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Learning Outcomes
Chapter 12
Describe how business risk and financial risk can affect a
firm’s capital structure.
Describe how businesses determine their optimal capital
structures.
Describe how leverage can be used to make capital
structure decisions, and discuss the effects (a) operating
leverage, (b) financial leverage, and (c) total leverage
have on risks associated with a firm.
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Learning Outcomes
Chapter 12
Discuss how managers consider liquidity when
determining the optimal capital structure for a firm.
Discuss the two general theories—that is, (a) trade-off
theory and (b) signaling theory—that have been
developed to explain what firms’ capital structures should
be and why firms’ capital structures differ.
Describe how and why capital structures vary among
firms in the United States and around the world.
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The Target Capital Structure
Capital Structure: The combination of debt
and equity used to finance a firm
Target Capital Structure: The ideal mix of
debt, preferred stock, and common equity
with which the firm plans to finance its
investments
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The Target Capital Structure
Four factors that influence capital structure
decisions:
 The firm’s business risk
 The firm’s tax position
 Financial flexibility
 Managerial attitude
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What is Business Risk?
The risk associated with the firm’s operations.
ignoring any fixed financing effects.
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Factors Affecting
Business Risk
Sales variability
Input price variability
Ability to adjust output prices for changes in
input prices
The extent to which costs are fixed: operating
leverage
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What is Operating Leverage?
Operating Leverage: Use of fixed operating
rather than variable costs
If most costs are fixed (do not decline when
demand falls) then firm has high DOL (degree
of operating leverage)
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What is Financial Risk?
Financial Leverage: The extent to which
fixed-income securities (debt and preferred
stock) are used in a firm’s capital structure
Financial Risk: Additional risk placed on
stockholders as as 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 type of
securities issued: More debt, more financial
risk.
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Determining the
Optimal Capital Structure:
Seek to maximize the price of the firm’s
stock.
Changes in use of debt will cause changes in
earnings per share, and thus, in the stock
price.
Cost of debt varies with capital structure.
Financial leverage increases risk.
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EPS Indifference Analysis
EPS Indifference Point:
The level of sales at which EPS will be the
same whether the firm uses debt or common
stock (pure equity) financing.
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The Effect of Capital Structure on Stock
Prices and the Cost of Capital
The optimal capital structure maximizes the
price of a firm’s stock
Always calls for a debt/assets ratio that is
lower than the one that maximizes expected
EPS.
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EPS Analysis and the Effects of Financial
Leverage
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Relationships Among Expected EPS, Risk
and Financial Leverage
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Indifference Point
The level of sales
at which EPS will
be the same
whether the firm
uses debt or
common stock
pricing
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The Effect of Capital Structure on Stock
prices and the Cost of Capital
The optimal capital structure is the one that
maximizes the price of the firm’s stock
This always calls for a debt/assets ratio that
is lower than the one that maximizes
expected EPS
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Relationship Between Capital Structure and
Cost of Capital
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Relationship Between Capital Structure and
Cost of Capital
Cost of Capital (%)
Cost of Equity, rs
Weighted Average Cost of
Capital, WACC
Minimum WACC = 11.1%
After-Tax Cost of Debt, rdT
Debt/Assets (%)
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Relationship Between Capital Structure and
Stock Price
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Cost of Equity at Different Capital Structures
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Degree of Operating Leverage (DOL)
The percentage change in operating income
(EBIT) associated with a given percentage
change in sales.
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Degree of Operating Leverage (DOL)
Sales
Variable operating costs (60%)
Gross profit
Fixed operating costs
Net operating income = EBIT
DOL 
Expected
Sales = –5%
Outcome of Expectations
$250,000
$237,500
(150,000)
(142,500)
100,000
95,000
(75,000)
(75,000)
25,000
20,000
%Δ
-5.0%
-5.0%
-5.0
0.0
-20.0
Gross profit $100,000

