CHAPTER 13 Capital Structure and Leverage

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

2. Key Concepts and Skills • Understand the effect of financial leverage on cash flows and cost of equity • Understand the impact of taxes and bankruptcy on capital structure choice

3. Part I Business Risk, Operating Leverage Financial Risk, Financial Leverage

4. 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 effect of financial leverage. Low risk Probability High risk 0 E(EBIT) EBIT

5. What determines business risk? • Uncertainty about demand (sales). • Uncertainty about output prices. • Uncertainty about costs. • Product, other types of liability. • Competition. • Operating leverage.

6. What is operating leverage, and how does it affect a firm’s business risk? • OL is defined as (%change in EBIT)/(%change in sales). • Operating leverage is high if the production requires higher fixed costs and low variable costs. • High fixed cost can leverage small increase in sales into high increase in EBIT.

7. Rev. Rev. $ $ } TC Profit TC FC FC QBE 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.

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

9. What is financial leverage?Financial risk? • Financial leverage is defined as (%change in NI) / (% change in EBIT) • High usage of debt can leverage small increase in EBIT into big increase in net income. • Financial leverage is high with high level of debt.

10. What is Financial risk? • Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. • More debt, more financial leverage, more financial risk. • More debt will concentrate business risk on stockholders because debt holders do not bear business risk (in case of no bankruptcy).

11. A summary

12. 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 40% tax rate 40% tax rate

13. 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

14. 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.

15. Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 6.0% 9.0% 12.0% BEP=EBIT/assets (basic earning power) FIRM L Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 4.8% 10.8% 16.8%

16. Risk and return for leveraged and unleveraged firms Expected Values: Firm UFirm L E(BEP) 15.0% = 15.0% E(ROE) 9.0% < 10.8% Risk Measures: Firm UFirm L σROE 2.12% < 4.24%

17. The Effect of Leverage on profitability • How does leverage affect the EPS and ROE of a firm? • When we increase the amount of debt financing, we increase the fixed interest expense • If we have a good year (BEP > kd), then we pay our fixed interest cost and we have more left over for our stockholders • If we have a bad year (BEP < kd), we still have to pay our fixed interest costs and we have less left over for our stockholders • Leverage amplifies the variation in both EPS and ROE

18. Conclusions • Basic earning power (BEP) is unaffected by financial leverage. • Firm L has higher expected ROE. • Firm L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

19. Quick Quiz • Explain the effect of leverage on expected ROE and risk

20. The degree of operating leverage is defined as: • a. % change in EBIT_____ • % change in Variable Cost • b. % change in EBIT • % change in Sales • c. % change in Sales • % change in EBIT • d. % change in EBIT_______________ • % change in contribution margin

21. Leverage will generally __________ shareholders' expected return and _________ their risk. • a. increase; decrease • b. decrease; increase • c. increase; increase • d. increase; do nothing to

22. If a 10 percent increase in sales causes EBIT to increase from $1mm to $1.50 mm, • what is its degree of operating leverage? • a. 3.6 • b. 4.2 • c. 4.7 • d. 5.0 • e. 5.5

23. Part II Capital Structure

24. Capital Restructuring • We are going to look at how changes in capital structure affect the value of the firm, all else equal • Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets • Increase leverage by issuing debt and repurchasing outstanding shares • Decrease leverage by issuing new shares and retiring outstanding debt

25. Choosing a Capital Structure • What is the primary goal of financial managers? • Maximize stockholder wealth • We want to choose the capital structure that will maximize stockholder wealth • We can maximize stockholder wealth by maximizing firm value (or equivalently minimizing WACC).

26. Optimal Capital Structure • Objective: Choose capital structure (mix of debt v. common equity) at which stock price is maximized. • Trades off higher ROE and EPS against higher risk. The tax-related benefits of leverage are offset by the debt’s risk-related costs.

27. What effect does increasing debt have on the cost of equity for the firm? • If the level of debt increases, the riskiness of the firm increases. • The cost of debt will increase because bond rating will deteriorates with higher debt level. • Moreover, the riskiness of the firm’s equity also increases, resulting in a higher ks.

28. The Hamada Equation • Not Required

29. Finding Optimal Capital Structure • The firm’s optimal capital structure can be determined two ways: • Minimizes WACC. • Maximizes stock price. • Both methods yield the same results.

