1. 1 Topics in Chapter 15: Capital Structure Business versus financial risk Impact of financial leverage on returns Analyzing alternative capital structures Optimal capital structure

2. 2 Business Risk Business risk: the risk facing a firm’s shareholders if it has no debt financing. Business risk is the risk associated with firm’s assets and the nature of the products it produces and sells. One measure of business risk is the standard deviation of EBIT.

3. 3 Factors Contributing to Business Risk Uncertainty about sales. Uncertainty about sale price. Uncertainty about input costs. Fixed operating costs. Foreign risk exposure.

4. Capital Structure To minimize the complexity of capital structure analysis, we simplify: No preferred stock financing: the firm’s capital consists of common equity and debt No financial assets 100% dividend payout, so g = 0 4

5. 5 Capital Structure We consider how changes in the firm’s capital structure affects WACC and firm value.

6. 6 Financial Risk Financial risk: the risk that results from debt financing. Measures of fin’l risk include debt ratio, debt/equity, times interest earned, etc. If a firm relies heavily on debt financing, it has high financial leverage and high financial risk. Why expose the firm to financial risk?

7. 7 Consider Two Hypothetical Firms Firm UFirm L No debt$10,000 of 12% debt $20,000 in assets 40% tax rate Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

8. 8 Impact of Leverage on Returns Firm UFirm L EBIT$3,000 Interest0 1,200 EBT$3,000$1,800 Taxes (40%)1,200720 NI$1,800$1,080 ROE9.0%10.8%

9. 9 Why does leveraging increase return? More cash flow goes to investors and less is paid in taxes in Firm L. Total dollars paid to investors: U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280. Taxes paid: U: $1,200; L: $720.

10. 10 Why Does Debt Financing Increase ROE? Firm L’s ROE is higher because its basic earning power (BEP) > interest rate. BEP = EBIT / (Total Assets) = 3,000 / 20,000 =.15 Firm L is borrowing at 12% and investing in assets that earn 15%.

11. 11 Conclusions L has higher expected ROE due to tax savings and smaller equity base. L also has more volatile returns because of fixed interest charges. Higher expected return is accompanied by higher risk.

12. 12 Capital Structure As a firm increases its use of debt: r s and r d increase WACC initially decreases, then increases

13. 13 Trade-off Theory of Capital Structure 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.

14. 14 Implications for Managers Use less debt financing if firm has: High business risk Special use assets Use more debt financing if firm has: High tax rate Low business risk

15. 15 Optimal Capital Structure The optimal capital structure results in Highest firm value Highest stock price per share Lowest WACC