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Chapter 13 Capital Structure and Leverage
Chapter 13 Capital Structure and Leverage
Capital Structure
and Leverage
2
The Central Issue
Can the use of debt increase the value of a
firm’s equity
Specifically, the firm’s stock price
Under certain conditions changing leverage
increases 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
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
8
Table 13.1
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
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:
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
A: EPS will rise if ROCE exceeds the after-tax cost of debt. ROCE is currently:
23.7M ( 1 - 0.40 )
ROCE = = 14.2%
Example
$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.
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
An Alternate Approach
Using ratios and information from financial
statements we can solve for unknown values
EPS = ROE × Book Value per share
ROE = EAT ÷ Equity
EAT = [EBIT – Interest] (1 – tax rate)
Interest = kd (Debt)
Therefore, EAT = [EBIT – (kd)(Debt)](1 – tax rate)
Equity = Total Capital – Debt
EPS = [[EBIT – (kd)(Debt)](1 – tax rate)] ÷ Total
Capital – Debt
14
An Alternate Approach
Using the previous example everything is known
except Debt
If we set EPS to $2 we can solve for the value of
Debt
$23.7M - (.12)(Debt)(1 - .4)
$2 = [ $10]
$100.0M - Debt
Debt = $45,156,25 0
15
Financial Leverage and
Financial Risk
Financial leverage is a two-edged sword
Multiplies good results into great results
Multiples bad results into terrible results
16
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?
17
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
18
Figure 13.2: The Effect of
Leverage on Stock Price
19
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
20
The Target Capital Structure
21
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
22
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
% ∆ EPS Somewhat
DFL = or % ∆ EPS = DFL × % ∆ EBIT tedious
% ∆ EBIT
An easier method of calculating DFL is:
EBIT
DFL =
EBIT - Interest
23
The Degree of Financial Leverage
(DFL)—A Measurement—Example
Q: Selected income statement and capital information for the Moberly Manufacturing Company
follow ($000):
Capital
Revenue $5,580 Debt $1,000
Cost/expense 4,200 Equity 7,000
EBIT $1,380 Total $8,000
Example
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.
24
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 $1,000 $4,000
Equity 7,000 4,000
Total $8,000 $8,000
Example
Current Proposed
EBIT $1,380 $1,380
Interest (15% of debt) 150 600 If business conditions
EBT $1,230 $780 remain unchanged, a
Tax (@40%) 492 312 higher EPS will result
EAT $738 $468 with the addition of
EPS $1.054 $1.170 debt.
25
The Degree of Financial Leverage
(DFL)—A Measurement—Example
A: Next, calculate DFL:
$1,380
DFLCurrent = = 1.12
Example
$1,380 - $150
$1,380
DFLProposed = = 1.77
$1,380 - $600
EPS will be much more volatile under the proposed plan. EPS will
change by a factor of 1.77 vs. 1.12.
26
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
27
Figure 13.3: EBIT – EPS Analysis for ABC
Corporation
(from Table 13.1, Columns 1 and 2)
It is
important to
determine When examining the ABC
the Corporation you can see that
indifference the 50% Debt and No
point, which Leverage lines intersect. At
occurs when the point of intersection ABC
the two is indifferent between the two
plans offer plans. However, to the left of
the same the intersection the 50% Debt
EBIT. plan is preferable, but to the
right of the point the No
Leverage plan is preferable.
28
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
29
Breakeven Analysis
30
Breakeven Analysis
Breakeven Diagrams
Breakeven occurs at the intersection of
revenue and total cost
• Represents the level of sales at which revenue
equals cost
31
Figure 13.5: The Breakeven
Diagram
32
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
33
Breakeven Analysis—Example
34
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
35
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
Example
month?
36
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)
37
Figure 13.6: Breakeven Diagram at
High and Low Operating Leverage
38
The Effect of Operating
Leverage—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?
Example
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:
39
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
40
The Degree of Operating Leverage
(DOL)—A Measurement
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:
Example
210($10 - $7)
DOLQ=210 = = 21
210($10 - $7) - $600
DOL at 300 units is:
41
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
42
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
43
Figure 13.9: The Compounding Effect of
Operating Leverage and Financial Leverage
44
The Compounding Effect of Operating
and Financial Leverage—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:
DOL DFL
Example
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.
45
Capital Structure Theory
46
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 = V d + V e
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
47
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
annual interest paid to bondholders total annual dividend paid to stockholders
Vf = +
kd ke
which is equivalent to saying
Returns drive value Operating Income
Vf =
in an inverse ka
relationship.
48
Figure 13.10: Variation in Value and
Average Return with Capital Structure
49
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
50
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
51
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
52
Figure 13.11: The
Independence Hypothesis
53
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)
54
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
55
Table 13.4
Total payments to
investors are higher
for the leveraged
company.
56
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
57
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
corporate tax rate x B x kd
PV of tax shield = = TB
kd
58
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
59
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.
60
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
61
Figure 13.13: MM Theory with
Taxes and Bankruptcy Costs
62
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?
63
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
64