 4.0x
EBIT
$25,000
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Degree of Financial Leverage (DFL)
The percentage change in earnings available
to common stockholders associated with a
given percentage change in EBIT.
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Degree of Financial Leverage (DFL)
Net operating income = EBIT
Interest
Earnings Before Taxes
Taxes (40%)
Net Income
DFL 
Expected
EBIT = –20%
Outcome of Expectations % Δ
25,000
20,000
-20.0
(12,500)
(12,500)
0.0
-40.0
7,500
12,500
( 5,000)
(3,000)
-40.0
4,500
-40.0
7,500
EBIT
$25,000
$25,000


 2.0x
EBIT - I $25,000 - $12,500 $12,500
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Degree of Total Leverage (DTL)
The percentage change in EPS that results
from a given percentage change in sales.
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Degree of Total Leverage (DTL)
DTL 
Gross profit
$100,000
$100,000


 8.0x
EBIT - I
$25,000 - $12,500 $12,500
Sales
Variable operating costs (60%)
Gross profit
Fixed operating costs
Net operating income = EBIT
Interest
Earnings Before Taxes
Taxes (40%)
Net Income
Expected
Outcome
$250,000
(150,000)
100,000
(75,000)
25,000
(12,500)
12,500
(5,000)
7,500
Sales = –5%
of Expectations
$237,500
(142,500)
95,000
(75,000)
20,000
(12,500)
7,500
(3,000)
4,500
%Δ
-5.0%
-5.0
-5.0
0.0
-20.0
0.0
-40.0
-40.0
-40.0
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Liquidity and Capital Structure
Difficulties with Analysis
We cannot determine exactly how either P/E ratios or equity
capitalization rates (rs values) are affected by different
degrees of financial leverage.
Managers may be more or less conservative than the
average stockholder, so management may set a different
target capital structure than the one that would maximize
the stock price.
Managers of large firms have a responsibility to provide
continuous service and must refrain from using leverage to
the point where the firm’s long-run viability is endangered.
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Liquidity and Capital Structure
Financial strength indicators
 Times-Interest-Earned (TIE) Ratio
• Ratio that measures the firm’s ability to meet
its annual interest obligations
• Calculated by dividing earnings before interest
and taxes by interest charges
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Capital Structure Theory
Tax benefit/Bankruptcy Trade-off Theory
Signaling Theory
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Trade-Off Theory
Interest is tax-deductible expense, therefore less
expensive than common or preferred stock.
Interest rates rise as debt/asset ratio increases; tax
rates fall at high debt levels; probability of
bankruptcy increases as debt/assets ratio increases.
At a threshold debt level(D/A1), the effects of point 2
are immaterial. The optimal debt level (D/A2) occurs
when the tax savings of additional debt are just
offset by the increase in bankruptcy costs.
Theory and empirical evidence support these ideas,
but the points cannot be identified precisely.
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Signaling Theory
Many large, successful firms use much less
debt than the trade-off theory suggests which
led to the development of the signaling
theory.
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Signaling Theory
Symmetric Information - Investors and managers have identical
information about the firm’s prospects.
Asymmetric Information - Managers have better information
about their firm’s prospects than do outside investors.
Signal - An action taken by a firm’s management that provides
clues to investors about how management views the firm’s
prospects
Reserve Borrowing Capacity
 Ability to borrow money at a reasonable cost when good
investment opportunities arise
 Firms often use less debt than “optimal” to ensure that they
can obtain debt capital later if needed.
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Variations in Capital Structures among
Firms
Wide variations in use of financial leverage
among industries and firms within an industry
 TIE measures how safe the debt is:
• percentage of debt
• interest rate on debt
• company’s profitability
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Capital Structures Around the World
We cannot state that one financial system is better
than another one in the sense of making the firms in
one country more efficient than those in another.
As U.S. firms become increasingly involved in
worldwide operations, they must become increasingly
aware of worldwide conditions, and they must be
prepared to adapt to conditions in the various
countries in which they do business.
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