Capital Structure and Leverage

Background • Capital structure refers to the mix of a firm’s debt and equity • Preferred stock is assumed to be part of a firm’s debt • Financial leverage refers to using borrowed money to enhance the effectiveness of invested equity • Financial leverage of 10% means the firm’s capital structure contains 10% debt and 90% equity

The Central Issue • Can the use of debt increase the value of a firm’s equity • Specifically, the firm’s stock price • Under certain conditions changing leverage increases stock price • An optimal capital structure maximizes stock price • The relationship between capital structure and stock price is not precise nor fully understood

Risk in the Context of Leverage • Leverage influences stock price • Alters the risk/return relationship in an equity investment • Measures of performance • Operating income (AKA: EBIT or Earnings Before Interest and Taxes) • Unaffected by leverage because it is calculated prior to the deduction for interest • Return on Equity (ROE) is Earnings after Taxes  Stockholders’ Equity • Earnings per Share (EPS) is Earnings after Taxes  number of shares • Investors regard EPS as an important indicator of future profitability

Risk in the Context of Leverage • Redefining Risk for Leverage-Related Issues • Leverage-related risk is variation in ROE and EPS • Business risk—variation in EBIT • Financial risk—additional variation in ROE and EPS brought about by financial leverage

Leverage and Risk—Two Kinds of Each • Relates to a company’s cost structure • Involves relative use of fixed and variable costs • Operating leverage has an influence on a firm’s business risk

Financial Leverage • Under certain conditions financial leverage can improve a firm’s ROE and EPS • However, at other times it may worsen EPS and ROE

Financial Leverage • Return on Capital Employed (ROCE) • Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE • When the ROCE exceeds the after-tax cost of debt, more leverage improves ROE and EPS • When ROCE is less than the after-tax cost of debt, more leverage makes ROE and EPS worse

Financial Leverage and Financial Risk • Financial leverage is a two-edged sword • Multiplies good results into great results • Multiples bad results into terrible results • ROE and EPS for leveraged firms experience more variation • Financial risk is the increased variability in financial results that comes from additional leverage

Putting the Ideas Together—The Effect on Stock Price • Leverage enhances performance while it adds risk, pushing stock prices in opposite directions • Enhanced performance makes the expected return on stock higher, driving up the stock’s price • The increased risk drives down the stock’s price • Which effect dominates, and when?

Real Investor Behavior and the Optimal Capital Structure • When leverage is low an increase in debt has a positive effect on investors • At high debt levels concerns about risk dominate and adding more debt decreases the stock’s price • As leverage increase its effect goes from positive to negative, which results in an optimum capital structure

Finding the Optimum—A Practical Problem • There is no way to determine the exact optimum amount of leverage for a particular company at a particular time • Appropriate level tends to vary according to • Nature of a company’s business • If firm has high business risk it should use less leverage • Economic climate • If the outlook is poor investors are likely to be more sensitive to risk • As a practical matter the optimum capital structure cannot be precisely located

The Target Capital Structure • A firm’s target capital structure is management’s estimate of the optimal capital structure • An approximation or best guess as to the amount of debt that will maximize the firm’s stock price

The Effect of Leverage When Stocks Aren’t Trading at Book Value • We’ve assumed that changes in leverage involve purchasing equity at book value • If this is not the case, things are more complex • Repurchasing stock at prices other than book value will have the same general impact on ROE, but not necessarily for EPS • However the important point is the direction of the stock price change, not the exact amount

The Degree of Financial Leverage (DFL)—A Measurement • Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS • The degree of financial leverage (DFL) relates relative changes in EBIT to relative changes in EPS Somewhat tedious • An easier method of calculating DFL is:

EBIT-EPS Analysis • Managers need a way to quantify and analyze the tradeoffs between risk and results when changing leverage levels • Provides a graphical portrayal of the trade-off • Involves graphing EPS as a function of EBIT for each leverage level • Portrays the results of leverage and helps to decide how much to use

Operating Leverage • Terminology and Definitions • Risk in Operations—Business Risk • Variation in EBIT • Fixed and Variable Costs and Cost Structure • Fixed costs don’t change with the level of sales, while variable costs do • Fixed costs include rent, depreciation, utilities, salaries • Variable costs include direct labor, direct materials, sales commissions • The mix of fixed and variable costs in a firm’s operations is its cost structure • Operating Leverage Defined • Refers to the amount of fixed costs in the cost structure

Breakeven Analysis • Used to determine the level of activity a firm must achieve to stay in business in the long run • Shows the mix of fixed and variable cost and the volume required for zero profit/loss • Profit/loss generally measured by EBIT

Breakeven Analysis • Breakeven Diagrams • Breakeven occurs at the intersection of revenue and total cost • Represents the level of sales at which revenue equals cost

Breakeven Analysis • The Contribution Margin • Every sale makes a contribution of the difference between price (P) and variable cost (V) • Ct = P – V • Can be expressed as a percentage of revenue • Known as the contribution margin (CM) • CM = (P – V)  P

Breakeven Analysis • Calculating the Breakeven Sales Level • EBIT is revenue minus cost, or • EBIT = PQ – VQ – FC • Breakeven occurs when revenue (PQ) equals total cost (VQ + FC), or • QB/E = FC (P – V) • Breakeven tells us how many units have to be sold to contribute enough money to pay for fixed costs • Can also be expressed in terms of dollar sales • SB/E = P(FC)  (P – V) or FC  CM

The Effect of Operating Leverage • As volume moves away from breakeven, profit or loss increases faster with more operating leverage • The Risk Effect • More operating leverage leads to larger variations in EBIT, or business risk • The Effect on Expected EBIT • Thus, when a firm is operating above breakeven, more operating leverage implies higher operating profit • If a firm is relatively sure of its operating level, it is in the firm’s best interests to trade variable costs for fixed cost (assuming the firm is operating above breakeven)

