Copyright © 2002 by Harcourt, Inc.All rights reserved. CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory

Copyright © 2002 by Harcourt, Inc.All rights reserved. Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. What is business risk? Probability EBITE(EBIT)0 Low risk High risk

Copyright © 2002 by Harcourt, Inc.All rights reserved. Business risk is affected primarily by: Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage.

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

Copyright © 2002 by Harcourt, Inc.All rights reserved. More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. What happens if variable costs change? Sales $ Rev. TC FC Q BE Sales $ Rev. TC FC Q BE } Profit

Copyright © 2002 by Harcourt, Inc.All rights reserved. Probability EBIT L Low operating leverage High operating leverage Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases. EBIT H

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Firm UFirm L No debt$10,000 of 12% debt$20,000 in assets40% tax rate Consider 2 Hypothetical Firms Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt (capital structure).

Copyright © 2002 by Harcourt, Inc.All rights reserved. Firm U: Unleveraged Prob EBIT$2,000$3,000$4,000 Interest EBT$2,000$3,000$4,000 Taxes (40%) 800 1,200 1,600 NI$1,200$1,800$2,400 Economy Bad Avg. Good

Copyright © 2002 by Harcourt, Inc.All rights reserved. Prob.* EBIT*$2,000$3,000$4,000 Interest 1,200 1,200 1,200 EBT$ 800$1,800$2,800 Taxes (40%) ,120 NI$ 480$1,080$1,680 *Same as for Firm U. Firm L: Leveraged Economy Bad Avg. Good

Copyright © 2002 by Harcourt, Inc.All rights reserved. Firm UBadAvg.Good BEP*10.0%15.0%20.0% ROE6.0%9.0%12.0% TIE Firm LBadAvg.Good BEP*10.0%15.0%20.0% ROE4.8%10.8%16.8% TIE1.67x2.5x3.3x *BEP same for Firms U and L. 888

Copyright © 2002 by Harcourt, Inc.All rights reserved. Expected Values: E(BEP)15.0%15.0% E(ROE)9.0%10.8% E(TIE)2.5x Risk Measures:  ROE 2.12%4.24% CV ROE U L 8

Copyright © 2002 by Harcourt, Inc.All rights reserved. For leverage to raise expected ROE, must have BEP > k d. Why? If k d > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Conclusions Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. L has higher expected ROE because BEP > k d. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

Copyright © 2002 by Harcourt, Inc.All rights reserved. If debt increases, TIE falls. EBIT is constant (unaffected by use of debt), and since Int = k d D, as D increases, TIE must fall. TIE =. EBIT Int

Copyright © 2002 by Harcourt, Inc.All rights reserved. Optimal Capital Structure That capital structure (mix of debt, preferred, and common equity) at which P 0 is maximized. Trades off higher E(ROE) and 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.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Describe the sequence of events in a recapitalization. Campus Deli announces the recapitalization. New debt is issued. Proceeds are used to repurchase stock. Debt issued Price per share Shares bought =.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Amount D/A D/E Bond borrowed ratio ratio rating k d Cost of Debt at Different Debt Levels after Recapitalization $ AA 8% A 9% BBB 11.5% 1, BB 14%

Copyright © 2002 by Harcourt, Inc.All rights reserved. Why does the bond rating and cost of debt depend upon the amount borrowed? As the firm borrows more money, the firm increases its risk causing the firm’s bond rating to decrease, and its cost of debt to increase.

Copyright © 2002 by Harcourt, Inc.All rights reserved. EPS 0 = = = $3.00. What would the earnings per share be if Campus Deli recapitalized and used these amounts of debt: $0, $250,000, $500,000, $750,000? Assume EBIT = $400,000, T = 40%, and shares can be repurchased at P 0 = $25. D = 0: (EBIT – k d D)(1 – T) Shares outstanding ($400,000)(0.6) 80,000

Copyright © 2002 by Harcourt, Inc.All rights reserved. D = $250, k d = 8%. = = 10,000. Shares repurchased $250,000 $25 TIE = = = 20×. $400 $20 EBIT I EPS 1 = = $3.26. [$400 – 0.08($250)](0.6) 80 – 10

Copyright © 2002 by Harcourt, Inc.All rights reserved. D = $500, k d = 9%. = = 20. Shares repurchased $500 $25 TIE = = = 8.9×. $400 $45 EBIT I EPS 2 = = $3.55. [$400 – 0.09($500)](0.6) 80 – 20

