Capital Structure Management in Practice 13 Capital Structure Management in Practice

Introduction This chapter focuses on tools of analysis that can assist managers in making capital structure decisions that will lead to a maximization of shareholder wealth. It develops techniques, derived from accounting data, for measuring operating and financial leverage.

Operating and Financial Leverage A firm’s use of assets and liabilities having fixed costs in an attempt to increase potential returns to stockholders Operating leverage The use of assets having fixed costs Financial leverage The use of liabilities (and preferred stock) having fixed costs

Various Categories of Costs From fixed operating or fixed capital costs Operating costs Costs of sales General, administrative, and selling expenses Capital costs Interest charges Preferred dividends Income taxes

Short-Run Costs Over the short run, certain operating costs within a firm vary directly with the level of sales whereas other costs remain constant, regardless of changes in the sales level. Costs that move in close relationship to changes in sales are called variable costs.

Short-Run Costs Variable costs are tied to the number of units produced and sold by the firm, rather than to the passage of time. They include raw material and direct labor costs, as well as sales commissions.

Short-Run Costs Over the short run, certain other operating costs are independent of sales or output levels. These, termed fixed costs, are primarily related to the passage of time. Depreciation on property, plant, and equipment; rent; insurance; lighting and heating bills; property taxes; and the salaries of management are all usually considered fixed costs.

Short-Run Costs If a firm expects to keep functioning, it must continue to pay these fixed costs, regardless of the sales level.

Short-Run Costs A third category, semivariable costs, can also be considered. Semivariable costs are costs that increase in a stepwise manner as output is increased. One cost that sometimes behaves in a stepwise manner is management salaries.

Short-Run Costs Whereas semivariable costs are generally considered fixed, this assumption is not always valid. A firm faced with declining sales and profits during an economic downturn may often cut the size of its managerial staff.

Short-Run Costs Panels (a), (b), and (c) of Figure 13.1 show the behavior of variable, fixed, and semivariable costs, respectively, over the firm’s output range.

Long-Run Costs Over the long run, all costs are variable. In time, a firm can change the size of its physical facilities and number of management personnel in response to changes in the level of sales. Fixed capital costs also can be changed in the long run.

Operating and Financial Leverage Operating leverage has fixed operating costs for its “fulcrum.” When a firm incurs fixed operating costs, a change in sales revenue is magnified into a relatively larger change in earnings before interest and taxes (EBIT). The multiplier effect resulting from the use of fixed operating costs is known as the degree of operating leverage.

Operating and Financial Leverage Financial leverage has fixed capital costs for its “fulcrum.” When a firm incurs fixed capital costs, a change in EBIT is magnified into a larger change in earnings per share (EPS). The multiplier effect resulting from the use of fixed capital costs is known as the degree of financial leverage.

Leverage Model DOL DFL % Sales % EBIT % EPS

Degree of Operating Leverage A firm’s degree of operating leverage (DOL) is defined as the multiplier effect resulting from the firm’s use of fixed operating costs. More specifically, DOL can be computed as the percentage change in earnings before interest and taxes (EBIT) resulting from a given percentage change in sales (output):

Degree of Operating Leverage The formula in the previous slide can be rewritten as follows (13.1): where ΔEBIT and ΔSales are the changes in the firm’s EBIT and sales, respectively.

Degree of Operating Leverage Because a firm’s DOL differs at each sales (output) level, it is necessary to indicate the sales (units of output or dollar sales) point X, at which operating leverage is measured.

Degree of Operating Leverage The degree of operating leverage is analogous to the elasticity concept of economics (for example, price and income elasticity) in that it relates percentage changes in one variable (EBIT) to percentage changes in another variable (sales).

Degree of Operating Leverage

Degree of Operating Leverage

Degree of Operating Leverage The calculation of the DOL can be illustrated using the Allegan Manufacturing Company example in Table 13.1. Since Allegan’s variable operating costs were $3 million at the current sales level of $5 million. Therefore, the firm’s variable operating cost ratio is ($3 million)/($5 million) = 0.60, or 60 percent.

