CHAPTER 13

Capital Structure and Leverage

   

Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory
13-1

What is business risk?



Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
Probability Low risk

High risk 0


E(EBIT)

EBIT

Note that business risk does not include financing effects.

13-2

What determines business risk?

    

Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage.

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Leverage
Leverage represents the use of fixed cost items to magnify the firm s performance. Managers have to decide on two issues: a. Determine the amount of fixed cost plant and equipment for the production process. b. Determine the amount of borrowed capital to be used to finance the assets.
13-4

Degree of Operating Leverage (DOL)



DOL is the percentage change in operating income that occurs as a result of a percentage change in sales. Measure of how sensitive net operating income is to percentage changes in sales. Measures the ability of the firm to use fixed cost to magnify the effects of changes in sales on its operating profit or EBIT.
DOL ! Total Contribution Sales  Variable Cost ! Operating Income/EBIT Sales  Variable Cost - Fixed Cost

Percentage Change in Operating Income DOL ! Percentage Change in Sales 13-5

DOL
Units

An Example
Operating Income Tandy Angan (60,000) (12,000) (36,000) (4,000) 12,000 4,000 24,000 12,000 36,000 20,000 60,000 28,000
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0 20,000 40,000 60,000 80,000 100,000

DOL

An Example

DOL if the firms move from 80,000 units to 100,000 units.

DOLTandy !

24 , 000 36 , 000 20 , 000 80 , 000 8, 000 20 , 000 20 , 000 80 , 000

v100 v100 v 100 v 100

! 2.7

DOLAngan !

! 1.6
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DOL

An Example
Unit Selling Price Unit Variable Cost Fixed Cost per year Present Capacity Tk. 10 5 5000 units

Suppose the company sale 5000 units. What will be the impact of 50% increase and decreases in sales on profit.
Capacity in Units Sales @ Tk. 10 per unit Less: Variable Cost @Tk. 5 per unit Net Profit Change in profit (+50%) ( -50%) 5000 units 7500 Units 2500 Units Tk. 50,000 Tk. 75000 Tk.25000 25,000 37,500 12,500 25,000 37,500 12,500 (+) 50% (-) 50% 13-8

DOL

An Example

Suppose the company incurs fixed cost of Tk. 10,000

Capacity in Units Sales @ Tk. 10 per unit Less: Variable Cost @Tk. 5 per unit Contribution Less: Fixed Cost Net Profit Change in profit

(+50%) ( -50%) 5000 units 7500 Units 2500 Units Tk. 50,000 Tk. 75000 Tk.25000 25,000 37,500 12,500 25,000 37,500 12,500 10,000 10,000 10,000 15,000 27,500 2,500 (+) 83.33% (-) 83.33%
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DOL

An Example
20,000 units Tk. 10 per unit Tk. 6 per unit Tk. 40000
.. Ans. 2 times

Data of a company are as follows:

Initial Sales Selling price Variable Cost per unit Fixed Cost
Calculate DOL for 20,000 units

Now, If the sales of the company increases by 50%, what will be the impact on profit?

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DOL

Exercise
A 5000 20 12 20000 20% B 5000 20 10 30000 20% C 5000 20 8 40000 20%

Data of a company are as follows:

Sales units Selling price (Tk per unit) Variable Cost per unit (Tk.) Fixed Cost (Taka) Proposed change in sales

Calculate DOL for and show the impact on profit

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DOL
Company Sales (Unit) Less: Variable Cost Contribution Less: Fixed Cost Net Profit DOL

Exercise
A 5000 100000 60,000 40,000 20,000 20,000 2 times B 5000 100000 50,000 50,000 30,000 20,000 2.5 times C 5000 100000 40,000 60,000 40,000 20,000 3 times

13-12

DOL

Exercise

Company Sales (Unit) Less: Variable Cost Contribution Less: Fixed Cost Net Profit Change in profit % change in profit

6000 6000 6000 120000 120000 120000 72,000 60,000 48,000 48,000 60,000 72,000 20,000 30,000 40,000 28,000 30,000 32,000 8000 10000 12000 (8000/20000)*100 (10000/20000)*100 (12000/20000)*100 40% 50% 60%

13-13

What is operating leverage, and how does it affect a firm s business risk?


Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

13-14

Effect of operating leverage



More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
$ Rev. $ TC Rev. Profit } TC FC FC QBE Sales QBE Sales
13-15

What happens if variable costs change?

