Chapter 15 Capital Structure and Leverage

8/19/2019 Chapter 15 Capital Structure and Leverage

1/61

Capital Structure andLeverageChapter 15


2/61

Objectives At the end of the chapter, you will be able to:

! explain why there may be differences in a firm’scapital structure measured on a book-value basis,market value basis or a target basis

! distinguish between business risk and financialrisk

! Explain the effects of debt financing on the firm’sexpected return and risk

! discuss the framework used when determining the

optimal capital structure! discuss the capital structure theory and explainwhy firms in different industries tend to havedifferent capital structures.


3/61

Capital Structure

• Target capital structure is themix of debt, preferred stock andcommon equity the firm wants tohave.

• Optimal Capital Structuremaximizes a firm’s stock price.


4/61

Weighing investor-suppliedCapital

• Book Value• Market Value

• Target


5/61

Trade offs

• Using more debt will raise therisk borne by stockholders

• Using more debt generally,increases the expected returnon equity.


6/61

Factors Influencing CapitalStructure Decisions

• Business Risk• Firm’s Tax Position

• Financial Flexibility

• Managerial Conservatism or Aggressiveness

• Operating Conditions – e.g. when StockPrice ! Intrinsic Value


7/61

Business Risk vs. Financial Risk

• Business Risk – riskiness of the firm’sassets if no debt is used.

• Financial Risk – additional risk placed onthe common stockholders as a result ofusing debt.


8/61

Business Risk Determinants

• Competition• Demand Variability• Sales Price Variability• Input Cost Variability• Product Obsolescence• Foreign risk exposure

• Regulatory risk and legal exposures• The extent to which costs are fixed: operating

leverage


9/61

Operating Leverage

• Operating leverage is the extent to whichfixed costs are used in a firm’s operations.

• If fixed costs are high, other things heldconstant, the greater is the business risk.

• High degree on operating leverage, otherfactors held constant, implies that arelatively small change in sales results inlarge change in ROE.


10/61

Operating Leverage

! !"# " $ %&'()* +( ,-./0 $ 1&'()* +( 2'3*4

! !"# " 6 %7 &8 ' 0697 &8: &;1! !"# " 2 &8102 &81 &;1• Operating Break even : EBIT = 0

• BEP " ;1027 &81


11/61

Effect of Operating Leverage

Sales

$ Rev.

TC

FC

QBE Sales

$ Rev.

TCFC

QBE

} Profit


12/61

Using operating leverage

• Typical situation: Can use operating leverageto get higher E(EBIT), but risk also increases.

Probability

EBITL

Low operating leverage

High operating leverage

EBITH


13/61

Conclusion on OperatingLeverage

• Holding other factors constant, thehigher the degree of operatingleverage, the greater the firm’sbusiness risk.


14/61


15/61

An example:Illustrating effects of financial leverage

• Two firms with the same operating leverage,business risk, and probability distribution ofEBIT.

• Only differ with respect to their use of debt(capital structure).

Firm U Firm LNo debt $10,000 of 12% debt$20,000 in assets $20,000 in assets40% tax rate 40% tax rate


16/61

Firm U: Unleveraged

EconomyBad Avg. Good

Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000

Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400


17/61

Firm L: Leveraged

EconomyBad Avg. Good

Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800

Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for Firm U.


18/61

Ratio comparison betweenleveraged and unleveraged firms

FIRM U Bad Avg GoodBEP 10.0% 15.0% 20.0%ROE 6.0% 9.0% 12.0%TIE ! ! !

FIRM L Bad Avg GoodBEP 10.0% 15.0% 20.0%ROE 4.8% 10.8% 16.8%TIE 1.67x 2.50x 3.30x


19/61

Risk and return for leveragedand unleveraged firms

Expected Values:Firm U Firm L

E(BEP) 15.0% 15.0%E(ROE) 9.0% 10.8%E(TIE) ! 2.5x

Risk Measures:Firm U Firm L

" ROE 2.12% 4.24%CVROE 0.24 0.39


20/61

ROE Probability

• Typical situation: Can use operating leverageto get higher E(ROE), but risk also increases.

Probability

ROE U

0% Debt

50%

ROE L


21/61


22/61

Conclusions

• Basic earning power (BEP) isunaffected by financial leverage.

• L has higher expected ROE becauseBEP > r d.• L has much wider ROE (and EPS)

swings because of fixed interest

charges. Its higher expected return isaccompanied by higher risk.


23/61

Determining Optimal CapitalStructure

• Seek to maximize the price of the firm’s stock.• Changes in use of debt will cause changes in

earnings per share, and, thus, in the stockprice.

• Cost of debt varies with capital structure.• Financial leverage increases risk.

• The optimal capital structure always calls for adebt/assets ratio that is lower than the one thatmaximizes expected EPS.


24/61

Sequence of events in arecapitalization.

• 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 issueddivided by price per share.

h d h b d d f


25/61

Why do the bond rating and cost ofdebt depend upon the amount of debt

borrowed?• As the firm borrows more money, the firm

increases its financial risk causing the

firm’s bond rating to decrease, and itscost of debt to increase.


