Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 13 Leverage and Capital Structure.

© 2012 Pearson Prentice Hall. All rights reserved. 13-2 Leverage Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners. Generally, increases in leverage result in increases in risk and return, whereas decreases in leverage result in decreases in risk and return. The amount of leverage in the firm’s capital structure— the mix of debt and equity—can significantly affect its value by affecting risk and return.

© 2012 Pearson Prentice Hall. All rights reserved. 13-3 Risks The probability that debt obligations will lead to bankruptcy depends on the level of a company’s business risk and financial risk. Business risk is the risk to the firm of being unable to cover operating costs. – In general, the higher the firm’s fixed costs relative to variable costs, the greater the firm’s operating leverage and business risk. – Business risk is also affected by revenue and cost stability. Financial Risk is the risk of being unable to meet its fixed interest and preferred stock dividends.

© 2012 Pearson Prentice Hall. All rights reserved. 13-4 Leverage: Breakeven Analysis Breakeven analysis is used to indicate the level of operations necessary to cover all costs and to evaluate the profitability associated with various levels of sales; also called cost-volume- profit analysis. The operating breakeven point is the level of sales necessary to cover all operating costs; the point at which EBIT = $0. –The first step in finding the operating breakeven point is to divide the cost of goods sold and operating expenses into fixed and variable operating costs. –Fixed costs are costs that the firm must pay in a given period regardless of the sales volume achieved during that period. –Variable costs vary directly with sales volume.

© 2012 Pearson Prentice Hall. All rights reserved. 13-6 Leverage: Breakeven Analysis (cont.) Rewriting the algebraic calculations in Table 13.2 as a formula for earnings before interest and taxes yields: EBIT = (P  Q) – FC – (VC  Q) Simplifying yields: EBIT = Q  (P – VC) – FC Setting EBIT equal to $0 and solving for Q (the firm ’ s breakeven point) yields:

© 2012 Pearson Prentice Hall. All rights reserved. 13-7 Leverage: Breakeven Analysis (cont.) Assume that Cheryl ’ s Posters, a small poster retailer, has fixed operating costs of $2,500. Its sale price is $10 per poster, and its variable operating cost is $5 per poster. What is the firm ’ s breakeven point?

© 2012 Pearson Prentice Hall. All rights reserved. 13-10 Operating Leverage: Measuring the Degree of Operating Leverage The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in Sales. A company’s DOL can be calculated in two different ways: Only companies that use fixed costs in the production process will experience operating leverage. Since fixed costs must always be paid, any increase in fixed costs increases the amount of revenues necessary just to break even (MORE RISK)

© 2012 Pearson Prentice Hall. All rights reserved. 13-11 Financial Leverage Financial leverage results from the presence of fixed financial costs in the firm’s income stream. Financial leverage can therefore be defined as the potential use of fixed financial costs to magnify the effects of changes in EBIT on the firm’s EPS. The two fixed financial costs most commonly found on the firm’s income statement are (1) interest on debt and (2) preferred stock dividends.

© 2012 Pearson Prentice Hall. All rights reserved. 13-12 Financial Leverage: Measuring the Degree of Financial Leverage The degree of financial leverage (DFL) measures the sensitivity of changes in EPS to changes in EBIT. Like the DOL, DFL can be calculated in two different ways: Only companies that use debt or other forms of fixed cost financing (like preferred stock) will experience financial leverage.

© 2012 Pearson Prentice Hall. All rights reserved. 13-13 Leverage: Total Leverage Total leverage results from the combined effect of using fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm’s earnings per share. Total leverage can therefore be viewed as the total impact of the fixed costs in the firm’s operating and financial structure.

© 2012 Pearson Prentice Hall. All rights reserved. 13-14 The Firm’s Capital Structure Capital structure is one of the most complex areas of financial decision making due to its interrelationship with other financial decision variables. Poor capital structure decisions can result in a high cost of capital, thereby lowering project NPVs and making them more unacceptable. Effective decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects, thereby increasing the value of the firm.

© 2012 Pearson Prentice Hall. All rights reserved. 13-15 The Firm’s Capital Structure: Capital Structure Theory Research suggests that there is an optimal capital structure range. It is not yet possible to provide financial managers with a precise methodology for determining a firm ’ s optimal capital structure. Nevertheless, financial theory does offer help in understanding how a firm ’ s capital structure affects the firm ’ s value.

