Finance management cengage 2013 chapter 014

Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory Chapter 14... Using Operating Leverage• Typical situation: Can use operating leverage to get higher

Capital Structure and Leverage

Business vs Financial Risk Optimal Capital Structure

Operating Leverage Capital Structure Theory

Chapter 14

What is business risk?

• The riskiness inherent in the firm’s operations if it

uses no debt.

• A commonly used measure of business risk is σ ROIC

Probability

EBIT E(ROIC)

0

Low risk

High risk

What determines business risk?

• Competition

• Uncertainty about demand (sales)

• Uncertainty about output prices

• Uncertainty about costs

• Product obsolescence

• Foreign risk exposure

• Regulatory risk and legal exposure

• Operating leverage

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.

• If most costs are fixed, hence do not decline when

demand falls, then the firm has high operating leverage.

Effect of Operating Leverage

• More operating leverage leads to more business

risk, for then a small sales decline causes a big profit decline.

}Profit

Using Operating Leverage

• Typical situation: Can use operating leverage to get

higher ROIC, but risk also increases.

Probability

Low operating leverage

High operating leverage

Return on Invested Capital (ROIC)

• ROIC measures the after-tax return that the

company provides for all its investors.

• ROIC doesn’t vary with changes in capital structure.

12%

000 ,

000 ,

2

$

(0.6) ($400,000)

capital supplied

Investor

-T)

EBIT(1 ROIC

=

=

−

=

What is financial leverage?

Financial risk?

• Financial leverage is the use of debt and preferred

stock.

• Financial risk is the additional risk concentrated on

common stockholders as a result of financial leverage.

Business Risk vs Financial Risk

• Business risk depends on business factors such as

competition, product obsolescence, and operating leverage.

• Financial risk depends only on the types of

securities issued.

– More debt, more financial risk.

– Concentrates business risk on stockholders.

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).

$20,000 invested capital $20,000 invested capital

Ratio Comparison Between Leveraged and

Risk and Return for Leveraged and Unleveraged

The Effect of Leverage on Profitability and Debt

Coverage

• For leverage to raise expected ROE, must have ROIC

> r d (1 – T).

• Why? If r d (1 – T) > ROIC, then after-tax interest

expense will be higher than the after-tax operating income produced by debt-financed assets, so

leverage will depress income.

• As debt increases, TIE decreases because EBIT is

unaffected by debt, but interest expense increases (Int Exp = r d D).

• Return on invested capital (ROIC) is unaffected by

financial leverage.

• L has higher expected ROE because ROIC > r d (1 – T).

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

fixed interest charges Its higher expected return is accompanied by higher risk.

Optimal Capital Structure

• The capital structure (mix of debt, preferred, and

common equity) at which P 0 is maximized

• Trades off higher E(ROE) and EPS against higher

risk The tax-related benefits of leverage are exactly offset by the debt’s risk-related costs.

• The target capital structure is the mix of debt,

preferred stock, and common equity with which the firm intends to raise capital.

Why do the bond rating and cost of debt depend

upon the amount of debt borrowed?

• As the firm borrows more money, the firm

increases its financial risk causing the firm’s bond rating to decrease, and its cost of debt to increase.

Sequence of Events in a Recapitalization

• Firm announces the recapitalization.

• New debt is issued

• Proceeds are used to repurchase stock.

– The number of shares repurchased is equal to the amount of debt issued divided by price per share.

Cost of Debt at Different Debt Ratios

Analyze the Recapitalization at Various Debt Levels

and Determine the EPS and TIE at Each Level

$3.00

000 ,

80

(0.6) ($400,000)

g outstandin Shares

T) D)(1

Determining EPS and TIE at Different Levels of

Debt (D = $250,000 and r d = 8%)

10,000

$25

000 ,

250

$ d

repurchase

$3.26

000 ,

10 000

, 80

(0.6) )]

000 ,

250 )($

08 0 ( 000 ,

400

$ [

g outstandin Shares

T) D)(1

400

$ Exp.

Int.

