Chapter 12

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 n The variability or uncertainty of a firm’s operating income (EBIT). EBIT

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock-holders

Business Risk n The variability or uncertainty of a firm’s operating income (EBIT). FIRM EBIT EPS Stock-holders

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 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. FIRM EBIT EPS Stock-holders

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. FIRM EBIT EPS Stock-holders

Financial Leverage n The use of fixed-cost sources of financing (debt, preferred stock) rather than variable-cost sources (common stock).

With high operating leverage, an increase in sales produces a relatively larger increase in operating income.

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

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

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 Financial Structure

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

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.

Modigliani-Miller Hypothesis n Firm value does not depend on capital structure.

Cost of Capital kc 0% debt financial leverage 100%debt. kc = cost of equity kd = cost of debt ko = cost of capital kc = cost of equity kd = cost of debt ko = cost of capital Modigliani-Miller Hypothesis

. Cost of Capital kc kd kd 0% debt financial leverage 100%debt

. Modigliani-Miller Hypothesis Cost of Capital kc kd kd 0% debt financial leverage 100%debt

Increasing leverage causes the cost of equity to rise. Modigliani-Miller Hypothesis Cost of Capital kc kd kd 0% debt financial leverage 100%debt

Modigliani-Miller Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. 0% debt financial leverage 100%debt

Modigliani-Miller Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt financial leverage 100%debt

Modigliani-Miller Hypothesis Cost of Capital kc kd kc Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt financial leverage 100%debt

kc kd Modigliani-Miller Hypothesis Cost of Capitalkcko kd 0% debt financial leverage 100%debt

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?

Remember this example? Tax effects of financing with debt with stock with debt with stock with debt EBIT 400, ,000 - interest expense 0 (50,000) EBT 400, ,000 - taxes (34%) (136,000) (119,000) EAT 264, ,000 - dividends (50,000) 0 Retained earnings 214, ,000

with stock with debt with stock with debt EBIT 400, ,000 - interest expense 0 (50,000) EBT 400, ,000 - taxes (34%) (136,000) (119,000) EAT 264, ,000 - dividends (50,000) 0 Retained earnings 214, ,000 Remember this example? Tax effects of financing with debt

Moderate Position Cost of Capital kc kd financial leverage kc kd

Moderate Position Cost of Capital kc kd financial leverage kc kd Even if the cost of equity rises as leverage increases, the cost of debt is very low...

Moderate Position Cost of Capital kc kd financial leverage kc kd because of the tax benefit associated with debt financing. associated with debt financing. Even if the cost of equity rises as leverage increases, the cost of debt is very low...

Moderate Position Cost of Capital kc kd financial leverage kc kd The low cost of debt reduces the cost of capital.

Moderate Position Cost of Capital kc kd financial leverage kc kd The low cost of debt reduces the cost of capital. ko

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.

Agency costs: costs associated with protecting bondholders. n Bondholders (principals) lend money to the firm and expect it to be invested wisely. n Stockholders own the firm and elect the board and hire managers (agents). n Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases. Why is 100% Debt not Optimal?

Moderate Position with Bankruptcy and Agency Costs Cost of Capital financial leverage kc kd

Cost of Capital financial leverage kc kd kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kd kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kd kc kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd Moderate Position with Bankruptcy and Agency Costs

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 Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd ko Moderate Position with Bankruptcy and Agency Costs

Cost of Capital financial leverage kc kdkckd ko 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