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Principles of Business Finance Fin 510

Principles of Business Finance Fin 510. Dr. Lawrence P. Shao Marshall University Spring 2002. CHAPTER 12 Capital Structure and Leverage. Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory. What is business risk?.

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Principles of Business Finance Fin 510

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  1. Principles of Business FinanceFin 510 Dr. Lawrence P. Shao Marshall University Spring 2002

  2. CHAPTER 12Capital Structure and Leverage • Business vs. financial risk • Optimal capital structure • Operating leverage • Capital structure theory

  3. 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

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

  5. 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.

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

  7. 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.

  8. 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.

  9. 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 use of debt (capital structure).

  10. 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

  11. 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.

  12. 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 U and L.

  13. 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

  14. Conclusions • Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. • BEP indicates the ability of the firm’s assets to generate (operating) income. • L has much wider ROE (EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

  15. 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.

  16. What are “signaling” effects in capital structure? • Managers have better information about a firm’s long-run value than outside investors. • Managers act in the best interests of current stockholders. Assumptions:

  17. Therefore, managers can be expected to: • 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.

  18. Estimated costs of debt and equity for Campus Deli (see p. 1): Amt. borrowed kd ks $0 10.0% 15.0% 250 10.0 15.5 500 11.0 16.5 750 13.0 18.0 1,000 16.0 20.0

  19. What’s WACC at D = 0, D = $500, D = $1,000? (Assets = $2,000,000) WACC = wdkd(1 - T) + wcks D = 0: WACC = 0 + 1.0(15%) = 15.0%. D = $500: WACC = .25(11%)(.6) + .75(16.5%) = 14.0%. D = $1,000: WACC = .50(16%)(.6) + .50(20.0%) = 14.8%.

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

  21. Value of Stock MM result Actual No leverage D/A 0 D1 D2

  22. The graph shows MM’s tax benefit vs. bankruptcy cost theory. • Signaling theory suggests firms should use less debt than MM suggest. • This unused debt capacity helps avoid stock sales, which depress P0 because of signaling effects.

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