CH 16

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CHAPTER 16
Capital Structure Decisions: The Basics nImpact of leverage on returns nBusiness versus financial risk nCapital structure theory nPerpetual cash flow example nSetting the optimal capital structure in practice
Copyright 2002 by Harcourt, Inc. All rights reserved.
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Consider Two Hypothetical Firms Firm U No debt $20,000 in assets 40% tax rate Firm L $10,000 of 12% debt $20,000 in assets 40% tax rate
Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.
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Impact of Leverage on Returns Firm U $3,000 0 $3,000 1 ,200 $1,800 9.0% Firm L $3,000 1,200 $1,800 720 $1,080 10.8%
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EBIT Interest EBT Taxes (40%) NI ROE

Copyright 2002 by Harcourt, Inc.
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Why does leveraging increase return? nTotal dollar return to investors:

lU: NI = $1,800. lL: NI + Int = $1,080 + $1,200 = $2,280. lDifference = $480.
nTaxes paid:
lU: $1,200; L: $720. lDifference = $480.
nMore EBIT goes to investors in Firm L. nEquity $ proportionally lower than NI.
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What is business risk?

nUncertainty about future operating income (EBIT). Probability
Low risk High risk
E(EBIT)
EBIT
nNote that business risk focuses on operating income, so it ignores financing effects.
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Factors That Influence Business Risk
nUncertainty about demand (unit sales). nUncertainty about output prices. nUncertainty about input costs. nProduct and other types of liability. nDegree of operating leverage (DOL).
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What is operating leverage, and how does it affect a firms business risk? nOperating leverage is the use of fixed costs rather than variable costs. nThe higher the proportion of fixed costs within a firms overall cost structure, the greater the operating leverage.
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nHigher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline.
$ Rev. TC $ Rev.
} Profit
TC FC QBE Sales
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FC QBE Sales
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Probability
Low operating leverage High operating leverage
EBITL
EBITH
nIn the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.
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Business Risk versus Financial Risk nBusiness risk:

lUncertainty in future EBIT. lDepends on business factors such as competition, operating leverage, etc. lAdditional business risk concentrated on common stockholders when financial leverage is used. lDepends on the amount of debt and preferred stock financing.
nFinancial risk:
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From a shareholders perspective, how are financial and business risk measured in the stand-alone sense? Stand-alone Business Financial = + risk . risk risk Stand-alone risk = ROE. Business risk = ROE(U). Financial risk = ROE - ROE(U).
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Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L?
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Firm U: Unleveraged Bad Prob. 0.25 EBIT $2,000 Interest 0 EBT $2,000 Taxes (40%) 800 NI $1,200
Economy Avg. Good 0.50 0.25 $3,000 $4,000 0 0 $3,000 $4,000 1,200 1,600 $1,800 $2,400
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Firm L: Leveraged Bad Prob.* 0.25 EBIT* $2,000 Interest 1,200 EBT $ 800 Taxes (40%) 320 NI $ 480 *Same as for Firm U.
Economy Avg. Good 0.50 0.25 $3,000 $4,000 1,200 1,200 $1,800 $2,800 720 1,120 $1,080 $1,680
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Firm U Bad Avg. Good BEP 10.0% 15.0% 20.0% ROI* 6.0% 9.0% 12.0% ROE 6.0% 9.0% 12.0% TIE Firm L Bad Avg. Good BEP 10.0% 15.0% 20.0% ROI* 8.4% 11.4% 14.4% ROE 4.8% 10.8% 16.8% TIE 1.7x 2.5x 3.3x *ROI = (NI + Interest)/Total financing.
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Profitability Measures: E(BEP) E(ROI) E(ROE) Risk Measures: U 15.0% 9.0% 9.0% 2.12% 0.24 8 L 15.0% 11.4% 10.8% 4.24% 0.39 2.5x
ROE
CV ROE E(TIE)
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Conclusions nBasic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. nL has higher expected ROI and ROE because of tax savings. nL has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk. (More...)
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nIn a stand-alone risk sense, Firm Ls stockholders see much more risk than Firm Us.
lU and L: ROE(U) = 2.12%. lU: ROE = 2.12%. lL: ROE = 4.24%.
nLs financial risk is ROE - ROE(U) = 4.24% - 2.12% = 2.12%. (Us is zero.)
(More...)
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nFor leverage to be positive (increase expected ROE), BEP must be > kd. nIf kd > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE. nIn the example, E(BEP) = 15% while interest rate = 12%, so leveraging works.
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Capital Structure Theory nMM theory

lZero taxes lCorporate taxes lCorporate and personal taxes
nTrade-off theory nSignaling theory nDebt financing as a managerial constraint

