Capital Structure Decisions Chapter 16 Capital Structure Decisions

Basic Definitions V = value of firm FCF = free cash flow WACC = weighted average cost of capital rs and rd are required returns of stock and debt ws and wd are percentages of the capital that are financed with stock and debt.

How can capital structure affect value? = ∑ ∞ t=1 FCFt (1 + WACC)t

Operating leverage Operating leverage is the change in EBIT caused by a change in quantity sold. High operating leverage implies that a small change in sales results in a large change in EBIT, NOPAT, ROIC, ROA, ROE. Usually, the higher the proportion of fixed costs relative to variable costs, the greater the operating leverage and business risk (the risk that common stockholders face if no debt).

1. Input Data   Plan A Plan U Plan L Required operating current assets $3 Required long-term assets $199 Resulting operating current liabilities $2 Total assets $202 Required capital (TA − Op. CL) $200 Book equity $150 Debt $0 $50 Interest rate 8% Sales price (P) $2.00 Tax rate (T) 40% Expected units sold (Q) 110 Fixed costs (F) $20 $60 Variable costs (V) $1.50 $1.00 2. Income Statements Sales revenue (P x Q) $220.0 Fixed costs 20.0 60.0 Variable costs (V x Q) 165.0 110.0 EBIT $35.0 $50.0 Interest 0.0 4.0 EBT $46.0 Tax 14.0 18.4 Net income $21.0 $30.0 $27.6 3. Key Performance Measures NOPAT = EBIT(1 − T) ROIC = NOPAT/Capital 10.5% 15.0% ROA = NI/Total assets 10.4% 14.9% 13.7% ROE = NI/Equity 18.4%

Operating Breakeven Q is quantity sold, F is fixed cost, V is variable cost, and P is price per unit. Operating breakeven = QBE EBIT= PQ-VQ-F=0; so QBE = F / (P – V) Plan A: QBE = 20 mil/ (2 – 1.5) = 40 mil unit Plan U: QBE = 60 mil/ (2 – 1) = 60 mil unit U has higher business risk

Financial leverage and financial risk Financial leverage: how much capital is financed by debt. Financial risk is the additional risk placed on common stockholder if there is debt. If ROIC > rd(1-T), then financial leverage increase ROE but also business risk.

1. Input Data   Plan A Plan U Plan L Required operating current assets $3 Required long-term assets $199 Resulting operating current liabilities $2 Total assets $202 Required capital (TA − Op. CL) $200 Book equity $150 Debt $0 $50 Interest rate 8% Sales price (P) $2.00 Tax rate (T) 40% Expected units sold (Q) 110 Fixed costs (F) $20 $60 Variable costs (V) $1.50 $1.00 2. Income Statements Sales revenue (P x Q) $220.0 Fixed costs 20.0 60.0 Variable costs (V x Q) 165.0 110.0 EBIT $35.0 $50.0 Interest 0.0 4.0 EBT $46.0 Tax 14.0 18.4 Net income $21.0 $30.0 $27.6 3. Key Performance Measures NOPAT = EBIT(1 − T) ROIC = NOPAT/Capital 10.5% 15.0% ROA = NI/Total assets 10.4% 14.9% 13.7% ROE = NI/Equity 18.4%

Effect of financial leverage (1) So, ROE is greater than without debt. What if unit sales drops?

1. Input Data   Plan A Plan U Plan L Required operating current assets $3 Required long-term assets $199 Resulting operating current liabilities $2 Total assets $202 Required capital (TA − Op. CL) $200 Book equity $150 Debt $0 $50 Interest rate 8% Sales price (P) $2.00 Tax rate (T) 40% Expected units sold (Q) 110 65 Fixed costs (F) $20 $60 Variable costs (V) $1.50 $1.00 2. Income Statements Sales revenue (P x Q) $220.0 $130.0 Fixed costs 20.0 60.0 Variable costs (V x Q) 165.0 65.0 EBIT $35.0 $5.0 Interest 0.0 4.0 EBT $1.0 Tax 14.0 2.0 0.4 Net income $21.0 $3.0 $0.6 3. Key Performance Measures NOPAT = EBIT(1 − T) ROIC = NOPAT/Capital 10.5% 1.5% ROA = NI/Total assets 10.4% 0.3% ROE = NI/Equity 0.4%

Effect of financial leverage (2) So, ROE is lower than without debt.

Capital Structure Theory MM theory: corporate tax Trade-off theory Signaling theory Pecking order

MM Theory: Corporate Taxes Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms. Therefore, more CF goes to investors and less to taxes when leverage is used. In other words, the debt “shields” some of the firm’s CF from taxes. WACC falls as debt is added.

Trade-off Theory MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.

Signaling Theory MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: issue stock if stock is overvalued. issue bonds if stock is undervalued. Investors understand this, so view new stock issue as a negative signal.

Pecking Order Theory Firms use internally generated funds first, because there are no flotation costs or negative signals. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals. If more funds are needed, firms then issue equity.

Implications for Managers Take advantage of tax benefits by issuing debt, especially if the firm has: High tax rate Stable sales Low operating leverage

Implications for Managers (Continued) Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has: Volatile sales High operating leverage Many potential investment opportunities

Implications for Managers (Continued) If manager has asymmetric information regarding firm’s future prospects, then avoid issuing equity if actual prospects are better than the market perceives.

Is there an optimal capital structure?

Compute WACC WACC = wd (1-T) rd + wce rs = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%) = 11.28% Repeat this for all different capital structures under consideration. Let’s do in-class practice.

Homework assignment Chapter 16 problem: 1. Review chapter 10 in Business Finance I.