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Chapter 15 Capital Structure Decisions

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Chapter 15 Outline 15.1 Operating and Financial Leverage Sales risk Operating risk Financial risk 15.2 The Modigliani and Miller Theorems The M&M Theories Bankruptcy Other factors that may affect the capital structure decision 15.3 Capital Structure in Practice Evaluating a company’s capital structure Surveys and observations Capital structure guidance 2

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We can break the uncertainty of a company’s earnings into three primary sources: 1. Sales risk, which is the uncertainty associated with the price and volume that the company produces and sells. 2. Operating risk, which is the uncertainty arising from the use of fixed operating costs relative to total operating costs. 3. Financial risk, which is the uncertainty arising from the use of fixed-cost sources of financing (that is, debt) relative to equity. 15.1 Operating and Financial Leverage 3

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Business Risk We refer to the combined influence of sales risk and operating risk as business risk because these are risks that are determined, in large part, on the line of business the company operates. For a given level of operating earnings, financial risk affects the earnings to owners. 4

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Business Risk Example Consider the Gearing Corporation, which produces gaskets. The production of gaskets, no matter the number of units produced and sold, costs $200 per year; therefore, the fixed operating costs are $200 per year. The variable cost of producing a gasket is $0.40, and Gearing sells each gasket for $1. For now, let us hold the number of units produced and sold to 1,000 units. What does Gearing’s income statement look like if it produces and sells 1,000 units? 5 Revenues$1,000 Operating expenses400 Fixed operating expenses200 Operating income$400

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Business Risk Example We now consider what might happen if things changed. Suppose, for example, the company issued a report that sales potential had increased, and it now expected to sell% more gaskets, so that sales revenues are expected to be $1,200: In this example, the company’s variable costs increase by the same 20% that sales increase, to 1,200 units × $0.40 = $480, but operating earnings increase by 30% to $520. This is due to operating leverage; some of the company’s operating costs are fixed and do not increase with sales. The greater the use of fixed costs in the operating cost structure, relative to variable operating costs, the greater the operating leverage. 6 Units produced and sold1,0001,200 Revenues$1,000$1,200 Operating expenses400480 Fixed operating expenses200 Operating income$400$520

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Now let’s consider what happens if sales drop by 20% to 800 units: Operating expenses declined by 20% (from $600 to $520), but operating income declined by 30% (from $400 to $280). Business Risk Example 7 Units produced and sold1,000800 Revenues$1,000$800 Operating expenses400320 Fixed operating expenses200 Operating income$400$280

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We can capture the sensitivity of operating earnings to the fixed operating costs with the degree of operating leverage (DOL), which is that ratio of the percentage change in operating earnings to the percentage change in unit sales: If we substitute Q for unit sales and represent the price per unit as P, the operating cost per unit as V, and the fixed operating cost as F, we can rearrange this to produce the DOL: In the case of Gearing, P = $1 V = $0.4 F = $200 Degree of Operating Leverage 8

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The difference between the sales price and the variable operating cost, P – V, is the contribution margin, which, when multiplied by the unit sales, is what is available to cover the fixed operating costs. The DOL therefore depends on the units sold, Q. We qualify our statements about the degree of operating leverage at specific level of units produced and sold. At 1,000 units produced and sold, the DOL is: DOL = ($1,000 – 400) ÷ ($1,000 – 400 – 200) = $600 ÷ $400 = 1.5 At 1,200 units produced and sold, the DOL is: DOL = ($1,200 – 480) ÷ ($1,200 – 480 – 200) = $720 ÷ $520 = 1.38 At 800 units produced and sold, the DOL is: DOL = ($800 – 320) ÷ ($800 – 320 – 200) = $480 ÷ $280 = 1.71 Degree of Operating Leverage 9

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We can tie together the operating profit margin and the degree of operating leverage by calculating the break-even point; that is, the units produced and sold at which the operating profit is zero. We can calculate the precise break-even point by setting the operating profit to zero and then solving for the units, Q: Q(P – V) – F = $0 Q($1 – 0.4) – 200 = $0 Q$0.6 = $200 Q = $200 ÷ $0.6 = 333.33 units Operating Break-Even 10

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We can guesstimate the break-even point using the following graph: Operating Break-Even 11 Operating Profit and Operating Leverage

