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CHAPTER 13
Capital Structure and Leverage

Business vs. financial risk


Optimal capital structure
Operating leverage
Capital structure theory
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What is business risk?

Uncertainty about future operating income


(EBIT), i.e., how well can we predict operating
income? Probability
Low risk

High risk

0 E(EBIT) EBIT
Note that business risk does not include
financing effects.
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Business risk is affected primarily by:

Uncertainty about demand (sales).


Uncertainty about output prices.
Uncertainty about costs.
Product, other types of liability.
Operating leverage.

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What is operating leverage, and how
does it affect a firm’s business risk?

Operating leverage is the use of


fixed costs rather than variable
costs.
If most costs are fixed, hence do
not decline when demand falls,
then the firm has high operating
leverage.
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More operating leverage leads to
more business risk, for then a small
sales decline causes a big profit
decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC

QBE Sales QBE Sales

What happens if variable costs change?


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Probability Low operating leverage

High operating leverage

EBITL EBITH

Typical situation: Can use operating


leverage to get higher E(EBIT), but
risk increases.
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What is financial leverage?


Financial risk?

Financial leverage is the use of


debt and preferred stock.
Financial risk is the additional risk
concentrated on common
stockholders as a result of
financial leverage.

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Business Risk vs. Financial Risk

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. Concentrates
business risk on stockholders.
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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).
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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
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Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
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Firm U Bad Avg. Good


BEP* 10.0% 15.0% 20.0%
ROE 6.0% 9.0% 12.0%

8
TIE

Firm L Bad Avg. Good


BEP* 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.5x 3.3x
*BEP same for Firms U and L.
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Expected Values:
U L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%

8
E(TIE) 2.5x

Risk Measures:
sROE 2.12% 4.24%
CVROE 0.24 0.39

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For leverage to raise expected ROE,


must have BEP > kd.
Why? If kd > BEP, then the interest
expense will be higher than the
operating income produced by
debt-financed assets, so leverage
will depress income.

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Conclusions

Basic earning power = BEP = EBIT/Total


assets is unaffected by financial
leverage.
L has higher expected ROE because
BEP > kd.
L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return is
accompanied by higher risk.
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If debt increases, TIE falls.

EBIT
TIE = .
Int

EBIT is constant (unaffected by use


of debt), and since Int = kdD, as D
increases, TIE must fall.
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Optimal Capital Structure


That capital structure (mix of debt,
preferred, and common equity) at which
P0 is maximized. Trades off higher
E(ROE) and EPS against higher risk.
The tax-related benefits of leverage are
exactly offset by the debt’s risk-related
costs.
The target capital structure is the mix of
debt, preferred stock, and common
equity with which the firm intends to
raise capital.
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Describe the sequence of events in a
recapitalization.

Campus Deli announces the


recapitalization.
New debt is issued.
Proceeds are used to repurchase
stock.
Debt issued
Shares bought = .
Price per share
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Cost of Debt at Different Debt Levels
after Recapitalization

Amount D/A D/E Bond


borrowed ratio ratio rating kd
$ 0 0 0 -- --
250 0.125 0.1429 AA 8%
500 0.250 0.3333 A 9%
750 0.375 0.6000 BBB 11.5%
1,000 0.500 1.0000 BB 14%
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Why does the bond rating and cost of
debt depend upon the amount
borrowed?

As the firm borrows more money, the


firm increases its risk causing the
firm’s bond rating to decrease, and its
cost of debt to increase.

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What would the earnings per share be
if Campus Deli recapitalized and used
these amounts of debt: $0, $250,000,
$500,000, $750,000? Assume EBIT =
$400,000, T = 40%, and shares can be
repurchased at P0 = $25.
D = 0: (EBIT – kdD)(1 – T)
EPS0 = Shares outstanding

($400,000)(0.6)
= 80,000 = $3.00.
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D = $250, kd = 8%.

Shares $250,000
repurchased = = 10,000.
$25

[$400 – 0.08($250)](0.6)
EPS1 =
80 – 10
= $3.26.

EBIT $400
TIE = = = 20×.
I $20
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D = $500, kd = 9%.

Shares $500
repurchased = = 20.
$25

[$400 – 0.09($500)](0.6)
EPS2 =
80 – 20
= $3.55.

EBIT $400
TIE = = = 8.9×.
I $45
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D = $750, kd = 11.5%.

Shares $750
repurchased = = 30.
$25

[$400 – 0.115($750)](0.6)
EPS3 =
80 – 30
= $3.77.

EBIT $400
TIE = = = 4.6×.
I $86.25
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D = $1,000, kd = 14%.

Shares $1,000
repurchased = = 40.
$25

[$400 – 0.14($1,000)](0.6)
EPS4 =
80 – 40
= $3.90.

EBIT $400
TIE = = = 2.9×.
I $140
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Stock Price (Zero Growth)

D1 EPS DPS
P0 = = = .
ks – g ks ks

If payout = 100%, then EPS = DPS and


E(g) = 0.
We just calculated EPS = DPS. To find
the expected stock price (P0), we must
find the appropriate ks at each of the
debt levels discussed.
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What effect would increasing debt


have on the cost of equity for the firm?