EBIT

Determining EPS and TIE at Different Levels of

Debt (D = $500,000 and r d = 9%)

20,000

$25

000 ,

500

$ d

repurchase

$3.55

000 ,

20 000

, 80

(0.6) )]

000 ,

500 )($

09 0 ( 000 ,

400

$ [

g outstandin Shares

T) D)(1

000 ,

400

$ EBIT

Determining EPS and TIE at Different Levels of

Debt (D = $750,000 and r d = 11.5%)

30,000

$25

000 ,

750

$ d

repurchase

$3.77

000 ,

30 000

, 80

(0.6) )]

000 ,

50 )($7 115

0 ( 000 ,

400

$ [

g outstandin Shares

T) D)(1

4

$86,250

000 ,

400

$ Exp.

Int.

EBIT

Determining EPS and TIE at Different Levels of

000 ,

1

$ d

repurchase

$3.90

000 ,

40 000

, 80

(0.6) )]

000 ,

0 )($1,00 14

0 ( 000 ,

400

$ [

g outstandin Shares

T) D)(1

400

$ EBIT

What effect does more debt have on a firm’s

• However, the risk of the firm’s equity also

increases, resulting in a higher r s.

The Hamada Equation

• Because the increased use of debt causes both the

costs of debt and equity to increase, we need to estimate the new cost of equity.

• The Hamada equation attempts to quantify the

increased cost of equity due to financial leverage.

• Uses the firm’s unlevered beta, which represents

the firm’s business risk as if it had no debt.

The Hamada Equation

b L = b U [1 + (1 – T)(D/E)]

• Suppose, the risk-free rate is 6%, as is the market

risk premium The unlevered beta of the firm is 1.0

We were previously told that invested capital was

$2,000,000.

Calculating Levered Betas and Costs of Equity

Table for Calculating Levered Betas and Costs of

Finding Optimal Capital Structure

• The firm’s optimal capital structure can be

determined two ways:

– Minimizes WACC.

– Maximizes stock price.

• Both methods yield the same results.

Table for Calculating Levered Betas and Costs of

Stock Price with Zero Growth

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

• EPS = DPS.

• To find the expected stock price ( ), we must find

the appropriate r s at each of the debt levels discussed.

r

DPS r

EPS g

r

D Pˆ

s s

Determining the Stock Price Maximizing Capital

What debt ratio maximizes EPS?

• Maximum EPS = $3.90 at D = $1,000,000, and

D/Cap = 50% (Remember DPS = EPS because payout = 100%.)

• Risk is too high at D/Cap = 50%.

What is Campus Deli’s optimal capital structure?

• P 0 is maximized ($26.89) at

D/Cap = $500,000/$2,000,000 = 25%, so optimal D/Cap = 25%.

• EPS is maximized at 50%, but primary interest is

stock price, not E(EPS).

• The example shows that we can push up E(EPS) by

using more debt, but the risk resulting from increased leverage more than offsets the benefit of higher E(EPS).

What if there were more/less business risk than originally

estimated, how would the analysis be affected?

• If there were higher business risk, then the

probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt

• However, lower business risk would lead to an

optimal capital structure with more debt.

How would these factors affect the target capital

structure?

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 money on lavish

perks?

7 Financial flexibility?

8 Firm’s growth rate?

Modigliani-Miller Irrelevance Theory

Modigliani-Miller Irrelevance Theory

• The graph shows MM’s tax benefit vs bankruptcy

cost theory.

• Logical, but doesn’t tell whole capital structure

story Main problem: assumes investors have same information as managers.

Incorporating Signaling Effects

• Signaling theory suggests firms should use less debt

than MM suggest.

• This unused debt capacity helps avoid stock sales,

which depress stock price because of signaling effects.

What are “signaling” effects in capital structure?

• What can managers be expected to do?

– Issue stock if they think stock is overvalued

– Issue debt if they think stock is undervalued

– As a result, investors view a stock offering negatively;

managers think stock is overvalued.

Conclusions on Capital Structure

• Need to make calculations as we did, but should

also recognize inputs are “guesstimates.”

• As a result of imprecise numbers, capital structure

decisions have a large judgmental content.

• We end up with capital structures varying widely

among firms, even similar ones in same industry.