CAPITAL STRUCTURE
AND LEVERAGE
13-1
LEARNING OBJECTIVES
n
n
n
n
Differentiate Business vs. financial risk
Discuss the Optimal capital structure
Discuss the Operating leverage
Discuss the Capital structure theory
13-2
Four factors influence the firm’s capital
structure decision
1. Business risk
n Uncertainty about future operating income
(EBIT) if it used on debt
n The greater the firm’s business risk, the lower
its optimal debt ratio
2. The firm’s tax position
A major reason for using debt is that interest is
deductible, which lowers the effective cost of
debt.
13-3
Four factors influence the firm’s capital
structure decision
3. Financial flexibility
This is the firm’s ability to raise capital with reasonable
terms under adverse conditions.
The greater the probable future need for capital, and
the worse the consequences of a capital shortage,
the stronger the balance sheet should be.
4.
The conservatism or aggressiveness of management
Firms with aggressive managers are more inclined to use
debt in an effort to boost profits.
13-4
What is business risk?
◦ Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
Low risk
Probability
High risk
0
E(EBIT)
EBIT
◦ Note that business risk does not include financing
effects.
13-5
What determines business
risk?
◦Uncertainty about demand (sales).
◦Uncertainty about output prices.
◦Uncertainty about costs.
◦Product, other types of liability.
◦Operating leverage.
13-6
Employing Leverage
◦ Leverage:
◦ Use of “fixed cost” items in the process of
magnifying earnings.
◦ Operating Leverage:
◦ Use of “fixed operating costs” in the process of
magnifying operating income (EBIT)
◦ Financial Leverage:
◦ Use of “fixed financial costs” (e.g., debt and
preferred stock financing) in the process of
magnifying earnings per share EPS. Our
discussion focuses on the use of debt financing.
13-7
Leverage and the Income Statement
Sales
- Fixed costs
- Variable costs
Operating Leverage
Total
Leverage
EBIT
- Interest
EBT
Financial Leverage
- Taxes
EAT
Note: EPS = EAT/(# shares)
[assuming no pfd. stock]
13-8
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.
13-9
Effect of operating leverage
◦ 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?
13-10
Using operating leverage
Low operating leverage
Probability
High operating leverage
EBITL
EBITH
◦ Typical situation: Can use operating leverage
to get higher E(EBIT), but risk also increases.
13-11
Operating Breakpoint
The amount quantity at which Sales = Costs, hence
when EBIT = 0.
Sales = Costs
P*Q = V*Q + F
Where P is average sales price per unit of output, Q is
units of output, V is variable cost per unit
EBIT = PQ – VQ- F = 0
Breakeven Q = F/(P-V)
13-12
EXAMPLE:
◦ A Company produces shoes with a selling
price of P250 each. The variable cost for
the production of shoes is P130. The fixed
costs incurred by the company is
P240,000.
◦ How many units should be produced to
breakeven?
13-13
EXAMPLE:
◦ A Company produces shoes with a selling
price of P250 each. The variable cost for
the production of shoes is P130. The fixed
costs incurred by the company is
P240,000.
◦ How many units should be produced to
breakeven?
Breakeven = F/ (P-V)
= 240,000 / (250 -130)
= 2,000 units
13-14
Plan A :
F = $40,000, P =$4, V=$3
Assets = $ 400,000
Plan B:
F = $120,000, P =$4, V=$2
Assets = $ 400,000
What plan has a higher number of units to
be breakeven?
13-15
Degree of Operating Leverage
The degree of operating leverage is defined as
the percentage change in operating income
(EBIT) that results from a given percentage
change in sales.
DOL = % change in EBIT / % change in sales
13-16
Degree of Operating Leverage
Another way to estimate DOL is:
DOLQ = Q (P-V) / [Q (P-V) – F] based on output
units Q
DOLS = S -VC / [S -VC – F] based on dollar sales
13-17
Plan A :
F = $40,000, P =$4, V=$3, Assets = $
400,000
Plan B:
F = $120,000, P =$4, V=$2, Assets = $
400,000
Assume the quantity produced is 100,000
units.
13-18
Plan A :
F = $40,000, P =$4, V=$3, Assets = $ 400,000
Plan B:
F = $120,000, P =$4, V=$2, Assets = $ 400,000
Assume the quantity produced is 100,000 units.
For Plan A:
DOLQ = Q (P-V) / [Q (P-V) – F]
= 100,000 (4-3) / [100,000 (4-3) – 40,000]
= 1.67
For Plan B:
DOLQ = 100,000 (4-2) /[100,000 (4-2)– 120,000]
= 2.5
The results suggest that if Plan A has 1% increase in sales, it’s EBIT will
increase by 1.67%, while for Project B the increase in EBIT will be 2.5%.
13-19
EXAMPLE:
Company A, which has sales of P800,000 in
year one, which further increased to
P1,000,000 in year two. In year one,
the operating expenses of the company
stood at P450,000, while in year two, the
same went up to P550,000.
Determine the DOL for Company A.
13-20
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.
13-21
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.
13-22
What is financial leverage?
Financial risk?
◦ Financial leverage is the extent to which fixedincome securities (debt and preferred stock) are
used in a firm’s capital structure
◦ Financial risk is an increase in stockholder’s risk
over and above the firm’s basic business risk,
resulting from the use of financial leverage.
◦ The use of debt (financial leverage)
concentrates the firm’s business risk on its
stockholders. This concentration occurs because
debtholders who receive fixed interest payments
bear none of the business risk.
13-23
An example:
Illustrating 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
No debt
$20,000 in assets
40% tax rate
Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate
13-24
Firm U: Unleveraged
Prob.
