A B C D E F G H I

1 Ch 14 Tool Kit 1/29/2001

2
3 Chapter 14. Tool Kit for Capital Structure Decisions: Part I
4
5 In Chapter 2, we introduced the idea that risk has two principal components, market risk and stand-alone risk. Market
6 risk is measured by beta, while stand-alone risk consists of both market risk plus an element of risk that can be eliminated
7 through diversification. In this chapter, we introduce two new dimensions of risk, business risk and financial risk.
8 Business risk is the risk inherent in the firm's operations, and it would be there even if used no debt. Financial risk is the
9 additional risk borne by the stockholders as a result of the use of debt.
10
11
12 BUSINESS RISK AND OPERATING LEVERAGE
13
14 Operating Leverage reflects amount of fixed costs embedded in a firm's operations. Thus, if a high percentage of a firm's
15 costs are fixed, hence continue even if sales decline, then the firm is said to have high operating leverage. High operating
16 leverage produces a situation where a small change in sales can result in a large change in operating income. The following
17 example compares two operational plans with different degrees of operating leverage. Using the input data given below, we
18 examine the firm's profitability under two operating plans, in different states of the economy. The probabilities of the
19 economic states are also given in the example.
20
21 Input Data Plan A Plan B
22 Low FC High FC
23 Price $2.00 $2.00 Product sells at same price regardless of how it is produced.
24 Variable costs $1.50 $1.00 Plan A has high variable costs; it doesn't use labor-saving equipment.
25 Fixed costs $20,000 $60,000 Plan B has high fixed costs (depreciation) due to the use of labor-saving equipment.
26 Invested capital $200,000 $200,000
27 Tax Rate 40% 40%
28 A's break-even units = 40,000. See table. B's breakeven units = 60,000. See
29 Operating Performance
30 Plan A: Low Fixed, High Variable Costs
31 Data Applicable to Both Plans Net Op Profit Return on
32 Units Dollar Operating Operating After Taxes Invested
33 Demand Probability Sold Sales Costs Profit (EBIT) (NOPAT) Capital
34 Terrible 0.05 0 $0 $20,000 ($20,000) ($12,000) -6.0%
35 Poor 0.2 40,000 $80,000 $80,000 $0 $0 0.0%
36 Average 0.5 100,000 $200,000 $170,000 $30,000 $18,000 9.0%
37 Good 0.2 160,000 $320,000 $260,000 $60,000 $36,000 18.0%
38 Wonderful 0.05 200,000 $400,000 $320,000 $80,000 $48,000 24.0%
39 Expected Values: 100,000 $200,000 $170,000 $30,000 $18,000 9.0%
40 Standard Deviation (SD):* 49,396 $98,793 $24,698 7.41%
41 Coefficient of Variation (CV): 0.49 0.49 0.82 0.82
42
43 *We used the function wizard rather than the formula to calculate the standard deviation. Click fx>Statistical>STDEVP.
44 Then click on each entry of the item whose SD we seek some number of times that is consistent with the item's probability
45 weight. Thus, for units sold, 0 has a probability of 0.05, so we click on it once. 40,000 units has a probability of 0.2, which
46 is 4 times as large as 0.05, so we click on it 4 times. Continuing, we click on 100,000 10 times, 160,000 4 times, and
47 200,000 one time. We have a total of 20 entries. We show a picture of the dialog box on the screen to the right.
48
49 Which plan is better? Based on expected profits and the return on invested capital, Plan B looks better. However, Plan B
50 is also riskier as measured by the standard deviation (SD) and the coefficient of variation (CV). So, we face a tradeoff
51 between risk and return--B is more profitable, but A is less risky. Someone will have to choose between the two plans, but
52 at this point we have no basis for making the choice.
 A B C D E F G H I
53
54 Note also that Plan A will break even at sales as low as 40,000 units, while Plan B would have a $20,000 loss at that level.
55 B's breakeven point is 50% higher, at 60,000 units.
56
57 The results generated above are graphed below
58
59
60
61
62 Plan A: Low Fixed Costs, Plan B: High Fixed Costs,
63
64
Low Operating Leverage High Operating Leverage
65