Using operating leverage

Probability Low operating leverage High operating leverage

EBITL


EBITH

Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.
13-16

Degree of Financial Leverage (DFL)



DFL may be defined as the percentage change in EPS as a result of a percentage change in EBIT. It is defined as the potential use of fixed financial costs to magnify the effect of changes in earning before interest and tax (EBIT) on the firms EPS

Percentage Change in EPS DFL ! Percentage Change in EBIT

EBIT DFL ! EBIT - Interest

13-17

What is financial leverage? Financial risk?



Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.

13-18

Business risk vs. Financial risk



Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued.
 

More debt, more financial risk. Concentrates business risk stockholders.

on

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An example: Illustrating effects of financial leverage



Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure).
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
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Firm U: Unleveraged
Prob. EBIT Interest EBT Taxes (40%) NI Economy Bad Avg. 0.25 0.50 $2,000 $3,000 0 0 $2,000 $3,000 1,200 800 $1,200 $1,800 Good 0.25 $4,000 0 $4,000 1,600 $2,400

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Firm L: Leveraged
Prob.* EBIT* Interest EBT Taxes (40%) NI
*Same as for Firm U.
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Economy Bad Avg. 0.25 0.50 $2,000 $3,000 1,200 1,200 $ 800 $1,800 720 320 $ 480 $1,080

Good 0.25 $4,000 1,200 $2,800 1,120 $1,680

Ratio comparison between leveraged and unleveraged firms

FIRM U
BEP ROE TIE

Bad
10.0% 6.0%

Avg
15.0% 9.0%

Good
20.0% 12.0%

FIRM L

Bad

Avg

Good
20.0% 16.8% 3.30x
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BEP 10.0% 15.0% ROE 4.8% 10.8% TIE 1.67x 2.50x BEP=Basic earning power = EBIT/TA

Risk and return for leveraged and unleveraged firms

Expected Values: E(BEP) E(ROE) E(TIE) Risk Measures:
ROE

Firm U 15.0% 9.0%

Firm L 15.0% 10.8% 2.5x

CVROE

Firm U 2.12% 0.24

Firm L 4.24% 0.39

13-24

The effect of leverage on profitability and debt coverage



For leverage to raise expected ROE, must have BEP > kd. Why? If kd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = kdD).
13-25

Conclusions


Basic earning power (BEP) is unaffected by financial leverage. L has higher expected ROE because BEP > kd. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

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Optimal Capital Structure



That capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. Trades off higher E(ROE) and EPS against higher risk. The taxrelated benefits of leverage are exactly offset by the debt s risk-related costs. The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.
13-27

Describe the sequence of events in a recapitalization.



 

Campus Deli 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 issued divided by price per share.
13-28

Cost of debt at different levels of debt, after the proposed recapitalization

Amount borrowed $ 0 250 500 750 1,000 D/A ratio 0 0.125 0.250 0.375 0.500 D/E ratio 0 0.1429 0.3333 0.6000 1.0000 Bond rating -AA A BBB BB

kd -8.0% 9.0% 11.5% 14.0%

13-29

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


As the firm borrows more money, the firm increases its financial risk causing the firm s bond rating to decrease, and its cost of debt to increase.

13-30

Analyze the proposed recapitalization at various levels of debt. Determine the EPS and TIE at each level of debt.
D ! $0 ( EBIT - k dD )( 1 - T ) EPS ! Shares outstanding ($400,000)(0.6) ! 80,000 ! $3.00

13-31

Determining EPS and TIE at different levels of debt. (D = $250,000 and kd = 8%)
$250,000 Shares repurchased ! ! 10,000 $25 ( EBIT - k dD )( 1 - T ) EPS ! Shares outstanding ($400,000 - 0.08($250,000))(0.6) ! 80,000 - 10,000 ! $3.26 EBIT $400,000 TIE ! ! ! 20x Int Exp $20,000
13-32

Determining EPS and TIE at different levels of debt. (D = $500,000 and kd = 9%)
$500,000 Shares repurchased ! ! 20,000 $25 ( EBIT - k dD )( 1 - T ) EPS ! Shares outstanding ($400,000 - 0.09($500,000))(0.6) ! 80,000 - 20,000 ! $3.55 EBIT $400,000 TIE ! ! ! 8.9x Int Exp $45,000
13-33

Determining EPS and TIE at different levels of debt. (D = $750,000 and kd = 11.5%)
$750,000 Shares repurchased ! ! 30,000 $25 ( EBIT - k dD )( 1 - T ) EPS ! Shares outstanding ($400,000 - 0.115($750,000))(0.6) ! 80,000 - 30,000 ! $3.77 EBIT $400,000 TIE ! ! ! 4.6x Int Exp $86,250
13-34

