Chapter 21 - Capital Structure Decisions

Prepared byPrepared byKen HartviksenKen Hartviksen

INTRODUCTION TOINTRODUCTION TO CORPORATE FINANCECORPORATE FINANCELaurence Booth Laurence Booth •• W. Sean Cleary W. Sean Cleary

Chapter 21 – Capital Structure DecisionsChapter 21 – Capital Structure Decisions

CHAPTER 21CHAPTER 21 Capital Structure DecisionsCapital Structure Decisions

CHAPTER 21 – Capital Structure Decisions 21 - 3

Lecture AgendaLecture Agenda

• Learning ObjectivesLearning Objectives• Important TermsImportant Terms• Financial LeverageFinancial Leverage• Determining Capital StructureDetermining Capital Structure• M&M Irrelevance TheoremM&M Irrelevance Theorem• Impact of TaxesImpact of Taxes• Financial Distress, Bankruptcy and Agency CostsFinancial Distress, Bankruptcy and Agency Costs• Other Factors affecting Capital StructureOther Factors affecting Capital Structure• Capital Structure in PracticeCapital Structure in Practice• Summary and ConclusionsSummary and Conclusions

– Concept Review QuestionsConcept Review Questions– Appendix 1 – Thunder Bay Industries – Indifference AnalysisAppendix 1 – Thunder Bay Industries – Indifference Analysis


Learning ObjectivesLearning Objectives

1.1. How business risk and financial risk affect a firm’s ROE and EPSHow business risk and financial risk affect a firm’s ROE and EPS

2.2. How indifference analysis may be used to compare financing How indifference analysis may be used to compare financing alternatives based on expected EBIT levelsalternatives based on expected EBIT levels

3.3. Modigliani and Miller’s irrelevance, argument, as well as the key Modigliani and Miller’s irrelevance, argument, as well as the key assumptions upon which it is basedassumptions upon which it is based

4.4. How the introduction of corporate taxes affects M&M’s irrelevance How the introduction of corporate taxes affects M&M’s irrelevance argumentargument

5.5. How financial distress and bankruptcy costs lead to the static trade-How financial distress and bankruptcy costs lead to the static trade-off theory of capital structureoff theory of capital structure

6.6. How information asymmetry problems and agency problems may How information asymmetry problems and agency problems may lead firms to follow a pecking order approach to financinglead firms to follow a pecking order approach to financing

7.7. How other factors such as firm size, profitability and growth, asset How other factors such as firm size, profitability and growth, asset tangibility, and market conditions can affect a firm’s capital tangibility, and market conditions can affect a firm’s capital structure.structure.


Important Chapter TermsImportant Chapter Terms

• Agency costsAgency costs• BankruptcyBankruptcy• Business riskBusiness risk• Cash flow-to-debt ratioCash flow-to-debt ratio• Corporate debt tax shieldCorporate debt tax shield• Direct costs of bankruptcyDirect costs of bankruptcy• EPS indifference pointEPS indifference point• Financial break-even Financial break-even

pointspoints• Financial distressFinancial distress• Financial leverageFinancial leverage• Financial leverage risk Financial leverage risk

premiumpremium

• Financial riskFinancial risk• Fixed burden coverage ratioFixed burden coverage ratio• Homemade leverageHomemade leverage• Indifference pointIndifference point• Indirect costs of bankruptcyIndirect costs of bankruptcy• Invested capitalInvested capital• M&M equity cost equationM&M equity cost equation• Modigliani and MillerModigliani and Miller• Pecking orderPecking order• Profit planning chartsProfit planning charts• Return on equity (ROE)Return on equity (ROE)• Return on invested capitalReturn on invested capital• Risk value of moneyRisk value of money• Static tradeoffStatic tradeoff

Introduction to LeverageIntroduction to Leverage

Financial LeverageFinancial Leverage


The Focus of this ChapterThe Focus of this Chapter

• You know:You know:– It is the responsibility of the financial manager to maximize It is the responsibility of the financial manager to maximize

shareholder wealth.shareholder wealth.– The after-tax cost of debt is significantly lower than the cost of The after-tax cost of debt is significantly lower than the cost of

equity primarily because of the tax-deductibility of interest equity primarily because of the tax-deductibility of interest expense…therefore, using debt has a cost advantage over expense…therefore, using debt has a cost advantage over equity.equity.

– The lower the cost of capital, the greater the value of the firm.The lower the cost of capital, the greater the value of the firm.– This chapter addresses the question:This chapter addresses the question:

Does the relative mix of financing used by a firm affect its value? If so, how and why and are what are the other impacts that capital structure can have on the firm?


In this Chapter You Will LearnIn this Chapter You Will Learn

1.1. The optimal (target) capital structure is the one that The optimal (target) capital structure is the one that maximizes the value of the firm and minimizes the maximizes the value of the firm and minimizes the cost of capital.cost of capital.

2.2. How lenders seek to protect themselves from How lenders seek to protect themselves from excessive use of corporate leverage through the use excessive use of corporate leverage through the use of protective covenants.of protective covenants.

3.3. The tax advantage to debt is offset at higher levels of The tax advantage to debt is offset at higher levels of financial leverage by costs associated with financial financial leverage by costs associated with financial distress and bankruptcy.distress and bankruptcy.

4.4. Firms depart from the target capital structure in Firms depart from the target capital structure in practice because of financing preferences and capital practice because of financing preferences and capital market conditions.market conditions.

Leverage: What is It?Leverage: What is It?

Capital Structure DecisionsCapital Structure Decisions


LeverageLeverage

• The increased volatility in operating income The increased volatility in operating income over time, created by the use of fixed costs in over time, created by the use of fixed costs in lieu of variable costs.lieu of variable costs.– Leverage magnifies profits and losses.Leverage magnifies profits and losses.

• There are two types:There are two types:– Operating leverageOperating leverage– Financial leverageFinancial leverage

• Both types of leverage have the same effect Both types of leverage have the same effect on shareholders but are accomplished in very on shareholders but are accomplished in very different ways, for very different purposes different ways, for very different purposes strategically.strategically.


Leverage Effects on Operating IncomeLeverage Effects on Operating Income

Years

When a firm increases the use of fixed costs it increases the volatility of operating income.

Normal volatility of operating income

Operating Income

+

0

-

Financial versus Operating LeverageFinancial versus Operating Leverage



Operating LeverageOperating LeverageWhat is it? How is it Increased?What is it? How is it Increased?

• Operating leverage is:Operating leverage is:– The increased volatility in operating income caused by fixed The increased volatility in operating income caused by fixed

operating costs.operating costs.

• You should understand that managers do make You should understand that managers do make decisions affecting the cost structure of the firm.decisions affecting the cost structure of the firm.

• Managers can, and do, decide to invest in assets that Managers can, and do, decide to invest in assets that give rise to additional fixed costs and the intent is to give rise to additional fixed costs and the intent is to reduce variable costs.reduce variable costs.– This is commonly accomplished by a firm choosing to become This is commonly accomplished by a firm choosing to become

more capital intensive and less labour intensive, thereby more capital intensive and less labour intensive, thereby increasing operating leverage.increasing operating leverage.