Revenues and costs

$200,000 $200,000
Revenues and costs

66 Revenu Revenue
es
$150,000 s
67 $150,000
$100,000 VC
68 $100,000
VC
69 FC $50,000 FC
70 $50,000 $0
71 $0
72 0 20000 40000 60000 80000 100000120000
73
Sales (units) Sales (units)
74
75
76 B has a much higher breakeven point, (2) that B has more leverage in the sense that a given change in sales
77 leads to a larger change in profits than for A.
78
79 We can see from the table that A's breakeven point is at 40,000 units. We can see from the table and also from the graph
80 that B's breakeven point is between 40,000 and 100,000 units, but we cannot tell the exact point. However, we can use the
81 following formula to find the exact breakeven point:
82
83 Q BE = FC
/ (P - VC) In words, the quantity at which a firm breaks even is found as the difference
84 between Price and Variable costs divided by Fixed costs.
85 Plan A
86 Q BE = FC ÷ (P - VC)
87 Q BE = $20,000 ÷ $2.00 - $1.50
88 Q BE = 40,000 Units.
89
90 Plan B
91 BE B = FC ÷ (P - VC)
92 BE B = $60,000 ÷ $2.00 - $1.00
93 BE B = 60,000 Units.
94
95 At this point, we know that Plan B has a higher expected rate of return, but it is also more risky. Our analysis is on
96 stand-alone risk. However, given a positive correlation between the firm's returns and that on the market, Plan B's higher
97 risk will result in a higher "unlevered beta." We do not calculate unlevered betas here, but in the next section we assume
98 that B's beta is 1.5, and we also assume that management believes that the choosing Plan B would lead to a higher stock
99 price than Plan A.
100
 A B C D E F G H I
101 FINANCIAL RISK AND LEVERAGE
102
103 Financial Leverage refers to the use of fixed-income securities (preferred stock and debt) in the capital structure. The
104 firm has a certain amount of business risk as discussed above in connection with operating leverage. This business risk is
105 measured by the firm's "unleveraged beta," which is the beta it would have if it had no debt. If the firm uses no financial
106 leverage, i.e., no debt or preferred stock, then each stockholder would bear that business risk in proportion to his or her
107 share of the stock. However, if the firm uses debt, then the business risk will be concentrated on its stockholders, and each
108 will have to bear more of that risk than if the firm had remained debt-free.
109
110 The risk of the stock is reflected in the stock's beta coefficient, and, as we discuss below, beta rises with the use of debt-- the
111 more debt, the higher the beta. The lowest beta is the one that would exist if no debt were used--this is the "unleveraged
112 beta," and it reflects the firm's business risk as discussed above.
113
114 In the following example we illustrate all this, continuing with the situation described in our operating leverage example. We
115 assume that the company decided on Plan B and thus requires $200,000 of capital. We also assume that the firm must
116 borrow in increments of $20,000, and that its debt cannot exceed $120,000 due to restrictions in it's corporate charter.
117 Further, we assume that Strasburg Inc currently has 10,000 shares of common stock outstanding, and that the company will
118 use debt to repurchase stock at the current market price.
119
120 Discussions with its bankers indicate that Strasburg can borrow different amounts, but the more it borrows, the higher the cost
121 of its debt.
122 Data for Table 14-1
123 Debt Cost Schedule
124 Amount
125 D/A ratio borrowed Cost of debt
126 0% $0 8.0%
127 10% $20,000 8.0%
128 20% $40,000 8.3%
129 30% $60,000 9.0%
130 40% $80,000 10.0%
131 50% $100,000 12.0%
132 60% $120,000 15.0%
133
134 OPTION 1: Finance Plan B entirely with common equity (Equity = 100%, Debt = 0%)
135 Data for Table 14-2
136 Assets $200,000
137 Debt ratio 0%
138 Equity Ratio 100%
139 Debt $0
140 Equity $200,000
141 Interest rate 8.00%
142 Tax rate 40%
143 Shares outstanding 10,000