Copyright © 2002 by Harcourt, Inc.All rights reserved. D = $750, k d = 11.5%. = = 30. Shares repurchased $750 $25 TIE = = = 4.6×. $400 $86.25 EBIT I EPS 3 = = $3.77. [$400 – 0.115($750)](0.6) 80 – 30

Copyright © 2002 by Harcourt, Inc.All rights reserved. D = $1,000, k d = 14%. = = 40. Shares repurchased $1,000 $25 TIE = = = 2.9×. $400 $140 EBIT I EPS 4 = = $3.90. [$400 – 0.14($1,000)](0.6) 80 – 40

Copyright © 2002 by Harcourt, Inc.All rights reserved. Stock Price (Zero Growth) If payout = 100%, then EPS = DPS and E(g) = 0. We just calculated EPS = DPS. To find the expected stock price (P 0 ), we must find the appropriate k s at each of the debt levels discussed. P 0 = = =. D 1 k s – g EPS k s DPS k s

Copyright © 2002 by Harcourt, Inc.All rights reserved. What effect would increasing debt have on the cost of equity for the firm? If the level of debt increases, the riskiness of the firm increases. We have already observed the increase in the cost of debt. However, the riskiness of the firm’s equity also increases, resulting in a higher k s.

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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 unlevered beta of a firm, which represents the business risk of a firm as if it had no debt.

Copyright © 2002 by Harcourt, Inc.All rights reserved. The Hamada Equation (cont’d) b L = b U [1 + (1 – T)(D/E)]. 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.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Calculating Levered Betas D = $250 b L = b U [1 + (1 – T)(D/E)] b L = 1.0[1 + (1 – 0.4)($250/$1,750)] b L = 1.0[1 + (0.6)(0.1429)] b L = k s = k RF + (k M – k RF )b L k s = 6.0% + (6.0%) = 12.51%. k s = k RF + (k M – k RF )b L

Copyright © 2002 by Harcourt, Inc.All rights reserved. Table for Calculating Levered Betas Amount borrowed $ ,000 D/A ratio 0.00% Levered Beta D/E ratio 0.00% k s 12.00%

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Minimizing the WACC Amount borrowed $ ,000 D/A ratio 0.00% WACC 12.00% E/A ratio % k s 12.00% k d (1 – T) 0.00%

Copyright © 2002 by Harcourt, Inc.All rights reserved. Amount Borrowed DPSk s P 0 $ 0$ % $ , , * 750, ,000, *Maximum: Since D = $500,000 and assets = $2,000,000, optimal D/A = 25%. Maximizing Stock Price

Copyright © 2002 by Harcourt, Inc.All rights reserved. See preceding slide. 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 debt ratio maximizes EPS?

Copyright © 2002 by Harcourt, Inc.All rights reserved. What is Campus Deli’s optimal capital structure? P 0 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).

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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).

Copyright © 2002 by Harcourt, Inc.All rights reserved. % D/A ksks WACC k d (1 – T) $ D/A P0P0 EPS

Copyright © 2002 by Harcourt, Inc.All rights reserved. If it were discovered that the firm had 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. On the other hand, lower business risk would lead to an optimal capital structure with more debt.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Other Factors to Consider When Establishing the Firm’s Target Capital Structure 1.Industry average debt ratio 2. TIE ratios under different scenarios 3. Lender/rating agency attitudes 4. Reserve borrowing capacity 5. Effects of financing on control 6. Asset structure 7. Expected tax rate

Copyright © 2002 by Harcourt, Inc.All rights reserved. How would these factors affect the Target Capital Structure? 1.Sales stability? 2.High operating leverage? 3.Increase in the corporate tax rate? 4.Increase in the personal tax rate? 5.Increase in bankruptcy costs? 6.Management spending lots of money on lavish perks?

Copyright © 2002 by Harcourt, Inc.All rights reserved. Value of Stock 0D1D1 D2D2 D/A MM result Actual No leverage

Copyright © 2002 by Harcourt, Inc.All rights reserved. The graph shows MM’s tax benefit vs. bankruptcy cost theory. Logical, but doesn’t tell whole capital structure story. Main problem--assumes investors have same information as managers.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Signaling theory suggests firms should use less debt than MM suggest. This unused debt capacity helps avoid stock sales, which depress P 0 because of signaling effects.

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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:

Copyright © 2002 by Harcourt, Inc.All rights reserved. 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.

Copyright © 2002 by Harcourt, Inc.All rights reserved. Conclusions on Capital Structure 1.Need to make calculations as we did, but should also recognize inputs are “guesstimates.” 2.As a result of imprecise numbers, capital structure decisions have a large judgmental content. 3.We end up with capital structures varying widely among firms, even similar ones in same industry.