CH 16

16 - 1
CHAPTER 16
Capital Structure Decisions:
The Basics
Impact of leverage on returns
Business versus financial risk
Capital structure theory
Perpetual cash flow example
Setting the optimal capital structure
in practice
Copyright 2002 by Harcourt, Inc. All rights reserved.
16 - 2
Consider Two Hypothetical Firms
Firm U Firm L
No debt $10,000 of 12%
debt
$20,000 in $20,000 in assets
assets
40%firms
Both tax rate 40%
have same tax rate
operating
leverage, business risk, and EBIT of
$3,000. They differ only with respect to
use of debt.
16 - 3
Impact of Leverage on Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROE 9.0% 10.8%

16 - 4
Why does leveraging increase return?
Total dollar return to investors:

U: NI = $1,800.
L: NI + Int= $1,080 + $1,200 = $2,280.
Difference= $480.
Taxes paid:
U: $1,200; L: $720.
Difference = $480.
More EBIT goes to investors in Firm L.
Equity $ proportionally lower than NI.
16 - 5
What is business risk?
Uncertainty about future operating income

(EBIT). Probability
Low risk
High risk
0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects.
16 - 6
Factors That Influence Business Risk
Uncertainty about demand (unit sales).

Uncertainty about output prices.
Uncertainty about input costs.
Product and other types of liability.
Degree of operating leverage (DOL).

16 - 7
What is operating leverage, and how

does it affect a firms business risk?
Operating leverage is the use of fixed

costs rather than variable costs.
The higher the proportion of fixed
costs within a firms overall cost
structure, the greater the operating
leverage.
(More...)

16 - 8
Higher operating leverage leads to

more business risk, because a small
sales decline causes a larger profit
decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales
(More...)
16 - 9
Probability Low operating leverage
High operating leverage
EBITL EBITH
In the typical situation, higher

operating leverage leads to higher
expected EBIT, but also increases risk.
16 - 10
Business Risk versus Financial Risk
Business risk:
Uncertainty in future EBIT.
Depends on business factors such as
competition, operating leverage, etc.
Financial risk:
Additional business risk concentrated on
common stockholders when financial
leverage is used.
Depends on the amount of debt and
preferred stock financing.

16 - 11
From a shareholders perspective, how

are financial and business risk
measured in the stand-alone sense?
Stand-alone = Business + Financial .

risk risk risk
Stand-alone risk = ROE.
Business risk = ROE(U).
Financial risk = ROE - ROE(U).

16 - 12
Now consider the fact that EBIT is not

known with certainty. What is the
impact of uncertainty on stockholder
profitability and risk for Firm U and
Firm L?

16 - 13
Firm U: Unleveraged
Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
16 - 14
Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
16 - 15
Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
8
8
8
TIE
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 8.4% 11.4% 14.4%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
*ROI = (NI + Interest)/Total financing.
16 - 16
Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROI) 9.0% 11.4%
E(ROE) 9.0% 10.8%
Risk Measures:
ROE 2.12% 4.24%
CVROE 0.24 0.39
E(TIE) 8 2.5x
16 - 17
Conclusions
Basic earning power = BEP = EBIT/Total
assets is unaffected by financial leverage.
L has higher expected ROI and ROE
because of tax savings.
L has much wider ROE (and EPS) swings
because of fixed interest charges. Its
higher expected return is accompanied
by higher risk.
(More...)
16 - 18
In a stand-alone risk sense, Firm Ls

stockholders see much more risk
than Firm Us.
U and L: ROE(U) = 2.12%.
U: ROE = 2.12%.
L: ROE = 4.24%.
Ls financial risk is ROE - ROE(U) =

4.24% - 2.12% = 2.12%. (Us is zero.)
(More...)
16 - 19
For leverage to be positive (increase

expected ROE), BEP must be > kd.
If kd > BEP, the cost of leveraging will
be higher than the inherent
profitability of the assets, so the use
of financial leverage will depress net
income and ROE.
In the example, E(BEP) = 15% while
interest rate = 12%, so leveraging
works.
16 - 20
Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Debt financing as a managerial constraint

16 - 21
MM Theory: Zero Taxes
MM prove, under a very restrictive set

of assumptions, that a firms value is
unaffected by its financing mix.
Therefore, capital structure is
irrelevant.
Any increase in ROE resulting from
financial leverage is exactly offset by
the increase in risk.

