1. Chapter 14 Capital Structure and Leverage

2. Background Capital structure - mix of a firm’s debt and equity
In this chapter preferred stock is considered debt
Financial Leverage - using borrowed money to multiply the effectiveness of equity
Financial leverage of 10% means the capital structure is 10% debt and 90% equity

3. Can the use of debt (leverage) increase the value of a firm’s equity?
The Central Issue
Can the use of debt (leverage) increase the value of a firm’s equity?
Can it increase stock price?
Under certain conditions changing leverage can increase stock price
But an increase in leverage also increases risk

4. Risk in the Context of Leverage
Leverage influences stock price
Measures of overall performance
EBIT (Earnings Before Interest and Taxes)
Return on Equity (ROE) is
Earnings per Share (EPS) is

5. Redefining Risk for Leverage-Related Issues
Leverage-related risk is variation in ROE and EPS
Business risk — variation in EBIT
Financial risk — additional variation in ROE and EPS due to financial leverage
Total risk is total variation in ROE and EPS

6. Figure 14-1 Business and Financial Risk

7. Leverage and Risk Two Kinds of Each
Financial Leverage
Associated with capital structure
Causes financial risk.
Operating Leverage
Associated with cost structure, the firm’s mix of fixed and variable cost
Influences a firm’s business risk => variation in EBIT

8. Financial Leverage Financial leverage may increase stock price
Can improve financial performance, as measured by ROE and EPS
May make performance worse
Always increases risk

9. Replacing equity with debt reduces Net Income due to interest expense.
Table 14-1 Effect of Increasing Financial Leverage when Return on Capital Exceeds After-Tax Cost of Debt
Replacing equity with debt reduces Net Income due to interest expense.
But if profitability is good, it reduces equity and number of shares faster than the decline in Net Income. Hence as debt increases, both EPS and ROE rise dramatically.

10. Effect Of Increased Leverage On Stock Price In Good Times
Based on ROE and EPS performance in good times, investors bid stock price up as debt is increased from low levels
Effect is eventually mitigated by the increasing financial risk from leverage
Under what conditions will increasing leverage improve ROE and EPS?

11. When Might Financial Leverage Help?
Return on Capital Employed
Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE
When the ROCE > the after-tax cost of debt, more leverage improves ROE and EPS
When ROCE < the after-tax cost of debt, more leverage makes ROE and EPS worse

12. Table 14-2 Effect of Increasing Financial Leverage when After-Tax Cost of Debt Exceeds Return on Capital
When ROCE is less than the after tax cost of debt, increasing leverage reduces EPS and ROE . That, along with increasing risk, has a very negative effect on investors and stock price falls.

13. Concept Connection Example 14-1 Managing EPS through Leverage
Will borrowing more money and retiring stock raise Albany’s EPC, and if so, what capital structure will achieve an EPS of $2?

14. Concept Connection Example 14-1 Managing EPS through Leverage

15. Concept Connection Example 14-1 Managing EPS through Leverage

16. Managing Through Leverage
Under certain conditions management may be able to manipulate financial results and stock price by changing the firm’s capital structure.
This is true, but must be done cautiously

17. An Alternate Approach (Optional)
Using ratios and information from financial statements to solve for unknown values: algebraic approach
EPS = ROE × Book Value per share
ROE = Net Income ÷ Equity
Net Income= [EBIT – Interest] (1 – tax rate)
Interest = kd (Debt)
Net Income = [EBIT – (kd)(Debt)](1 – tax rate)
Equity = Total Capital – Debt

18. Table 14-3 Financial Leverage and Risk
Financial leverage is a two-edged sword
Multiplies good results into great results
Multiplies bad results into terrible results

19. Putting the Ideas Together— The Effect on Stock Price
During periods of good performance, leverage enhances results in terms of ROE and EPS
Leverage adds variability (risk) to financial performance when operating results change
These effects push stock prices in opposite directions

20. Real Investor Behavior and the Optimal Capital Structure
When leverage is low, an increase has a positive effect on investors
At high debt levels, risk concerns overwhelm benefit of enhanced performance thus additional leverage decreases stock price
As leverage increases, its effect goes from positive to negative

21. Figure 14-2 The Effect of Leverage on Stock Price

22. Finding the Optimum— A Practical Problem
1. A firm with good profit prospects and little or no debt is probably missing an opportunity by not using borrowed money if interest rates are reasonable.
2. For most businesses, the optimal capital structure is somewhere between 30% and 50% debt.
3. Debt levels above 60% create excessive risk and should be avoided.

