Business finance ch 13 capital structure and leverage

CHAPTER 13 Capital Structure and Leverage     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  Note that business risk does not include financing effects E(EBIT) EBIT 13-2 What determines business risk?  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?  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 13-4 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  What happens if variable costs change? FC FC QBE Sales QBE Sales 13-5 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 13-6 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 13-7 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 13-8 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 Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate 13-9 Firm U: Unleveraged Prob EBIT Interest EBT Taxes (40%) NI Economy Bad Avg 0.25 0.50 $2,000 $3,000 0 $2,000 $3,000 800 1,200 $1,200 $1,800 Good 0.25 $4,000 $4,000 1,600 $2,400 13-10 Table for calculating levered betas and costs of equity Amount borrowed $ D/A ratio D/E Levered ratio Beta 0.00% 0.00% 1.00 ks 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 13-30 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 13-31 Table for calculating WACC and determining the minimum WACC Amount D/A ratio borrowed 0.00% $ 12.50 250 25.00 500 37.50 750 50.00 1,000 E/A ratio ks kd (1 – T) WACC 100.00% 12.00% 0.00% 12.00% 87.50 12.51 4.80 11.55 75.00 13.20 5.40 11.25 62.50 14.16 6.90 11.44 50.00 15.60 8.40 12.00 * Amount borrowed expressed in terms of thousands of dollars 13-32 Table for determining the stock price maximizing capital structure Amount Borrowed DPS ks P0 $3.00 12.00% $25.00 250,000 3.26 12.51 26.03 500,000 3.55 13.20 26.89 750,000 3.77 14.16 26.59 1,000,000 3.90 15.60 25.00 $ 13-33 What debt ratio maximizes EPS?  Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50% (Remember DPS = EPS because payout = 100%.)  Risk is too high at D/A = 50% 13-34 What is Campus Deli’s optimal capital structure?  P0 is maximized ($26.89) at D/A = $500,000/$2,000,000 = 25%, so optimal D/A = 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) 13-35 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 13-36 Other factors to consider when establishing the firm’s target capital structure Industry average debt ratio TIE ratios under different scenarios Lender/rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rate 13-37 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? 13-38 Modigliani-Miller Irrelevance Theory Value of Stock MM result Actual No leverage D1 D2 D/A 13-39 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 13-40 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 13-41 What are “signaling” effects in capital structure?  Assume:   Managers have better information about a firm’s long-run value than outside investors Managers act in the best interests of current stockholders 13-42 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 13-43 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 13-44 ... as a result of financial leverage 13- 7 Business risk vs Financial risk  Business risk depends on business factors such as competition, product liability, and operating leverage  Financial risk... by higher risk 13- 15 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... financial risk Concentrates business risk on stockholders 13- 8 An example: Illustrating effects of financial leverage  Two firms with the same operating leverage, business risk, and probability distribution