Chapter 14 Capital Structure and Leverage Business vs. Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory If a firm wants to grow it needs capital. Capital comes in either mainly in debt or equity Debt’s advantage is (1) interest is tax-deductible and thus lower’s the cost of debt (2) the cost of debt is fixed so the shareholders get whatever residual of the firm’s return no matter how high Debt’s disadvantage: (1) the more debt the more risky the firm is which increases it’s costs of capital (2) if the firm is not able to meet its interest payments it will be bankrupt. Because of the disadvantage of debt, firms with volatile earnings and cash flows tend not to use debt. Those with low risk (i.e. business risk) use it. Is debt better than equity? Should firms finance with all equity or all debt? If it is a mix, what is the optimal mix?

Debt or Equity What are some advantages of debt? Interest is tax-deductible and thus lower’s the cost of debt The cost of debt is fixed so the shareholders get whatever residual of the firm’s return no matter how high What are some disadvantages of debt? The more debt the more risky the firm is which increases it’s costs of capital. Firms not able to meet their interest payments will go bankrupt. Is debt better than equity? Should firms finance with all equity or all debt? If it is a mix, what is the optimal mix?

Optimal Capital Structure Optimal Capital Structure: The capital structure that maximizes a firm’s stock price. Setting the capital structure involves a trade-off between risk & return: Using more debt will raise risk. But it also generally increases the expected return on equity. Therefore, we seek to find the capital structure that strikes a balance between risk and return so as to maximize the stock price.

Four primary factors influence capital structure decisions: Business risk. The firm’s tax position. Financial flexibility. Managerial conservatism or aggressiveness.

What is business risk? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Business Risk is the riskiness inherent in the firm’s operations if it uses no debt. Probability EBIT E(EBIT) Low risk High risk In 220 we looked at risk from the investor’s stand point of view. Stand-alone risk? Diversifiable risk? Market risk? Now we look ar risk from the corporation’s stand point of view which are (a) business risk and (b) financial risk Give examples of firms with low and high business risk Business risk is the most important determinant of a firm’s capital structure

Give examples of firms with low and high business risk..

What determines business risk? Competition Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product obsolescence Foreign risk exposure Regulatory risk and legal exposure Operating leverage What is the relationship between business risk and each of these factors Legal exposure: BP and the oil spill. Pharmaceutical companies and tobacco companies?

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. Operating leverage basically measures how a change in sales changes EBIT? High leverage means small changes have big effects

Effect of Operating Leverage More operating leverage leads to more business risk, meaning a small sales decline causes a big profit decline. Break-even point is where operating profits equal costs. Can we calculate it? Sales $ Rev. TC FC QBE } Profit The first graph, FC is low but TC is steep which indicates high VC. Vice versa for the 2nd graph Break-even point is where operating profits equal costs. Can we calculate it? EBIT=P*Q-VC*Q-F=0 How does operating leverage affect business risk?

Using Operating Leverage Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases. Probability EBITL Low operating leverage High operating leverage EBITH Can firms control their operating leverage? A lot. Industry however plays a major role (give examples on high and low operating leverage industries) Electric utilities, telephone companies, airlines, steel mills, and chemical companies must have large investments in fixed assets; and this results in high fixed costs and operating leverage. Similarly, pharmaceutical, auto, computer, and other companies must spend heavily to develop new products; and product-development costs increase operating leverage. Grocery stores and service businesses such as accounting and consulting firms, on the other hand, generally have significantly lower fixed costs and hence lower operating leverage. Still, although industry factors do exert a major influence, all firms have some

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. Stockholders face the business risk of the firm. Using debt makes that higher.

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.

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 U: Unleveraged

Firm L: Leveraged

Ratio Comparison Between Leveraged and Unleveraged Firms

Risk and Return for Leveraged and Unleveraged Firms Financial leverage increases expected returns but it also increases risk

The Effect of Leverage on Profitability and Debt Coverage For leverage to raise expected ROE, must have BEP > rd. Why? If rd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, but interest expense increases (Int Exp = rdD).

Conclusions Basic earning power (BEP) is unaffected by financial leverage. L has higher expected ROE because BEP > rd. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk. Because of the pros/cons and debt, firms have to weight these for their case to come up with the optimal capital structure

Financial leverage and EPS As debt increase: Shares outstanding decline causing an increase in EPS Interest increases causing a decrease in EPS In the region below 50% debt ratio: Interest charges rise, but this effect is more than offset by the declining number of shares outstanding as debt is substituted for equity. EPS peaks at a debt ratio of 50%, beyond which interest rates rise so rapidly that EPS falls in spite of the falling number of shares outstanding

Does that mean that optimal capital structure (for the firm in the previous slide) calls for 50% debt?