EBIT
Interest
EBT
Taxes (40%)
NI
Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
0
0
$2,000
$3,000
800
1,200
$1,200
$1,800
Good
0.25
$4,000
0
$4,000
1,600
$2,400
13-25
Firm L: Leveraged
Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI
Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
1,200
1,200
$ 800
$1,800
320
720
$ 480
$1,080
Good
0.25
$4,000
1,200
$2,800
1,120
$1,680
*Same as for Firm U.
13-26
Essential Formulas
◦ Basic Earning Power (BEP)
BEP = EBIT / Total Assets
This ratio shows the raw earning power of
the firm’s assets, before the influence of
taxes and leverage.
It is useful for comparing firms with different
tax situations and different degrees of
financial leverage.
13-27
Essential Formulas
◦ Times Interest Earned (TIE) ratio =
EBIT / Interest charges
A measure of the firm’s ability to meet its
annual interest payments.
◦ Return on Equity=
Net Income / Shareholder’s Equity
13-28
Ratio comparison between
leveraged and unleveraged firms
FIRM U
Bad
BEP
ROE
TIE
FIRM L
BEP
ROE
TIE
Avg
10.0%
6.0%
∞
Bad
Good
15.0%
9.0%
∞
Avg
10.0%
4.8%
1.67x
20.0%
12.0%
∞
Good
15.0%
10.8%
2.50x
20.0%
16.8%
3.30x
13-29
The effect of leverage on profitability and
debt coverage
◦ 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.
◦ As debt increases, TIE decreases because
EBIT is unaffected by debt, and interest
expense increases (Int Exp = kdD).
13-30
CONCLUSIONS
◦ Basic earning power (BEP) 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.
13-31
Degree of Financial Leverage
◦ The degree of financial degree is defined as the
percentage change in EPS that results from a given
percentage change in EBIT.
DFL = % change in EPS / % change in EBIT.
or
= EBIT / [EBIT – Interest]
EPS = Net Income / Ave. # of shares
outstanding
Note: If interest expense = 0, DFL = 1.0 (i.e., without any debt financing,
the % change in EPS would be equal to the % change in EBIT). By
incurring interest expense (debt financing) the firm’s % change in EPS
will be greater than the % change in EBIT.
13-32
◦Jayco has $2 million in sales, variable
costs of 70% of sales, fixed costs of
$100,000 and annual interest expense
of $50,000.
◦What is the degree of financial
leverage?
13-33
ACTIVITY
ABC Inc. has operating income or (EBIT) of P5 million
in Year 1, with interest expense of P1 million, and has
10 million shares outstanding.
1. What is the company’s EPS for Year 1?
2. What is the company’s DFL for Year 1?
Assume ABC has a 20% increase in operating
income in Year 2. The interest expense remain
unchanged in Year 2.
3. What is the company’s EPS for Year 2?
13-34
Degree of Total Leverage
Combining operating and financial leverage
The greater the use of fixed operating costs as
measured by DOL, the more sensitive EBIT will be
to change in sales
The greater the use of debt as measured by DFL,
the more sensitive EPS will be to changes in EBIT
13-35
If a firm uses a considerable amount of
both operating leverage and financial
leverage then a slight change in sales will
lead to wide fluctuations in EPS.
The degree of total leverage, which
combines the degree of operating
leverage and financial leverage, shows
how a given change in sales will affect
EPS.
13-36
Formula for DTL
DTL = DOL* DFL
= (%D EBIT/ %D sales) * (%D EPS/ %D EBIT)
= %D EPS/ %D sales
DTL = [Q (P-C)] / [Q(P-V)-F-I]
DTL = [S-VC] / [ S-VC-F-I ]
shows that 1% change in sales will result in a
difference the computed DTL% in its earnings
per share
13-37
Formula for DTL
% D in EPS
DCL =
% D in Sales
Q( P - V )
=
Q( P - V ) - F - I
S - VC
S - VC
=
=
S - VC - F - I
EBT
æ % D in EBIT öæ % D in EPS ö
=ç
֍
÷
è % D in Sales øè % D in EBIT ø
= (DOL)(DFL)
13-38
◦ XYZ Company had an EBIT of P5 million in
the current financial year whereas it was
P3 million in the previous fiscal year. The
sales revenue during the same period
increased from P60 million to P80
million. The net income in the previous
year is P1.8 million and the company has 1
million outstanding shares. The company’s
net income increased by 50% with no
increase in the outstanding shares.
◦ Determine the company’s DTL.
13-39
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 taxrelated 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.
13-40
What effect does 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.
13-41
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.
13-42
The Hamada Equation
βL = βU[ 1 + (1 - T) (D/E)]
◦ Suppose, 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. Tax rate is 40%.
13-43
Calculating levered betas
and costs of equity
If D = $250,000
βL = 1.0 [ 1 + (0.6)($250K/$1,750K) ]
βL = 1.0857
ks = kRF + (kM – kRF) βL
ks = 6.0% + (6.0%) 1.0857
ks = 12.51%
13-44
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.
13-45
What if there were 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.
13-46
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
13-47
What are “signaling” effects in
capital structure?
◦Assume:
◦Managers have better
information about a firm’s longrun value than outside investors.
◦Managers act in the best interests
of current stockholders.
13-48
What can managers be
expected to do?
◦ 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.
13-49
CONCLUSIONS
◦ Need to make calculations as we did,
but should also recognize inputs are
“guesstimates.”
◦ As a result of imprecise numbers,
capital structure decisions have a
large judgmental content.
◦ We end up with capital structures
varying widely among firms, even
similar ones in same industry.
13-50