Operating LeverageOperating LeverageAdvantages and DisadvantagesAdvantages and Disadvantages

Advantages:Advantages:– Magnification of profits to the shareholders if the firm is Magnification of profits to the shareholders if the firm is

profitable.profitable.– Operating efficiencies (faster production, fewer errors, higher Operating efficiencies (faster production, fewer errors, higher

quality) usually result increasing productivity, reducing quality) usually result increasing productivity, reducing ‘downtime’ etc.‘downtime’ etc.

Disadvantages:Disadvantages:– Magnification of losses to the shareholders if the firm does not Magnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.earn enough revenue to cover its costs.– Higher break even pointHigher break even point– High capital cost of equipment and the illiquidity of such an High capital cost of equipment and the illiquidity of such an

investment make it:investment make it:• Expensive (more difficult to finance)Expensive (more difficult to finance)• Potentially exposed to technological obsolescence, etc.Potentially exposed to technological obsolescence, etc.


Financial LeverageFinancial LeverageWhat is it? How is it Increased?What is it? How is it Increased?

• Your textbook defines financial leverage as:Your textbook defines financial leverage as:– The increased volatility in operating income caused The increased volatility in operating income caused

by the corporate use of sources of capital that carry by the corporate use of sources of capital that carry fixed financial costs.fixed financial costs.

• Financial leverage can be increased in the Financial leverage can be increased in the firm by:firm by:– Selling bonds or preferred stock (taking on financial Selling bonds or preferred stock (taking on financial

obligations with fixed annual claims on cash flow)obligations with fixed annual claims on cash flow)– Using the proceeds from the debt to retire equity (if Using the proceeds from the debt to retire equity (if

the lenders don’t prohibit this through the bond the lenders don’t prohibit this through the bond indenture or loan agreement)indenture or loan agreement)


Financial LeverageFinancial LeverageAdvantages and DisadvantagesAdvantages and Disadvantages

Advantages:Advantages:– Magnification of profits to the shareholders if the firm is Magnification of profits to the shareholders if the firm is

profitable.profitable.– Lower cost of capital at low to moderate levels of financial Lower cost of capital at low to moderate levels of financial

leverage because interest expense is tax-deductible.leverage because interest expense is tax-deductible.

Disadvantages:Disadvantages:– Magnification of losses to the shareholders if the firm does not Magnification of losses to the shareholders if the firm does not

earn enough revenue to cover its costs.earn enough revenue to cover its costs.– Higher break even point.Higher break even point.– At higher levels of financial leverage, the low after-tax cost of At higher levels of financial leverage, the low after-tax cost of

debt is offset by other effects such as:debt is offset by other effects such as:• Present value of the rising probability of bankruptcy costsPresent value of the rising probability of bankruptcy costs• Agency costsAgency costs• Lower operating income (EBIT), etc.Lower operating income (EBIT), etc.


Effects of Operating and Financial LeverageEffects of Operating and Financial LeverageSummarySummary

• Equity holders bear the added risks associated with the Equity holders bear the added risks associated with the use of leverage.use of leverage.

• The higher the use of leverage (either operating or The higher the use of leverage (either operating or financial) the higher the risk to the shareholder.financial) the higher the risk to the shareholder.

• Leverage therefore can and does affect shareholders Leverage therefore can and does affect shareholders required rate of return, and in turn this influences the cost required rate of return, and in turn this influences the cost of capital.of capital.

HIGHER LEVERAGE = HIGHER COST OF CAPITALHIGHER LEVERAGE = HIGHER COST OF CAPITAL

Financial LeverageFinancial Leverage



Business RiskBusiness Risk

• All firms experience variability in sales and operating All firms experience variability in sales and operating (fixed and variable) operating costs over time.(fixed and variable) operating costs over time.– Some firms operate in a highly volatile industry (for example oil Some firms operate in a highly volatile industry (for example oil

and gas) and we would say the firm has a high degree of and gas) and we would say the firm has a high degree of business risk.business risk.

– Other firms operate in a very stable industry where revenues Other firms operate in a very stable industry where revenues and expenses don’t change much from year to year throughout and expenses don’t change much from year to year throughout the business cycle; these firms have low business risk.the business cycle; these firms have low business risk.

• Business risk is the variability of a firm’s operating Business risk is the variability of a firm’s operating income caused by operational risk.income caused by operational risk.– Business risk is measured by the standard deviation of EBIT.Business risk is measured by the standard deviation of EBIT.


Financial LeverageFinancial LeverageRisk and LeverageRisk and Leverage

• Lenders to the firm insulate themselves from risk Lenders to the firm insulate themselves from risk through financial contracting:through financial contracting:

• Lending money through a formal, legally-binding contract.Lending money through a formal, legally-binding contract.• Demanding a fixed rate of return on the money they lend to the Demanding a fixed rate of return on the money they lend to the

firm, in-keeping with their required return on monies borrowed.firm, in-keeping with their required return on monies borrowed.• Demanding other promises that will protect the lender’s interests Demanding other promises that will protect the lender’s interests

over the life of the loan/investment.over the life of the loan/investment.• Demanding a high priority in the priority of claims list in the event Demanding a high priority in the priority of claims list in the event

of corporate dissolution/bankruptcy.of corporate dissolution/bankruptcy.

• Shareholders bear the risk associated with business Shareholders bear the risk associated with business risk, and the added risks associated with the use of risk, and the added risks associated with the use of leverage because they are residual claimants of the leverage because they are residual claimants of the firm.firm.


Return on Investment (ROI)Return on Investment (ROI)Financial LeverageFinancial Leverage

Return on Investment (ROI)Return on Investment (ROI)– is the return on all the capital provided by investors; EBIT is the return on all the capital provided by investors; EBIT

minus taxes divided by invested capital.minus taxes divided by invested capital.– Invested Capital (IC) is a firm’s capital structure consisting of Invested Capital (IC) is a firm’s capital structure consisting of

shareholders’ equity and short- and long-term debt.shareholders’ equity and short- and long-term debt.

)1(

BSE

TEBITROI

[ 21-2]

But we know the claims on the numerator

(operating income after taxes) are very

different, and so too are the risks each

provider of capital is exposed.


Return on Equity (ROE)Return on Equity (ROE)Financial LeverageFinancial Leverage

ROE – is the return earned by equity holders ROE – is the return earned by equity holders on their investment in the companyon their investment in the company– ROE = net income divided by shareholders’ equity.ROE = net income divided by shareholders’ equity.

)1)((

SE

TBREBITROE D

[ 21-1]


ROI versus ROEROI versus ROEFinancial LeverageFinancial Leverage

• If the firm is completely financed by equity: If the firm is completely financed by equity: ROE = ROI.ROE = ROI.

• Let us examine the effects of sales volatility Let us examine the effects of sales volatility on ROI and ROE given different levels of on ROI and ROE given different levels of financial leverage.financial leverage.



