CHAPTER 13
Capital Structure and Leverage
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Business vs. financial risk
Optimal capital structure
Operating leverage
Capital structure theory
13-1
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.
13-2
What determines business risk?
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Uncertainty about demand (sales)
Uncertainty about output prices
Uncertainty about costs
Product, other types of liability
Operating leverage
13-3
What is operating leverage, and how
does it affect a firm’s business risk?

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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.
13-4
What is financial leverage?
Financial risk?

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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.
13-5
Business risk vs. Financial risk
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Business risk depends on business
factors such as competition, product
liability, and operating leverage.
Financial risk depends only on the
types of securities issued.
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More debt, more financial risk.
Concentrates business risk on
stockholders.
13-6
Problem # 1 (Breakeven
Analysis)
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A company’s fixed operating costs are $500,000, its
variable costs are $3.00 per unit, and the product’s
sales price is $4.00. What is the company’s
breakeven point; that is, at what unit sales volume
would its income equal its costs?
Given: SP = $4/unit; Var. Cost = $3/unit & Fixed
=$500,000
QBE = Fixed Costs / (Selling Price – Variable Cost)
QBE = $500,000 / ($4.00 - $3.00)
QBE = 500,000 units.
13-7
Problem #2 (Financial
Leverage Effects)
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Firms HL and LL are identical except for their leverage
ratios and the interest rates they pay on debt. Each has
$20 million in assets, $4 million of EBIT, and is in the 40
% federal-plus-state tax bracket. Firm HL, however, has a
debt ratio (D/A) of 50 % and pays 12 % interest on its
debt, whereas LL has a 30 % debt ratio and pays only 10
% interest on its debt.
Calculate the rate of return on equity (ROE) for each firm.
Observing that HL has a higher ROE, LL’s treasurer is
thinking of raising the debt ratio from 30 to 60 %, even
though that would increase LL’s interest rate on all debt
to 15 %. Calculate the new ROE for LL.
13-8
Problem #2 (Financial
Leverage Effects)

Given:
Assets
EBIT
Taxes
Debt Ratio
Interest Rate
HL
LL
$20 mil
$20 mil
$ 4 mil
$ 4 mil
40%
40%
50%
30%
12%
10%
Solution: See Excel Spreadsheet
13-9
The effect of leverage on
profitability and debt coverage
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For leverage to raise expected ROE, must
have BEP > rd.
Why? If rd > 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 = rdD).
13-10
Conclusions
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Basic earning power (BEP) is unaffected
by financial leverage.
L has higher expected ROE because BEP
> rd.
L has much wider ROE (and EPS) swings
because of fixed interest charges. Its
higher expected return is accompanied by
higher risk.
13-11
Optimal Capital Structure
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The 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 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.
13-12
Problem #3 (Optimal Capital
Structure)
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Jackson Trucking Company is in the process of
setting its tar- get capital structure. The CFO believes
the optimal debt ratio is somewhere between 20 and
50 %, and her staff has compiled the following
projections for EPS and the stock price at various
debt levels:
Assuming that the firm uses only debt and common
equity, what is Jackson’s optimal capital structure? At
what debt ratio is the company’s WACC minimized?
13-13
Problem #3 (Optimal Capital
Structure)

