CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory

What is business risk? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. Low risk Probability High risk E(EBIT) EBIT

What determines business risk? Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage

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.

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.

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.

Problem # 1 (Breakeven Analysis) A company’s fixed operating costs are $500,000, its variable costs are $3.00 per unit, and the product’s sales price is $4.00. What is the company’s breakeven point; that is, at what unit sales volume would its income equal its costs? Given: SP = $4/unit; Var. Cost = $3/unit & Fixed =$500,000 QBE = Fixed Costs / (Selling Price – Variable Cost) QBE = $500,000 / ($4.00 - $3.00) QBE = 500,000 units.

Problem #2 (Financial Leverage Effects) Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $20 million in assets, $4 million of EBIT, and is in the 40 % federal-plus-state tax bracket. Firm HL, however, has a debt ratio (D/A) of 50 % and pays 12 % interest on its debt, whereas LL has a 30 % debt ratio and pays only 10 % interest on its debt. Calculate the rate of return on equity (ROE) for each firm. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt ratio from 30 to 60 %, even though that would increase LL’s interest rate on all debt to 15 %. Calculate the new ROE for LL.

Problem #2 (Financial Leverage Effects) Given: HL LL Assets $20 mil $20 mil EBIT $ 4 mil $ 4 mil Taxes 40% 40% Debt Ratio 50% 30% Interest Rate 12% 10% Solution: See Excel Spreadsheet

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, and 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.

Optimal Capital Structure The capital structure (mix of debt, preferred, and common equity) at which P0 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.

Problem #3 (Optimal Capital Structure) Jackson Trucking Company is in the process of setting its tar- get capital structure. The CFO believes the optimal debt ratio is somewhere between 20 and 50 %, and her staff has compiled the following projections for EPS and the stock price at various debt levels: Assuming that the firm uses only debt and common equity, what is Jackson’s optimal capital structure? At what debt ratio is the company’s WACC minimized?

Problem #3 (Optimal Capital Structure) The optimal capital structure is that capital structure where WACC is minimized and stock price is maximized. Because Jackson’s stock price is maximized at a 30% debt ratio, the firm’s optimal capital structure is 30% debt and 70% equity. This is also the debt level where the firm’s WACC is minimized.

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.

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.

Calculating levered betas and costs of equity If D = $250, bL = 1.0 [ 1 + (0.6)($250/$1,750) ] bL = 1.0857 rs = rRF + (rM – rRF) bL rs = 6.0% + (6.0%) 1.0857 rs = 12.51%

CHAPTER 14 Distributions to shareholders: Dividends and share repurchases Investor preferences on dividends Signaling effects Residual model Dividend reinvestment plans Stock repurchases Stock dividends and stock splits

What is dividend policy? The decision to pay out earnings versus retaining and reinvesting them. Dividend policy includes High or low dividend payout? Stable or irregular dividends? How frequent to pay dividends? Announce the policy?

Dividend irrelevance theory Investors are indifferent between dividends and retention-generated capital gains. Investors can create their own dividend policy If they want cash, they can sell stock. If they don’t want cash, they can use dividends to buy stock. Proposed by Modigliani and Miller and based on unrealistic assumptions (no taxes or brokerage costs), hence may not be true. Need an empirical test.

Why investors might prefer dividends May think dividends are less risky than potential future capital gains. If so, investors would value high-payout firms more highly, i.e., a high payout would result in a high P0.

Why investors might prefer capital gains May want to avoid transactions costs Maximum tax rate is the same as on dividends, but … Taxes on dividends are due in the year they are received, while taxes on capital gains are due whenever the stock is sold. If an investor holds a stock until his/her death, beneficiaries can use the date of the death as the cost basis and escape all previously accrued capital gains.

What’s the “information content,” or “signaling,” hypothesis? Investors view dividend increases as signals of management’s view of the future. Since managers hate to cut dividends, they won’t raise dividends unless they think the raise is sustainable. However, a stock price increase at time of a dividend increase could reflect higher expectations for future EPS, not a desire for dividends.

What’s the “clientele effect”? Different groups of investors, or clienteles, prefer different dividend policies. Firm’s past dividend policy determines its current clientele of investors. Clientele effects impede changing dividend policy. Taxes & brokerage costs hurt investors who have to switch companies.

The residual dividend model Find the retained earnings needed for the capital budget. Pay out any leftover earnings (the residual) as dividends. This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

Problem #4 (Residual dividend model) Axel Telecommunications has a target capital structure that consists of 70% debt and 30% equity. The company anticipates that its capital budget for the upcoming year will be $3,000,000. If Axel reports net income of $2,000,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio? Given: 70% Debt; 30% Equity; Capital budget = $3,000,000; NI = $2,000,000; Dividend payout ratio = ?

Problem #4 (Residual dividend model) Equity retained = 0.3($3,000,000) = $900,000. NI $2,000,000 - Additions to RE 900,000 Earnings remaining $1,100,000 Payout = 1,100,000/2,000,000 = 55%

Comments on Residual Dividend Policy Advantage Minimizes new stock issues and flotation costs. Disadvantages Results in variable dividends Sends conflicting signals Increases risk Doesn’t appeal to any specific clientele. Conclusion – Consider residual policy when setting long-term target payout, but don’t follow it rigidly from year to year.

Stock Repurchases Buying own stock back from stockholders Reasons for repurchases: As an alternative to distributing cash as dividends. To dispose of one-time cash from an asset sale. To make a large capital structure change.

Problem #5 (Stock Repurchase) Beta Industries has net income of $2,000,000 and it has 1,000,000 shares of common stock outstanding. The company’s stock currently trades at $32 a share. Beta is considering a plan in which it will use available cash to repurchase 20 per- cent of its shares in the open market. The repurchase is expected to have no effect on either net income or the company’s P/E ratio. What will be its stock price following the stock repurchase? Given: NI = $2,000,000; Shares = 1,000,000; P0 = $32; Repurchase = 20%; New P0 = ? 

Problem #5 (Stock Repurchase) Repurchase = 0.2  1,000,000 = 200,000 shares. Repurchase amount = 200,000  $32 = $6,400,000. EPSOld = NI/Shares = 2m/1m = $2.00. P/E = 32/2 = 16. EPSNew = 2m / (1m – 200k) = 2m / 800k = $2.50.  PriceNew = EPSnew  P/E = $2.50(16) = $40.  

Stock dividends vs. Stock splits Stock dividend: Firm issues new shares in lieu of paying a cash dividend. If 10%, get 10 shares for each 100 shares owned. Stock split: Firm increases the number of shares outstanding, say 2:1. Sends shareholders more shares.

Problem # 6 (Stock Split) Gamma Medical’s stock trades at $90 a share. The company is contemplating a 3-for-2 stock split. Assuming that the stock split will have no effect on the market value of its equity, what will be the company’s stock price following the stock split? Given:P0 = $90; Split = 3 for 2; New P0 = ? New Price = $90 / (3/2) = $90 / 1.5 = $60