© 2012 Pearson Prentice Hall. All rights reserved. 13-16 The Firm’s Capital Structure: Capital Structure Theory (cont.) In 1958, Franco Modigliani and Merton H. Miller (commonly known as “ M and M ” ) demonstrated algebraically that, assuming perfect markets, the capital structure that a firm chooses does not affect its value.

© 2012 Pearson Prentice Hall. All rights reserved. 13-17 The Firm’s Capital Structure: Capital Structure Theory (cont.) Many researchers, including M and M, have examined the effects of less restrictive assumptions on the relationship between capital structure and the firm ’ s value. –The result is a theoretical optimal capital structure based on balancing the benefits and costs of debt financing. –The major benefit of debt financing is the tax shield, which allows interest payments to be deducted in calculating taxable income. –The cost of debt financing results from (1) the increased probability of bankruptcy caused by debt obligations, (2) the agency costs of the lender ’ s constraining the firm ’ s actions, and (3) the costs associated with managers having more information about the firm ’ s prospects than do investors.

© 2012 Pearson Prentice Hall. All rights reserved. 13-18 The Firm’s Capital Structure: Capital Structure Theory (cont.) Tax Benefits –Allowing firms to deduct interest payments on debt when calculating taxable income reduces the amount of the firm ’ s earnings paid in taxes, thereby making more earnings available for bondholders and stockholders. –The deductibility of interest means the cost of debt, r i, to the firm is subsidized by the government. –Letting r d equal the before-tax cost of debt and letting T equal the tax rate, from Chapter 9, we have r i = r d  (1 – T).

© 2012 Pearson Prentice Hall. All rights reserved. 13-19 The Firm’s Capital Structure: Capital Structure Theory (cont.) Probability of Bankruptcy –The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends largely on its level of both business risk and financial risk. –Business risk is the risk to the firm of being unable to cover its operating costs. –In general, the greater the firm ’ s operating leverage — the use of fixed operating costs — the higher its business risk. –Although operating leverage is an important factor affecting business risk, two other factors — revenue stability and cost stability — also affect it. –Firms with high business risk therefore tend toward less highly leveraged capital structures, and firms with low business risk tend toward more highly leveraged capital structures.

© 2012 Pearson Prentice Hall. All rights reserved. 13-20 The Firm’s Capital Structure: Capital Structure Theory (cont.) Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates of sales and the associated levels of earnings before interest and taxes (EBIT) from its forecasting group: There is a 25% chance that sales will total $400,000, a 50% chance that sales will total $600,000, and a 25% chance that sales will total $800,000. Fixed operating costs total $200,000, and variable operating costs equal 50% of sales. These data are summarized, and the resulting EBIT calculated, in the following table:

© 2012 Pearson Prentice Hall. All rights reserved. 13-22 The Firm’s Capital Structure: Capital Structure Theory (cont.) Probability of Bankruptcy –The firm ’ s capital structure directly affects its financial risk, which is the risk to the firm of being unable to cover required financial obligations. –The penalty for not meeting financial obligations is bankruptcy. –The more fixed-cost financing — debt (including financial leases) and preferred stock — a firm has in its capital structure, the greater its financial leverage and risk. –The total risk of a firm — business and financial risk combined — determines its probability of bankruptcy.

© 2012 Pearson Prentice Hall. All rights reserved. 13-31 The Firm’s Capital Structure: Capital Structure Theory (cont.) Agency Costs Imposed by Lenders –As noted in Chapter 1, the managers of firms typically act as agents of the owners (stockholders). –The owners give the managers the authority to manage the firm for the owners ’ benefit. –The agency problem created by this relationship extends not only to the relationship between owners and managers but also to the relationship between owners and lenders. –To avoid this situation, lenders impose certain monitoring techniques on borrowers, who as a result incur agency costs.

