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Chapter 13 Capital Structure and Leverage

Learning Objectives

After reading this chapter, students should be able to:

Explain why capital structure policy involves a trade-off between risk and return, and list the four primary
factors that influence capital structure decisions.

Distinguish between a firm s business risk and its financial risk. Explain how operating leverage contributes to a firm s business risk and conduct a breakeven analysis,
complete with a breakeven chart.

Define financial leverage and explain its effect on expected !"E, expected E#$, and the risk borne by
stockholders.

%riefly explain what is meant by a firm s optimal capital structure. $pecify the effect of financial leverage on beta using the &amada e'uation, and transform this e'uation
to calculate a firm s unlevered beta, b(.

)llustrate through a graph the premiums for financial risk and business risk at different debt levels. *ist the assumptions under which +odigliani and +iller proved that a firm s value is unaffected by its
capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure.

*ist a number of factors or practical considerations firms generally consider when making capital
structure decisions.

%riefly explain the extent that capital structure varies across industries, individual firms in each industry,
and different countries.

Chapter 13: Capital Structure and Leverage

Learning Objectives

85

Lecture Suggestions
,his chapter is rather long, but it is also modular, hence sections can be omitted without loss of continuity. ,herefore, if you are experiencing a time crunch, you could skip selected sections. -hat we cover, and the way we cover it, can be seen by scanning the slides and )ntegrated .ase solution for .hapter /0, which appears at the end of this chapter solution. 1or other suggestions about the lecture, please see the 2*ecture $uggestions3 in .hapter 4, where we describe how we conduct our classes. DAYS O C!A"#$%: & O' 58 DAYS (5)*+inute periods,

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Lecture Suggestions

Chapter 13: Capital Structure and Leverage

Ans.ers to $nd*o/*Chapter 0uestions


13*1 "perating leverage is the extent to which fixed costs are used in a firm s operations. )f operating leverage is increased 5fixed costs are high6, then even a small decline in sales can lead to a large decline in profits and in its !"E. a2 ,he breakeven point will be lowered. b2 ,he effect on the breakeven point is indeterminant. An increase in fixed costs will increase the breakeven point. &owever, a lowering of the variable cost lowers the breakeven point. $o it s unclear which effect will have the greater impact. c2 ,he breakeven point will be increased because fixed costs have increased. d2 ,he breakeven point will be lowered. 13*3 )f sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. .onse'uently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are sub7ect to only moderate fluctuations, or relatively stable sales. An increase in the personal tax rate makes both stocks and bonds less attractive to investors because it raises the tax paid on dividend and interest income. .hanges in personal tax rates will have differing effects, depending on what portion of an investment s total return is expected in the form of interest or dividends versus capital gains. 1or example, a high personal tax rate has a greater impact on bondholders because more of their return will be taxed sooner at the new higher rate. An increase in the personal tax rate will cause some investors to shift from bonds to stocks because of the attractiveness of capital gains tax deferrals. ,his raises the cost of debt relative to e'uity. )n addition, a lower corporate tax rate reduces the advantage of debt by reducing the benefit of a corporation s interest deduction that discourages the use of debt. .onse'uently, the net result would be for firms to use more e'uity and less debt in their capital structures. a2 An increase in the corporate tax rate would encourage a firm to increase the amount of debt in its capital structure because a higher tax rate increases the interest deductibility feature of debt. b2 An increase in the personal tax rate would cause investors to shift from bonds to stocks due to the attractiveness of the deferral of capital gains taxes. ,his would raise the cost of debt relative to e'uity8 thus, firms would be encouraged to use less debt in their capital structures. c2 1irms whose assets are illi'uid and would have to be sold at 2fire sale3 prices should limit their use of debt financing. .onse'uently, this would discourage the firm from increasing the amount of debt in its capital structure. d2 )f changes to the bankruptcy code made bankruptcy less costly, then firms would tend to increase the amount of debt in their capital structures. e2 1irms whose earnings are more volatile and thus have higher business risk, all else e'ual, face a greater chance of bankruptcy and, therefore, should use less debt than more stable firms. 13*#harmaceutical companies use relatively little debt because their industries tend to be cyclical, oriented toward research, or sub7ect to huge product liability suits. (tility companies, on the other Answers and Solutions 83

13*1

13*&

13*5

Chapter 13: Capital Structure and Leverage

hand, use debt relatively heavily because their fixed assets make good security for mortgage bonds and also because their relatively stable sales make it safe to carry more than average debt. 13*3 E%), depends on sales and operating costs that generally are not affected by the firm s use of financial leverage, because interest is deducted from E%),. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financing difficulties. ,hus, financial leverage can influence sales and cost, hence E%),, if excessive leverage causes investors, customers, and employees to be concerned about the firm s future. Expected E#$ is generally measured as E#$ for the coming years, and we typically do not reflect in this calculation any bankruptcy-related costs. Also, E#$ does not reflect 5in a ma7or way6 the increase in risk and rs that accompanies an increase in the debt ratio, whereas # 9 does reflect these factors. ,hus, the stock price will be maximi:ed at a debt level that is lower than the E#$maximi:ing debt level. ,he tax benefits from debt increase linearly, which causes a continuous increase in the firm s value and stock price. &owever, bankruptcy-related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. $ee 1igure /0-; in the textbook. -ith increased competition after the breakup of A,<,, the new A,<, and the seven %ell operating companies business risk increased. -ith this component of total company risk increasing, the new companies probably decided to reduce their financial risk, and use less debt, to compensate. -ith increased competition the chance of bankruptcy increases and lowering debt usage makes this less of a possibility. )f we consider the tax issue alone, interest on debt is tax deductible8 thus, the higher the firm s tax rate the more beneficial the deductibility of interest is. &owever, competition and business risk have tended to outweigh the tax aspect as we can see from the actual debt ratios of the %ell companies. ,he firm may want to assess the asset investment and financing decisions 7ointly. 1or instance, the highly automated process would re'uire fancy, new e'uipment 5capital intensive6 so fixed costs would be high. A less automated production process, on the other hand, would be labor intensive, with high variable costs. )f sales fell, the process that demands more fixed costs might be detrimental to the firm if it has much debt financing. ,he less automated process, however, would allow the firm to lay off workers and reduce variable costs if sales dropped8 thus, debt financing would be more attractive. "perating leverage and financial leverage are interrelated. ,he highly automated process would increase the firm s operating leverage8 thus, its optimal capital structure would call for less debt. "n the other hand, the less automated process would call for less operating leverage8 thus, the firm s optimal capital structure would call for more debt.

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13*4

13*1)

13*11

88

Answers and Solutions

Chapter 13: Capital Structure and Leverage

Solutions to $nd*o/*Chapter "roble+s

13*1

=%E > =%E >

1 # ?

@B99,999 @A.99 @0.99 =%E > B99,999 units.

