Chapter 15
Capital
Structure
Decisions
Chapter 15 Outline
15.1 Operating and
Financial Leverage
•Sales risk
•Operating risk
•Financial risk
2
15.2 The Modigliani
and Miller Theorems
•The M&M Theories
•Bankruptcy
•Other factors that may
affect the capital
structure decision
15.3 Capital Structure
in Practice
•Evaluating a
company’s capital
structure
•Surveys and
observations
•Capital structure
guidance
15.1 Operating and Financial
Leverage
 We can break the uncertainty of a company’s
earnings into three primary sources:
1.
2.
3.
3
Sales risk, which is the uncertainty associated with
the price and volume that the company produces
and sells.
Operating risk, which is the uncertainty arising
from the use of fixed operating costs relative to
total operating costs.
Financial risk, which is the uncertainty arising from
the use of fixed-cost sources of financing (that is,
debt) relative to equity.
Business Risk


4
We refer to the combined
influence of sales risk and
operating risk as business
risk because these are risks
that are determined, in
large part, on the line of
business the company
operates.
For a given level of
operating earnings,
financial risk affects the
earnings to owners.
Business Risk Example

Consider the Gearing Corporation, which produces gaskets.
The production of gaskets, no matter the number of units
produced and sold, costs $200 per year; therefore, the fixed
operating costs are $200 per year. The variable cost of
producing a gasket is $0.40, and Gearing sells each gasket
for $1. For now, let us hold the number of units produced
and sold to 1,000 units. What does Gearing’s income
statement look like if it produces and sells 1,000 units?
Revenues
Operating expenses
400
Fixed operating expenses
200
Operating income
5
$1,000
$400
Business Risk Example

We now consider what might happen if things changed. Suppose, for example,
the company issued a report that sales potential had increased, and it now
expected to sell% more gaskets, so that sales revenues are expected to be
$1,200:
Units produced and sold
1,000
1,200
$1,000
$1,200
Operating expenses
400
480
Fixed operating expenses
200
200
$400
$520
Revenues
Operating income

6
In this example, the company’s variable costs increase by the same 20% that
sales increase, to 1,200 units × $0.40 = $480, but operating earnings increase
by 30% to $520. This is due to operating leverage; some of the company’s
operating costs are fixed and do not increase with sales. The greater the use of
fixed costs in the operating cost structure, relative to variable operating costs,
the greater the operating leverage.
Business Risk Example
 Now let’s consider
20% to 800 units:
Units produced and sold
what happens if sales drop by
1,000
800
$1,000
$800
Operating expenses
400
320
Fixed operating expenses
200
200
$400
$280
Revenues
Operating income
 Operating expenses declined by 20% (from $600
to $520), but operating income declined by 30%
(from $400 to $280).
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Degree of Operating
Leverage

We can capture the sensitivity of operating earnings to the fixed
operating costs with the degree of operating leverage (DOL),
which is that ratio of the percentage change in operating earnings
to the percentage change in unit sales:

If we substitute Q for unit sales and represent the price per unit as
P, the operating cost per unit as V, and the fixed operating cost as F,
we can rearrange this to produce the DOL:

In the case of Gearing,
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P = $1
V = $0.4
F = $200
Degree of Operating
Leverage

The difference between the sales price and the variable
operating cost, P – V, is the contribution margin, which,
when multiplied by the unit sales, is what is available to
cover the fixed operating costs. The DOL therefore depends
on the units sold, Q. We qualify our statements about the
degree of operating leverage at specific level of units
produced and sold.
At 1,000 units produced and sold, the DOL is:
DOL = ($1,000 – 400) ÷ ($1,000 – 400 – 200) = $600 ÷ $400 = 1.5
At 1,200 units produced and sold, the DOL is:
DOL = ($1,200 – 480) ÷ ($1,200 – 480 – 200) = $720 ÷ $520 = 1.38
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At 800 units produced and sold, the DOL is:
DOL = ($800 – 320) ÷ ($800 – 320 – 200) = $480 ÷ $280 = 1.71
Operating Break-Even


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We can tie together the operating profit margin and
the degree of operating leverage by calculating the
break-even point; that is, the units produced and sold
at which the operating profit is zero.
We can calculate the precise break-even point by
setting the operating profit to zero and then solving for
the units, Q:
Q(P – V) – F = $0
Q($1 – 0.4) – 200 = $0
Q$0.6 = $200
Q = $200 ÷ $0.6 = 333.33 units
Operating Break-Even

