Topics in Chapter 15: Capital Structure Business versus financial risk Impact of financial leverage on returns Analyzing alternative capital structures Optimal capital structure

Business Risk Business risk: the risk facing a firm’s shareholders if it has ______________. Business risk is the risk associated with firm’s assets and the nature of the products it produces and sells. One measure of business risk is the standard deviation of EBIT.

Factors Contributing to Business Risk Uncertainty about _______________. Uncertainty about sale _____________. Uncertainty about input ____________. Fixed operating costs. Foreign risk exposure.

Capital Structure To minimize the complexity of capital structure analysis, we simplify: No preferred stock financing: the firm’s capital consists of common equity and debt No __________________________ assets 100% dividend payout, so _____________

Capital Structure We saw in Chapter 11 that the value of the firm is the PV of expected FCFs, discounted at the WACC (plus marketable securities, if any). Now, we consider how changes in the firm’s capital structure affects FCF &/or WACC, and hence the firm value.

Capital Structure As a firm increases its use of debt: rs and rd ____________________ WACC initially _____________________, then ______________________ Excessive use of debt might cause FCF to decrease, due to greater risk of financial distress & bankruptcy

Financial Distress Financial distress resulting from debt financing includes: Direct costs of _____________________ ______________________ costs because bankruptcy is more likely (loss of customers, loss of key employees, etc.)

Financial Risk Financial risk: the risk that results from ______________________ financing. Measures of fin’l risk include debt ratio, debt/equity, times interest earned, etc. If a firm relies heavily on debt financing, it has high financial leverage and high financial risk. Why expose the firm to financial risk?

Consider Two Hypothetical Firms Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets 40% tax rate Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

Impact of Leverage on Returns Firm U Firm L EBIT $3,000 Interest 1,200 EBT $1,800 Taxes (40%) 1 ,200 720 NI $1,080 ROE 9.0% 10.8%

Why does leveraging increase return? More cash flow goes to investors and less is paid in taxes in Firm L. Total dollars paid to investors: U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280. Taxes paid: U: $1,200; L: $720.

Why Does Debt Financing Increase ROE? Firm L’s ROE is higher because its basic earning power (BEP) > interest rate. BEP = EBIT / (Total Assets) = 3,000 / 20,000 = .15 Firm L is borrowing at 12% and investing in assets that earn 15%.

Conclusions L has higher expected ROE due to tax savings and smaller equity base. L has more volatile returns because of fixed interest charges. Higher expected return is accompanied by higher risk.

Other issues in Capital Structure Theory Trade-off theory Signaling theory Pecking order

Trade-off Theory of Capital Structure At low leverage levels, __________ benefits outweigh bankruptcy ________ At high levels, bankruptcy ___________ outweigh _____________ benefits. An optimal capital structure exists that balances these costs and benefits.

Signaling Theory Managers have better information than investors. They will: Sell stock if stock is __________________. Sell bonds if stock is _________________. Investors understand this, so view new stock sales as a __________________ ___________________.

Pecking Order Theory Firms use retained earnings first, because there are no ______________ or negative __________________. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and no negative ___________________ to investors. New equity is issued only as a last resort.

Empirical Evidence Tax benefits are important– $1 debt adds about $0.10 to value. Bankruptcies are costly– average costs are 10% to 20% of firm value. Firms don’t make quick corrections when stock price changes cause their debt ratios to change.

Implications for Managers Use _______ debt financing if firm has: High business risk Many potential investment opportunities Special use assets High tax rate Low business risk

Choosing Capital Structure: Definitions V = value of firm = D + S D = market value of debt S = market value of stock rs & rd are costs of stock & equity wce and wd are the percentage of financing from equity and debt Varying wce and wd result in alternative capital structures

Choosing the Optimal Capital Structure: Example Currently is all-equity financed. Expected EBIT = $500,000. Firm expects zero growth. 100,000 shares outstanding; P0 = $25; T = 40%; b = 1.0; rRF = 6%; RPM = 6%.