• Using this base income statement:Using this base income statement:

• The following three slides show three different financing strategies The following three slides show three different financing strategies and the impacts on ROE, ROI, EPS for break-even, normal, and and the impacts on ROE, ROI, EPS for break-even, normal, and high sales levels:high sales levels:

Sales $1,000Variable costs 300Fixed costs 158EBIT $542Interest 42Taxable Income $500Tax (40%) 200Net Income $300

Table 21-1 Example Income Statement


Financial LeverageFinancial LeverageIncome Statement – No Financial LeverageIncome Statement – No Financial Leverage

-77.5% 100.0% 140.0%

Sales $225 $1,000 $1,400Variable costs 68 300 420Fixed costs 158 158 158EBIT -$1 $542 $822Interest 0 0 0Taxable Income -$1 $542 $822Tax (40%) 0 217 329Net Income -$0 $325 $493

Invested capital = $1,700 100.0%Debtholders' investment = $0 0.0%Shareholders' Equity = $1,700 100.0%

ROI = 0.0% 19.1% 29.0%ROE = 0.0% 19.1% 29.0%EPS (1,700 shares) = $0.00 $0.19 $0.29


This assumes a 0.0 debt/equity ratio

ROE = ROI because no use of debt financing.


Financial LeverageFinancial LeverageIncome Statement – Base CaseIncome Statement – Base Case

-71.5% 100.0% 140.0%

Sales $285 $1,000 $1,400Variable costs 86 300 420Fixed costs 158 158 158EBIT $42 $542 $822Interest 42 42 42Taxable Income -$0 $500 $780Tax (40%) 0 200 312Net Income -$0 $300 $468

Invested capital = $1,700 100.0%Debtholders' investment = $700 41.2%Shareholders' Equity = $1,000 58.8%

ROI = 1.5% 19.1% 29.0%ROE = -0.1% 42.9% 66.9%EPS (1000 shares) = $0.00 $0.30 $0.47


This assumes a 0.70 debt/equity ratio

ROE is levered compared to ROI because of the moderate

use of debt financing.


Financial LeverageFinancial LeverageIncome Statement with High Financial LeverageIncome Statement with High Financial Leverage

-65.4% 100.0% 140.0%

Sales $346 $1,000 $1,400Variable costs 104 300 420Fixed costs 158 158 158EBIT $84 $542 $822Interest 84 $84 $84Taxable Income $0 $458 $738Tax (40%) 0.08 183.2 295.2Net Income $0 $275 $443

Invested capital = $1,700 100.0%Debtholders' investment = $1,400 82.4%Shareholders' Equity = $300 17.6%

ROI = 3.0% 19.1% 29.0%ROE = 0.0% 91.6% 147.6%EPS (300 shares) = $0.00 $0.92 $1.48


ROE is more volatile than ROI because of the high use

of financial leverage.



• Consider the equation for ROE:Consider the equation for ROE:

)1)((

SE

TBREBITROE D

[ 21-1]

EBIT – Interest expense = EBTEBT times (1 – T) = Net Income

The equation reduce to net income divided by BV of shareholders’ equity.



• Equation 21 – 2 is the definition of ROI:Equation 21 – 2 is the definition of ROI:

• If we re-express EBIT (1-T) in the ROE If we re-express EBIT (1-T) in the ROE equation, we get:equation, we get:

)1(

BSE

TEBITROI

[ 21-2]



• This is the financial leverage equation:This is the financial leverage equation:

• ROI measures the return that the firm earns ROI measures the return that the firm earns from operations, but DOES NOT explicitly from operations, but DOES NOT explicitly considered how the firm is financed.considered how the firm is financed.

)1((SE

BTRROIROIROE D [ 21-3]



• If we rearrange Equation 21 – 3, grouping like terms If we rearrange Equation 21 – 3, grouping like terms involving ROI we get:involving ROI we get:

• The second term is fixed.The second term is fixed.• The first term depends on the firm’s uncertain ROI.The first term depends on the firm’s uncertain ROI.• This means we can graph ROE against ROI as a This means we can graph ROE against ROI as a

straight line.straight line.See Figure 21 -1 on the following slide.See Figure 21 -1 on the following slide.

)1()1(SE

BTR

SE

BROIROE D [ 21-4]



21 - 1 FIGURE

ROE

80

60

40

20

ROI

-20

-40

-60

All Equity

D/E =0.70

-16 -12 -8 -4 0 4 8 12 16 20 24 28 32 36 40

Slope of the all equity

line is = 1.0.

In this case ROI = ROE.

D/E = 0.70.

Slope of the line > 1.0.

Above the intercept with the

horizontal axis, ROE

>ROI.

Financial Break-even points where ROE = 0Indifference point where ROEs for different financing strategies are equal.



Financial Break-even point:Financial Break-even point:– Points at which a firm’s ROE is zero.Points at which a firm’s ROE is zero.

Indifference Point:Indifference Point:– Points at which two financing strategies provide the Points at which two financing strategies provide the

same ROE. same ROE.


Financial LeverageFinancial LeverageThe Rules of Financial LeverageThe Rules of Financial Leverage

• For value-maximizing firms, the use of debt For value-maximizing firms, the use of debt increases the expected ROE so shareholders increases the expected ROE so shareholders expect to be better off by using debt financing, expect to be better off by using debt financing, rather than equity financing.rather than equity financing.

• Financing with debt increases the variability of Financing with debt increases the variability of the firm’s ROE, which usually increases the risk the firm’s ROE, which usually increases the risk to the common shareholders.to the common shareholders.

• Financing with debt increases the likelihood of Financing with debt increases the likelihood of the firm running into financial distress and the firm running into financial distress and possibly even bankruptcy.possibly even bankruptcy.



70% D/E Ratio 100% Equity

ROI (%)10 14.48 1030 48.48 30

Range 34 20

Table 21-2 Varying ROI Values

ROE (%)

ROI reflects the business risk of the firm.

ROE =ROI in the all equity firm.

ROE increases as the firm finances with more debt.



70% D/E Ratio 100% Equity

ROI (%)-10 -19.52 -1040 65.48 40

Range 85 50

Table 21-3 Wider Variation ROI Values

ROE (%)

Wider variation in ROI means magnified ROE over a still wider range than ROI.


Financial Leverage Financial Leverage Investing Using LeverageInvesting Using Leverage

• Figure 21 – 2 illustrates the monthly returns Figure 21 – 2 illustrates the monthly returns from investing in the S&P/TSX Composite from investing in the S&P/TSX Composite Index using two different financing strategies:Index using two different financing strategies:

1.1. Investing in the index (all equity)Investing in the index (all equity)2.2. Investing in the index with 80% borrowed on margin.Investing in the index with 80% borrowed on margin.

• The added volatility of gains and losses over The added volatility of gains and losses over time is clearly evident.time is clearly evident.

• These principles of leverage apply to These principles of leverage apply to corporations as well as householdscorporations as well as households

(See Figure 21 – 2 on the following slide)(See Figure 21 – 2 on the following slide)


Financial Leverage Financial Leverage Investing Using LeverageInvesting Using Leverage

21 - 2 FIGURE

Indifference AnalysisIndifference Analysis



Financial LeverageFinancial LeverageIndifference AnalysisIndifference Analysis

• Is a profit planning technique used to forecast Is a profit planning technique used to forecast the EPS-EBIT relationships under different the EPS-EBIT relationships under different financing scenarios.financing scenarios.