Determining EPS and TIE at different levels of debt. (D = $1,000,000 and kd = 14%)
$1,000,000 Shares repurchase d ! ! 40,000 $25 ( EBIT - k dD )( 1 - T ) EPS ! Shares outstandin g ($400,000 - 0.14($1,000,000))(0.6) ! 80,000 - 40,000 ! $3.90 EBIT $400,000 TIE ! ! ! 2.9x Int Exp $140,000
13-35

Stock Price, with zero growth

D1 EPS DPS P0 ! ! ! ks ks - g ks


 

If all earnings are paid out as dividends, E(g) = 0. EPS = DPS To find the expected stock price (P0), we must find the appropriate ks at each of the debt levels discussed.
13-36

What effect does increasing debt have on the cost of equity for the firm?


If the level of debt increases, the riskiness of the firm increases. We have already observed the increase in the cost of debt. However, the riskiness of the firm s equity also increases, resulting in a higher ks.

13-37

The Hamada Equation



Because 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.
13-38

The Hamada Equation

L

U[

1 + (1 - T) (D/E)]

Suppose, the risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is 1.0. We were previously told that total assets were $2,000,000.
13-39

Calculating levered betas and costs of equity

If D = $250,
L L

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

ks = kRF + (kM kRF) L ks = 6.0% + (6.0%) 1.0857 ks = 12.51%

13-40

Table for calculating levered betas and costs of equity

Amount borrowed $ 0 250 500 750 1,000 D/A ratio 0.00% 12.50 25.00 37.50 50.00 D/E Levered ratio Beta 0.00% 1.00 14.29 33.33 60.00 100.00 1.09 1.20 1.36 1.60 ks 12.00% 12.51 13.20 14.16 15.60
13-41

Finding Optimal Capital Structure



The firm s optimal capital structure can be determined two ways:

 

Minimizes WACC. Maximizes stock price.

Both methods yield the same results.

13-42

Table for calculating WACC and determining the minimum WACC

Amount D/A ratio borrowed 0.00% $ 0 12.50 250 25.00 500 37.50 750 50.00 1,000 E/A ratio ks 12.51 13.20 14.16 15.60 kd (1 T) WACC 12.00% 11.55 11.25 11.44 12.00
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100.00% 12.00% 0.00% 87.50 75.00 62.50 50.00 4.80 5.40 6.90 8.40

* Amount borrowed expressed in terms of thousands of dollars

Table for determining the stock price maximizing capital structure

Amount Borrowed DPS ks P0

0 250,000 500,000 750,000

$3.00 3.26 3.55 3.77 3.90

12.00% 12.51 13.20 14.16 15.60

$25.00 26.03 26.89 26.59 25.00

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1,000,000

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%.

13-45

What is Campus Deli s optimal capital structure?



P0 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 is stock price, not E(EPS). The example shows that we can push up E(EPS) by using more debt, but the risk resulting from increased leverage more than offsets the benefit of higher E(EPS).
13-46

What if there were more/less business risk than originally estimated, how would the analysis be affected?


If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt. On the other hand, lower business risk would lead to an optimal capital structure with more debt.

13-47

Other factors to consider when establishing the firm s target capital structure
1. 2. 3. 4. 5. 6. 7.

Industry average debt ratio TIE ratios under different scenarios Lender/rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rate
13-48

How would these factors affect the target capital structure?

1. 2. 3. 4. 5. 6.

Sales stability? High operating leverage? Increase in the corporate tax rate? Increase in the personal tax rate? Increase in bankruptcy costs? Management spending lots of money on lavish perks?
13-49

Modigliani-Miller Irrelevance Theory

Value of Stock

MM result

Actual

No leverage
D/A
13-50

D1

D2

Modigliani-Miller Irrelevance Theory



The graph shows MM s tax benefit vs. bankruptcy cost theory. Logical, but doesn t tell whole capital structure story. Main problem-assumes investors have same information as managers.

13-51

Incorporating signaling effects



Signaling theory suggests firms should use less debt than MM suggest. This unused debt capacity helps avoid stock sales, which depress stock price because of signaling effects.
13-52

What are signaling effects in capital structure?



Assume:


Managers have better information about a firm s long-run value than outside investors. Managers act in the best interests of current stockholders.

13-53

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 common stock offering as a negative signal-managers think stock is overvalued.

13-54

Conclusions on Capital Structure



Need to make calculations as we did, but should also recognize inputs are guesstimates. As a result of imprecise numbers, capital structure decisions have a large judgmental content. We end up with capital structures varying widely among firms, even similar ones in same industry.
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