26/61

Cost of debt at different debt ratios

Amountborrowed

D/Aratio

D/E ratio Bondrating

rd

$ 0 0 0 -- --

250 0.125 0.143 AA 8.0%

500 0.250 0.333 A 9.0%

750 0.375 0.600 BBB 11.5%

1,000 0.500 1.000 BB 14.0%

A l h i li i i


27/61

Analyze the recapitalization at variousdebt levels and determine the EPS and

TIE at each level.

$3.00

80,000(0.6)($400,000)

goutstandinShares

)T-1)(Dr-EBIT( EPS

$0D

d

=

=

=

=

D i i EPS d TIE diff


28/61

Determining EPS and TIE at differentlevels of debt.

(D = $250,000 and r d = 8%)

20x$20,000

$400,000

ExpIntEBIT

TIE

$3.26

10,000-80,000000))(0.6)0.08($250,-($400,000

goutstandinShares)T-1)(Dr-EBIT(

EPS

10,000$25

$250,000 drepurchaseShares

d

===

=

=

=

==


29/61


(D = $500,000 and r d = 9%)

8.9x$45,000

$400,000

ExpIntEBIT

TIE

$3.55

20,000-80,000000))(0.6)0.09($500,-($400,000


EPS

20,000$25


d

===

=

=

=

==

D i i EPS d TIE diff


30/61


(D = $750,000 and r d = 11.5%)

4.6x$86,250

$400,000 ExpInt

EBIT TIE

$3.77

30,000-80,000),000))(0.60.115($750-($400,000


EPS

30,000$25


d

===

=

=

=

==

D t i i EPS d TIE t diff t


31/61


(D = $1,000,000 and r d = 14%)

2.9x$140,000$400,000

ExpIntEBIT TIE

$3.90

40,000-80,0006)0,000))(0.0.14($1,00-($400,000


EPS

40,000$25

$1,000,000 drepurchaseShares

d

===

=

=

=

==


32/61

Stock Price, with zero growth

• If all earnings are paid out as dividends,E(g) = 0.

•

EPS = DPS• To find the expected stock price (P 0), wemust find the appropriate r s at each of thedebt levels discussed.

sss

10 r

DPS

rEPS

g-r

D P ===


33/61

What effect does more debthave on a firm’s cost of equity?

• If the level of debt increases, the riskinessof the firm increases.

• We have already observed the increase inthe cost of debt.

• However, the riskiness of the firm’s equityalso increases, resulting in a higher r s.


34/61

The Hamada Equation

• Because the increased use of debt causes boththe costs of debt and equity to increase, weneed to estimate the new cost of equity.

• The Hamada equation attempts to quantify theincreased cost of equity due to financialleverage.

• Uses the unlevered beta of a firm, whichrepresents the business risk of a firm as if it hadno debt.


35/61

The Hamada Equation

bL = b U[ 1 + (1 – T) (D/E)]

• Suppose, the risk-free rate is 6%, asis the market risk premium. The

unlevered beta of the firm is 1.0. Wewere previously told that total assetswere $2,000,000.


36/61

Calculating levered betas and costsof equity

If D = $250,

bL = 1.0 [ 1 + (0.6)($250/$1,750) ]bL = 1.0857

r s = r RF + (r M – r RF) bL r s = 6.0% + (6.0%) 1.0857r s = 12.51%


37/61

Table for calculating levered betasand costs of equity

Amountborrowed

D/Aratio

D/E ratio Leveredbeta

rs

$ 0 0% 0% 1.00 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


38/61

Finding Optimal Capital Structure

• The firm’s optimal capital structurecan be determined two ways:

– Minimizes WACC. – Maximizes stock price.

• Both methods yield the same results.


39/61

Table for calculating leveredbetas and costs of equity

Amountborrowed

D/Aratio

E/A ratio r s rd(1-T) WACC

$ 0 0% 100% 12.00% -- 12.00%

250 12.50 87.50 12.51 4.80% 11.55

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


40/61

Determining the stock pricemaximizing capital structure

Amountborrowed

DPS r s P0

$ 0 $3.00 12.00% $25.00

250 3.26 12.51 26.03

500 3.55 13.20 26.89

750 3.77 14.16 26.59

1,000 3.90 15.60 25.00


41/61

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%.


42/61

What is the firm’s optimal capitalstructure?

• 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 isstock price, not E(EPS).• The example shows that we can push up

E(EPS) by using more debt, but the risk resultingfrom increased leverage more than offsets thebenefit of higher E(EPS).


