4What 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 effect of financial leverage.Low riskProbabilityHigh riskE(EBIT)EBIT
5What determines business risk? Uncertainty about demand (sales).Uncertainty about output prices.Uncertainty about costs.Product, other types of liability.Competition.Operating leverage.
6What is operating leverage, and how does it affect a firm’s business risk? OL is defined as (%change in EBIT)/(%change in sales).Operating leverage is high if the production requires higher fixed costs and low variable costs.High fixed cost can leverage small increase in sales into high increase in EBIT.
7Effect of operating leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.Sales$Rev.TCFCQBE}Profit
8Using operating leverage Low operating leverageProbabilityHigh operating leverageEBITLEBITHTypical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.
9What is financial leverage? Financial risk? Financial leverage is defined as (%change in NI) / (% change in EBIT)High usage of debt can leverage small increase in EBIT into big increase in net income.Financial leverage is high with high level of debt.
10What is Financial risk?Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.More debt, more financial leverage, more financial risk.More debt will concentrate business risk on stockholders because debt holders do not bear business risk (in case of no bankruptcy).
11A summary Operating Leverage Financial Leverage Business Risk Financial Risk%change in EBIT/%change in sales%change in NI/%change in EBITVariability in the firm’s expected EBIT.Additional variability in net income available to common shareholders.Increase with higher fixed costIncrease with higher debtIncrease with high OL.Increase with high FL.If a firm already has high business risk, you may want to use less debt to get less financial risk. If a firm has less business risk, you may afford high financial risk.
12An example: Illustrating effects of financial leverage Two firms with the same operating leverage, business risk, and probability distribution of EBIT.Only differ with respect to their use of debt (capital structure).Firm U Firm LNo debt $10,000 of 12% debt$20,000 in assets $20,000 in assets40% tax rate 40% tax rate
14Firm L: Leveraged Economy Bad Avg. Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000Interest 1, , ,200EBT $ $1,800 $2,800Taxes (40%) ,120NI $ $1,080 $1,680*Same as for Firm U.
15Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg GoodBEP % % %ROE % % %BEP=EBIT/assets (basic earning power)FIRM L Bad Avg GoodROE % % %
16Risk and return for leveraged and unleveraged firms Expected Values:Firm U Firm LE(BEP) 15.0% = 15.0%E(ROE) 9.0% < 10.8%Risk Measures:σROE 2.12% < 4.24%
17The Effect of Leverage on profitability How does leverage affect the EPS and ROE of a firm?When we increase the amount of debt financing, we increase the fixed interest expenseIf we have a good year (BEP > kd), then we pay our fixed interest cost and we have more left over for our stockholdersIf we have a bad year (BEP < kd), we still have to pay our fixed interest costs and we have less left over for our stockholdersLeverage amplifies the variation in both EPS and ROERemind the students that if we increase the amount of debt in a restructuring, we are decreasing the amount of outstanding shares.
18ConclusionsBasic earning power (BEP) is unaffected by financial leverage.Firm L has higher expected ROE.Firm L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.
19Quick QuizExplain the effect of leverage on expected ROE and risk
20The degree of operating leverage is defined as: a % change in EBIT_____% change in Variable Costb % change in EBIT% change in Salesc. % change in Sales% change in EBITd. % change in EBIT_______________% change in contribution margin
21Leverage will generally __________ shareholders' expected return and _________ their risk. a. increase; decreaseb. decrease; increasec. increase; increased. increase; do nothing to
22what is its degree of operating leverage? a. 3.6 b. 4.2 c. 4.7 d. 5.0 If a 10 percent increase in sales causes EBIT to increase from $1mm to $1.50 mm,what is its degree of operating leverage?a. 3.6b. 4.2c. 4.7d. 5.0e. 5.5
24Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equalCapital restructuring involves changing the amount of leverage a firm has without changing the firm’s assetsIncrease leverage by issuing debt and repurchasing outstanding sharesDecrease leverage by issuing new shares and retiring outstanding debt
25Choosing a Capital Structure What is the primary goal of financial managers?Maximize stockholder wealthWe want to choose the capital structure that will maximize stockholder wealthWe can maximize stockholder wealth by maximizing firm value (or equivalently minimizing WACC).Remind students that the WACC is the appropriate discount rate for the risk of the firm’s assets. We can find the value of the firm by discounting the firm’s expected future cash flows at the discount rate – the process is the same as finding the value of anything else. Since value and discount rate move in opposite directions, firm value will be maximized when WACC is minimized.
