Corporate Finance
ACS Program
W9
Leverage &
Capital
Structure
Introduction to Capital structure
1. Increase the Income from assets
2. Decreasing the cost of capital
3.
Maximizing the
net cash flow
There are only two ways in which a business
L
5.
Get the new
Debt
Financing
6.
Increase the
assets
7.
Increase the
Income
1. The first is debt. The essence of debt is
that you promise to make fixed payments in
E
Assets
can make money :
Liabilities & Equities
4.
Reinvest in
Equity
the future (interest payments and repaying
principal). If you fail to make those
payments, you lose control of your
business.
2. The other is equity. With equity, you do get
whatever cash flows are left over after you
have made debt payments.
Leverage
Leverage
• Leverage results from using borrowed
capital as a funding source when
investing to expand the firm's asset
base and generate returns on risk
capital.
When cost of operations
(COGS and Opex) are
largely fixed, small
changes of revenue will
to much larger in EBIT
• Leverage is an investment strategy of
using borrowed money—specifically,
the use of various financial instruments
or borrowed capital—to increase the
potential return of an investment.
• Leverage can also refer to the amount
of debt a firm uses to finance assets
Relationship between EBIT
and EPS. Tax depend on
profit. Interest and preferred
dividend usually fixed. When
its large, small changes in
EBIT produce larger changes
in EPS
Leverage
High business risk industry tends
to maintain a lower financial risk
Lower business risk industry
tends to have a higher financial
risk
Breakeven Analysis
Breakeven Analysis (cost-volume-profit) is used to :
•
To calculate the OBP, cost of goods sold and operating expenses
must be categorized as fixed or variable.
•
To determine the level of operations necessary to
cover all costs
•
To evaluate the profitability associated with various
levels of sales
•
Variable costs vary directly with the level of sales and are a
function of volume, not time.
The firm’s operating breakeven point (OBP) is the level
of sales necessary to cover all operating expenses
•
Examples would include direct labor and shipping.
•
Fixed costs are a function of time and do not vary with sales
volume.
•
Examples would include rent and fixed overhead
At the OBP, operating profit (EBIT) is equal to zero.
Breakeven Analysis
Algebraic Approach
•
Using the following variables, the operating portion of a firm’s income statement may
be recast as follows:
P
Q
FC
VC
•
=
=
=
=
sales price per unit
sales quantity in units
fixed operating costs per period
variable operating costs per unit
𝐹𝐶
Letting EBIT = 0 and solving for Q, we get: 𝑄 =
𝑃 − 𝑉𝐶
𝐸𝐵𝐼𝑇 = 𝑃 𝑥 𝑄 − 𝐹𝐶 − (𝑉𝐶 𝑥 𝑄)
Breakeven Analysis
Algebraic Approach
•
Example: Omnibus Posters has fixed operating costs of $2,500, a sales price of $10/poster, and
variable costs of $5/poster. Find the OBP.
2500
𝑄=
= 500 𝑝𝑜𝑠𝑡𝑒𝑟𝑠
10 − 5
•
This implies that if Omnibus sells exactly 500 posters, its revenues will just equal its costs (EBIT = $0).
EBIT = (P x Q) - FC - (VC x Q)
EBIT = ($10 x 500) - $2,500 - ($5 x 500)
EBIT = $5,000 - $2,500 - $2,500 = $0
Breakeven Analysis
Graphic Approach
Total Revenue
EBIT at Various Levels of Quantity Sold
Total Costs
Total FC
14,000
Quantity
Total
Total
Total
Total
Sold
Revenue
Costs
FC
VC
0
0
2,500
2,500
0
500
5,000
5,000
2,500
2,500
0
1,000
10,000
7,500
2,500
5,000
2,500
1,500
15,000
10,000
2,500
7,500
5,000
2,000
20,000
12,500
2,500
10,000
7,500
2,500
25,000
15,000
2,500
12,500
10,000
3,000
30,000
17,500
2,500
15,000
12,500
12,000
(2,500)
revenue/costs ($)
EBIT
10,000
BEP
8,000
6,000
4,000
2,000
-
Omnibus Posters has fixed operating costs of $2,500, a sales
price of $10/poster, and variable costs of $5/poster. Find the
OBP.