If the level of debt increases, the


riskiness of the firm increases.
We have already observed the
increase in the cost of debt.
However, the riskiness of the firm’s
equity also increases, resulting in a
higher ks.
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The Hamada Equation

Because the increased use of debt


causes both the costs of debt and
equity to increase, we need to
estimate the new cost of equity.
The Hamada equation attempts to
quantify the increased cost of equity
due to financial leverage.
Uses the unlevered beta of a firm,
which represents the business risk
of a firm as if it had no debt.
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The Hamada Equation (cont’d)

bL = bU[1 + (1 – T)(D/E)].

The risk-free rate is 6%, as is the


market risk premium. The unlevered
beta of the firm is 1.0. We were
previously told that total assets were
$2,000,000.
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Calculating Levered Betas

D = $250 ks = kRF + (kM – kRF)bL


bL = bU[1 + (1 – T)(D/E)]
bL = 1.0[1 + (1 – 0.4)($250/$1,750)]
bL = 1.0[1 + (0.6)(0.1429)]
bL = 1.0857.
ks = kRF + (kM – kRF)bL
ks = 6.0% + (6.0%)1.0857 = 12.51%.
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Table for Calculating Levered Betas

Amount D/A D/E Levered


borrowed ratio ratio Beta ks
$ 0 0.00% 0.00% 1.00 12.00%
250 12.50 14.29 1.09 12.51
500 25.00 33.33 1.20 13.20
750 37.50 60.00 1.36 14.16
1,000 50.00 100.00 1.60 15.60
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Finding Optimal Capital Structure

The firm’s optimal capital structure


can be determined two ways:
Minimizes WACC.
Maximizes stock price.
Both methods yield the same results.

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Minimizing the WACC

Amount D/A ratio E/A


borrowed ratio ks kd (1 – T) WACC
0.00%
$ 0 100.00% 12.00% 0.00% 12.00%
12.50
250 87.50 12.51 4.80 11.55
25.00
500 75.00 13.20 5.40 11.25
37.50
750 62.50 14.16 6.90 11.44
50.00
1,000 50.00 15.60 8.40 12.00

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Maximizing Stock Price


Amount
Borrowed DPS ks P0

$ 0 $3.00 12.00% $25.00


250,000 3.26 12.51 26.03
500,000 3.55 13.20 26.89*
750,000 3.77 14.16 26.59
1,000,000 3.90 15.60 25.00
*Maximum: Since D = $500,000 and assets =
$2,000,000, optimal D/A = 25%.
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What debt ratio maximizes EPS?

See preceding slide. Maximum EPS =


$3.90 at D = $1,000,000, and D/A =
50%. (Remember DPS = EPS because
payout = 100%.)
Risk is too high at D/A = 50%.

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What is Campus Deli’s optimal capital


structure?

P0 is maximized ($26.89) at D/A =


$500,000/$2,000,000 = 25%, so
optimal D/A = 25%.
EPS is maximized at 50%, but
primary interest is stock price, not
E(EPS).
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The example shows that we can


push up E(EPS) by using more
debt, but the risk resulting from
increased leverage more than
offsets the benefit of higher
E(EPS).

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%

15 ks
WACC
kd(1 – T)

0 .25 .50 .75 D/A


$

P0
EPS

D/A
.25 .50
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If it were discovered that the firm had
more/less business risk than originally
estimated, how would the analysis be
affected?

If there were higher business risk, then


the probability of financial distress would
be greater at any debt level, and the
optimal capital structure would be one
that had less debt. On the other hand,
lower business risk would lead to an
optimal capital structure with more debt.
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Other Factors to Consider When
Establishing the Firm’s 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
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How would these factors affect the
Target Capital Structure?

1. Sales stability?
2. High operating leverage?
3. Increase in the corporate tax rate?
4. Increase in the personal tax rate?
5. Increase in bankruptcy costs?
6. Management spending lots of
money on lavish perks?
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Value of Stock
MM result

Actual

No leverage

D/A
0 D1 D2

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The graph shows MM’s tax benefit


vs. bankruptcy cost theory.
Logical, but doesn’t tell whole
capital structure story. Main
problem--assumes investors have
same information as managers.

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Signaling theory suggests firms


should use less debt than MM
suggest.
This unused debt capacity helps
avoid stock sales, which depress
P0 because of signaling effects.

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What are “signaling” effects in capital
structure?

Assumptions:

Managers have better information


about a firm’s long-run value than
outside investors.
Managers act in the best interests
of current stockholders.

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Therefore, managers can be expected to:

Issue stock if they think stock is


overvalued.
Issue debt if they think stock is
undervalued.
As a result, investors view a common
stock offering as a negative signal--
managers think stock is overvalued.
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Conclusions on Capital Structure

1. Need to make calculations as we did,


but should also recognize inputs are
“guesstimates.”
2. As a result of imprecise numbers,
capital structure decisions have a
large judgmental content.
3. We end up with capital structures
varying widely among firms, even
similar ones in same industry.
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