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By consulting with the marketing management of the company, the financial managers at Gearing have determined the price at which they can sell the gaskets based on the volume of sales: When we introduce the demand function for the product, we introduce more variability in the operating profit margin. Hence, operating earnings are affected by both sales risk and operating risk. Sales Risk 12 Unit SalesPrice per Gasket 200–799$1.10 800–1299$1.00 1300 and above$0.90

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Problem: A company expects to sell 18,000 units of its product at a price of $5 per unit. The variable cost to produce a unit is $3, and the company has fixed operating costs of $30,000. Calculate the following: A. Contribution margin B. Operating earnings C. Degree of operating leverage at 18,000 units D. Percentage change in operating earnings if the company’s sales are 5 percent higher E. Break-even units produced and sold Operating Leverage 13

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Solution: A. Contribution margin = $5 – 3 = $2 B. [18,000 x ($5 – 3) – 30,000] = $6,000 C. [18,000 x ($5 – 3)] ÷ [18,000 x ($5 – 3) – 30,000] = 6 D. 6 x 5% = 30% [Check: 18,000 x ($5 – 3) – 30,000 = 7,800, which is 30% higher than 6,000] E. Q($5 – 3) – 30,000 = 0; Q = 30,000 ÷ 2 = 15,000 units Operating Leverage 14

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Financial leverage - the use of debt to finance a company’s assets. Financial leverage results in earnings to owners that vary more than a similar company that finances its assets with equity. Consider three choices of capital structure for the Gearing Company: Structure One, Structure Two, and Structure Three. With Structure One, Gearing finances its assets solely with equity, whereas with Structures Two and Three, Gearing finances its assets with both debt and equity, as we show in the following table. Financial Leverage 15

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Structure One Structure Two Structure Three Assets$2,000 Debt$0$500$1,000 Equity$2,000$1,500$1,000 Number of shares2,0001,5001,000 Debt-to-invested capital0.000.250.50 Debt-to-equity0.000.331.00 Alternative Financing Strategies for the Gearing Company 16

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Invested capital - a sum total of capital in a company’s capital structure, consisting of debt and equity. The invested capital for all three structures is the same: $2,000. Now let’s consider the income statement of each company, which we show in the following table. For now, we are holding units produced and sold to 1,000, sold at a sales price of $1 per unit. Financial Leverage 17

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Structure One Structure Two Structure Three Revenues$1,000 Operating expenses400 Fixed operating expenses200 Operating income$400 Interest02550 Taxable income$400$375$350 Taxes140131123 Net income$260$244$228 Effect of Alternative Financing Strategies on the Income Statement 18

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We have ratios that we can use to measure the profitability of the companies, including the return on equity and the return on invested capital. As you have seen in previous chapters, we calculate the return on equity (ROE) by comparing net profit with equity: Therefore, the ROE is affected by interest on debt. The return on invested capital (ROI), on the other hand, is the ratio of operating income to invested capital: Returns and Financial Leverage 19

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We provide the three returns for each company in the following table, holding operating earnings constant at $400. As you can see, the return on invested capital is the same, no matter the financing. This is because the operating income after tax, which is $400 – 140 = $260, and the invested capital, the $2,000, are same no matter the financing. The return on equity, however, increases with more debt because the operating earnings after tax remain the same, but the amount of equity declines from $2,000 (Structure One) to $1,000 (Structure Three). In the case of Structures Two and Three, Gearing pays the creditors a fixed amount, but anything the company makes beyond that flows to shareholders. Hence, the benefit from financial leverage. Returns and Financial Leverage 20 Structure One Structure Two Structure Three Return on invested capital20% Return on equity13%16%23%

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Financial breakeven point - return on investment or quantity produced or sold at which a company’s ROE is zero. Indifference point - the quantity produced and sold or return on investment at which two financing strategies provide the same return on equity. EPS indifference point - the EBIT level at which two financing alternatives generate the same EPS. Financial Break-Even 21

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Companies must deal with both of these risks in making decisions. We can see how the two are combined by examining the degree of total leverage (DTL). DTL captures the leveraging effects of both the operating risk and the financial risk, using the sum total of the fixed operating costs and the fixed financing costs as the fulcrum. Combining Operating and Financial Risk 22