© 2012 Pearson Prentice Hall. All rights reserved. 13-32 The Firm’s Capital Structure: Capital Structure Theory (cont.) Asymmetric Information –Asymmetric information is the situation in which managers of a firm have more information about operations and future prospects than do investors. –A pecking order is a hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing. –A signal is a financing action by management that is believed to reflect its view of the firm ’ s stock value; generally, debt financing is viewed as a positive signal that management believes the stock is “ undervalued, ” and a stock issue is viewed as a negative signal that management believes the stock is “ overvalued. ”

© 2012 Pearson Prentice Hall. All rights reserved. 13-33 The Firm’s Capital Structure: Capital Structure Theory (cont.) What, then, is the optimal capital structure, even if it exists (so far) only in theory? –Because the value of a firm equals the present value of its future cash flows, it follows that the value of the firm is maximized when the cost of capital is minimized. where EBIT= earnings before interest and taxes T=tax rate NOPAT=net operating profits after taxes, which is the after-tax operating earnings available to the debt and equity holders, EBIT  (1 – T) rara =weighted average cost of capital

© 2012 Pearson Prentice Hall. All rights reserved. 13-35 EBIT-EPS Approach to Capital Structure The EBIT – EPS approach is an approach for selecting the capital structure that maximizes earnings per share (EPS) over the expected range of earnings before interest and taxes (EBIT). We can plot coordinates on the EBIT – EPS graph by assuming specific EBIT values and calculating the EPS associated with them. Such calculations for three capital structures — debt ratios of 0%, 30%, and 60% — for Cooke Company were presented in Table 13.12. For EBIT values of $100,000 and $200,000, the associated EPS values calculated there are summarized in the table below the graph in Figure 13.6.

© 2012 Pearson Prentice Hall. All rights reserved. 13-37 EBIT-EPS Approach to Capital Structure: Considering Risk in EBIT-EPS Analysis When interpreting EBIT – EPS analysis, it is important to consider the risk of each capital structure alternative. Graphically, the risk of each capital structure can be viewed in light of two measures: 1.the financial breakeven point (EBIT-axis intercept) 2.the degree of financial leverage reflected in the slope of the capital structure line: The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk.

© 2012 Pearson Prentice Hall. All rights reserved. 13-39 Choosing the Optimal Capital Structure: Estimating Value The value of the firm associated with alternative capital structures can be estimated by using one of the standard valuation models, such as the zero-growth model. Although some relationship exists between expected profit and value, there is no reason to believe that profit-maximizing strategies necessarily result in wealth maximization. It is therefore the wealth of the owners as reflected in the estimated share value that should serve as the criterion for selecting the best capital structure.

© 2012 Pearson Prentice Hall. All rights reserved. 14-43 The Basics of Payout Policy: Elements of Payout Policy The term payout policy refers to the decisions that a firm makes regarding whether to distribute cash to shareholders, how much cash to distribute, and the means by which cash should be distributed.

© 2012 Pearson Prentice Hall. All rights reserved. 14-44 The Mechanics of Payout Policy: Cash Dividend Payment Procedures At quarterly or semiannual meetings, a firm ’ s board of directors decides whether and in what amount to pay cash dividends. If the firm has already established a precedent of paying dividends, the decision facing the board is usually whether to maintain or increase the dividend, and that decision is based primarily on the firm ’ s recent performance and its ability to generate cash flow in the future. Boards rarely cut dividends unless they believe that the firm ’ s ability to generate cash is in serious jeopardy.

© 2012 Pearson Prentice Hall. All rights reserved. 14-45 The Mechanics of Payout Policy: Cash Dividend Payment Procedures (cont.) The date of record (dividends) is set by the firm ’ s directors, the date on which all persons whose names are recorded as stockholders receive a declared dividend at a specified future time. A stock is ex dividend for a period, beginning 2 business days prior to the date of record, during which a stock is sold without the right to receive the current dividend. The payment date is set by the firm ’ s directors, the actual date on which the firm mails the dividend payment to the holders of record.

© 2012 Pearson Prentice Hall. All rights reserved. 14-47 Relevance of Payout Policy The financial literature has reported numerous theories and empirical findings concerning payout policy. Although this research provides some interesting insights about payout policy, capital budgeting and capital structure decisions are generally considered far more important than payout decisions. In other words, firms should not sacrifice good investment and financing decisions for a payout policy of questionable importance. The most important question about payout policy is this: Does payout policy have a significant effect on the value of a firm?

