CHAPTER 15 CAPITAL STRUCTURE
& LEVERAGE
MEASURING CAPITAL STRUCTURE
Definitions
•
Capital are investor supplied funds such as
short and long-term loans from individuals
and institutions, preferred stock, common
stock and retained earnings
•
Capital structure is the mix of debt,
preferred stock, and common equity that is
used to finance the firm’s assets
•
Optimal capital structure is the capital
structure that maximizes a stock’s intrinsic
value
Debt
Book
Value
Market
Value
Target
Value
Equity
Book value of
debt is the
accounting value
of the debt,
which was
recorded as per
the historical
data or
amortization
schedule of the
debt
Book value is the
amount of
money
shareholders
would receive if
assets were
liquidated and
liabilities paid
off.
Market price
investors would
be willing to buy
a company's
debt. A
company's debt
doesn't always
come in the form
of publicly
traded bonds,
which have a
specified market
value.
Market value is
the value of
a company
according to the
markets—based
on the current
stock price and
the number of
outstanding
shares.
The target capital structure of a
company refers to the capital which
the company is striving to obtain
BUSINESS RISK
Definition
• The riskiness inherent in the firm’s
operations if it uses no debt
• The uncertainty (variability) about
projections of future operating earnings. It
is the single most important determinant
of capital structure
• If other elements are the same, the lower a
firm's business risk, the higher its optimal
debt ratio
Components
• Sales risk is the uncertainty regarding the
price and quantity of the firm's goods and
services. If the demand for and the price of
a firm's goods and services are stable, its
sales risk is considered low.
•
Operating risk is the uncertainty caused by
a firm's operating cost structure. If a high
percentage of operating costs are fixed
costs, operating risk is considered to be
high. More controllable by management
What determines business risk?
• Competition
• Uncertainty about demand (sales)
• Uncertainty about output prices
• Uncertainty about costs
• Product obsolescence
• Foreign risk exposure
• Regulatory risk and legal exposure
• Operating leverage project
How is it measured?
A commonly used measure of business risk is
ROIC.
Return on Invested Capital (ROIC)
 Measures the after-tax return for all of
its investors
 It doesn’t vary with changes in capital
structure
 ROIC = EBIT (1-T) / Total Invested
Capital
OPERATING LEVERAGE
Definitions
•
The extent to which fixed costs are used in
the firm’s operations
•
A company that has high operating
leverage is a company with a large
proportion of fixed input costs, whereas a
company with largely variable input costs is
said to have low operating leverage
Effects of Operating Leverage
•
More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.
•
A company with a high degree of operating
leverage that has a small change in sales will
experience a large change in profits and rate
of return. This is due to the fact that because
the company has a large fixed cost
component, any increase in sales will cause
an even greater increase in net income,
since the fixed costs have already been
incurred.
OPERATING LEVERAGE
Definition
•
Operating leverage can be used by
management to increase ROIC, but it
also increases risk and ROIC
variability
Statement 1: A firm's business risk is largely
determined by the financial characteristics of its
industry, especially by the amount of debt the
average firm in the industry uses.
Statement 2: Business risk is affected by both
variability of demand and input prices.
a. Both statements are true
b. Both statements are false
c. Only Statement 1 is true
d. Only Statement 2 is true
Answer: D. S1 is false. Business risk is the risk
without considering debt, its about demand and
use of fixed costs. S2 is true.
FINANCIAL RISK
Definition
• The increase in stockholder’s risk over and above
the firm’s basic business risk
• Increase in debt doesn’t change ROIC but it does
affect the risk of the stockholder
• Remember that debtholders have a priority
claim over stockholder’s, so as debt increases,
the risk of the stockholder also increases
Financial Leverage
• Financial leverage is the extent of the use of debt
and preferred stock in the capital leverage
EFFECTS OF FINANCIAL LEVERAGE: AN
EXAMPLE
• 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)
BUSINESS RISK VS FINANCIAL RISK
 Firms should reduce financing risk when
business risk is high (unfavorable economic
and environmental forecasts and/or high
fixed cost component in cost structure)



EBIT is the same for both companies
NI is lower for Firm L because of interest
expense
Will ROE also be lower for Firm L?
* Times Interest earned (TIE)
• σROIC stays the same
• σROE is different, normally higher if ROIC is
greater than after-tax cost of debt
Statement 1: Financial risk refers to the extra
risk borne by debtholders as a result of a firm's
use of debt as compared with their risk if the
firm had used no debt.
