13-1 CHAPTER 13 Capital Structure and Leverage Business vs. Financial Risk Optimal capital structure Operating Leverage Capital structure theory

14-2 Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. What is business risk? Probability EBITE(EBIT)0 Low risk High risk

14-3 Business risk Uncertainty Sales Output Prices Costs Product Liability Operating Leverage

14-4 What is operating leverage, and how does it affect a firm’s business risk? Operating Leverage Use of fixed costs rather than variable costs If most costs are fixed (do not decline when demand falls) the firm has high operating leverage. Examples

14-5 Effect of operating leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. What happens if variable costs change? Sales $ Rev. TC FC Q BE Sales $ Rev. TC FC Q BE } Profit

14-6 Using operating leverage Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases. Probability EBIT L Low operating leverage High operating leverage EBIT H

14-7 Financial Leverage Financial Risk Financial Leverage: Use of debt and preferred stock Financial Risk is the additional risk concentrated on common stockholders as a result of financial leverage

14-8 Business Risk vs. Financial Risk Business risk depends on business factors: Competition Product Liability Operating Leverage. Financial risk depends on types of securities issued More debt, more financial risk Concentrates business risk on stockholders.

14-9 Illustrate 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 40% tax rate

14-10 Firm U: Unleveraged Economy Bad Avg. Good Probability EBIT$2,000$3,000$4,000 Interest EBT$2,000$3,000$4,000 Taxes (40%) 800 1,200 1,600 NI$1,200$1,800$2,400

14-11 Firm L: Leveraged Economy Bad Avg. Good Probability* EBIT*$2,000$3,000$4,000 Interest 1,200 1,200 1,200 EBT$ 800$1,800$2,800 Taxes (40%) ,120 NI$ 480$1,080$1,680 *Same as for Firm U.

14-12 Ratio comparison between leveraged and unleveraged firms FIRM UBadAvgGood BasicEarnPwr 10.0% 15.0% 20.0% ROE 6.0% 9.0% 12.0% TIE ∞ ∞ ∞ FIRM LBadAvgGood BasicEarnPwr 10.0% 15.0% 20.0% ROE 4.8% 10.8% 16.8% TIE 1.67x 2.50x 3.30x BEP = Basic Earning Power TIE = Times Interest Earned

14-13 Risk and Return for leveraged and unleveraged firms Expected Values: Firm UFirm L E(BEP)15.0%15.0% E(ROE) 9.0%10.8% E(TIE) ∞ 2.5x Risk Measures: Firm UFirm L σ ROE 2.12%4.24% CV ROE

14-14 The effect of leverage on profitability and debt coverage For leverage to raise expected ROE, must have BEP > r d (cost of debt). If r d > BEP, interest expense higher than operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = r d D).

14-15 Conclusions Basic Earning Power (BEP) is unaffected by financial leverage. L has higher expected ROE because BEP > r d. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

14-16 Optimal Capital Structure Capital structure (mix of debt, preferred, and common equity) at which Price 0 is maximized Trades off higher E(ROE) and EPS against higher risk Target capital structure: mix of debt, preferred stock, and common equity with which the firm intends to raise capital

14-17 Cost of debt at different debt ratios Amount borrowed D/A ratio D/E ratio Bond rating rdrd $ AA8.0% A9.0% BBB11.5% 1, BB14.0%

14-18 Bond rating and cost of debt depend upon the amount of debt borrowed As the business borrows more money Increases financial risk Bond rating decreases Cost of debt increases (investors need more return for increased risk)

14-19 Financial Leverage Interest Rates: Page 450

14-20 What effect does more debt have on a firm’s cost of equity? When debt increases, riskiness of the business increases Cost of debt increases Riskiness of equity also increases -- resulting in a higher r s

14-21 Target capitalization Page 455 Shows stock price Shows WACC (Weighted Average Cost Capital)

14-22 Debt ratio maximizes Stock Price As debt increases, cost of debt increases As debt increase return to equity increases WACC decreases to a point Then increases Highest stock price is ALSO lowest WACC

14-23 Other factors to consider when establishing target capital structure 1. Industry average debt ratio 2. TIE ratios under different scenarios 3. Lender/rating agency attitudes 4. Reserve borrowing capacity 5. Effects of financing on control 6. Asset structure 7. Expected tax rate

14-24 Factors affect target capital structure 1. Sales stability 2. Operating leverage 3. Corporate tax rate 4. Personal tax rate 5. Bankruptcy costs

14-25 Conclusions on Capital Structure Need to make calculations as we did, but should also recognize inputs are guesses. As a result of imprecise numbers, capital structure decisions are largely judgmental. We end up with capital structures varying widely among firms, even similar ones in same industry.