500
1,000
sales (posters)
1,500
2,000
Operating and Financial Leverage
Effect of Leverage on Income Statement
Net Sales
Variable Cost (60% of sales)
Fixed Cost
EBIT
Interest Expense
EBT
Tax (30%)
Net Income
Base Case
Normal
700,000
420,000
200,000
80,000
20,000
60,000
18,000
42,000
Operating and Financial Leverage
Effect of Leverage on Income Statement
Worse Case
Sales decrease 10%
Net Sales
630,000
Variable Cost (60% of sales)
378,000
Fixed Cost
200,000
EBIT
52,000
Interest Expense
20,000
EBT
32,000
Tax (30%)
9,600
Net Income
22,400
- 46.67%
Base Case
Best Case
Normal
Sales Increase 10%
700,000
770,000
420,000
462,000
200,000
200,000
80,000
108,000
20,000
20,000
60,000
88,000
18,000
26,400
42,000
61,600
46.67%
Operating and Financial Leverage
Degree of Operating Leverage
• Operating leverage = the potential use of fixed operating costs to magnify the effects of changes in
sales on the firm’s EBIT  Effective operating cost
• The degree of operating leverage (DOL) measures the sensitivity of changes in EBIT to changes in
Sales.
• Only companies that use fixed costs in the production process will experience operating leverage.
Operating and Financial Leverage
Degree of Operating Leverage
Worse Case
Sales decrease 10%
Net Sales
630,000
Variable Cost (60% of sales)
378,000
Fixed Cost
200,000
EBIT
52,000
Interest Expense
20,000
EBT
32,000
Tax (30%)
9,600
Net Income
22,400
EBIT Decrease
35%
Base Case
Best Case
Normal
Sales Increase 10%
700,000
770,000
420,000
462,000
200,000
200,000
80,000
108,000
20,000
20,000
60,000
88,000
18,000
26,400
42,000
61,600
EBIT Increase
35%
DOL = % Change in EBIT = 35% = 3.50
% Change in Sales
10%
Because of the presence of fixed costs in the firm’s
production process, a 10% increase in Sales will result in a
35% increase in EBIT. Note that in the absence of operating
leverage (if Fixed Costs were zero), the DOL would equal 1
and a 10% increase in Sales would result in a 10% increase
in EBIT.
𝐷𝑂𝐿 =
𝑆𝑎𝑙𝑒𝑠 −𝑉𝐶
𝑆𝑎𝑙𝑒𝑠 −𝑉𝐶 −𝐹𝐶
700 −420
= 700 −420 −200 = 3.50
Operating and Financial Leverage
Degree of Operating Leverage
Company A Company B
Net Sales
Variable Cost (60% of sales)
Fixed Cost
55,000
33,000
10,000
30,000
18,000
5,000
Net Sales - VC
Net Sales - VC - FC
22,000
12,000
12,000
7,000
1.83
1.71
DOL
𝐷𝑂𝐿 =
𝑆𝑎𝑙𝑒𝑠 − 𝑉𝐶
𝑆𝑎𝑙𝑒𝑠 − 𝑉𝐶 − 𝐹𝐶
If both companies experience 20% increase in sales, ………
EBIT of Company A will increase 36.6%
EBIT of Company B will increase 34.2%
Operating and Financial Leverage
Degree of Financial Leverage
• Financial leverage = potential use of fixed financial costs to magnify the effects of changes in EBIT on
the firm’s EPS
• The degree of financial leverage (DFL) measures the sensitivity of changes in EPS to changes in EBIT.
• Only companies that use debt or other forms of fixed cost financing (like preferred stock) will
experience financial leverage.
Operating and Financial Leverage
Degree of Financial Leverage
Worse Case
Sales decrease 10%
Net Sales
630,000
Variable Cost (60% of sales)
378,000
Fixed Cost
200,000
EBIT
52,000
Interest Expense
20,000
EBT
32,000
Tax (30%)
9,600
Net Income
# shares
EPS
22,400
42,000
0.53
EPS Decrease
46.67%
Base Case
Best Case
Normal
Sales Increase 10%
700,000
770,000
420,000
462,000
200,000
200,000
80,000
108,000
20,000
20,000
60,000
88,000
18,000
26,400
42,000
42,000
1.00
61,600
42,000
1.47
EPS Increase
46.67%
DFL = % Change in EPS = 46.67% = 1.33
% Change in EBIT
35.00%
In this case, the DFL is greater than 1 which indicates the
presence of debt financing. In general, the greater the
DFL, the greater the financial leverage and the greater
the financial risk.
