Chapter 14: Capital Structure and LeverageJune 20, 2016 USLS
Learning ObjectivesExplain why there may be difference in a
firms capital structure - book value vs market value vs target
basis (LO1)Business risk vs financial risk and effect of debt
financing (LO2)Optimal capital structure (LO3)Capital structure
theory (LO4)
(LO1) BV vs. MV vs. TargetCapital = debt + preferred stock +
common stock + retained earningsCapital structureOptimal capital
structure
(LO1) BV vs. MV vs. TargetIt doesnt matter whether a company is
big or small. Capital structure matters. It always has and always
will.Michael Miliken
(LO1) BV vs. MV vs. TargetEquitySelling shares of
ownershipHighest risk/highest returnDebtSelling debt
(LO1) BV vs. MV vs. TargetThere is no formula for optimal
capital structure.Optimal structure minimizes WACC.Why is cost of
equity greater than cost of debt?
(LO1) BV vs. MV vs. TargetBook value, market value, or target
areas?WACC - We need to know the cost.Most records are on book
value.Market value is volatile.Most CFOs use a benchmark.
(LO2) Business Risk vs Financial RiskBusiness riskThe risk
inherent in the firms operations if it uses no debt.The probability
of loss inherent in an organization's operations and environment
(such as competition and adverse economic conditions) that may
impair its ability to provide returns on investment.
(LO2) Business Risk vs Financial RiskFinancial riskAdditional
risk placed on common stockholders as a result of the decision to
finance with debt.The possibility that shareholders will lose money
when they invest in a company that has debt, if the company's cash
flow proves inadequate to meet its financial obligations.
(LO2) Business Risk vs Financial Risk
(LO2) Business Risk vs Financial RiskOperating
leverageRelationship between fixed costs and variable costs.The
higher the firms fixed costs, the greater the business risk.
(LO2) Business Risk vs Financial Risk
(LO2) Business Risk vs Financial Risk
(LO2) Business Risk vs Financial Risk
(LO2) Business Risk vs Financial RiskFinancial leveragethe use
of debt and preferred stock.
(LO2) Business Risk vs Financial Risk
(LO2) Business Risk vs Financial Risk
Firm U: NOT Leveraged
Firm L: Leveraged
Firm U vs Firm L
Let us solve for ROE and TIE
(LO2) Business Risk vs Financial Risk
(LO2) Business RiskThe higher the firms fixed costs, the greater
the business risk.Business risk is best measured by the standard
deviation of ROIC. ROIC is the debt-free equivalent of ROE.High
degree of operating leverage implies that small changes in sales
result in large changes in ROIC.Higher the operating leverage, the
higher the business risk.
(LO2) Financial RiskUsing debt increases risk to
stockholders.Increased risk result in increased expected rate of
return/ROE on the part of shareholders.Changes in the use of debt
would case changes in EPS.
(LO2) Business Risk and Financial RiskDOLDFLDTLBreakevenWACC
(LO3) Optimal Capital StructureUsing debt increases EPS -
increases stock price (positive)But debt also increases risk -
reduce stock price (negative)Optimal capital structure = balance
both positive and negative
(LO3) Optimal Capital StructureSeek to implement an optimal
capital structure that maximises the price of the firms
stock.Lowest WACCHighest stock priceA little below the capital
structure that maximises EPS
(LO3) Optimal Capital Structure - WACCWACC =
[Wd(rd)(1-T)]+Wc(rs)
(LO3) Optimal Capital Structure - rsBecause 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.
(LO3) Optimal Capital Structure - Hamada Equation
(LO3) Optimal Capital Structure - Hamada Equation
(LO3) Optimal Capital Structure - Hamada Equation
(LO3) Optimal Capital Structure - Hamada Equation
(LO3) Optimal Capital Structure - Hamada Equation
(LO3) Optimal Capital Structure
(LO4) Capital Structure Theory The Effect of Taxes The Effect of
Potential Bankruptcy Trade-offTheory Signaling Theory
SEATWORKP14-1P14-4P14-5P14-8
The capital structure that maximises intrinsic value also
minimizes WACC.Footnote 1
