Copyright © 1999 Addison Wesley Longman CHAPTER CHAPTER 13 The Theory of Capital Structure Copyright © 1999 Addison Wesley Longman 1

Objectives Why leverage affects shareholder wealth Different types of leverage Break even analysis Theories of capital structure EBIT–EPS analysis

A Firm’s Capital The long term funds it uses to finance its investments. A firm’s capital structure is the mixture of debt, equity, and preferred stock it uses to supply this capital.

Adding Debt Adding debt to the capital structure increases the volatility of the cash flows, which means the firm’s risk is increased.

Table 13.1 Effect of Leverage on EPS and ROE All Equity 50% Equity Assets $1,000 $1,000 Debt 0 –$500 Equity $1,000 $500 Debt–equity ratio 0% 100% Shares outstanding 100 50 Share price $10 $10 Interest rate on debt NA 10%

Table 13.1 Panel A: All Equity Financing Weak Most Likely Strong Sales Sales Sales EBIT $25 $200 $400 Less interest –0 –0 –0 Net income $25 $200 $400 EPS $0.25 $2 $4 ROE 2.5% 20% 40%

Table 13.1 Panel B: 50% Debt Financing Weak Most Likely Strong Sales Sales Sales EBIT $25 $200 $400 Less interest –$50 –$50 –$50 Net income ($25) $150 $350 EPS ($0.50) $3.00 $7.00 ROE (5%) 30% 70%

An Alternative Way to View the Effect of Leverage: Graph EBIT against EPS for different levels of debt. Adding debt increases the slope of the line.

FIGURE 13.1 EPS–EBIT Analysis 2

Types of Leverage So far we have focused on the effect of debt. This is called financial leverage. The degree of financial leverage is computed as: DFL = Percent change in EPS Percent change in EBIT

Operating Leverage Measures the amount of fixed cost a firm employs. Typically fixed cost imply fixed assets. DOL = Percent change in EBIT Percent change in sales

DOL vs. DFL The degree of total leverage deals with the entire balance sheet. The DOL deals with the top half of the income statement while the DFL deals with the bottom.

DTL DTL = Percent change in EPS Percent change in sales

Table 13.2 Financial Leverage Unit sales 50 100 150 Sales $50.00 $100.00 $150.00 Less variable cost –$25.00 –$50.00 –$75.00 DOL Less fixed cost – 10.00 – 10.00 – 10.00 EBIT $15.00 $40.00 $65.00 DTL Less interest –$10.00 –$10.00 –$10.00 Net profits before taxes $ 5.00 $30.00 $55.00 Less taxes –$ 2.00 –$12.00 –$22.00 DFL Net profits after taxes $ 3.00 $18.00 $33.00 EPS (1 share outstanding) $ 3.00 $18.00 $33.00

DTL = DOL x DFL If DOL is high the DFL is often kept low so that the DTL will not be too high to be acceptable to investors. This is one factor that determines a firm’s capital structure.

Additional Debt As additional debt is used the firm becomes more risky. This raises the cost of both debt and equity.

The goal of financial managers will be to maximize firm values. This occurs when WACCAT is minimized.

Table 13.3 Selecting the Optimal Capital Structure Percentage of After Tax Cost Cost of Capital from Debt Debt (kd) Equity (ke) WACCAT 0% NA 11% 11.00% 10 3% 11 10.08 20 3 11 9.16 30 4 12 9.12 40 5 13 9.00 50 7 15 9.60 60 9 16 9.64 70 11 18 10.02 80 13 20 10.24 90 15 23 10.40 100 18 25 10.80

Early Theories Miller and Modiglioni argue that in perfect markets (without taxes), firm values would not change as capital structure changed.

They based their theory on the idea that the value of a firm does not change depending on who has claims against it.

