1 Topics in Chapter 16: Capital Structure Business risk & financial risk Impact of financial leverage on returns Analyzing alternative capital structures Optimal capital structure

Capital Structure To minimize the complexity of capital structure analysis, we simplify: No preferred stock financing: the firm’s capital consists of common equity and debt No financial assets (no nonoperating assets) 100% dividend payout, so g = 0 2

3 Capital Structure We saw in Chapter 15 that the value of the firm is the PV of expected FCFs, discounted at the WACC (plus marketable securities, if any). Now, we consider how changes in the firm’s capital structure affects WACC, and hence the firm value.

4 Business Risk Business risk: the risk facing a firm’s shareholders if it has no debt financing. Business risk is the risk associated with firm’s assets and the nature of the products it produces and sells.

Business Risk Measures of business risk include the standard deviation of EBIT and the standard deviation of basic earning power (BEP). BEP = EBIT / Total Assets 5

6 Financial Risk Financial risk: the risk that results from debt financing. Measures of fin’l risk include debt ratio, debt/equity,  of ROE, etc. If a firm relies heavily on debt financing, it has high financial leverage and high financial risk. Why expose the firm to financial risk?

7 Consider Two Hypothetical Firms Firm UFirm L No debt$10,000 of 12% debt $20,000 in assets 40% tax rate Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

8 Impact of Leverage on Returns Firm UFirm L EBIT$3,000 Interest0 1,200 EBT$3,000$1,800 Taxes (40%)1, NI$1,800$1,080 ROE9.0%10.8%

9 Why does leveraging increase return? More cash flow goes to investors and less is paid in taxes in Firm L. Total dollars paid to investors: U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280. Taxes paid: U: $1,200; L: $720.

10 Why Does Debt Financing Increase ROE? Firm L’s ROE is higher because its basic earning power (BEP) > interest rate. BEP = EBIT / (Total Assets) = 3,000 / 20,000 =.15 Firm L is borrowing at 12% and investing in assets that earn 15%.

11 Conclusions L has higher expected ROE due to tax savings and smaller equity base. L has more volatile returns because of fixed interest charges. Higher expected return is accompanied by higher risk.

12 Capital Structure As a firm increases its use of debt: r s and r d increase WACC initially decreases, then increases

13 Trade-off Theory of Capital Structure At low leverage levels, tax benefits of debt outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.

14 Implications for Managers Use less debt financing if firm has: High business risk Special use assets Use more debt financing if firm has: High tax rate Low business risk

15 Optimal Capital Structure The optimal capital structure results in Highest firm value Highest stock price per share Lowest WACC