Determining the Financing Mix n Operating Leverage n Financial Leverage n Capital Structure
2 concepts that enhance our understanding of risk... 1) Operating Leverage - affects a firm’s business risk. 2) Financial Leverage - affects a firm’s financial risk.
Business Risk n The variability or uncertainty of a firm’s operating income (EBIT).
Business Risk Affected by: n Sales volume variability n Competition n Cost variability n Product diversification n Product demand n Operating Leverage
Operating Leverage n The use of fixed operating costs as opposed to variable operating costs. n A firm with relatively high fixed operating costs will experience more variable operating income if sales change.
Financial Risk n The variability or uncertainty of a firm’s earnings per share (EPS) and the increased probability of insolvency that arises when a firm uses financial leverage.
Financial Leverage n The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).
Capital Structure How do we want to finance our firm’s assets?
Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity CapitalStructure
Why is Capital Structure Important? n 1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments. n 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. n 3) The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.
What is the Optimal Capital Structure? n In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. n This is known as the Modigliani-Miller hypothesis, or the Independence Hypothesis: firm value is independent of capital structure.
n In a “perfect markets” environment, capital structure is irrelevant. n In other words, changes in capital structure do not affect firm value. Modigliani-Miller Hypothesis
2) Moderate Position n The previous hypothesis examines capital structure in a “perfect market.” n The moderate position examines capital structure under more realistic conditions. n For example, what happens if we include corporate taxes?
Moderate Position n So, what does the tax benefit of debt financing mean for the value of the firm? n The more debt financing used, the greater the tax benefit, and the greater the value of the firm. n So, this would mean that all firms should be financed with 100% debt, right? n Why are firms not financed with 100% debt?
Why is 100% Debt not Optimal? Bankruptcy costs: costs of financial distress. n Financing becomes difficult to get. n Customers leave due to uncertainty. n Possible restructuring or liquidation costs if bankruptcy occurs.
Cost of Capital financial leverage kc kd kc kd If a firm borrows too much, the costs of debt and equity will spike upward, due to bankruptcy costs and agency costs. Moderate Position with Bankruptcy and Agency Costs
Cost of Capital financial leverage kc kdkckd ko Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital. Moderate Position with Bankruptcy and Agency Costs
Cost of Capital financial leverage kc kdkckd ko Moderate Position with Bankruptcy and Agency Costs