Download 13 - Finance

Capital Structure
and Leverage
Chapter 13
© 2003 South-Western/Thomson Learning
Background

Capital structure refers to the mix of a firm’s
debt and equity



Preferred stock is assumed to be part of a firm’s
debt
Financial leverage refers to using borrowed
money to enhance the effectiveness of invested
equity
Financial leverage of 10% means the firm’s
capital structure contains 10% debt and 90%
equity
2
The Central Issue

Can the use of debt increase the value of a
firm’s equity


Under certain conditions changing leverage
increases stock price


Specifically, the firm’s stock price
An optimal capital structure maximizes stock price
The relationship between capital structure and
stock price is not precise nor fully understood
3
Risk in the Context of Leverage

Leverage influences stock price


Alters the risk/return relationship in an equity investment
Measures of performance

Operating income (AKA: EBIT or Earnings Before Interest and
Taxes)
• Unaffected by leverage because it is calculated prior to the
deduction for interest


Return on Equity (ROE) is Earnings after Taxes  Stockholders’
Equity
Earnings per Share (EPS) is Earnings after Taxes  number of
shares
• Investors regard EPS as an important indicator of future
profitability
4
Risk in the Context of Leverage

Redefining Risk for Leverage-Related
Issues

Leverage-related risk is variation in ROE and
EPS
• Business risk—variation in EBIT
• Financial risk—additional variation in ROE and
EPS brought about by financial leverage
5
Figure 13.1: Business and
Financial Risk
6
Leverage and Risk—Two Kinds
of Each

Relates to a company’s cost structure


Involves relative use of fixed and variable
costs
Operating leverage has an influence on a
firm’s business risk
7
Financial Leverage

Under certain conditions financial
leverage can improve a firm’s ROE and
EPS

However, at other times it may worsen EPS
and ROE
8
Table 13.1
As the firm’s debt
ratio rises, both
EPS and ROE rise
dramatically. While
EAT falls, the
number of shares
outstanding falls at
a faster rate as
debt replaces
equity.
9
Financial Leverage

Return on Capital Employed (ROCE)

Measures the profitability of operations before financing
charges but after taxes on a basis comparable to ROE
ROCE =


EBIT 1 - tax rate 
debt + equity
When the ROCE exceeds the after-tax cost of debt,
more leverage improves ROE and EPS
When ROCE is less than the after-tax cost of debt,
more leverage makes ROE and EPS worse
10
Table 13.2
ABC is now
doing rather
poorly—ROE and
ROCE are quite
low. As the firm
adds leverage,
EPS and ROE
decrease.
11
Financial Leverage—Example
Q: Selected financial information for the Albany Corporation follows:
Albany Corporation at $10M Debt
($000 except for per-share amounts)
EBIT
Example
Interest (@12%)
EBT
Tax (@40%)
EAT
$23,700
1,200
$22,500
9,000
Debt
Equity
$10,000
90,000
Capital
$100,000
Number of shares=
9,000,000
$13,500
Stock price = $10 per share
ROE = EAT  equity = $13,500  $90,000 = 15%
EPS = EAT  number of shares = $13,500  9,000,000 = $1.50
The treasurer feels debt can be traded for equity without immediately affecting the price of the stock or the
rate at which the firm can borrow. Management believes it is in the best interest of the company and its
stockholders to move the firm’s EPS from its current level up to $2.00 per share. However, no
opportunities are available to increase operating profit (EBIT) above the current level of $23.7 million. Will
borrow more money and retiring stock raise Albany’s EPS, and if so what capital structure will achieve an
EPS of $2.00?
12
Financial Leverage—Example
Example
A: EPS will rise if ROCE exceeds the after-tax cost of debt. ROCE is currently:
23.7M 1 - 0.40 
 14.2%
$100.0M
The after-tax cost of debt is 12% x (1 – 0.4), or 7.2%. Since 7.2% < 14.2%,
trading equity for debt will increase EPS.
ROCE =
Using trial and error, you can determine that $45 million of debt is the approximate
amount of debt that makes the firm’s EPS equal $2.00.
13
Financial Leverage and
Financial Risk

Financial leverage is a two-edged sword
Multiplies good results into great results
 Multiples bad results into terrible results

ROE and EPS for leveraged firms
experience more variation
 Financial risk is the increased variability
in financial results that comes from
additional leverage

14
Putting the Ideas Together—The
Effect on Stock Price

Leverage enhances performance while it
adds risk, pushing stock prices in
opposite directions
Enhanced performance makes the expected
return on stock higher, driving up the stock’s
price
 The increased risk drives down the stock’s
price

• Which effect dominates, and when?
15
Real Investor Behavior and the
Optimal Capital Structure
When leverage is low an increase in debt
has a positive effect on investors
 At high debt levels concerns about risk
dominate and adding more debt
decreases the stock’s price
 As leverage increase its effect goes from
positive to negative, which results in an
optimum capital structure

16
Figure 13.2: The Effect of
Leverage on Stock Price
17
Finding the Optimum—A
Practical Problem

There is no way to determine the exact
optimum amount of leverage for a particular
company at a particular time

Appropriate level tends to vary according to
• Nature of a company’s business
• If firm has high business risk it should use less leverage
• Economic climate
• If the outlook is poor investors are likely to be more sensitive
to risk

As a practical matter the optimum capital
structure cannot be precisely located
18
The Target Capital Structure

A firm’s target capital structure is
management’s estimate of the optimal
capital structure

An approximation or best guess as to the
amount of debt that will maximize the firm’s
stock price
19
The Effect of Leverage When Stocks
Aren’t Trading at Book Value
We’ve assumed that changes in leverage
involve purchasing equity at book value
 If this is not the case, things are more
complex


Repurchasing stock at prices other than
book value will have the same general
impact on ROE, but not necessarily for EPS
• However the important point is the direction of the
stock price change, not the exact amount
20
The Degree of Financial Leverage
(DFL)—A Measurement

Financial leverage magnifies changes in EBIT
into larger changes in ROE and EPS

The degree of financial leverage (DFL) relates
relative changes in EBIT to relative changes in EPS
DFL =

%  EPS
or %  EPS = DFL  %  EBIT
%  EBIT
Somewhat
tedious
An easier method of calculating DFL is:
DFL =
EBIT
EBIT - Interest
21
The Degree of Financial Leverage
(DFL)—A Measurement—Example
Q: Selected income statement and capital information for the Moberly Moped Manufacturing
Company follow ($000):
Capital
Revenue
Example
Cost/expense
EBIT
$5,580
4,200
$1,380
Debt
Equity
Total
$1,000
7,000
$8,000
Currently 700,000 shares of common stock are outstanding. The firm pays 15% interest
on its debt and anticipates that it can borrow as much as it reasonably needs at that rate.
The income tax rate is 40%
Moberly is interested in boosting the price of its stock. To do that management is
considering restructuring capital to 50% debt in the hope that the increased EPS will have
a positive effect on price. However, the economic outlook is shaky, and the company’s
CFO thinks there’s a good chance that a deterioration in business conditions will reduce
EBIT next year. At the moment Moberly’s stock sells for its book value of $10 per share.
Estimate the effect of the proposed restructuring on EPS. Then use the degree of financial
leverage to assess the increase in risk that will come along with it.
22
The Degree of Financial Leverage
(DFL)—A Measurement (Example)
A: Since the equity is trading at book value, this is a relatively simple example.
Current
Proposed
Capital
Debt
Example
Equity
Total
Shares outstanding
$1,000
$4,000
7,000
4,000
$8,000
$8,000
700,000
400,000
Current
EBIT
Proposed
$1,380
$1,380
150
600
$1,230
$780
492
312
EAT
$738
$468
EPS
$1.054
$1.170
Interest (15% of debt)
EBT
Tax (@40%)
If business conditions
remain unchanged, a
higher EPS will result
with the addition of
debt.
23
The Degree of Financial Leverage
(DFL)—A Measurement—Example
Example
A: Next, calculate DFL:
$1,380
 1.12
$1,380 - $150
$1,380
=
 1.77
$1,380 - $600
DFLCurrent =
DFLProposed
EPS will be much more volatile under the proposed plan. EPS will change by a factor of
1.77 vs. 1.12.
24
EBIT-EPS Analysis


Managers need a way to quantify and analyze
the tradeoffs between risk and results when
changing leverage levels
Provides a graphical portrayal of the trade-off


Involves graphing EPS as a function of EBIT for
each leverage level
Portrays the results of leverage and helps to
decide how much to use
25
Figure 13.3: EBIT – EPS Analysis for ABC
Corporation
(from Table 13.1, Columns 1 and 2)
It is
important to
determine
the
indifference
point, which
occurs when
the two
plans offer
the same
EBIT.
When examining the ABC
Corporation you can see that
the 50% Debt and No
Leverage lines intersect. At
the point of intersection ABC
is indifferent between the two
plans. However, to the left of
the intersection the 50% Debt
plan is preferable, but to the
right of the point the No
Leverage plan is preferable.
26
Operating Leverage

Terminology and Definitions

Risk in Operations—Business Risk
• Variation in EBIT

Fixed and Variable Costs and Cost Structure
• Fixed costs don’t change with the level of sales, while
variable costs do
• Fixed costs include rent, depreciation, utilities, salaries
• Variable costs include direct labor, direct materials, sales
commissions
• The mix of fixed and variable costs in a firm’s operations is
its cost structure

Operating Leverage Defined
• Refers to the amount of fixed costs in the cost structure
27
Breakeven Analysis
Used to determine the level of activity a
firm must achieve to stay in business in
the long run
 Shows the mix of fixed and variable cost
and the volume required for zero
profit/loss


Profit/loss generally measured by EBIT
28
Breakeven Analysis

Breakeven Diagrams

Breakeven occurs at the intersection of
revenue and total cost
• Represents the level of sales at which revenue
equals cost
29
Figure 13.5: The Breakeven
Diagram
30
Breakeven Analysis

The Contribution Margin

Every sale makes a contribution of the
difference between price (P) and variable
cost (V)
• Ct = P – V

Can be expressed as a percentage of
revenue
• Known as the contribution margin (CM)
• CM = (P – V)  P
31
Example
Breakeven Analysis—Example
Q: Suppose a company can make a unit of product for $7 in
variable labor and materials, and sell it for $10. What are the
contribution and contribution margin?
A: The contribution per unit is $3, or $10 - $7, while the contribution
margin is $3  $10, or 30%.
32
Breakeven Analysis

Calculating the Breakeven Sales Level

EBIT is revenue minus cost, or
• EBIT = PQ – VQ – FC

Breakeven occurs when revenue (PQ)
equals total cost (VQ + FC), or
• QB/E = FC  (P – V)
• Breakeven tells us how many units have to be sold to
contribute enough money to pay for fixed costs
• Can also be expressed in terms of dollar sales
• SB/E = P(FC)  (P – V) or FC  CM
33
Example
Breakeven Analysis—Example
Q: What is the breakeven sales level in units and dollars for a
company that can make a unit of product for $7 in variable costs
and sell it for $10, if the firm has fixed costs of $1,800 per
month?
A: The breakeven point in units is $1,800  ($10 - $7) = 600 units.
The breakeven point in dollars is $10 per unit times 600 units, or
$6,000, which could also be calculated as $1,800  0.30. Thus,
the firm must sell 600 units per month to cover fixed costs.
34
The Effect of Operating
Leverage


As volume moves away from breakeven, profit or loss
increases faster with more operating leverage
The Risk Effect


More operating leverage leads to larger variations in EBIT, or
business risk
The Effect on Expected EBIT

Thus, when a firm is operating above breakeven, more
operating leverage implies higher operating profit
• If a firm is relatively sure of its operating level, it is in the firm’s
best interests to trade variable costs for fixed cost (assuming the
firm is operating above breakeven)
35
Figure 13.6: Breakeven Diagram at
High and Low Operating Leverage
36
The Effect of Operating
Leverage—Example
Example
Q: Suppose Firm A has fixed costs of $1,000 per period, sells its product for $10,
and has variable costs of $8 per unit. Further, suppose Firm B has fixed costs
of $1,500 and also sells its product for $10 a unit. Both firms are at the same
breakeven point. What variable cost must Firm B have if it is to achieve the
same breakeven point as Firm A? State the trade-off at the breakeven point.
Which structure is preferred if there’s a choice?
A: Both firms have a breakeven point of 500 units (Firm A: $1,000  $2). We need
to solve the breakeven formula for Firm B’s variable costs per unit:
QB/EFirm B = FC  (P – VB)
500 units = $1,500  ($10 – VB)
VB = $7
Thus, at breakeven, a $1
differential in contribution
makes up for a $500
difference in fixed cost.
The preferred structure depends on volatility—if sales are expected to be highly
volatile, the lower fixed cost structure might be better in the long run.
37
The Degree of Operating Leverage
(DOL)—A Measurement
Operating leverage amplifies changes in
sales volume into larger changes in EBIT
 DOL relates relative changes in volume
(Q) to relative changes in EBIT

%  EBIT
Q(P - V)
DOL =
or
%Q
Q(P - V) - FC
38
The Degree of Operating Leverage
(DOL)—A Measurement
Example
Q: The Albergetti Corp. sells its product at an average price of $10. Variable costs
are $7 per unit and fixed costs are $600 per month. Evaluate the degree of
operating leverage when sales are 5% and then 50% above the breakeven
level.
A: First, compute the breakeven volume: $600  ($10 - $7) = 200 units.
Breakeven plus 5% is 200 x 1.05 or 210 units, while breakeven plus 50% is 200
x 1.50 or 300 units. DOL at 210 units is:
DOLQ=210 =
210($10 - $7)
 21
210($10 - $7) - $600
DOL at 300 units is:
DOLQ=300
300($10 - $7)
=
3
300($10 - $7) - $600
Note that DOL decreases
as the output level
increases above
breakeven.
39
Comparing Operating and
Financial Leverage





Financial and operating leverage are similar in that both can
enhance results while increasing variation
Financial leverage involves substituting debt for equity in the firm’s
capital structure
Operating leverage involves substituting fixed costs for variable
costs in the firm’s cost structure
Both methods involve substituting fixed cash outflows for variable
cash outflows
Both kinds of leverage make their respective risks larger as the
levels of leverage increase


However, financial risk is non-existent if debt is not present, while
business risk would still exist even if no operating leverage existed
Financial leverage is more controllable than operating leverage
40
The Compounding Effect of
Operating and Financial Leverage


The effects of financial and operating leverage
compound one another
Changes in sales are amplified by operating leverage
into larger relative changes in EBIT

Which in turn are amplified into still larger relative changes in
ROE and EPS by financial leverage
• The effect is multiplicative, not additive


Thus, fairly modest changes in sales can lead to dramatic
changes in ROE and EPS
The combined effect can be measured using degree of
total leverage (DTL)

DTL = DOL × DFL
41
Figure 13.9: The Compounding Effect of
Operating Leverage and Financial
Leverage
42
The Compounding Effect of Operating
and Financial Leverage—Example
Example
Q: The Allegheny Company is considering replacing a manual production process
with a machine. The money to buy the machine will be borrowed. The
replacement of people with a machine will alter the firm’s cost structure in favor
of fixed costs, while the loan will move the capital structure in the direction of
more debt. The firm’s leverage positions at expected output levels with and
without the project are summarized as follows:
Current
DOL
DFL
2.0
1.5
Proposed
3.5
2.5
The economic outlook is uncertain and some managers fear a decline in sales of
as much as 10% in the coming year. Evaluate the effect of the proposed project
on risk in financial performance.
A: The firm’s current DTL is 2 x 1.5, or 3, meaning a 10% decline in sales could
result in a 30% decline in EPS. Under the proposal, the DTL will be much
higher: 8.75, or 3.5 x 2.5, meaning a 10% drop in sales could lead to a 87.5%
drop in EPS.
43
Capital Structure Theory

Does capital structure affect stock price
and the market value of the firm?


If so, is there an optimal structure that
maximizes either or both?
Results indicate that capital structure
does impact stock prices but there’s no
way to determine the optimal structure
with any precision
44
Background—The Value of the
Firm

Notation



Vd = market value of the firm’s debt
Ve = market value of the firm’s stock or equity
Vf = market value of the firm in total
• Vf = Vd + Ve

Investors’ returns on the firm’s securities will be



Kd = return on an investment in debt
Ke = return on an investment in equity
Theory begins by assuming a world without taxes or
transaction costs, so investors’ returns are exactly
component capital costs

Ka = average cost of capital
45
Background—The Value of the
Firm

Value is Based on Cash Flow Which Comes
from Income


Earnings ultimately determine value because all
cash flows paid to investors come from earnings
Dividends and interest payments are both
perpetuities
• The firm’s market value is the sum of their present values
Vf =
annual interest paid to bondholders total annual dividend paid to stockholders

kd
ke
which is equivalent to saying
Returns drive value
in an inverse
relationship.
Vf =
Operating Income
ka
46
Figure 13.10: Variation in Value and
Average Return with Capital Structure
The value of the firm
and the firm’s stock
price reach a
maximum when the
average cost of capital
is minimized.
47
The Early Theory by Modigliani
and Miller (MM)

Restrictive Assumptions in the Original
Model

In 1958 MM published their first paper on
capital structure
• Included numerous restrictions such as
• No income taxes
• Securities trade in perfectly efficient capital markets
with no transaction costs
• No costs to bankruptcy
• Investors and companies can borrow as much as they
want at the same rate
48
The Early Theory by Modigliani
and Miller (MM)

The Assumptions and Reality
Realistically income taxes exist
 Realistically the costs of bankruptcy are
quite large
 Realistically individuals cannot borrow at the
same rate as companies and interest rates
usually rise as more money is borrowed

49
The Early Theory by Modigliani
and Miller (MM)

The Result
Under MM’s initial set of restrictions, value is
independent of capital structure
 As cheaper debt is added the cost of equity
increases because of increased risk

• However the weight of the more expensive equity
is decreasing while the weight of the cheaper
debt is increasing, leading to a constant weighted
average cost of capital
50
Figure 13.11: The
Independence Hypothesis
51
The Early Theory by Modigliani
and Miller (MM)

The Arbitrage Concept


Arbitrage means making a profit by buying and selling the
same thing at the same time in two different markets
MM proposed that arbitrage by equity investors would hold the
value of the firm constant as debt levels changed
• Equity investors could sell shares in a leveraged firm and buy
shares in an unleveraged firm by borrowing money on their own

Interpreting the Result

The MM result implies that leverage affects value because of
market imperfections
• Such as taxes and transaction costs (including bankruptcy)
52
Relaxing the Assumptions—
More Insights

Financing and the U.S. Tax System

Tax system favors debt financing over equity
financing
• Interest expense on debt is tax deductible while
dividends on stock are not
53
Table 13.4
The All Equity firm
pays more taxes
because it receives
no interest expense
deduction.
Total payments to
investors are
higher for the
leveraged
company.
54
Relaxing the Assumptions—
More Insights

Including Corporate Taxes in the MM
Theory

When taxes exist operating income (OI)
must be split between investors and the
government
• This lowers the firm’s value compared to what it
would be if no taxes existed
• Amount of reduction depends on the firm’s use of
leverage
• Use of debt reduces taxable income which reduces
taxes
55
Including Corporate Taxes in
the MM Theory

In the MM model with taxes interest provides a
tax shield that reduces government’s share of
the firm’s earnings

When a firm uses debt financing the government’s
take is reduced by (corporate tax rate × interest
expense) every year
• Present value of tax shield = (corporate tax rate × interest
expense)  kd
• Since interest is the amount of debt (B) times the interest
rate on the debt, the above equation can be written as
PV of tax shield =
corporate tax rate x B x k d
= TB
kd
56
Including Corporate Taxes in
the MM Theory
Having debt in the capital structure
increases a firm’s value by the magnitude
of that debt times the tax rate
 The benefit of debt accrues entirely to
stockholders because bond returns are
fixed

57
Figure 13.12: MM Theory with
Taxes
In the MM model with taxes
value increases steadily as
leverage is added. Thus, the
firm’s value is maximized with
100% debt. Note that kd
remains constant across all
levels of debt.
58
Including Bankruptcy Costs in
the MM Theory

As leverage increases past a certain point,
investors begin raising their required rates of
return


The probability of bankruptcy failure increases
Eventually the weighted average cost of capital
will be minimized and the firm value will be
maximized

The MM model with taxes and bankruptcy costs
concludes that an optimal capital structure exists
59
Figure 13.13: MM Theory with
Taxes and Bankruptcy Costs
60
An Insight into Mergers and
Acquisitions
In many mergers one company buys the
stock of another company called the
target
 The buying company needs to buy
shares of the target company at a
premium over the current market price

Paying twice the current market value for a
target firm is not unheard of
 Why do companies do this?

61
An Insight into Mergers and
Acquisitions

One argument is that target firms may be
underutilizing their debt capacity


Thus, a restructuring of capital may raise the value
of the target firm
Acquiring firms often raise the cash needed to
buy the target firm’s shares with debt

The resulting merged business ends up with more
debt than the individual firms had before the merger
• May theoretically be justified if adding debt adds value
62