Optimal Capital Structure The capital structure (mix of debt, preferred, and common equity) at which the stock price is maximized. Trades off higher E(ROE) & EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debt’s risk-related costs. The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital. The capital structure that maximize P is also the one that minimizes WACC It is easier to do it using WACC

Optimal Capital Structure The capital structure that maximizes stock price is also the one that minimizes WACC.. It is easier to do it using WACC

Sequence of Events in a Recapitalization Firm announces the recapitalization. New debt is issued. Proceeds are used to repurchase stock. The number of shares repurchased is equal to the amount of debt issued divided by price per share. Define recapitalization

Cost of Debt at Different Debt Ratios Amount Borrowed D/A Ratio D/E Ratio Bond Rating rd $ 0 -- 250,000 0.125 0.143 AA 8.0% 500,000 0.250 0.333 A 9.0% 750,000 0.375 0.600 BBB 11.5% 1,000,000 0.500 1.000 BB 14.0%

Why do the bond rating and cost of debt depend upon the amount of debt borrowed? As the firm borrows more money, the firm increases its financial risk causing the firm’s bond rating to decrease, and its cost of debt to increase.

Analyze the recapitalization at various debt levels & determine the EPS and TIE at each level. Assume: EBIT =400,000; T=40%; shares outstanding=80,000

Determining EPS and TIE at Different Levels of Debt (D = $250,000 and rd = 8%)

Determining EPS and TIE at Different Levels of Debt (D = $500,000 and rd = 9%)

Determining EPS and TIE at Different Levels of Debt (D = $750,000 and rd = 11.5%)

Determining EPS and TIE at Different Levels of Debt (D = $1,000,000 and rd = 14%)

Stock Price with Zero Growth If all earnings are paid out as dividends, E(g) = 0. EPS = DPS. To find the expected stock price ( ), we must find the appropriate rs at each of the debt levels discussed.

What effect does more debt have on a firm’s cost of equity? If the level of debt increases, the firm’s risk increases. We have already observed the increase in the cost of debt. However, the risk of the firm’s equity also increases, resulting in a higher rs.

The Hamada Equation Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity. The Hamada equation attempts to quantify the increased cost of equity due to financial leverage. Uses the firm’s unlevered beta, which represents the firm’s business risk as if it had no debt.

The Hamada Equation bL = bU[1 + (1 – T)(D/E)] Suppose, the risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is 1.0. We were previously told that total assets were $2,000,000. Explain the variables. If D=0 then there is only the business risk to affect the firm’s beta

Calculating Levered Betas & Costs of Equity If D = $250,000 bL = 1.0[1 + (0.6)($250,000/$1,750,000)] = 1.0857 rs = rRF + (rM – rRF)bL = 6.0% + (6.0%)1.0857 = 12.51% Cost of equity = risk-free rate + business risk premium + financial risk premium

Table for Calculating Levered Betas and Costs of Equity Amount Borrowed D/A Ratio D/E Ratio Levered Beta rs $ 0 0% 1.00 12.00% 250,000 12.5 14.29 1.09 12.51 500,000 25 33.33 1.20 13.20 750,000 37.5 60.00 1.36 14.16 1,000,000 50 100.00 1.60 15.60 Get Unlevered beta and then see how the firm’s cost of equity or WACC would be at each level of debt

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.

Table for Calculating Levered Betas and Costs of Equity Amount Borrowed D/A Ratio E/A Ratio rs rd(1 – T) WACC $ 0 0% 100% 12.00% -- 250,000 12.50 87.50 12.51 4.80% 11.55 500,000 25.00 75.00 13.20 5.40% 11.25 750,000 37.50 62.50 14.16 6.90% 11.44 1,000,000 50.00 15.60 8.40% 12.00 Using more debt does not makes the WACC go always down, why?

Determining the Stock Price Maximizing Capital Structure Amount Borrowed DPS rs P0 $ 0 $3.00 12.00% $25.00 250,000 3.26 12.51 26.03 500,000 3.55 13.20 26.89 750,000 3.77 14.16 26.59 1,000,000 3.90 15.60 25.00 Draw the relationship between D/A and P and WACC

What debt ratio maximizes EPS? Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%. (Remember DPS = EPS because payout = 100%.) Risk is too high at D/A = 50%.

What is Campus Deli’s optimal capital structure? P0 is maximized ($26.89) at D/A = $500,000/$2,000,000 = 25%, so optimal D/A = 25%. EPS is maximized at 50%, but primary interest is stock price, not E(EPS). The example shows that we can push up E(EPS) by using more debt, but the risk resulting from increased leverage more than offsets the benefit of higher E(EPS).

What if there were more/less business risk than originally estimated, how would the analysis be affected? If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt. However, lower business risk would lead to an optimal capital structure with more debt. This is why across industries we would see different levels of leverage depending on business risk. Give examples (biotechnology vs telecommunications)

How would these factors affect the target capital structure? Sales stability? High operating leverage? Increase in the corporate tax rate? Increase in the personal tax rate? Increase in bankruptcy costs? Management spending lots of money on lavish perks?

Zain held a monopoly for many years on telecommunications in Kuwait Zain held a monopoly for many years on telecommunications in Kuwait. Do you think when Ooredoo entered the scene and started competing with Zain, that this affected Zain’s optimal capital structure?