• The indifference point is where:The indifference point is where:

EPSEPS(Financing strategy 1)(Financing strategy 1)=EPS=EPS(Financing strategy 2)(Financing strategy 2)


Financial Leverage Financial Leverage Indifference AnalysisIndifference Analysis

• The formula for EPS, given EBIT, interest on debt (RThe formula for EPS, given EBIT, interest on debt (RDDB), the B), the corporate tax rate (T), and the number of common shares corporate tax rate (T), and the number of common shares outstanding (#):outstanding (#):

• We can rearrange the definition of EPS and show how it varies We can rearrange the definition of EPS and show how it varies with EBIT:with EBIT:

#

)1)(( TBREBITEPS D

[ 21-5]


Financial Leverage Financial Leverage Indifference AnalysisIndifference Analysis

• EPS is a simple linear function of EBIT:EPS is a simple linear function of EBIT:

• This is illustrated in the EPS-EBIT graph in This is illustrated in the EPS-EBIT graph in Figure 21 – 3 found on the following slide:Figure 21 – 3 found on the following slide:

#

)1(

#

)1( TEBITTBREPS D

[ 21-6]


Financial Leverage Financial Leverage EPS-EBIT (Profit Planning) ChartsEPS-EBIT (Profit Planning) Charts

21 - 3 FIGURE

0.8

0.6

0.4

0.2

0

-0.2

-0.4

-0.6 EPS 0% D/E EPS 70% D/E

-567-397-312-227 -142 57 28 113 198 283 368 453 538 623 708 793 878 963 1048 1133

Indifference point.

The horizontal intercept of the 70% D/E line is greater by the added interest expense that must be covered before producing earnings available

for common shareholders.


Financial Leverage Financial Leverage EPS-EBIT (Profit Planning) ChartsEPS-EBIT (Profit Planning) Charts

• The slope of the lines are a function of the The slope of the lines are a function of the number of common shares outstanding number of common shares outstanding (dilution of EPS).(dilution of EPS).– The all equity line will have a lower slope because The all equity line will have a lower slope because

every dollar of net income is divided by more common every dollar of net income is divided by more common shares.shares.

• The horizontal intercept is greater for the The horizontal intercept is greater for the debt financing line because the firm must debt financing line because the firm must cover its interest expense before earnings cover its interest expense before earnings begin to accrue to the benefit of begin to accrue to the benefit of shareholders.shareholders.

Determining Capital StructureDetermining Capital Structure




• Table 21 – 4 demonstrates the 1990 results of a Table 21 – 4 demonstrates the 1990 results of a Conference Board survey of 119 U.S. Conference Board survey of 119 U.S. companies to determine their capital structure.companies to determine their capital structure.

• External sources of information include:External sources of information include:– (#2) checking with their advisors, and(#2) checking with their advisors, and– (#5) examining other firms in the industry.(#5) examining other firms in the industry.

• The three primary sources of information are:The three primary sources of information are:– (#4) impact on profits(#4) impact on profits– (#3) risk(#3) risk– (#1) analysis of cash flows(#1) analysis of cash flows



1. Analysis of cash flows 23.0%2. Consultations 18.3%3. Risk considerations 16.5%4. Impact on profits 14.0%5. Industry comparisons 12.0%6. Other 3.4%Source: Data from Conference Board, 1990

Table 21-4 Determinants of Capital Structure

Primary sources include:• Analysis of cash flows• Risk consideration• Impact on profits


Determining Capital StructureDetermining Capital StructureUseful RatiosUseful Ratios

• Stock ratios (balance sheet ratios) that are Stock ratios (balance sheet ratios) that are helpful include:helpful include:– Total debt to total assetsTotal debt to total assets– Debt to equity ratioDebt to equity ratio

• Flow ratios make use of information taken Flow ratios make use of information taken from the income statement and when from the income statement and when combined with balance sheet data help to combined with balance sheet data help to determine the ability of the firm to service its determine the ability of the firm to service its debt.debt.



• Fixed Burden Coverage Ratio:Fixed Burden Coverage Ratio:

– An expanded interest coverage ratio that looks at a An expanded interest coverage ratio that looks at a broader measure of both income and the broader measure of both income and the expenditures associated with debt.expenditures associated with debt.

)1/()Pref.Div.( TSFI

EBITDACoverageBurdenFixed

[ 21-7]



• Cash-flow-to-debt ratio (CFTD)Cash-flow-to-debt ratio (CFTD)

– A direct measure of the cash flow over a period that is A direct measure of the cash flow over a period that is available to cover a firm’s stock of outstanding debt.available to cover a firm’s stock of outstanding debt.

Debt

EBITDACFTD [ 21-8]



IG Non-IG

Coverage 4.01 1.45Leverage (%) 46.2 67.4Cash flow-to-debt (%) 18.3 8.10Liquidity (%) 3.66 4.45Profit margin (%) 6.26 1.39Return on assets (%) 8.41 6.92Sales stability 7.14 5.60Total assets ($ billion) 6.31 1.19Altman Z score 2.17 1.62

Table 21-5 Moody's Average Credit Ratios

Source: Data from M oody's Investor Services, "The Distribution of Common Financial Ratios by Rating and Industry for North American Non-Financial Corporations," December 2004.

Investment grade (IG) companies

have at least a BBB bond rating.

Altman Z score is a weighted average of several key

ratios and is a useful predictor

of a firm’s probability of bankruptcy.


Determining Capital StructureDetermining Capital StructureAltman Z ScoreAltman Z Score

• Altman’s prediction of bankruptcy equation:Altman’s prediction of bankruptcy equation:

• Where:Where:XX11 = working capital divided by total assets = working capital divided by total assets

XX22 = retained earnings divided by total assets = retained earnings divided by total assets

XX33 = EBIT divided by total assets = EBIT divided by total assets

XX44 = market values of total equity divided by non-equity book liabilities = market values of total equity divided by non-equity book liabilities

XX55 = sales divided by total assets = sales divided by total assets

999060334121 54321 X.X.X.X.X.Z [ 21-9]

The Modigliani and Miller Irrelevance The Modigliani and Miller Irrelevance TheoremTheorem



The Modigliani and Miller (M&M) The Modigliani and Miller (M&M) Irrelevance TheoremIrrelevance Theorem

M&M and Firm ValueM&M and Firm Value

• The theorem that concludes (under some The theorem that concludes (under some simplifying assumptions) that the value of the simplifying assumptions) that the value of the firm should not be affected by the manner in firm should not be affected by the manner in which it is financed.which it is financed.– How the firm is financed is irrelevant.How the firm is financed is irrelevant.


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremAssumptionsAssumptions

Assumptions about the Real World:Assumptions about the Real World:• Markets are perfect in the sense that there are no Markets are perfect in the sense that there are no

transactions costs or asymmetric information problemstransactions costs or asymmetric information problems• No taxesNo taxes• There is no risk of costly bankruptcy or associated financial There is no risk of costly bankruptcy or associated financial

distressdistress

Modeling Assumptions:Modeling Assumptions:• There exist two firms in the same “risk class” with different There exist two firms in the same “risk class” with different

levels of debtlevels of debt• The earnings of both firms are perpetuitiesThe earnings of both firms are perpetuities


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremArbitrage ArgumentArbitrage Argument

Arbitrage is a powerful economic force in capital Arbitrage is a powerful economic force in capital markets.markets.

Where two identical assets trade at different prices, Where two identical assets trade at different prices, market traders will spot the opportunity to earn market traders will spot the opportunity to earn riskless profits.riskless profits.

• Traders will sell the overvalued asset and buy the Traders will sell the overvalued asset and buy the undervalued asset.undervalued asset.

• This activity will cause the price of the overvalued asset to This activity will cause the price of the overvalued asset to fall, and the price of the undervalued asset to rise until the fall, and the price of the undervalued asset to rise until the two are priced the same.two are priced the same.