26Optimal Capital Structure Objective: Choose capital structure (mix of debt v. common equity) at which stock price is maximized.Trades off higher ROE and EPS against higher risk. The tax-related benefits of leverage are offset by the debt’s risk-related costs.
27What effect does increasing debt have on the cost of equity for the firm? If the level of debt increases, the riskiness of the firm increases.The cost of debt will increase because bond rating will deteriorates with higher debt level.Moreover, the riskiness of the firm’s equity also increases, resulting in a higher ks.
29Finding Optimal Capital Structure The firm’s optimal capital structure can be determined two ways:Minimizes WACC.Maximizes stock price.Both methods yield the same results.
30Table for calculating WACC and determining the minimum WACC ks12.00%12.5113.2014.1615.60kd (1 – T)0.00%4.805.406.908.40Amount borrowed$250K500K750K1,000KD/A ratio0.00%12.5025.0037.5050.00WACC12.00%11.5511.2511.4412.00
31Table for determining the stock price maximizing capital structure AmountBorrowedEPSkPs$$3.0012.00%$25.00250K3.2612.5126.03500K3.5513.2026.89750K3.7714.1626.591,000K3.9015.6025.00
32What is this firm’s optimal capital structure? Stock price P0 is maximized ($26.89) at D/A = 25%, so optimal D/A = 25%.EPS is maximized at 50%(EPS= $3.90), but primary interest is stock price, not E(EPS).We could push up E(EPS) by using more debt, but the higher risk more than offsets the benefit of higher E(EPS).
33Capital Structure Theory Under Five Special Cases Case I – AssumptionsNo corporate or personal taxesNo bankruptcy costsCase II – AssumptionsCorporate taxes, but no personal taxesCase III – AssumptionsBankruptcy costsCase IV – AssumptionsManagers have private informationCase V – AssumptionsManagers tend to waste firm money and not work hard.
34Case I: Ignoring taxes and Bankruptcy Cost The value of the firm is NOT affected by changes in the capital structureThe cash flows of the firm do not change, therefore value doesn’t changeThe WACC of the firm is NOT affected by capital structureIn this case, capital structure does not matter.The main point with case I is that it doesn’t matter how we divide our cash flows between our stockholders and bondholders, the cash flow of the firm doesn’t change. Since the cash flows don’t change; and we haven’t changed the risk of existing cash flows, the value of the firm won’t change.
36Case II consider taxes but ignore bankruptcy cost Interest expense is tax deductibleTherefore, when a firm adds debt, it reduces taxes, all else equalThe reduction in taxes increases the firm value. Other things equal, the less tax paid to the IRS, the better off the firm.Point out that the government effectively pays part of our interest expense for us; it is subsidizing a portion of the interest payment.
37Case II consider taxes but ignore bankruptcy cost The value of the firm increases by the present value of the annual interest tax shieldValue of a levered firm = value of an unlevered firm + PV of interest tax shield (VL = VU + DTC)The WACC decreases as D/E increases because of the government subsidy on interest paymentsRU is the cost of capital for an unlevered firm = RA for an unlevered firmVU is jus the PV of the expected future cash flow from assets for an unlevered firm.
40Case III consider both taxes and bankruptcy cost Now we add bankruptcy costsAs the D/E ratio increases, the probability of bankruptcy increases. This increased probability will increase the expected bankruptcy costs
41Bankruptcy Costs (financial distress cost) Direct bankruptcy costsLegal and administrative costsCreditors will stop lending money to the firm.Indirect bankruptcy costsLarger than direct costs, but more difficult to measure and estimateAlso have lost sales, interrupted operations and loss of valuable employees
42Case IIIAt some point, the additional value of the interest tax shield will be offset by the expected bankruptcy costAfter this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added
44Case III (also called Modigliani-Miller static Theory) The graph shows MM’s tax benefit vs. bankruptcy cost theory.With more debt, initially firm will benefit from tax reduction.With high debt, the threat of financial distress becomes severe.As financial conditions weaken, expected costs of financial distress can be large enough to outweigh the tax shield of debt financing.Optimal debt level is some trade-off point.
45Conclusions Case I – no taxes or bankruptcy costs No optimal capital structure. Debt level does not matter.Case II – corporate taxes but no bankruptcy costsOptimal capital structure is 100% debtMore debt—more tax shield—higher firm value.Case III – corporate taxes and bankruptcy costsOptimal capital structure is part debt and part equityOccurs where the marginal tax benefit from debt is just offset by the increase in bankruptcy costs
47Case IV--Incorporating signaling effects When managers know private information about the firm’s future than the market, there is a signaling effect.Signaling theory suggests when firms issue new stocks, stock price will fall. Why?
