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Capital Structure and Leverage

Capital Structure and Leverage. Business vs. financial risk Operating leverage Financial leverage Optimal capital structure Capital structure theory. What is business risk?. Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?

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Capital Structure and Leverage

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  1. Capital Structure and Leverage • Business vs. financial risk • Operating leverage • Financial leverage • Optimal capital structure • Capital structure theory

  2. What is business risk? • Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? • Note that business risk does not include financing effects. Probability Low risk High risk 0 E(EBIT) EBIT

  3. Business risk is affected primarily by: • Uncertainty about demand (sales). • Uncertainty about output prices. • Uncertainty about costs. • Product, other types of liability. • Operating leverage.

  4. 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.

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

  6. Operating Breakeven : Amount of sales that leads to zero EBIT EBIT = P*Q-V*Q-F=0 QBE=F/(P-V) Degree of Operating Leverage (DOL) DOL= % change in EBIT/%change in SALES Operating Leverage

  7. EBIT =(P-V)Q-F dEBIT/dQ=P-V DOL= dEBIT/dQ * Q/EBIT = Q*(P-V) /[Q*(P-V) –F] Operating Leverage

  8. Probability Low operating leverage High operating leverage EBITL EBITH Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.

  9. 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.

  10. Financial Leverage DFL= % change in EPS/%change in EBIT EPS=NI /N=(EBIT-I)(1-T) /N N:number of common stock outstanding dEPS /dEBIT=(1-T) /N EBIT /EPS=EBIT /[(EBIT-I)(1-T) /N] DFL=EBIT /(EBIT-I)

  11. Financial Breakeven Amount of EBIT that leads to zero EPS EPS =(EBIT-I)(1-T) /N=0 EBITBE=I

  12. 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 on stockholders.

  13. Consider 2 Hypothetical Firms Firm UFirm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to the use of debt (capital structure).

  14. Capial Structures of the Two Firms A=$20,000=D+E for both firms EU=$20,000 DU=$0 EL=$10,000 DL=$10,000

  15. Firm U: Unleveraged Economy BadAvg.Good Prob. 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest 0 0 0 EBT $2,000 $3,000 $4,000 Taxes (40%) 800 1,200 1,600 NI $1,200 $1,800 $2,400

  16. Firm L: Leveraged Economy BadAvg.Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 *Same as for Firm U.

  17. 8 8 8 Firm U Bad Avg. Good BEP* 10.0% 15.0% 20.0% ROE 6.0% 9.0% 12.0% TIE Firm L Bad Avg. Good BEP* 10.0% 15.0% 20.0% ROE 4.8% 10.8% 16.8% TIE 1.67x 2.5x 3.3x *BEP same for Firms U and L.

  18. Expected Values: E(BEP) 15.0% 15.0% E(ROE) 9.0% 10.8% E(TIE) 2.5x Risk Measures: sROE 2.12% 4.24% CVROE 0.24 0.39 U L 8

  19. For leverage to raise ROE, must have BEP > kd (avg. and good states). • 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.

  20. NI=[EBIT-Dkd](1-T) A=D+E ROE=NI /(A-D)=[EBIT-Dkd](1-T) /(A-D) =[EBIT/A-(D/A)kd](1-T) /(1-D/A) =[BEP-DR kd](1-T) /(1-DR) where DR=D/A

  21. dROE/dDR=[(1-T)(BEP-kd)] / (1-DR)2 (1-T)(BEP-kd)>0 implies BEP-kd>0 or BEP>kd q.e.d.

  22. Conclusions • Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. • L has higher expected ROE because BEP > kd with probability of 0.75. • L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

  23. If debt increases, TIE falls. TIE = EBIT I EBIT is constant (unaffected by use of debt), and since I = kdD, as D increases, TIE must fall.

  24. 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 tax-related 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.

  25. Describe the sequence of events in a recapitalization. • Consider another firm, Hannibal Inc., which announces a recapitalization. • New debt is issued. • Proceeds are used to repurchase stock. Debt issued Price per share Shares bought = .

  26. Cost of debt at different debt levels after recapitalization Amount D/A D/E Bond borrowed ratio ratio rating kd K$ 0 0 0 -- -- 250 0.125 0.1429 AA 8% 500 0.250 0.3333 A 9% 750 0.375 0.6000 BBB 11.5% 1,000 0.500 1.0000 BB 14%

  27. Why does the bond rating and cost of debt depend upon the amount borrowed? As the firm borrows more money, the firm increases its risk causing the firm’s bond rating to decrease, and its cost of debt to increase.