• The traders will earn abnormal profits from these trades until The traders will earn abnormal profits from these trades until the prices of the two securities move into equilibrium.the prices of the two securities move into equilibrium.

Table 21 – 6 illustrates the two different positions and the equal payoffsTable 21 – 6 illustrates the two different positions and the equal payoffs


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremArbitrage ArgumentArbitrage Argument

Market participants who find levered investments Market participants who find levered investments trading for a greater value, can trading for a greater value, can undo the leverageundo the leverage and and earn abnormal profits.earn abnormal profits.

Arbitrage will force assets with equal payoffs to trade for Arbitrage will force assets with equal payoffs to trade for the same price.the same price.

Table 21 – 6 illustrates the two different positions and the equal payoffsTable 21 – 6 illustrates the two different positions and the equal payoffs


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and Firm ValueM&M and Firm Value

Portfolios (Actions) Cost Payoff

Portfolio A: αVU α EBIT

Buy α of unlevered firm

Portfolio B:

Buy α of levered firm's equity αSL α(EBIT αKD D )

Buy α of levered firm's debt αD αKD D

Total portfolio α(SL + D) α EBIT

Table 21-6 M&M Arbitrage Table I

Net payoffs are equal

Portfolio A and B must be priced equally despite their different financial structures because the payoffs are equal.


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and Firm ValueM&M and Firm Value

Where payoffs are identical for two different assets, both should be priced the same.

The value of the levered firm (VL) is equal to the value of its debt plus the value of its equity (SL + D) and this must equal the value of the unlevered firm (VU).

Debt cannot destroy value.

LLU VDSV [ 21-10]


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremPersonal Leverage and Corporate LeveragePersonal Leverage and Corporate Leverage


Portfolio C: αSL α(EBIT - KD D )


Portfolio D:

Buy α of levered firm's equity αVU α EBIT

Buy α of levered firm's debt αD - αKD D

Total portfolio α(VU - D) α(EBIT - KD D )

Table 21-7 M&M Arbitrage Table II


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremHomemade LeverageHomemade Leverage

• Homemade leverage is the creation of the Homemade leverage is the creation of the same effect of a firm’s financial leverage same effect of a firm’s financial leverage through the use of personal leverage.through the use of personal leverage.

• This means that individuals can:This means that individuals can:– Buy an unlevered firm, and through the use of Buy an unlevered firm, and through the use of

personal debt, replicate corporate leverage, orpersonal debt, replicate corporate leverage, or– Buy a levered firm, and undo its effects.Buy a levered firm, and undo its effects.


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M and The Cost of CapitalM&M and The Cost of Capital

• M&M made a modeling assumption (to simplify the M&M made a modeling assumption (to simplify the calculations and focus analysis on the leverage issue) that calculations and focus analysis on the leverage issue) that the firm’s earnings represent a the firm’s earnings represent a perpetuityperpetuity::

K

D)(EBIT-KS

e

DL [ 21-11]



• The cost of equity capital is simply the earnings yield and is The cost of equity capital is simply the earnings yield and is estimated as follows:estimated as follows:

S

D)(EBIT-KK

L

De [ 21-12]



• Since the value of the firm is unchanged by leverage, we Since the value of the firm is unchanged by leverage, we can define the unlevered value (can define the unlevered value (VVUU) by discounting the ) by discounting the firm’s expected EBIT by it unlevered equity cost (firm’s expected EBIT by it unlevered equity cost (KKUU):):

VDSV

EBITV LL

UU [ 21-13]


(M&M) Irrelevance Theorem(M&M) Irrelevance TheoremM&M Equity Cost EquationM&M Equity Cost Equation

• To determine who equity cost varies with the debt-equity To determine who equity cost varies with the debt-equity ratio, we solve for EBIT, and substitute it for EBIT in the ratio, we solve for EBIT, and substitute it for EBIT in the leveraged equity cost equation:leveraged equity cost equation:

• If the firm has no debt, the equity investor requires KIf the firm has no debt, the equity investor requires KUU (cost (cost of unlevered equity).of unlevered equity).

• KKUU depends on depends on business riskbusiness risk of the firm. of the firm.• As the firm uses debt, the equity cost increases due to the As the firm uses debt, the equity cost increases due to the

financial leverage risk premiumfinancial leverage risk premium..

/)( SDKKKK LDUue [ 21-14]



• In a world without taxes, the WACC (KIn a world without taxes, the WACC (KUU) is simply the ) is simply the weighted average of the cost of debt and the cost of equity:weighted average of the cost of debt and the cost of equity:

• Figure 21 – 4 illustrates M&M without corporate taxes (the Figure 21 – 4 illustrates M&M without corporate taxes (the irrelevance model) where the cost of equity (irrelevance model) where the cost of equity (KKEE) rises in a ) rises in a prescribed manner to offset the lower cost of debt (prescribed manner to offset the lower cost of debt (KKDD) ) producing WACC that remains unchanged by the use of producing WACC that remains unchanged by the use of financial leverage.financial leverage.

V

DK

V

SKK DEU [ 21-15]



20 - 4 FIGURE

Debt-Equity Ratio

Debt Cost KD

Equity Cost KE

WACC

%



• If WACC remains the same regardless of the financial If WACC remains the same regardless of the financial strategy used by the firm:strategy used by the firm:– VVLL = V = VUU

– Financial strategy is irrelevantFinancial strategy is irrelevant

• As the use of debt financing is increased, the cost of As the use of debt financing is increased, the cost of equity will rise…so even if EPS is increased through equity will rise…so even if EPS is increased through the use of debt financing, that benefit is offset by a the use of debt financing, that benefit is offset by a higher discount rate.higher discount rate.

• From a shareholder wealth perspective, under the From a shareholder wealth perspective, under the M&M assumptions, financing strategy is irrelevant.M&M assumptions, financing strategy is irrelevant.

The Impact of Corporate Taxes on The The Impact of Corporate Taxes on The Irrelevance TheoremIrrelevance Theorem



The Impact of TaxesThe Impact of TaxesIntroducing Corporate TaxesIntroducing Corporate Taxes

• The value of firms drop in the presence of corporate taxes.The value of firms drop in the presence of corporate taxes.• The higher the tax rate, the lower the value of the firm.The higher the tax rate, the lower the value of the firm.

)1(

K

TEBITV

UU

[ 21-16]


The Impact of TaxesThe Impact of TaxesCorporate Tax Effect on Levered EquityCorporate Tax Effect on Levered Equity


Portfolio E: αSL α(EBIT - KD D )(1-T)


Portfolio D:

Buy α of levered firm's equity αVU α EBIT(1-T)

Buy α of levered firm's debt αD(1-T) - αKD D

Total portfolio α(VU - D)(1-T) α(EBIT - KD D )(1-T)

Table 21-8 M&M with Taxes



• To avoid arbitrage the value of the firm must equal: To avoid arbitrage the value of the firm must equal:

VVUU – D(1-t) = S – D(1-t) = SLL

VVLL = S = SLL + D, therefore: + D, therefore:

The value of the firm with leverage is the value without leverage The value of the firm with leverage is the value without leverage plus the corporate debt tax shield from debt financing.plus the corporate debt tax shield from debt financing.