13*1

,he optimal capital structure is that capital structure where -A.. is minimi:ed and stock price is maximi:ed. %ecause Cackson s stock price is maximi:ed at a 09D debt ratio, the firm s optimal capital structure is 09D debt and E9D e'uity. ,his is also the debt level where the firm s -A.. is minimi:ed. a2 Expected E#$ for 1irm .: E5E#$.6 > 9./5-@4.A96 F 9.45@/.0B6 F 9.A5@B./96 F 9.45@;.;B6 F 9./5@/4.G96 > -@9.4A F @9.4E F @4.9A F @/.EE F @/.4G > @B./9. 5Hote that the table values and probabilities are dispersed in a symmetric manner such that the answer to this problem could have been obtained by simple inspection.6 b2 According to the standard deviations of E#$, 1irm % is the least risky, while . is the riskiest. &owever, this analysis does not consider portfolio effectsIif . s earnings increase when most other companies decline 5that is, its beta is low6, its apparent riskiness would be reduced. Also, standard deviation is related to si:e, or scale, and to correct for scale we could calculate a coefficient of variation 5Jmean6: A % . E5E#$6 @B./9 A.49 B./9 @0.G/ 4.KG A.// .? > JE5E#$6 9.E/ 9.E9 9.;/

13*3

%y this criterion, . is still the most risky. 13*& 1rom the &amada e'uation, b > b(L/ F 5/ M ,65DJE6N, we can calculate b( as b( > bJL/ F 5/ M ,65DJE6N. b( > /.4JL/ F 5/ M 9.A65@4,999,999J@;,999,9996N b( > /.4JL/ F 9./BN b( > /.9A0B.

Chapter 13: Capital Structure and Leverage

Answers and Solutions

84

13*5

a2 **: DJ,A > 09D. E%), )nterest 5@G,999,999 9./96 E%, ,ax 5A9D6 Het income @A,999,999 G99,999 @0,A99,999 /,0G9,999 @4,9A9,999

!eturn on e'uity > @4,9A9,999J@/A,999,999 > /A.GD. &*: DJ,A > B9D. E%), )nterest 5@/9,999,999 9./46 E%, ,ax 5A9D6 Het income @A,999,999 /,499,999 @4,;99,999 /,/49,999 @/,G;9,999

!eturn on e'uity > @/,G;9,999J@/9,999,999 > /G.;D. b2 **: DJ,A > G9D. E%), )nterest 5@/4,999,999 9./B6 E%, ,ax 5A9D6 Het income @A,999,999 /,;99,999 @4,499,999 ;;9,999 @/,049,999

!eturn on e'uity > @/,049,999J@;,999,999 > /G.BD. Although ** s return on e'uity is higher than it was at the 09D leverage ratio, it is lower than the /G.;D return of &*. )nitially, as leverage is increased, the return on e'uity also increases. %ut, the interest rate rises when leverage is increased. ,herefore, the return on e'uity will reach a maximum and then decline. 13*a2 $ales 1ixed costs ?ariable costs ,otal costs Oain 5loss6 b2 =%E > ;,999 units @499,999 /A9,999 /49,999 @4G9,999 5@ G9,9996 /;,999 units @AB9,999 /A9,999 4E9,999 @A/9,999 @ A9,999

@/A9,999 1 > > /A,999 units. @/9 # ?

$%E > =%E5#6 > 5/A,99965@4B6 > @0B9,999.

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Answers and Solutions

Chapter 13: Capital Structure and Leverage

Dollars ;99,999

G99,999

$ales .osts

A99,999

499,999 1ixed .osts 9 B /9 /B 49 (nits of "utput 5,housands6

c2 )f the selling price rises to @0/, while the variable cost per unit remains fixed, # M ? rises to @/G. ,he end result is that the breakeven point is lowered. =%E >
@/A9,999 1 > > ;,EB9 units. @/G # ?

$%E > =%E5#6 > 5;,EB965@0/6 > @4E/,4B9.


Dollars ;99,999 $ales G99,999 .osts A99,999

499,999 1ixed .osts (nits of "utput 5,housands6

/9

/B

49

,he breakeven point drops to ;,EB9 units. ,he contribution margin per each unit sold has been increased8 thus the variability in the firm s profit stream has been increased, but the opportunity for magnified profits has also been increased. d2 )f the selling price rises to @0/ and the variable cost per unit rises to @40, # M ? falls to @;. ,he end result is that the breakeven point increases. =%E >
@/A9,999 1 > > /E,B99 units. @; #- ?

$%E > =%E5#6 > 5/E,B9965@0/6 > @BA4,B99. ,he breakeven point increases to /E,B99 units because the contribution margin per each unit sold has decreased.

Chapter 13: Capital Structure and Leverage

Answers and Solutions

41

Dollars ;99,999 $ales .osts

G99,999

A99,999

499,999 1ixed .osts (nits of "utput 5,housands6

/9

/B

49

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Ho leverage: Debt > 98 E'uity > @/A,999,999. $tat e / 4 0 #s 9.4 9.B 9.0 E%), @A,499,999 4,;99,999 E99,999 5E%), M rdD65/ M ,6 @4,B49,999 /,G;9,999 A49,999 !"E$ 9./; 9./4 9.90 !PE > #$5!"E6 #$5!"E$ M !PE64 9.99//0 9.999// 9.99/GK 9.994K0 9.9BA

9.90G 9.9G9 9.99K 9./9B ?ariance > $tandard deviation >

!PE > /9.BD. 4 > 9.994K0. > B.AD. .? > J!PE > B.ADJ/9.BD > 9.B/A. *everage ratio > /9D: Debt > @/,A99,9998 E'uity > @/4,G99,9998 rd > KD. $tat e / 4 0 #s 9.4 9.B 9.0 E%), @A,499,999 4,;99,999 E99,999 5E%), M rdD65/ M ,6 @4,AAA,A99 /,G9A,A99 0AA,A99 !"E$ 9./KA 9./4E 9.94E !PE > #$5!"E6 #$5!"E$ M !PE64 9.99/0; 9.999/0 9.994/4 9.990G0 9.9G9

9.90K 9.9GA 9.99; 9./// ?ariance > $tandard deviation >

!PE > //./D. 4 > 9.990G0. > GD. .? > GDJ//./D > 9.BA/. 41 Answers and Solutions Chapter 13: Capital Structure and Leverage

*everage ratio > B9D: Debt > @E,999,9998 E'uity > @E,999,9998 rd > //D. $tat e / 4 0 #s 9.4 9.B 9.0 E%), @A,499,999 4,;99,999 E99,999 5E%), M rdD65/ M ,6 @4,9B;,999 /,4/;,999 5A4,9996 !"E$ 9.4KA 9./EA 59.99G6 !PE > #$5!"E6 #$5!"E$ M !PE64 9.99AB9 9.999AB 9.99GEB 9.9//E9 9./9;

9.9BK 9.9;E 59.9946 9./AA ?ariance > $tandard deviation >

!PE > /A.AD. 4 > 9.9//E9. > /9.;D. .? > /9.;DJ/A.AD > 9.EB9. *everage ratio > G9D: D > @;,A99,9998 E > @B,G99,9998 rd > /AD. $tat e / 4 0 #s 9.4 9.B 9.0 E%), @A,499,999 4,;99,999 E99,999 5E%), M rdD65/ M ,6 @/,;/A,A99 KEA,A99 54;B,G996 !"E$ 9.04A 9./EA 59.9B/6 !PE > #$5!"E6 #$5!"E$ M !PE64 9.99GKK 9.999G; 9.9/9G9 9.9/;4E 9./0B

