Chapter 13

1. Chapter 13 Leverage and Capital Structure (or How Much Debt and How Much Fixed Costs Should a Company Have?)

2. Three Questions: • How does DEBT change the risk of a company’s stock? • What else changes the risk of a company’s stock? • Hint: The amount of fixed costs vs. variable costs! • How much debt should a company have?

3. How much does a Change in Revenue… Income Statement Review: Revenue = Sales - Fixed Costs - Variable Costs EBIT - Interest Expense - Tax Expense Net Income = Earnings (and EPS) Change NI and EPS? Hint: It’s a function of fixed operating costs and fixed financing costs!

4. Here are the questions: • How much does EBIT change when Sales changes? • How much does NI (and EPS)change when EBIT changes? • Because Variability of EPS causes variability in the stocks price • Measured by a high β %ΔSales %ΔEBIT %ΔNI • What are the sources of EPS variability? • Recall Salesvariability is a function of the product • What company characteristicscause changes in Sales to be magnified (LEVERED) and causegreater change in NI (and EPS) – and therefore greater β?

5. Determinants of Beta What causes variability of EPS (and therefore variable stock price)? • Cyclicality of Revenues • Not the same volatility of revenues (soap vs. drugs) • A function of the Nature of the product (soap vs. steel) • Operating Leverage • The mix of fixedand variableoperating costs • Sometimes the nature of the product • But could be in-source vs. out-source • Financial Leverage • The mix of fixedand variablefinancingcosts • The amount of Debt • Debt (which requires fixedinterest payments) relative to the amount of Equity (which gets what’s left)

6. Determinants of Beta • Cyclicality of Revenues • Nature of the product (soap vs yachts) • Operating Leverage • The mix of fixedand variableoperatingcosts • Financial Leverage • The mix of fixed and variablefinancingcosts (amount of debt) • All three have an impact on the variabilityof Net Income (or EPS) • EPS is the money available for the stockholders • Variability in EPS causes variability in stock returns • This effects Beta and the Expected Return: E(R) = Rf + β[E(RM) – Rf] The Point: For a given variability in sales (cyclicality), more fixed costs or more debtmeans more variability of NI and therefore higher risk and higher required return

7. Cyclicality of Revenues • Nature of the product: Does the company sell: • Consumer products • βP&G = 0.46 • Not very cyclical • Office Products and Supplies • βOffice Depot = 3.71 • Very cyclical

8. %DEBIT DOL = %D Sales • Degree of Operating Leverage • Mix of Fixedand Variablecosts • DOL increases as fixed costs rise relative to variable costs • DOL magnifies the effects of cyclicality on EBIT Formula:

9. Financial Leverage • The Mix of Debt and Equityfinancing • Function of fixed interest payments • Financial Leverage magnifies the effects of cyclicality on NI (and EPS) • Financial Leverage is measured by the usual leverage measures • See Chapter 3 • Measured by Debt/Equity • Or Debt/Value = Debt/(Equity + Debt)

10. %ΔSales  %ΔEBIT  %ΔNI • How does a 10% change in Sales change what the owners get (NI)? • If Sales change by 10%, how much does NIchange? • How do Operating Leverage and Financial Leverage change stock risk? More Fixed Costs and more Debt make the stock riskier!

11. Beta of the Firm’s Assets: βAssets • As opposed to the beta of the firms stock: βEquity • A business is defined by its assets • Truck companies have trucks • Biotech companies have labs • Consumer product companies have soap-making machines • A company’s beta for just its products • The Cyclicalityand its DOL(Fixed vs. Variable Costs) • Is called the Asset Beta (βAssets) • A company’s beta foreverything • Including its financial leverage (the mix of debt and equity) • Is called the Equity Beta (βEquity) • Equity Betais the CAPM Beta • The Beta we talked about in Chapter 11 • E(R) = Rf + β[E(RM) – Rf]