DT VV UL [ 21-17]

Corporate Debt Tax Shield



• The total claims of corporate taxes, debt The total claims of corporate taxes, debt holders, and equity holders are borne by the holders, and equity holders are borne by the pre-tax cash flow produced by the firm.pre-tax cash flow produced by the firm.

• If the firm uses more debt, and interest on If the firm uses more debt, and interest on that debt is tax-deductible, this produces a that debt is tax-deductible, this produces a greater tax shield, reducing the government greater tax shield, reducing the government share of the value of the private enterprise, share of the value of the private enterprise, the WACC must go down.the WACC must go down.– Here we assume a zero-sum game (that value is not Here we assume a zero-sum game (that value is not

destroyed through the use of financial leverage)destroyed through the use of financial leverage)


The Impact of TaxesThe Impact of TaxesFirm Value with Corporate TaxesFirm Value with Corporate Taxes

Taxes

EquityDebt

21 - 5 FIGURE



• The tax –corrected value of Equation 21-14 is:The tax –corrected value of Equation 21-14 is:

• Both the interest cost and the financial leverage risk-premium on Both the interest cost and the financial leverage risk-premium on the equity cost are reduced by (1- T)the equity cost are reduced by (1- T)

• As the use of debt increases, WACC decreases, and therefore the As the use of debt increases, WACC decreases, and therefore the value of the firm in a world with corporate taxes should increase value of the firm in a world with corporate taxes should increase

(See Figure 21 – 6 on the following slide)(See Figure 21 – 6 on the following slide)

/)1)(( SDTKKKK LDUUe [ 21-18]


The Impact of TaxesThe Impact of TaxesM&M with Corporate TaxesM&M with Corporate Taxes

21 - 6 FIGURE

Debt-Equity Ratio

Debt Cost KD(1-T)

Equity Cost KE

WACC

%


The Impact of TaxesThe Impact of TaxesWACC with Corporate TaxesWACC with Corporate Taxes

• WACC declines continuously with the use of debt financing.WACC declines continuously with the use of debt financing.• WACC equation corrected for the tax-deductibility of WACC equation corrected for the tax-deductibility of

interest expense is:interest expense is:

)1( TKV

DK

V

SWACC De [ 21-19]


The Impact of TaxesThe Impact of TaxesTax-Extended M&M Equity Cost EquationTax-Extended M&M Equity Cost Equation

• The ‘beta’ version of Equation 21 – 18 allows us to adjust for the The ‘beta’ version of Equation 21 – 18 allows us to adjust for the systematic risk of the firm:systematic risk of the firm:

• Equity cost without any debt is the risk-free rate plus the market risk Equity cost without any debt is the risk-free rate plus the market risk premium (MRP) times the unlevered beta coefficient.premium (MRP) times the unlevered beta coefficient.

• This equation allows us to unlever betas to get the unlevered equity This equation allows us to unlever betas to get the unlevered equity cost.cost.

• There is one important flaw in this equation – it is assumed that There is one important flaw in this equation – it is assumed that 100% debt financing is optimal.100% debt financing is optimal.

• To address that issue, we must relax M&M’s assumptions regarding To address that issue, we must relax M&M’s assumptions regarding risk of financial distress or bankruptcy.risk of financial distress or bankruptcy.

)/)1(1( SDTMRPRFK LUe [ 21-20]

Incorporating Financial Distress, Incorporating Financial Distress, Bankruptcy and Agency CostsBankruptcy and Agency Costs



BankruptcyBankruptcyIntroductionIntroduction

• Bankruptcy is a state of insolvency that Bankruptcy is a state of insolvency that occurs when a firm commits an act of occurs when a firm commits an act of bankruptcy, such as non-payment of interest, bankruptcy, such as non-payment of interest, and creditors enforce their legal rights to and creditors enforce their legal rights to recoup money, or when a firm voluntarily recoup money, or when a firm voluntarily declares bankruptcy in an effort to be declares bankruptcy in an effort to be protected while reorganizing to become protected while reorganizing to become solvent again.solvent again.


ReorganizationReorganization

• Firms can be reorganized under:Firms can be reorganized under:– Companies Creditors Arrangements Act (CCAA)Companies Creditors Arrangements Act (CCAA)

• Used by larger more complex firms with debt > $5mUsed by larger more complex firms with debt > $5m• Flexible – allowing the firm to pursue agreements with Flexible – allowing the firm to pursue agreements with

creditors/employees, to raise new financingcreditors/employees, to raise new financing• Trustee is appointed by the court and there is a stay-of-Trustee is appointed by the court and there is a stay-of-

proceedingsproceedings

– Bankruptcy Insolvency Act (BIA)Bankruptcy Insolvency Act (BIA)• Limited scope to prevent creditors from seizing assetsLimited scope to prevent creditors from seizing assets• No DIP financingNo DIP financing• No provision to impose a settlement on all creditorsNo provision to impose a settlement on all creditors


Costs of BankruptcyCosts of BankruptcyDirect CostsDirect Costs

Direct Costs:Direct Costs:– Costs incurred as a direct result of bankruptcy Costs incurred as a direct result of bankruptcy

including:including:• Liquidation of assetsLiquidation of assets• Loss of tax losses (potential tax shield benefits)Loss of tax losses (potential tax shield benefits)• Legal and accounting costsLegal and accounting costs


Costs of BankruptcyCosts of BankruptcyIndirect CostsIndirect Costs

Indirect Costs:Indirect Costs:– Financial distress costs are losses to a firm prior to declaration Financial distress costs are losses to a firm prior to declaration

of bankruptcy including:of bankruptcy including:• Agency costsAgency costs• Increasing costs of doing business:Increasing costs of doing business:

– Creditors tightening trade credit termsCreditors tightening trade credit terms– Lending increasing risk premiums and increasing monitoring Lending increasing risk premiums and increasing monitoring

surveillancesurveillance– loss of key staff and increases in recruitment and retention costsloss of key staff and increases in recruitment and retention costs– Distracted management focused on financing and not on management Distracted management focused on financing and not on management

of business operations.of business operations.• Reduced sales revenue:Reduced sales revenue:

– Management is distracted by financial issuesManagement is distracted by financial issues– Customers may become wary and look for other suppliersCustomers may become wary and look for other suppliers

(Figure 21 – 8 illustrates the rising value of distress costs with increasing debt)(Figure 21 – 8 illustrates the rising value of distress costs with increasing debt)


Static TradeoffStatic TradeoffFirm Value and Financial Distress CostsFirm Value and Financial Distress Costs

21 - 8 FIGURE

Distress Costs

VU + DT

Debt Ratio

Value


Costs of BankruptcyCosts of BankruptcyAgency CostsAgency Costs

Agency Costs:Agency Costs:– It is possible for shareholders (and Board of Directors) to act in their It is possible for shareholders (and Board of Directors) to act in their

own best interests at the expense of debt holders.own best interests at the expense of debt holders.– When under financial stress sometimes:When under financial stress sometimes:

• Preferential treatment of creditors.Preferential treatment of creditors.• Assets may be dissipated to related but solvent companies.Assets may be dissipated to related but solvent companies.• Moral hazard (where management may take extraordinary risks that will be Moral hazard (where management may take extraordinary risks that will be

ultimately borne by the debt holders, not the equity holders) (asymmetric ultimately borne by the debt holders, not the equity holders) (asymmetric payoff of an option)payoff of an option)

– Being aware of these risks, lenders take action to protect their interests Being aware of these risks, lenders take action to protect their interests including:including:

• Moratorium on further debt.Moratorium on further debt.• Increases in rates on adjustable-rate debt.Increases in rates on adjustable-rate debt.• Demands for additional surveillance of financial performance.Demands for additional surveillance of financial performance.• Take the firm to court to enforce rights.Take the firm to court to enforce rights.

