Income statement Sales XXX,XXX Less:variable cost X,XXX Contribution XX,XXX Fixed cost X,XXX EBIT XX,XXX Less: Interest X,XXX EBT XX,XXX Less: Tax X,XXX EAT X,XXX

Business risk Factors influence a firm’s business risk Uncertainty associated with a firm’s projection of its operating income Risk faced by shareholders on an all equity firm (business risk does not include financing effects.) Factors influence a firm’s business risk Demand of outputs Price and costs of outputs Competition Amount of operating leverage used by the firm

Operating leverage and business risk? Operating leverage is the extent to which fixed costs are used in the firm’s operation Total costs = fixed costs + variable costs If most costs are fixed, hence do not decline when demand falls, then the firm has high 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 Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.

Degree of operating leverage  EBIT/EBIT  Sales/Sales = Sales – Variable Costs Sales – Variable Costs – Fixed Costs

Capital structure Balance sheet $ $ Assets 100 Share capital ? Debt ? $ $ Assets 100 Share capital ? Debt ? 100 100

Financial leverage Use of debt/preference share Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.  Use of debt/preference share  Financial leverage   expected return

Degree of financial leverage  EPS/EPS  EBIT/EBIT = Sales – Variable Costs – Fixed Costs Sales – VC – Fixed Costs - Interests

Consider 2 Hypothetical Firms 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 Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt (capital structure).

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 EBT $ 800 Taxes (40%) 320 NI $ 480 $1,080 $1,680 *Same as for Firm U.

Firm U Bad Avg. Good ROE 6.0% 9.0% 12.0% Firm L Bad Avg. Good ROE 4.8% 10.8% 16.8%

Degree of total leverage  EPS/EPS  Sales/Sales = Sales – Variable Costs Sales – VC – Fixed Costs - Interests

Financial Leverage and EPS Debt No Debt Advantage to debt Break-even point EPS EBI in dollars, no taxes Disadvantage to debt (2.00) EBIT

Fin Risk & Bus. Risk D E E Financial risk A Business risk E= A+ (A - D) (Debt/Equity) Financial risk A Business risk D E

Double-edged sword of leverage use Things go well when revenue rises but vice versa Therefore, leverage use, either operating or financial, magnifies the original fluctuation in the revenue Reaction of investor : Cost of capital   stock price 

Business Risk vs. Financial Risk SUMMARY Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued: More debt, more financial risk.

What types of capital do firms use? Debt Preferred stock Common equity Retained earnings New common stock

Company Cost of Capital Opportunity cost that investors could earn today on capital market securities that have the same risk. Firm value = Equity + Debt = PV(cash flow from projects)

Should we focus on before-tax or after-tax capital costs? Stockholders focus on after-tax capital costs, i.e., use after-tax costs in WACC. Only kd (cost of debt) needs adjustment.

Should we focus on historical costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

Company Cost of Capital simple approach (All equity financed) Company Cost of Capital (COC) is based on the average beta of the assets. The average Beta of the assets is based on the % of funds in each asset.

Discount rate A company’s cost of capital can be compared to the CAPM required return. 13 5.5 SML Required return Company Cost of Capital Project Beta 1.26

Two ways to determine cost of common equity, ks: 1. CAPM: ks = kRF + (kM – kRF)b. Dividend model: ks = D1/P0 + g.

Component Cost of Debt Suppose Kd is 10%; Interest is tax deductible, so assuming tax rate of 40% kd AT = kd BT(1 – T) = 10%(1 – 0.40) = 6%.

E, D, and V are all market values W A C C COC = rportfolio = rassets rassets = WACC = rdebt (D) + requity (E) (V) (V) Bassets = Bdebt (D) + Bequity (E) (V) (V) IMPORTANT E, D, and V are all market values requity = rf + Bequity ( rm - rf )

Cost of capital for new projects Modify CAPM (account for proper risk) Use COC unique to project, rather than Company COC

What factors influence a company’s composite WACC? Market conditions. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

Find the company’s cost of capital based on the CAPM, given these inputs: Target debt ratio = 40%. kd = 12%. kRF = 7%. Tax rate = 40%. Beta of equity = 1.7. Market risk premium = 6%.

Beta = 1.7, so it has more market risk than average. The required return on equity: ks = kRF + (kM – kRF)bDiv. = WACCDiv. = wdkd(1 – T) + wcks = 13.2%.

Capital structure Balance sheet $ $ Assets 100 Share capital ? Debt ? $ $ Assets 100 Share capital ? Debt ? 100 100

The Capital-Structure Question and The Pie Theory The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = B + S If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible. S B Value of the Firm

Basic issues (1) Cash flows are generated by assets Capital structure is a way of packaging these cash flows and selling them to security holders, i.e. debt and equity Should packaging add value? Can overall size of pie be affected by the method of slicing it?

Basic issues (2) Capital structure is irrelevant to shareholders wealth maximisation The value of the firm (size of pie) is determined by capital budgeting decision Capital structure determine only how the pie is sliced. Increased the debt will increase both the risk and expected return to equity.