𝐷𝐹𝐿 =
𝐸𝐵𝐼𝑇
80
=
= 1.33
𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
80 − 20
Operating and Financial Leverage
Degree of Financial Leverage
𝐷𝐹𝐿 =
𝐸𝐵𝐼𝑇
108
=
= 1.23
𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
108 − 20
𝐸𝐵𝐼𝑇
52
𝐷𝐹𝐿 =
=
= 1.62
𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
52 − 20
In this case, we can see that the DFL is related to the expected level of EBIT. However, the DFL declines if the firm performs better than
expected. Note also, however, that the DFL will rise if the firm performs worse than expected.
Operating and Financial Leverage
Degree of Total Leverage (DTL)
Worse Case
Sales decrease 10%
Net Sales
630,000
Variable Cost (60% of sales)
378,000
Fixed Cost
200,000
EBIT
52,000
Interest Expense
20,000
EBT
32,000
Tax (30%)
9,600
Net Income
# shares
EPS
22,400
42,000
0.53
EPS Decrease
46.67%
Base Case
Best Case
Normal
Sales Increase 10%
700,000
770,000
420,000
462,000
200,000
200,000
80,000
108,000
20,000
20,000
60,000
88,000
18,000
26,400
42,000
42,000
1.00
61,600
42,000
1.47
EPS Increase
46.67%
DTL = % Change in EPS =
% Change in Sales
46.7%
10%
= 4.67
In this case, the DTL is greater than 1 which indicates the
presence of both fixed operating and fixed financing
costs. In general, the greater the DTL, the greater the
financial leverage and the greater the operating leverage.
Operating and Financial Leverage
Degree of Total Leverage (DTL)
The relationship between the DTL, DOL, and DFL is illustrated in the following equation:
DTL = DOL x DFL
Applying this to our example at a sales level of $770, we get:
DTL = 3.50 x 1.33 = 4.67
Which is the same result we obtained using either the point or interval estimates at that sales level.
Capital
Structure
Outline
• The Capital Structure Question and The Pie Theory
• Maximizing Firm Value versus Maximizing Stockholder Interests
• Financial Leverage and Firm Value: An Example
• Modigliani and Miller: Proposition II (No Taxes)
• Taxes
Capital Structure and the Pie
• The value of a firm is defined to be the sum of the
value of the firm’s debt and the firm’s equity.
V=B+S
• B is the market value of the debt
• S is the market value of the equity
• If the goal of the firm’s management is to make the
firm as valuable as possible, then the firm should
pick the debt-equity ratio that makes the pie as big
as possible.
S
B
Value of the Firm
Stockholder Interests
There are two important questions:
1. Why should the stockholders care about maximizing firm value? Perhaps they should be interested in
strategies that maximize shareholder value.
2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?
As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm
increases.
Financial Leverage, EPS, and ROE
Consider an all-equity firm that is contemplating going into debt. (Maybe some of the original
shareholders want to cash out.)
Current
Assets
Proposed
20.000
20.000
0
8.000
20.000
12.000
Debt to Equity Ratio
0%
60%
Interest Rate
n/a
8%
Shares outstanding
400
240
50
50
Debt
Equity
Share Price
EPS and ROE Under Current Structure
Recession
Expected
Expansion
$1,000
$2,000
$3,000
0
0
0
$1,000
$2,000
$3,000
EPS
$2.50
$5.00
$7.50
ROA
5%
10%
15%
ROE
5%
10%
15%
EBIT
Interest
Net income
Current Shares Outstanding = 400 shares
EPS and ROE Under Proposed Structure
Recession
Expected
Expansion
$1,000
$2,000
$3,000
640
640
640
Net income
$360
$1,360
$2,360
EPS
$1.50
$5.67
$9.83
ROA
1.8%
6.8%
11.8%
ROE
3.0%
11.3%
19.7%
EBIT
Interest
Proposed Shares Outstanding = 240 shares
Financial Leverage and EPS
12.00
Debt
10.00
EPS
8.00
6.00
4.00
No Debt
Advantage
to debt
Break-even
point
2.00
0.00
1,000
(2.00)
Disadvantage
to debt
2,000
3,000
EBIT (no taxes
Assumptions of the M&M Model
• Homogeneous Expectations
• Homogeneous Business Risk Classes
• Perpetual Cash Flows
• Perfect Capital Markets:
› Perfect competition
› Firms and investors can borrow/lend at the same rate
› Equal access to all relevant information
› No transaction costs
› No taxes
Homemade Leverage: An Example
Recession
EPS of Unlevered Firm
2.50
Earnings for 40 shares
100
Less interest on $800 (8%)
64
Net Profits
36
ROE (Net Profits / $1,200)
3.0%
Expected
5.00
200
64
136
11.3%
Expansion
7.50
300
64
236
19.7%
We are buying 40 shares of a $50 stock, using $800 in margin. We get the same
ROE as if we bought into a levered firm.