FIGURE 13.2 Effect of Leverage on Firm Value Without Taxes

Table 13.4 Cost of Capital without Taxes Percent Debt in Capital Structure Cost of Debt Cost of Equity WACCAT 10% 0.06 0.16 0.15 30 0.06 0.19 0.15 50 0.08 0.22 0.15 70 0.10 0.27 0.15 90 0.12 0.42 0.15

When taxes are added to the Miller-Modiglioni model Firm value increases as additional debt is added. The government is paying a portion of the cost of the capital.

FIGURE 13.3 Effect of Leverage on Firm Value with and Without Taxes 4

Table 13.5 Cost of Capital with Tax Shield Percent Debt in Capital After-Tax Cost Structure Cost of Debt of Equity WACCAT 10% 0.06(1 – 0.4) = 0.036 0.16 0.148 30 0.06(1 – 0.4) = 0.036 0.19 0.144 50 0.08(1 – 0.4) = 0.048 0.22 0.134 70 0.10(1 – 0.4) = 0.06 0.27 0.123 90 0.12(1 – 0.4) = 0.072 0.42 0.107

Since firms are not usually 100% debt financed, additional factors must be at work. These include: Agency cost Bankruptcy cost

Agency Costs As equity falls, financial managers have the incentive to increase risk-taking since debt holders will lose if things go badly, but shareholders capture the gain if things go well.

Debt holders are aware of this, they increase their required return to compensate for the increased risk.

Bankruptcy Costs As debt levels increase, customers and employees may fear the firm will go bankrupt. Firms producing products that require maintenance or support may lose customers. The best employees may leave for more security.

Agency Costs, Bankruptcy Costs, and the Miller-Modiglioni Model When these factors are added to the model, they offset the value of the tax shield provided by debt.

The optimal capital structure occurs when the value of the tax shield equals the sum of the bankruptcy and agency costs.

FIGURE 13.4 Optimal Capital Structure 5

Other Factors Affect Capital Structure (FRICTO) Flexibility Lower debt allows the firm the option to raise funds quickly if an opportunity surfaces.

Risk The risk caused by increased debt must be consistent with the wishes of the shareholders. Income Does the firm have a steady income sufficient to retire the debt? Control Will selling the stock cause control to shift?

Timing Are interest rates and market conditions more suited to one type of financing over another?

Other Other important issues that may affect the decision: Taxes Management attitudes and risk preferences Projected firm profitability Lender attitudes Investment opportunities

Research Suggests . . . If managers make errors in picking the optimal capital structure, firm value may not be greatly lowered. The curve relating debt to firm value is relatively flat.

FIGURE 13.5 Effect on Firm Value of Different Debt Levels 6

EBIT–EPS Analysis Selects, between specific financing alternatives, the option that maximizes EPS 1. Increasing debt causes the line relating EBIT to EPS to grow steeper.

2. Beyond the crossover point EPS is higher with more debt. 3. Below the crossover point EPS is higher with more equity.

FIGURE 13.6 EBIT–EPS Indifference Point Analysis 7

To Find the Crossover Point: Set the EPS for the debt option equal to the EPS for the equity option. Solve for EBIT

(EBIT - Interestdebt ) (1-T) (EBIT- Interestequity ) (1-T) ndebt nequity where Interestdebt = The interest due if the debt option is selected Interestequity = The interest due if the equity option is selected ndebt = The number of shares outstanding if the debt option is selected nequity = The number of shares outstanding if the equity option is selected T = The firm’s tax rate

Example A firm can finance its expansion by selling either $5,000,000 of 8% coupon bonds or $5,000,000 of equity at $20 per share. There are $1 million worth of shares outstanding. Taxes are 37%

Solution 1. Interest on debt: $5,000,000 x .08 = $400,000 2. If equity is used $5,000,000 / 20 = 250,000 shares will be issued

FIGURE 13.7 EBIT–EPS Analysis of Right Start, Inc. 8

Solution, cont. If EBIT is expected to be $3,000,000, the debt option will be chosen since expected EBIT is greater than the crossover point.