Determining the Finance Mix Learning Objectives 1. Understanding the difference between risk and financial risk. 2. Use the technique of break-even analysis in a variety of analytical settings. 3. Distinguish among the financial concepts of operating leverage, financial leverage, and combined leverage. 4. Calculate the firm’s degree of operating leverage, financial leverage, and combined leverage. 5. Understand the concept of an optimal capital structure. Learning Objectives 6. 7. 8. 9. 10. Explain the main underpinnings of capital structure theory. Understand and be able to graph the moderate position on capital structure importance. Incorporate the concepts of agency costs and free cash flow into a discussion on capital structure management. Use the basic tools of capital structure management. Understand how business risk and global sales impact the multinational firm. Slide Contents 1. 2. 3. 4. 5. 6. 7. 8. 9. Principles Used in this chapter Risk Break-even Analysis Operating and Financial leverage Planning the Financing Mix Capital Structure Theory Capital Structure Management (Basic Tools) Capital Structure Management (Survey Results) Finance and the Multinational Firm 1. Principles Used in this Chapter Principles Used in this Chapter • Principle 1: – The Risk-Return Tradeoff – We Won’t Take on Additional Risk Unless We Expect to Be Compensated With Additional Return • Principle 3: – Cash-Not Profits-Is King • Principle 7: – The Agency Problem – Managers Won’t Work for the Owners Unless It’s in Their Best Interest • Principle 8: – Taxes Bias Business Solutions 2. Risk Risk • The variability associated with expected revenue or income streams. Such variability may arise due to: – Choice of business line (business risk). – Choice of an operating cost structure (operating risk). – Choice of capital structure (financial risk). Business Risk • Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates. There are four determinants of business risk: 1. The stability of the domestic economy 2. The exposure to, and stability of, foreign economies 3. Sensitivity to the business cycle, and 4. Competitive pressures in the firm’s industry. Operating Risk • Operating risk is the variation in the firm’s operating earnings that results from the firm’s cost structure (mix of fixed and variable operating costs). • Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues. Financial Risk Financial Risk is the variation in earnings as a result of a firm’s financing mix or proportion of financing that requires a fixed return. 3. Break-even Analysis Break-even Analysis • Break-even analysis is used to determine the break-even quantity of a firm’s output by examining the relationships among the firm’s cost structure, volume of output, and profit. • Break-even may be calculated in units or sales dollars. Break-even point indicates the point of sales or units at which EBIT is equal to zero. Break-even Analysis Use of break-even model enables the financial officer: 1. To determine the quantity of output that must be sold to cover all operating costs, as distinct from financial costs. 2. To calculate the EBIT that will be achieved at various output levels. Keown Martin 15 Petty Chapter 12 Elements of Break-even Model Break-even analysis requires information on the following: 1. Fixed Costs 2. Variable Costs 3. Total Revenue 4. Total Volume Break-even analysis requires classification of costs into two categories: – Fixed costs or indirect costs – Variable costs or direct costs • Since all costs are variable in the long-run, breakeven analysis is a short-run concept. Fixed or Indirect Costs • These costs do not vary in total amount as sales volume or the quantity of output changes. – As production volume increases, fixed costs per unit of product falls, as fixed costs are spread over a larger and larger quantity of output (but total remains the same). – Fixed costs vary per unit but remain fixed in total. – The total fixed costs are generally fixed for a specific range of output. Break-even Point (BEP) • BEP = Point at which EBIT equals zero • EBIT = (Sales price per unit) (units sold) – [(variable cost per unit) (units sold) + (total fixed cost)] BEP for Pierce Grain Company Example • Selling price = $10 per unit • Variable cost = $6 per unit • Fixed cost = $100,000 • BEP (Units) = Total Fixed costs (Unit sales price – Unit variable cost) = 100000/4 = 25000 units 4. Operating and Financial Leverage Operating Leverage • Operating leverage measures the sensitivity of the firm’s EBIT to fluctuation in sales, when a firm has fixed operating costs. • If the firm has no fixed operating costs, EBIT will change in proportion to the change in sales. Operating Leverage • Operating Leverage (OL) = % change in EBIT % change in sales • Thus % change in EBIT = OL X % change in sales Where : % change in EBIT = EBITt1 – EBITt / EBITt % Change in sales =Salest1 – Salest / Salest Operating Leverage Example: If a company has an operating leverage of 6, then what is the change in EBIT if sales increase by 5%? Percentage change in EBIT = Operating leverage X Percentage change in sales = 5% x 6 = 30% Thus if the firm increases sales by 5%, EBIT will increase by 30% Operating Leverage Operating leverage is present when: – Percentage change in EBIT / Percentage change in sales > 1.00 • The greater the firm’s degree of operating leverage, the more the profits will vary in response to change in sales. Operating Leverage for Pierce Grain Operating Leverage for Pierce Grain • Due to operating leverage, even though the sales increase by only 20%, EBIT increases by 120%. (and vice versa, if sales dropped by 20%, EBIT will fall by 120%; see next slide) • If Pierce had no operating leverage (i.e. all of its operating costs were variable), then the increase in EBIT would have been in proportion to increase in sales, i.e. 20%. Financial Leverage • Financial leverage is financing a portion of the firm’s assets with securities bearing a fixed rate of return in hopes of increasing the return to the common stockholders. • Thus, the decision to use preferred stock or debt exposes the common stockholders to financial risk. • Variability of EBIT is magnified by firm’s use of financial leverage. Three financing plans for Pierce Grain Three financing plans for Pierce Grain • Plan A: 0% debt – no financial risk • Plan B: 25% debt – moderate financial risk • Plan C: 40% debt – higher financial risk • See next slide for impact of financial leverage on earnings per share (EPS). The use of financial leverage magnifies the impact of changes in EBIT on earnings per share. • A firm is employing financial leverage and exposing its owners to financial risk when: – Percentage change in EPS divided by Percentage change in EBIT is greater than 1.00 Combined Leverage • Operating leverage causes changes in sales revenues to cause even greater changes in EBIT; furthermore, changes in EBIT due to financial leverage create large variations in both EPS and total earnings available to common shareholders. • Not surprisingly, combining operating and financial leverage causes rather large variations in EPS Combined Leverage • Combined Leverage = Percentage change in EPS/Percentage change in sales • Or combined leverage = Operating Leverage X Financial Leverage • See table 12-6 Combining Operating and Financial Leverage 5. Planning the Financing Mix Capital Structure • Financial Structure – Mix of all items that appear on the right-hand side of the company’s balance sheet • Capital Structure – Mix of the long-term sources of funds used by the firm – Financial Structure – Current liabilities = Capital Structure Financial Structure Designing a prudent financial structure requires answers to the following: 1. How should a firm best divide its total fund sources between short- and long-term components? 2. Capital structure management: In what proportions relative to the total should the various forms of permanent financing be utilized? • This chapter focuses on the second question. Capital Structure Management • A firm should mix the permanent sources of funds in a manner that will maximize the company’s stock price, or minimize the cost of capital. • A proper mix of funds sources is called the “optimal capital structure”. 