Our personal debt-equity ratio is:
𝐵
800
=
= 66,67%
𝑆
1.200
Homemade Un Leverage: An Example
Recession
EPS of Levered Firm
$1.50
Earnings for 24 shares
$36
Plus interest on $800 (8%)
$64
Net Profits
$100
ROE (Net Profits / $1,200)
5%
Expected
$5.67
$136
$64
$200
10%
Expansion
$9.83
$236
$64
$300
15%
Buying 24 shares of an otherwise identical levered firm along with some of the
firm’s debt gets us to the ROE of the unlevered firm.
This is the fundamental insight of M&M
MM Proposition I (No Taxes)
• We can create a levered or unlevered position by adjusting the
trading in our own account.
• This homemade leverage suggests that capital structure is irrelevant
in determining the value of the firm:
VL = VU
MM Proposition II (No Taxes)
RoE = RoC + RoD
Proposition II
Leverage increases the risk and return to stockholders
Rs = R0 +
𝐵
( ) (R0
𝑆𝐿
- RB)
RB is the interest rate (cost of debt)
Rs is the return on (levered) equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
SL is the value of levered equity
MM Proposition II (No Taxes)
The derivation is straightforward:
𝑅𝑊𝐴𝐶𝐶 =
𝐵
𝐵+𝑆
𝐵
𝐵+𝑆
𝑥 𝑅𝐵 +
𝐵+𝑆
𝑆
𝐵
𝑥
𝐵+𝑆
𝐵
𝑆
𝐵
𝑆
𝑥 𝑅𝐵 +
𝑆
𝐵+𝑆
𝐵+𝑆
𝑆
𝑥
𝑆
𝐵+𝑆
𝐵+𝑆
𝑆
𝑥 𝑅𝐵 + 𝑅𝑆 =
𝑥 𝑅𝑆
Then set 𝑅𝑊𝐴𝐶𝐶 = 𝑅0
𝑥 𝑅𝑆 = 𝑅0
𝑥 𝑅𝐵 +
𝑥 𝑅𝐵 +𝑅𝑆 =
𝑆
𝐵+𝑆
𝐵
𝑆
𝑥 𝑅𝑆 =
𝐵+𝑆
𝑆
𝑥 𝑅0
Multiply both side with
𝑥 𝑅0
𝑥 𝑅0 + 𝑅0
𝑅𝑆 = 𝑅0 +
𝐵
𝑆
(𝑅0 - 𝑅𝐵)
𝐵+𝑆
𝑆
Cost of capital: R (%)
MM Proposition II (No Taxes)
R0
RS  R0 
RWACC 
B
 ( R0  RB )
SL
B
S
 RB 
 RS
BS
BS
RB
RB
Debt-to-equity Ratio B
S
MM Propositions I & II (With Taxes)
• Value of the Firm
EBIT x (1 - TC)
• Proposition I (with Corporate Taxes)
› Firm value increases with leverage
VL = VU + TC B
• Proposition II (with Corporate Taxes)
› Some of the increase in equity risk and return is offset by the interest tax shield
𝑅𝑆 = 𝑅0 +
𝐵
𝑆
(𝑅0 - 𝑅𝐵 )
TC B is leverage increase the value of the firm by the tax shield
RB is the interest rate (cost of debt)
RS is the return on equity (cost of equity)
R0 is the return on unlevered equity (cost of capital)
B is the value of debt
S is the value of levered equity
MM Proposition I (With Taxes)
Total Cash Flow to all Share holder :
𝐸𝐵𝐼𝑇 − 𝑅𝐵𝐵 𝑥 1 − 𝑇𝐶 + 𝑅𝐵𝐵
Clearly
𝐸𝐵𝐼𝑇 − 𝑅𝐵𝐵 𝑥 1 − 𝑇𝐶 + 𝑅𝐵𝐵 = 𝐸𝐵𝐼𝑇 𝑥 1 − 𝑇𝐶 - 𝑅𝐵𝐵 𝑥 1 − 𝑇𝐶 + 𝑅𝐵𝐵
= 𝐸𝐵𝐼𝑇 𝑥 1 − 𝑇𝐶 - 𝑅𝐵𝐵 + 𝑅𝐵𝐵 𝑇𝐶 + 𝑅𝐵𝐵
= 𝐸𝐵𝐼𝑇 𝑥 1 − 𝑇𝐶 + 𝑅𝐵𝐵 𝑇𝐶
MM Proposition I (With Taxes)
Start with M&M Proposition I with taxes: VL = VU + TC B
Since VL = S + B  S + B = VU + TC B
VU = S + B (1 – TC )
The cash flows from each side of the balance sheet must equal:
𝑆𝑅𝑆 + 𝐵𝑅𝐵 = 𝑉𝑈𝑅0 + 𝑇𝑐𝐵𝑅𝐵
𝑆𝑅𝑆 + 𝐵𝑅𝐵 = [𝑆 + 𝐵 1 − 𝑇𝐶 ] 𝑅0 + 𝑇𝑐𝐵𝑅𝐵  Divide both side by S