(Figure 21 – 7 illustrates the shareholder’s one year call option value on the underlying firm)(Figure 21 – 7 illustrates the shareholder’s one year call option value on the underlying firm)


Financial Distress, Bankruptcy, and Financial Distress, Bankruptcy, and Agency CostsAgency Costs

The Firm Value as a Call Option for ShareholdersThe Firm Value as a Call Option for Shareholders

21 - 7 FIGURE

Underlying Firm Value

No limited liability

$50 million debt

Equity Payoff

0


Costs of BankruptcyCosts of BankruptcySummarySummary

Costs of Bankruptcy are very high.Costs of Bankruptcy are very high.

Probability of Bankruptcy and Financial Distress Probability of Bankruptcy and Financial Distress costs rise exponentially as the use of debt costs rise exponentially as the use of debt increases.increases.

These costs rob value from both shareholders These costs rob value from both shareholders and potentially debt holders.and potentially debt holders.


Costs of BankruptcyCosts of BankruptcyStatic Tradeoff ModelStatic Tradeoff Model

Figure 21 – 9 illustrates the impact of bankruptcy and Figure 21 – 9 illustrates the impact of bankruptcy and financial distress costs on M&M with corporate taxes.financial distress costs on M&M with corporate taxes.– Cost of equity rises throughout as more debt is added.Cost of equity rises throughout as more debt is added.– The cost of debt rises at higher levels of debt.The cost of debt rises at higher levels of debt.– WACC falls initially because the benefits of the tax-deductibility WACC falls initially because the benefits of the tax-deductibility

of interest expense out-weigh the marginal increases in of interest expense out-weigh the marginal increases in component costs, however, at higher levels of debt, the tax-component costs, however, at higher levels of debt, the tax-advantage of debt is offset and the value of the firm falls when advantage of debt is offset and the value of the firm falls when WACC starts to rise. WACC starts to rise.


Static Tradeoff ModelStatic Tradeoff Model21 - 9 FIGURE

WACC

Ke

D/E*

Cost (%)

KD

Debt-to-equity

Firm Value

Other Factors Affecting Capital Other Factors Affecting Capital Structure DecisionsStructure Decisions



Other Factors Affecting Capital StructureOther Factors Affecting Capital StructurePecking OrderPecking Order

• Static Trade off model ignores two issues:Static Trade off model ignores two issues:1.1. Information asymmetry problemsInformation asymmetry problems

2.2. Agency problemsAgency problems

• These factors are likely responsible for what These factors are likely responsible for what Myers and Donaldson call the Myers and Donaldson call the pecking orderpecking order..

• The pecking order is the order in which firms The pecking order is the order in which firms prefer to raise financing prefer to raise financing

1.1. starting with internal cash flow, starting with internal cash flow,

2.2. debt and debt and

3.3. finally issuing common equity.finally issuing common equity.

Capital Structure in PracticeCapital Structure in Practice



Capital Structure in PracticeCapital Structure in Practice

• Factors favouring corporate ability and Factors favouring corporate ability and willingness to issue debt:willingness to issue debt:– Profitability (so the firm can use the tax shield benefit Profitability (so the firm can use the tax shield benefit

of interest-deductibility).of interest-deductibility).– Unencumbered tangible assets to be used as Unencumbered tangible assets to be used as

collateral for secured debt.collateral for secured debt.– Stable business operations over time.Stable business operations over time.– Corporate size.Corporate size.– Growth rate of the firm.Growth rate of the firm.– Capital market conditionsCapital market conditions


Summary and ConclusionsSummary and Conclusions

In this chapter you have learned:In this chapter you have learned:– The three effects of leverage: expected ROE tends to increase, The three effects of leverage: expected ROE tends to increase,

the variability of the ROE increases, and the risk of financial the variability of the ROE increases, and the risk of financial distress increases.distress increases.

– The major determinants of the firm’s capital structure decision The major determinants of the firm’s capital structure decision are its impact on profits, risk and cash flows.are its impact on profits, risk and cash flows.

– Impacts can be assessed by profit planning charts, financial Impacts can be assessed by profit planning charts, financial break-even analysis and use of standard ratiosbreak-even analysis and use of standard ratios

– Debt creates value because interest on debt is tax-deductibleDebt creates value because interest on debt is tax-deductible– The tax incentive to use debt is offset by the resulting financial The tax incentive to use debt is offset by the resulting financial

distress and bankruptcy costsdistress and bankruptcy costs– In a dynamic world, firms depart from the static trade-off optimal In a dynamic world, firms depart from the static trade-off optimal

debt ratio over time, then refinance to bring it back in line with debt ratio over time, then refinance to bring it back in line with the target debt ratio.the target debt ratio.

– Actual capital structures are constantly changing as firms take Actual capital structures are constantly changing as firms take advantage of market conditions.advantage of market conditions.

Concept Review QuestionsConcept Review Questions



Concept Review Question 1Concept Review Question 1Business and Financial RiskBusiness and Financial Risk

Define business risk and financial risk.Define business risk and financial risk.

Appendix 1Appendix 1Thunder Bay IndustriesThunder Bay Industries

Exercise in Indifference AnalysisExercise in Indifference Analysis


Thunder Bay IndustriesThunder Bay IndustriesThe ProblemThe Problem

Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years. Thunder Bay Industries has experienced rapid growth in sales revenue over the past four years. The company is now operating at 100% of capacity and must expand in order to meet the The company is now operating at 100% of capacity and must expand in order to meet the demand for its new line of video games. demand for its new line of video games.

The current financial statements for Thunder Bay Industries are as follows:The current financial statements for Thunder Bay Industries are as follows:

Thunder Bay IndustriesThunder Bay IndustriesBalance SheetBalance Sheet

as at December 31, 20xxas at December 31, 20xx($ '000s Cdn.)($ '000s Cdn.)