9.9GB 9.9;E 59.9/B6 9./0E ?ariance > $tandard deviation >

!PE > /0.ED. 4 > 9.9/;4E. > /0.BD. .? > /0.BDJ/0.ED > 9.K;B 9.KK. As leverage increases, the expected return on e'uity rises up to a point. %ut as the risk increases with increased leverage, the cost of debt rises. $o after the return on e'uity peaks, it then begins to fall. As leverage increases, the measures of risk 5both the standard deviation and the coefficient of variation of the return on e'uity6 rise with each increase in leverage. 13*8 1acts as given: .urrent capital structure: 4BD debt, EBD e'uity8 r !1 > BD8 r+ M r!1 > GD8 , > A9D8 rs > /AD. $tep /: Determine the firm s current beta. rs > r!1 F 5r+ M r!16b /AD > BD F 5GD6b KD > GDb Chapter 13: Capital Structure and Leverage Answers and Solutions 43

/.B > b. $tep 4: Determine the firm s unlevered beta, b(. b( > b*JL/ F 5/ M ,65DJE6N > /.BJL/ F 5/ M 9.A659.4BJ9.EB6N > /.BJ/.49 > /.4B. $tep 0: Determine the firm s beta under the new capital structure. b* > b(L/ F 5/ M ,65DJE6N > /.4BL/ F 5/ M 9.A659.BJ9.B6N > /.4B5/.G6 > 4. $tep A: Determine the firm s new cost of e'uity under the changed capital structure. rs > r!1 F 5r+ M r!16b > BD F 5GD64 > /ED. 13*4 a2 ,he current dividend per share, D9, > @A99,999J499,999 > @4.99. D/ > @4.995/.9B6 > @4./9. ,herefore, #9 > D/J5rs M g6 > @4./9J59./0A M 9.9B6 > @4B.99. b2 $tep /: .alculate E%), before the recapitali:ation: E%), > @/,999,999J5/ M ,6 > @/,999,999J9.G > @/,GGG,GGE. Hote: ,he firm is /99D e'uity financed, so there is no interest expense. $tep 4: .alculate net income after the recapitali:ation: L@/,GGG,GGE M 9.//5@/,999,9996N9.G > @K0A,999. $tep 0: .alculate the number of shares outstanding after the recapitali:ation: 499,999 M 5@/,999,999J@4B6 > /G9,999 shares. $tep A: .alculate D/ after the recapitali:ation: D9 > 9.A5@K0A,999J/G9,9996 > @4.00B. D/ > @4.00B5/.9B6 > @4.AB/EB. $tep B: .alculate #9 after the recapitali:ation: #9 > D/J5rs M g6 > @4.AB/EBJ59./AB M 9.9B6 > @4B.;9EK @4B.;/. 13*1) a2 1irm A /. 1ixed costs > @;9,999.

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Answers and Solutions

Chapter 13: Capital Structure and Leverage

4. ?ariable costJunit >

%reakeven sales 1ixed costs %reakeven units


>

@499,999 @;9,999 @/49,999 > > @A.;9 Junit . 4B,999 4B,999

0. $elling priceJunit >

%reakevensales @499,999 > > @;.99 Junit . %reakevenunits 4B,999

1irm % /. 1ixed costs > @/49,999. 4. ?ariable costJunit > >

%reakeven sales 1ixed costs %reakeven units


@4A9,999 @/49,999 09,999

> @A.99Junit.

0. $elling priceJunit >

@4A9,999 %reakeven sales > > @;.99Junit. 09,999 %reakeven units

b2 1irm % has the higher operating leverage due to its larger amount of fixed costs. c2 "perating profit > 5$elling price65(nits sold6 M 1ixed costs M 5?ariable costsJunit65(nits sold6. 1irm A s operating profit > @;Q M @;9,999 M @A.;9Q. 1irm % s operating profit > @;Q M @/49,999 M @A.99Q. $et the two e'uations e'ual to each other: @;Q M @;9,999 M @A.;9Q > @;Q M @/49,999 M @A.99Q -@9.;Q > -@A9,999 Q > @A9,999J@9.;9 > B9,999 units. $ales level > 5$elling price65(nits6 > @;5B9,9996 > @A99,999. At this sales level, both firms earn @;9,999: #rofitA > @;5B9,9996 M @;9,999 M @A.;95B9,9996 > @A99,999 M @;9,999 M @4A9,999 > @;9,999. #rofit% > @;5B9,9996 M @/49,999 M @A.995B9,9996 > @A99,999 M @/49,999 M @499,999 > @;9,999. 13*11 a2 (sing the standard formula for the weighted average cost of capital, we find: -A.. > wdrd5/ M ,6 F wcrs Chapter 13: Capital Structure and Leverage Answers and Solutions 45

> 59.465;D65/ M 9.A6 F 59.;65/4.BD6 > /9.KGD. b2 ,he firmRs current levered beta at 49D debt can be found using the .A#+ formula. rs > r!1 F 5r+ M r!16b /4.BD > BD F 5GD6b b > /.4B. c2 ,o 2unlever3 the firmRs beta, the &amada e'uation is used. b* /.4B /.4B b( > b(L/ F 5/ M ,65DJE6N > b(L/ F 5/ M 9.A659.4J9.;6N > b(5/./B6 > /.9;GKBE.

d2 ,o determine the firm s new cost of common e'uity, one must find the firm s new beta under its new capital structure. .onse'uently, you must 2relever3 the firmRs beta using the &amada e'uation: b*,A9D b*,A9D b*,A9D b( > b(L/ F 5/ M ,65DJE6N > /.9;GKBE L/ F 5/ M 9.A659.AJ9.G6N > /.9;GKBE5/.A6 > /.B4/E0K.

,he firmRs cost of e'uity, as stated in the problem, is derived using the .A#+ e'uation. rs > r!1 F 5r+ M r!16b rs > BD F 5GD6/.B4/E0K rs > /A./0D. e2 Again, the standard formula for the weighted average cost of capital is used. !emember, the -A.. is a marginal, after-tax cost of capital and hence the relevant before-tax cost of debt is now K.BD and the cost of e'uity is /A./0D. -A.. > wdrd5/ M ,6 F wcrs > 59.A65K.BD65/ M 9.A6 F 59.G65/A./0D6 > /9.EGD. /2 ,he firm should be advised to proceed with the recapitali:ation as it causes the -A.. to decrease from /9.KGD to /9.EGD. As a result, the recapitali:ation would lead to an increase in firm value.

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a2 -ithout new investment: $ales ?. 1. E%), )nterest E%, ,ax 5A9D6 Het income @/4,KG9,999 /9,499,999 /,BG9,999 @ /,499,999 0;A,999S @ ;/G,999 04G,A99 @ A;K,G99

S)nterest > 9.9;5@A,;99,9996 > @0;A,999.

