CHAPTER 13 Capital Structure and Leverage

1. CHAPTER 13Capital Structure and Leverage Business vs. financial risk Operating leverage Optimal capital structure Capital structure theory

2. Target Capital Structure • The mix of debt, preferred stock and common equity with which the firm plans to finance its investments (Weighted in WACC) • Capital structure policy involves a trade-off between risk and return : • Using more debt raise the riskiness of the firm’s earning stream • However, a higher debt ratio generally leads to a higher expected rate of return on equity.

3. The higher risk associated with greater debt tends to lower the stock’s price. • But, the higher expected rate of return make the stock more attractive to investors- which in turn ultimately increase the stock’s price. Therefore, there is an optimal capital structure. • The optimal capital structure is the one that strike a balance between risk and return so as to maximize the price of the stock

4. Factors Influence Capital Structure Decision • There are 4 primary factor that influence the capital structure decisions : • The firm’s business risk, or the riskiness that would be inherent in the firm’s operation if it used no debt. The greater the firm’s business risk, the lower the amount of debt that is optimal. • The firm’s tax position. Interest is tax deductive, which lowers the effective cost of debt [Kd(1-T)]. (If a firm’s income already is sheltered from taxes by accelerated depreciation, investment tax credit will not be as advantageous) • Financial flexibility, or the ability to raise capital on reasonable term under adverse conditions • Managerial conservatism or aggressiveness with regards to borrowing. Some manager are more aggressive than others, hence, some firm are inclined to use debt in effort to boost profits.

5. Business and Financial Risk • What is business risk-Variability or uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. * Firm uses no debt financing – s/h bear all the business risk Low risk Probability High risk 0 E(EBIT) EBIT

6. What determines business risk? • Uncertainty about demand (sales)/Demand Variability. • Uncertainty about output prices/Sales price Variability. • Uncertainty about costs/Input cost Variability. • Product, other types of liability. • Operating leverage.

7. What is operating leverage, and how does it affect a firm’s business risk? • As noted, business risk depends in Operating Leverage. • Operating leverage is the use of fixed costs rather than variable costs. (the extent to which fixed cost are used in a firm’s operation) • If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage. • The high degree of operating leverage, implies that a relatively small change in sales result in large change in ROE [NI/Equity] (even a small decline in sales can lead to a large decline in ROE), thus the higher a firm fixed cost, the greater the business risk . • Therefore, the higher the fixed cost indicate the higher the degree of operating leverage, thus the greater its business risk.

8. Rev. Rev. $ $ } TC Profit TC FC FC (B)QBE (A)QBE Sales Sales Effect of operating leverage • More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. • Plan A used less fixed cost, so its depreciation, maintenance or property taxes would low. However, the total operating cost line have steeper slope, indicating that variable cost per unit are higher. • Plan B used more fixed cost, less VC, thus the total operating cost line is less steeper. • The BE (Sales*Q –VC*Q –FC) point is higher under the plan B.Thus under this plan need high volume of sales in order to meet the fixed payment.-high risk

9. Using operating leverage • Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.(The higher E(EBIT) is sufficient to compensate for the higher risk) Low operating leverage Probability High operating leverage EBITL EBITH

10. What is financial leverage andFinancial risk? • Financial leverage is reflect the amount of debt used in the capital structure.(use of debt and preferred stock) • Debt carries a fixed obligation of interest payment. Thus,it add additional risk to the shareholder. • Therefore,when a firm decide to finance with debt (Financial leverage), it add additional risk to common shareholder which known as Financial risk.

11. 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. • The operating leverage effect the asset structure of the firm, while the financial leverage effect the debt-equity mix.

12. Business risk vs. Financial Risk Operating Leverage Financial Leverage

13. 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 UFirm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets $20,000 in equity $10,000 in equity 40% tax rate 40% tax rate Share outstd. 1000 Share outstd. 500

14. Firm U: Unleveraged Economy Bad Avg. 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

15. Firm L: Leveraged Economy Bad Avg. 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.

16. Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg Good BEP 10.0% 15.0% 20.0% EPS $1.20 $1.80 $2.40 ROE 6.0% 9.0% 12.0% TIE ∞ ∞ ∞ *BEP – EBIT/TA FIRM L Bad Avg Good BEP 10.0% 15.0% 20.0% EPS $0.96 $2.16 $3.36 ROE 4.8% 10.8% 16.8% TIE 1.67x 2.50x 3.30x

17. Risk and return for leveraged and unleveraged firms Expected Values: Firm UFirm L E(BEP) 15.0% 15.0% E(EPS) $1.82 $2.16 E(ROE) 9.0% 10.8% E(TIE) ∞ 2.5x Risk Measures: Firm UFirm L σROE 2.12% 4.24% CVROE 0.24 0.39

18. 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. • The EPS would be higher when debt is used. • Thus, when firm using leverage has both good and bad effects: higher leverage increase the EPS but also increase the risk.

19. 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.

20. Determine the Optimal Capital Structure • Optimal Capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. • Stock prices are positively related to expected dividend but negatively related to the required return on equity (P=D1/Ks-g) • Firm with higher earnings are able to pay higher dividends, so to the extent that higher debt level raise E(EPS), leverage work to increase the stock price. • However, high debt levels increase the firm risk, and that raise the cost of equity and work to reduce the stock price.

21. Determine Optimal Capital Structure • However, it is difficult to estimate how a given change in capital structure will effect stock price. • The capital structure that also maximized stock price is also the one that minimize the WACC. • Thus, it easier for the firm’s to predict how a capital structure change will effect WACC rather than the stock price. Many manager use changes in WACC to guide their capital structure decision.

22. Table for calculating WACC and determining the minimum 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 $ 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 * Amount borrowed expressed in terms of thousands of dollars

23. What effect does increasing debt have on the cost of equity for the firm? • At begin when the firm use low-cost debt, WACC decline • However, as the debt ratio increases, the riskiness of the firm increases, thus the cost of both debt and equity also rise, at first slowly then at faster and faster rate.

24. Stock Price, with zero growth • Recall that the capital structure that minimizes the WACC is also the capital structure that firm stock price. • Based on the example, the appropriate way to evaluate the effect of stock price is using the zero growth stock valuation model. • 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.

25. Table for determining the stock price maximizing capital structure 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

26. What debt ratio maximizes stock price and minimize WACC? • Maximum stock price (P0)= $26.89 at DPS=$3.55 and Ks=13.2% • Minimum WACC at 11.25% at D = $500,000, and D/A = 25%. (Remember DPS = EPS because payout = 100%) • Thus, the optimal capital structure is 25% debt and 75% equity

27. 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%.

28. Modigliani-Miller Irrelevance Theory Value of Stock MM result Actual No leverage D/A 0 D1 D2

29. 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.

30. Other factors to consider when establishing the firm’s target capital structure • 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

31. How would these factors affect the target capital structure? • 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?

32. 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.

33. 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.

34. 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.

35. 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.