7/31/2019 Fm - Chapter 7

1/44

Business vs. financial risk

Optimal capital structure

Operating leverage

Capital structure theory

7/31/2019 Fm - Chapter 7

2/44

Uncertainty about future operating income (EBIT),i.e., how well can we predict operating income?

Note that business risk does not include financingeffects.

Probability

EBITE(EBIT)0

Low risk

High risk

7/31/2019 Fm - Chapter 7

3/44

Uncertainty about demand (sales).

Uncertainty about output prices.

Uncertainty about costs. Product, other types of liability.

Operating leverage.

7/31/2019 Fm - Chapter 7

4/44

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

If most costs are fixed, hence do notdecline when demand falls, then thefirm has high operating leverage.

7/31/2019 Fm - Chapter 7

5/44

More operating leverage leads to morebusiness risk, for then a small sales declinecauses a big profit decline.

What happens if variable costs change?

Sales

$ Rev.

TC

FC

QBE Sales

$ Rev.

TC

FC

QBE

} Profit

7/31/2019 Fm - Chapter 7

6/44

Typical situation: Can use operating leverageto get higher E(EBIT), but risk also increases.

Probability

EBITL

Low operating leverage

High operating leverage

EBITH

7/31/2019 Fm - Chapter 7

7/44

Financial leverage is the use of debtand preferred stock.

Financial risk is the additional riskconcentrated on common stockholdersas a result of financial leverage.

7/31/2019 Fm - Chapter 7

8/44

Business risk depends on businessfactors such as competition, product

liability, and operating leverage. Financial risk depends only on the

types of securities issued. More debt, more financial risk.

Concentrates business risk onstockholders.

7/31/2019 Fm - Chapter 7

9/44

Two firms with the same operating leverage,business risk, and probability distribution ofEBIT.

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

7/31/2019 Fm - Chapter 7

10/44

EconomyBad Avg. Good

Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000

Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400

7/31/2019 Fm - Chapter 7

11/44

EconomyBad Avg. Good

Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800

Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680

*Same as for Firm U.

7/31/2019 Fm - Chapter 7

12/44

FIRM U Bad Avg GoodBEP 10.0% 15.0% 20.0%

ROE 6.0% 9.0% 12.0%TIE

FIRM L Bad Avg GoodBEP 10.0% 15.0% 20.0%

ROE 4.8% 10.8% 16.8%

TIE 1.67x 2.50x 3.30x

7/31/2019 Fm - Chapter 7

13/44

Expected Values:

Firm U Firm L

E(BEP) 15.0% 15.0%

E(ROE) 9.0% 10.8%E(TIE) 2.5x

Risk Measures:

Firm U Firm LROE 2.12% 4.24%

CVROE 0.24 0.39

7/31/2019 Fm - Chapter 7

14/44

For leverage to raise expected ROE, musthave BEP > kd.

Why? If kd > BEP, then the interest expensewill be higher than the operating incomeproduced by debt-financed assets, soleverage will depress income.

As debt increases, TIE decreases becauseEBIT is unaffected by debt, and interestexpense increases (Int Exp = kdD).

7/31/2019 Fm - Chapter 7

15/44

Basic earning power (BEP) isunaffected by financial leverage.

L has higher expected ROE becauseBEP > kd.

L has much wider ROE (and EPS)swings because of fixed interest

charges. Its higher expected returnis accompanied by higher risk.

7/31/2019 Fm - Chapter 7

16/44

That capital structure (mix of debt,preferred, and common equity) at which P0

is maximized. Trades off higher E(ROE)and EPS against higher risk. The tax-related benefits of leverage are exactlyoffset by the debts risk-related costs.

The target capital structure is the mix ofdebt, preferred stock, and common equitywith which the firm intends to raise capital.

7/31/2019 Fm - Chapter 7

17/44

Campus Deli announces therecapitalization.

New debt is issued. Proceeds are used to repurchase

stock. The number of shares repurchased is

equal to the amount of debt issueddivided by price per share.

7/31/2019 Fm - Chapter 7

18/44

Amount D/A D/E Bondborrowed ratio ratio rating kd

$ 0 0 0 -- --

250 0.125 0.1429 AA 8.0%

500 0.250 0.3333 A 9.0%

750 0.375 0.6000 BBB 11.5%

1,000 0.500 1.0000 BB 14.0%

7/31/2019 Fm - Chapter 7

19/44

As the firm borrows more money, thefirm increases its financial risk

causing the firms bond rating todecrease, and its cost of debt toincrease.

7/31/2019 Fm - Chapter 7

20/44

$3.00

80,000

(0.6)($400,000)

goutstandinShares

)T-1)(Dk-EBIT(EPS

$0D

d

7/31/2019 Fm - Chapter 7

21/44

20x$20,000

$400,000

ExpInt

EBITTIE

$3.26

10,000-80,000

000))(0.6)0.08($250,-($400,000

goutstandinShares

)T-1)(Dk-EBIT(EPS

10,000$25

$250,000drepurchaseShares

d

7/31/2019 Fm - Chapter 7

22/44

8.9x$45,000

$400,000

ExpInt

EBITTIE

$3.55

20,000-80,000

000))(0.6)0.09($500,-($400,000

goutstandinShares

)T-1)(Dk-EBIT(EPS

20,000$25

$500,000drepurchaseShares

d

7/31/2019 Fm - Chapter 7

23/44

4.6x$86,250

$400,000

ExpInt

EBITTIE

$3.77

30,000-80,000

),000))(0.60.115($750-($400,000

goutstandinShares

)T-1)(Dk-EBIT(EPS

30,000$25

$750,000drepurchaseShares

d

7/31/2019 Fm - Chapter 7

24/44

7/31/2019 Fm - Chapter 7

25/44

If all earnings are paid out as dividends,E(g) = 0.