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Answers and Solutions

Chapter 13: Capital Structure and Leverage

/. E#$"ld > @A;K,G99J4A9,999 > @4.9A. -ith new investment: $ales ?. 59.;65@/9,499,9996 1. E%), )nterest E%, ,ax 5A9D6 Het income Debt @/4,KG9,999 ;,/G9,999 /,;99,999 @ 0,999,999 /,/9A,999SS @ /,;KG,999 EB;,A99 @ /,/0E,G99 $tock @/4,KG9,999 ;,/G9,999 /,;99,999 @ 0,999,999 0;A,999 @ 4,G/G,999 /,9AG,A99 @ /,BGK,G99

SS)nterest > 9.9;5@A,;99,9996 F 9./95@E,499,9996 > @/,/9A,999. 4. E#$D > @/,/0E,G99J4A9,999 > @A.EA. 0. E#$$ > @/,BGK,G99JA;9,999 > @0.4E. E#$ should improve, but expected E#$ is significantly higher if financial leverage is used. b2 E#$

5$ales ?. 1 )65/ ,6 H 5#= ?= 1 )65/ ,6 > . H


>

E#$Debt >

5@4;.; = @/;./00 = @/,;99,999 @/,/9A,999659.G6 4A9,999 5@/9.GGE = @4,K9A,999659.G6 > . 4A9,999 5@/9.GGE = @4,/;A,999659.G6 . A;9,999

E#$$tock > ,herefore,

5@/9.GGE = @4,/;A,999659.G6 5/9.GGE = @4,K9A,999659.G6 > A;9,999 4A9,999 @/9.GGE= > @0,G4A,999 = > 00K,EB9 units.
,his is the 2indifference3 sales level, where E#$debt > E#$stock. c2 E#$"ld >

5@4;.; = @44.GGE = @/,BG9,999 @0;A,99965 9.G6 >9 4A9,999 @G./00= > @/,KAA,999 = > 0/G,KBE units.

,his is the =%E considering interest charges.

Chapter 13: Capital Structure and Leverage

Answers and Solutions

43

E#$Hew,Debt >

5@4;.; = @/;./00 = @4,K9A,999659.G6 >9 4A9,999 @/9.GGE= > @4,K9A,999 = > 4E4,4B9 units. 5@ /9.GGE = @4,/;A,999659. G6 >9 A;9,999 @/9.GGE= > @4,/;A,999 = > 49A,EB9 units.

E#$Hew,$tock >

d2 At the expected sales level, AB9,999 units, we have these E#$ values: E#$"ld $etup > @4.9A. E#$Hew,Debt > @A.EA. E#$Hew,$tock > @0.4E. -e are given that operating leverage is lower under the new setup. Accordingly, this suggests that the new production setup is less risky than the old oneIvariable costs drop very sharply, while fixed costs rise less, so the firm has lower costs at 2reasonable3 sales levels. )n view of both risk and profit considerations, the new production setup seems better. ,herefore, the 'uestion that remains is how to finance the investment. ,he indifference sales level, where E#$ debt > E#$stock, is 00K,EB9 units. ,his is well below the AB9,999 expected sales level. )f sales fall as low as 4B9,999 units, these E#$ figures would result: E#$Debt >

L@4;.;54B 9,9996 @/;./0054B9,9996 @4,K9A,999N59.G6 > -@9.BK. 4A9,999 L@4;.;54B 9,9996 @/;./0054B9,9996 @4,/;A,999N59.G6 > @9.G9. A;9,999

E#$$tock >

,hese calculations assume that # and ? remain constant, and that the company can obtain tax credits on losses. "f course, if sales rose above the expected AB9,999 level, E#$ would soar if the firm used debt financing. )n the 2real world3 we would have more information on which to base the decisionIcoverage ratios of other companies in the industry and better estimates of the likely range of unit sales. "n the basis of the information at hand, we would probably use e'uity financing, but the decision is really not obvious.

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Answers and Solutions

Chapter 13: Capital Structure and Leverage

13*13

(se of debt 5millions of dollars6: #robability $ales E%), 5/9D6 )nterestS E%, ,axes 5A9D6 Het income Earnings per share 549 million shares6 9.0 @4,4B9.9 44B.9 EE.A @ /AE.G BK.9 @ ;;.G @A.A0 9.A @4,E99.9 4E9.9 EE.A @ /K4.G EE.9 @ //B.G @B.E; 9.0 @0,/B9.9 0/B.9 EE.A @ 40E.G KB.9 @ /A4.G @E./0

S)nterest on debt > 5@4E9 9./46 F .urrent interest expense > @04.A F @AB > @EE.A. Expected E#$ > 59.0965@A.A06 F 59.A965@B.E;6 F 59.0965@E./06 > @B.E; if debt is used. 4Debt > 59.0965@A.A0 M @B.E;64 F 59.A965@B.E; M @B.E;64 F 59.0965@E./0 M @B.E;64 > /.9KA. $tandard deviation of E#$ if debt financing is used: Debt > .? >
/.9KA > @/.9B.

@/.9B > 9./;. @B.E; @4E9 E5E%),6 > > 0.AK. @EE.A )

E5,)EDebt6 >

DebtJAssets > 5@GB4.B9 F @099 F @4E96J5@/,0B9 F @4E96 > EB.BD. (se of stock 5millions of dollars6: #robability $ales E%), )nterest E%, ,axes 5A9D6 Het income Earnings per share 54A.B million shares6S 9.0 @4,4B9.9 44B.9 AB.9 @ /;9.9 E4.9 @ /9;.9 @A.A/ 9.A @4,E99.9 4E9.9 AB.9 @ 44B.9 K9.9 @ /0B.9 @B.B/ 9.0 @0,/B9.9 0/B.9 AB.9 @ 4E9.9 /9;.9 @ /G4.9 @G.G/

SHumber of shares > 5@4E9 millionJ@G96 F 49 million > A.B million F 49 million > 4A.B million. E#$E'uity > 59.0965@A.A/6 F 59.A965@B.B/6 F 59.0965@G.G/6 > @B.B/. 4E'uity > 59.0965@A.A/ M @B.B/64 F 59.A965@B.B/ M @B.B/64 F 59.0965@G.G/ M @B.B/64 > 9.E4G9. E'uity >
9.E4G9 > @9.;B.

Chapter 13: Capital Structure and Leverage

Answers and Solutions

44

.? >

@9.;B > 9./B. @B.B/ @4E9 > G.99. @AB

E5,)E$tock6 >

@GB4.B9 F @099 Debt > > B;.;D. @/,0B9 F @4E9 Assets

(nder debt financing the expected E#$ is @B.E;, the standard deviation is @/.9B, the .? is 9./;, and the debt ratio increases to EB.BD. 5,he debt ratio had been E9.GD.6 (nder e'uity financing the expected E#$ is @B.B/, the standard deviation is @9.;B, the .? is 9./B, and the debt ratio decreases to B;.;D. At this interest rate, debt financing provides a higher expected E#$ than e'uity financing8 however, the debt ratio is significantly higher under the debt financing situation as compared with the e'uity financing situation. %ecause E#$ is not significantly greater under debt financing compared to e'uity financing, while the risk is noticeably greater, e'uity financing should be recommended.

1))

Answers and Solutions

Chapter 13: Capital Structure and Leverage

Co+prehensive5Spreadsheet "roble+
Note to Instructors: #he solution to this proble+ is not provided to students at the bac6 o/ their te7t2 8nstructors can access the Excel /ile on the te7tboo69s :eb site or the 8nstructor9s %esource CD2 13*1& ,ax rate > A9D8 r!1 > B.9D8 b( > /.48 r+ M r!1 > G.9D 1rom data given in the problem and table we can develop the following table: DJA 9.99 9.49 9.A9 9.G9 9.;9 EJA /.99 9.;9 9.G9 9.A9 9.49 DJE 9.9999 9.4B99 9.GGGE /.B999 A.9999 rd E.99D ;.99 /9.99 /4.99 /B.99 rd5/ M ,6 A.49D A.;9 G.99 E.49 K.99 *everaged betaa /.49 /.0; /.G; 4.4; A.9; rsb /4.49D /0.4; /B.9; /;.G; 4K.A; -A..c /4.49D //.B; //.AB //.EK /0./9