Degree of Operating Leverage Suppose the firm increased sales by 10 percent to $5.5 million while keeping fixed operating costs constant at $1 million and the variable (operating) cost ratio at 60 percent. As can be seen in Table 13.2, this would increase the firm’s earnings before interest and taxes (EBIT) to $1.2 million.

Degree of Operating Leverage

Degree of Operating Leverage Substituting the two sales figures ($5 million and $5.5 million) and associated EBIT figures ($1 million and $1.2 million) into equation yields the following:

Degree of Operating Leverage A DOL of 2.0 is interpreted to mean that each 1 percent change in sales from a base sales level of $5 million results in a 2 percent change in EBIT in the same direction as the sales change. In other words, a sales increase of 10 percent results in a 20% increase in EBIT. Similarly, a 10 percent decrease in sales produces a 20% decrease in EBIT.

Degree of Operating Leverage The greater a firm’s DOL, the greater the magnification of sales changes into EBIT changes.

Degree of Operating Leverage Another equation that can be used to compute a firm’s DOL more easily is Equation (13.2) as follows: Note: EBIT = Sales – Variable costs – Fixed costs

Degree of Operating Leverage Inserting data from Table 13.1 on the Allegan Manufacturing Company into Equation (13.2) gives the following: This result is the same as that obtained using the more complex Equation (13.1).

Degree of Operating Leverage

Degree of Operating Leverage Table 13.3 shows the DOL at various sales levels for Allegan Mangan Manufacturing Company. Note that Allegan’s DOL is largest (in absolute value terms) when the firm is operating at the break-even sales point [that is, where Sales = $2,500,000 and EBIT = Sales – Variable Operating Costs – Fixed Operating Costs = $2,500,000 – 0.6($2,500,000) – $1,000,000 = $0].

Degree of Operating Leverage Note also that the firm’s DOL is negative below the break-even sales level. A negative DOL indicates the percentage reduction in operating losses that occurs at the result of a 1 percent increase in output. For example, the DOL of -1.50 at a sales level of $1,500,000 indicates that, from a base sales level of $1,500,000, the firm’s operating losses are reduced by 1.5 percent for each 1 percent increase in output.

Degree of Operating Leverage A firm’s DOL is a function of the nature of the production process. If the firm employs large amounts of labor-saving equipment in its operations, it tends to have relatively high fixed operating costs and relatively low variable operating costs. Such a cost structure yields a high DOL, which results in large operating profits (positive EBIT) if sales are high and large operating losses (negative EBIT) if sales are depressed.

Degree of Financial Leverage A firm’s degree of financial leverage (DFL) is computed as the percentage change in earnings per share (EPS) resulting from a given percentage change in earnings before interest and taxes (EBIT):

Degree of Financial Leverage The formula in the previous slide can also be written as Equation (13.3) as follows: where ΔEPS and ΔEBIT are the changes in EPS and EBIT, respectively.

Degree of Financial Leverage Because a firm’s DFL is different at each EBIT level, it is necessary to indicate the EBIT point, X, at which financial leverage is being measured.

Degree of Financial Leverage

Degree of Financial Leverage Using the information contained in Table 13.4 and shown in Figure 13.2, the degree of financial leverage used by the Allegan Manufacturing Company can be calculated. The firm’s EPS level is $3.00 at an EBIT level of $1 million. At an EBIT level of $1.2 million, EPS equals $4.20. Substituting these quantities into the Equation yields the following:

Degree of Financial Leverage A DFL of 2.0 indicates that each 1 percent change in EBIT from a base EBIT level of $1 million results in a 2 percent change in EPS in the same direction as the EBIT change.

Degree of Financial Leverage The formula of DFL can also be rewritten as follows (13.4): where I is the firm’s interest payments, Dp the firm’s preferred dividend payments, T the firm’s marginal income tax rate, and X the level of EBIT at which the firm’s DFL is being measured.

Degree of Financial Leverage For the firm with no preferred stock, Equation (13.4) becomes the following: where EBT represents earnings before taxes.

Degree of Financial Leverage Unlike interest payments, preferred dividend payments are not tax deductible. Therefore, on a comparable tax basis, a dollar of preferred dividends costs the firm more than a dollar of interest payments. Dividing preferred dividends in Equation (13.4) by (1 – T) puts interest and preferred dividends on an equivalent, pretax basis.