The optimal capital structure is that capital
structure where WACC is minimized and stock price
is maximized. Because Jackson’s stock price is
maximized at a 30% debt ratio, the firm’s optimal
capital structure is 30% debt and 70% equity.
This is also the debt level where the firm’s WACC is
minimized.
13-14
The Hamada Equation
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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.
13-15
The Hamada Equation
bL = bU[ 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.
13-16
Calculating levered betas and
costs of equity
If D = $250,
bL = 1.0 [ 1 + (0.6)($250/$1,750) ]
bL = 1.0857
rs = rRF + (rM – rRF) bL
rs = 6.0% + (6.0%) 1.0857
rs = 12.51%
13-17
CHAPTER 14
Distributions to shareholders:
Dividends and share repurchases
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Investor preferences on dividends
Signaling effects
Residual model
Dividend reinvestment plans
Stock repurchases
Stock dividends and stock splits
13-18
What is dividend policy?
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The decision to pay out earnings versus
retaining and reinvesting them.
Dividend policy includes
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High or low dividend payout?
Stable or irregular dividends?
How frequent to pay dividends?
Announce the policy?
13-19
Dividend irrelevance theory
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Investors are indifferent between dividends
and retention-generated capital gains.
Investors can create their own dividend policy
 If they want cash, they can sell stock.
 If they don’t want cash, they can use
dividends to buy stock.
Proposed by Modigliani and Miller and based
on unrealistic assumptions (no taxes or
brokerage costs), hence may not be true.
Need an empirical test.
13-20
Why investors might prefer dividends
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May think dividends are less risky
than potential future capital gains.
If so, investors would value highpayout firms more highly, i.e., a high
payout would result in a high P0.
13-21
Why investors might prefer capital gains
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May want to avoid transactions costs
Maximum tax rate is the same as on
dividends, but …
 Taxes on dividends are due in the year
they are received, while taxes on capital
gains are due whenever the stock is sold.
 If an investor holds a stock until his/her
death, beneficiaries can use the date of the
death as the cost basis and escape all
previously accrued capital gains.
13-22
What’s the “information content,”
or “signaling,” hypothesis?
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Investors view dividend increases as signals
of management’s view of the future.
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Since managers hate to cut dividends,
they won’t raise dividends unless they
think the raise is sustainable.
However, a stock price increase at time of a
dividend increase could reflect higher
expectations for future EPS, not a desire for
dividends.
13-23
What’s the “clientele effect”?
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Different groups of investors, or
clienteles, prefer different dividend
policies.
Firm’s past dividend policy determines
its current clientele of investors.
Clientele effects impede changing
dividend policy. Taxes & brokerage
costs hurt investors who have to
switch companies.
13-24
The residual dividend model
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Find the retained earnings needed for the capital
budget.
Pay out any leftover earnings (the residual) as
dividends.
This policy minimizes flotation and equity signaling
costs, hence minimizes the WACC.
 Target

Dividends  Net Income -  equity
 ratio
  Total 
 

   capital 
  budget 
 

13-25
Problem #4 (Residual dividend
model)
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Axel Telecommunications has a target capital
structure that consists of 70% debt and 30%
equity. The company anticipates that its capital
budget for the upcoming year will be $3,000,000.
If Axel reports net income of $2,000,000 and it
follows a residual dividend payout policy, what will
be its dividend payout ratio?
Given: 70% Debt; 30% Equity; Capital budget =
$3,000,000; NI = $2,000,000; Dividend payout
ratio = ?
13-26
Problem #4 (Residual dividend
model)
 Target

Dividends  Net Income -  equity
 ratio
  Total 
 

   capital 
  budget 
 

Equity retained = 0.3($3,000,000) = $900,000.
NI
- Additions to RE
Earnings remaining
$2,000,000
900,000
$1,100,000
Payout = 1,100,000/2,000,000 = 55%
13-27
Comments on Residual
Dividend Policy
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Advantage
 Minimizes new stock issues and flotation
costs.
Disadvantages
 Results in variable dividends
 Sends conflicting signals
 Increases risk
 Doesn’t appeal to any specific clientele.
Conclusion – Consider residual policy when
setting long-term target payout, but don’t
follow it rigidly from year to year.
13-28
Stock Repurchases
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Buying own stock back from
stockholders
Reasons for repurchases:
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As an alternative to distributing cash as
dividends.
To dispose of one-time cash from an
asset sale.
To make a large capital structure change.
13-29
Problem #5 (Stock
Repurchase)
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Beta Industries has net income of $2,000,000 and
it has 1,000,000 shares of common stock
outstanding. The company’s stock currently trades
at $32 a share. Beta is considering a plan in which
it will use available cash to repurchase 20 per- cent
of its shares in the open market. The repurchase is
expected to have no effect on either net income or
the company’s P/E ratio. What will be its stock
price following the stock repurchase?
Given: NI = $2,000,000; Shares = 1,000,000; P0 =
$32; Repurchase = 20%; New P0 = ?
13-30
Problem #5 (Stock
Repurchase)
Repurchase = 0.2  1,000,000 = 200,000 shares.
Repurchase amount = 200,000  $32
= $6,400,000.
EPSOld = NI/Shares = 2m/1m = $2.00.
P/E = 32/2 = 16.
EPSNew = 2m / (1m – 200k) = 2m / 800k = $2.50.
PriceNew = EPSnew  P/E = $2.50(16) = $40.
13-31
Stock dividends vs. Stock splits
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Stock dividend: Firm issues new shares
in lieu of paying a cash dividend. If
10%, get 10 shares for each 100 shares
owned.
Stock split: Firm increases the number
of shares outstanding, say 2:1. Sends
shareholders more shares.
13-32
Problem # 6 (Stock Split)
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Gamma Medical’s stock trades at $90 a share.
The company is contemplating a 3-for-2 stock
split. Assuming that the stock split will have no
effect on the market value of its equity, what will
be the company’s stock price following the stock
split?
Given:P0 = $90; Split = 3 for 2; New P0 = ?
New Price = $90 / (3/2)
= $90 / 1.5
= $60
13-33