Hotes: a ,hese beta estimates were calculated using the &amada e'uation, b* > b(L/ F 5/ M ,65DJE6N. b ,hese rs estimates were calculated using the .A#+, rs > r!1 F 5r+ M r!16b. c ,hese -A.. estimates were calculated with the following e'uation: -A.. > wd5rd65/ M ,6 F 5wc65rs6. a2 ,he firm s optimal capital structure is that capital structure which minimi:es the firm s -A... Elliott s -A.. is minimi:ed at a capital structure consisting of A9D debt and G9D e'uity. At that capital structure, the firm s -A.. is //.ABD. b2 )f the firm s business risk increased, the firm s target capital structure would consist of less debt and more e'uity. c2 )f .ongress dramatically increases the corporate tax rate, then the tax deductibility of interest would be greater. ,his should lead to an increase in the firm s use of debt in its capital structure. d2
35% 30% 25% 20% 15% 10% 5% 0% 35% 0% 30% 25% 20%
A-T Cost of Debt (rd) Cost of Equity Cost of WACC A-T Cost of Debt (rd) Cost of Equity Cost of WACC

Capital Costs Vs. D/A

Capital Cost Vs. D/E


20% 40% 60% 80% 100%

Chapter 13: Capital Structure and Leverage 10%


5% 0% 0.00 1.00 2.00

15%

Comprehensive Spreadsheet !roblem

1)1

3.00

4.00

,he top graph is like the one in the textbook, because it uses the DJA ratio on the hori:ontal axis. ,he bottom graph is a bit like ++ showed in their original article in that the cost of e'uity is linear and the -A.. does not turn up sharply. )t is not exactly like ++ because it uses DJA rather than DJ?, and also because ++ assumed that rd is constant whereas we assume the cost of debt rises with leverage. Hote too that the minimum -A.. is at the DJA and DJE levels indicated in the table, and also that the -A.. curve is very flat over a broad range of debt ratios, indicating that -A.. is not sensitive to debt over a broad range. ,his is important, as it demonstrates that management can use a lot of discretion as to its capital structure, and that it is "T to alter the debt ratio to take advantage of market conditions in the debt and e'uity markets, and to increase the debt ratio if many good investment opportunities are available.

1)1

Comprehensive Spreadsheet !roblem

Chapter 13: Capital Structure and Leverage

8ntegrated Case
13*15

Ca+pus Deli 8nc2 Optimal Capital Structure


Assu+e that ;ou have just been hired as business +anager o/ Ca+pus Deli (CD,< .hich is located adjacent to the ca+pus2 Sales .ere =1<1))<))) last ;ear> variable costs .ere -)? o/ sales> and /i7ed costs .ere =&)<)))2 #here/ore< $@8# totaled =&))<)))2 @ecause the universit;9s enroll+ent is capped< $@8# is e7pected to be constant over ti+e2 @ecause no e7pansion capital is reAuired< CD pa;s out all earnings as dividends2 Assets are =1 +illion< and 8)<))) shares are outstanding2 #he +anage+ent group o.ns about 5)? o/ the stoc6< .hich is traded in the over* the*counter +ar6et2 CD currentl; has no debtBit is an all*eAuit; /ir+Band its 8)<))) shares outstanding sell at a price o/ =15 per share< .hich is also the boo6 value2 #he /ir+9s /ederal*plus*state ta7 rate is &)?2 On the basis o/ state+ents +ade in ;our /inance te7t< ;ou believe that CD9s shareholders .ould be better o// i/ so+e debt /inancing .ere used2 :hen ;ou suggested this to ;our ne. boss< she encouraged ;ou to pursue the idea< but to provide support /or the suggestion2 8n toda;9s +ar6et< the ris6*/ree rate< r%'< is -? and the +ar6et ris6 pre+iu+< rC D r%'< is -?2 CD9s unlevered beta< bE< is 12)2 CD currentl; has no debt< so its cost o/ eAuit; (and :ACC, is 11?2 8/ the /ir+ .ere recapitaliFed< debt .ould be issued< and the borro.ed /unds .ould be used to repurchase stoc62 Stoc6holders< in turn< .ould use /unds provided b; the repurchase to bu; eAuities in other /ast*/ood co+panies si+ilar to CD2 You plan to co+plete ;our report b; as6ing and then ans.ering the /ollo.ing Auestions2 A2 (1, :hat is business ris6G :hat /actors in/luence a /ir+9s business ris6G

Chapter 13: Capital Structure and Leverage

Integrated Case

1)3

Ans.er:

HSho. S13*1 through S13*3 here2I

@usiness ris6 is the ris6iness

inherent in the /ir+9s operations i/ it uses no debt2 A /ir+9s business ris6 is a//ected b; +an; /actors< including these: (1, variabilit; in the de+and /or its output< (1, variabilit; in the price at .hich its output can be sold< (3, variabilit; in the prices o/ its inputs< (&, the /ir+9s abilit; to adjust output prices as input prices change< (5, the a+ount o/ operating leverage used b; the /ir+< and (-, special ris6 /actors (such as potential product liabilit; /or a drug co+pan; or the potential cost o/ a nuclear accident /or a utilit; .ith nuclear plants,2 A2 (1, :hat is operating leverage< and ho. does it a//ect a /ir+9s business ris6G HSho. S13*& through S13*- here2I Operating leverage is the e7tent to .hich /i7ed costs are used in a /ir+9s operations2 8/ a high percentage o/ the /ir+9s total costs are /i7ed< and hence do not decline .hen de+and /alls< then the /ir+ is said to have high operating leverage2 Other things held constant< the greater a /ir+9s operating leverage< the greater its business ris62 @2 (1, :hat is +eant b; the ter+s J/inancial leverageK and J/inancial ris6KG

Ans.er:

Ans.er:

HSho. S13*3 here2I 'inancial leverage re/ers to the /ir+9s decision to /inance .ith /i7ed*inco+e securities< such as debt and pre/erred stoc62 'inancial ris6 is the additional ris6< over and above the co+pan;9s inherent business ris6< borne b; the stoc6holders as a result o/ the /ir+9s decision to /inance .ith debt2

@2

(1,

!o. does /inancial ris6 di//er /ro+ business ris6G HSho. S13*8 here2I As .e discussed above< business ris6 depends on a nu+ber o/ /actors such as sales and cost variabilit;< and operating

Ans.er:

1)&

Integrated Case

Chapter 13: Capital Structure and Leverage

leverage2 'inancial ris6< on the other hand< depends on onl; one /actor Bthe a+ount o/ /i7ed*inco+e capital the co+pan; uses2 C2 o.< to develop an e7a+ple that can be presented to CD9s +anage+ent as an illustration< consider t.o h;pothetical /ir+s< 'ir+ E< .ith Fero debt /inancing< and 'ir+ L< .ith =1)<))) o/ 11? debt2 @oth /ir+s have =1)<))) in total assets and a &)? /ederal*plus*state ta7 rate< and the; have the /ollo.ing $@8# probabilit; distribution /or ne7t ;ear: "robabilit; )215 )25) )215 (1, $@8# =1<))) 3<))) &<)))

Co+plete the partial inco+e state+ents and the /ir+s9 ratios in #able 8C 13*12

Chapter 13: Capital Structure and Leverage

Integrated Case

1)5

#able 8C 13*12 8nco+e State+ents and %atios Assets $Auit; "robabilit; Sales Oper2 costs $@8# 8nt2 (11?, $@# #a7es (&)?, et inco+e @$" %O$ #8$ 323 $(@$", $(%O$, $(#8$, @$" %O$ #8$ =1)<))) =1)<))) )215 = -<))) &<))) = 1<))) ) = 1<))) 8)) = 1<1)) 1)2)? -2)? 'ir+ E =1)<))) =1)<))) )25) = 4<))) -<))) = 3<))) ) = 3<))) 1<1)) = 1<8)) 152)? 42)? 152)? 42)? 325? 121? ) =1)<))) =1)<))) )215 =11<))) 8<))) = &<))) ) = &<))) 1<-)) = 1<&)) 1)2)? 112)? =1)<))) =1)<))) )215 = -<))) &<))) = 1<))) 1<1)) = 8)) 31) = &8) 1)2)? &28? 123 'ir+ L =1)<))) =1)<))) )25) = 4<))) -<))) = 3<))) = = ? ? =1)<))) =1)<))) )215 =11<))) 8<))) = &<))) 1<1)) = 1<8)) 1<11) = 1<-8) 1)2)? 1-28?