The Degree of Operating Leverage (DOL)—A Measurement • Operating leverage amplifies changes in sales volume into larger changes in EBIT • DOL relates relative changes in volume (Q) to relative changes in EBIT

Comparing Operating and Financial Leverage • Financial and operating leverage are similar in that both can enhance results while increasing variation • Financial leverage involves substituting debt for equity in the firm’s capital structure • Operating leverage involves substituting fixed costs for variable costs in the firm’s cost structure • Both methods involve substituting fixed cash outflows for variable cash outflows • Both kinds of leverage make their respective risks larger as the levels of leverage increase • However, financial risk is non-existent if debt is not present, while business risk would still exist even if no operating leverage existed • Financial leverage is more controllable than operating leverage

The Compounding Effect of Operating and Financial Leverage • The effects of financial and operating leverage compound one another • Changes in sales are amplified by operating leverage into larger relative changes in EBIT • Which in turn are amplified into still larger relative changes in ROE and EPS by financial leverage • The effect is multiplicative, not additive • Thus, fairly modest changes in sales can lead to dramatic changes in ROE and EPS • The combined effect can be measured using degree of total leverage (DTL) • DTL = DOL × DFL

Capital Structure Theory • Does capital structure affect stock price and the market value of the firm? • If so, is there an optimal structure that maximizes either or both? • Results indicate that capital structure does impact stock prices but there’s no way to determine the optimal structure with any precision

Background—The Value of the Firm • Notation • Vd = market value of the firm’s debt • Ve = market value of the firm’s stock or equity • Vf = market value of the firm in total • Vf = Vd + Ve • Investors’ returns on the firm’s securities will be • Kd = return on an investment in debt • Ke = return on an investment in equity • Theory begins by assuming a world without taxes or transaction costs, so investors’ returns are exactly component capital costs • Ka = average cost of capital

Background—The Value of the Firm • Value is Based on Cash Flow Which Comes from Income • Earnings ultimately determine value because all cash flows paid to investors come from earnings • Dividends and interest payments are both perpetuities • The firm’s market value is the sum of their present values Returns drive value in an inverse relationship.

The Early Theory by Modigliani and Miller (MM) • Restrictive Assumptions in the Original Model • In 1958 MM published their first paper on capital structure • Included numerous restrictions such as • No income taxes • Securities trade in perfectly efficient capital markets with no transaction costs • No costs to bankruptcy • Investors and companies can borrow as much as they want at the same rate

The Early Theory by Modigliani and Miller (MM) • The Assumptions and Reality • Realistically income taxes exist • Realistically the costs of bankruptcy are quite large • Realistically individuals cannot borrow at the same rate as companies and interest rates usually rise as more money is borrowed

The Early Theory by Modigliani and Miller (MM) • The Result • Under MM’s initial set of restrictions, value is independent of capital structure • As cheaper debt is added the cost of equity increases because of increased risk • However the weight of the more expensive equity is decreasing while the weight of the cheaper debt is increasing, leading to a constant weighted average cost of capital

The Early Theory by Modigliani and Miller (MM) • The Arbitrage Concept • Arbitrage means making a profit by buying and selling the same thing at the same time in two different markets • MM proposed that arbitrage by equity investors would hold the value of the firm constant as debt levels changed • Equity investors could sell shares in a leveraged firm and buy shares in an unleveraged firm by borrowing money on their own • Interpreting the Result • The MM result implies that leverage affects value because of market imperfections • Such as taxes and transaction costs (including bankruptcy)

Relaxing the Assumptions—More Insights • Financing and the U.S. Tax System • Tax system favors debt financing over equity financing • Interest expense on debt is tax deductible while dividends on stock are not

Relaxing the Assumptions—More Insights • Including Corporate Taxes in the MM Theory • When taxes exist operating income (OI) must be split between investors and the government • This lowers the firm’s value compared to what it would be if no taxes existed • Amount of reduction depends on the firm’s use of leverage • Use of debt reduces taxable income which reduces taxes

Including Corporate Taxes in the MM Theory • In the MM model with taxes interest provides a tax shield that reduces government’s share of the firm’s earnings • When a firm uses debt financing the government’s take is reduced by (corporate tax rate × interest expense) every year • Present value of tax shield = (corporate tax rate × interest expense)  kd • Since interest is the amount of debt (B) times the interest rate on the debt, the above equation can be written as

Including Corporate Taxes in the MM Theory • Having debt in the capital structure increases a firm’s value by the magnitude of that debt times the tax rate • The benefit of debt accrues entirely to stockholders because bond returns are fixed

Including Bankruptcy Costs in the MM Theory • As leverage increases past a certain point, investors begin raising their required rates of return • The probability of bankruptcy failure increases • Eventually the weighted average cost of capital will be minimized and the firm value will be maximized • The MM model with taxes and bankruptcy costs concludes that an optimal capital structure exists

An Insight into Mergers and Acquisitions • In many mergers one company buys the stock of another company called the target • The buying company needs to buy shares of the target company at a premium over the current market price • Paying twice the current market value for a target firm is not unheard of • Why do companies do this?

An Insight into Mergers and Acquisitions • One argument is that target firms may be underutilizing their debt capacity • Thus, a restructuring of capital may raise the value of the target firm • Acquiring firms often raise the cash needed to buy the target firm’s shares with debt • The resulting merged business ends up with more debt than the individual firms had before the merger • May theoretically be justified if adding debt adds value

Capital Structure and Leverage