Chapter 14 Capital Structure and Leverage

Background

Capital structure - mix of a firm’s debt and equity– In this chapter preferred stock is considered

debt

Financial Leverage - using borrowed money to multiply the effectiveness of equity– Financial leverage of 10% means the capital

structure is 10% debt and 90% equity

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The Central Issue

Can the use of debt (leverage) increase the value of a firm’s equity?– Can it increase stock price?

Under certain conditions changing leverage can increase stock price– But an increase in leverage also increases

risk

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Risk in the Context of Leverage

Leverage influences stock price

Measures of overall performance– EBIT (Earnings Before Interest and Taxes) – Return on Equity (ROE) is

– Earnings per Share (EPS) is

equity

Income NETROE

shares ofnumber

Income NETEPS

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 due to financial leverage– Total risk is total variation in ROE and EPS

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Figure 14-1 Business and Financial Risk

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Leverage and Risk Two Kinds of Each

Financial Leverage

Associated with capital structure

Causes financial risk.

Operating Leverage

Associated with cost structure, the firm’s mix of fixed and variable cost

Influences a firm’s business risk => variation in EBIT

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Financial Leverage

Financial leverage may increase stock price – Can improve financial performance, as measured

by ROE and EPS– May make performance worse – Always increases risk

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Table 14-1 Effect of Increasing Financial Leverage when Return on Capital Exceeds After-Tax Cost of Debt

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Replacing equity with debt reduces Net Income due to interest expense.But if profitability

is good, it reduces equity and number of

shares faster than the decline in Net Income. Hence as

debt increases, both EPS and

ROE rise dramatically.

Effect Of Increased Leverage On Stock Price In Good Times

Based on ROE and EPS performance in good times, investors bid stock price up as debt is increased from low levels

Effect is eventually mitigated by the increasing financial risk from leverage

Under what conditions will increasing leverage improve ROE and EPS?

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When Might Financial Leverage Help? Return on Capital Employed

– Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE

EBIT 1 - tax rateROCE =

debt + equity

When the ROCE > the after-tax cost of debt, more leverage improves ROE and EPS

When ROCE < the after-tax cost of debt, more leverage makes ROE and EPS worse

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Table 14-2 Effect of Increasing Financial Leverage when After-Tax Cost of Debt Exceeds Return on Capital

When ROCE is less than the after tax

cost of debt, increasing

leverage reduces EPS and ROE .

That, along with increasing risk, has

a very negative effect on investors

and stock price falls.

Concept Connection Example 14-1Managing EPS through Leverage

Will borrowing more money and retiring stock raise Albany’s EPC, and if so, what capital structure will achieve an EPS of $2?

Concept Connection Example 14-1Managing EPS through Leverage

Concept Connection Example 14-1Managing EPS through Leverage

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Managing Through Leverage

Under certain conditions management may be able to manipulate financial results and stock price by changing the firm’s capital structure. This is true, but must be done cautiously

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An Alternate Approach (Optional)Using ratios and information from financial statements to solve for unknown values: algebraic approach

EPS = ROE × Book Value per shareROE = Net Income ÷ EquityNet Income= [EBIT – Interest] (1 – tax rate)

Interest = kd (Debt)– Net Income = [EBIT – (kd)(Debt)](1 – tax rate)

Equity = Total Capital – Debt

share) per valueBook Debt) - capital

(Total(

)T1)(Debt)(k(EBIT[EPS d

Table 14-3 Financial Leverage and Risk

Financial leverage is a two-edged sword– Multiplies good results into great results– Multiplies bad results into terrible results

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Putting the Ideas Together—The Effect on Stock Price

During periods of good performance, leverage enhances results in terms of ROE and EPS

Leverage adds variability (risk) to financial performance when operating results change

These effects push stock prices in opposite directions

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Real Investor Behavior and the Optimal Capital Structure

When leverage is low, an increase has a positive effect on investors

At high debt levels, risk concerns overwhelm benefit of enhanced performance thus additional leverage decreases stock price

As leverage increases, its effect goes from positive to negative

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Figure 14-2 The Effect of Leverage on Stock Price

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Finding the Optimum—A Practical Problem

1. A firm with good profit prospects and little or no debt is probably missing an opportunity by not using borrowed money if interest rates are reasonable.

2. For most businesses, the optimal capital structure is somewhere between 30% and 50% debt.

3. Debt levels above 60% create excessive risk and should be avoided.

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The Target Capital Structure

A firm’s target capital structure is management’s estimate of the optimal capital structure

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The Effect of Leverage When Stocks Aren’t Trading at Book Value

Changes in leverage not involving the purchase of equity at book value are more complex

Repurchasing stock for retirement at prices other than book value will have the same general impact on ROE, but not necessarily for EPS

EPS = ROE x (book value per share)

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The Degree of Financial Leverage (DFL)A Measurement

Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS

DFL quantifies the effectiveness of leverage by relating relative changes to EPS and EBIT

EBITDFL =

EBIT - Interest

EBIT- EPS Analysis

Provides a visual/graphic representation of effect of leverage on EPS

Helps managers analyze and quantify the tradeoffs between risk and results when deciding on leverage policy

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Figure 14-3 EBIT – EPS Analysis for ABC Corp (from Table 14.1, Columns 1 and 2)

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For the Arizona Balloon Corporation the 50%

Debt and No Leverage lines intersect. At the point of intersection

ABC is indifferent between the two

leverage options. To the right of the intersection,

where EBIT is above $100,000, the 50% Debt plan is preferable, but to the left the company is

better off without leverage.

It is important to

determine the indifference point, which occurs when the two plans

offer the same EBIT.

Operating Leverage

Terminology and Definitions

– “Operations” - a firm’s business activities excluding long-term financing

Income statement items from sales through EBIT

– Risk in Operations — Business Risk

Variations in EBIT due to many reasons (sales, costs, management)

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Operating Leverage

Fixed Costs

– Don’t change with the level of sales

– Include rent, depreciation, utilities, salaries

Variable Costs – Change with the

level of sales– Include direct

labor, direct materials, sales commissions

Fixed and Variable Costs and Cost Structure

Cost Structure – the mix of fixed and variable costs in a firm’s operations

Breakeven Analysis

Determines the level of activity a firm must achieve to stay in business in the long run

Shows the mix of fixed and variable costs and the volume required for zero profit/loss

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Figure 14-4 Fixed, Variable, and Total Cost

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Figure 14-5 The Breakeven Diagram

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Breakeven occurs at the intersection of revenue and total cost, QB/E

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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

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Concept Connection Example 14-4Contribution

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?

The contribution per unit is Ct = P – V

= $10 - $7= $3

while the contribution margin is:

Cm = P – V P

= $3 / $10 = 0.3 = 30%

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Breakeven AnalysisCalculating the Breakeven Sales Level

EBIT = PQ – VQ – FC

– Breakeven occurs when EBIT = 0 or revenue (PQ) equals total cost (VQ + FC). Then solve for QB/E

– Breakeven shows how many units must be sold to pay for (cover) fixed costs

– Can be expressed in terms of dollar sales

)VP(

FQ C

EB

M

CCEB C

F

P

)VP(F

S

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Concept Connection Example 14-5 Breakeven

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?

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.

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– When a firm is operating above breakeven, more

operating leverage implies higher operating profit

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Figure 14-6 Breakeven Diagram at High and Low Operating Leverage

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Concept Connection 14-6 The Effect of Operating Leverage

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Suppose the low-leverage firm in Figure 14-6a has fixed costs of $1,000 per period, sells its product for $10, and has variable costs of $8 per unit. Further suppose that the high-leverage firm in Figure 14-6b 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 the high-leverage firm have if it is to achieve the same breakeven point as the low-leverage firm? State the trade-off at the breakeven point. Which structure is preferred if there’s a choice?

Concept Connection Example 14-6 The Effect of Operating Leverage

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Both firms have a breakeven point of 500 units (Low-leveraged

firm: $1,000 $2). We need to solve the breakeven formula for

the high-leveraged firm’s variable costs per unit:

QB/E-a = FC (P – Va) = 500 units

QB/E-b = FC (P – Vb) = 500 units

500 units = $1,500 ($10 – Vb)

Vb = $7And Ct = $10 - $7 = $3

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.

At breakeven, a $1differential in contribution

makes up for a $500difference in fixed cost.

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

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C

% EBIT Q(P - V)DOL = or

% Q Q(P - V) - F

Concept Connection Example 14-7 Degree of Operating Leverage (DOL)

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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.

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:

DOL at 300 units is: Note that DOLdecreases

as the output levelincreases above

breakeven.

Q=210

210($10 - $7)DOL = 21

210($10 - $7) - $600

Q=300

300($10 - $7)DOL = 3

300($10 - $7) - $600

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Comparing Operating and Financial Leverage

Financial Leverage involves substituting debt for equity in the firm’s capital structure– Is more controllable than

operating leverage

Operating Leverage involves substituting fixed costs for variable costs in the firm’s cost structure

•Both can enhance results while increasing variation•Both involve substituting fixed cash outflows for variable cash outflows•Both make their respective risks larger as levels of leverage increase

Figure 14-7 The Similar Functions of Operating and Financial Leverage

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Figure 14-8 Risk and Cost Relationships between Operating and Financial Leverage

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The Compounding Effect of Operating and Financial Leverage

Effects of financial and operating leverage compound one another

Changes in sales are amplified by operating leverage into larger relative changes in EBIT

Changes in EBIT are amplified by financial leverage into larger relative changes in ROE and EPS

Result: Modest changes in sales can lead to dramatic changes in ROE and EPS

Combined effect is measured by DTL, the degree of total leverage

DTL = DOL × DFL

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Figure 14-9 The Compounding Effect of Operating Leverage and Financial Leverage

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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?– Capital structure does impact stock prices – There is an optimal– But no precise way to find it

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Background The Value of the FirmNotation– 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

The average cost of capital is a weighted average of the costs of debt and equity– ka = average cost of capital

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Background The Value of the Firm

Value is based on cash flow, which comes from income– Dividends and interest payments are both perpetuities

The firm’s market value is the sum of its present values

Operating income =

And

edf VVV

Returns drive value in an inverse

relationship.

af k

OIV

DIOI

Figure 14-10 Variation in Value and Average Return with Capital Structure

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The value of the firm and the firm’s stock

price each reach maxima when the

average cost of capital is minimized.

The Early Theory by Modigliani and Miller (MM)

Restrictive Assumptions in Original Model– The 1958 MM 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

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The Early Theory by Modigliani and Miller (MM)

The Assumptions and Reality– Income taxes exist– Bankruptcy costs are quite high– Individuals cannot borrow at the same rate

as companies and – Interest rates usually rise as more money is

borrowed

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The Early Theory by Modigliani and Miller (MM)

The result– The independence hypothesis: value is

independent of capital structure– As cheaper debt is added, the cost of equity

increases because of increased risk

Arbitrage concept

Interpreting the result

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Figure 14-11 The Independence Hypothesis (a)

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Figure 14-11 The Independence Hypothesis (b)

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Relaxing the Assumptions—More Insights

Financing and the U.S. Tax System– Tax system favors debt financing over equity

financing

Including Corporate Taxes in the MM Theory– Interest provides a tax shield that reduces

government’s share of the firm’s earnings– Value is increased by the PV of the tax shield.

The benefit of debt is the tax rate times the debt amount.

– The benefit of debt accrues entirely to stockholders since bond returns are fixed.

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Table 14-4 The Tax System Favors Debt Financing

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Tax Shield

Interest is tax deductible, so if there’s debt and an amount of interest, I, the government gets

T(OI − I) = T(OI) − TI

PV of tax shield is

TBk

TBk

k

TI

d

d

d

Figure 14-12 MM Theory with Taxes

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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.

Including Bankruptcy Costs in the MM Theory

As leverage increases past a certain point, concern about bankruptcy losses increases – Debt and equity investors raise required returns

– ka passes its minimum as price and value peak

Hence value and price are maximized at an optimal capital structure where the average cost of capital is a minimum

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Figure 14-13 MM Theory with Taxes and Bankruptcy Costs

An Insight into Mergers and Acquisitions

In many mergers, a firm buys the stock of a target company at a premium over its market price/value

If the target was undervalued due to lack of debt, the increase in value from adding leverage may be more than the premium paid for the target’s stock

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