? 1)28? 125 ? &21? )2-

1)-

Integrated Case

Chapter 13: Capital Structure and Leverage

Ans.er:

HSho. S13*4 through S13*11 here2I state+ents:

!ere are the /ull; co+pleted

Assets $Auit; "robabilit; $@8# 8nt2 (11?, $@# #a7es (&)?, et inco+e @$" %O$ #8$ 323 $(@$", $(%O$, $(#8$, @$" %O$ #8$ C2 (1,

=1)<))) =1)<))) )215 = 1<))) ) = 1<))) 8)) = 1<1)) 1)2)? -2)?

'ir+ E =1)<))) =1)<))) )25) = 3<))) ) = 3<))) 1<1)) = 1<8)) 152)? 42)? 152)? 42)? 325? 121? )

=1)<))) =1)<))) )215 = &<))) ) = &<))) 1<-)) = 1<&)) 1)2)? 112)?

=1)<))) =1)<))) )215 = 1<))) 1<1)) = 8)) 31) = &8)

'ir+ L =1)<))) =1)<))) )25) = 3<))) 1<1)) = 1<8)) 31) = 1<)8)

=1)<))) =1)<))) )215 = &<))) 1<1)) = 1<8)) 1<11) = 1<-8)

1)2)?152)?1)2)? &28?1)28?1-28? 123 152)? 1)28? 125 325? &21? )2-

@e prepared to discuss each entr; in the table and to e7plain ho. this e7a+ple illustrates the e//ect o/ /inancial leverage on e7pected rate o/ return and ris62

Ans.er:

HSho. S13*13 through S13*15 here2I Conclusions /ro+ the anal;sis: 12 #he /ir+9s basic earning po.er< @$" L $@8#5#otal assets< is una//ected b; /inancial leverage2 12 'ir+ L has the higher e7pected %O$: $(%O$E, L )215(-2)?, M )25)(42)?, M )215(112)?, L 42)?2

Chapter 13: Capital Structure and Leverage

Integrated Case

1)3

$(%O$L, L )215(&28?, M )25)(1)28?, M )215(1-28?, L 1)28?2 #here/ore< the use o/ /inancial leverage has increased the e7pected pro/itabilit; to shareholders2 #a7 savings cause the higher :ith a higher r d< interest e7pected %O$L2 (8/ the /ir+ uses debt< the stoc6 is ris6ier< .hich then causes rd and rs to increase2 increases< so the interest ta7 savings increases2, 32 'ir+ L has a .ider range o/ %O$s< and a higher standard deviation o/ %O$< indicating that its higher e7pected return is acco+panied b; higher ris62 #o be precise: %O$ (Enlevered, L 1211?< and CN L )21&2 %O$ (Levered, L &21&?< and CN L )2342 #hus< in a stand*alone ris6 sense< 'ir+ L is t.ice as ris6; as 'ir+ EBits business ris6 is 1211?< but its stand*alone ris6 is &21&?< so its /inancial ris6 is &21&? D 1211? L 1211?2 &2 :hen $@8# L =1<)))< %O$E O %O$L< and leverage has a negative i+pact on pro/itabilit;2 !o.ever< at the e7pected level o/ $@8#< %O$L O %O$E2 52 Leverage .ill al.a;s boost e7pected %O$ i/ the e7pected unlevered %OA e7ceeds the a/ter*ta7 cost o/ debt2 !ere $(%OA, L $(Enlevered %O$, L 42)? O rd(1 D #, L 11?()2-, L 321?< so the use o/ debt raises e7pected %O$2 -2 'inall;< note that the #8$ ratio is huge (unde/ined< or in/initel; large, i/ no debt is used< but it is relativel; lo. i/ 5)? debt is used2 #he e7pected #8$ .ould be larger than 125 i/ less debt .ere used< but s+aller i/ leverage .ere increased2

1)8

Integrated Case

Chapter 13: Capital Structure and Leverage

D2

A/ter spea6ing .ith a local invest+ent ban6er< ;ou obtain the /ollo.ing esti+ates o/ the cost o/ debt at di//erent debt levels (in thousands o/ dollars,: A+ount @orro.ed = ) 15) 5)) 35) 1<))) Debt5Assets %atio )2))) )2115 )215) )2335 )25)) Debt5$Auit; %atio )2)))) )21&14 )23333 )2-))) 12)))) @ond %ating B AA A @@@ @@ rd B 82)? 42) 1125 1&2)

o. consider the opti+al capital structure /or CD2 (1, #o begin< de/ine the ter+s Jopti+al capital structureK and Jtarget capital structure2K Ans.er: HSho. S13*1- here2I #he opti+al capital structure is the capital

structure at .hich the ta7*related bene/its o/ leverage are e7actl; o//set b; debt9s ris6*related costs2 At the opti+al capital structure< (1, the total value o/ the /ir+ is +a7i+iFed< (1, the :ACC is +ini+iFed< and the price per share is +a7i+iFed2 #he target capital structure is the +i7 o/ debt< pre/erred stoc6< and co++on eAuit; .ith .hich the /ir+ plans to raise capital2 D2 (1, :h; does CD9s bond rating and cost o/ debt depend on the a+ount o/ +one; borro.edG Ans.er: 'inancial ris6 is the additional ris6 placed on the co++on stoc6holders as a result o/ the decision to /inance .ith debt2 Conceptuall;< stoc6holders /ace a certain a+ount o/ ris6 that is inherent in a /ir+9s operations2 8/ a /ir+ uses debt (/inancial leverage,< this concentrates the business ris6 on co++on stoc6holders2

Chapter 13: Capital Structure and Leverage

Integrated Case

1)4

'inancing .ith debt increases the e7pected rate o/ return /or an invest+ent< but leverage also increases the probabilit; o/ a large loss< thus increasing the ris6 borne b; stoc6holders2 As the a+ount o/ +one; borro.ed increases< the /ir+ increases its ris6 so the /ir+9s bond rating decreases and its cost o/ debt increases2 D2 (3, Assu+e that shares could be repurchased at the current +ar6et price o/ =15 per share2 Calculate CD9s e7pected $"S and #8$ at debt levels o/ =)< =15)<)))< =5))<)))< =35)<)))< and =1<)))<)))2 !o. +an; shares .ould re+ain a/ter recapitaliFation under each scenarioG Ans.er: HSho. S13*13 through S13*15 here2I #he anal;sis /or the debt levels being considered (in thousands o/ dollars and shares, is sho.n belo.: At D L =): $"S L
H $@8# rd ( D ,I( 1 # , = & ))<)))()2- , L L =32))2 8 )<))) Shares outstandin g

