Practical financial managment 7e LASHER chapter 14

1. Foundations. 2. Financial Background: A Review of Accounting, Financial Statements, and Taxes. 3. Cash Flows and Financial Analysis. 4. Financial Planning. 5. The Financial System, Corporate Governance, and Interest. Part II: DISCOUNTED CASH FLOW AND THE VALUE OF SECURITIES. 6. Time Value of Money. 7. The Valuation and Characteristics of Bonds. 8. The Valuation and Characteristics of Stock. 9. Risk and Return. Part III: BUSINESS INVESTMENT DECISIONS--CAPITAL BUDGETING. 10. Capital Budgeting. 11. Cash Flow Estimation. 12. Risk Topics and Real Options in Capital Budgeting. 13. Cost of Capital. Part IV: LONG-TERM FINANCING ISSUES. 14. Capital Structure and Leverage. 15. Dividends. Part V: OPERATIONS ISSUES--WORKING CAPITAL MANAGEMENT AND PLANNING. 16. The Management of Working Capital. 17. Corporate Restructuring. 18. International Finance.

Chapter 14 Capital Structure and Leverage

Capital structure - mix of a firm’s debt and equity

– In this chapter preferred stock is considered debt

Financial Leverage - using borrowed money to multiply the effectiveness of

equity

– Financial leverage of 10% means the capital structure is 10% debt and 90% equity

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The Central Issue

Can the use of debt (leverage) increase the value of a firm’s equity?

– Can it increase stock price?

Under certain conditions changing leverage can increase stock price

– But an increase in leverage also increases risk

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Risk in the Context of Leverage

Leverage influences stock price

Measures of overall performance

number

Income NET

Redefining Risk for Leverage-Related Issues

Leverage-related risk is variation in ROE and EPS

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Figure 14-1 Business and Financial Risk

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Leverage and Risk Two Kinds of Each

Financial Leverage

Associated with capital structure

Causes financial risk

Financial Leverage

Financial leverage may increase stock price

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Table 14-1 Effect of Increasing Financial Leverage when Return on Capital Exceeds After-Tax Cost of

Debt

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Replacing equity with debt reduces Net Income due to interest expense.

But if profitability is good, it reduces equity and number of shares faster than the decline

in Net Income Hence as debt increases, both EPS and ROE rise dramatically

Effect Of Increased Leverage On Stock Price In Good Times

Based on ROE and EPS performance in good times, investors bid stock price up

as debt is increased from low levels

Effect is eventually mitigated by the increasing financial risk from leverage

Under what conditions will increasing leverage improve ROE and EPS?

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When Might Financial Leverage Help?

Return on Capital Employed

– Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE

Table 14-2 Effect of Increasing Financial Leverage when After-Tax Cost of Debt Exceeds Return on Capital

When ROCE is less than the after tax cost of debt, increasing leverage reduces EPS and ROE That, along with increasing risk, has a very negative effect on investors and stock price falls.

Concept Connection Example 14-1 Managing EPS through Leverage

Will borrowing more money and retiring stock raise Albany’s EPC, and if so, what capital structure will achieve

an EPS of $2?

Concept Connection Example 14-1 Managing EPS through Leverage

Concept Connection Example 14-1 Managing EPS through Leverage

Managing Through Leverage

Under certain conditions management may be able to manipulate

financial results and stock price by changing the firm’s capital structure This is true, but must be done cautiously

An Alternate Approach (Optional)

Using ratios and information from financial statements to solve for unknown values: algebraic approach

EPS = ROE × Book Value per share

ROE = Net Income ÷ Equity

Net Income= [EBIT – Interest] (1 – tax rate)

Interest = kd (Debt)

Equity = Total Capital – Debt

share) per

value

Book Debt)

Total (

) T 1 )(

Debt )(

k ( EBIT [

Table 14-3 Financial Leverage and Risk

Financial leverage is a two-edged sword

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Putting the Ideas Together—

The Effect on Stock Price

During periods of good performance, leverage enhances results in terms of ROE and EPSLeverage adds variability (risk) to financial performance when operating results changeThese effects push stock prices in opposite directions

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Real Investor Behavior and the Optimal Capital Structure

When leverage is low, an increase has a positive effect on investors

At high debt levels, risk concerns overwhelm benefit of enhanced performance thus additional leverage decreases stock price

As leverage increases, its effect goes from positive to negative

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Figure 14-2 The Effect of

Leverage on Stock Price

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Finding the Optimum—

A Practical Problem

1 A firm with good profit prospects and little or no debt is probably missing an

opportunity by not using borrowed money if interest rates are reasonable.

2 For most businesses, the optimal capital structure is somewhere between 30% and 50% debt.

3 Debt levels above 60% create excessive risk and should be avoided.

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The Target Capital Structure

A firm’s target capital structure is management’s estimate of the optimal capital structure

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The Effect of Leverage When Stocks Aren’t Trading at Book Value

Changes in leverage not involving the

purchase of equity at book value are more complex

Repurchasing stock for retirement at prices other than book value will have the same general impact on ROE, but not necessarily for EPS

EPS = ROE x (book value per share)

EBIT - Interest

EBIT- EPS Analysis

Provides a visual/graphic representation of effect of leverage on EPS

Helps managers analyze and quantify the tradeoffs between risk and results when deciding on leverage policy

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Figure 14-3 EBIT – EPS Analysis for ABC Corp (from Table 14.1, Columns 1 and

It is important to

determine the

indifference point,

which occurs when the

two plans offer the

same EBIT.

