1. 1 Capital Structure Decisions Ch 16 and 17

2. 2 Issues Business risk and operating leverage Business risk and financial risk Financial risk and financial leverage Determining optimal capital structure Capital structure theories  MM Theory  Trade-off theory  Signaling theory  Pecking order theory

3. 3 Leverage for Ford and Johnson & Johnson Ford Motor Johnson & Johnson from yahoo.marketguide.com

4. 4 Optimal Capital Structure Capital Structure policy involves a risk- return trade-off.  An increase in debt raises the risk to shareholders  But an increase in debt generally leads to higher return on equity (ROE).  Higher risk has a negative impact on stock prices but a higher ROE has a positive impact.  There must be an optimal trade-off

5. 5 Primary factors affecting capital structures Business Risk  Higher Business Risk  Lower Optimal Debt Ratio Tax Position  High Marginal Tax Rate  Higher Optimal Debt Ratio Financial Flexibility  Greater Need for Future Funds  Lower Optimal Debt Ratio now

6. 6 Uncertainty about future operating income (EBIT). Note that business risk focuses on operating income, so it ignores financing effects. What is business risk? Probability EBITE(EBIT)0 Low risk High risk

7. 7 Factors That Influence Business Risk Uncertainty about demand (unit sales). Uncertainty about output prices. Uncertainty about input costs. Product and other types of liability. Degree of operating leverage (DOL). And many others

8. 8 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. The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.

9. 9 Example: Operating Leverage Conduct sensitivity (or scenario) analyses and measure expected ROE and standard deviations of ROEs

10. 10 Higher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline. Sales $ Rev. TC FC Q BE Sales $ Rev. TC FC Q BE Profit } Example: Operating Leverage

11. 11 Operating Leverage In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.

12. 12 Business Risk versus Financial Risk Business risk:  Uncertainty in future EBIT.  Usually refers to riskiness inherent in the firm’s normal operating activities if it used no debt.  Depends on business factors such as competition, demand variability, sales price variability, operating leverage, etc. Financial risk:  Additional business risk concentrated on common stockholders as a result of using debt (or financial leverage) is used.

13. 13 Stand-alone risk Stand-aloneBusinessFinancial riskriskrisk = +.

14. 14 Financial Risk Financial Leverage  Additional risk placed on the stockholders as a result of the decision to finance with debt  We will look at the impact of financial risk on ROE and NI for different levels of debt.

15. 15 Financial Risk Why some firms carry a low debt?  The higher the percentage of debt, the riskier the debt, hence the higher the interest rate lenders will charge. Why some firms carry a high debt?  The debt is tax-deductible, so the firm can achieve a high ROE.

16. 16 Example: Financial Leverage Assume the tax rate, t is 30%. The firm B’s long-term debt carries an interest rate of 8%. Firm A Firm B $0 Debt $50 Debt $100 Equity $50 Equity $100 $100 Assume 3 possible outcomes EBIT Poor$0 Average$10 Excellent$20

17. 17 Example: Financial Leverage (Continued) 1. Calculate Return on Equity (ROE) for each of the three economics conditions for Firm A and Firm B. 2. Graph your results. 3. At what level of EBIT would these two firms’ stockholders be equally well off?

18. 18 Financial Leverage and the Impact on ROE Disadvantage to debt ROE Debt No Debt Break-even point Advantage to debt EBIT

19. 19 Financial Leverage and the Impact on ROE Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. A levered firm has higher expected ROI and ROE because of tax savings. A levered firm has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

20. 20 Determining Optimal Capital Structure Capital structures vary considerably across and within industries. Managers should choose the capital structure that maximizes the firm’s stock price, not profit.

21. 21 Determining Optimal Capital Structure Table 16-3 Figure 16-8 The Hamada Equation  Beta changes with leverage.  b= b u [1+(1-T)(D/E)]  An increase debt ratio tends to increase in beta. As a result, it will eventually increase cost of equity.

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24. 24 Determining Optimal Capital Structure WACC  In this example, the WACC is minimized at D/A = 40%, the same debt level that maximizes stock price.  Since the value of a firm is the present value of future operating income, the lowest discount rate (WACC) leads to the highest value.

25. 25 Capital Structure Theories MM theory  Zero taxes  Corporate taxes  Corporate and personal taxes Trade-off theory Signaling theory Pecking order Theory

26. 26 Capital Structure Theory MM (Modigliani and Miller)  No Taxes Capital structure is irrelevant. (Pie Theory) Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk. Does not consider tax effects.

27. 27 Capital Structure Theory MM (Modigliani and Miller)  Corporate Taxes Corporate tax laws favor debt financing over equity financing Firms should use almost 100% debt financing to maximize value.

28. 28 Capital Structure Theory MM (Modigliani and Miller)  Corporate and Personal Taxes Personal taxes lessen the advantage of corporate debt. Corporate taxes favor debt financing. Personal taxes favor equity financing.  Income proceeds from bonds are taxed at personal income tax rates going up to 39.6 percent.  Long-term capital gains are taxed at a lower rate.

29. 29 Capital Structure Theory Trade-Off Theory (Figure 16-9)  MM theory ignores bankruptcy costs, which increase as more leverage is used.  At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits.  An optimal capital structure exists that balances these costs and benefits.

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32. 32 Capital Structure Theory Signaling Theory  MM assumed that investors and managers have the same information.  But, managers often have better information (Information Asymmetry). Thus, they would: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal.  In addition, investors may fear earning dilutions when additional stocks are issued, so they re-evaluate stocks negatively.

33. 33 Capital Structure Theory Pecking-Order Theory  Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Rule 1  Use internal financing first. Rule 2  Issue debt next, equity last.  The pecking-order Theory is at odds with the trade-off theory: There is no target D/E ratio. Profitable firms use less debt. Companies like “financial slack” (or internal finance)

34. 34 Optimal Capital Structure and Cost of Capital: George Pacific Co. “On a market-value basis, our debt-to-capital ratio was 47 percent. By employing this capital structure, we believe that our weighted average cost of capital is nearly optimized – at approximately 10 percent …..”

35. 35 WACC Estimates for Some Large U. S. Corporations CompanyWACC Intel12.9% General Electric11.9 Motorola11.3 Coca-Cola11.2 Walt Disney10.0 AT&T 9.8 Wal-Mart 9.8 Exxon 8.8 H. J. Heinz 8.5 BellSouth 8.2

36. Common Size Balance Sheet For S&P Composite Index Firms during 2005 36

37. Common Size Income Statement For S&P Composite Index Firms during 2005 37

38. Financial Ratios 2005 Ratios for selected firms 38