12. More about Financial Leverage • How does debt change Equity Beta? • Recall a Portfolio’s Beta is the weighted average beta of the components • So the Company’s Total Beta is the weighted average beta of the stocks and bonds issued to finance the company βPortfolio = E/V βEquity + D/V βDebt • But the Total Beta is really Asset Beta βAssets= E/V βEquity + D/V βDebt

13. Beta and Financial Leverage • We have this relationship: βAssets= E/V βEquity + D/V βDebt • But think about βDebt βDebt = Cov(RDebt,RMkt)/Var(RMkt) Covariance of debt and the market is close to zero βDebt≈ 0 βAssets= E/V βEquity + 0 • Since V = E + D: βAssets= E/(E + D) βEquity βEquity= βAssets(E + D)/E βEquity= βAssets(E/E + D/E) βEquity= βAssets (1 + D/E)

14. Example: • CMG is financed only with equity (no debt) • Called an “unlevered firm” • The beta of its stock is 0.72 (βEquity) • What is the beta of its assets given that it has no debt? βEquity= βAssets(1 + D/E)= βAssets (1 + 0/E)= βAssets (1) βEquity= βAssets= 0.72 • If CMG were to issue enough debt to buy back 20% of its outstanding stock, what would happen to the beta of the remaining stock? D/E = 0.20/0.80 = 0.25 βEquity = βAssets(1 + D/E) = 0.72(1 + 0.25) = 0.90 The market risk of CMG (βEquity) increases by 25% Solely from a financing decision!

15. One More Important Point: • A company can be thought of as the sum of its individual products or projects • Each product or project has its own NPV • The valueof that product or project is its NPV • So the value of a firm is the sum of each product or project’s NPV So how do DOL and Debt effect value?

16. Recap: Determinants of Equity Beta And the effect of Debt on Risk • Cyclical nature of the product • Degree of operating Leverage • DOL = %ΔEBIT/%ΔSales • Is this a business decision? Cyclicality and DOL determine βAssets • Financial Leverage (amount of debt) • βEquity= βAssets (1 + D/E) Given βAssets, Debt determines βEquity

17. The Progression (Derivation): Firm Value is the sum of the NPVs the projects or products: • Value = NPV1 + NPV2 + NPV3 + … For each projects or products, NPV is the PV of CFs less the Cost: • NPV = CF0 + CF1/(1+R) +…+CFN/(1+R)N WACC is the R for each of the company’s projects: • WACC = WE RE+ WD RD(1 - T) RD is the YTM on existing debt REis from the CAPM and is a function of βE • RE= Rf + βE[E(RM) – Rf] βE is a function of three things: • The Cyclicality of the product (steel vs. soap) • The Degree of Operating Leverage (FC vs. VC) • Financial Leverage (the amount of debt or fixed vs. variable financing) Cyclicality and DOL give the Asset Beta: (βA) Debt gives the Equity Beta: βE • βE= βA(1 + D/E)

18. How Does Debt Change Company Value? • Cyclicality of the product and the method of production (DOL) gives Asset Beta (βA) • Given βA, the Amount of Debt gives the Equity Beta (βE) • βE= βA(1 + D/E) • Given the βE, the CAPM gives the cost of equity capital (RE) • RE= Rf + βE[E(RM) – Rf] • Given βA, Amount of Debt gives the cost of debt capital (RD) • The Amount of Debt, RE and RD give the WACC • WACC = E/V RE + D/V RD(1 - T) • The WACC (which is R) gives the NPV for each project or product • NPV = CF0 + CF1/(1+R) +…+ CFN/(1+R)N • The sum of the NPVs is the Value of the company. So how does the Amount of Debt affect Value?

19. How Does Debt Change Company Value? • WACC is the discount rate for the NPVs • Company Value is the sum of the NPVs So the lower the WACC… The greater the Value!

