Capital Structure and Leverage Chapter 15 Capital Structure and Leverage

What is business risk? The riskiness inherent in the firm’s operations if it uses no debt. A commonly used measure of business risk is ROIC.

Determinants and measures of business risk There are many factors determining business risk: Competition Uncertainties about demand, output prices, costs Foreign risk exposure Regulatory risk and legal exposure, etc. ROIC measures the after-tax return that the company provides for all its investors. ROIC doesn’t vary with changes in capital structure.

What is financial leverage? Financial risk? Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. Financial risk depends only on the types of securities issued, while business risk depends on business factors. More debt, more financial risk. Concentrates business risk on stockholders.

An Example: Illustrating Effects of Financial Leverage Two firms with the same business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure). Firm U Firm L No debt $10,000 of 12% debt $20,000 invested capital 40% tax rate

Firm U: Unleveraged Economy Bad Average Good Probability 0.25 0.50 EBIT $2,000 $3,000 $4,000 Interest EBT Taxes (40 %) 800 1,200 1,600 NI $1,200 $1,800 $2,400

Firm L: Leveraged Economy Bad Average Good Probability * 0.25 0.50 EBIT $2,000 $3,000 $4,000 Interest 1,20 EBT $ 8 00 1 , 2 Taxes (40%) 32 7 1, 12 NI 48 $1, 68 The same as for Firm U.

Ratio Comparison Between Leveraged and Unleveraged Firms Firm U Bad Average Good ROIC 6.0% 9.0% 12.0% ROE 6.0 9.0 12.0 Firm L 4.8 10.8 16.8

Risk and Return for Leveraged and Unleveraged Firms Expected values: Firm U Firm L E(ROIC) 9.0% E(ROE) 9.0 % 10.8 Risk measures:  ROIC 2.12% ROE 4.24%

Conclusions Return on invested capital (ROIC) is unaffected by financial leverage. For leverage to raise expected ROE, ROIC > rd(1 – T). If rd(1 – T) > ROIC, then after-tax interest expense will be higher than the after-tax operating income produced by debt-financed assets, so leverage will depress income. L has higher expected ROE because ROIC > rd(1 – T). L has much wider ROE swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

Leverage and cost of capital As the firm borrows more money, the firm increases its financial risk causing the firm’s bond rating to decrease, and its cost of debt to increase. The risk of the firm’s equity also increases, resulting in a higher rs. The Hamada equation attempts to quantify the increased cost of equity due to financial leverage. bL = bU[1 + (1 – T)(D/E)] For example, if total invested capital is $20,000 and D = $5,000, then E = $15,000. If T = 40% and bU is 1.0, bL = 1.0[1 + (0.6)($5,000/$15,000)] = 1.2.

Optimal Capital Structure and Modigliani-Miller Irrelevance Theory Optimal capital structure is the mix of debt, preferred and common equity, at which P0 is maximized. The starting point for analyzing capital structure is a frictionless financial environment. In this environment the value of the firm is not affected by its financing mix. (Modigliani and Miller Irrelevance Theory) M&M’s frictionless environment: no income taxes; no transaction costs of issuing debt or equity securities; investors can borrow on the same terms as the firm.; the various stakeholders of the firm are able to costlessly resolve any conflicts of interest among themselves.

Example Firm U No Debt. EBIT = dividends = $3,000 1,000 shares. PV = $3,000/0.15 = $20,000. P0 is $20. Firm L EBIT = $3,000 Issued bonds that have a face value of $10,000 at 12% PV of bonds = $10,000 (riskless interest rate: 12%) Dividends = EBIT – $1,200 = $1,800 PV of 500 shares is $10,000 according to M&M. P0 of Firm L is the same as Firm U’s at $20.

Example (cont.) Since Firm L offers exactly the same future cash flows as Firm U, the market value of Firm L should be $20,000, which is the same as Firm U’s. Cash flows from Firm L and Firm U: For example, suppose Firm L’s stock price is $19 per share instead of $20. Then, one can replicate or synthesize Firm U stock by buying proportional amounts of the stock and bonds of Firm L.

Example (cont.) Merton Miller explained M-M theory in terms of a pie: “Think of the firm as a gigantic pizza, divided into quarters. If you cut each quarter in half into eighths, the M&M proposition says that you will have more pieces, but not more pizza.” Although a share of stock in each of the companies has the same price, Firm L’s stock has a higher expected return and higher risk than Firm U’s stock. Future EBIT is a random variable. But the interest payments will be the same regardless of the realized value of EBIT. According to the Hamada equation, if bU is 1, bL is 2 and rS of Firm L is 1.8. Therefore, P0 of Firm L is $20.

Creating Value through Financing Decisions In the real world, however, there are many frictions that make capital structure matter very much. Finding the optimal capital structure for a corporation involves making trade-offs that depend on the particular legal and tax environment. Ways that management can add value through its capital structure decisions: By its choice of capital structure the firm can reduce its costs such as taxes or bankruptcy costs. By its choice of capital structure the firm can reduce conflicts of interest among stakeholders in the firm.