We can guesstimate the break-even point using the following graph:
Operating Profit and
Operating Leverage
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Sales Risk
 By consulting with the marketing management of
the company, the financial managers at Gearing
have determined the price at which they can sell
the gaskets based on the volume of sales:
Unit Sales
Price per Gasket
200–799
$1.10
800–1299
$1.00
1300 and above
$0.90
 When we introduce the demand function for the
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product, we introduce more variability in the
operating profit margin. Hence, operating
earnings are affected by both sales risk and
operating risk.
Operating Leverage
 Problem: A company expects to sell 18,000
units of its product at a price of $5 per unit. The
variable cost to produce a unit is $3, and the
company has fixed operating costs of $30,000.
Calculate the following:
A. Contribution margin
B. Operating earnings
C. Degree of operating leverage at 18,000 units
D. Percentage change in operating earnings if the
company’s sales are 5 percent higher
E. Break-even units produced and sold
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Operating Leverage
 Solution:
A. Contribution margin = $5 – 3 = $2
B. [18,000 x ($5 – 3) – 30,000] = $6,000
C. [18,000 x ($5 – 3)] ÷ [18,000 x ($5 – 3) – 30,000] = 6
D. 6 x 5% = 30% [Check: 18,000 x ($5 – 3) – 30,000 =
7,800, which is 30% higher than 6,000]
E. Q($5 – 3) – 30,000 = 0; Q = 30,000 ÷ 2 = 15,000
units
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Financial Leverage
 Financial leverage
- the use of debt to finance a
company’s assets.



15
Financial leverage results in earnings to owners that
vary more than a similar company that finances its
assets with equity.
Consider three choices of capital structure for the
Gearing Company: Structure One, Structure Two, and
Structure Three.
With Structure One, Gearing finances its assets solely
with equity, whereas with Structures Two and Three,
Gearing finances its assets with both debt and equity,
as we show in the following table.
Alternative Financing Strategies for
the Gearing Company
Structure
One
Assets
Structure
Two
Structure
Three
$2,000
$2,000
$2,000
$0
$500
$1,000
$2,000
$1,500
$1,000
2,000
1,500
1,000
Debt-to-invested capital
0.00
0.25
0.50
Debt-to-equity
0.00
0.33
1.00
Debt
Equity
Number of shares
16
Financial Leverage
 Invested
capital - a sum total of capital in a
company’s capital structure, consisting of
debt and equity.
 The
invested capital for all three structures is
the same: $2,000.
 Now let’s consider the income statement of
each company, which we show in the following
table. For now, we are holding units produced
and sold to 1,000, sold at a sales price of $1 per
unit.
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Effect of Alternative Financing
Strategies on the Income
Statement
Structure
One
Structure
Two
Structure
Three
$1,000
$1,000
$1,000
Operating expenses
400
400
400
Fixed operating expenses
200
200
200
$400
$400
$400
0
25
50
$400
$375
$350
140
131
123
$260
$244
$228
Revenues
Operating income
Interest
Taxable income
Taxes
Net income
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Returns and Financial
Leverage

We have ratios that we can use to measure the
profitability of the companies, including the return on
equity and the return on invested capital. As you have
seen in previous chapters, we calculate the return on
equity (ROE) by comparing net profit with equity:

Therefore, the ROE is affected by interest on debt. The
return on invested capital (ROI), on the other hand, is
the ratio of operating income to invested capital:
19
Returns and Financial
Leverage



We provide the three returns for each company in the following table, holding
operating earnings constant at $400.
Structure
One
Structure
Two
Structure
Three
Return on invested capital
20%
20%
20%
Return on equity
13%
16%
23%
As you can see, the return on invested capital is the same, no matter the financing.
This is because the operating income after tax, which is $400 – 140 = $260, and the
invested capital, the $2,000, are same no matter the financing.
The return on equity, however, increases with more debt because the operating
earnings after tax remain the same, but the amount of equity declines from $2,000
(Structure One) to $1,000 (Structure Three). In the case of Structures Two and
Three, Gearing pays the creditors a fixed amount, but anything the company makes
beyond that flows to shareholders. Hence, the benefit from financial leverage.
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Financial Break-Even
 Financial breakeven
point - return on
investment or quantity produced or sold at
which a company’s ROE is zero.
 Indifference point - the quantity produced
and sold or return on investment at which two
financing strategies provide the same return
on equity.
 EPS indifference point - the EBIT level at
which two financing alternatives generate the
same EPS.
21
Combining Operating and
Financial Risk
 Companies must deal with both of these risks
in making decisions.
 We can see how the two are combined by
examining the degree of total leverage (DTL).