20. How Does Debt Change WACC and Value? • WACC = WERE + WDRD(1 - T) • In generally, RD < RE • Why? • And RD(1-T) < RE • So more Debt  Lower WACC  HIGHER VALUE But adding Debt Increases βE • βE = βA(1 + D/E) • Increasing βE increases RE • RE= Rf + βE[E(RM) – Rf] • So more Debt Higher WACC  LOWER VALUE Which Dominates?

21. So How Much Debt? • Lots of math which we will skip! Here is the general idea: • Start with no debt • Adding a little debt can Lower WACCand Increase Value • Lower RD and tax benefit offsets higher RE • As more debt is added • RD Increases • But still lower than RE • So WACC is still lower and value increases • As more and more debt is added • RD (and after tax RD) is greater that RE • WACC increases and value decrease

22. Determinants of the Amount of Debt • Volatility of EBIT • Cyclicality of the product • DOL (FC vs. VC - Method of Production) • Measured by βAssets • Assets Needed by the business • High vs. Low capital requirements • Airlines – high debt • Software – low debt • So low volatility, high capital industries tend to have more debt • Also the nature of the assets: Are the assets easily marketable?

23. Debt Levels for different Industries • Ratio of Debt to Total Capital (%) = D/V = D/(E + D) • Ratio of Debt to Equity (%) = D/E

24. Modigliani & Miller • These theories, formulas and propositions were developed by Franco Modigliani and Merton Miller MM I (without Taxes) • “Changing how the pie is sliced does not make it any bigger.” • A firm’s total value is not affected by its capital structure: VL= VU MM II (without Taxes) • Changing capital structure does increase equity risk and equity return but doesnot change the WACC RE= RA + (RA – RD)D/E MM I (with Taxes): • With taxes, adding debt does increase firm value. Firm value does depend on its capital structure: VL = VU + TC x D MM II (with Taxes): • With taxes Leverage increases equity risk and equity return and does decrease WACC. RE= RA + (RA – RD)(1 – TC)D/E

25. Corporate Dividend Policy Main Results: • The price of a stock decreases by the amount of a cash dividend • But, what if instead of paying a dividend, Cash is used to repurchase shares? • Then the share price increases by the amount that would have been paid

26. Example: • Company has Earnings (NI) = $500,000 • Number of Shares = 100,000 • EPS = $5.00 • Assume PE Ratio = 20x • PE accounts for Current Earnings, Risk of Earnings and Growth • Share Price for the current EPS = $5.00 x 20 = $100 • Company also has $100,000 in Excess Cash • Excess Cash per Share = $100,000/100,000 = $1 • Total Share Value = $100 + $1 = $101 • Two Choices to pay Excess Cash to Shareholders: • Pay $1.00 per share dividend • Repurchase $100,000/$101 = 990 Shares

27. Pay $1.00 per share dividend • Share Value before Dividend = $101 • EPS = $5.00 • PE Ratio = 20x • Share Price given Earnings = $5 x 20 = $100 • Excess Cash per Share = $100,000/100,000 = $1 • Share price = $101 • After Dividend • Still have same current and expected earnings ($500,000) • Same number of Shares so EPS = $500,000/100,000 = $5 • Same PE Ratio = 20 • Paying excess cash does not change NPVGO • Share Value = $5 x 20 = $100 • Plus $1 in cash All Shareholders have = $100 share + $1 cash

28. Repurchase $100,000/$101 = 990 Shares • Share Value before Repurchase = $101 • EPS = $5.00 • PE Ratio = 20x • Share Price given Earnings = $5 x 20 = $100 • Excess Cash per Share = $100,000/100,000 = $1 • Share price = $101 • After Repurchase • Still have same current and expected earnings ($500,000) • Fewer Shares: 100,000 – 990 = 99,010 shares • So higher EPS = $500,000/99,010 = $5.05 • Same PE Ratio = 20 • Paying out Excess Cash does not change NPVGO • Share Value = $5.05 x 20 = $101 990 Shareholders have $101 in cash 99,010 Shareholders have $101 share

29. Price Drop from Cash Dividend – MSFT On November 15, 2004, MSFT paid a $3.08 dividend