CHAPTER 13

Capital Structure and Leverage

Business vs. financial risk

Optimal capital structure
Operating leverage
Capital structure theory
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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

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 Part I

Business Risk, Operating Leverage

Financial Risk, Financial Leverage

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 What is business risk?
Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
Probability Low risk

High risk

0 E(EBIT) EBIT

Note that business risk does not include effect of

financial leverage.
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What determines business risk?
Uncertainty about demand (sales).
Uncertainty about output prices.
Uncertainty about costs.
Product, other types of liability.
Competition.
Operating leverage.

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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.

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 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.
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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.
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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).

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A summary
Operating Financial Business Financial
Leverage Leverage Risk Risk
%change in %change in Variability in Additional
EBIT/%change in NI/%change in EBIT the firms variability in net
sales expected EBIT. income available
to common
shareholders.
Increase with Increase with higher Increase with Increase with high
higher fixed cost debt high OL. 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.

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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 Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
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 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

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 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.

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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 Bad Avg Good
BEP 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%

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Risk and return for leveraged
and unleveraged firms
Expected Values:
Firm U Firm L
E(BEP) 15.0% = 15.0%
E(ROE) 9.0% < 10.8%

Risk Measures:
Firm U Firm L
ROE 2.12% < 4.24%

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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.

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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

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 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.

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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 ks kd (1 T) WACC
0.00%
$ 0 12.00% 0.00% 12.00%
12.50
250K 12.51 4.80 11.55
25.00
500K 13.20 5.40 11.25
37.50
750K 14.16 6.90 11.44
50.00
1,000K 15.60 8.40 12.00

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Table for determining the stock
price maximizing capital structure
Amount
Borrowed EPS ks P0

$ 0 $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).

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Capital Structure Theory Under
Five Special Cases
Case I Assumptions
No corporate or personal taxes
No bankruptcy costs
Case II Assumptions
Corporate taxes, but no personal taxes
No bankruptcy costs
Case III Assumptions
Bankruptcy costs
Corporate taxes, but no personal taxes
Case IV Assumptions
Managers have private information
Case V Assumptions
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Managers tend to waste firm money and not work hard.
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

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3 cases

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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.
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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.

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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.

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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. High sales volatility? decrease
2. High operating leverage? decrease
3. Increase in the corporate tax rate?
increase

4. Increase in bankruptcy costs? decrease

5. Management spending lots of money
on lavish perks? increase

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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. flotation costs
b. default beta coefficients
c. direct bankruptcy costs
d. indirect bankruptcy costs
e. 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