#8$ L At D L =15)<))):

$@8# 8nterest

L 2

Shares repurchased L =15)<)))5=15 L 1)<)))2 %e+aining shares outstanding L 8)<))) D 1)<))) L 3)<)))2 ( ote: $"S and #8$ calculations are in thousands o/ dollars2, $"S L
H= & )) )2 )8 (=15),I()2 -, L =321-2 3)

#8$ L =1 ) L 1) 2 At D L =5))<))): Shares repurchased L =5))<)))5=15 L 1)<)))2

= & ))

11)

Integrated Case

Chapter 13: Capital Structure and Leverage

%e+aining shares outstanding L 8)<))) D 1)<))) L -)<)))2 ( ote: $"S and #8$ calculations are in thousands o/ dollars2, $"S L
H= & )) )2 )4 (=5)),I()2 -, L =32552 -)

#8$ L = & 5 L 824 2 At D L =35)<))): Shares repurchased L =35)<)))5=15 L 3)<)))2 %e+aining shares outstanding L 8)<))) D 3)<))) L 5)<)))2 ( ote: $"S and #8$ calculations are in thousands o/ dollars2, $"S L
H= & )) )21 15 (=35),I()2 -), L =32332 5)

= & ))

#ie L = 8- 2 1 5 L &2- 2 At D L =1<)))<))): Shares repurchased L =1<)))<)))5=15 L &)<)))2 %e+aining shares outstanding L 8)<))) D &)<))) L &)<)))2 ( ote: $"S and #8$ calculations are in thousands o/ dollars2, $"S L
H= & )) )21 & (=1<))),I( )2-), L =324)2 &)

= & ))

#8$ L =1 & ) L 124 2 D2 (&, Esing the !a+ada eAuation< .hat is the cost o/ eAuit; i/ CD recapitaliFes .ith =15)<))) o/ debtG =5))<)))G =35)<)))G =1<)))<)))G Ans.er: HSho. S13*1- through S13*3) here2I

= & ))

Chapter 13: Capital Structure and Leverage

Integrated Case

111

r%' L -2)? bE L 12) #a7 rate L &)2)? A+ount @orro.eda = ) 15) 5)) 35) 1<))) otes:
a b c

rC D r%' L -2)? #otal assets L =1<))) Debt5$Auit; %atioc )2))? 1&214 33233 -)2)) 1))2)) Levered @etad 12)) 12)4 121) 12312-)

Debt5Assets %atiob )2))? 1125) 152)) 3325) 5)2))

rse 112))? 11251 1321) 1&21152-)

Data given in proble+2 Calculated as a+ount borro.ed divided b; total assets2 Calculated as a+ount borro.ed divided b; eAuit; (total assets less Calculated using the !a+ada eAuation< bL L bEH1 M (1 D #,(D5$,I2 Calculated using the CA"C< rs L r%' M (rC D r%',b< given the ris6*/ree

a+ount borro.ed,2
d e

rate< the +ar6et ris6 pre+iu+< and using the levered beta as calculated .ith the !a+ada eAuation2 D2 (5, Considering onl; the levels o/ debt discussed< .hat is the capital structure that +ini+iFes CD9s :ACCG Ans.er: HSho. S13*31 and S13*31 here2I r%' L -2)? bE L 12) #a7 rate L &)2)?
A+ount @orro.eda Debt5Assets %atiob $Auit;5Assets %atioc Debt5$Auit; %atiod Levered @etae

rC D r%' L -2)? #otal assets L =1<)))

rs/

rda

rd(1 D #,

:ACCg

) 15) 5)) 35)

)2))? 1125) 152)) 3325) 5)2))

1))2))? 8325) 352)) -125) 5)2))

)2))? 1&214 33233 -)2)) 1))2))

12)) 12)4 121) 12312-)

112))? 11251 1321) 1&21152-)

)2)? 82) 42) 1125 1&2)

)2)? &28 52& -24 82&

112))? 11255 11215 112&& 112))

1<))) 111

Integrated Case

Chapter 13: Capital Structure and Leverage

otes:
a b c d

Data given in proble+2 Calculated as a+ount borro.ed divided b; total assets2 Calculated as 1 D D5A2 Calculated as a+ount borro.ed divided b; eAuit; (total assets less Calculated using the !a+ada eAuation< bL L bEH1 M (1 D #,(D5$,I2 Calculated using the CA"C< rs L r%' M (rC D r%',b< given the ris6*/ree rate<

a+ount borro.ed,2
e /

the +ar6et ris6 pre+iu+< and using the levered beta as calculated .ith the !a+ada eAuation2
g

Calculated using the :ACC eAuation< :ACC L .drd(1 D #, M .crs2

CD9s :ACC is +ini+iFed at a capital structure that consists o/ 15? debt and 35? eAuit;< or a :ACC o/ 11215?2 D2 (-, :hat .ould be the ne. stoc6 price i/ CD recapitaliFes .ith =15)<))) o/ debtG =5))<)))G =35)<)))G =1<)))<)))G %ecall that the pa;out ratio is 1))?< so g L )2 Ans.er: HSho. S13*33 here2I :e can calculate the price o/ a constant gro.th stoc6 as D"S divided b; rs +inus g< .here g is the e7pected gro.th rate in dividends: ") L D15(rs D g,2 Since in this case all earnings are paid out to the stoc6holders< D"S L $"S2 'urther< because no earnings are plo.ed bac6< the /ir+9s $@8# is not e7pected to gro.< so g L )2 !ere are the results: Debt Level = ) 15)<))) 5))<))) 35)<))) 1<)))<))) PCa7i+u+ D"S =32)) 3213255 3233 324) rs 112))? 11251 1321) 1&21152-) Stoc6 "rice =152)) 1-2)3 1-284P 1-254 152))

Chapter 13: Capital Structure and Leverage

Integrated Case

113

D2

(3,

8s $"S +a7i+iFed at the debt level that +a7i+iFes share priceG :h; or .h; notG

Ans.er:

HSho. S13*3& here2I

:e have seen that $"S continues to increase

be;ond the =5))<))) opti+al level o/ debt2 #here/ore< /ocusing on $"S .hen +a6ing capital structure decisions is not correctB.hile the $"S does ta6e account o/ the di//erential cost o/ debt< it does not account /or the increasing ris6 that +ust be borne b; the eAuit; holders2 D2 (8, Considering onl; the levels o/ debt discussed< .hat is CD9s opti+al capital structureG Ans.er: HSho. S13*35 here2I A capital structure .ith =5))<))) o/ debt produces the highest stoc6 price< =1-284> hence< it is the best o/ those considered2 D2 (4, :hat is the :ACC at the opti+al capital structureG 8nitial debt level: Debt5#otal assets L )?< so #otal assets L 8nitial eAuit; L =15 8)<))) shares L =1<)))<)))2 :ACC L
= 5)) < ))) = 1 < ))) < ))) (4?,()2-), M = 1 <5)) < ))) = 1 < ))) < ))) (1321?,

Ans.er:

