CHAPTER 13

Capital Structure and

Leverage

Business vs. financial risk

Optimal capital structure
Operating leverage
Capital structure theory
13-1

Key Concepts and Skills

Understand the effect of financial
leverage on cash flows and cost of
equity
Understand the impact of taxes
and bankruptcy on capital structure
choice

13-2

Part I
Business Risk, Operating
Leverage
Financial Risk, Financial
Leverage

13-3

What is business risk?

Uncertainty about future operating income (EBIT),

i.e., how well can we predict operating income?
Low risk

Probability

High risk
0

E(EBIT)

EBIT

Note that business risk does not include effect of

financial leverage.
13-4

What determines business

risk?

Uncertainty about demand (sales).

Uncertainty about output prices.
Uncertainty about costs.
Product, other types of liability.
Competition.
Operating leverage.

13-5

What is operating leverage, and

how does it affect a firms
business risk?

OL is defined as (%change in EBIT)/

(%change in sales).
Operating leverage is high if the
production requires higher fixed
costs and low variable costs.
High fixed cost can leverage small
increase in sales into high increase in
EBIT.
13-6

Effect of operating
leverage

More operating leverage leads to more

business risk, for then a small sales
decline causes a big profit decline.
Rev.

Rev.
$
TC

} Profit
TC
FC

FC
QBE

Sales

QBE

Sales
13-7

Using operating leverage

Low operating leverage

Probability

High operating leverage

EBITL

EBITH

Typical situation: Can use operating leverage

to get higher E(EBIT), but risk also increases.
13-8

What is financial leverage?

Financial risk?

Financial leverage is defined as

(%change in NI) / (% change in
EBIT)
High usage of debt can
leverage small increase in EBIT
into big increase in net income.
Financial leverage is high with
high level of debt.
13-9

What is Financial risk?

Financial risk is the additional risk

concentrated on common
stockholders as a result of financial
leverage.

More debt, more financial leverage,

more financial risk.
More debt will concentrate business risk on
stockholders because debt holders do not
bear business risk (in case of no bankruptcy).
13-10

A summary
Operating
Leverage

Financial
Leverage

Business
Risk

Financial
Risk

%change in EBIT/
%change in sales

%change in NI/
%change in EBIT

Variability in
the firms
expected
EBIT.

Additional
variability in net
income
available to
common
shareholders.

Increase with
higher fixed cost

Increase with
higher debt

Increase with
high OL.

Increase with
high FL.

If a firm already has high business risk, you may want to use less debt
to get less financial risk. If a firm has less business risk, you may afford
high financial risk.

13-11

An example:
Illustrating effects of financial
leverage

Two firms with the same operating

leverage, business risk, and probability
distribution of EBIT.
Only differ with respect to their use of
debt (capital structure).
Firm U
No debt
$20,000
40% tax

Firm L
$10,000 of 12% debt
in assets
$20,000 in assets
rate 40% tax rate
13-12

Firm U: Unleveraged
Prob.
EBIT
Interest
EBT
Taxes (40%)
NI

Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
0
0
$2,000
$3,000
800
1,200
$1,200
$1,800

Good
0.25
$4,000
0
$4,000
1,600
$2,400

13-13

Firm L: Leveraged
Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI

Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
1,200
1,200
$ 800
$1,800
320
720
$ 480
$1,080

Good
0.25
$4,000
1,200
$2,800
1,120
$1,680

*Same as for Firm U.

13-14

Ratio comparison between

leveraged and unleveraged
firms
FIRM U

Bad Avg Good

BEP
10.0%
15.0%
20.0%
ROE
6.0%
9.0%
12.0%
BEP=EBIT/assets (basic earning power)

FIRM L
BEP
ROE

Bad Avg Good

10.0%
4.8%

15.0%
10.8%

20.0%
16.8%

13-15

Risk and return for leveraged

and unleveraged firms
Expected Values:
Firm U
E(BEP)
15.0%
E(ROE)
9.0%

=
<

Firm L
15.0%
10.8%

<

Firm L
4.24%

Risk Measures:
ROE

Firm U
2.12%

13-16

The Effect of Leverage on

profitability

How does leverage affect the EPS and ROE of a firm?

