1. Chapter 12 CAPITAL STRUCTURE AND LEVERAGE © 2000 South-Western College Publishing

2. CAPITAL STRUCTURE The mix of debt and equity within a firm's capital (Consider preferred stock a form of debt) Financial Leverage The use of debt is Financial Leverage THE CENTRAL ISSUE Can the use of leverage affect the value of a firm's equity or its stock price? RISK IN THE CONTEXT OF LEVERAGE Define risk as variation in recorded financial performance measured at ROE and EPS TM 12-1 Slide 1 of 2

3. PERFORMANCE MEASURES TM 12-1 Slide 2 of 2

4. Variation in Recorded Financial Performance Arises from Two Sources Variation in Business Operations The Use of Debt in the Capital Structure (Leverage) BUSINESS RISK Variation in operating performance measured at EBIT FINANCIAL RISK The additional variation in ROE and EPS (over that in EBIT) caused by the use of Financial Leverage TM 12-2 Slide 1 of 2

5. Sources ofVariation PerformanceVariations as Risk Variation in Business BusinessOperations Create Variation EBIT in EBIT Business Risk Plus Additional Variation fromFinancial Risk Financingthe Effects of debt Financing Leads to Overall PerformanceVariation in Risk in Measured byROE and EPS Financial ROE and EPS Performance Figure 12-1 Business and Financial Risk TM 12-2 Slide 2 of 2

6. THE GOOD NEWS CONSIDER THE EFFECT OF INCREASING LEVERAGE GOOD WHEN BUSINESS IS GOOD TM 12-3 Slide 1 of 2

7. Leverage Analysis Arizona Hot Air Balloon Corporation ($000) Leverage Scenarios #1 #2 #3 0% Debt50% Debt80% Debt Capital Debt -$ 500 $ 800 Equity$ 1,000 500 200 Total$ 1,000$ 1,000$ 1,000 Shares @ $10 100,000 50,000 20,000 Rev$ 1,000$ 1,000$ 1,000 Cost/Exp 800 800 800 EBIT$ 200$ 200$ 200 Interest (10%) - 50 80 EBT$ 200$ 150$ 120 Tax (40%) 80 60 48 EAT$ 120$ 90$ 72 ROE12%18%36% EPS$1.20$1.80$3.60 TM 12-3 Slide 2 of 2

8. WHEN DOES LEVERAGE HELP? The Return on Capital vs. the Cost of Debt LEVERAGE HELPS IF: ROCE > After Tax Cost of Debt TM 12-4

9. But Leverage Works Both Ways THE BAD NEWS POOR CONSIDER THE EFFECT OF INCREASING LEVERAGE WHEN BUSINESS IS POOR TM 12-5

10. Leverage Analysis Arizona Hot Air Balloon Corporation ($000) Leverage Scenarios #1 #2 #3 0% Debt50% Debt80% Debt Capital Debt -$ 500 $ 800 Equity$ 1,000 500 200 Total$ 1,000$ 1,000$ 1,000 Shares @ $10 100,000 50,000 20,000 Rev$ 800$ 800$ 800 Cost/Exp 720 720 720 EBIT$ 80$ 80$ 80 Interest (10%) - 50 80 EBT$ 80$ 30$ - Tax (40%) 32 12 - EAT$ 48$ 18$ - ROE4.8%1.8%0% EPS$0.48$0.18$0.00 TM 12-5

11. FINANCIAL LEVERAGE AND FINANCIAL RISK Financial leverage good Multiplies good results into great results bad Multiplies bad results into terrible results ROE and EPS make wider swings with more leverage The incremental variation is financial risk TM 12-6 Slide 1 of 2

12. ROE Column #1Column #3 No Debt 80% Debt Good Times Good Times (Table 12-1) 12.0%36.0% Bad Times Bad Times (Table 12-2) 4.8% 0.0% Difference 7.2%36.0% Incremental Difference in ROE Due to Financial Leverage = 36.0% - 7.2% = 28.8% Change in ROE due to Business Risk = 7.2% Change in ROE due to Financial Risk = 28.8% 36.0% Table 12-3 Financial Leverage and Risk TM 12-6 Slide 2 of 2

13. PUTTING THE IDEAS TOGETHER - THE EFFECT ON STOCK PRICE 1. During periods of reasonably good performance, leverage enhances results in terms of ROE and EPS which drives stock price up. 2. Leverage adds variability to financial performance when operating results change. This means performance is riskier with more leverage which drives stock price down. Both become more pronounced as leverage increases. The effects drive stock prices in opposite directions At low levels of leverage the positive effect dominates, while at high levels the negative effect is stronger TM 12-7 Slide 1 of 3