23. The Target Capital Structure
A firm’s target capital structure is management’s estimate of the optimal capital structure

24. The Effect of Leverage When Stocks Aren’t Trading at Book Value
Changes in leverage not involving the
purchase of equity at book value are more complex
Repurchasing stock for retirement at prices other than book value will have the same general impact on ROE, but not necessarily for EPS
EPS = ROE x (book value per share)

25. The Degree of Financial Leverage (DFL) A Measurement
Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS
DFL quantifies the effectiveness of leverage by relating relative changes to EPS and EBIT

26. EBIT- EPS Analysis
Provides a visual/graphic representation of effect of leverage on EPS
Helps managers analyze and quantify the tradeoffs between risk and results when deciding on leverage policy

27. Figure 14-3 EBIT – EPS Analysis for ABC Corp (from Table 14
Figure 14-3 EBIT – EPS Analysis for ABC Corp (from Table 14.1, Columns 1 and 2)
For the Arizona Balloon Corporation the 50% Debt and No Leverage lines intersect. At the point of intersection ABC is indifferent between the two leverage options. To the right of the intersection, where EBIT is above $100,000, the 50% Debt plan is preferable, but to the left the company is better off without leverage.
It is important to determine the indifference point, which occurs when the two plans offer the same EBIT.

28. Operating Leverage Terminology and Definitions
“Operations” - a firm’s business activities excluding long-term financing
Income statement items from sales through EBIT
Risk in Operations — Business Risk
Variations in EBIT due to many reasons (sales, costs, management)

29. Fixed and Variable Costs and Cost Structure
Operating Leverage
Fixed and Variable Costs and Cost Structure
Variable Costs
Change with the level of sales
Include direct labor, direct materials, sales commissions
Fixed Costs
Don’t change with the level of sales
Include rent, depreciation, utilities, salaries
Cost Structure – the mix of fixed and variable costs in a firm’s operations

30. Breakeven Analysis
Determines the level of activity a firm must achieve to stay in business in the long run
Shows the mix of fixed and variable costs and the volume required for zero profit/loss

31. Figure 14-4 Fixed, Variable, and Total Cost

32. Figure 14-5 The Breakeven Diagram
Breakeven occurs at the intersection of revenue and total cost, QB/E

33. Breakeven Analysis Ct = P – V CM = (P – V) P The Contribution Margin
Every sale makes a contribution of the difference between price (P) and variable cost (V)
Ct = P – V
Can be expressed as a percentage of revenue
Known as the contribution margin (CM)
CM = (P – V) P

34. Concept Connection Example 14-4 Contribution
Suppose a company can make a unit of product for $7 in variable labor and materials, and sell it for $10. What are the contribution and contribution margin?
The contribution per unit is
Ct = P – V
= $10 - $7
= $3
while the contribution margin is:
Cm = P – V P
= $3 / $10 = 0.3 = 30%

35. Breakeven Analysis
Calculating the Breakeven Sales Level
EBIT = PQ – VQ – FC
Breakeven occurs when EBIT = 0 or revenue (PQ) equals total cost (VQ + FC). Then solve for QB/E
Breakeven shows how many units must be sold to pay for (cover) fixed costs
Can be expressed in terms of dollar sales

36. Concept Connection Example 14-5 Breakeven
What is the breakeven sales level in units and dollars for a company that can make a unit of product for $7 in variable costs and sell it for $10, if the firm has fixed costs of $1,800 per month?
The breakeven point in units is
$1,800  ($10 - $7) = 600 units.
The breakeven point in dollars is $10 per unit times 600 units, or $6,000, which could also be calculated as $1,800 / 0.30.
Thus, the firm must sell 600 units per month to cover fixed costs.

37. The Effect of Operating Leverage
As volume moves away from breakeven, profit or loss increases faster with more operating leverage
The Risk Effect
More operating leverage leads to larger variations in EBIT, or business risk
The Effect on Expected EBIT
When a firm is operating above breakeven, more operating leverage implies higher operating profit

38. Figure 14-6 Breakeven Diagram at High and Low Operating Leverage

39. Concept Connection 14-6 The Effect of Operating Leverage
Suppose the low-leverage firm in Figure 14-6a has fixed costs of $1,000 per period, sells its product for $10, and has variable costs of $8 per unit. Further suppose that the high-leverage firm in Figure 14-6b has fixed costs of $1,500 and also sells its product for $10 a unit.
Both firms are at the same breakeven point. What variable cost must the high-leverage firm have if it is to achieve the same breakeven point as the low-leverage firm? State the trade-off at the breakeven point. Which structure is preferred if there’s a choice?

40. Concept Connection Example 14-6 The Effect of Operating Leverage
Both firms have a breakeven point of 500 units (Low-leveraged firm: $1,000  $2). We need to solve the breakeven formula for the high-leveraged firm’s variable costs per unit:
QB/E-a = FC  (P – Va) = 500 units
QB/E-b = FC  (P – Vb) = 500 units
500 units = $1,500  ($10 – Vb)
Vb = $7
And Ct = $10 - $7 = $3
The preferred structure depends on volatility—if sales are expected to be highly volatile, the lower fixed cost structure might be better in the long run.
At breakeven, a $1
differential in contribution
makes up for a $500
difference in fixed cost.

