CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory

Key Concepts and Skills Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice

Business Risk, Operating Leverage Financial Risk, Financial Leverage Part I Business Risk, Operating Leverage Financial Risk, Financial Leverage

What 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 risk Probability High risk E(EBIT) EBIT

What determines business risk? Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Competition. Operating leverage.

What 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.

Effect of operating leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. Sales $ Rev. TC FC QBE } Profit

Using operating leverage Low operating leverage Probability High operating leverage EBITL EBITH Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.

What 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.

What 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).

A summary Operating Leverage Financial Leverage Business Risk Financial Risk %change in EBIT/%change in sales %change in NI/%change in EBIT Variability in the firm’s expected EBIT. Additional variability in net income available to common shareholders. Increase with higher fixed cost Increase with higher debt Increase 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.

An 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 L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate

Firm U: Unleveraged Economy Bad Avg. Good Prob. 0.25 0.50 0.25 EBIT $2,000 $3,000 $4,000 Interest 0 0 0 EBT $2,000 $3,000 $4,000 Taxes (40%) 800 1,200 1,600 NI $1,200 $1,800 $2,400

Firm L: Leveraged Economy Bad Avg. Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 *Same as for Firm U.

Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 6.0% 9.0% 12.0% BEP=EBIT/assets (basic earning power) FIRM L Bad Avg Good ROE 4.8% 10.8% 16.8%

Risk and return for leveraged and unleveraged firms Expected Values: Firm U Firm L E(BEP) 15.0% = 15.0% E(ROE) 9.0% < 10.8% Risk Measures: σROE 2.12% < 4.24%

The 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 expense If we have a good year (BEP > kd), then we pay our fixed interest cost and we have more left over for our stockholders If we have a bad year (BEP < kd), we still have to pay our fixed interest costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE Remind the students that if we increase the amount of debt in a restructuring, we are decreasing the amount of outstanding shares.

Conclusions Basic 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.

Quick Quiz Explain the effect of leverage on expected ROE and risk

The degree of operating leverage is defined as: a. % change in EBIT_____ % change in Variable Cost b. % change in EBIT % change in Sales c. % change in Sales % change in EBIT d. % change in EBIT_______________ % change in contribution margin

Leverage will generally __________ shareholders' expected return and _________ their risk. a. increase; decrease b. decrease; increase c. increase; increase d. increase; do nothing to

what 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. 3.6 b. 4.2 c. 4.7 d. 5.0 e. 5.5

Part II Capital Structure

Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equal Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets Increase leverage by issuing debt and repurchasing outstanding shares Decrease leverage by issuing new shares and retiring outstanding debt

Choosing a Capital Structure What is the primary goal of financial managers? Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We 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.

Optimal 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.

What 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.

The Hamada Equation Not Required

Finding 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.

Table for calculating WACC and determining the minimum WACC ks 12.00% 12.51 13.20 14.16 15.60 kd (1 – T) 0.00% 4.80 5.40 6.90 8.40 Amount borrowed $ 0 250K 500K 750K 1,000K D/A ratio 0.00% 12.50 25.00 37.50 50.00 WACC 12.00% 11.55 11.25 11.44 12.00

Table for determining the stock price maximizing capital structure Amount Borrowed EPS k P s $ 0 $3.00 12.00% $25.00 250K 3.26 12.51 26.03 500K 3.55 13.20 26.89 750K 3.77 14.16 26.59 1,000K 3.90 15.60 25.00

What 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).

Capital Structure Theory Under Five Special Cases Case I – Assumptions No corporate or personal taxes No bankruptcy costs Case II – Assumptions Corporate taxes, but no personal taxes Case III – Assumptions Bankruptcy costs Case IV – Assumptions Managers have private information Case V – Assumptions Managers tend to waste firm money and not work hard.

Case I: Ignoring taxes and Bankruptcy Cost The value of the firm is NOT affected by changes in the capital structure The cash flows of the firm do not change, therefore value doesn’t change The WACC of the firm is NOT affected by capital structure In 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.

Figure 13.3

Case II consider taxes but ignore bankruptcy cost Interest expense is tax deductible Therefore, when a firm adds debt, it reduces taxes, all else equal The 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.

Case II consider taxes but ignore bankruptcy cost The value of the firm increases by the present value of the annual interest tax shield Value 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 payments RU is the cost of capital for an unlevered firm = RA for an unlevered firm VU is jus the PV of the expected future cash flow from assets for an unlevered firm.

Illustration of Case II

Case III consider both taxes and bankruptcy cost Now we add bankruptcy costs As the D/E ratio increases, the probability of bankruptcy increases. This increased probability will increase the expected bankruptcy costs

Bankruptcy Costs (financial distress cost) Direct bankruptcy costs Legal and administrative costs Creditors will stop lending money to the firm. Indirect bankruptcy costs Larger than direct costs, but more difficult to measure and estimate Also have lost sales, interrupted operations and loss of valuable employees

Case III At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost After this point, the value of the firm will start to decrease and the WACC will start to increase as more debt is added

Case 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.

Conclusions Case I – no taxes or bankruptcy costs No optimal capital structure. Debt level does not matter. Case II – corporate taxes but no bankruptcy costs Optimal capital structure is 100% debt More debt—more tax shield—higher firm value. Case III – corporate taxes and bankruptcy costs Optimal capital structure is part debt and part equity Occurs where the marginal tax benefit from debt is just offset by the increase in bankruptcy costs

3 cases

Case 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?

What 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.

Case 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.

Case 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.

Case 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.

Observed Capital Structure In Reality Capital structure does differ by industries. Even for firms in same industry, capital structures may vary widely. Lowest levels of debt Drugs with 2.75% debt Computers with 6.91% debt Highest levels of debt Steel with 55.84% debt Department stores with 50.53% debt See Table 13.5 in the book for more detail

Conclusions 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.”  .

How would these factors affect the target capital structure? High sales volatility? decrease High operating leverage? decrease Increase in the corporate tax rate? increase Increase in bankruptcy costs? decrease Management spending lots of money on lavish perks? increase

The 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.

A 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.

The unlevered cost of capital is a. the cost of capital for a firm with no equity in its capital structure b. the cost of capital for a firm with no debt in its capital structure c. the interest tax shield times pretax net income d. the cost of preferred stock for a firm with equal parts debt and common stock in its capital structure e. equal to the profit margin for a firm with some debt in its capital structure

The explicit costs associated with corporate default, such as legal expenses, are the ____ of the firm a. flotation costs b. default beta coefficients c. direct bankruptcy costs d. indirect bankruptcy costs e. default risk premia

The implicit costs associated with corporate default, such as lost sales, are the of the firm a. flotation costs b. default beta coefficients c. direct bankruptcy costs d. indirect bankruptcy costs e. default risk premia

Which 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.

Which 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.

If 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. more b. less c. It does not matter.

a. 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.