Statement 2: A firm’s capital structure does not
affect its free cash flows as discussed in the text,
because FCF reflects only operating cash flows,
which are available to service debt, to pay
dividends to stockholders, and for other
purposes.
a. Both statements
are true
b. Both statements
are false
c. Only Statement 1 is
true
d. Only Statement 2 is
true
Answer: D. S1 as it’s the
stockholders who bear the
extra risk. S2 is true.
USE OF FINANCIAL LEVERAGE
Effects of Leverage on Profitability and Debt
Coverage
• For leverage to raise expected ROE, must have ROIC
> r (1 – T).
d
• Why? If r (1 – T) > ROIC, then after-tax interest
d
expense will be higher than the after-tax operating
income produced by debt-financed assets, so
leverage will depress income.
• As debt increases, TIE decreases because EBIT is
unaffected by debt, but interest expense increases
(Int Exp = r D)
d
Conclusions
• Return on invested capital (ROIC) is unaffected by
financial leverage.
• L has higher expected ROE because ROIC > r (1 – T).
d
• L has much wider ROE (and EPS) swings because of
fixed interest charges. Its higher expected return is
accompanied by higher risk.
Companies HD and LD have identical tax rates, total
assets, total investor-supplied capital, and returns on
investors’ capital (ROIC), and their ROICs exceed their
after-tax costs of debt, rd(1 – T). However, Company
HD has a higher debt ratio and thus more interest
expense than Company LD. Which of the following
statements is CORRECT?
a. Company HD has a higher net income than
Company LD.
b. Company HD has a lower ROA than Company
LD.
c. Company HD has a lower ROE than Company
LD.
d. The two companies have the same ROA.
Answer: B. HD has lower income so lower ROA.
COST OF DEBT AT DIFFERENT DEBT RATIOS
 Bond rating and cost of debt changes as the
amount of debt changes
 As the firm borrows more money, the firm
increases its financial risk causing the firm’s bond
rating to decrease, and its cost of debt to
increase
 Risk premium changes!
OPTIMAL CAPITAL STRUCTURE
Definition
Which of the following events is likely to encourage
a company to raise its target debt ratio, other things
held constant?
a. An increase in the corporate tax rate.
b. An increase in the company’s operating leverage.
c. The Federal Reserve tightens interest rates in an
effort to fight inflation.
d. The company's stock price hits a new high.
Answer: A. It makes sense to raise debt when tax
rates are high, because it creates higher tax shields
or lower after-tax interest expense
You work for the CEO of a new company that plans to
manufacture and sell a new product, a watch that has
an embedded TV set and a magnifying glass crystal.
The issue now is how to finance the company, with
only equity or with a mix of debt and equity. Expected
operating income is $400,000. Other data for the firm
are shown below. How much higher or lower will the
firm's expected ROE be if it uses some debt rather
than all equity, i.e., what is ROEL - ROEU?
• The capital structure (mix of debt, preferred, and common equity) at which P is maximized or WACC is
0
minimized
• 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.
Dynamics of Debt & Equity
HOW TO
RECAPITALIZE?
Sequence
of Events
in a Share
Purchase
Recapitalization
•
•
•
Firm announces the recapitalization.
New debt is issued.
Proceeds are used to repurchase stock.
– The number of shares repurchased is equal to the amount of debt issued divided by price per shar
EFFECT OF RECAPITALIZATION TO EPS & TIE
Analyze the Recapitalization at Various Debt Levels and Determine the EPS and TIE at Each Level
Formulas
•
•
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.
HAMADA EQUATION
Definition
•
•
•
•
•
Hamada equation distinguishes the financial risk with that of the business risk of a levered firm.
It is used to help understand how a company’s cost of capital will be affected when leverage is applied.
Higher beta coefficients mean riskier companies.
Hamada’s Equation is a hybrid of the Modigliani-Miller and Capital Asset Pricing Model theorems.
Uses the firm’s unlevered beta, which represents the firm’s business risk as if it had no debt .
CALCULATING LEVERED BETAS & COSTS OF EQUITY
BREAKING DOWN r
s
r = Risk-free rate (6%)
S
+ Business/market risk premium (6%)
+ Financial risk premium (0.51%)
= 12.51%
TABLE FOR CALCULATING LEVERED BETAS AND COST OF EQUITY
What effect does more debt have
on a firm’s cost of equity?
•
•
•
If the level of debt increases,
the firm’s risk increases
Cost of debt increases
Risk of the firm’s equity also increases,
resulting in a higher r
s.
HOW TO FIND THE OPTIMAL CAPITAL STRUCTURE –MINIMIZING WACC
• If all earnings are paid out as dividends, E(g) = 0.
• EPS = DPS.
• To find the expected stock price ( P ), we must find the
0
appropriate r at each of the debt levels discussed
s
P̂0 
D1
EPS DPS


rs  g
rs
rs
OPTIMAL CAPITAL STRUCTURE – RELEVANCE OF EPS
What debt ratio maximizes EPS?