14. Stock Price % Debt 0% Optimal 100% C/S Figure 12-2 The Effect of Leverage on Stock Price TM 12-7 Slide 2 of 3

15. Finding The Optimum Is A Practical Problem Generally Accepted Wisdom 1. A firm with good profit prospects and little or no debt is probably missing an opportunity by not using borrowed money if interest rates are reasonable. 2. For most businesses the optimal capital structure lies somewhere between 30% and 50% debt. 3. Debt levels above 60% create excessive risk, and should be avoided. TM 12-7 Slide 3 of 3

16. MEASURING LEVERAGE Example 12-2 Moberly Moped Manufacturing Company ($000) Revenue$5,580Capital Cost/Expense 4,200 Debt $1,000 EBIT$1,380 Equity 7,000 Total $8,000 Stock: 700,000 shares, selling at book value of $10 Interest: 15%Tax rate: 40% Moberly is interested in boosting stock price by restructuring capital to 50% debt. However, the economic outlook is shaky, and EBIT may decline. Estimate the effect of restructuring on EPS. Use the DFL to assess the risk impact. TM 12-8

17. Solution: Calculate the current and proposed capital structures: CurrentProposed Capital Debt$1,000$4,000 Equity$7,000$4,000 Total$8,000$8,000 Shares outstdg 700,000 400,000 Calculate projected EAT and EPS at the current level of business for both capital structures: CurrentProposed EBIT$1,380$1,380 Interest (15%) 150 600 EBT$1,230$ 780 Tax (@ 40%) 492 312 EAT$ 738$ 468 EPS $1.054$1.170 TM 12-9 Slide 1 of 2

18. Calculate the DFL under each structure: EPS will be more volatile under proposed structure. Illustrate with 30% decline in EBIT. Current structure: Proposed structure: Apply to projected EPSs : Current: $1.054(1 -.336) = $.70 Proposed: $1.170(1 -.531) = $.55 Implication: EPS may be lower under proposal in bad times. Gives management a sense of the trade-off with respect to risk TM 12-9 Slide 2 of 2

19. USING LEVERAGE CONCEPTS TO MANAGE CAPITAL STRUCTURE EBIT-EPS ANALYSIS EPS $4.00 50% Debt $3.00 No Advantage $1.00 EBIT $100 $200 $300 $400 Advantage to Equity EBIT-EPS Analysis Figure 12-3 Arizona Hot Air Balloon Corporation, From Table 12-1, Columns 1 and 2 TM 12-10 to debt Leverage $2.00

20. OPERATING LEVERAGE The mix of fixed and variable cost in a firm's Cost Structure BREAKEVEN ANALYSIS Best understood through BREAKEVEN ANALYSIS Cost REV Total Cost Profit LossFixed Cost Q Q B/E Figure 12-5 The Breakeven Diagram TM 12-11 Slide 1 of 3

21. THE ALGEBRA OF BREAKEVEN Contribution (to profit and fixed cost) C t = P - V where C t is the contribution, P is price, and V is variable cost per unit Contribution margin TM 12-11 Slide 2 of 3

22. Breakeven Sales Level EBIT = PQ - VQ - F C Where P = Price per unit V = Variable cost per unit Q = Quantity sold, and F C = Total fixed cost At Breakeven::0 = PQ - VQ - F C Q(P - V) -F C = 0 TM 12-11 Slide 3 of 3

23. THE EFFECT OF OPERATING LEVERAGE With More Operating Leverage Profits (at EBIT) Improve Faster as Output Increases Above the Breakeven Level BUT Losses (at EBIT) Increase Faster as Output Falls Below the Breakeven Level THEREFORE Operating Leverage can enhance performance BUT Always Increases Business Risk TM 12-12 Slide 1 of 2

24. Profit EBIT Cost Cost FC Loss (EBIT) FC Q A B A B Low Operating LeverageHigh Operating Leverage (a) (b) Figure 12-6 Breakeven Diagrams at High and Low Operating Leverage THE DEGREE OF OPERATING LEVERAGE (DOL) - A MEASUREMENT TM 12-12 Slide 2 of 2

25. CONCEPT SUMMARY Improved Operating Performance Sales EBIT Leverage Amplified Changes Improved Financial Performance EBIT ROE and EPS Leverage Amplified Changes Figure 12-7 The Similar Functions of Operating and Financial Leverage TM 12-13 Slide 1 of 2

26. OperatingFinancial Leverage Creates Risk Amplifies Existing and Amplifies Relationship Business Risk Financial Risk Cash Substitutes fixed Substitutes fixed Outflows cost for variable return debt for cost in cost variable return structureequity in capital structure Figure 12-8 Risk and Cost Relationships Between Operating and Financial Leverage TM 12-13 Slide 2 of 2

27. THE COMPOUNDING EFFECT OF OPERATING AND FINANCIAL LEVERAGE DTL = DOL DFL Variation Operating Variation Financial Variation in in in Sales Leverage EBIT Leverage ROE and EPS Figure 12-9 The Compounding Effect of Operating and Financial Leverage TM 12-14