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Nassim N. Taleb, Daniel G. Goldstein, and Mark W. Spitznagel point out six mistakes that are made in risk management: 1. Managing risk by predicting extreme events 2. Using the past to manage risk 3. Not considering advice intended to instruct what not to do 4. Measuring risk by standard deviation 5. Not factoring in human behavior 6. Seeking optimization, without considering vulnerability Summary of Risk Management Mistakes 23

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Capital structure theory is dominated by the work of economists Franco Modigliani and Merton Miller (M&M). It is in fact a very powerful theorem for which (in part) the authors won the Nobel Prize in economics in 1985. Although the theory that they developed does not prescribe a particular capital structure for a company, it does provide a way of looking at the factors that should be considered in selecting a capital structure. The M&M theory comprises three different scenarios: 1. A world without taxes or costs of financial distress 2. A world with taxes, but no costs of financial distress 3. A world with taxes and costs of financial distress Note: financial distress is a state of business failing where bankruptcy seems imminent if dramatic action is not taken 15.2 The Modigliani and Miller Theorems 24

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In the first part of the M&M capital structure theory, we assume that there are no transactions costs or asymmetric information, no taxes, and no costs of financial distress; in other words, the company operates in a perfect capital market. The company’s value is like a pizza—does how you slice it up into debt or equity affect the size of the pizza? No. Therefore, in a world without taxes and where there is no cost of being in financial distress, the capital structure that a company chooses should not matter. BOTTOM LINE: The value of the company is not affected by its capital structure. Part 1: No Taxes, No Costs of Financial Distress 25

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In the second part, M&M starts with the assumptions of the first part, but then introduces taxes, with companies permitted to deduct interest in determining their taxable income. When they do this, capital structure matters: The more debt in the capital structure, the greater the value of the company. The reason for this is that, without costs of financial distress, a company benefits from the tax deductibility of interest, which lowers its tax bill and hence increases its value. BOTTOM LINE: If interest on debt is tax deductible but there are no costs to financial distress, the more debt, the greater the value of the company. Part 2: Taxes, but no Costs to Financial Distress 26

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In the third part, M&M relaxes the assumption of no costs of financial distress. What this means is that if the company assumes too much financial risk, there is a risk that the company will incur costs and possibly bankruptcy. Ultimately, the benefit from the tax deductibility of interest is outweighed by the costs of financial distress. BOTTOM LINE: Taking on more debt, relative to equity, will increase the value of the company to a point, after which the costs of financial distress will offset the benefit from interest deductibility. Part 3: Taxes and Costs to Financial Distress 27

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Bankruptcy - a legal status of a company that permits the company to deal with debt problems. May occur in one of two ways: 1. The company commits an act of default, such as the nonpayment of interest, and creditors enforce their legal rights as a result. 2. The company voluntarily declares bankruptcy. Bankruptcy 28

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CompanyIndustryYearTotal Assets (in billions) Lehman Brothers HoldingsInvestment banking2008$638 Washington Mutual Inc.Financial services2008$328 WorldComTelecommunications2002$104 General MotorsAutomobile manufacturing2009$91 CITFinancial services2009$71 EnronEnergy2001$66 ConsecoFinancial services2002$61 ChryslerAutomobile manufacturing2009$39 Thornburg MortgageFinancial services2009$37 Pacific Gas and ElectricNatural gas and electricity2001$36 TexacoOil and gas1987$35 Financial Corporation of AmericaSavings and loan1988$34 RefcoFinancial services2005$33 IndyMac BancorpFinancial services2008$33 Global CrossingTelecommunications2002$30 29 Largest U.S. Bankruptcy Filings Through 2010

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How well does the static trade-off model explain capital structures? It certainly captures the main effects. However, it largely ignores two important issues: 1. Information asymmetry problems: the effect of informational differences among shareholders, creditors, and management 2. Agency problems: the fact that managers make these decisions on behalf of the shareholders, but they have their own interests at stake as well Other Factors that May Affect the Capital Structure Decision 30

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We know from theory that the tax deductibility of interest makes debt more attractive than equity, but only to a point because the more debt, vis-à-vis equity, that a company has, the greater the likelihood of incurring costs of financial distress. Let’s first consider some standard financial ratios that are often used. We can think of these ratios as stock or flow ratios. Stock ratios are measures such as the debt-to-equity (D/E) and debt ratios. These ratios measure the amount of outstanding debt relative to total assets, total capital, or the amount of equity. Flow ratios include times-interest-earned and cash flow debt ratio. Both stock and flow financial leverage ratios are used by the bond-rating agencies and others as a quick check on the company’s financing, and they are also often used to limit the amount of debt a company can raise through its trust indenture. 15.3 Capital Structure in Practice 31