When we increase the amount of debt financing, we
increase the fixed interest expense
If we have a good year (BEP > kd), then we pay our
fixed interest cost and we have more left over for
our stockholders
If we have a bad year (BEP < kd), we still have to
pay our fixed interest costs and we have less left
over for our stockholders
Leverage amplifies the variation in both EPS and
ROE
13-17

Conclusions

Basic earning power (BEP) is

unaffected by financial leverage.
Firm L has higher expected ROE.
Firm L has much wider ROE (and
EPS) swings because of fixed
interest charges. Its higher
expected return is accompanied
by higher risk.

13-18

Quick Quiz

Explain the effect of leverage on

expected ROE and risk

13-19

The degree of operating leverage is defined

as:
a.
% change in EBIT_____
% change in Variable Cost
b.
% change in EBIT
% change in Sales
c.
% change in Sales
% change in EBIT
d.
% change in EBIT_______________
% change in contribution margin
13-20

Leverage will generally __________

shareholders' expected return and
_________ their risk.
a. increase; decrease
b. decrease; increase
c. increase; increase
d. increase; do nothing to
13-21

If a 10 percent increase in sales causes

EBIT to increase from $1mm to $1.50 mm,

what is its degree of operating

leverage?
a. 3.6
b. 4.2
c. 4.7
d. 5.0
e. 5.5
13-22

Part II
Capital Structure

13-23

Capital Restructuring
We are going to look at how changes in capital
structure affect the value of the firm, all else
equal
Capital restructuring involves changing the
amount of leverage a firm has without
changing the firms assets
Increase leverage by issuing debt and
repurchasing outstanding shares
Decrease leverage by issuing new shares and
retiring outstanding debt

13-24

Choosing a Capital
Structure

What is the primary goal of financial

managers?

Maximize stockholder wealth

We want to choose the capital structure

that will maximize stockholder wealth
We can maximize stockholder wealth by
maximizing firm value (or equivalently
minimizing WACC).

13-25

Optimal Capital Structure

Objective: Choose capital structure

(mix of debt v. common equity) at
which stock price is maximized.
Trades off higher ROE and EPS
against higher risk. The tax-related
benefits of leverage are offset by
the debts risk-related costs.
13-26

What effect does increasing debt

have on the cost of equity for the
firm?

If the level of debt increases, the

riskiness of the firm increases.
The cost of debt will increase
because bond rating will
deteriorates with higher debt level.
Moreover, the riskiness of the
firms equity also increases,
resulting in a higher ks.
13-27

The Hamada Equation

Not Required

13-28

Finding Optimal Capital

Structure

The firms optimal capital

structure can be determined two
ways:

Minimizes WACC.
Maximizes stock price.

Both methods yield the same

results.
13-29

Table for calculating WACC

and determining the
minimum WACC
Amount D/A ratio
borrowed
0.00%
$
0
12.50
250K
25.00
500K
37.50
750K
50.00
1,000K

ks

kd (1 T) WACC

12.00% 0.00%

12.00%

12.51

4.80

11.55

13.20

5.40

11.25

14.16

6.90

11.44

15.60

8.40

12.00
13-30

Table for determining the

stock price maximizing
capital structure
Amount
Borrowed

EPS

ks

P0

$3.00

12.00%

$25.00

250K

3.26

12.51

26.03

500K

3.55

13.20

26.89

750K

3.77

14.16

26.59

1,000K

3.90

15.60

25.00

13-31

What is this firms optimal

capital structure?