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DTL captures the leveraging effects of both the
operating risk and the financial risk, using the sum
total of the fixed operating costs and the fixed
financing costs as the fulcrum.
Summary of Risk Management
Mistakes
 Nassim N. Taleb,
Daniel G. Goldstein, and Mark W.
Spitznagel point out six mistakes that are made in
risk management:
1.
2.
3.
4.
5.
6.
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Managing risk by predicting extreme events
Using the past to manage risk
Not considering advice intended to instruct what not
to do
Measuring risk by standard deviation
Not factoring in human behavior
Seeking optimization, without considering vulnerability
15.2 The Modigliani and Miller
Theorems

Capital structure theory is dominated by the work of
economists Franco Modigliani and Merton Miller (M&M).


It is in fact a very powerful theorem for which (in part) the authors won the
Nobel Prize in economics in 1985.
Although the theory that they developed does not prescribe a particular
capital structure for a company, it does provide a way of looking at the
factors that should be considered in selecting a capital structure. The M&M
theory comprises three different scenarios:
1.
A world without taxes or costs of financial distress
2.
A world with taxes, but no costs of financial distress
3.
A world with taxes and costs of financial distress
Note: financial distress is a state of business failing where bankruptcy seems
imminent if dramatic action is not taken
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Part 1: No Taxes, No Costs of
Financial Distress


In the first part of the M&M capital structure theory,
we assume that there are no transactions costs or
asymmetric information, no taxes, and no costs of
financial distress; in other words, the company
operates in a perfect capital market.
The company’s value is like a pizza—does how you
slice it up into debt or equity affect the size of the
pizza? No.

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Therefore, in a world without taxes and where there is no
cost of being in financial distress, the capital structure that a
company chooses should not matter.
BOTTOM LINE: The value of the company is not affected by its
capital structure.
Part 2: Taxes, but no Costs to
Financial Distress
 In the second part, M&M starts with the
assumptions of the first part, but then introduces
taxes, with companies permitted to deduct
interest in determining their taxable income.
When they do this, capital structure matters:

26
The more debt in the capital structure, the greater the
value of the company. The reason for this is that, without
costs of financial distress, a company benefits from the
tax deductibility of interest, which lowers its tax bill and
hence increases its value.
BOTTOM LINE: If interest on debt is tax deductible but
there are no costs to financial distress, the more debt, the
greater the value of the company.
Part 3: Taxes and Costs to
Financial Distress
 In the third part, M&M relaxes the assumption
of no costs of financial distress.


What this means is that if the company assumes too
much financial risk, there is a risk that the company will
incur costs and possibly bankruptcy.
Ultimately, the benefit from the tax deductibility of
interest is outweighed by the costs of financial distress.
BOTTOM LINE: Taking on more debt, relative to equity, will
increase the value of the company to a point, after which the
costs of financial distress will offset the benefit from interest
deductibility.
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Bankruptcy
 Bankruptcy
- a legal status of a company that
permits the company to deal with debt
problems.

28
May occur in one of two ways:
1. The company commits an act of default, such as
the nonpayment of interest, and creditors
enforce their legal rights as a result.
2. The company voluntarily declares bankruptcy.
Largest U.S. Bankruptcy Filings Through 2010
Company
Industry
Year
Total Assets
(in billions)
Lehman Brothers Holdings
Investment banking
2008
$638
Washington Mutual Inc.
Financial services
2008
$328
WorldCom
Telecommunications
2002
$104
General Motors
Automobile manufacturing
2009
$91
CIT
Financial services
2009
$71
Enron
Energy
2001
$66
Conseco
Financial services
2002
$61
Chrysler
Automobile manufacturing
2009
$39
Thornburg Mortgage
Financial services
2009
$37
Pacific Gas and Electric
Natural gas and electricity
2001
$36
Texaco
Oil and gas
1987
$35
Financial Corporation of America
Savings and loan
1988
$34
Refco
Financial services
2005
$33
IndyMac Bancorp
Financial services
2008
$33
Global Crossing
Telecommunications
2002
$30
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Other Factors that May Affect
the Capital Structure Decision
 How
well does the static trade-off model
explain capital structures? It certainly captures
the main effects. However, it largely ignores
two important issues:
1.
2.
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Information asymmetry problems: the effect of
informational differences among shareholders,
creditors, and management
Agency problems: the fact that managers make
these decisions on behalf of the shareholders, but
they have their own interests at stake as well
15.3 Capital Structure in
Practice


We know from theory that the tax deductibility of interest
makes debt more attractive than equity, but only to a point
because the more debt, vis-à-vis equity, that a company has, the
greater the likelihood of incurring costs of financial distress.
Let’s first consider some standard financial ratios that are often
used. We can think of these ratios as stock or flow ratios.