41. The Degree of Operating Leverage (DOL)—A Measurement
Operating leverage amplifies changes in sales volume into larger changes in EBIT
DOL relates relative changes in volume (Q) to relative changes in EBIT

42. Concept Connection Example 14-7 Degree of Operating Leverage (DOL)
The Albergetti Corp. sells its product at an average price of $10. Variable costs are $7 per unit and fixed costs are $600 per month. Evaluate the degree of operating leverage when sales are 5% and then 50% above the breakeven level.
First, compute the breakeven volume: $600  ($10 - $7) = 200 units. Breakeven plus 5% is 200 x 1.05 or 210 units, while breakeven plus 50% is 200 x 1.50 or 300 units. DOL at 210 units is:
DOL at 300 units is:
Note that DOL
decreases
as the output level
increases above
breakeven.

43. Comparing Operating and Financial Leverage
Operating Leverage involves substituting fixed costs for variable costs in the firm’s cost structure
Financial Leverage
involves substituting debt for equity in the firm’s capital structure
Is more controllable than operating leverage
Both can enhance results while increasing variation
Both involve substituting fixed cash outflows for variable cash outflows
Both make their respective risks larger as levels of leverage increase

44. Figure 14-7 The Similar Functions of Operating and Financial Leverage

45. Figure 14-8 Risk and Cost Relationships between Operating and Financial Leverage

46. The Compounding Effect of Operating and Financial Leverage
Effects of financial and operating leverage compound one another
Changes in sales are amplified by operating leverage into larger relative changes in EBIT
Changes in EBIT are amplified by financial leverage into larger relative changes in ROE and EPS
Result: Modest changes in sales can lead to dramatic changes in ROE and EPS
Combined effect is measured by DTL, the degree of total leverage
DTL = DOL × DFL

47. Figure 14-9 The Compounding Effect of Operating Leverage and Financial Leverage

48. Capital Structure Theory
Does capital structure affect stock price and the market value of the firm?
If so, is there an optimal structure that maximizes either or both?
Capital structure does impact stock prices
There is an optimal
But no precise way to find it

49. Background The Value of the Firm
Notation
Vd = market value of the firm’s debt
Ve = market value of the firm’s stock or equity
Vf = market value of the firm in total
Vf = Vd + Ve
Investors’ returns on the firm’s securities will be
kd = return on an investment in debt
ke = return on an investment in equity
The average cost of capital is a weighted average of the costs of debt and equity
ka = average cost of capital

50. Background The Value of the Firm
Value is based on cash flow, which comes from income
Dividends and interest payments are both perpetuities
The firm’s market value is the sum of its present values
Operating income =
And
Returns drive value in an inverse relationship.

51. Figure 14-10 Variation in Value and Average Return with Capital Structure
The value of the firm and the firm’s stock price each reach maxima when the average cost of capital is minimized.

52. The Early Theory by Modigliani and Miller (MM)
Restrictive Assumptions in Original Model
The 1958 MM paper on capital structure included numerous restrictions such as
No income taxes
Securities trade in perfectly efficient capital markets with no transaction costs
No costs to bankruptcy
Investors and companies can borrow as much as they want at the same rate

53. The Early Theory by Modigliani and Miller (MM)
The Assumptions and Reality
Income taxes exist
Bankruptcy costs are quite high
Individuals cannot borrow at the same rate as companies and
Interest rates usually rise as more money is borrowed

54. The Early Theory by Modigliani and Miller (MM)
The result
The independence hypothesis: value is independent of capital structure
As cheaper debt is added, the cost of equity increases because of increased risk
Arbitrage concept
Interpreting the result

55. Figure 14-11 The Independence Hypothesis (a)

56. Figure 14-11 The Independence Hypothesis (b)

57. Relaxing the Assumptions— More Insights
Financing and the U.S. Tax System
Tax system favors debt financing over equity financing
Including Corporate Taxes in the MM Theory
Interest provides a tax shield that reduces government’s share of the firm’s earnings
Value is increased by the PV of the tax shield. The benefit of debt is the tax rate times the debt amount.
The benefit of debt accrues entirely to stockholders since bond returns are fixed.

58. Table 14-4 The Tax System Favors Debt Financing58

59. Tax Shield
Interest is tax deductible, so if there’s debt and an amount of interest, I, the government gets
T(OI − I) = T(OI) − TI
PV of tax shield is

60. Figure 14-12 MM Theory with Taxes
In the MM model with taxes, value increases steadily as leverage is added. Thus, the firm’s value is maximized with 100% debt. Note that kd remains constant across all levels of debt.

61. Including Bankruptcy Costs in the MM Theory
As leverage increases past a certain point, concern about bankruptcy losses increases
Debt and equity investors raise required returns
ka passes its minimum as price and value peak
Hence value and price are maximized at an optimal capital structure where the average cost of capital is a minimum

62. Figure 14-13 MM Theory with Taxes and Bankruptcy Costs

63. An Insight into Mergers and Acquisitions
In many mergers, a firm buys the stock of a target company at a premium over its market price/value
If the target was undervalued due to lack of debt, the increase in value from adding leverage may be more than the premium paid for the target’s stock