𝑅𝑆 +
𝐵
𝐵
𝐵
𝑅𝐵 = [1 +
1 − 𝑇𝐶 ] 𝑅0 + 𝑇𝑐𝑅𝐵
𝑆
𝑆
𝑆
𝑅𝑆 = 𝑅0 +
𝐵
1 − 𝑇𝐶 ] 𝑥 (𝑅0 − 𝑅𝐵)
𝑆
The Effect of Financial Leverage
Cost of capital: R
(%)
RS  R0 
RS  R0 
B
 ( R0  RB )
SL
B
 (1  TC )  ( R0  RB )
SL
R0
RWACC 
B
SL
 RB  (1  TC ) 
 RS
BSL
B  SL
RB
Debt-to-equity
ratio (B/S)
Total Cash Flow to Investors
All Equity
Recession
$1,000
0
$1,000
$350
Expected
$2,000
0
$2,000
$700
Expansion
$3,000
0
$3,000
$1,050
$650
$1,300
$1,950
Recession
Expected
Expansion
$1,000
$2,000
$3,000
640
640
640
EBT
$360
$1,360
$2,360
Taxes (Tc = 35%)
$126
$476
$826
Total Cash Flow
$234+640
$884+640
$1,534+640
$874
$1,524
$2,174
$650+$224
$1,300+$224
$1,950+$224
$874
$1,524
$2,174
EBIT
Interest
EBT
Taxes (Tc = 35%)
Total Cash Flow
EBIT
Interest ($800 @ 8% )
Leverage
EBIT(1-Tc)+TCRBB
Total Cash Flow to Investors
All-equity firm
S
B
Levered firm
S
B
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of
the unlevered firm.
This is how cutting the pie differently can make the pie “larger.” -the government takes a
smaller slice of the pie!
Capital Structure Theory
Tax Benefits
• Allowing companies to deduct interest payments when computing taxable income lowers the amount of
corporate taxes.
• This in turn increases firm cash flows and makes more cash available to investors.
• In essence, the government is subsidizing the cost of debt financing relative to equity financing.
Capital Structure
• Capital structure is one of the most complex
areas of financial decision making due to its
interrelationship with other financial decision
variables.
• Poor capital structure decisions can result in a
high cost of capital, thereby lowering project
NPVs and making them more unacceptable.
• Effective decisions can lower the cost of
capital, resulting in higher NPVs and more
acceptable projects, thereby increasing the
value of the firm.
Capital Structure
High business risk industry tends
to maintain a lower financial risk
Lower business risk industry
tends to have a higher financial
risk
Capital Structure Theory
Probability of Bankruptcy
• The probability that debt obligations will lead to bankruptcy depends on the level of a company’s business
risk and financial risk.
• Business risk is the risk to the firm of being unable to cover operating costs.
• In general, the higher the firm’s fixed costs relative to variable costs, the greater the firm’s operating
leverage and business risk.
• Business risk is also affected by revenue and cost stability
• The firm’s capital structure - the mix between debt versus equity - directly impacts financial leverage.