144
145
146 Pre-tax Taxes Net
147 Demand Probability EBIT Interest Income 40% Income ROE EPS
148 Terrible 0.05 ($60,000) $0 ($60,000) ($24,000) ($36,000) -18.00% ($3.60)
149 Poor 0.2 ($20,000) $0 ($20,000) ($8,000) ($12,000) -6.00% ($1.20)
150 Normal 0.5 $40,000 $0 $40,000 $16,000 $24,000 12.00% $2.40
151 Good 0.2 $100,000 $0 $100,000 $40,000 $60,000 30.00% $6.00
152 Wonderful 0.05 $140,000 $0 $140,000 $56,000 $84,000 42.00% $8.40
153
154 Expected values: $40,000 $0 $40,000 $16,000 $24,000 12.00% $2.40
155 Standard Deviation: 14.82% $2.96
156 Coefficient of Variation: 1.23 1.23
 A B C D E F G H I
157
158 OPTION 2: Finance Plan B with $100,000 of debt and $100,000 of equity (50% equity, 50% debt)
159
160 Assets $200,000
161 Debt ratio 50%
162 Equity Ratio 50%
163 Debt $100,000
164 Equity $100,000
165 Interest rate 12%
166 Tax Rate 40%
167 Shares outstanding 5,000
168
169
170 Pre-tax Taxes Net
171 Demand Probability EBIT Interest Income 40% Income ROE EPS
172 Terrible 0.05 ($60,000) $12,000 ($72,000) ($28,800) ($43,200) -43.20% ($8.64)
173 Poor 0.2 ($20,000) $12,000 ($32,000) ($12,800) ($19,200) -19.20% ($3.84)
174 Normal 0.5 $40,000 $12,000 $28,000 $11,200 $16,800 16.80% $3.36
175 Good 0.2 $100,000 $12,000 $88,000 $35,200 $52,800 52.80% $10.56
176 Wonderful 0.05 $140,000 $12,000 $128,000 $51,200 $76,800 76.80% $15.36
177
178 Expected values: $40,000 $12,000 $28,000 $11,200 $16,800 16.80% $3.36
179 Standard Deviation: 29.64% $5.93
180 Coefficient of Variation: 1.76 1.76
181
182 Typically, financial leverage increases the expected rate of return on equity. In this case, the return on equity rises from
183 12% to 18%. However, this higher return comes at a price--the higher the debt ratio, the greater the risk as indicated by
184 the coefficient of variation, which rises from 1.23 to 1.76.
185
186 In the tables just above, we calculated the expected EPS and risk measures at zero debt and at 50% debt. We can use an
187 Excel Data Table to calculate these values at a number of different debt ratios, as shown below.
188
189 D/A Ratio Exp. EPS Std dev of EPS CV of EPS
190 50% $3.36 $5.93 1.76
191 0% $2.40 $2.96 1.23 Minimum risk
192 10% $2.56 $3.29 1.29
193 20% $2.75 $3.70 1.35
194 30% $2.97 $4.23 1.43
195 40% $3.20 $4.94 1.54
196 50% $3.36 $5.93 1.76 Maximum EPS
197 60% $3.30 $7.41 2.25
198
199 There's a conflict between risk and return so we must decide on a tradeoff, i.e., must decide the optimal capital structure.
200
201 DETERMINING THE OPTIMAL CAPITAL STRUCTURE
202
203 The optimal capital structure is the one that maximizes the stock price. Also, that same capital structure minimizes the
204 WACC. To find--or, really, estimate--the optimal capital structure, we need information on how capital structure affects
205 the costs of debt and equity. The effects on debt are usually estimated by talking with bankers and investment
206 bankers--Strasburg's debt cost schedule as shown above was determined in this way. The effects on the cost of equity are
207 determined in various ways, but one logical starting point is the Hamada Equation, which is explained below.
208
209 THE HAMADA EQUATION
210
211 Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine
212 beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of
213 equity associated with those debt ratios. Here is the Hamada equation:
 A B C D E F G H I
214
215 bL = bU x [1 + (1-T) x (D/E)]
216
217 Here bL is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax rate, D is the
218 market value of the debt, and E is the market value of the equity.
219
220 In the table below, we apply the Hamada equation to Strasburg Electronics, given its unlevered beta and tax rate.
221
222 BU 1.5
223 Tax rate 40%
224
225 D/A D/E BL
226 0.0 0.00 1.50
227 0.1 0.11 1.60
228 0.2 0.25 1.73
229 0.3 0.43 1.89
230 0.4 0.67 2.10
231 0.5 1.00 2.40
232 0.6 1.50 2.85
233
234 As the table shows, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the
