Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 24 Chapter 12 Capital Structure

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 24 The Target Capital Structure Risk—greater risk means greater costs to raise funds Financial flexibility—a stronger financial position—that is, stronger balance sheet—generally implies the firm is better able to raise funds in the capital markets, especially in slumping economies Managerial attitude (conservatism or aggressiveness)—some financial managers are more conservative than others when it comes to using debt, thus they are inclined to use less debt, all else equal.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 24 The Business Risk and Financial Risk Business Risk—Uncertainty inherent in projections of future returns (ROE or ROA) if the firm uses no debt. Financial Risk—Additional risk associated with using debt or preferred stock. Beware: The use of debt intensifies the firm’s business risk borne by the common stockholders.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 24 The Optimal Capital Structure EBIT/EPS Analysis Example: A firm that has no debt and assets equal to €400,000 can issue debt and repurchase shares of stock at €10 per share based on the following schedule: AmountDebt/AssetCost ofShares of Stock Equityof DebtRatioDebt, k d Outstanding €400,000€ 00.0%0.0%40, ,00080, , ,000160, , ,000240, ,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 24 Determining the Optimal Capital Structure—EBIT/EPS Analysis Assuming that operating expenses, such as cost of goods sold, depreciation, and so forth, are not affected by capital structure decisions, the firm is expected to generate the operating income, EBIT, as follows: Boom0.1$200,000 Normal0.6120,000 Recession0.340,000 Type of EconomyProbabilityEBIT = NOI

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 24 Determining the Optimal Capital Structure—EBIT/EPS Analysis Debt/Assets = 0: Debt = €0 Equity = €400,000 Interest = €0Shares of stock = €400,000/€10 = 40,000 EBIT€200,000€120,000€40,000 Interest(_____0)( 0)( 0) Taxable income, EBT200,000120,00040,000 Taxes (40%)( 80,000)( 48,000)(16,000) Net income€120,000€72,000€24,000 Type of EconomyBoomNormalRecession Probability EPS = NI/(40,000 shrs) €3.00€1.80€0.60 Expected EPS€1.56  EPS €0.72

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 24 Determining the Optimal Capital Structure—EBIT/EPS Analysis EBIT€200,000€120,000€40,000 Interest( 4,800)( 4,800)( 4,800) Taxable income, EBT195,200115,20035,200 Taxes (40%)( 78,080)( 46,080)(14,080) Net income€117,120€69,120€21,120 Type of EconomyBoomNormalRecession Probability EPS = NI/(32,000 shrs) €3.66€2.16€0.66 Expected EPS€1.86  EPS €0.90 Debt/Assets = 20%: Debt = 0.2(€400,000) = €80,000Equity = €400,000 - €80,000 = €320,000 Interest = 0.06(€80,000) = €4,800Shares of stock = €320,000/€10 = 32,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 24 Determining the Optimal Capital Structure—EBIT/EPS Analysis EBIT€200,000€120,000€40,000 Interest( 14,400)( 14,400)( 14,400) Taxable income, EBT185,600105,60025,600 Taxes (40%)( 74,240)( 42,240)(10,240) Net income€111,360€63,360€15,360 Type of EconomyBoomNormalRecession Probability EPS = NI/(24,000 shrs) €4.64€2.64€0.64 Expected EPS€2.24  EPS €1.20 Debt/Assets = 40%: Debt = 0.4(€400,000) = €160,000Equity = €400,000 - €160,000 = €240,000 Interest = 0.09(€160,000) = €14,400Shares of stock = €240,000/€10 = 24,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 24 Determining the Optimal Capital Structure—EBIT/EPS Analysis EBIT€200,000€120,000€40,000 Interest( 48,000)( 48,000)( 48,000) Taxable income, EBT152,00072,000( 8,000) Taxes (40%)( 60,800)( 28,800) 3,200 Net income€ 91,200€43,200( €4,800) Type of EconomyBoomNormalRecession Probability EPS = NI/(16,000 shrs) €5.70€2.70€(0.30) Expected EPS€2.10  EPS €1.80 Debt/Assets = 60%: Debt = 0.6(€400,000) = €240,000Equity = €400,000 - €240,000 = €160,000 Interest = 0.20(€240,000) = €48,000Shares of stock = €160,000/€10 = 16,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 24 Determining the Optimal Capital Structure—EBIT/EPS Analysis Summarizing the results, we have: 0.0%$1.56$ ProportionExpectedStandard of DebtEPSDeviation 0.0%$1.56$