• Financial leverage measures the extent to which a firm employs fixed cost financing sources such as debt
and preferred stock.
• The greater a firm’s financial leverage, the greater will be its financial risk - the risk of being unable to meet
its fixed interest and preferred stock dividends.
Capital Structure Theory
Agency Costs Imposed by Lenders
•
When a firm borrows funds by issuing debt, the interest rate charged by lenders is based on the lender’s assessment of the risk of the
firm’s investments.
•
After obtaining the loan, the firm (stockholders/managers) could use the funds to invest in riskier assets.
•
If these high risk investments pay off, the stockholders received all benefit, but if do not pay off, the lenders share in the costs.
•
To avoid this, lenders impose various monitoring costs on the firm.
•
Examples of these monitoring costs would include:
•
increase the rate on future debt issues,
•
denying future loan requests,
•
imposing loan agreement provisions.
Capital Structure Theory
Asymmetric Information
• Asymmetric information results when managers of a firm have more information about operations and
future prospects than do investors.
• Asymmetric information can impact the firm’s capital structure as follows:
• Suppose management has identified an extremely lucrative (menguntungkan) investment
opportunity and needs to raise capital. Based on this opportunity, management believes its stock is
undervalued since the investors have no information about the investment.
• In this case, management will raise the funds using debt since they believe/know the stock is
undervalued (underpriced) given this information. In this case, the use of debt is viewed as a positive
signal to investors regarding the firm’s prospects
• On the other hand, if the outlook for the firm is poor, management will issue equity instead since they
believe/know that the price of the firm’s stock is overvalued (overpriced). Issuing equity is therefore
generally thought of as a “negative” signal.
Capital Structure
So What is the Optimal Capital Structure?
•
In general, it is believed that the market value of a company is maximized when the
cost of capital (the firm’s discount rate) is minimized.
•
The value of the firm can be defined algebraically as follows:
V = EBIT (1 - t) = NOPAT
ra
ra
Where :
t = Tax rate
NOPAT = Net operating profit after tax
ra = weighted average cost of capital (WACC)
Optimal Capital Structure
•
An example of how this might work using actual numbers is demonstrated below:
Cost of Capital & Firm Value for Alternative Capital Structures
Source of
Capital
Capital
Structure 1
Capital
Structure 2
Firm Value ($)
13%
$300
Capital
Structure 3
12%
$250
9%
Debt
25%
40%
70%
Equity
75%
60%
30%
WACC
10%
8%
13%
11%
$200
10%
$150
$100
8%
$50
7%
6%
$25%
40%
70%
Total Debt/Total Assets
Expected Future
Annual Cash Flows $
20 $
20 $
20
$
200 $
250 $
160
Firm Value
WACC & Firm Value
WACC (%)
WACC
Value
EPS-EBIT Approach to Capital Structure
•
The EPS-EBIT approach to capital structure involves selecting the capital structure that maximizes EPS over the expected
range of EBIT.
•
Using this approach, the emphasis is on maximizing the owners returns (EPS).
•
A major shortcoming of this approach is the fact that earnings are only one of the determinants of shareholder wealth
maximization.
•
This method does not explicitly consider the impact of risk.
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EPS-EBIT Approach to Capital Structure
Example
The capital structure of JGS, a soft drink manufacturer is shown in the table below. Currently, JGS uses only equity in its
capital structure. Thus the current debt ratio is 0.00%. Assume JGS is in the 40% tax bracket.