Degree of Financial Leverage As shown in Figure 13.2, Allegan will have EPS = $0 at an EBIT level of $500,000. With this level of EBIT, there is just enough operating earnings to pay interest ($250,000) and preferred dividends (after-tax). Using the Equation (13.4), it can be seen that DFL will be maximized at that level of EBIT where EPS = 0.

Degree of Financial Leverage Consider again the data presented in Table 13.1 on the Allegan Manufacturing Company. According to that table, EBIT = $1 million, I = $250,000, Dp = $150,000, and T = 40 percent, or 0.40.

Degree of Financial Leverage Substituting these values into the Equation (13.4) yields the following: This result is the same as that obtained using Equation (13.3).

Degree of Financial Leverage Just as a firm can change its DOL by raising or lowering fixed operating costs, it can also change its DFL by increasing or decreasing fixed capital costs. The amount of fixed capital costs incurred by a firm depends primarily on the mix of debt, preferred stock, and common stock equity in the firm’s capital structure.

Degree of Financial Leverage Thus, a firm that has a relatively large proportion of debt and preferred stock in its capital structure will have relatively large fixed capital costs and a high DFL.

Degree of Combined Leverage Combined leverage occurs whenever a firm employs both operating leverage and financial leverage in an effort to increase the returns to common stockholders.

Degree of Combined Leverage Combined leverage represents the magnification of sales increases (or decreases) into relatively larger earnings per share increases (or decreases), resulting from the firm’s use of both types of leverage. The joint multiplier effect is known as the degree of combined leverage.

Degree of Combined Leverage A firm’s degree of combined leverage (DCL) is computed as the percentage change in earnings per share resulting from a given percentage change in sales:

Degree of Combined Leverage The formula in the previous slide can be rewritten as Equation (13.5) as follows: where ΔEPS and ΔSales are the changes in a firm’s EPS and sales, respectively, and X represents the level of sales at which the firm’s combined leverage is measured.

Degree of Combined Leverage The degree of combined leverage is also equal to the product of the degree of operating leverage and the degree of financial leverage. DCL at X = DOL*DFL (13.6)

Degree of Combined Leverage To simplify matters, Equations (13.2) and (13.4) can be substituted into Equation (13.6) to obtain a new formula for determining the DCL in terms of basic income statement quantities:

Degree of Combined Leverage These three formulas for calculating DCL can be illustrated using the Allegan Manufacturing Company example. Equation (13.5) can be used to calculate Allegan’s DCL with the data from Tables 13.1 and 13.2.

Degree of Combined Leverage The EPS level was $3.00 at a sales level of $5 million and $4.20 at a sales level of $5.5 million. Substituting these values into Equation (13.5) yields the following:

Degree of Combined Leverage Substituting Sales = $5,000,000; Variable costs = $3,000,000; EBIT = $1,000,000; I = $250,000; Dp = $150,000; and T = 40% into Equation (13.7) gives the same value for Allegan’s DCL:

Degree of Combined Leverage Also, recall from the earlier discussion of operating and financial leverage for Allegan that DOL = 2.0 and DFL = 2.0. Substituting these values into Equation (13.6) yields a DCL value identical to that just calculated: DCL at $5,000,000 = 2.0*2.0 = 4.0

Degree of Combined Leverage This DCL is interpreted to mean that each 1 percent change in sales from a base sales level of $5 million results in a 4 percent change in Allegan’s EPS.

Degree of Combined Leverage The degree of combined leverage used by a firm is a measure of the overall variability of EPS due to fixed operating and capital costs as sales levels vary. Fixed operating and capital costs can be combined in many ways to achieve a desire DCL. In other words, a number of possible trade-offs can be made between operating and financial leverage.

Degree of Combined Leverage Equation (13.6) shows that DCL is a function of DOL and DFL. If a firm has relatively high DOL, for example, and wishes to achieve a certain DCL, it can offset this high DOL with a lower DFL. Or it may have a high DFL, in which case it would aim for a lower DOL.

