Chapter 12

1. Chapter 12

2. Determining the Financing Mix

3. Determining the Financing Mix • Operating Leverage • Financial Leverage • Capital Structure

4. 2 concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.

5. Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

6. EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

7. FIRM EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

8. FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

9. Stock- holders FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

10. Stock- holders FIRM EPS EBIT Business Risk • The variability or uncertainty of a firm’s operating income (EBIT).

11. Business Risk Affected by: • Sales volume variability • Competition • Cost variability • Product diversification • Product demand • Operating Leverage

12. Operating Leverage • The use of fixed operating costs as opposed to variable operating costs. • A firm with relatively high fixed operating costs will experience more variable operating income if sales change.

13. Financial Risk • The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

14. Stock- holders FIRM EPS EBIT Financial Risk • The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

15. Stock- holders FIRM EPS EBIT Financial Risk • The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.

16. Financial Leverage • The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

17. With high operating leverage, an increase in sales produces a relatively larger increase in operating income.

18. Debt Common Equity Preferred Capital Structure How do we want to finance our firm’s assets?

19. Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity

20. Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity

21. Balance Sheet Current Current AssetsLiabilities Debt and FixedPreferred Assets Shareholders’ Equity Financial Structure

22. Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity

23. Balance Sheet Current Current Assets Liabilities Debtand Fixed Preferred Assets Shareholders’ Equity Capital Structure

24. Why is Capital Structure Important? • 1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments. • 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. • 3) The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.

25. What is the Optimal Capital Structure? • In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. • This is known as the Modigliani-Miller hypothesis, or the Independence Hypothesis: firm value is independent of capital structure.

26. Modigliani-Miller Hypothesis • Firm value does not depend on capital structure.

27. Modigliani-Miller Hypothesis Cost of Capital kc = cost of equity kd = cost of debt ko = cost of capital . kc 0% debt financial leverage 100%debt

28. Cost of Capital kc kd kd 0% debt financial leverage 100%debt Modigliani-Miller Hypothesis .

29. Cost of Capital kc kd kd 0% debt financial leverage 100%debt Modigliani-Miller Hypothesis .

30. Cost of Capital kc kd kd 0% debt financial leverage 100%debt Modigliani-Miller Hypothesis Increasing leverage causes the cost of equity to rise.

31. Increasing leverage causes the cost of equity to rise. kc Cost of Capital kc kd kd 0% debt financial leverage 100%debt Modigliani-Miller Hypothesis

32. Increasing leverage causes the cost of equity to rise. kc Cost of Capital What will be the net effect on the overall cost of capital? kc kd kd 0% debt financial leverage 100%debt Modigliani-Miller Hypothesis

33. Increasing leverage causes the cost of equity to rise. kc Cost of Capital What will be the net effect on the overall cost of capital? kc kd kd 0% debt financial leverage 100%debt Modigliani-Miller Hypothesis

34. kc Cost of Capital ko kd 0% debt financial leverage 100%debt Modigliani-Miller Hypothesis kc kd

35. Modigliani-Miller Hypothesis • In a “perfect markets” environment, capital structure is irrelevant. • In other words, changes in capital structure do not affect firm value.

36. 2) Moderate Position • The previous hypothesis examines capital structure in a “perfect market.” • The moderate position examines capital structure under more realistic conditions. • For example, what happens if we include corporate taxes?

37. Remember this example?Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

38. Remember this example?Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

39. kc kd Moderate Position kc Cost of Capital kd financial leverage

40. kc kd Moderate Position Even if the cost of equity rises as leverage increases, the cost of debt is very low... kc Cost of Capital kd financial leverage

41. kc kd Moderate Position Even if the cost of equity rises as leverage increases, the cost of debt is very low... kc Cost of Capital because of the tax benefit associated with debt financing. kd financial leverage

42. kc kd Moderate Position The low cost of debt reduces the cost of capital. kc Cost of Capital kd financial leverage

43. kc kd Moderate Position The low cost of debt reduces the cost of capital. kc Cost of Capital ko kd financial leverage

44. Moderate Position • So, what does the tax benefit of debt financing mean for the value of the firm? • The more debt financing used, the greater the tax benefit, and the greater the value of the firm. • So, this would mean that all firms should be financed with 100% debt, right? • Why are firms not financed with 100% debt?

45. Why is 100% Debt not Optimal? Bankruptcy costs: costs of financial distress. • Financing becomes difficult to get. • Customers leave due to uncertainty. • Possible restructuring or liquidation costs if bankruptcy occurs.

46. Why is 100% Debt not Optimal? Agency costs: costs associated with protecting bondholders. • Bondholders (principals) lend money to the firm and expect it to be invested wisely. • Stockholders own the firm and elect the board and hire managers (agents). • Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases.

47. Cost of Capital kc kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

48. Cost of Capital kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

49. Cost of Capital kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

50. Cost of Capital kc kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs