Chapter 14 Capital Structure and Leverage Business vs Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory 14-1 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is business risk? • The riskiness inherent in the firm’s operations if it uses no debt Probability Low risk High risk • E(ROIC) EBIT A commonly used measure of business risk is σROIC 14-2 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 14-3 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 not decline when demand falls, then the firm has high operating leverage 14-4 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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? 14-5 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Using Operating Leverage • Typical situation: Can use operating leverage to get higher ROIC, but risk also increases Probability Low operating leverage High operating leverage ROICL ROICH 14-6 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Return on Invested Capital (ROIC) • ROIC measures the after-tax return that the company provides for all its investors • ROIC doesn’t vary with changes in capital structure EBIT(1 − T) Investor-supplied capital ($400,000)(0.6) = $2,000,000 = 12% ROIC = 14-7 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 14-8 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Business Risk vs Financial Risk • Business risk depends on business factors such as competition, product obsolescence, and operating leverage • Financial risk depends only on the types of securities issued – More debt, more financial risk – Concentrates business risk on stockholders 14-9 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 invested capital 40% tax rate Firm L $10,000 of 12% debt $20,000 invested capital 40% tax rate 14-10 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Calculating Levered Betas and Costs of Equity If D = $250, bL = 1.0[1 + (0.6)($250/$1,750)] = 1.0857 rs = rRF + (rM – rRF)bL = 6.0% + (6.0%)1.0857 = 12.51% 14-29 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Table for Calculating Levered Betas and Costs of Equity Amount Borrowed $ D/Cap Ratio D/E Ratio Levered Beta rs 0% 0% 1.00 12.00% 250 12.50 14.29 1.09 12.51 500 25.00 33.33 1.20 13.20 750 37.50 60.00 1.36 14.16 1,000 50.00 100.00 1.60 15.60 14-30 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 14-31 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Table for Calculating Levered Betas and Costs of Equity Amount D/Cap E/Cap Borrowed Ratio Ratio $ 0% 100% 250 12.50 87.50 500 25.00 75.00 750 37.50 62.50 1,000 50.00 50.00 rs 12.00% 12.51 13.20 14.16 15.60 rd(1 – T) -4.80% 5.40% 6.90% 8.40% WACC 12.00% 11.55 11.25 11.44 12.00 14-32 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Stock Price with Zero Growth ˆP0 = D1 = EPS = DPS rs − g rs rs • • • If all earnings are paid out as dividends, E(g) = EPS = DPS To find the expected stock price (Pˆ0 ), we must find the appropriate rs at each of the debt levels discussed 14-33 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Determining the Stock Price Maximizing Capital Structure Amount Borrowed $ DPS $3.00 rs P0 12.00% 250 3.26 12.51 $25.00 26.03 500 3.55 13.20 26.89 750 3.77 14.16 26.59 1,000 3.90 15.60 25.00 14-34 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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% 14-35 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What is Campus Deli’s optimal capital structure? • P0 is maximized ($26.89) at D/Cap = $500,000/$2,000,000 = 25%, so optimal D/Cap = 25% • 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) 14-36 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 14-37 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part How would these factors affect the target capital structure? Sales stability? High operating leverage? Increase in the corporate tax rate? Increase in the personal tax rate? Increase in bankruptcy costs? Management spending lots of money on lavish perks? Financial flexibility? Firm’s growth rate? 14-38 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Modigliani-Miller Irrelevance Theory 14-39 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Modigliani-Miller Irrelevance Theory • The graph shows MM’s tax benefit vs bankruptcy cost theory • Logical, but doesn’t tell whole capital structure story Main problem: assumes investors have same information as managers 14-40 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Incorporating Signaling Effects • Signaling theory suggests firms should use less debt than MM suggest • This unused debt capacity helps avoid stock sales, which depress stock price because of signaling effects 14-41 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part What are “signaling” effects in capital structure? • Assumptions: – 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 – As a result, investors view a stock offering negatively; managers think stock is overvalued 14-42 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 14-43 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part [...]... $2,400 14-11 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Firm L: Leveraged Probability* Bad 0.25 Economy Average 0.50 Good 0.25 EBIT * Interest EBT Taxes (40%) NI $2,000 1,200 $ 800 320 $ 480 $3,000 1,200 $1,800 720 $1,080 $4,000 1,200 $2,800 1,120 $1,680 *Same as for Firm U 14-12 © 2013 Cengage Learning... 3.3x 14-13 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Risk and Return for Leveraged and Unleveraged Firms Expected values: E(ROIC) E(ROE) E(TIE) Firm U 9.0% 9.0 % ∞ Firm L 9.0% 10.8 % 2.5× Firm U 2.12% 2.12% 0 Firm L 2.12% 4.24% 0.6× Risk measures: σ ROIC σ ROE σ TIE 14-14 © 2013 Cengage Learning... 14-17 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Why do the bond rating and cost of debt depend upon the amount of debt borrowed? • 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 14-18 © 2013 Cengage. .. per share 14-19 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Cost of Debt at Different Debt Ratios Amount Borrowed $ 0 D/Cap Ratio 0 D/E Ratio Bond Rating rd 0 250 0.125 0.143 AA 8.0% 500 0.250 0.333 A 9.0% 750 0.375 0.600 BBB 11.5% 1,000 0.500 1.000 BB 14.0% 14-20 © 2013 Cengage Learning All... debt 14-27 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 invested capital was $2,000,000 14-28 © 2013 Cengage Learning... 50.00 100.00 1.60 15.60 14-30 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part 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 14-31 © 2013 Cengage Learning All Rights Reserved... T) > ROIC, then after-tax interest 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 = rdD) 14-15 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible... © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Stock Price with Zero Growth ˆP0 = D1 = EPS = DPS rs − g rs rs • • • If all earnings are paid out as dividends, E(g) = 0 EPS = DPS To find the expected stock price (Pˆ0 ), we must find the appropriate rs at each of the debt levels discussed 14-33 © 2013. .. levels discussed 14-33 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Determining the Stock Price Maximizing Capital Structure Amount Borrowed $ 0 DPS $3.00 rs P0 12.00% 250 3.26 12.51 $25.00 26.03 500 3.55 13.20 26.89 750 3.77 14.16 26.59 1,000 3.90 15.60 25.00 14-34 © 2013 Cengage Learning All Rights... $750,000 Shares repurchased = = 30,000 $25 (EBIT − rdD)(1 − T) EPS = Shares outstandin g [$400,000 − (0.115)($750,000)](0.6) = 80,000 − 30,000 = $3.77 EBIT $400,000 TIE = = = 4.6x Int Exp $86,250 14-24 © 2013 Cengage Learning All Rights Reserved May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part Determining EPS and TIE at Different Levels of Debt (D