Degree of Combined Leverage To illustrate, assume that a firm is considering purchasing assets that will increase fixed operating costs. To offset this high DOL, the firm may want to decrease the proportion of debt in its capital structure, thereby reducing fixed financial costs and the DFL.

Effect of Leverage on Shareholder Wealth and the Cost of Capital Firms are limited in the amount of combined (i.e., operating and financial) leverage that can be used in seeking to increase EPS and shareholder wealth. Recall from Chapter 12 (see Figures 12.4, 12.5, and 12.6) that the use of “excessive” amounts of financial leverage caused the market value of the firm (i.e., shareholder wealth) to decline and the cost of capital to rise.

Effect of Leverage on Shareholder Wealth and the Cost of Capital Like financial leverage, the use of increasing amounts of combined leverage increases the risk of financial distress. As this risk increases, investors will require higher rates of return on the funds supplied to the firm in the form of preferred and common equity and debt.

Effect of Leverage on Shareholder Wealth and the Cost of Capital In other words, because of the financial distress costs and agency costs associated with “excessive” combined leverage, the firm will have to pay higher costs for its funds. These higher costs will tend to offset the returns gained from the combined leverage, resulting in a decline in the market value of the firm and a rise in its cost of capital.

How Can You Find the Probability of EPS? Probability of negative EPS Loss level of EBIT is the amount of EBIT needed to cover interest charged and preferred dividends. The Z value can be looked up in Table V (Normal Distribution).

How Can You Find the Probability of EPS? It is possible to make more formal statements about the financial risk facing a company if the probability distribution of future operating income (EBIT) is approximately normal and the mean and standard deviation can be estimated.

How Can You Find the Probability of EPS? The number of standard deviation, z, that a particular value of EBIT is from the expected value, EBIT^, can be computed as Equation (13.8) as follows: where  is the standard deviation of EBIT.

How Can You Find the Probability of EPS? Equation (13.8), along with the probability values from Table V in the back of the book, can be used to compute the probability that EBIT will be less than (or greater than) some particular value.

How Can You Find the Probability of EPS? For example, consider the case of the Travco Manufacturing Corporation. Given the current capital structure of Travco, the company has interest payment obligations of $500,000 for the coming year. The company has no preferred stock. The $500,000 in interest represents the loss level for Travco.

How Can You Find the Probability of EPS? If EBIT falls below $500,000, losses will be incurred (EPS will be negative). At EBIT levels above $500,000, Travco will have positive earnings per share.

How Can You Find the Probability of EPS? Based upon past experience, Travco’s managers have estimated that the expected value of EBIT over the coming year is $700,000 with a standard deviation of $200,000 and that the distribution of operating income is approximately normal, as illustrated in Figure 13.3.

How Can You Find the Probability of EPS? With this information, it is possible to compute the probability of Travco having negative earnings per share over the coming year (or, conversely, the probability of having positive earnings per share).

How Can You Find the Probability of EPS? Using Equation (13.8), the probability of Travco having negative EPS is equal to the probability of having EBIT below the loss of $500,000, or In other words, a level of EBIT of $500,000 is 1.0 standard deviation below the mean.

How Can You Find the Probability of EPS? From Table V, it can be seen that the probability associated with a value that is less than or equal to 1.0 standard deviation below the mean is 15.87 percent. Thus, there is a 15.87 percent chance that Travco will have negative earnings per share (i.e., the shaded area in Figure 13.3) with its current capital structure. Conversely, there is an 84.13 percent chance (=100% – 15.87%) of having positive earnings per share.

EBIT-EPS Analysis An analytical technique called EBIT-EPS analysis can be used to help determine when debt financing is advantageous and when equity financial is advantageous.

EBIT-EPS Analysis Consider the Yuma Corporation with a present capital structure consisting only of common stock (35 million shares). Plan 1, equity financing, would involve the sale of an additional 15 million shares of common stock at $20 each. Plan 2, debt financing, would involve the sale of $300 million of 10 percent long-term debt.

EBIT-EPS Analysis If the firm adopts Plan 1, it remains totally equity financial. If, however, the firm adopts Plan 2, it becomes partially debt financed. Because Plan 2 involves the use of financial leverage, this financing issue is basically one of whether it is in the best interests of the firm’s existing stockholders to employ financial leverage.