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 24 EPS Indifference Analysis EPS(€) Sales (€ millions) 0 Fixed operating costs = €600,000 Variable cost ratio = 70% 100% Stock Financing 40% Debt Financing Advantage of Debt Advantage of Equity EPS Indifference €2.12 million 0.54

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 24 Capital Structure — Stock Price The optimal capital structure is the mix of debt and equity that maximizes the value of the firm—that is, its stock price—not the EPS. The proportion of debt in the optimal capital structure will be less than the proportion of debt needed to maximize EPS because the market valuation of the stock, P 0, considers the risk associated with the firm’s operations expected well into the future and EPS is based only on the firm’s operations expected for the next few years.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 24 Capital Structure—Stock Price and the Cost of Equity, k s The relationship of the cost of equity, k s, and the amount of debt the firm uses to finance its assets can be illustrated as follows: k RF % Debt in Capital Structure Required Return on Equity, k s (%) Risk-free rate of return k s = k RF + Risk Premium Total Risk Premium Premium for business risk at a particular level of operations Premium for financial risk

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 24 Capital Structure—Stock Price and the Cost of Capital, WACC The relationship of the after-tax cost of debt, kdT, cost of equity, ks, and WACC might be: % Debt in Capital Structure Cost of Capital, WACC (%) Cost of equity, k s After-tax cost of debt, k dT WACC Minimum WACC Optimal Amount of Debt (30%)

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 24 Capital Structure - WACC If the firm uses only equity to finance its assets (that is, zero debt is used) then WACC = ks As the firm begins to use some debt for financing, WACC declines, primarily because the tax benefit offered by the debt more than offsets the increased cost of equity At some point the tax benefit associated with debt is more than offset by increases in the before-tax cost of debt and the cost of equity that result from increases in the risk associated with the additional debt and, at this point, WACC begins to increase The point where WACC is the lowest is the optimal capital structure—this is the point where the value of the firm is maximized

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 24 Operating Leverage All else equal, if a firm can reduce its operating leverage, it can use more debt (that is, increase its financial leverage), and vice versa, and maintain the same degree of risk. Degree of operating leverage (DOL) refers to the percentage change in operating income—designated either NOI or EBIT—that results from a particular percentage change in sales. DOL can be computed as follows: Q = number of products (units) the firm currently sells P =sales price per unit V =variable cost per unit F=fixed operating costs S =current sales stated in dollars such that S = Q  P VC =total variable costs of operations such that VC = Q  V

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 24 Operating Leverage Expected Sales = –5% Outcomeof Expectations % Δ Sales Variable operating costs (60%) Gross profit Fixed operating costs Net operating income = EBIT Sales$250,000 Variable operating costs (60%) Gross profit Fixed operating costs Net operating income = EBIT Sales$250,000 Variable operating costs (60%)(150,000) Gross profit Fixed operating costs Net operating income = EBIT Sales$250,000 Variable operating costs (60%)(150,000) Gross profit100,000 Fixed operating costs Net operating income = EBIT Sales$250,000 Variable operating costs (60%)(150,000) Gross profit100,000 Fixed operating costs(75,000) Net operating income = EBIT Sales$250,000$237,500 Variable operating costs (60%)(150,000) Gross profit100,000 Fixed operating costs(75,000) Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000) Gross profit100,000 Fixed operating costs(75,000) Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500) Gross profit100,000 Fixed operating costs(75,000) Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,000 Fixed operating costs(75,000) Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095,000 Fixed operating costs(75,000) Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095, Fixed operating costs(75,000) Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095, Fixed operating costs(75,000)(75,000) Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095, Fixed operating costs(75,000)(75,000)0.0 Net operating income = EBIT25,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095, Fixed operating costs(75,000)(75,000)0.0 Net operating income = EBIT25,00020,000 Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095, Fixed operating costs(75,000)(75,000)0.0 Net operating income = EBIT25,00020, Sales$250,000 Variable operating costs (60%)(150,000) Gross profit100,000 Fixed operating costs(75,000) Net operating income = EBIT25,000 Risk = variability

