, and the risk of financialdistress increases.distress increases.

± ± The major determinants of the firm¶s capital structure decisionThe major determinants of the firm¶s capital structure decisionare its impact on pr ofits, risk and cash flows.are its impact on pr ofits, risk and cash flows.

± ± Impacts can be assessed by pr ofit planning charts, financialImpacts can be assessed by pr ofit planning charts, financialbreakbreak--even analysis and use of standard ratioseven analysis and use of standard ratios

± ± Debt creates value because interest on debt is taxDebt creates value because interest on debt is tax--deductibledeductible ± ± The tax incentive to use debt is offset by the resulting financialThe tax incentive to use debt is offset by the resulting financial

distress and bankruptcy costsdistress and bankruptcy costs

± ± In a dynamic world, firms depart fr om the static tradeIn a dynamic world, firms depart fr om the static trade--off optimaloff optimaldebt ratio over time, then refinance to bring it back in line with debt ratio over time, then refinance to bring it back in line with the target debt ratio.the target debt ratio.

± ± Actual capital structures are constantly changing as firms take Actual capital structures are constantly changing as firms takeadvantage of market conditions.advantage of market conditions.



Concept Review QuestionsConcept Review Questions


C t R i Q ti 1C t R i Q ti 1




Concept Review Question 1Concept Review Question 1Business and Financial RiskBusiness and Financial Risk

Define business risk and financial risk.Define business risk and financial risk.



Appendix 1 Appendix 1

Thunder Bay IndustriesThunder Bay Industries

Exercise in Indifference AnalysisExercise in Indifference Analysis

Th d B I d t iTh d B I d t i




Thunder Bay IndustriesThunder Bay IndustriesThe Pr oblemThe Pr oblem

Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years . Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years . The company is now operating at 100% of capacity and must expand in order to meet theThe company is now operating at 100% of capacity and must expand in order to meet thedemand for its new line of video games. demand for its new line of video games.

The current financial statements for Thunder Bay Industries are as follows:The current financial statements for Thunder Bay Industries are as follows:


Balance Sheet Balance Sheet as at D ecember 31, 20xxas at D ecember 31, 20xx($ ' 000s Cdn.) ($ ' 000s Cdn.)

Assets:Assets: Liabilities and Owner's Equity:Liabilities and Owner's Equity:CashCash 1,0001,000 Accounts payableAccounts payable 550550Accounts receivableAccounts receivable 2,1002,100 AccrualsAccruals 2 492 49InventoriesInventories 2,7662,766 Other current liabilitiesOther current liabilities 11Net Fixed AssetsNet Fixed Assets 16,2 4416,2 44 8% bonds maturing in 10 years8% bonds maturing in 10 years 5,0005,000

_______ _______ C ommon stock (100,000 outstanding) C ommon stock (100,000 outstanding) 1,0001,000Retained earningsRetained earnings 15,31015,310

Total AssetsTotal Assets $ 22,110$ 22,110 Total Liabilities and Owner's EquityTotal Liabilities and Owner's Equity $ 22,110$ 22,110

The most recent income statement is found on the following slide:The most recent income statement is found on the following slide:

Th d B I d t iTh d B I d t i





Thunder Bay IndustriesThunder Bay IndustriesIncome Statement Income Statement

for the year ended D ecember 31, 20xx for the year ended D ecember 31, 20xx($ '000s C dn) ($ '000s C dn)

SalesSales $ 2 5,00 2 $ 2 5,00 2

C ost of Goods SoldC ost of Goods Sold 18,2 52 18,2 52 Gross Margin on SalesGross Margin on Sales $ 6,750 $ 6,750 Administrative and Selling ExpensesAdministrative and Selling Expenses 4,000 4,000 Earnings before Interest Expense and TaxesEarnings before Interest Expense and Taxes 2,750 2,750 Interest expenseInterest expense 400 400 Earnings before taxEarnings before tax $ 2,350 $ 2,350 TaxesTaxes 1,0111,011Net IncomeNet Income $1,339$1,339

If the firm does not expand, it sales growth will stall at the current $ 2 5mIf the firm does not expand, it sales growth will stall at the current $ 2 5mlevel or less. If the company undertakes the planned expansionlevel or less. If the company undertakes the planned expansionmanagement has identified a probability distribution for possible EBITmanagement has identified a probability distribution for possible EBITlevels:levels:






If the firm does not expand, it sales growth will stall at the current $25m level or less. If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company undertakes the planned expansion management has identified aIf the company undertakes the planned expansion management has identified aprobability distribution for possible EBIT levels:probability distribution for possible EBIT levels:

Possible EBITPossible EBIT ProbabilityProbability$2,200$2,200 .1.1

$2,700$2,700 .4.4$3,200$3,200 .4.4$3.700$3.700 .1.1

The planned expansion will require Thunder Bay Industries to raise $10,000,000 inThe planned expansion will require Thunder Bay Industries to raise $10,000,000 innew capital. If raised in the form of bonds, the bonds would carry a 6.5% couponnew capital. If raised in the form of bonds, the bonds would carry a 6.5% couponrate. New common stock could be sold for $250.00 per share.rate. New common stock could be sold for $250.00 per share.