EBIT-EPS Analysis

EBIT-EPS Analysis

EBIT-EPS Analysis Table 13.5 illustrates the calculation of EPS at two different assumed levels of EBIT for both financing plans. Because the relationship between EBIT and EPS is linear, the two points calculated in Table 13.5 can be used to graph the relationship for each financing plan, as shown in Figure 13.4.

EBIT-EPS Analysis In this example, earnings per share at EBIT levels less than $100 million are higher using the equity financing alternative. Correspondingly, at EBIT levels greater than $100 million, earnings per share are higher with debt financing. The $100 million figure is called the EBIT-EPS indifference point.

EBIT-EPS Analysis By definition, the earnings per share for the debt and equity financing alternatives are equal at the EBIT-EPS indifference point (13.9): EPS (debt financing) = EPS (equity financing)

EBIT-EPS Analysis This equation may be written as Equation (13.10) as follows: where EBIT is earnings before interest and taxes; Id (Ie) is the firm’s total interest payments if the debt (equity) alternative is chosen; and Nd (Ne) represents the number of common shares outstanding for the debt (equity) alternatives. The firm’s effective tax rate is indicated as T, and Dp is the amount of preferred dividends for the firm.

EBIT-EPS Analysis This equation may be used to calculate directly the EBIT level at which earnings per share for the two alternatives are equal. The data from the example shown in Table 13.5 yield the EBIT-EPS indifference point:

EBIT-EPS Analysis Note that in the equity financing alternative, a 66.67 percent increase in EBIT (from $75 million to $125 million) results in a 66.67 percent increase in earnings per share (from $0.90 to $1.50), or, by Equation (13.3), a degree of financial leverage of DFL = 66.67%  66.67% = 1

EBIT-EPS Analysis Similarly, in the debt financing alternative, a 66.67 percent increase in EBIT (from $75 million to $125 million) results in a 111.69 percent increase in earnings per share (from $0.77 to $1.63), or a degree of financial leverage of DFL = 111.69%  66.67% = 1.68

EBIT-EPS Analysis A comparable magnification of earnings per share will occur if EBIT declines. This wider variation in earnings per share, which occurs with the debt financing alternative, is an illustration of financial risk, because financial risk is defined as the increased variability in earnings per share due to the firm’s use of debt.

EBIT-EPS Analysis All other thing being equal, an increase in the proportion of debt financing is said to increase the financial risk of the firm.

Graphical Analysis of EBIT - EPS Debt Financing Advantage to equity financing Equity Financing Indifference Point Advantage to debt financing EBIT

EBIT-EPS Analysis and Capital Structure Decisions The tools of EBIT-EPS analysis and the theory of an optimal capital structure can help a firm choose an appropriate capital structure. This section uses an example to develop a five-step procedure designed to assist financial managers in making capital structure decisions.

EBIT-EPS Analysis and Capital Structure Decisions Balboa Department Stores has been 100 percent financial with equity funds since the firm was founded. While analyzing a major expansion program, the firm has decided to consider alternative capital structures.

EBIT-EPS Analysis and Capital Structure Decisions In particular, it has been suggested that the firm should use this expansion program as an opportunity to increase the long-term debt ratio from the current level of 0 percent to a new level of 30 percent. Interest on the proposed new debt will amount to $100,000 per year.

EBIT-EPS Analysis and Capital Structure Decisions Step 1: Compute the expected level of EBIT after the expansion. Based on Balboa’s past operating experience and a projection of the impact of the expansion, it estimates its expected EBIT to be $500,000 per year under normal operating circumstances.

EBIT-EPS Analysis and Capital Structure Decisions Step 2: Estimate the variability of this level of operating earnings. Based on the past performance of the company over several business cycles, the standard deviation of operating earnings is estimated to be $200,000 per year. (Operating earnings are assumed to be normally distributed, or at least approximately so.)

EBIT-EPS Analysis and Capital Structure Decisions Step 3: Compute the indifference point between the two financing alternative. This calculation will determine whether it is preferable to add new debt or to maintain the all-equity capital structure. Using the techniques of EBIT-EPS analysis previously discussed, the indifference point is computed to be $300,000.

EBIT-EPS Analysis and Capital Structure Decisions Step 4: Analyze these estimates in the context of the risk the firm is willing to assume. After considerable discussion, it has been decided that the firm is willing to accept a 25 percent chance that operating earnings in any year will be below the indifference point and a 5 percent chance that the firm will have to report a loss in any year.

EBIT-EPS Analysis and Capital Structure Decisions To compute this analysis, it is necessary to compute the probability that operating earnings will be below the indifference point, that is, the probability that EBIT will be less than $300,000.

EBIT-EPS Analysis and Capital Structure Decisions This is equivalent on the standard normal curve (using Equation (13.8)) to the following: or 1.0 standard deviation below the mean.

EBIT-EPS Analysis and Capital Structure Decisions The probability that EBIT will be less than 1.0 standard deviation below the mean is 15.87 percent; this is determined from Table V. Therefore, on the basis of the indifference point criterion, the proposed new capital structure appears acceptable.

EBIT-EPS Analysis and Capital Structure Decisions The probability of incurring losses must now be analyzed. This is the probability that EBIT will be less than the required interest payments of $100,000. On the standard normal curve, this corresponds to the following: or 2.0 standard deviations below the mean.

EBIT-EPS Analysis and Capital Structure Decisions The probability that EBIT will be less than 2.0 standard deviations below the mean is 2.28 percent, as shown in Table V. According to this criterion, the proposed capital structure also seems acceptable.

EBIT-EPS Analysis and Capital Structure Decisions If either or both of these tests had shown the proposed capital structure to have an unacceptable level of risk, the analysis would have been repeated for lower levels of debt than the proposed 30 percent rate.

EBIT-EPS Analysis and Capital Structure Decisions Similarly, because the proposed capital structure has exceeded the standards set by the firm, management might want to consider even higher levels of debt than the proposed 30 percent.

EBIT-EPS Analysis and Capital Structure Decisions Step 5: Examine the market evidence to determine whether the proposed capital structure is too risky. This evaluation should be made in relation to the following: the firm’s level of business risk, industry norms for leverage ratios and coverage ratios, and the recommendations of the firm’s investment bankers.

EBIT-EPS Analysis and Capital Structure Decisions This step is undertaken only after a proposed capital structure has met the “internal” tests for acceptability.

EBIT-EPS Analysis and Capital Structure Decisions Financial leverage is a double-edged sword: it enhances expected returns, but it also increases risk. If the increase in perceived risk is greater than the increase in expected returns, the firm’s weighted average costs of capital may rise instead of fall, and the firm’ stock price and market value will decline.

EBIT-EPS Analysis and Capital Structure Decisions It is important to note that a firm need not feel constrained by industry standards in setting its own capital structure. If, for example, a firm has traditionally been more profitable than the average firm in the industry, or if a firm’s operating income is more stable than the operating income of the average firm, a higher level of financial leverage can probably be tolerated.

EBIT-EPS Analysis and Capital Structure Decisions The final choice of a capital structure involves a careful analysis of expected future returns and risks relative to other firms in the industry.

EBIT-EPS Analysis and Stock Prices An important question arising from EBIT-EPS analysis is the impact of financial leverage on the firm’s common stock price. Specifically, which alternative results in the higher stock price?

EBIT-EPS Analysis and Stock Prices Returning to the Yuma Corporation example discussed earlier (see Table 13.5), suppose the company is able to operate at the $125 million EBIT level. Then, if the company chooses the debt financing alternative, its EPS will equal $1.63, and if it chooses the equity alternative, its EPS will be $1.50. But the stock price depends on the price-earnings (P/E) ratio that the stock market assigns to each alternative.

EBIT-EPS Analysis and Stock Prices Suppose the stock market assigns a P/E ratio of 16.0 to the company’s common stock if the equity alternative is chosen and a P/E ratio of 15.4 if the debt alternative is chosen.