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MM Theory: Zero Taxes nMM prove, under a very restrictive set of assumptions, that a firms value is unaffected by its financing mix. nTherefore, capital structure is irrelevant. nAny increase in ROE resulting from financial leverage is exactly offset by the increase in risk.
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MM Theory: Corporate Taxes nCorporate tax laws favor debt financing over equity financing. nWith corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. nFirms should use almost 100% debt financing to maximize value.
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MM Theory: Corporate and Personal Taxes nPersonal taxes lessen the advantage of corporate debt:
lCorporate taxes favor debt financing. lPersonal taxes favor equity financing.
nUse of debt financing remains advantageous, but benefits are less than under only corporate taxes. nFirms should still use 100% debt.
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Hamadas Equation nMM theory implies that beta changes with leverage. nbU is the beta of a firm when it has no debt (the unlevered beta) nbL = bU(1 + (1 - T)(D/E)) nIn practice, D/E is measured in book values when bL is calculated.
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Trade-off Theory nMM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. nAt low leverage levels, tax benefits outweigh bankruptcy costs. nAt high levels, bankruptcy costs outweigh tax benefits. nAn optimal capital structure exists that balances these costs and benefits.
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Signaling Theory nMM assumed that investors and managers have the same information. nBut, managers often have better information. Thus, they would:
lSell stock if stock is overvalued. lSell bonds if stock is undervalued.
nInvestors understand this, so view new stock sales as a negative signal. nImplications for managers?
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Debt Financing As a Managerial Constraint nOne agency problem is that managers can use corporate funds for non-value maximizing purposes. nThe use of financial leverage:
lBonds free cash flow. lForces discipline on managers.
nHowever, it also increases risk of financial distress.

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Perpetual Cash Flow Example Expected EBIT = $500,000; will remain constant over time. Firm pays out all earnings as dividends (zero growth). Currently is all-equity financed. BV of equity = MV of equity 100,000 shares outstanding. P0 = $20; T = 40%; kRF = 6%; RP M = 4%
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Component Cost Estimates Amount Borrowed (000) $ 0 250 500 750 1,000 kd
10.0% 11.0 13.0 16.0
If company recapitalizes, debt would be issued to repurchase stock.

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nThe MM and Miller models cannot be applied directly because several assumptions are violated. lkd is not a constant. lBankruptcy and agency costs exist. nIn practice, Hamadas equation is used to find kS for the firm with different levels of debt.
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The Optimal Capital Structure nCalculate the cost of equity at each level of debt. nCalculate the value of equity at each level of debt. nCalculate the total value of the firm (value of equity + value of debt) at each level of debt. nThe optimal capital structure maximizes the total value of the firm.
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Sequence of Events in a Recapitalization nFirm announces the recapitalization. nInvestors reassess their views and estimate a new equity value. nNew debt is issued and proceeds are used to repurchase stock at the new equilibrium price.
(More...)
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n Shares Debt issued = . Bought New price/share nAfter recapitalization firm would have more debt but fewer common shares outstanding. nAn analysis of several debt levels is given next.
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Cost of Equity at Zero Debt nSince the firm has 0 growth, its current value, $2,000,000, is given by Dividends/kS = (EBIT)(1-T)/kS = 500,000 (1 - 0.40)/ kS nkS = 15.0% = unlevered cost of equity. nbU = (kS - kRF)/RP M = (15 - 6)/4 = 2.25
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Cost of Equity at Each Debt Level nHamadas equation says that bL = bU (1 + (1-T)(D/E))
Debt(000s) 0 250 500 750 1,000 D/E 0 0.142 0.333 0.600 1.000 bL 2.25 2.44 2.70 3.06 3.60 kS 15.00% 15.77 16.80 18.24 20.40
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D = $250, kd = 10%, ks = 15.77%. S1 = (EBIT - kdD)(1 - T) ks [$500 - 0.1($250)](0.6) = = $1,807. 0.1577
V1 = S 1 + D1 = $1,807 + $250 = $2,057. P1 = $2,057 100 = $20.57.