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 24 Financial Leverage Degree of financial leverage refers to the percentage change in EPS that results from a particular percentage change in earnings before interest and taxes, EBIT. DFL is computed as follows: I = interest paid on debt

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 24 Financial Leverage Expected Sales = –5% Outcomeof Expectations % Δ Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095, Fixed operating costs(75,000)(75,000)0.0 Net operating income = EBIT25,00020, Interest Earnings Before Taxes Taxes (40%) Net Income Interest(12,500) Earnings Before Taxes Taxes (40%) Net Income Interest(12,500) Earnings Before Taxes12,500 Taxes (40%) Net Income Interest(12,500) Earnings Before Taxes12,500 Taxes (40%)(5,000) Net Income Interest(12,500) Earnings Before Taxes12,500 Taxes (40%)(5,000) Net Income7,500 Interest(12,500)(12,500) Earnings Before Taxes12,500 Taxes (40%)(5,000) Net Income7,500 Interest(12,500)(12,500)0.0 Earnings Before Taxes12,500 Taxes (40%)(5,000) Net Income7,500 Interest(12,500)(12,500)0.0 Earnings Before Taxes12,5007,500 Taxes (40%)(5,000) Net Income7,500 Interest(12,500)(12,500)0.0 Earnings Before Taxes12,5007, Taxes (40%)(5,000) Net Income7,500 Interest(12,500)(12,500)0.0 Earnings Before Taxes12,5007, Taxes (40%)(5,000)(3,000) Net Income7,500 Interest(12,500)(12,500)0.0 Earnings Before Taxes12,5007, Taxes (40%)(5,000)(3,000)-40.0 Net Income7,500 Interest(12,500)(12,500)0.0 Earnings Before Taxes12,5007, Taxes (40%)(5,000)(3,000)-40.0 Net Income7,5004,500 Interest(12,500)(12,500)0.0 Earnings Before Taxes12,5007, Taxes (40%)(5,000)(3,000)-40.0 Net Income7,5004, Risk = variability

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 24 Total Leverage Degree of total leverage (DTL) refers to the percentage change in EPS that results from a particular percentage change in sales. DTL combines DOL and DFL, and it is computed as follows:

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 24 Total Leverage Expected Sales = –5% Outcomeof Expectations % Δ Sales$250,000$237, % Variable operating costs (60%)(150,000)(142,500)-5.0 Gross profit100,00095, Fixed operating costs(75,000)(75,000)0.0 Net operating income = EBIT25,00020, Interest(12,500)(12,500)0.0 Earnings Before Taxes12,5007, Taxes (40%)(5,000)(3,000)-40.0 Net Income7,5004, Risk = variability; thus the greater the degree of leverage (operating, financial, or both), the greater the risk associated with the firm

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 24 Liquidity and Capital Structure A firm might not operate at the optimal capital structure because: It might be difficult, if not impossible, to determine the optimal capital structure. Managers might be reluctant to take on the amount of debt necessary to achieve the optimal capital structure—that is, a conservative attitude toward debt might exist. The firm provides important, needed services, and operating at the optimal mix of capital might endanger the firm’s ability to survive. Financial liquidity is important to such firms.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 23 of 24 Capital Structure—Trade-Off Theory The value of a firm increases as it uses more and more debt. Ignores the costs associated with bankruptcy, which can be considerable If bankruptcy costs are considered, there is a point where the benefit of the tax deductibility of debt is more than offset by increases in the cost of debt and the cost of equity that result from the risk associated with the firm’s heavy use of debt

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 24 of 24 Capital Structure—Signaling Theory Studies have shown that when firms issue new common stock to raise funds the per share value of the stock decreases. –Perhaps this occurs because managers would only issue new common stock if they felt that the firm’s future prospects were unfavorable. –When debt is issued, only the contracted costs need to be paid—that is, fixed interest and the repayment of the debt—and the remaining gains from the favorable projects accrue to the stockholders. –Age of a firm—younger firms generally do not have the same access to financial markets as older, more established firms