•
•
•
Maximum EPS = $3.90 at D = $1,000,000, and D/Cap. = 50%. (Remember DPS = EPS because payout =
100%.)
Risk is too high at D/Cap. = 50%.
P is maximized ($26.89) at D/Cap. = $500,000/$2,000,000 = 25%, so optimal D/Cap. = 25%.
0
•
•
EPS is maximized at 50%, but primary interest is stock price, not E(EPS).
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).
HOW DOES RISK AFFECT CAPITAL STRUCTURE
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.
•
However, lower business risk would lead to an optimal capital structure with more debt .
MILLER –MODIGLIANI THEORY
The M&M Theorem in Perfectly Efficient Markets (M&M I)
This is the first version of the M&M Theorem with the assumption of perfectly efficient markets. The assumption implies that companies
operating in the world of perfectly efficient markets do not pay any taxes, the trading of securities is executed without any transaction
costs, bankruptcy is possible but there are no bankruptcy costs, and information is perfectly symmetrical.
st
•
1 Proposition - claims that the company’s capital structure does not impact its value. Since the value of a company is calculated
as the present value of future cash flows, the capital structure cannot affect it. Also, in perfectly efficient markets, companies do
not pay any taxes. Therefore, the company with a 100% leveraged capital structure does not obtain any benefits from taxdeductible interest payments.
V =V
L
U
nd
•
2 Proposition - states that the company’s cost of equity is directly proportional to the company’s leverage level. An increase in
leverage level induces higher default probability to a company. Therefore, investors tend to demand a higher cost of equity
(return) to be compensated for the additional risk.
M&M Theorem in the Real World
The second version of the M&M Theorem was developed to better suit real-world conditions. The assumptions
of the newer version imply that companies pay taxes; there are transaction, bankruptcy, and agency costs; and
information is not symmetrical.
st
•
1 Proposition - states that tax shields that result from the tax-deductible interest payments make the value of a
levered company higher than the value of an unlevered company. The main rationale behind the theorem is that taxdeductible interest payments positively affect a company’s cash flows. Since a company’s value is determined as the
present value of the future cash flows, the value of a levered company increases.
V = V + (τ x D)
L
U
C
nd
•
2 Proposition - The second proposition for the real-world condition states that the cost of equity has a directly
proportional relationship with the leverage level. But tax shields make it less sensitive
EFFECTS OF POTENTIAL BANKRUPTCY & TRADEOFF THEORY
•
•
The graph shows MM’s tax benefit vs. bankruptcy cost
theory.
Trade-off Theory – the theory that states that firms trade
off the tax benefits of debt financing against problem
caused by potential bankruptcy
SIGNALLING EFFECTS IN CAPITAL STRUCTURE
Assumptions
•
Information about the company is asymmetric
•
Managers have better information about a firm’s long-run value than outside investors.
•
Managers act in the best interests of current stockholders
What can managers be expected to do?
•
•
Issue stock if they think stock is overvalued
Issue debt if they think stock is undervalued and/or prospects are bright
•
As a result, investors view a stock offering negatively; managers think stock is overvalued.
Implications
•
Signaling theory suggests firms should use less debt than MM suggest, and maintain a reserve
borrowing capacity, in case good opportunities come along
•
This unused debt capacity helps avoid stock sales, which depress stock price because of signaling
effects.
FACTORS THAT AFFECT CAPITAL STRUCTURE
How would these factors affect the target capital structure?
CONCLUSIONS ON CAPITAL STRUCTURE
•
•
•
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.
A major contribution of the Miller model is that it demonstrates, other things held constant, that
a. personal taxes increase the value of using corporate debt.
b. personal taxes lower the value of using corporate debt.
c. personal taxes have no effect on the value of using corporate debt.
d. financial distress and agency costs reduce the value of using corporate debt.
Answer: B. Personal taxes lowers the income of debt investors
Which of the following statements is CORRECT?
a) In general, a firm with low operating leverage also has a small proportion of its total costs in the form of
fixed costs.
b)
c)
d)
There is no reason to think that changes in the personal tax rate would affect firms’ capital structure
decisions.
A firm with a relatively high business risk is more likely to increase its use of financial leverage than a
firm with low business risk, assuming all else equal.
If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC
by increasing its use of debt.
Answer: A
Which of the following statements is CORRECT?
a. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the
WACC must also increase.
b. The capital structure that maximizes the stock price is generally the capital structure that also
maximizes earnings per share.
c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase
their debt ratios.
d. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always
increase its WACC.
Answer: C