EPS = DPS To find the expected stock price (P0), we

must find the appropriate ks at each of thedebt levels discussed.

sss

10

k

DPS

k

EPS

g-k

DP

7/31/2019 Fm - Chapter 7

26/44

If the level of debt increases, theriskiness of the firm increases.

We have already observed the increasein the cost of debt.

However, the riskiness of the firmsequity also increases, resulting in ahigher ks.

7/31/2019 Fm - Chapter 7

27/44

Because the increased use of debt causesboth the costs of debt and equity to increase,we need to estimate the new cost of equity.

The Hamada equation attempts to quantify theincreased cost of equity due to financialleverage.

Uses the unlevered beta of a firm, whichrepresents the business risk of a firm as if ithad no debt.

7/31/2019 Fm - Chapter 7

28/44

L = U[ 1 + (1 - T) (D/E)]

Suppose, the risk-free rate is 6%, asis the market risk premium. The

unlevered beta of the firm is 1.0. Wewere previously told that total assetswere $2,000,000.

7/31/2019 Fm - Chapter 7

29/44

If D = $250,

L = 1.0 [ 1 + (0.6)($250/$1,750) ]L = 1.0857

ks = kRF + (kM kRF) Lks = 6.0% + (6.0%) 1.0857

ks = 12.51%

7/31/2019 Fm - Chapter 7

30/44

Amountborrowed

$ 0

250

500750

1,000

D/Aratio

0.00%

12.50

25.0037.50

50.00

LeveredBeta

1.00

1.09

1.201.36

1.60

D/Eratio

0.00%

14.29

33.3360.00

100.00

ks

12.00%

12.51

13.20

14.16

15.60

7/31/2019 Fm - Chapter 7

31/44

The firms optimal capital structure canbe determined two ways:

Minimizes WACC. Maximizes stock price.

Both methods yield the same results.

7/31/2019 Fm - Chapter 7

32/44

D/A ratio

0.00%

12.50

25.00

37.50

50.00

WACC

12.00%

11.55

11.25

11.44

12.00

E/Aratio

100.00%

87.50

75.00

62.50

50.00

ks

12.00%

12.51

13.20

14.16

15.60

kd (1 T)

0.00%

4.80

5.40

6.90

8.40

Amountborrowed

$ 0

250

500

750

1,000

* Amount borrowed expressed in terms of thousands of dollars

7/31/2019 Fm - Chapter 7

33/44

AmountBorrowed DPS ks P0

$ 0 $3.00 12.00% $25.00

250,000 3.26 12.51

500,000 3.55 13.20

26.03

26.89

750,000 3.77 14.16 26.59

1,000,000 3.90 15.60 25.00

7/31/2019 Fm - Chapter 7

34/44

Maximum EPS = $3.90 at D = $1,000,000,and D/A = 50%. (Remember DPS = EPSbecause payout = 100%.)

Risk is too high at D/A = 50%.

7/31/2019 Fm - Chapter 7

35/44

P0 is maximized ($26.89) at D/A =$500,000/$2,000,000 = 25%, so optimal D/A =25%.

EPS is maximized at 50%, but primary interestis stock price, not E(EPS).

The example shows that we can push up

E(EPS) by using more debt, but the riskresulting from increased leverage more thanoffsets the benefit of higher E(EPS).

7/31/2019 Fm - Chapter 7

36/44

If there were higher business risk, then theprobability of financial distress would begreater at any debt level, and the optimalcapital structure would be one that had lessdebt. On the other hand, lower businessrisk would lead to an optimal capital

structure with more debt.

7/31/2019 Fm - Chapter 7

37/44

1. Industry average debt ratio

2. TIE ratios under different scenarios

3. Lender/rating agency attitudes4. Reserve borrowing capacity

5. Effects of financing on control

6. Asset structure

7. Expected tax rate

7/31/2019 Fm - Chapter 7

38/44

1. Sales stability?

2. High operating leverage?

3. Increase in the corporate tax rate?4. Increase in the personal tax rate?

5. Increase in bankruptcy costs?

6. Management spending lots of moneyon lavish perks?

7/31/2019 Fm - Chapter 7

39/44

Value of Stock

0 D1 D2D/A

MM result

Actual

No leverage

7/31/2019 Fm - Chapter 7

40/44

The graph shows MMs tax benefit vs.bankruptcy cost theory.

Logical, but doesnt tell whole capitalstructure story. Main problem--assumesinvestors have same information asmanagers.

7/31/2019 Fm - Chapter 7

41/44

Signaling theory suggests firms shoulduse less debt than MM suggest.

This unused debt capacity helps avoidstock sales, which depress stock pricebecause of signaling effects.

7/31/2019 Fm - Chapter 7

42/44

Assume: Managers have better information about a

firms long-run value than outside investors.

Managers act in the best interests of currentstockholders.

7/31/2019 Fm - Chapter 7

43/44

Issue stock if they think stock isovervalued.

Issue debt if they think stock isundervalued.

As a result, investors view a commonstock offering as a negative signal--

managers think stock is overvalued.

7/31/2019 Fm - Chapter 7

44/44

Need to make calculations as we did, butshould also recognize inputs areguesstimates.

As a result of imprecise numbers, capitalstructure decisions have a large judgmentalcontent.

We end up with capital structures varyingwidely among firms, even similar ones in sameindustry.