6. Capital Structure Theory Capital Structure Theory • Theory focuses on the effect of financial leverage on the overall cost of capital to the enterprise. • In other words, Can the firm affect its overall cost of funds, either favorably or unfavorably, by varying the mixture of financing used? • Firms strive to minimize the cost of using financial capital. M&M’s Independence Hypothesis • According to Modigliani & Miller, neither the total value of the firm nor the cost of capital is influenced by the firm's capital structure. In other words, the financing decision is irrelevant! • Their conclusions were based on restrictive assumptions (such as no taxes, perfect or efficient markets). M&M’s Independence Hypothesis • Figure 12-5 that shows that firm’s value remains the same , despite the differences in financing mix. M&M’s Independence Hypothesis • Figure 12-6 shows that the firm’s cost of capital remains constant , although cost of equity rises with increased leverage. Extensions to Independence Hypothesis • How is the capital structure decision affected when we consider: – Tax benefit on interest expense – Possibility of financial distress – Agency cost of debt Impact of taxes on capital structure • Interest expense is tax deductible. • Because interest is deductible, the use of debt financing should result in higher total market value for firms outstanding securities. • Tax Shield benefit = rd(m)(t) r = rate, m = principal, t = marginal tax rate • Interest on debt is tax deductible. ==> higher the interest expense, the taxes lower • Thus, one would suggest that firms should maximize Debt … indeed, firms should go for 100% debt to maximize tax shield benefits!! • But, we generally do not see 100% debt in the real world. Why not? • Two possible explanations are: – Bankruptcy costs – Agency costs Impact of Bankruptcy on Capital structure • The Probability that a firm will be unable to meet its debt obligations increases with debt. Thus probability of bankruptcy (and hence costs) increases with increased leverage. Threat of financial distress causes the cost of debt to rise. • As financial conditions weaken, expected costs of default can be large enough to outweigh the tax shield benefit of debt financing. Impact of Bankruptcy on Capital structure • So higher debt does not lead to higher value. After a point debt reduces the value of the firm to shareholders. • This explains a tendency to restrain from maximizing the use of debt. • Debt capacity indicates the maximum proportion of debt the firm can include in its capital structure and still maintain its lowest composite cost of capital (see figure 12-7). Agency Costs • To ensure that agent-managers act in shareholders best interest, firms must: 1. Have proper incentives 2. Monitor decisions -bonding the managers -auditing financial statements -structuring the organization in unique ways that limit useful managerial decisions -reviewing the costs and benefits of management perquisites • The costs of the incentives and monitoring must be borne by the stockholders. Impact of Agency Costs on Capital Structur • Capital structure management also gives rise to agency costs. Bondholders are principals as essentially they have given a loan to the corporation, that is owned by shareholders. • Agency problems stem from conflicts of interest between stockholders and bondholders. For example, pursuing risky projects may benefit stockholders, but may not be appreciated by bondholders • Bondholders greatest fear is default by corporation or misuse of funds leading to financial distress. Impact of Agency Costs on Capital Structure • Agency costs may be minimized by agreeing to include several protective covenants in the bond contract • Bond covenants impose costs (such as periodic disclosure) and impose constraints (on the type of project management can undertake, Collateral, distribution of dividends, and limits on further borrowing) • Thus agency costs of debt reduces the attractiveness of debt and decreases the value of the firm. • Figure 12-8 indicates the trade-offs. For example, increasing the protective covenants will reduce the interest cost but increase the monitoring cost (which is eventually borne by the shareholders). Summary of Capital Structure Theory • Market value of levered firm = Market value of unlevered firm + Present value of tax shields - Present value of Financial distress costs - Present value of agency costs 7. Capital Structure Management WACC and Debt Ratios Weighted Average Cost of Capital and Debt Ratios 11.40% 11.20% 11.00% 10.80% 10.40% 10.20% 10.00% 9.80% 9.60% Debt Ratio 63 100% 90% 80% 70% 60% 50% 40% 30% 