© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Eugene F. Brigham & Joel F. Houston 2-1 Fundamentals of Financial Management Concise 8E

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Capital Structure and Leverage Business Risk Operating Leverage Financial Risk Optimal Capital Structure Capital Structure Theory Chapter FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is business risk? The riskiness inherent in the firm’s operations if it uses no debt. A commonly used measure of business risk is  ROIC. Probability EBITE(ROIC) 0 Low risk High risk 13-3 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 13-4 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Effect of Operating Leverage 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 13-6 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Using Operating Leverage Typical situation: Can use operating leverage to get higher ROIC, but risk also increases. Probability ROIC L ROIC H Low operating leverage High operating leverage 13-7 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Invested Capital (ROIC) ROIC measures the after-tax return that the company provides for all its investors. ROIC doesn’t vary with changes in capital structure FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Business Risk vs. Financial Risk Business risk depends on business factors such as competition, product obsolescence, and operating leverage. Financial risk depends only on the types of securities issued. – More debt, more financial risk. – Concentrates business risk on stockholders FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 Firm L No debt $10,000 of 12% debt $20,000 invested capital 40% tax rate FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Firm U: Unleveraged Economy Bad Average Good Probability 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, FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Firm L: Leveraged Economy Bad Average Good Probability* EBIT* $2,000 $3,000 $4,000 Interest 1, EBT $ 800 $1,8 $2,8 Taxes (40%) ,120 NI $ 480 $1,080 $1,680 * Same as for Firm U FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Ratio Comparison Between Leveraged and Unleveraged Firms Firm U Bad Average Good ROIC 6.0% 9.0% 12.0% ROE TIE    Firm L Bad Average Good ROIC 6.0% 9.0% 12.0% ROE TIE 1.7x 2.5x 3.3x FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Risk and Return for Leveraged and Unleveraged Firms  Expected values: Firm U Firm L E(ROIC) 9.0% E(ROE) 9.0% 10.8% E(TIE) 2.5× Risk measures: Firm U Firm L  ROIC 2.12%  ROE 2.12% 4.24%  TIE 00.6× FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. The Effect of Leverage on Profitability and Debt Coverage For leverage to raise expected ROE, must have ROIC > r d (1 – T). Why? If r d (1 – T) > ROIC, then after-tax interest expense will be higher than the after-tax 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 = r d D) FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Conclusions Return on invested capital (ROIC) is unaffected by financial leverage. L has higher expected ROE because ROIC > r d (1 – T). L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Optimal Capital Structure The 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Cost of Debt at Different Debt Ratios Amount Borrowed D/Cap. Ratio D/E Ratio Bond Ratingrdrd $ AA8.0% A9.0% BBB11.5% 1, BB14.0% FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Analyze the Recapitalization at Various Debt Levels and Determine the EPS and TIE at Each Level D = $ FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Determining EPS and TIE at Different Levels of Debt (D = $250,000 and r d = 8%) FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Determining EPS and TIE at Different Levels of Debt (D = $500,000 and r d = 9%) FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Determining EPS and TIE at Different Levels of Debt (D = $750,000 and r d = 11.5%) FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Determining EPS and TIE at Different Levels of Debt (D = $1,000,000 and r d = 14%) FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 r s FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. The Hamada Equation b L = b U [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 invested capital was $2,000, FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Calculating Levered Betas and Costs of Equity If D = $250, b L = 1.0[1 + (0.6)($250/$1,750)] = r s = r RF + (r M – r RF )b L = 6.0% + (6.0%) = 12.51% FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Table for Calculating Levered Betas and Costs of Equity Amount Borrowed D/Cap. Ratio D/E Ratio Levered Betarsrs $ 0 0% % , FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Table for Calculating Levered Betas and Costs of Equity Amount Borrowed D/Cap. Ratio E/Cap. Ratiorsrs r d (1 – T)WACC $ 0 0%100%12.00% % % % % , % FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 r s at each of the debt levels discussed FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Determining the Stock Price Maximizing Capital Structure Amount BorrowedDPSrsrs P0P0 $ 0$ %$ , FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What debt ratio maximizes EPS? Maximum EPS = $3.90 at D = $1,000,000, and D/Cap. = 50%. (Remember DPS = EPS because payout = 100%.) Risk is too high at D/Cap. = 50% FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is Campus Deli’s optimal capital structure? P 0 is maximized ($26.89) at D/Cap. = $500,000/$2,000,000 = 25%, so optimal D/Cap. = 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) FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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? 7.Financial flexibility? 8.Firm’s growth rate? FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Modigliani-Miller Irrelevance Theory FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Modigliani-Miller Irrelevance Theory 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Incorporating Signaling Effects 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 stock offering negatively ; managers think stock is overvalued FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 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 FINANCIAL RISKBUSINESS RISKCAP STRUCT THEORYOPER LEVERAGEOPT CAP STRUCT