Choosing the Optimal Capital Structure: Example Initially: rs = rRF + b (RPM) = 6 + 1 (6) = 12% = WACC S0 = P0 x n0 = $25 x 100,000 = $2,500,000 V0 = S0 + D0 = $2,500,000

Estimates of Cost of Debt % financed with debt, wd rd 0% - 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.

The Cost of Equity at Different Levels of Debt: Hamada’s Equation bU is the beta of a firm when it has no debt (the unlevered beta) Hamada’s equation allows us to calculate beta at different levels of debt: bL = bU [1 + (1 - T)(D/S)]

The Cost of Equity for wd = 20% Use Hamada’s equation to find beta: bL= bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity: rs= rRF + bL (RPM) = 6% + 1.15 (6%) = 12.9%

Cost of Equity vs. Leverage wd D/S bL rs 0% 0.00 1.000 12.00% 20% 0.25 1.150 12.90% 30% 0.43 1.257 13.54% 40% 0.67 1.400 14.40% 50% 1.00 1.600 15.60%

The WACC for wd = 20% WACC = wd (1-T) rd + wce rs Repeat this for all capital structures under consideration.

WACC vs. Leverage wd rd rs WACC 0% 0.0% 12.00% 20% 8.0% 12.90% 11.28% 30% 8.5% 13.54% 11.01% 40% 10.0% 14.40% 11.04% 50% 12.0% 15.60% 11.40%

Corporate Value for wd = 20% V = FCF(1+g) / (WACC-g) g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). NOPAT = ($500,000)(1-0.40) = $300,000. V = $300,000 / 0.1128 = $2,659,574.

Corporate Value vs. Leverage wd WACC Corp. Value 0% 12.00% $2,500,000 20% 11.28% $2,659,574 30% 11.01% $2,724,796 40% 11.04% $2,717,391 50% 11.40% $2,631,579

Debt and Equity for wd = 20% The dollar value of debt is: D1 = wd x V1 = 0.2 ($2,659,574) = $531,915. S1 = V1 – D1 S1 = $2,659,574 - $531,915 = $2,127,659.

Debt and Stock Value vs. Leverage wd Debt, D Stock Value, S 0% $0 $2,500,000 20% $531,915 $2,127,660 30% $817,439 $1,907,357 40% $1,086,957 $1,630,435 50% $1,315,789 Note: these are rounded; see Ch 15 Mini Case.xls for full calculations.

Wealth of Shareholders Value of the equity declines as more debt is issued, because debt is used to repurchase stock. But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).

Stock Price for wd = 20% The firm issues debt, which changes its WACC, which changes value. The firm then uses debt proceeds to repurchase stock. Stock price changes when firm announces recapitalization. (More…)

Stock Price for wd = 20% (Continued) The stock price upon announcement reflects shareholder wealth: S1, the new total value of stock Cash paid in repurchase. (More…)

Stock Price for wd = 20% (Continued) D0 and n0 are debt and outstanding shares before recap. D1 - D0 is equal to cash that will be used to repurchase stock. S1 + (D1 - D0) = new wealth of shareholders. (More…)

Stock Price for wd = 20% (Continued) P1 = S1 + (D1 – D0) n0 P1 = $2,127,660 + ($531,915 – 0) 100,000 P1 = $26.596 per share.

Number of Shares Repurchased # Repurchased = (D1 - D0) / P1 # Rep. = ($531,915 – 0) / $26.596 = 20,000. # Remaining = n1 = S1 / P1 n1 = $2,127,660 / $26.596 = 80,000.

Price per Share vs. Leverage # shares wd P Repurch. Remaining 0% $25.00 100,000 20% $26.60 20,000 80,000 30% $27.25 30,000 70,000 40% $27.17 40,000 60,000 50% $26.32 50,000

Optimal Capital Structure wd = 30% is optimal: Highest corporate value Lowest WACC Highest stock price per share But wd = 40% is close. Optimal range is pretty flat.