EBIT-EPS Analysis and Stock Prices Recalling from Chapter 3 that the P/E ratio was defined as the market price per share of common stock (P0) divided by the current earnings per share (EPS), the common stock price can be calculated for both alternatives as follows: P0 = (P/E ratio)(EPS) Equity alternative: P0 = (16.0)($1.50) = $24.00 Debt alternative: P0 = (15.4)($1.63) = $25.10

EBIT-EPS Analysis and Stock Prices These calculations show that in this case the stock market places a higher value on the company’s stock if the debt alternative is chosen rather than the equity alternative.

EBIT-EPS Analysis and Stock Prices Note that the stock market assigned a slightly lower P/E ratio to the debt alternative. The stock market recognized the increased financial risk associated with the debt alternative, but this increased risk was more than offset by the increased EPS possible with the use of debt.

EBIT-EPS Analysis and Stock Prices To carry the Yuma Corporation example one important step further, suppose the company, while operating at the $125 million EBIT level, chooses an even higher debt capital structure, which causes its EPS to increase to $2.25.

EBIT-EPS Analysis and Stock Prices Suppose further that the stock market feels that this high-debt capital structure significantly increases the company’s financial risk—to the point where bankruptcy could occur if EBIT levels turned downward in a recession. If the stock market assigns a P/E ratio of 10.0, for example, the stock price would be $22.50 (= $2.25*10.0), and it would be clear that this change in capital structure is not desirable.

EBIT-EPS Analysis and Stock Prices It is important to emphasize that the P/E ratios in the preceding example are simply assumptions. As an analytical technique, EBIT-EPS analysis does not provide a complete solution to the optimal capital structure question.

EBIT-EPS Analysis and Stock Prices In summary, the firm potentially can show increased earnings to its stockholders by increasing its level of financial risk. However, because increases in risk tend to increase the cost of capital (which is analogous to a decrease in the P/E ratio), the firm’s management has to assess the trade-off between the higher earnings per share for its stockholders and the higher costs of capital.

Cash Insolvency Analysis In Chapter 3, the times interest earned and fixed-charge coverage ratios were introduced. These ratios provide an indicator of the ability of a firm to meet its interest and other fixed charge obligations (including lease payments, sinking fund payments, and preferred dividends) out of current operating income.

Cash Insolvency Analysis Also, in that chapter, liquidity ratios such as the current ratio and the quick ratio, were introduced. Liquidity ratios provide a simple measure of a firm’s ability to meet its obligations, especially in the near term. In that chapter, we also indicated that the best measure of a firm’s cash adequacy can be obtained by preparing a detailed cash budget, which is discussed in greater detail in Chapter 15.

Cash Insolvency Analysis Coverage ratios and liquidity ratios do not provide an adequate picture of a firm’s solvency position. A firm is said to be technically insolvent if it is unable to meet its current obligations. A more comprehensive measure of the ability of a firm to meet its obligations must consider both the cash on hand and the cash expected to be generated in the future.

Cash Insolvency Analysis Donaldson has suggested that a firm’s level of fixed financial charges (including interest, preferred dividends, sinking fund obligations, and lease payments), and thus its debt-carrying capacity, should depend on the cash balances and net cash flows that can be expected to be available in a worst-case (recessionary environment) scenario. This analysis requires the preparation of a detailed cash budget under assumed recessionary conditions.

Cash Insolvency Analysis Donaldson defines a firm’s net cash balance in a recession, CBR, to be Equation (13.12) as follows: CBR = CB0 + FCFR where CB0 is the cash (and marketable securities) balance at the beginning of the recession, and FCFR is the free cash flows expected to be generated during the recession.

Cash Insolvency Analysis Free cash flow represents the portion of a firm’s total cash flow available to service additional debt, to make dividend payments to common stockholders, and to invest in other projects.

Cash Insolvency Analysis For example, suppose MINECO, a natural resource company, reported a cash (and marketable securities) balance of approximately $154 million. Suppose also that management anticipates free cash flows of $210 million during a projected one-year recession. These free cash flows reflect both operating cash flows during the recession and current required fixed financial charges.

Cash Insolvency Analysis Under the current capital structure, consisting of approximately 32 percent debt, the cash balance at the end of the recession would be $364 million ($154 million plus $210 million). Assume that the management of MINECO is considering a change in its capital structure that would add an additional $280 million of annual after-tax interest and sinking fund payments (i.e., fixed financial charges).