Modigliani-Miller Irrelevance Theory MM proved, under a restrictive set of assumptions, that a firm’s value should be unaffected by its capital structure. MM assumptions: There are no taxes. There are no transaction costs. There are no bankruptcy costs. Investors can borrow at the same rate as corporations. All investors have the same information as management about the firm’s future investment opportunities. EBIT is not affected by the use of debt. MM says that a firm’s capital structure is irrelevant. No matter how you cut the pie it stays the same. Assumptions: no taxes, no bankruptcy costs, no information asymmetry, EBIT is not affected by the use of debt After this original theory they updated it with taking into account taxes. Because interest expense is tax deductible, the more debt the firm has the higher profits for the stockholders and therefore firms should take on 100% debt. John Graham found that the tax benefits of debt are 7%. So if a firm with no leverage takes on the average level of debt, it’s value would go up by 7%. MM says no bankruptcy and no associated costs. That’s not the case in real life. Bankruptcy problems and the probability of facing bankruptcy increases as you increase debt. Hence, expected bankruptcy costs increase as debt increases because the probability is increasing and possible the costs are increasing too. This results in firms staying away from debt in order not to incur such costs. This resulted in the trade-off theory which says firms trade-off between the tax benefits of debt and the cost of bankruptcy. You increase until you reach a value, D2, where the costs of bankruptcy exceed the benefits of debt. Before D1, bankruptcy was immaterial, but after D1 it starts to kick in and that’s why the increase in value slows down

M&M Theory Many of these assumptions are unrealistic, so what is the benefit? By showing us what is needed for capital structure to be irrelevant, they are indicting what conditions make capital structure relevant. MM says that a firm’s capital structure is irrelevant. No matter how you cut the pie it stays the same. Assumptions: no taxes, no bankruptcy costs, no information asymmetry, EBIT is not affected by the use of debt After this original theory they updated it with taking into account taxes. Because interest expense is tax deductible, the more debt the firm has the higher profits for the stockholders and therefore firms should take on 100% debt. John Graham found that the tax benefits of debt are 7%. So if a firm with no leverage takes on the average level of debt, it’s value would go up by 7%. MM says no bankruptcy and no associated costs. That’s not the case in real life. Bankruptcy problems and the probability of facing bankruptcy increases as you increase debt. Hence, expected bankruptcy costs increase as debt increases because the probability is increasing and possible the costs are increasing too. This results in firms staying away from debt in order not to incur such costs. This resulted in the trade-off theory which says firms trade-off between the tax benefits of debt and the cost of bankruptcy. You increase until you reach a value, D2, where the costs of bankruptcy exceed the benefits of debt. Before D1, bankruptcy was immaterial, but after D1 it starts to kick in and that’s why the increase in value slows down

Trade-Off Theory States that firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy.

When we relax the “no tax” and “no bankruptcy cost” assumptions..

Signaling Theory It relaxes the assumption that managers and shareholders have the same information. Signaling theory suggests firms should use less debt than MM suggest. This unused debt capacity helps avoid stock sales, which depress stock price because of signaling effects. Having asymmetric information between managers and shareholders has significant effects of the firm’s capital structure. If you have a good project and you know you will do well in it. Would you bring in someone extra as an investor or take on more debt? If you bring investors, you will share the loss but you will share the profits too. We would expect firms with favorable future to avoid selling stocks and instead raise debt. Vice versa?

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

What can managers be expected to do? 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. So what should firms do? Firms should maintain a reserve borrowing capacity to allow them to borrow debt when good opportunities come up

Using Debt to Constrain Managers Recall the conflict between shareholders & managers The more cash the manager has at his disposal, the higher the chance of misusing it Reduce the cash at hand: Higher dividends Higher debt Leverage Buyouts (LBOs) The more cash the manager has, the higher the potential to misuse it (give examples) More debt, means more interest payments. Therefore managers will be more disciplined in order to be able to meet such payments

Pecking Order Hypothesis Managers have preference when it comes to sources of capital Firms finance in the following order: Internal funds (e.g. retained earnings, accounts payable) Debt New equity Why is this good? 1) It’s cheaper to use internal funds or debt because they don’t have any flotation costs. Signaling effects.

Conclusions on Capital Structure Need to make calculations as we did, but should also recognize inputs are “guesstimates.” As a result of imprecise numbers, capital structure decisions have a large judgmental content. We end up with capital structures varying widely among firms, even similar ones in same industry.

Book, Market, or “Target” Weight What is capital? Capital structure? Optimal capital structure? Debt: book or market value? Equity: book or market value? Target weights For equity many financial theorist suggest using market value. Why? However, many use book value because of the volatility of the firm’s stock price which would mean volatile weights. Maintaining a single debt ratio is hard. Firms from quarter to quarter have changes in their accounting numbers and therefore does that mean they need to change their capital structure every quarter? Or if they are using market values, every day? That’s why firms use target capital structure range