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Shares $250 = = 12.15. repurchased $20.57 Shares = n 1 = 100 - 12.15 = 87.85. remaining Check on stock price: S1 P1 = n = $1,807 = $20.57. 1 87.85 Other debt levels treated similarly.
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Value of Equity at Each Debt Level nEquity Value = Dividends/kS

Debt(000s) 0 250 500 750 1,000 kD na 10% 11% 13% 16% Divs 300 285 267 241.5 204 kS 15.00% 15.77 16.80 18.24 20.40 E 2,000 1,807 1,589 1,324 1,000
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Total Value of Firm
Debt (000s) 0 250 500 750 1,000
E 2,000 1,807 1,589 1,324 1,000
Total Value 2,000 2,057 2,089 2,074 2,000
Price per Share $20.00 20.57 20.89 20.74 20.00
Total Value is Maximized with 500,000 in debt.

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Calculate EPS at debt of $0, $250K, $500K, and $750K, assuming that the firm begins at zero debt and recapitalizes to each level in a single step. Net income = NI = [EBIT - kd D](1 - T). EPS = NI/n.
D $ 0 250 500 750 NI $300 285 267 242 n 100.00 87.85 76.07 63.84 EPS $3.00 3.24 3.51 3.78
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nEPS continues to increase beyond the $500,000 optimal debt level. nDoes this mean that the optimal debt level is $750,000, or even higher?
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Find the WACC at each debt level.

D $ 0 250 500 750 1,000 S $2,000 1,807 1,589 1,324 1,000 V $2,000 2,057 2,089 2,074 2,000 kd Ks WACC -- 15.00% 15.0% 10% 15.77 14.6 11.0 16.80 14.4 13.0 18.24 14.5 13.0 20.40 15.0
e.g. D = $250: WACC = ($250/$2,057)(10%)(0.6) + ($1,807/$2,057)(15.77%) = 14.6%.

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nThe WACC is minimized at D = $500,000, the same debt level that maximizes stock price. nSince the value of a firm is the present value of future operating income, the lowest discount rate (WACC) leads to the highest value.
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How would higher or lower business risk affect the optimal capital structure? nAt any debt level, the firms probability of financial distress would be higher. Both kd and ks would rise faster than before. The end result would be an optimal capital structure with less debt. nLower business risk would have the opposite effect.
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Is it possible to do an analysis exactly like the one above for most firms?
nNo. The analysis above was based on the assumption of zero growth, and most firms do not fit this category. nFurther, it would be very difficult, if not impossible, to estimate ks with any confidence.
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What type of analysis should firms conduct to help find their optimal, or target, capital structure? nFinancial forecasting models can help show how capital structure changes are likely to affect stock prices, coverage ratios, and so on.
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nForecasting models can generate results under various scenarios, but the financial manager must specify appropriate input values, interpret the output, and eventually decide on a target capital structure. nIn the end, capital structure decision will be based on a combination of analysis and judgment.
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What other factors would managers consider when setting the target capital structure? nDebt ratios of other firms in the industry. nPro forma coverage ratios at different capital structures under different economic scenarios. nLender and rating agency attitudes (impact on bond ratings).
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nReserve borrowing capacity. nEffects on control. nType of assets: Are they tangible, and hence suitable as collateral? nTax rates.

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EBIT Interest EBT Taxes (40%) NI ROE

Why does leveraging increase return? nTotal dollar return to investors:

What is business risk?

Factors That Influence Business Risk

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Low operating leverage High operating leverage

Business Risk versus Financial Risk nBusiness risk:

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Capital Structure Theory nMM theory

nTrade-off theory nSignaling theory nDebt financing as a managerial constraint

nHowever, it also increases risk of financial distress.

If company recapitalizes, debt would be issued to repurchase stock.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Copyright 2002 by Harcourt, Inc.

D = $250, kd = 10%, ks = 15.77%. S1 = (EBIT - kdD)(1 - T) ks [$500 - 0.1($250)](0.6) = = $1,807. 0.1577

V1 = S 1 + D1 = $1,807 + $250 = $2,057. P1 = $2,057 100 = $20.57.

Copyright 2002 by Harcourt, Inc.

Value of Equity at Each Debt Level nEquity Value = Dividends/kS

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Total Value of Firm

Debt (000s) 0 250 500 750 1,000

E 2,000 1,807 1,589 1,324 1,000

Total Value 2,000 2,057 2,089 2,074 2,000

Price per Share $20.00 20.57 20.89 20.74 20.00

Total Value is Maximized with 500,000 in debt.

Copyright 2002 by Harcourt, Inc.

Copyright 2002 by Harcourt, Inc.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

Find the WACC at each debt level.

e.g. D = $250: WACC = ($250/$2,057)(10%)(0.6) + ($1,807/$2,057)(15.77%) = 14.6%.

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Copyright 2002 by Harcourt, Inc.

All rights reserved.

Copyright 2002 by Harcourt, Inc.

All rights reserved.

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