16-1

CHAPTER 16Capital Structure and Leverage

Business vs. Financial Risk

Operating & Financial Leverage

Optimal Capital Structure

Capital Structure theory

Capital Structure Example

16-2

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

16-3

Business Risk is “Uncertainty” about future Operating Income (EBIT)

Note: Business Risk DOES NOT include financing risks

Business Risk

Probability

EBITE(EBIT)0

Low risk

High risk

16-4

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)

16-5

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)

16-6

Effect of Operating Leverage

More Operating Leverage leads to more Business Risk: Small Sales decline causes a Big Profit decline (and vice versa)

Sales

$ Rev.

TC

FC

QBE Sales

$ Rev.

TC

FC

QBE

} Profit

16-7

Using Operating Leverage

Can use Operating Leverage to get higher EBIT, but risk also increases

Probability

EBITL

Low operating leverage

High operating leverage

EBITH

16-8

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

16-9

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

16-10

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 Firm L

No debt $10,000 of 12% debt (50%)

$20,000 in assets $20,000 in assets

40% tax rate 40% tax rate

16-11

Financial Leverage ExampleUnleveraged Economy

Bad Avg. GoodProb. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

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 $2,800Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

16-12

Ratio Comparison between Leveraged & 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

16-13

Risk & Return between Leveraged & 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

σROE 2.12% 4.24%

CVROE 0.24 0.39

16-14

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 (σROE & CV)

Higher Expected Return is accompanied by Higher Risk

16-15

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

16-16

MM vs. Trade-off Theory

MM theory ignores Bankruptcy (financial distress) Costs, which increase as more Debt is used

VL = VU + TD

Trade-off Theory includes Bankruptcy

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

An Optimal capital structure exists that balances costs and tax benefits

16-17

Trade-off Theory vs MM

Value of Stock

0 D1 D2

D/A

MM with no bankruptcy risk

Actual Value

No leverage

Value reduced by potential bankruptcy

Value added by Debt tax benefits

16-18

“Signaling” effects in Capital Structure

Managers (Insiders) have better information

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

Firms keep “Reserve Borrowing Capacity” Avoid new stock issues

Able to borrow for opportunities & emergencies

Signaling theory suggests firms should use less Debt than MM suggest

16-19

Other Capital Structure Issues

Use of Debt to Constrain Managers

Investment Opportunity Set (IOS)

High IOS: Lower Debt Levels

Low IOS: Higher Debt Levels

Higher Business Risk

Increases probability of Bankruptcy

Optimal capital structure has less debt

See “Checklist” at end of Chapter

16-20

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)

16-21

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

16-22

Cost of debt at different debt levels(Investment Banker Estimates)

Amount D/A D/E Bond

borrowed ratio ratio rating rd

$ 0 0 0 -- --

250 0.125 0.1429 AA 8.0%

500 0.250 0.3333 A 9.0%

750 0.375 0.6000 BBB 11.5%

1,000 0.500 1.0000 BB 14.0%

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Determine the EPS and TIE at each level of debt

$3.00

80,000

(0.6)($400,000)

goutstandin Shares

) T - 1 )( Dr - EBIT ( EPS

$0 D

d

16-24

Determining EPS and TIE (D = $250,000 and rd = 8%)

20x $20,000

$400,000

Exp Int

EBIT TIE

$3.26

10,000- 80,000

000))(0.6)0.08($250, - ($400,000

goutstandin Shares

) T - 1 )( Dr - EBIT ( EPS

10,000 $25

$250,000 drepurchase Shares

d

16-25

Summary of EPS & TIE Ratios

Amount Borrowed

EPS TIE Ratio

0 $3.00 ∞

250 3.26 20x

500 3.55 8.89x

750 3.77 4.64x

1000 3.90 2.85

16-26

Stock Price, with zero growth

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

sss

10

r

DPS

r

EPS

g - r

D P

16-27

Calculating “Beta” & “rs” from Hamada Equation & CAPM

Hamada Equation: βL = βU[ 1 + (1 - T) (D/E)]

βL = 1.0 [ 1 + (0.6)($250/$1,750) ]

βL = 1.09

CAPM: rs = rRF + (rM – rRF) βL

rs = 6.0% + (6.0%) 1.0857

rs = 12.51%

16-28

Summary of “Betas” & “rs” at different levels of Debt

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

rs

12.00%

12.51

13.20

14.16

15.60

16-29

Summary of WACC at different levels of Debt

D/A (Wd)

ratio

0.00%

12.50

25.00

37.50

50.00

WACC

12.00%

11.55

11.25

11.44

12.00

E/A (Ws)

ratio

100.00%

87.50

75.00

62.50

50.00

rs

12.00%

12.51

13.20

14.16

15.60

rd (1 – T)

0.00%

4.80

5.40

6.90

8.40

Amount

borrowed

$ 0

250

500

750

1,000

* Amount borrowed expressed in terms of thousands of dollars

16-30

Summary of Stock Price at different levels of Debt

Amount

Borrowed EPS/DPS rs P0

$ 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

16-31

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