235 cost of equity and then on the WACC. Here we assume that the risk-free rate is 6% and the required return on the market
236 is 10%. We also assume that Strasburg pays out all of its earnings as dividends, hence its earnings and dividends are not
237 expected to grow. Therefore, its stock price can be found by using the perpetuity equation, Price = Dividend/k s.
238
239 Risk-free rate, kRF: 6%
240 Market return, kM: 10%
241 Data for Table 14-3
242 D/A ratio D/E ratio A-T kD EPS = DPS Estimated beta Cost of equity Est. Price P/E Ratio WACC
243 0% 0.00% 4.8% $2.40 1.50 12.0% $20.00 8.33 12.00%
244 10% 11.11% 4.8% $2.56 1.60 12.4% $20.65 8.06 11.64%
245 20% 25.00% 5.0% $2.75 1.73 12.9% $21.33 7.75 11.32%
246 30% 42.86% 5.4% $2.97 1.89 13.5% $21.90 7.38 11.10%
247 40% 66.67% 6.0% $3.20 2.10 14.4% $22.22 6.94 11.04%
248 50% 100.00% 7.2% $3.36 2.40 15.6% $21.54 6.41 11.40%
249 60% 150.00% 9.0% $3.30 2.85 17.4% $18.97 5.75 12.36%
250
251 We see that the stock price is maximized, and the WACC is minimized, if the firm finances with 40% debt and 60%
252 equity. This is the optimal capital structure.
253
254 We can graph the key data in the table above.
255
256
257
Cost of Capital Graph
258 20.0%
259 18.0%
260 16.0%
261 14.0%
262 12.0%
Debt
263 10.0%
Equity
264 8.0%
6.0% WACC
265
4.0%
266
2.0%
267 0.0%
268 0% 10% 20% 30% 40% 50% 60% 70%
269
270 Debt Ratio
271
 A B C D E F G H I
272
273
274 MARKET VALUE WEIGHTS AND RECAPITALIZATION
275 The WACC should be calculated using market value weights for D and E.
276
277
278 As soon as a firm announces plans to recapitalize (borrow and use the funds to buy back debt), shareholders will know that the price
279 per share will be higher after the recapitalization. Because they know this, they will be unwilling to sell any stock back to the
280 company during the recapitalization at the price that the stock was before the announcement to recapitalize. Instead, they will only
281 sell it back at a price that is equal to the expected price after the recapitization. Here is the sequence of events. (1) The price per
282 share is at the pre-announcement value based on the current capital structure. (2) The company announces plans to recapitalize.
(3) The stock price immediately jumps up to the equilibrium level. (4) The company uses all the debt it raises to buy back as many
283
shares of stock as it can at the equilibrium price. (5) The post-buyback price is equal to the new dividends (based on the new level of
284 interest payments and debt), the cost of equity (based on the new capital structure), and the new number of shares (based on the
285 number that were bought back). This is the equilbrium stock price.
286
287 MV of the equity is Dividends/ks
288 Risk-free rate, kRF: 6% The total value of the firm is the value of the
289 Market return, kM: 10% debt plus the value of the equity.
290 Risk Premium: RP 4%
291 Tax Rate, T 40%
292 Data for Table 14-4
Earnings
293 After Tax =Expected MV of Total Value
Debt kD kS Dividends Equity of Firm WACC
294 $0 4.8% 12.0% $24,000 $200,000 $200,000 12.000%
295 20,000 4.8% 12.4% 23,040 185,806 205,806 11.661%
296 40,000 5.0% 12.9% 22,008 170,605 210,605 11.396%
297 60,000 5.4% 13.5% 20,760 153,291 213,291 11.252%
298 80,000 6.0% 14.4% 19,200 133,333 213,333 11.250%
299 100,000 7.2% 15.6% 16,800 107,692 207,692 11.556%
300 120,000 9.0% 17.4% 13,200 75,862 195,862 12.254%
301
302 The total value of the firm is maximized, and the WACC is minimized at a debt level of $80,000, which corresponds to a D/TA ratio
303 of 40%. This is the same debt level that maximizes stock price when book values are used.
304
305
306 RECAPITALIZATION The equilibrium price per share is the
307 market value of the debt plus the market
308 value of the equity divided by the original
309 number of shares outstanding.
310
311
Original Equilibrium Shares after
312 Total Value Shares Price per Shares the Earnings =