Assets:Assets: Liabilities and Owner's Equity:Liabilities and Owner's Equity:CashCash 1,0001,000 Accounts payableAccounts payable 550550Accounts receivableAccounts receivable 2,1002,100 AccrualsAccruals 249249InventoriesInventories 2,7662,766 Other current liabilitiesOther current liabilities 11Net Fixed AssetsNet Fixed Assets 16,24416,244 8% bonds maturing in 10 years8% bonds maturing in 10 years 5,0005,000

______________ Common stock (100,000 outstanding)Common stock (100,000 outstanding) 1,0001,000Retained earningsRetained earnings 15,31015,310

Total AssetsTotal Assets $22,110$22,110 Total Liabilities and Owner's EquityTotal Liabilities and Owner's Equity $22,110$22,110

The most recent income statement is found on the following slide:The most recent income statement is found on the following slide:



Thunder Bay IndustriesThunder Bay IndustriesIncome StatementIncome Statement

for the year ended December 31, 20xxfor the year ended December 31, 20xx($ '000s Cdn)($ '000s Cdn)

SalesSales $25,002$25,002Cost of Goods SoldCost of Goods Sold 18,25218,252Gross Margin on SalesGross Margin on Sales $ 6,750$ 6,750Administrative and Selling ExpensesAdministrative and Selling Expenses 4,0004,000Earnings before Interest Expense and TaxesEarnings before Interest Expense and Taxes 2,7502,750Interest expenseInterest expense 400 400Earnings before taxEarnings before tax $ 2,350$ 2,350TaxesTaxes 1,0111,011Net IncomeNet Income $1,339$1,339

If the firm does not expand, it sales growth will stall at the current If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company undertakes the planned expansion $25m level or less. If the company undertakes the planned expansion management has identified a probability distribution for possible EBIT management has identified a probability distribution for possible EBIT levels:levels:



If the firm does not expand, it sales growth will stall at the current $25m level or If the firm does not expand, it sales growth will stall at the current $25m level or less. If the company undertakes the planned expansion management has less. If the company undertakes the planned expansion management has identified a probability distribution for possible EBIT levels:identified a probability distribution for possible EBIT levels:

Possible EBITPossible EBIT ProbabilityProbability$2,200$2,200 .1.1$2,700$2,700 .4.4$3,200$3,200 .4.4$3.700$3.700 .1.1

The planned expansion will require Thunder Bay Industries to raise $10,000,000 The planned expansion will require Thunder Bay Industries to raise $10,000,000 in new capital. If raised in the form of bonds, the bonds would carry a 6.5% in new capital. If raised in the form of bonds, the bonds would carry a 6.5% coupon rate. New common stock could be sold for $250.00 per share.coupon rate. New common stock could be sold for $250.00 per share.

Find the EBIT/EPS indifference point. What is the probability that EBIT will be Find the EBIT/EPS indifference point. What is the probability that EBIT will be greater than the indifference point? Which method of financing is most likely to greater than the indifference point? Which method of financing is most likely to maximize earnings per share? What method of financing do you recommend? maximize earnings per share? What method of financing do you recommend? Why? Discuss the limitations of indifference analysis. Prepare a properly Why? Discuss the limitations of indifference analysis. Prepare a properly labeled diagram of the EBIT/EPS analysis.labeled diagram of the EBIT/EPS analysis.


Thunder Bay IndustriesThunder Bay IndustriesThe SolutionThe Solution

You can first determine the expected EBIT for next year and using that, You can first determine the expected EBIT for next year and using that, determine the standard deviation of that EBIT. These calculations will be determine the standard deviation of that EBIT. These calculations will be useful later when we try to determine the probability that EBIT will be less useful later when we try to determine the probability that EBIT will be less than, or greater than the indifference point.than, or greater than the indifference point.

Possible EBIT Probability Wtd EBIT$2,200,000 10.0% $220,0002,700,000 40.0% 1,080,0003,200,000 40.0% 1,280,0003,700,000 10.0% 370,000

Expected EBIT = $2,950,000

110,403$

11.403

500,162

56250000,25000,2556250

)750(1.)250(4.)250(4.)750(1. 2222

EBIT


Thunder Bay IndustriesThunder Bay IndustriesThe Solution …The Solution …

Next set up equations for EPS for each alternative Next set up equations for EPS for each alternative source of financing, equate them, substitute in known source of financing, equate them, substitute in known values and solve for the common EBIT.values and solve for the common EBIT.

000,675,2$

000,100

)43.1)(000,650000,400(

000,40000,100

)43.1)(000,400(

)1)(()1)((

)1)((

)1)((

1

21

21

1

1

21

21

1

EBIT

EBITEBIT

n

TBRBREBIT

nn

TBREBIT

EPSEPS

n

TBRBREBITEPS

nn

TBREBITEPS

DDD

debtcommon

DDdebt

Dcommon



Our prediction for EPS at EBIT=$2,675,000 for the common Our prediction for EPS at EBIT=$2,675,000 for the common

share financing alternative is:share financing alternative is:

26.9$000,100

)43.1)(000,050,1$000,675,2($

26.9$000,140

)43.1)(000,400$000,675,2($

Debt

ecommonshar

EPS

EPS



The probability than EBIT will favour common stock financing The probability than EBIT will favour common stock financing (ie. be less than the indifference point) is:(ie. be less than the indifference point) is:

Where:Where:zz = the number of standard deviations away from the mean = the number of standard deviations away from the mean

XX = the point of interest = the point of interest

= the standard deviation of the probability distribution= the standard deviation of the probability distribution

= the mean of the probability distribution= the mean of the probability distribution

X

z6822.0

110,403

000,950,2000,675,2

z



The negative sign indicates that the point of interest (X) or The negative sign indicates that the point of interest (X) or (indifference point) lies on the left-hand side of the mean. It (indifference point) lies on the left-hand side of the mean. It lies .6822 of 1 standard deviation away from the mean.lies .6822 of 1 standard deviation away from the mean.

Going to the table for Values of the Standard Normal Distribution Going to the table for Values of the Standard Normal Distribution Function we find the area under the curve between the point of Function we find the area under the curve between the point of interest and the mean of the distribution to be:interest and the mean of the distribution to be:

.2517 or 25.27%.2517 or 25.27%

Therefore, the probability that EBIT will exceed the indifference point Therefore, the probability that EBIT will exceed the indifference point (favouring debt financing) is 75.17% The probability that EBIT will be (favouring debt financing) is 75.17% The probability that EBIT will be below the indifference point (favouring equity financing is (1- .7517) below the indifference point (favouring equity financing is (1- .7517) 24.83%.24.83%.

(These normal distribution is plotted on the following chart.)(These normal distribution is plotted on the following chart.)

6822.0

110,403

000,950,2000,675,2

z



(These relationships are now plotted on the following indifference chart.)(These relationships are now plotted on the following indifference chart.)

6822.0

110,403

000,950,2000,675,2

z

=$2,950,000X=$2,675,000

Area = .2517

Area = .5



(This chart illustrates that debt financing is forecast to produce higher EPS than (This chart illustrates that debt financing is forecast to produce higher EPS than the equity alternative.)the equity alternative.)

=$2,950,000X=$2,675,000

Area = .2517

Area = .5

EPS

Equity Financing

DebtFinancing

$400,000 $1,050,000

$9.26


CopyrightCopyright

Copyright © 2007 John Wiley & Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights Sons Canada, Ltd. All rights reserved. Reproduction or reserved. Reproduction or translation of this work beyond that translation of this work beyond that permitted by Access Copyright (the permitted by Access Copyright (the Canadian copyright licensing Canadian copyright licensing agency) is unlawful. Requests for agency) is unlawful. Requests for further information should be further information should be addressed to the Permissions addressed to the Permissions Department, John Wiley & Sons Department, John Wiley & Sons Canada, Ltd.Canada, Ltd. The purchaser may The purchaser may make back-up copies for his or her make back-up copies for his or her own use only and not for distribution own use only and not for distribution or resale.or resale. The author and the The author and the publisher assume no responsibility publisher assume no responsibility for errors, omissions, or damages for errors, omissions, or damages caused by the use of these files or caused by the use of these files or programs or from the use of the programs or from the use of the information contained herein.information contained herein.

Documents

Chapter 21 - Capital Structure Decisions