48What are “signaling” effects in capital structure? Assume managers have better information about a firm’s long-run prospect than outside investors. They will issue stock if they think stock is overvalued; they will issue debt if they think stock is undervalued.But outside investors are not stupid. They view a common stock offering as a negative signal--managers think stock is overvalued.
49Case IV--Incorporating signaling effects Conclusion: firms should maintain a lower debt level so that in case the firm needs to raise money in the future, it can issue debt rather than sell new stocks.
50Case V—High debt constrains managers’ bad behavior When would you more likely to go to a lavish restaurant?1. After receiving a good salary.2. After receiving a lot of credit card bills.
51Case V—High debt constrains managers’ bad behavior Managers tend to spend a lot of cash on lavish offices, corporate jets, etc.With more debt, the need to pay interest and the threat of bankruptcy remind managers to waste less and work harder.The fact that managers are not born to work whole heartedly for stockholders suggests using more debt.
52Observed Capital Structure In Reality Capital structure does differ by industries. Even for firms in same industry, capital structures may vary widely.Lowest levels of debtDrugs with 2.75% debtComputers with 6.91% debtHighest levels of debtSteel with 55.84% debtDepartment stores with 50.53% debtSee Table 13.5 in the book for more detail
53Conclusions on Capital Structure Need to recognize inputs (such as bankruptcy cost) are “guesstimates.”As a result of imprecise estimates, capital structure decisions have a large judgmental content.It may also mean you might feel the knowledge is not very “systematic” in this chapter. The textbook says that “if you feel our discussion of capital structure theory imprecise and somewhat confusing, you are not alone.” .
54How would these factors affect the target capital structure? High sales volatility? decreaseHigh operating leverage? decreaseIncrease in the corporate tax rate? increaseIncrease in bankruptcy costs? decreaseManagement spending lots of money on lavish perks? increase
55The tax savings of the firm derived from the deductibility of interest expense is called the: a. Interest tax shield.b. Depreciable basis.c. Financing umbrella.d. Current yield.e. Tax-loss carryforward savings.
56A firm's optimal capital structure occurs where? a. EPS are maximized, and WACC is minimized.b. Stock price is maximized, and EPS are maximized.c. Stock price is maximized, and WACC is maximized.d. WACC is minimized, and stock price is maximized.e. All of the above.
57The unlevered cost of capital is a. the cost of capital for a firm with no equity in its capital structureb. the cost of capital for a firm with no debt in its capital structurec. the interest tax shield times pretax net incomed. the cost of preferred stock for a firm with equal parts debt and common stock in its capital structuree. equal to the profit margin for a firm with some debt in its capital structure
58The explicit costs associated with corporate default, such as legal expenses, are the ____ of the firma. flotation costsb. default beta coefficientsc. direct bankruptcy costsd. indirect bankruptcy costse. default risk premia
59The implicit costs associated with corporate default, such as lost sales, are the of the firm a. flotation costsb. default beta coefficientsc. direct bankruptcy costsd. indirect bankruptcy costse. default risk premia
60Which of the following conclusions can be drawn from M&M Proposition I with taxes (case II in our slides)?a. The value of an unlevered firm exceeds the value of a levered firm by the present value of the interest tax shield.b. There is a linear relationship between the amount of debt in a levered firm and its value.c. A levered firm can increase its value by reducing debt.d. The optimal amount of leverage for a firm is not possible to determine.e. The value of a levered firm is equal to its aftertax EBIT discounted by the unlevered cost of capital.
61Which of the following statements regarding leverage is true? a. If things go poorly for the firm, increased leverage provides greater returns to shareholders (as measured by ROE and EPS).b. As a firm levers up, shareholders are exposed to more risk.c. The benefits of leverage will be greater for a firm with substantial accumulated losses or other types of tax shields compared to a firm without many tax shields.d. The benefits of leverage always outweigh the costs of financial distress.
62If managers in a firm tend to waste shareholders’ money by spending too much on corporate jets, lavish offices, and so on,then a firm may wants to use______ debt to mitigate this behavior.a. moreb. lessc. It does not matter.
63a. Issue debt to maintain the returns of equity holders. If you know that your firm is facing relatively poor prospects but needs new capital, and you know that investors do not have this information, signaling theory would predict that you would:a. Issue debt to maintain the returns of equity holders.b. Issue equity to share the burden of decreased equity returns between old and new shareholders.c. Be indifferent between issuing debt and equity.d. Postpone going into capital markets until your firm’s prospects improve.