M&M (Debt Policy Doesn’t Matter) Independent hypothesis When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

M&M (Debt Policy Doesn’t Matter) Assumptions Homogeneous expectations Homogeneous business risk classes Homogeneous expectation - same view on a co’s earnings and risk firms with same degree of risk can be grouped together (measured by WACC) Perpetual cash flows Perfect capital market

Assumptions- Perfect capital market Perfect competition Corporate leverage is replicable by individual investors (firms and investors can borrow/lend at the same rate) Symmetric information - equal assess to all relevant information No taxes No bankruptcy costs Symmetric information No growth, i.e. EPS = DPS

No Magic in Financial Leverage MM'S PROPOSITION I (no tax) Firm value is not affected by leverage Valuation is independent of the debt ratio i.e. VL = VU = Value of debt + Value of levered equity

Value of a firm ø ö ç è æ  + = r E D The total market value of the firm is the net present value of the income stream. For a firm with a constant perpetual income stream: C1 V = ––––––– WACC ø ö ç è æ  + = S d WACC r E D

WACC (Traditional) Cost of capital rE rE =WACC rD D V

( ) M&M Proposition II E r D - + = d o e Leverage increases risk and return to shareholders E ( ) d o e r D - + =

WACC rE rD D V Cost of capital The WACC is constant because the cost of equity capital rises to exactly offset the effect of cheaper debt rE WACC is constant rD D V

Leverage and Returns ø ö ç è æ X + = E D A  ( ) D A E  - + =

M&M Proposition II (no tax) Leverage increases risk and return to shareholders Shareholders require compensation for increased use of debt which exactly offsets the cheaper cost of debt financing.

Proposition I (with corporate taxes) Dependence hypothesis Firm value increases with leverage Value of leveraged firm = Value of unleveraged firm + PV(tax shield on interest) i.e. VL = VU + TCD

All-equity firm Levered firm Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes All-equity firm Levered firm S G S G B The levered firm pays less in taxes than does the all-equity firm. Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

MM Proposition II (with taxes) d o s r D - + = (1 - Tc) = WACC r ø ö ç è æ  + S d E D (1 - Tc)

Tax shield of interest payment PV of Tax Shield = (assume perpetuity) D x rD x Tc rD = D x Tc Example: D = 1000 rD = 10% Tc = 20% Tax benefit = 1000 x (.10) x (.20) = $20 PV of $20 perpetuity = 20 / .10 = $200

Implications With corporate tax, leverage create value due to tax shield created by debt Part of the cost and risk is shared by government It suggests firm should be 100% financed by debt. In reality, no such firm. Why?

100 % financed by debt Not exist because Unable to use up tax shield Personal tax favour equity as capital gains tax can be deferred but tax on interest income cannot. Cost of financial distress Agency problems created by excessive debt

Other views on capital structure Agency theory Trade-off theory Signalling Approach Pecking order theory

Agency theory Incentive to take large risks Incentive to under investment Milking the project Stockholders have incentives to play games. These games lead to poor investment and operating decisions.

Trade-off theory Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy. Market Value = Value if all Equity financed + PV Tax Shield - PV Costs of Financial Distress A trade-off between costs of financial distress and tax savings

Integration of Tax Effects and Financial Distress Costs Value of firm under MM with corporate taxes and debt Value of firm (V) Present value of tax shield on debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt Value of unlevered firm Debt (B) B* Optimal amount of debt

Costs of financial distress

Trade-off theory: Implications Firms with low bankruptcy costs will have greater debt e.g. hotel (not care after sale services) Firms with tangible assets will borrow more than firms with specialised, intangible assets or valuable growth opportunities. Cannot explain why the more successful firms generally have the most conservative capital structure.

Signalling approach 1. Stock-for-debt Stock price exchange offers falls Debt-for-stock Stock price exchange offers rises 2. Issuing common stock drives down stock prices; repurchase increases stock prices. 3. Issuing straight debt has a small negative impact.

Signalling approach Asymmetric information If changes in capital structure can alter the market’s perception, the firm’s financial structure is no longer relevant. 2. A signal of management provides clues to investors how management views the firm’s prospects. Managers think that the shares are “overpriced” Managers know more and that they try to time issues Investors interpret decision to issue new equity as bad news so price decline Firms, being unable to sell equity at fair price may sacrifice +ve NPV projects

Pecking order theory Priority in funds raising Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient. Priority in funds raising Internally generated cash flow Cash and marketable securities in business Debt Equity

Pecking order theory Firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. (Asymmetric information). The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance. Financial slack is valuable (avoid given up +ve NPV projects due to low issue price of common stock).

How Firms Establish Capital Structure Most Corporations Have Low Debt-Asset Ratios. Changes in Financial Leverage Affect Firm Value. Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes. Another interpretation is that firms signal good news when they lever up. There are Differences in Capital Structure Across Industries. There is evidence that firms behave as if they had a target Debt to Equity ratio.

Factors in Target D/E Ratio Taxes If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt. Types of Assets The costs of financial distress depend on the types of assets the firm has. Uncertainty of Operating Income Even without debt, firms with uncertain operating income have high probability of experiencing financial distress. Pecking Order and Financial Slack Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.