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A number of financial ratios help us evaluate just how much of a debt obligation the company has incurred. There are basically two types of financial leverage ratios: ratios that measure the debt burden, and coverage ratios, which measure the company’s ability to satisfy its debt obligations. Financial Leverage Ratios RatioCalculationInterpretation Debt ratioThe proportion of total assets financed with debt Debt-equity ratioHow much debt is used to finance the company for every dollar of equity Equity multiplierThe total assets of the company for every dollar of equity Times interest earnedHow many times the company can satisfy its interest obligation from operating earnings Cash flow-to-debt ratioThe inverse of this ratio is the number of years it would take to pay off the debt using cash flow from operations 32

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Credit rating services use financial ratios, among other information, to evaluate the creditworthiness of companies and the default risk of debt obligations. Moody’s, one of the major rating services, periodically provides data on the most commonly used credit ratios and how they are correlated with their credit ratings. Debt Ratings 33 CriterionInvestment GradeSpeculative Interest coverage6.5 times2.1 times Asset coverage2.4 times1.4 times Financial leverage43.6%66.8% Cash flow-to-debt28.4%12.7% Return on assets6.3%1.9% Net profit margin7.8%2.1% Liquidity4.6%3.9% Financial Ratios by Moody’s Debt Ratings

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Another measure of the financial health of a company is the Altman Z-score. This is weighted average of several key ratios that Professor Ed Altman found were useful for predicting a company’s probability of bankruptcy. His prediction equation is as follows: Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 0.999X 5 where: X 1 is working capital divided by total assets X 2 is retained earnings divided by total assets X 3 is EBIT divided by total assets X 4 is market values of total equity divided by nonequity book liabilities X 5 is sales divided by total assets Altman’s Z-Score 34

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John Graham and Campbell Harvey surveyed U.S. companies regarding factors that affect management’s decision to issue debt. The most often-cited factor is financial flexibility, followed closely by credit ratings. Other oft-cited factors in their survey include earnings and cash flow volatility, sufficiency of internally generated funds, the level of interest rates, and tax savings from interest deductibility. Surveys and Observations 35 Debt as a Percentage of Invested Capital, for Selected Industries

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Factors in the Determination of the Level of Debt 36

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So what is a company to do? A company selects its capital structure based on a number of factors: Is the company profitable? What type of assets does the company have? How risky is the company’s underlying business? Is the company profitable? Is it growing? Why might companies deviate from their target capital structure? Of course, companies deviate from their target capital structure when they are offered a good deal. In terms of financing, this means that if the company observes attractive interest rates for debt financing, it might lean more heavily on debt financing. Capital Structure Guidance 37

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The basic Modigliani and Miller (M&M) arguments assess whether the capital structure decision creates value. The conclusion was that under some simplifying assumptions, issuing debt does not create value. This is because the company is not doing anything that others can’t do just as well; that is, borrow money. In essence, the M&M argument is that companies should stick to doing things where they have a comparative advantage, and it is difficult to see how borrowing money is such because we can all do it. Once we introduce the fact that interest on debt is tax deductible, whereas dividends to the common shareholders are not, it means that there is a tax shield value to raising debt. Hence, there is a transfer of wealth to the private sector from the government as the company finances with debt. This tax incentive to using debt is offset by the resulting financial distress and bankruptcy costs, as discussed in the static trade-off model. Chapter Summary 38

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As its name implies, the static trade-off model does not take into account dynamic effects. The pecking order theory, on the other hand, does account for these dynamic effects as companies tend to first use internal cash flow, then debt, and will only raise new common equity as a last resort. The result is that companies depart from the static trade-off optimal debt ratio over time, and then refinance to bring their debt ratio back in line with their target ratio. Therefore, actual capital structures are constantly changing as companies take advantage of market conditions. Chapter Summary 39

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Capital structure decisions in practice focus on a company’s target capital structure and the company’s ability to satisfy debt obligations. Financial managers not only worry about how new debt affects a company’s credit rating, but they also worry about how capital structure decisions affect dividends and the reported earnings per share. Chapter Summary 40

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