1. Capital Structure Decisions
Business vs. financial risk
Capital structure theory

2. 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

3. Factors That Influence Business Risk
Uncertainty about demand (unit sales).
Uncertainty about output prices.
Uncertainty about input costs.
Product, other types of liability.
Degree of operating leverage (DOL).

4. 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.

5. What happens if variable costs change?
More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
Rev.
Rev. $ $ TC
Profit TC FC FC
QBE
Sales
QBE
Sales
What happens if variable costs change?

6. Probability
Low operating leverage
High operating leverage
EBITL
EBITH
Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.

7. 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.

8. 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.

9. How are financial and business risk measured in a stand-alone risk framework, i.e., the stock is not held in a portfolio?
Stand-alone Business Financial
risk risk risk =
Stand-alone risk = sROE.
Business risk = sROE(U).
Financial risk = sROE - sROE(U).

10. Consider 2 hypothetical firms
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt.

11. Firm U: Unleveraged
Economy
Bad Avg. Good
Prob
EBIT $2,000 $3,000 $4,000
Interest
EBT $2,000 $3,000 $4,000
Taxes (40%) , ,600
NI $1,200 $1,800 $2,400

12. Firm L: Leveraged
Economy
Bad Avg. Good
Prob.*
EBIT* $2,000 $3,000 $4,000
Interest 1, , ,200
EBT $ $1,800 $2,800
Taxes (40%) ,120
NI $ $1,080 $1,680
*Same as for Firm U.

13. Firm U Bad Avg. Good
BEP* 10.0% 15.0% 20.0%
ROI 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE 8 8 8
Firm L Bad Avg. Good
BEP* 10.0% 15.0% 20.0%
ROI 8.4% 11.4% 14.4%
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.5x 3.3x
*BEP same for U and L.

14. Profitability Measures:
E(BEP) 15.0% 15.0%
E(ROI) 9.0% 11.4%
E(ROE) 9.0% 10.8%
Risk Measures:
sROE 2.12% 4.24%
CVROE 0.24% 0.39%
E(TIE) 2.5x
U L 8

15. L has higher expected ROI and ROE because of tax savings.
Conclusions
Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage.
L has higher expected ROI and ROE because of tax savings.
L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.
(More...)

16. In a stand-alone risk sense, Firm L is much riskier than Firm U.
L’s business risk is sROE(U) = 2.12%.
L’s stand-alone risk is sROE = 4.24%.
L’s financial risk is sROE - sROE(U) = 4.24% % = 2.12%. (U’s is zero.)

17. For leverage to raise expected ROE, must have ROA > kd(1 - T)
For leverage to raise expected ROE, must have ROA > kd(1 - T). (ROA = ROEU = 9%.)
Why? If kd(1 - T) > ROA, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress net income and ROE.

18. Capital Structure Theory
MM theory
Trade-off theory
Signaling theory
Debt financing as a managerial constraint

19. MM Theory
The effect of taxes
There is no tax on debt( bond).
The effect of bankruptcy costs
Threat of bankruptcy from using debt.

20. Trade-off theory
Trade-off between the use of debt (bond) and equity (preferred stock and common stock).
Trade-off between bankruptcy cost and the effect of tax

21. Signaling theory
Symmetric information - same information
Asymmetric information - managers have better information than investors
Firms with favorable future - use debt
Firms with poor prospects - use equity

22. Debt financing as a managerial constraint
Excess cash flow
Spending in higher div., stock repurchase
Shift capital structure- to use more debt
LBOs (Leveraged Buyouts)- using debt to finance the purchase of the company’s share.