10% 20% 9.40% 0 WACC 10.60% Current Cost of Capital: Disney • Equity – Cost of Equity = – Market Value of Equity = – Equity/(Debt+Equity ) = 13.85% $50.88 Billion 82% • Debt – After-tax Cost of debt = – Market Value of Debt = – Debt/(Debt +Equity) = 7.50% (1-.36) = 4.80% $ 11.18 Billion 18% • Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22% Estimating Cost of Equity Current Beta = 1.25 Unlevered Beta = 1.09 Market premium = 5.5% T.Bond Rate = 7.00% Debt Ratio 0%0% 10% 20% 30% 40% 50% 60% 70% 80% 90% D/E Ratio 1.09 11% 25% 43% 67% 100% 150% 233% 400% 900% Beta 13.00% 1.17 1.27 1.39 1.56 1.79 2.14 2.72 3.99 8.21 Cost of Equity 13.43% 13.96% 14.65% 15.56% 16.85% 18.77% 21.97% 28.95% 52.14% t=36% Estimating Cost of Debt D/(D+E) D/E $ Debt 0.00% 0.00% $0 10.00% 11.11% $6,207 Calculation Details = [D/(D+E)]/( 1 -[D/(D+E)]) = [D/(D+E)]* Firm Value Step EBITDA Depreciation EBIT $5,559 Interest Taxable Income Tax Net Income $3,558 $6,693 $1,134 $5,559 $0 $5,559 $2,001 $3,272 $6,693 $1,134 Kept constant as debt changes. $447 = Interest Rate * $ Debt = EBIT - Interest $5,112 = Tax Rate * Taxable Income $1,840 = Taxable Income - Tax 2 Pre-tax Int. cov Likely Rating AAA Interest Rate Eff. Tax Rate 36.00% ∞ AAA 7.20% 36.00% 12.44 = EBIT/Int. Exp Based upon interest coverage 7.20% Interest rate for given rating See notes on effective tax rate 3 4 5 After-tax kd 4.61% 4.61% =Interest Rate * (1 - Tax Rate) 1 Firm Value = 50,888+11,180= $62,068 66 The Ratings Table If Interest Coverage Ratio is Estimated Bond Rating Default spread > 8.50 6.50 - 8.50 5.50 - 6.50 4.25 - 5.50 3.00 - 4.25 2.50 - 3.00 2.00 - 2.50 1.75 - 2.00 1.50 - 1.75 1.25 - 1.50 0.80 - 1.25 0.65 - 0.80 0.20 - 0.65 < 0.20 AAA AA A+ A A– BBB BB B+ B B– CCC CC C D 0.20% 0.50% 0.80% 1.00% 1.25% 1.50% 2.00% 2.50% 3.25% 4.25% 5.00% 6.00% 7.50% 10.00% A Test: Can you do the 20% level? D/(D+E) D/E $ Debt 0.00% 0.00% $0 10.00% 11.11% $6,207 EBITDA Depreciation $6,693 $1,134 $6,693 $1,134 EBIT $5,559 $5,559 Interest Expense Pre-tax Int. cov $0 ∞ $447 12.44 Likely Rating Interest Rate Eff. Tax Rate AAA 7.20% 36.00% AAA 7.20% 36.00% Cost of Debt 4.61% 4.61% 20.00% Second Iteration Disney’s Cost of Capital Schedule Debt Ratio Cost of Equity AT Cost of Debt Cost of Capital 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 13.00% 13.43% 13.96% 14.65% 15.56% 16.85% 18.77% 21.97% 28.95% 52.14% 4.61% 4.61% 4.99% 5.28% 5.76% 6.56% 7.68% 7.68% 7.97% 9.42% 13.00% 12.55% 12.17% 11.84% 11.64% 11.70% 12.11% 11.97% 12.17% 13.69% 8. Capital Structure Management (Survey Results) The Ten Factors • A survey of 392 corporate executives reveals the following ten factors as important determinants of capital structure decision: 1. Financial flexibility • 2. : Firm’s bargaining position is better if it has choices Credit Rating: • Downgrading of credit rating will increase borrowing costs and thus managers try to avoid anything that will trigger credit downgrades The Ten Factors 3. Insufficient internal funds • 4. 5. Firms follow a pecking order for raising funds – internal funds followed by debt and then equity. Level of interest rates • : : Firms tend to borrow when interest rates are low relative to their expectations Interest tax savings The Ten Factors 6. Transaction costs and fees • 7. 8. Cost of issuing equity is relatively higher than debt, making equity a less attractive source. Equity valuation • : : If shares are undervalued, firms will like to issue debt, and vice versa. Competitor: • Firms from similar businesses tend to have similar capital structures. The Ten Factors 9. Bankruptcy/distress costs • 10. : Higher existing debt will increase the likelihood of financial distress. Customer/supplier discomfort • : High levels of debt will increase discomfort among customers (fearing disruption in supply) and suppliers (fearing disruption in demand and late/non payment on existing contracts). 9. Finance and the Multinational Firm Finance and the Multinational Firm: Business Risk and Global Sales Business risk is both multidimensional and international, and is affected by: 1. The sensitivity of the firm’s product demand to general economic conditions 2. The degree of competition to which the firm is exposed 3. Product diversification 4. Growth prospects, and 5. Global sales volumes and production output.