Cash Insolvency Analysis The effect would be a cash balance at the end of the recession of CBR = $154 million + $210 million – $280 million = $84 million The managers of MINECO must decide if this projected cash balance of $84 million leaves them enough of a cushion in a recession.

Cash Insolvency Analysis This analysis can be enhanced if it is possible to specify the probability distribution of expected free cash flows during a recession.

Cash Insolvency Analysis For example, if the MINECO managers believe, based upon past experience, that free cash flows are approximately normally distributed [see panel (a) of Figure 13.5] with an expected value during a one-year recession (FCFR) of $210 million and a standard deviation of $140 million, they can compute the probability of running out of cash if the new debt is added.

Cash Insolvency Analysis The probability of running out of cash is equal to the probability of ending the recession with a cash balance of less than $0.

Cash Insolvency Analysis The probability distribution of MINECO’s cash balance [panel (b) of Figure 13.5] will have the same shape (i.e., approximately normal with a standard deviation, σ, of $140 million) as the probability distribution of free cash flows [panel (a) of Figure 13.5], except that it will be shifted to the left from a mean (FCFR) of $210 million to a mean (CBR) of $84 million (= $154 million + $210 million – $280 million).

Cash Insolvency Analysis Employing an expression similar to Equation (13.8), a cash balance of $0 is equivalent on the standard normal curve to the following:

Cash Insolvency Analysis From Table V, the probability of a z value of -0.60 or less is 27.43 percent. Thus, with an additional $280 million in fixed financial charges, the probability of MINECO running out of cash during a one-year recession is about 27 percent [i.e., shaded area in panel (b) of Figure 13.5].

Cash Insolvency Analysis The MINECO managers may feel that this is too much risk to assume. If they only want to assume a 5 percent risk of running out of cash during a one-year recession, they can determine the amount of additional interest and sinking fund payments (i.e., fixed financial charges) that can be safely added.

Cash Insolvency Analysis First, find the number of standard deviation (z) to the left of the mean that gives a 5 percent probability of occurrence in the lower tail of the distribution (i.e., the shaded area in Figure 13.6). From Table V, this value of z is found to be approximately -1.65.

Cash Insolvency Analysis Next, we calculate the expected cash balance (CBR) needed at the end of a one-year recession if the risk of running out of cash is to be held to 5 percent:

Cash Insolvency Analysis Finally, since MINECO expects to enter the recession with $154 million in cash and to generate $210 million in free cash flow during a one-year recession, it can take on just $133 million (= $154 million + $210 million – $231 million) in additional fixed financial charges.

Cash Insolvency Analysis The willingness of management to assume the risk associated with running out of cash depends on several factors, including funds available from outstanding lines of credit with banks and the sale of new long-term debt, preferred stock, and common stock, and the potential funds realized by cutting back on expenses during a business downturn, reducing dividends, and selling assets.

Factors Considered in Capital Structure Decisions Industry Standard Financial analysts, investment bankers, bond rating agencies, common stock investors, and commercial bankers normally compare the financial risk for a firm, as measured by its interest and fixed-charge coverage ratios and its long-term debt ratio, with industry standards or norms.

Factors Considered in Capital Structure Decisions Profitability and Need for Funds Highly profitable firms, with limited needs for funds, tend to have lower debt ratios when compared with less profitable firms. Firms that undertake highly leveraged restructurings may temporarily have debt ratios that are significantly above the optimal level until funds from asset sales, new equity issues, or operations can be generated to pay off the debt holders.

Factors Considered in Capital Structure Decisions Lender and Bond-Rater Requirements Lenders and bond-rating agencies often impose restrictions on a firm’s capital structure choices as a condition for extending credit or maintaining a bond or preferred stock rating.

Factors Considered in Capital Structure Decisions Managerial Risk Aversion Management’s willingness to assume risk often has a major impact on the capital structure chosen by the firm, although the relative risk aversion of management does not influence the firm’s optimal capital structure. Some managers adopt unusually risky or unusually low-risk capital structures. When a suboptimal capital structure is chosen, the financial marketplace will normally penalize a firm for this action.