CHAPTER 16 Capital Structure Decisions: The Basics

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Copyright © 2002 by Harcourt, Inc. All rights reserved.

CHAPTER 16Capital 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

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Consider Two Hypothetical Firms

Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

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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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%

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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.

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Uncertainty about future operating income (EBIT).

Note that business risk focuses on operating income, so it ignores financing effects.

What is business risk?

Probability

EBITE(EBIT)0

Low risk

High risk

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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).

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What is operating leverage, and how does it affect a firm’s business risk?

Operating leverage is the use of fixed costs rather than variable costs.

The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.

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Higher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline.

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Sales

$ Rev.TC

FC

QBE Sales

$ Rev.

TC

FC

QBE

Profit}

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Probability

EBITL

Low operating leverage

High operating leverage

EBITH

In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.

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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.

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From a shareholder’s perspective, how are financial and business risk

measured in the stand-alone sense?

Stand-alone Business Financialrisk risk risk= + .

Stand-alone risk = ROE.

Business risk = ROE(U).

Financial risk = ROE - ROE(U).

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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?

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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

*Same as for Firm U.

EconomyBad 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

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*ROI = (NI + Interest)/Total financing.

8 8 8

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%

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

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Profitability Measures:

U L

E(BEP) 15.0% 15.0%

E(ROI) 9.0% 11.4%

E(ROE) 9.0% 10.8%

Risk Measures:

ROE2.12% 4.24%

CVROE 0.24 0.39

E(TIE) 2.5x8

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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.

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In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.

U and L: ROE(U) = 2.12%.

U: ROE = 2.12%.

L: ROE = 4.24%.

L’s financial risk is ROE - ROE(U) = 4.24% - 2.12% = 2.12%. (U’s is zero.)

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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.”

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Capital Structure Theory

MM theoryZero taxesCorporate taxesCorporate and personal taxes

Trade-off theory

Signaling theory

Debt financing as a managerial constraint

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MM Theory: Zero Taxes

MM prove, under a very restrictive set of assumptions, that a firm’s 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.

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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.

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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.

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Hamada’s 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.

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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.

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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?

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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.

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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%

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Component Cost Estimates

If company recapitalizes, debt would be issued to repurchase stock.

Amount

Borrowed (000) kd

$ 0 -

250 10.0%

500 11.0

750 13.0

1,000 16.0

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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, Hamada’s equation is used to find kS for the firm with different levels of debt.

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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.

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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.

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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.

= .

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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)/kS

kS = 15.0% = unlevered cost of equity.

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

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Cost of Equity at Each Debt Level

Hamada’s 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

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

S1 =

= = $1,807.

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

P1 = = $20.57.

[$500 - 0.1($250)](0.6)0.1577

$2,057 100

(EBIT - kdD)(1 - T)ks

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Shares $250 repurchased $20.57

Shares remaining

Check on stock price:

P1 = = = $20.57.

Other debt levels treated similarly.

S1

n1

$1,80787.85

= = 12.15.

= n1 = 100 - 12.15 = 87.85.

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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

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Total Value of Firm

Total Value is Max-imized with 500,000 in debt.

Debt (000s) E

Total Value

Price per Share

0 2,000 2,000 $20.00

250 1,807 2,057 20.57

500 1,589 2,089 20.89

750 1,324 2,074 20.74

1,000 1,000 2,000 20.00

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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 $3.00250 285 87.85 3.24

500 267 76.07 3.51750 242 63.84 3.78

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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?

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Find the WACC at each debt level.

e.g. D = $250:WACC = ($250/$2,057)(10%)(0.6)

+ ($1,807/$2,057)(15.77%)= 14.6%.

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

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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.

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At any debt level, the firm’s 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.

How would higher or lowerbusiness risk affect

the optimal capital structure?

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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.

Is it possible to do an analysis exactly like the one above for most firms?

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Financial forecasting models can help show how capital structure changes are likely to affect stock prices, coverage ratios, and so on.

What type of analysis should firms conduct to help find their optimal, or

target, capital structure?

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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.

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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).

What other factors would managers consider when setting the target

capital structure?

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Reserve borrowing capacity.

Effects on control.

Type of assets: Are they tangible, and hence suitable as collateral?

Tax rates.

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CHAPTER 16 Capital Structure Decisions: The Basics