16 - 22
MM Theory: Corporate Taxes
Corporate tax laws favor debt

financing over equity financing.
With corporate taxes, the benefits of
financial leverage exceed the risks:
More EBIT goes to investors and less
to taxes when leverage is used.
Firms should use almost 100% debt
financing to maximize value.
16 - 23
MM Theory: Corporate and

Personal Taxes
Personal taxes lessen the advantage

of corporate debt:
Corporate taxes favor debt financing.
Personal taxes favor equity financing.
Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.
Firms should still use 100% debt.
16 - 24
Hamadas Equation
MM theory implies that beta changes

with leverage.
bU is the beta of a firm when it has no
debt (the unlevered beta)
bL = bU(1 + (1 - T)(D/E))
In practice, D/E is measured in book
values when bL is calculated.
16 - 25
Trade-off Theory
MM theory ignores bankruptcy (financial

distress) costs, which increase as more
leverage is used.
At low leverage levels, tax benefits
outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh
tax benefits.
An optimal capital structure exists that
balances these costs and benefits.

16 - 26
Signaling Theory
MM assumed that investors and managers
have the same information.
But, managers often have better
information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view new
stock sales as a negative signal.
Implications for managers?

16 - 27
Debt Financing As
a Managerial Constraint
One agency problem is that

managers can use corporate funds
for non-value maximizing purposes.
The use of financial leverage:
Bonds free cash flow.
Forces discipline on managers.
However, it also increases risk of
financial distress.
16 - 28
Perpetual Cash Flow Example
Expected EBIT = $500,000; will remain

constant over time.
Firm pays out all earnings as
dividends (zero growth).
Currently is all-equity financed. BV of
equity = MV of equity
100,000 shares outstanding.
P0 = $20; T = 40%; kRF = 6%; RPM = 4%
16 - 29
Component Cost Estimates
Amount
Borrowed (000) kd
$ 0 -
250 10.0%
500 11.0
750 13.0
1,000 16.0
If company recapitalizes, debt would be
issued to repurchase
Copyright 2002 by Harcourt, Inc.
stock. All rights reserved.
16 - 30
The MM and Miller models cannot

be applied directly because several
assumptions are violated.
kd is not a constant.
Bankruptcy and agency costs
exist.
In practice, Hamadas equation is
used to find kS for the firm with
different levels of debt.
16 - 31
The Optimal Capital Structure
Calculate the cost of equity at each

level of debt.
Calculate the value of equity at each
level of debt.
Calculate the total value of the firm
(value of equity + value of debt) at each
level of debt.
The optimal capital structure maximizes
the total value of the firm.
16 - 32
Sequence of Events in a
Recapitalization
Firm announces the recapitalization.

Investors reassess their views and
estimate a new equity value.
New debt is issued and proceeds are
used to repurchase stock at the new
equilibrium price.
(More...)
16 - 33
Shares Debt issued

= .
Bought New price/share
After recapitalization firm would have
more debt but fewer common shares
outstanding.
An analysis of several debt levels is
given next.

16 - 34
Cost of Equity at Zero Debt
Since the firm has 0 growth, its current

value, $2,000,000, is given by
Dividends/kS = (EBIT)(1-T)/kS
= 500,000 (1 - 0.40)/k S
kS = 15.0% = unlevered cost of equity.
bU = (kS - kRF)/RPM = (15 - 6)/4 = 2.25

16 - 35
Cost of Equity at Each Debt Level
Hamadas equation says that

bL = bU (1 + (1-T)(D/E))
Debt(000s) D/E bL kS
0 0 2.25 15.00%
250 0.142 2.44 15.77
500 0.333 2.70 16.80
750 0.600 3.06 18.24
1,000 1.000 3.60 20.40
16 - 36
D = $250, kd = 10%, ks = 15.77%.

(EBIT - kdD)(1 - T)
S1 = ks
[$500 - 0.1($250)](0.6)
= 0.1577 = $1,807.
V1 = S1 + D1 = $1,807 + $250 = $2,057.

$2,05
P1 = 7 = $20.57.
100
16 - 37
Shares $250
= = 12.15.
repurchased $20.57
Shares
= n1 = 100 - 12.15 = 87.85.
remaining
Check on stock price:

S1 $1,807
P1 = = = $20.57.
n1 87.85
Other debt levels treated similarly.
16 - 38
Value of Equity at Each Debt Level
Equity Value = Dividends/kS
Debt(000s) kD Divs kS E
0 na 300 15.00% 2,000
250 10% 285 15.77 1,807
500 11% 267 16.80 1,589
750 13% 241.5 18.24 1,324
1,000 16% 204 20.40 1,000

16 - 39
Total Value of Firm
Debt Total Price per

(000s) E Value Share
0 2,000 2,000 $20.00
250 1,807 2,057 20.57 Total Value
500 1,589 2,089 20.89 is Max-
750 1,324 2,074 20.74 imized with
1,000 1,000 2,000 20.00 500,000 in
debt.
16 - 40
Calculate EPS at debt of $0, $250K,

$500K, and $750K, assuming that the
firm begins at zero debt and recap-
italizes to each level in a single step.
Net income = NI = [EBIT - kd D](1 - T).