Stock price P0 is maximized ($26.89) at

D/A = 25%, so optimal D/A = 25%.
EPS is maximized at 50%(EPS= $3.90),
but primary interest is stock price, not
E(EPS).
We could push up E(EPS) by using more
debt, but the higher risk more than
offsets the benefit of higher E(EPS).
13-32

Capital Structure Theory

Under Five Special Cases

Case I Assumptions

Case II Assumptions

Bankruptcy costs
Corporate taxes, but no personal taxes

Case IV Assumptions

Corporate taxes, but no personal taxes

No bankruptcy costs

Case III Assumptions

No corporate or personal taxes

No bankruptcy costs

Managers have private information

Case V Assumptions

Managers tend to waste firm money and not work hard.

13-33

Case I:

Ignoring taxes and Bankruptcy

Cost

The value of the firm is NOT affected by

changes in the capital structure
The cash flows of the firm do not
change, therefore value doesnt change
The WACC of the firm is NOT affected
by capital structure
In this case, capital structure does not
matter.
13-34

Figure 13.3

13-35

Case II

consider taxes but ignore

bankruptcy cost

Interest expense is tax deductible

Therefore, when a firm adds debt,
it reduces taxes, all else equal
The reduction in taxes increases
the firm value. Other things equal,
the less tax paid to the IRS, the
better off the firm.

13-36

Case II

consider taxes but ignore

bankruptcy cost

The value of the firm increases by

the present value of the annual
interest tax shield

Value of a levered firm = value of an

unlevered firm + PV of interest tax
shield (VL = VU + DTC)
The WACC decreases as D/E increases
because of the government subsidy on
interest payments

13-37

13-38

Illustration of Case II

13-39

Case III

consider both taxes and

bankruptcy cost

Now we add bankruptcy costs

As the D/E ratio increases, the
probability of bankruptcy
increases. This increased
probability will increase the
expected bankruptcy costs

13-40

Bankruptcy Costs (financial distress

cost)

Direct bankruptcy costs

Legal and administrative costs

Creditors will stop lending money to the firm.

Indirect bankruptcy costs

Larger than direct costs, but more difficult to

measure and estimate
Also have lost sales, interrupted operations
and loss of valuable employees
13-41

Case III
At some point, the additional value of
the interest tax shield will be offset by
the expected bankruptcy cost
After this point, the value of the firm will
start to decrease and the WACC will start
to increase as more debt is added

13-42

13-43

Case III

(also called Modigliani-Miller static

Theory)

The graph shows MMs tax benefit vs.

bankruptcy cost theory.
With more debt, initially firm will benefit
from tax reduction.
With high debt, the threat of financial
distress becomes severe.
As financial conditions weaken, expected
costs of financial distress can be large
enough to outweigh the tax shield of debt
financing.
Optimal debt level is some trade-off point.
13-44

Conclusions

Case I no taxes or bankruptcy costs

No optimal capital structure. Debt level does not
matter.
Case II corporate taxes but no bankruptcy costs
Optimal capital structure is 100% debt
More debtmore tax shieldhigher firm value.
Case III corporate taxes and bankruptcy costs
Optimal capital structure is part debt and part
equity
Occurs where the marginal tax benefit from debt is
just offset by the increase in bankruptcy costs
13-45

3 cases

13-46

Case IV--Incorporating signaling

effects

When managers know private

information about the firms
future than the market, there is
a signaling effect.
Signaling theory suggests when
firms issue new stocks, stock
price will fall. Why?
13-47

What are signaling effects

in capital structure?

Assume managers have better information

about a firms long-run prospect than outside
investors. They will issue stock if they think
stock is overvalued; they will issue debt if
they think stock is undervalued.

But outside investors are not stupid. They

view a common stock offering as a negative
signal--managers think stock is overvalued.
13-48

Case IV--Incorporating signaling

effects

Conclusion: firms should

maintain a lower debt level so
that in case the firm needs to
raise money in the future, it can
issue debt rather than sell new
stocks.

13-49

Case VHigh debt constrains

managers bad behavior

When would you more likely to

go to a lavish restaurant?

1. After receiving a good salary.

2. After receiving a lot of credit card
bills.

13-50

Case VHigh debt constrains

managers bad behavior

Managers tend to spend a lot of cash

on lavish offices, corporate jets, etc.
With more debt, the need to pay
interest and the threat of bankruptcy
remind managers to waste less and
work harder.
The fact that managers are not born to
work whole heartedly for stockholders
suggests using more debt.
13-51

Observed Capital Structure In

Reality

Capital structure does differ by

industries. Even for firms in same
industry, capital structures may vary
widely.