30. 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 250K 500K 750K 1,000K D/A ratio 0.00% 12.50 25.00 37.50 50.00 WACC 12.00% 11.55 11.25 11.44 12.00

31. Table for determining the stock price maximizing capital structure Amount Borrowed EPS k P s 0 $ 0 $3.00 $25.00 12.00% 3.26 26.03 250K 12.51 3.55 26.89 500K 13.20 3.77 26.59 14.16 750K 15.60 3.90 25.00 1,000K

32. What is this firm’s optimal capital structure? • Stock price P0 is maximized ($26.89) at D/A = 25%, so optimal D/A = 25%. • EPS is maximized at 50%(EPS= $3.90), but primary interest is stock price, not E(EPS). • We could push up E(EPS) by using more debt, but the higher risk more than offsets the benefit of higher E(EPS).

33. Capital Structure Theory Under Five Special Cases • Case I – Assumptions • No corporate or personal taxes • No bankruptcy costs • Case II – Assumptions • Corporate taxes, but no personal taxes • No bankruptcy costs • Case III – Assumptions • Bankruptcy costs • Corporate taxes, but no personal taxes • Case IV – Assumptions • Managers have private information • Case V – Assumptions • Managers tend to waste firm money and not work hard.

34. Case I: Ignoring taxes and Bankruptcy Cost • The value of the firm is NOT affected by changes in the capital structure • The cash flows of the firm do not change, therefore value doesn’t change • The WACC of the firm is NOT affected by capital structure • In this case, capital structure does not matter.

35. Figure 13.3

36. Case II consider taxes but ignore bankruptcy cost • Interest expense is tax deductible • Therefore, when a firm adds debt, it reduces taxes, all else equal • The reduction in taxes increases the firm value. Other things equal, the less tax paid to the IRS, the better off the firm.

37. Case II consider taxes but ignore bankruptcy cost • The value of the firm increases by the present value of the annual interest tax shield • Value of a levered firm = value of an unlevered firm + PV of interest tax shield (VL = VU + DTC) • The WACC decreases as D/E increases because of the government subsidy on interest payments

39. Illustration of Case II

40. Case III consider both taxes and bankruptcy cost • Now we add bankruptcy costs • As the D/E ratio increases, the probability of bankruptcy increases. This increased probability will increase the expected bankruptcy costs

41. Bankruptcy Costs (financial distress cost) • Direct bankruptcy costs • Legal and administrative costs • Creditors will stop lending money to the firm. • Indirect bankruptcy costs • Larger than direct costs, but more difficult to measure and estimate • Also have lost sales, interrupted operations and loss of valuable employees

42. Case III • At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost • After this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

44. Case III (also called Modigliani-Miller static Theory) • The graph shows MM’s tax benefit vs. bankruptcy cost theory. • With more debt, initially firm will benefit from tax reduction. • With high debt, the threat of financial distress becomes severe. • As financial conditions weaken, expected costs of financial distress can be large enough to outweigh the tax shield of debt financing. • Optimal debt level is some trade-off point.

45. Conclusions • Case I – no taxes or bankruptcy costs • No optimal capital structure. Debt level does not matter. • Case II – corporate taxes but no bankruptcy costs • Optimal capital structure is 100% debt • More debt—more tax shield—higher firm value. • Case III – corporate taxes and bankruptcy costs • Optimal capital structure is part debt and part equity • Occurs where the marginal tax benefit from debt is just offset by the increase in bankruptcy costs

46. 3 cases

47. Case IV--Incorporating signaling effects • When managers know private information about the firm’s future than the market, there is a signaling effect. • Signaling theory suggests when firms issue new stocks, stock price will fall. Why?

48. What are “signaling” effects in capital structure? • Assume managers have better information about a firm’s long-run prospect than outside investors. They will issue stock if they think stock is overvalued; they will issue debt if they think stock is undervalued. • But outside investors are not stupid. They view a common stock offering as a negative signal--managers think stock is overvalued.

49. Case IV--Incorporating signaling effects • Conclusion: firms should maintain a lower debt level so that in case the firm needs to raise money in the future, it can issue debt rather than sell new stocks.

50. Case V—High debt constrains managers’ bad behavior • When would you more likely to go to a lavish restaurant? 1. After receiving a good salary. 2. After receiving a lot of credit card bills.