28. CAPITAL STRUCTURE THEORY NOTATION V d = Market Value of the firm's debt V e = Market Value of the firm's stock (equity) V f = Market Value of the firm in total Hence, V f = V d + V e Investors' returns on the firm's securities will be: k d = return on an investment in debt (bonds) k e = return on an investment in equity (stock) k a = average cost of capital (Initially we ignore taxes and transactions costs) TM 12-15 Slide 1 of 2

29. VALUE COMES FROM OPERATING INCOME (OI = EBIT) OI = I + D where I = Total annual interest payment to bondholders, and D = Total annual dividend payment to stockholders Debt is assumed to be perpetual and there is no growth and THINK OF RETURNS AS DRIVING VALUE TM 12-15 Slide 2 of 2

30. GRAPHIC PORTRAYALS V f, P s % Debt k a % Debt Figure 12-10 Variation in Value and Average Return with Capital Structure TM 12-16

31. THE EARLY THEORY BY MODIGLIANI AND MILLER Restrictive Assumptions 1. There are no income taxes. 2. Securities trade in perfectly efficient capital markets in which there are no transaction costs. 3. Investors and companies can borrow as much as they want at the same rate. That is, a. Rates don't go up as one borrows more money, and b. The rate is the same for investors and companies Subtlety No Costs Associated With Bankruptcy INDEPENDENCE HYPOTHESIS THE RESULT: INDEPENDENCE HYPOTHESIS Value Is Independent Of Structure Supported The "Operating Income View" TM 12-17 Slide 1 of 2

32. Value Firm's Value % Debt (a) Firm's Value Constant with Leverage The Independence Hypothesis Capital Costs k e k a k d % Debt (b) Capital Component Costs and Leverage The Independence Hypothesis Figure 12-11 TM 12-17 Slide 2 of 2

33. THE ARBITRAGE CONCEPT Arbitrage: making a profit by buying and selling the same thing at the same time in two different markets. If the value of a firm were to go up due to adding leverage, shareholders could get a better return by 1. selling those shares, 2. borrowing some money on their own, and 3. investing in a similar but unleveraged company. The arbitrage is between the leveraged and unleveraged companies. The sell-off drives the price of the leveraged firm down. The buying drives the price of the unleveraged firm up. Holding the two together keeps the value of any firm constant as leverage increases. The theory provided behavioral support for the operating income argument. INTERPRETING THE RESULT Leverage affects value due to market imperfections (taxes, transaction costs) not because of the basic interaction of investors and companies. TM 12-18

34. FINANCING AND THE U.S. TAX SYSTEM All 50% Debt Equity50% Equity EBIT$ 100$ 100 Interest (10% of debt) 50 EBT$ 100$ 50 Tax (40% of EBT) 40 20 Net Income (EAT)$ 60$ 30 Dividend 60 30 Net Retained$ 0$ 0 Capital Debt$ 500 Equity$ 1,000 500 Total Capital$ 1,000$ 1,000 Payments to Investors Interest 0$ 50 Dividends$ 60 30 Total$ 60$ 80 TM 12-19

35. INCLUDING CORPORATE TAXES IN THE MM THEORY If T = tax rate, and I = Interest TI is the tax shield associated with debt financing PV of tax shield = Then if B = Debt, I = B k d, and PV of tax shield = TB accrues entirely to stockholders since the value of bonds is fixed by contract terms and interest rates. TM 12-20 Slide 1 of 2

36. Market Value with Leverage Value without Leverage % Debt (a) Value of the Firm as a Function of Leverage MM Theory with Taxes Capital Costs k e k a k d (1-T) % Debt (b) Cost of Capital as a Function of Leverage MM Theory with Taxes Figure 12-12 TM 12-20 Slide 2 of 2

37. Bankruptcy costs increase investors' concerns that they will incur losses as risk increases with leverage, which depresses price as leverage increases. Market Value with Value Taxes { { Value Including Bankruptcy Costs Value without Leverage % Debt Optimal Capital Structure (a) Value of the Firm as a Function of Leverage MM Theory with Taxes and Bankruptcy Costs TM 12-21 Slide 1 of 2 INCLUDING BANKRUPTCY COSTS IN THE MM THEORY

38. Capital Costs k e k a k d (1-T) % Debt, Leverage Optimal Capital Structure (b) Cost of Capital as a Function of Leverage MM Theory with Taxes and Bankruptcy Costs Figure 12-13 TM 12-21 Slide 2 of 2

39. CONCLUSION In the MM model with taxes and bankruptcy costs, additional leverage increases the value of a firm when total leverage is relatively low. However, after a maximum, further increases reduce value. The theory does not locate the maximum. The same result was developed intuitively for different reasons: MM attribute the benefit of leverage solely to taxes The intuitive approach recognizes the impact of improved performance on investors' perceptions Both attribute leverage's negative effects to risk AN INSIGHT INTO MERGERS AND ACQUISITIONS The increase in value associated with initially adding leverage may justify paying a high price to acquire an unleveraged firm with debt. TM 12-22