EPS = NI/n.
D NI n EPS
$ 0 $300 100.00 $3.00
250 285 87.85 3.24
500 267 76.07 3.51
750 242 63.84 3.78
16 - 41
EPS continues to increase beyond

the $500,000 optimal debt level.
Does this mean that the optimal
debt level is $750,000, or even
higher?

16 - 42
Find the WACC at each debt level.

D S V kd Ks WACC
$ 0 $2,000 $2,000 -- 15.00% 15.0%
250 1,807 2,057 10% 15.77 14.6
500 1,589 2,089 11.0 16.80 14.4
750 1,324 2,074 13.0 18.24 14.5
1,000 1,000 2,000 13.0 20.40 15.0
e.g. D = $250:
WACC = ($250/$2,057)(10%)(0.6)
+ ($1,807/$2,057)(15.77%)
= 14.6%.
16 - 43
The WACC is minimized at D =

$500,000, the same debt level that
maximizes stock price.
Since the value of a firm is the
present value of future operating
income, the lowest discount rate
(WACC) leads to the highest value.

16 - 44
How would higher or lower

business risk affect
the optimal capital structure?
At any debt level, the firms probability

of financial distress would be higher.
Both kd and ks would rise faster than
before. The end result would be an
optimal capital structure with less debt.
Lower business risk would have the
opposite effect.
16 - 45
Is it possible to do an analysis exactly

like the one above for most firms?
No. The analysis above was based on

the assumption of zero growth, and
most firms do not fit this category.
Further, it would be very difficult, if
not impossible, to estimate ks with
any confidence.

16 - 46
What type of analysis should firms

conduct to help find their optimal, or
target, capital structure?
Financial forecasting models can

help show how capital structure
changes are likely to affect stock
prices, coverage ratios, and so on.
(More...)
16 - 47
Forecasting models can generate

results under various scenarios, but
the financial manager must specify
appropriate input values, interpret
the output, and eventually decide on
a target capital structure.
In the end, capital structure decision
will be based on a combination of
analysis and judgment.

16 - 48
What other factors would managers

consider when setting the target
capital structure?
Debt ratios of other firms in the

industry.
Pro forma coverage ratios at different
capital structures under different
economic scenarios.
Lender and rating agency attitudes
(impact on bond ratings).
16 - 49
Reserve borrowing capacity.

Effects on control.
Type of assets: Are they tangible,
and hence suitable as collateral?
Tax rates.

CH 16

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 16

Uploaded by

Copyright:

Available Formats

16 - 1

Consider Two Hypothetical Firms

Impact of Leverage on Returns

Copyright 2002 by Harcourt, Inc. All rights reserved.

Why does leveraging increase return?

Total dollar return to investors:

What is business risk?

Uncertainty about future operating income

Factors That Influence Business Risk

Uncertainty about demand (unit sales).

Copyright 2002 by Harcourt, Inc. All rights reserved.

What is operating leverage, and how

Operating leverage is the use of fixed

Copyright 2002 by Harcourt, Inc. All rights reserved.

Higher operating leverage leads to

QBE Sales QBE Sales

Probability Low operating leverage

High operating leverage

In the typical situation, higher

Business Risk versus Financial Risk

Copyright 2002 by Harcourt, Inc. All rights reserved.

From a shareholders perspective, how

Stand-alone = Business + Financial .

Business risk = ROE(U).

Financial risk = ROE - ROE(U).

Now consider the fact that EBIT is not

Copyright 2002 by Harcourt, Inc. All rights reserved.

In a stand-alone risk sense, Firm Ls

Ls financial risk is ROE - ROE(U) =

For leverage to be positive (increase

Capital Structure Theory

Copyright 2002 by Harcourt, Inc. All rights reserved.

MM Theory: Zero Taxes

MM prove, under a very restrictive set

Copyright 2002 by Harcourt, Inc. All rights reserved.

MM Theory: Corporate Taxes

Corporate tax laws favor debt

MM Theory: Corporate and

Personal taxes lessen the advantage

MM theory implies that beta changes

MM theory ignores bankruptcy (financial

Copyright 2002 by Harcourt, Inc. All rights reserved.

Copyright 2002 by Harcourt, Inc. All rights reserved.

One agency problem is that

Perpetual Cash Flow Example

Expected EBIT = $500,000; will remain

Component Cost Estimates

The MM and Miller models cannot

The Optimal Capital Structure

Calculate the cost of equity at each

Firm announces the recapitalization.

Shares Debt issued

Copyright 2002 by Harcourt, Inc. All rights reserved.

Cost of Equity at Zero Debt

Since the firm has 0 growth, its current

kS = 15.0% = unlevered cost of equity.

bU = (kS - kRF)/RPM = (15 - 6)/4 = 2.25

Cost of Equity at Each Debt Level

Hamadas equation says that

D = $250, kd = 10%, ks = 15.77%.

V1 = S1 + D1 = $1,807 + $250 = $2,057.

Check on stock price:

Value of Equity at Each Debt Level