  28. (EBIT – kdD)(1 – T) Shares outstanding What would the earnings per share beif Hannibal recapitalized and used these amounts of debt: $0, $250,000, $500,000, $750,000? Assume EBIT = $400,000, T = 40%, and shares can be repurchased at P0 = $25.Nu=80,000 D = 0: EPS0 = = = $3.00. ($400,000)(0.6) 80,000

  29. $250,000 $25 Sharesrepurchased = = 10,000. [$400 – 0.08($250)](0.6) 80 – 10 EPS1 = = $3.26. EBIT I $400 $20 TIE = = = 20×. D = $250K, kd = 8%.

  30. $500 $25 Sharesrepurchased = = 20. [$400 – 0.09($500)](0.6) 80 – 20 EPS2 = = $3.55. EBIT I $400 $45 TIE = = = 8.9×. D = $500K, kd = 9%.

  31. $750 $25 Sharesrepurchased = = 30. [$400 – 0.115($750)](0.6) 80 – 30 EPS3 = = $3.77. D = $750K, kd = 11.5%. EBIT I $400 $86.25 TIE = = = 4.6×.

  32. $1,000 $25 Sharesrepurchased = = 40. [$400 – 0.14($1,000)](0.6) 80 – 40 EPS4 = = $3.90. EBIT I $400 $140 TIE = = = 2.9×. D = $1,000K, kd = 14%.

  33. Stock Price (Zero Growth) D1ks – g EPSks DPSks P0 = = = . If payout = 100%, then EPS = DPS and E(g) = 0. We just calculated EPS = DPS. To find the expected stock price (P0), we must find the appropriate ks at each of the debt levels discussed.

  34. What effect would 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.

  35. 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.

  36. The Hamada Equation (cont’d) bL = bU [1 + (1 – T)(D/E)]. 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(80K*$25).

  37. Calculating Levered Betas D = $250K ks = kRF + (kM – kRF)bL bL = bU[1 + (1 – T)(D/E)] bL = 1.0[1 + (1 – 0.4)($250/$1,750)] bL = 1.0[1 + (0.6)(0.1429)] bL = 1.0857. ks = kRF + (kM – kRF)bL ks = 6.0%+ (6.0%)1.0857 = 12.51%.

  38. Table for Calculating Levered Betas ks 12.00% 12.51 13.20 14.16 15.60 Amount borrowed K$ 0 250 500 750 1,000 D/A ratio 0.00% 12.50 25.00 37.50 50.00 D/E ratio 0.00% 14.29 33.33 60.00 100.00 Levered Beta 1.00 1.09 1.20 1.36 1.60

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

  40. P0 = DPS/ks Amount Borrowed DPS k P s 0 $ 0 $3.00 $25.00 12.00% 3.26 26.03 250,000 12.51 3.55 26.89* 500,000 13.20 3.77 26.59 14.16 750,000 15.60 3.90 25.00 1,000,000 *Maximum: Since D = $500,000 and assets = $2,000,000, optimal D/A = 25%.

  41. What debt ratio maximizes EPS? See preceding slide. Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%. Risk is too high at D/A = 50%.

  42. What is Hannibal’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).

  43. 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).

  44. % ks 15 WACC kd(1 – T) D/A 0 .25 .50 .75 $ P0 EPS D/A .25 .50

  45. If it were discovered that the firm had 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 of more debt.

  46. Total risk Total risk is the combination of business risk and financial risk. Degree of total leverage: DTL= DOL* DFL =% change in EPS/%change in SALES If DOL then DFL should  to keep DTL constant

  47. Total Breakeven The amount of sales that leads to zero EPS [(P-V)Q-F-I](1-T) /N=0 QBE=(F-I)/(P-V)

  48. Other factors to consider when establishing the firm’s target capital structure? 1. Industry average debt ratio 2. TIE ratios under different scenarios 3. Lender/rating agency attitudes 4. Reserve borrowing capacity 5. Effects of financing on control 6. Asset structure 7. Expected tax rate

  49. How would these factors affect the Target Capital Structure? 1. Sales stability? 2. High operating leverage? 3. Increase in the corporate tax rate? 4. Increase in the personal tax rate? 5. Increase in bankruptcy costs? 6. Management spending lots of money on lavish perks?

  50. Long-term Debt Ratios for Selected Industries IndustryLong-Term Debt Ratio Pharmaceuticals 20.00% Computers 25.93 Steel 39.76 Aerospace 43.18 Airlines 56.33 Utilities 56.52 Source: Dow Jones News Retrieval. Data collected through December 17, 1999.

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