JGS Current Capital Structure
Long-term debt
$
-
Common stock (25,000 shares @ $20)
$
500,000
Total Capital (assets)
$
500,000
JSG's Zero Leverage Financing Plan
EPS-EBIT coordinates for JSG’s current capital structure can
be found by assuming two EBIT values and calculating the
associated EPS as follows:
EBIT
$
100,000
Interest
$
EBT
$
100,000
$
200,000
T
$
40,000
$
80,000
NI
$
60,000
$
120,000
EPS
$
2.40
$
4.80
-
$
$
200,000
-
$6.00
EPS ($)
$5.00
$4.80
$4.00
$3.00
$2.00
$2.40
$1.00
$$100,000
$200,000
EBIT ($)
EPS-EBIT Approach to Capital Structure
JSG is considering altering its capital structure while maintaining its original $500,000 capital base as shown in the table below:
JSG's Alternative Current and Alternative Capital Structures
Debt Ratio Total Assets
Debt
-
Equity
Int. Rate (%) Annual Int. ($) No. of Shares
0%
$ 500,000 $
$ 500,000
0.0%
$
-
25,000
30%
$ 500,000 $ 150,000 $ 350,000
10.0%
$
15,000
17,500
60%
$ 500,000 $ 300,000 $ 200,000
16.5%
$
49,500
10,000
We can use this information to calculate the EPS-EBIT coordinates as shown on the following slide:
EPS-EBIT Approach to Capital Structure
Capital Structure
30% Debt Ratio
EBIT
$ 100,000
60% Debt Ratio
$ 200,000
$ 100,000
$ 200,000
Interest $
15,000
$
15,000
$
49,500
$
EBT
$
85,000
$ 185,000
$
50,500
$ 150,500
T
$
34,000
$
74,000
$
20,200
$
60,200
NI
$
51,000
$ 111,000
$
30,300
$
90,300
EPS
$
2.91
$
$
3.03
$
9.03
6.34
49,500
EPS-EBIT Analysis
EPS (0% Debt)
EPS (30% Debt)
EPS (60% Debt)
EPS($)
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
($2.00)
$-
$100,000
$200,000
($4.00)
EBIT($)
Choosing the Optimal Capital Structure
•
The following discussion will attempt to create a framework for making capital budgeting decisions that maximizes shareholder wealth -- i.e.,
considers both risk and return.
•
Perhaps the best way to demonstrate this is through the following example:
Assume that JSG is attempting to choose the best of several alternative capital structures -- specifically, debt ratios of 0, 10, 20, 30, 40, 50,
and 60 percent. Furthermore, for each of these capital structures, the firm has estimated EPS, the CV of EPS, and required return
Estim ated Share Value Resulting from Alternative Capital Structures
for JSG Com pany
Debt
Expected
Estim ated
Estim ated
Estim ated
Ratio
EPS
CV of EPS
Requ. Return
Share Price
0%
$
2.40
0.71
11.5%
$
20.87
10%
$
2.55
0.74
11.7%
$
21.79
20%
$
2.72
0.78
12.1%
$
22.48
30%
$
2.91
0.83
12.5%
$
23.28
40%
$
3.12
0.91
14.0%
$
22.29
50%
$
3.18
1.07
16.5%
$
19.27
60%
$
3.03
1.40
19.0%
$
15.95
Other Influences on Capital Structure Choice
Flexibility
Maintaining financial flexibility simply means that a company would like to give itself slack in terms of being able
to raise additional capital to support working capital requirements if desirable investment opportunities arise.
As a result, most firms try to ensure that they have excess borrowing capacity available by keeping debt levels at
manageable levels.
Timing
The sale of securities by most firms depend not only on the investment opportunities available but also on the the cost of
capital at a particular point in time.
Successful companies usually try to forecast and take advantage of changing market conditions to lower their overall cost
of raising funds.
Other Influences on Capital Structure Choice
Corporate Control
Many firms avoid the issuance of new equity because it may cause existing controlling shareholders to lose their ability to
influence the direction of the company.
As a result, most companies are reluctant to issue new shares of stock and instead issue debt when additional funds are
needed.
Maturity Matching
Many firms also try to match the maturity of their source of financing with the maturity of the
assets they are using the funds to finance. As a result, the capital structure of a firm is
determined in part by the types of investments it makes.
Summary: No Taxes
• In a world of no taxes, the value of the firm is unaffected
by capital structure.
• This is M&M Proposition I:
VL = VU
• Proposition I holds because shareholders can achieve
any pattern of payouts they desire with homemade
leverage.
• In a world of no taxes, M&M Proposition II states that
leverage increases the risk and return to stockholders.
Rs = R0 +
𝐵
( ) (R0
𝑆𝐿
- RB)
Summary: Taxes
• In a world of taxes, but no bankruptcy costs, the value of the firm increases with
leverage.
• This is M&M Proposition I:
VL = VU + TC B
• Proposition I holds because shareholders can achieve any pattern of payouts they
desire with homemade leverage.
• In a world of taxes, M&M Proposition II states that leverage increases the risk and
return to stockholders.
𝐵
𝑅𝑆 = 𝑅0 +
1 − 𝑇𝐶 ] 𝑥 (𝑅0 − 𝑅𝐵)
𝑆