43/61

Plotting figures in Graphs

Debt/Assets

kd ExpectedEPS

EstimatedBeta

ks = [kRF +(kM œk RF)! s]

EstimatedPrice

ResultingP/E Ratio

WACC

0% - $2.40 1.50 12.0% $20.00 8.33 12.00%10 8.0% 2.56 1.60 12.4 20.65 8.06 11.64

20 8.3 2.75 1.73 12.9 21.33 7.75 11.3230 9.0 2.97 1.89 13.5 21.90 7.38 11.1040 10.0 3.20 2.10 14.4 22.22 6.94 11.04

50 12.0 3.36 2.40 15.6 21.54 6.41 11.4060 15.0 3.30 2.85 17.4 18.97 5.75 12.36

Rel tionship Bet een


44/61

44

Relationship BetweenCapital Structure and EPS

0

0.5

1

1.5

2

2.5

3

3.5

0 10 20 30 40 50 60

Maximum EPS = $3.36Expected EPS ($)

Debt/Assets (%)


45/61

45

0

5

10

15

20

0 10 20 30 40 50 60

Cost of Equity, k s

Cost of Capital (%)

Debt/Assets (%)

WACC

Minimum = 11.04%

Relationship BetweenCapital Structure and Cost of Capital


46/61

46

18

19

20

21

22

23

24

0 10 20 30 40 50 60

Maximum = $22.22

Stock Price ($)

Debt/Assets (%)

Relationship BetweenCapital Structure and Stock Price

What if there were more/less business


47/61

What if there were more/less businessrisk than originally estimated, how would

the analysis be affected?

• If there were higher business risk, thenthe probability of financial distress would

be greater at any debt level, and theoptimal capital structure would be one thathad less debt.

• However, lower business risk would leadto an optimal capital structure with moredebt.

f l


48/61

EPSEPSEBIT

EBIT

Percentage change in EPSPercentage change in EBIT

EBITEBIT - IntDFL = = =

Degree of Financial Leverage(DFL)

• The percentage change in earnings availableto common stockholders associated with agiven percentage change in EBIT.

This equation assumes the firm has nopreferred stock.


49/61

49

S - VCS - VC - F - Int Gross Profit

EBIT - IntDTL = =

Q(P - V)Q(P - V) - F - Int

DTL =

DTL = DOL X DFL

Degree of Total Leverage (DTL)

• The percentage change in EPS that resultsfrom a given percentage change in sales.


50/61

50

Capital Structure Theory

• Trade-off Theory

• Signaling Theory

• The Effect of Taxes

• The Effect of Potential Bankruptcy


51/61

51

Trade-Off Theory(Modigliani and Miller)

1. Theory:1. Interest is tax-deductible expense, therefore less expensive

than common or preferred stock.

2. So, 100% debt is the preferred capital structure.

2. Theory:1. Interest rates rise as debt/asset ratio increases2. Tax rates fall at high debt levels (lowers debt tax shield)3. Probability of bankruptcy increases as debt/assets ratio

increases.


52/61

52

Trade-Off Theory (continued)

3. Two levels of debt:

1. Threshold debt level (D/A 1) = where bankruptcy costsbecome material

2. Optimal debt level (D/A 2) = where marginal tax shelterbenefits = marginal bankruptcy–related costs

3. Between these two debt levels, the firm’s stock price rises,but at a decreasing rate

4. So, the optimal debt level = optimal capital structure


53/61

53

Trade-Off Theory (cont)

4. Theory and empirical evidence support theseideas, but the points cannot be identifiedprecisely.

5. Many large, successful firms use much lessdebt than the theory suggests—leading todevelopment of signaling theory.


54/61

Modigliani-Miller Irrelevance Theory

Value of Stock

0 D 1 D2 D/A

MM result

Actual

No leverage


55/61

55

Signaling Theory

• Symmetric Information – Investors and managers have identical information

about the firm’s prospects.

• Asymmetric Information – Managers have better information about their firm’s

prospects than do outside investors.


56/61

56

Signaling Theory

• Signal – An action taken by a firm’s management that

provides clues to investors about howmanagement views the firm’s prospects

• Result: Reserve Borrowing Capacity – Ability to borrow money at a reasonable cost when

good investment opportunities arise – Firms often use less debt than “optimal” to ensure

that they can obtain debt capital later if needed.


57/61

Incorporating signaling effects

• Signaling theory suggests firmsshould use less debt than MM

suggest.• This unused debt capacity helps

avoid stock sales, which depress

stock price because of signalingeffects.

Wh “ i li ” ff i


58/61

What are “signaling” effects incapital structure?

• Assumptions: – Managers have better information about a firm’s long-

run value than outside investors. – Managers act in the best interests of current

stockholders.• What can managers be expected to do?

– 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.

U i g D bt Fi i g t


59/61

Using Debt Financing toConstrain Managers

• Conflicts of interest among managersespecially if there is excess cash

• Leveraged Buyout

V i ti i C it l St t


60/61

60

Variations in Capital Structuresamong Firms• Wide variations in use of financial leverage

among industries and firms within an industry – TIE (times interest earned ratio) measures how safe

the debt is:• percentage of debt• interest rate on debt• company’s profitability


61/61

Closing Prayer

Numbers 6:24-26“ The Lord bless you and keep you, the Lordmake his face shine upon you and begracious to you; the Lord turn His facetoward you and give you peace.”

Documents

Chapter 15 Capital Structure and Leverage