© 2012 Pearson Prentice Hall. All rights reserved. 14-48 Relevance of Payout Policy: Residual Theory of Dividends The residual theory of dividends is a school of thought that suggests that the dividend paid by a firm should be viewed as a residual — the amount left over after all acceptable investment opportunities have been undertaken. Using the residual theory of dividends, the firm would treat the dividend decision in three steps, as follows: –Determine its optimal level of capital expenditures, which would be the level that exploits all of a firm ’ s positive NPV projects. –Using the optimal capital structure proportions, estimate the total amount of equity financing needed to support the expenditures generated in Step 1. –Because the cost of retained earnings, r r, is less than the cost of new common stock, r n, use retained earnings to meet the equity requirement determined in Step 2. If retained earnings are inadequate to meet this need, sell new common stock. If the available retained earnings are in excess of this need, distribute the surplus amount — the residual — as dividends.

© 2012 Pearson Prentice Hall. All rights reserved. 14-49 Relevance of Payout Policy: The Dividend Irrelevance Theory The dividend irrelevance theory is Miller and Modigliani ’ s theory that in a perfect world, the firm ’ s value is determined solely by the earning power and risk of its assets (investments) and that the manner in which it splits its earnings stream between dividends and internally retained (and reinvested) funds does not affect this value. –In a perfect world (certainty, no taxes, no transactions costs, and no other market imperfections), the value of the firm is unaffected by the distribution of dividends. –Of course, real markets do not satisfy the “ perfect markets ” assumptions of Modigliani and Miller ’ s original theory.

© 2012 Pearson Prentice Hall. All rights reserved. 14-50 Relevance of Payout Policy: The Dividend Irrelevance Theory (cont.) The clientele effect is the argument that different payout policies attract different types of investors but still do not change the value of the firm. –Tax-exempt investors may invest more heavily in firms that pay dividends because they are not affected by the typically higher tax rates on dividends. –Investors who would have to pay higher taxes on dividends may prefer to invest in firms that retain more earnings rather than paying dividends. –If a firm changes its payout policy, the value of the firm will not change — what will change is the type of investor who holds the firm ’ s shares.

© 2012 Pearson Prentice Hall. All rights reserved. 14-51 Relevance of Payout Policy: Arguments for Dividend Relevance Dividend relevance theory is the theory, advanced by Gordon and Lintner, that there is a direct relationship between a firm ’ s dividend policy and its market value. The bird-in-the-hand argument is the belief, in support of dividend relevance theory, that investors see current dividends as less risky than future dividends or capital gains.

© 2012 Pearson Prentice Hall. All rights reserved. 14-52 Relevance of Payout Policy: Arguments for Dividend Relevance (cont.) Studies have shown that large changes in dividends do affect share price. –Informational content is the information provided by the dividends of a firm with respect to future earnings, which causes owners to bid up or down the price of the firm ’ s stock. –The agency cost theory says that a firm that commits to paying dividends is reassuring shareholders that managers will not waste their money. –Although many other arguments related to dividend relevance have been put forward, empirical studies have not provided evidence that conclusively settles the debate about whether and how payout policy affects firm value.

© 2012 Pearson Prentice Hall. All rights reserved. 14-53 Factors Affecting Dividend Policy Dividend policy represents the firm ’ s plan of action to be followed whenever it makes a dividend decision. First consider five factors in establishing a dividend policy: 1.legal constraints 2.contractual constraints 3.the firm ’ s growth prospects 4.owner considerations 5.market considerations

© 2012 Pearson Prentice Hall. All rights reserved. 14-54 Other Forms of Dividends A stock dividend is the payment, to existing owners, of a dividend in the form of stock. –In a stock dividend, investors simply receive additional shares in proportion to the shares they already own. –No cash is distributed, and no real value is transferred from the firm to investors. –Instead, because the number of outstanding shares increases, the stock price declines roughly in line with the amount of the stock dividend. –In an accounting sense, the payment of a stock dividend is a shifting of funds between stockholders ’ equity accounts rather than an outflow of funds.

© 2012 Pearson Prentice Hall. All rights reserved. 14-55 Other Forms of Dividends (cont.) A stock split is a method commonly used to lower the market price of a firm ’ s stock by increasing the number of shares belonging to each shareholder. –Stock splits are often made prior to issuing additional stock to enhance that stock ’ s marketability and stimulate market activity. –It is not unusual for a stock split to cause a slight increase in the market value of the stock, attributable to its informational content and to the fact that total dividends paid commonly increases slightly after a split. –A reverse stock split is a method used to raise the market price of a firm ’ s stock by exchanging a certain number of outstanding shares for one new share.

Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 13 Leverage and Capital Structure.

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Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 13 Leverage and Capital Structure.

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