Lowest levels of debt

Drugs with 2.75% debt

Computers with 6.91% debt

Highest levels of debt

Steel with 55.84% debt

Department stores with 50.53% debt
13-52

Conclusions on Capital
Structure

Need to recognize inputs (such as

bankruptcy cost) are guesstimates.
As a result of imprecise estimates, capital
structure decisions have a large
judgmental content.
It may also mean you might feel the
knowledge is not very systematic in
this chapter. The textbook says that if
you feel our discussion of capital
structure theory imprecise and somewhat
confusing, you are not alone. .
13-53

How would these factors

affect the target capital
structure?
1.
2.
3.

High sales volatility? decrease

High operating leverage? decrease
Increase in the corporate tax rate?
increase

4.

Increase in bankruptcy costs?

decrease

5.

Management spending lots of

money on lavish perks? increase
13-54

The tax savings of the firm derived

from the deductibility of interest
expense is called the:

a. Interest tax shield.

b. Depreciable basis.
c. Financing umbrella.
d. Current yield.
e. Tax-loss carryforward
savings.
13-55

A firm's optimal capital

structure occurs where?

a. EPS are maximized, and WACC is

minimized.
b. Stock price is maximized, and EPS
are maximized.
c. Stock price is maximized, and WACC
is maximized.
d. WACC is minimized, and stock price
is maximized.
e. All of the above.
13-56

The unlevered cost of capital

is

a. the cost of capital for a firm with no equity

in its capital structure
b. the cost of capital for a firm with no debt in
its capital structure
c. the interest tax shield times pretax net
income
d. the cost of preferred stock for a firm with
equal parts debt and common stock in its
capital structure
e. equal to the profit margin for a firm with
some debt in its capital structure
13-57

The explicit costs associated with

corporate default, such as legal
expenses, are the
____ of the firm

a. flotation costs

b. default beta coefficients

c. direct bankruptcy costs

d. indirect bankruptcy costs

e. default risk premia

13-58

The implicit costs associated with

corporate default, such as lost sales,
are the
of the firm

a.
b.
c.
d.
e.

flotation costs
default beta coefficients
direct bankruptcy costs
indirect bankruptcy costs
default risk premia

13-59

Which of the following conclusions

can be drawn from M&M Proposition
I with taxes (case II in our slides)?

a.The value of an unlevered firm exceeds the

value of a levered firm by the present value of the
interest tax shield.
b. There is a linear relationship between the
amount of debt in a levered firm and its value.
c.A levered firm can increase its value by
reducing debt.
d. The optimal amount of leverage for a firm is
not possible to determine.
e.The value of a levered firm is equal to its
aftertax EBIT discounted by the unlevered cost of
capital.
13-60

Which of the following statements

regarding leverage is true?

a. If things go poorly for the firm, increased

leverage provides greater returns to
shareholders (as measured by ROE and EPS).
b. As a firm levers up, shareholders are
exposed to more risk.
c. The benefits of leverage will be greater for
a firm with substantial accumulated losses or
other types of tax shields compared to a firm
without many tax shields.
d. The benefits of leverage always outweigh
the costs of financial distress.
13-61

If managers in a firm tend to waste

shareholders money by spending too
much on corporate jets, lavish offices, and
so on,
then a firm may wants to use______ debt
to mitigate this behavior.

a. more

b. less

c. It does not matter.

13-62

If you know that your firm is facing relatively poor

prospects but needs new capital, and you know
that investors do not have this information,
signaling theory would predict that you would:

a. Issue debt to maintain the returns of

equity holders.
b. Issue equity to share the burden of
decreased equity returns between old
and new shareholders.
c. Be indifferent between issuing debt
and equity.
d. Postpone going into capital markets
until your firms prospects improve.
13-63