Debt of Firm Outstanding Share Repurchased Repurchase Dividends EPS
313 $0.00 $200,000 10,000 $20.000 - 10,000.0 $24,000.0
$2.40
314 $20,000 $205,806 10,000 $20.581 971.8 9,028.2 $23,040.0
$2.55
315 $40,000 $210,605 10,000 $21.060 1,899.3 8,100.7 $22,008.0
$2.72
316 $60,000 $213,291 10,000 $21.329 2,813.1 7,186.9 $20,760.0
$2.89
317 $80,000 $213,333 10,000 $21.333 3,750.0 6,250.0 $19,200.0
$3.07
318 $100,000 $207,692 10,000 $20.769 4,814.8 5,185.2 $16,800.0
$3.24
319 $120,000 $195,862 10,000 $19.586 6,126.8 3,873.2 $13,200.0
$3.41
320
321 The price per share is maximized at the same debt level that total firm value is maximized, and WACC is minimized.
322 Notice that EPS does not reach a maximum, although the stock price does reach a maximum of $21.33.
323
324
325 Free Cash Flow Value of Firm V operations is equal to NOPAT/WACC since growth is zero.
 A B C D E F G H I
326
327 NOPAT WACC V operations
328 $24,000.00 12.000% $200,000.00
329 $24,000 11.661% $205,806
330 $24,000 11.396% $210,605
331 $24,000 11.252% $213,291
332 $24,000 11.250% $213,333
333 $24,000 11.556% $207,692
334 $24,000 12.254% $195,862
 J K L M N O P Q
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
it is produced.
23
labor-saving
24 equipment.
e to the use
25 of labor-saving equipment.
26
27
28 B's breakeven units = 60,000. See calculation below.
29
30 Plan B: High Fixed, Low Variable Costs
31 Net Op Profit Return on
32 Operating Operating After Taxes Invested
33 Costs Profit (EBIT) (NOPAT) Capital
34 $60,000 ($60,000) ($36,000) -18.0%
35 $100,000 ($20,000) ($12,000) -6.0%
36 $160,000 $40,000 $24,000 12.0%
37 $220,000 $100,000 $60,000 30.0%
38 $260,000 $140,000 $84,000 42.0%
39 $160,000 $40,000 $24,000 12.0%
40 $49,396 14.82%
41 1.23 1.23
42
43 You must scroll down the dialog box to make all the entries.
44
45
46
47
48
49
50
51
52
 J K L M N O P Q
53
54
55
56
57
58
59
60
61
High Fixed
62 Costs,
63
perating 64
Leverage
65
66 Revenue
s
67
68 VC
69 FC
70
71
72
73
ales (units)
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94 Further discussion of Operating Leverage
95
96 1. The beta of the ith asset can be found using this equation:
97
98 bi = r i,m ( SDi / SDm )
99
100 Here rim is the correlation coefficient between the asset and the market and the
 J K L M N O P Q
101 SDs are the standard deviations of the asset and the market.
102 2. We could estimate the SD of the market, based on historical data. The
103 approximate SD for large company stocks is 27.9%, and 25.76% for small
104 company stocks. Assume SD Market = 25%
105 3. We could calculate the historical r between some traded assets and the market,
106 and make an educated guess about r for non-traded assets, like Strasburg's project.
107 4. Assume that Strasburg's management estimates the project correlation with
108 the market to be 0.75. So, the returns move up and down with the market, which
109 is typical. r = 0.75
110 5. We calculated above the SD for A and B as follows:
111
112 SD(A) = 7.41%
113 SD(B) = 14.82%
114 6. We can now apply the formula to find betas for Plans A and B:
115
116 A's beta = 0.22
117
118 B's beta = 0.44
119 operating risk. These betas could be used in the Hamada equation as described
120 below to bring in financial risk and thus to get an idea of total risk with
121 with different operating and financial plans.
122
123 8. This type analysis is not commonly applied because of the difficult of obtaining
124 sufficiently accurate data. However, it is useful as a framework for thinking
125 the issues. Moreover, as market and operating data becomes increasingly
126 available, the framework will become increasingly operational.
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154
155
156
 J K L M N O P Q
272
273
274
275
276
277
278
279
280
281
282
283
284
285
286
287
288
289
290
291
292

293

294
295
296
297
298
299
300
301
302
303
304
305
306
307
308
309
310
311

312

313
314
315
316
317
318
319
320
321
322
323
324
325