L 1235? M 424)? L 11215?2 ote: 8/ .e had (1, used the eAuilibriu+ price /or repurchasing shares and (1, used +ar6et value .eights to calculate :ACC< then .e could be sure that the :ACC at the price*+a7i+iFing capital structure .ould be the +ini+u+2 Esing a constant =15 purchase price< and boo6 value .eights< inconsistencies +a; creep in2

11&

Integrated Case

Chapter 13: Capital Structure and Leverage

$2

Suppose ;ou discovered that CD had +ore business ris6 than ;ou originall; esti+ated2 Describe ho. this .ould a//ect the anal;sis2 :hat i/ the /ir+ had less business ris6 than originall; esti+atedG

Ans.er:

HSho. S13*3- here2I 8/ the /ir+ had higher business ris6< then< at an; debt level< its probabilit; o/ /inancial distress .ould be higher2 8nvestors .ould recogniFe this< and both rd and rs .ould be higher than originall; esti+ated2 8t is not sho.n in this anal;sis< but the end result .ould be an opti+al capital structure .ith less debt2 Conversel;< lo.er business ris6 .ould lead to an opti+al capital structure that included +ore debt2

'2

:hat are so+e /actors a +anager should consider .hen establishing his or her /ir+9s target capital structureG

Ans.er:

HSho. S13*33 and S13*38 here2I

Since it is di//icult to Auanti/; the

capital structure decision< +anagers consider the /ollo.ing judg+ental /actors .hen +a6ing capital structure decisions: 12 12 #he average debt ratio /or /ir+s in their industr;2 "ro /or+a #8$ ratios at di//erent capital structures under di//erent scenarios2 32 &2 52 -2 32 82 42 Lender5rating agenc; attitudes2 %eserve borro.ing capacit;2 $//ects o/ /inancing on control2 Asset structure2 $7pected ta7 rate2 Canage+ent attitudes2 Car6et conditions2

1)2 'ir+9s internal conditions2


Chapter 13: Capital Structure and Leverage Integrated Case 115

112 'ir+9s operating leverage2 112 'ir+9s gro.th rate2 132 'ir+9s pro/itabilit;2

Optional 0uestion
Codigliani and Ciller proved< under a ver; restrictive set o/ assu+ptions< that the value o/ a /ir+ .ill be +a7i+iFed b; /inancing al+ost entirel; .ith debt2 :h;< according to CC< is debt bene/icialG Ans.er: CC argued that using debt increases the value o/ the /ir+ because interest is ta7 deductible2 #he govern+ent< in e//ect< pa;s part o/ the interest< and this lo.ers the cost o/ debt relative to the cost o/ eAuit;< +a6ing debt /inancing +ore attractive than eAuit; /inancing2 "ut another .a;< since interest is deductible< the +ore debt a co+pan; uses< the lo.er its ta7 bill< and the +ore o/ its operating inco+e /lo.s through to investors< so the greater its value2

Optional 0uestion
:hat assu+ptions underlie the CC theor;G Are these assu+ptions realisticG Ans.er: CC9s 6e; assu+ptions are as /ollo.s: 12 12 32 &2 #here are no bro6erage costs2 #here are no ta7es2 8nvestors can borro. at the sa+e rate as corporations2 8nvestors have the sa+e in/or+ation as +anagers about the /ir+9s /uture invest+ent opportunities2 52 All o/ the /ir+9s debt is ris6less< regardless o/ ho. +uch it uses2 (#here are no ban6ruptc; costs2,

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Chapter 13: Capital Structure and Leverage

-2

$@8# is not a//ected b; the use o/ debt2

#hese assu+ptions are obviousl; unrealisticBinvestors do incur bro6erage /ees and personal inco+e ta7es> the; cannot borro. at the sa+e rate as corporations> and the; do not have the sa+e in/or+ation as the /ir+9s +anagers regarding /uture invest+ent opportunities2 Also< corporate debt is ris6;< especiall; i/ a /ir+ uses lots o/ debt< and the interest rate .ill rise as the debt level increases2

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113

'igure 8C 13*12 %elationship bet.een Capital Structure and Stoc6 "rice

Nalue o/ 'ir+9s Stoc6

D1

D1

Leverage< D5A

Q2

"ut labels on 'igure 8C 13*1< and then discuss the graph as ;ou +ight use it to e7plain to ;our boss .h; CD +ight .ant to use so+e debt2

Ans.er:

HSho. S13*34 and S13*&) here2I

#he use o/ debt per+its a /ir+ to

obtain ta7 savings /ro+ the deductibilit; o/ interest2 So the use o/ so+e debt is good> ho.ever< the possibilit; o/ ban6ruptc; increases the cost o/ using debt2 At higher and higher levels o/ debt< the ris6 o/ ban6ruptc; increases< bringing .ith it costs associated .ith potential /inancial distress2 Custo+ers reduce purchases< 6e; e+plo;ees leave< and so on2 #here is so+e point< generall; .ell belo. a debt ratio o/ 1))?< at .hich proble+s associated .ith potential ban6ruptc; +ore than o//set the ta7 savings /ro+ debt2 #heoreticall;< the opti+al capital structure is /ound at the point .here the +arginal ta7 savings just eAual the +arginal ban6ruptc;* related costs2 !o.ever< anal;sts cannot identi/; this point .ith precision /or an; given /ir+< or /or /ir+s in general2 Anal;sts can help +anagers deter+ine an opti+al range /or their /ir+9s debt ratios< but

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the capital structure decision is still +ore judg+ental than based on precise calculations2 !2 !o. does the e7istence o/ as;++etric in/or+ation and signaling a//ect capital structureG Ans.er: HSho. S13*&1 through S13*&& here2I /inancing gives signals to investors2 #he as;++etric in/or+ation 'ir+s .ith good invest+ent

concept is based on the pre+ise that +anage+ent9s choice o/ opportunities .ill not .ant to share the bene/its .ith ne. stoc6holders< so the; .ill tend to /inance .ith debt2 'ir+s .ith poor prospects< on the other hand< .ill .ant to /inance .ith stoc62 8nvestors 6no. this< so .hen a large< +ature /ir+ announces a stoc6 o//ering< investors ta6e this as a signal o/ bad ne.s< and the stoc6 price declines2 'ir+s 6no. this< so the; tr; to avoid having to sell ne. co++on stoc62 #his +eans +aintaining a reserve o/ borro.ing capacit; so that .hen good invest+ents co+e along< the; can be /inanced .ith debt2

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Optional 0uestion
You +ight e7pect the price o/ a +ature /ir+9s stoc6 to decline i/ it announces a stoc6 o//ering2 :ould ;ou e7pect the sa+e reaction i/ the issuing /ir+ .ere a ;oung< rapidl; gro.ing co+pan;G Ans.er: 8/ a +ature /ir+ sells stoc6< the price o/ its stoc6 .ould probabl; decline2 A +ature /ir+ should have other /inancing alternatives< so a stoc6 issue .ould signal that its earnings potential is not good2 A ;oung< rapidl; gro.ing /ir+< ho.ever< +a; have so +an; good invest+ent opportunities that it si+pl; cannot raise all the eAuit; it needs as retained earnings< and investors 6no. this2 #here/ore< the stoc6 price o/ a ;oung< rapidl; gro.ing /ir+ .ould probabl; not /all because o/ a ne. stoc6 issue< especiall; i/ the /ir+9s +anagers announce that the; are not selling an; o/ their o.n shares in the o//ering2

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Integrated Case

Chapter 13: Capital Structure and Leverage