31
Stock ratios are measures such as the debt-to-equity (D/E) and debt ratios.
These ratios measure the amount of outstanding debt relative to total
assets, total capital, or the amount of equity.
Flow ratios include times-interest-earned and cash flow debt ratio.
Both stock and flow financial leverage ratios are used by the bond-rating
agencies and others as a quick check on the company’s financing, and they
are also often used to limit the amount of debt a company can raise through
its trust indenture.
Financial Leverage Ratios


A number of financial ratios help us evaluate just how much of a
debt obligation the company has incurred.
There are basically two types of financial leverage ratios: ratios that
measure the debt burden, and coverage ratios, which measure the
company’s ability to satisfy its debt obligations.
Ratio
Debt ratio
Debt-equity ratio
Equity multiplier
Times interest earned
Cash flow-to-debt ratio
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Calculation
Debt
Total assets
Interpretation
The proportion of total assets
financed with debt
Debt
Equity
How much debt is used to
finance the company for every
dollar of equity
Total assets
Equity
The total assets of the company
for every dollar of equity
Earnings before interest and taxes
Interest
How many times the company
can satisfy its interest obligation
from operating earnings
Cash flow from operations
Debt
The inverse of this ratio is the
number of years it would take to
pay off the debt using cash flow
from operations
Debt Ratings


Credit rating services use financial ratios, among other
information, to evaluate the creditworthiness of
companies and the default risk of debt obligations.
Moody’s, one of the major rating services, periodically
provides data on the most commonly used credit ratios
and how they are correlated with their credit ratings.
Criterion
Financial Ratios by
Moody’s Debt Ratings
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Investment Grade
Speculative
Interest coverage
6.5 times
2.1 times
Asset coverage
2.4 times
1.4 times
Financial leverage
43.6%
66.8%
Cash flow-to-debt
28.4%
12.7%
Return on assets
6.3%
1.9%
Net profit margin
7.8%
2.1%
Liquidity
4.6%
3.9%
Altman’s Z-Score

Another measure of the financial health of a company is
the Altman Z-score.

This is weighted average of several key ratios that Professor Ed
Altman found were useful for predicting a company’s probability of
bankruptcy. His prediction equation is as follows:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 0.999X5
where:
X1 is working capital divided by total assets
X2 is retained earnings divided by total assets
X3 is EBIT divided by total assets
X4 is market values of total equity divided by nonequity book
liabilities
X5 is sales divided by total assets
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Surveys and Observations
 John Graham and Campbell Harvey surveyed U.S.
companies regarding factors that affect
management’s decision to issue debt.

The most often-cited factor is financial flexibility,
followed closely by credit ratings. Other oft-cited factors
in their survey include earnings and cash flow volatility,
sufficiency of internally generated funds, the level of
interest rates, and tax savings from interest deductibility.
Debt as a Percentage of
Invested Capital, for Selected
Industries
35
Factors in the Determination of
the Level of Debt
36
Capital Structure Guidance
 So what is a company to do? A company selects its
capital structure based on a number of factors:





Is the company profitable?
What type of assets does the company have?
How risky is the company’s underlying business?
Is the company profitable? Is it growing?
Why might companies deviate from their target capital
structure?

37
Of course, companies deviate from their target capital
structure when they are offered a good deal. In terms of
financing, this means that if the company observes attractive
interest rates for debt financing, it might lean more heavily
on debt financing.
Chapter Summary

The basic Modigliani and Miller (M&M) arguments assess
whether the capital structure decision creates value. The
conclusion was that under some simplifying assumptions,
issuing debt does not create value. This is because the
company is not doing anything that others can’t do just as
well; that is, borrow money.


Once we introduce the fact that interest on debt is tax
deductible, whereas dividends to the common shareholders
are not, it means that there is a tax shield value to raising debt.
Hence, there is a transfer of wealth to the private sector from
the government as the company finances with debt.

38
In essence, the M&M argument is that companies should stick to
doing things where they have a comparative advantage, and it is
difficult to see how borrowing money is such because we can all do it.
This tax incentive to using debt is offset by the resulting financial
distress and bankruptcy costs, as discussed in the static trade-off
model.
Chapter Summary




39
As its name implies, the static trade-off model does not take
into account dynamic effects.
The pecking order theory, on the other hand, does account
for these dynamic effects as companies tend to first use
internal cash flow, then debt, and will only raise new
common equity as a last resort.
The result is that companies depart from the static trade-off
optimal debt ratio over time, and then refinance to bring
their debt ratio back in line with their target ratio.
Therefore, actual capital structures are constantly changing
as companies take advantage of market conditions.
Chapter Summary
 Capital structure decisions in practice focus on
a company’s target capital structure and the
company’s ability to satisfy debt obligations.
 Financial managers not only worry about how
new debt affects a company’s credit rating,
but they also worry about how capital
structure decisions affect dividends and the
reported earnings per share.
40