Find the EBIT/EPS indifference point . What is the probability that EBIT will beFind the EBIT/EPS indifference point . What is the probability that EBIT will begreater than the indifference point? Which method of financing is most likely togreater than the indifference point? Which method of financing is most likely tomaximize earnings per share? What method of financing do you recommend? Why?maximize earnings per share? What method of financing do you recommend? Why?Discuss the limitations of indifference analysis. Prepare a properly labeled diagramDiscuss the limitations of indifference analysis. Prepare a properly labeled diagramof the EBIT/EPS analysis.of the EBIT/EPS analysis.





Thunder Bay IndustriesThunder Bay IndustriesThe SolutionThe Solution

You can first determine the expected EBIT for next year and using that,You can first determine the expected EBIT for next year and using that,determine the standard deviation of that EBIT. These calculations will be usefuldetermine the standard deviation of that EBIT. These calculations will be usefullater when we try to determine the probability that EBIT will be less than, orlater when we try to determine the probability that EBIT will be less than, orgreater than the indifference point .greater than the indifference point .

Possi le EB T Pro a ility W td EB T

$2,200,000 10.0% $220,0002,700,000 40.0% 1,080,000

3,200,000 40.0% 1,280,000

3,700,000 10.0% 370,000

Expected EBIT = $2,950,000

110,403$

11.403

500,162

56250000,25000,2556250

)750(1.)250(4.)250(4.)750(1. 2222

!

!

!

!

! EB I ¦ W







Thunder Bay IndustriesThunder Bay IndustriesThe Solution «The Solution «

Our prediction for EPS at EBIT=$2,675,000 for the commonOur prediction for EPS at EBIT=$2,675,000 for the common

share financing alternative is:share financing alternative is:

26.9$000,100

)43.1)(000,050,1$000,675,2($

26.9$000,140

)43.1)(000,400$000,675,2($

!

!

!

!

Debt

ecommonshar

EP S

EP S






The probability than EBIT will favour common stock financing (ie. The probability than EBIT will favour common stock financing (ie. be less than the indifference point) is:be less than the indifference point) is:

Where:Where:zz = the number of standard deviations away from the mean= the number of standard deviations away from the mean

XX = the point of interest = the point of interest EE= the standard deviation of the probability distribution= the standard deviation of the probability distribution

QQ = the mean of the probability distribution= the mean of the probability distribution

W

Q

!

X

z 6822.0

110,403

000,950,2000,675,2

!

! z

Thunder Bay IndustriesThunder Bay Industries000,950,2000,675,2

!z





The negative sign indicates that the point of interest (X) or (indifferenceThe negative sign indicates that the point of interest (X) or (indifferencepoint) lies on the left point) lies on the left--hand side of the mean. It lies .6822 of 1 standardhand side of the mean. It lies .6822 of 1 standarddeviation away from the mean.deviation away from the mean.

Going to the table for Values of the Standard Normal DistributionGoing to the table for Values of the Standard Normal Distribution

Function we find the area under the curve between the point of interest Function we find the area under the curve between the point of interest and the mean of the distribution to be:and the mean of the distribution to be:

.2517 or 25.27%.2517 or 25.27%

Therefore, the probability that EBIT will exceed the indifference point Therefore, the probability that EBIT will exceed the indifference point (favouring debt financing) is 75.17% The probability that EBIT will be(favouring debt financing) is 75.17% The probability that EBIT will bebelow the indifference point (favouring equity financing is (1below the indifference point (favouring equity financing is (1-- .7517).7517)24.83%.24.83%.

(These normal distribution is plotted on the following chart .)(These normal distribution is plotted on the following chart .)

6822.0

110,403

!

z

Thunder Bay IndustriesThunder Bay Industries000,950,2000,675,2

! z





(These relationships are now plotted on the following indifference chart .) (These relationships are now plotted on the following indifference chart .)

6822.0

110,403

!

Q=$2,950,000X=$2,675,000

Area =

.2517

Area = .5






(This chart illustrates that debt financing is forecast to produce higher EPS than the(This chart illustrates that debt financing is forecast to produce higher EPS than theequity alternative.) equity alternative.)

Q=$2,950,000

X=$2,675,000

Area =.2517

Area = .5

EPS

EquityFinancing

DebtFinancing

$400,000 $1,050,000

$9.26



Documents

Capital Structure Decisions 3642