Operating Leverage

Terminology and Definitions

Income statement items from sales through EBIT

Variations in EBIT due to many reasons (sales, costs, management)

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Operating Leverage

Fixed Costs

salaries

Variable Costs

sales commissions

Fixed and Variable Costs and Cost Structure

Figure 14-4 Fixed, Variable, and

Total Cost

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Figure 14-5 The Breakeven Diagram

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Breakeven occurs at the intersection of revenue and total cost, QB/E

Breakeven Analysis

The Contribution Margin

cost (V)

Ct = P – V

CM = (P – V)

P

– Breakeven shows how many units must be sold to pay for (cover) fixed costs

– Can be expressed in terms of dollar sales

) V P

(

F

E B

B

C

F P

) V P

Concept Connection Example 14-5 Breakeven

What is the breakeven sales level in units and dollars for a company that can make a unit of product for $7 in variable costs and sell it for $10, if the firm has fixed costs of $1,800 per month?

The breakeven point in units is

$1,800 ÷ ($10 - $7) = 600 units

The breakeven point in dollars is $10 per unit times 600 units, or $6,000, which could also be calculated as $1,800 / 0.30

Thus, the firm must sell 600 units per month to cover fixed costs.

The Effect of Operating Leverage

As volume moves away from breakeven, profit or loss increases faster with more operating leverage

The Risk Effect

The Effect on Expected EBIT

operating profit

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Figure 14-6 Breakeven Diagram at High and Low Operating Leverage

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Concept Connection 14-6 The Effect of Operating Leverage

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Suppose the low-leverage firm in Figure 14-6a has fixed costs of $1,000 per period, sells its product for $10, and has variable costs of $8 per unit Further suppose that the high-leverage firm in Figure 14-6b has fixed costs of $1,500 and also sells its product for $10 a unit

Both firms are at the same breakeven point What variable cost must the high-leverage firm have if it is to achieve the same breakeven point as the low-leverage firm? State the trade-off

at the breakeven point Which structure is preferred if there’s a choice?

Concept Connection Example 14-6 The Effect of Operating Leverage

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Both firms have a breakeven point of 500 units (Low-leveraged firm: $1,000 ÷ $2) We need to solve the

breakeven formula for the high-leveraged firm’s variable costs per unit:

QB/E-a = FC ÷ (P – Va) = 500 units

QB/E-b = FC ÷ (P – Vb) = 500 units

500 units = $1,500 ÷ ($10 – Vb)

Vb = $7

And Ct = $10 - $7 = $3

The preferred structure depends on volatility—if sales are expected to be highly volatile, the lower fixed cost

structure might be better in the long run.

At breakeven, a $1 differential in contribution makes up for a $500 difference in fixed cost.

The Degree of Operating Leverage (DOL)—A Measurement

Operating leverage amplifies changes in sales volume into larger changes in EBIT

DOL relates relative changes in volume (Q) to relative changes in EBIT

Concept Connection Example 14-7 Degree of Operating Leverage (DOL)

DOL at 300 units is:

Note that DOL decreases

as the output level increases above breakeven.

– Is more controllable than operating leverage

Operating Leverage involves substituting fixed costs for variable costs in the firm’s cost structure

•Both can enhance results while increasing variation

•Both involve substituting fixed cash outflows for variable cash

outflows

•Both make their respective risks larger as levels of leverage

increase

Figure 14-7 The Similar Functions of Operating and Financial

Leverage

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Figure 14-8 Risk and Cost Relationships between Operating and

Financial Leverage

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The Compounding Effect of Operating and Financial Leverage

Effects of financial and operating leverage compound one another

Changes in sales are amplified by operating leverage into larger relative changes in EBIT

Changes in EBIT are amplified by financial leverage into larger relative changes in ROE and EPS

Result: Modest changes in sales can lead to dramatic changes in ROE and EPS

Combined effect is measured by DTL, the degree of total leverage

DTL = DOL × DFL

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Figure 14-9 The Compounding Effect of Operating Leverage and

Financial Leverage

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Capital Structure Theory

Does capital structure affect stock price and the market value of the firm?

If so, is there an optimal structure that maximizes either or both?

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Background The Value of the Firm

Notation

– Vd = market value of the firm’s debt

– Ve = market value of the firm’s stock or equity

– Vf = market value of the firm in total

Vf = Vd + Ve

Investors’ returns on the firm’s securities will be

– kd = return on an investment in debt

– ke = return on an investment in equity

The average cost of capital is a weighted average of the costs of debt and equity

– ka = average cost of capital

Background The Value of the Firm

Value is based on cash flow, which comes from income

– Dividends and interest payments are both perpetuities

The firm’s market value is the sum of its present values

Figure 14-10 Variation in Value and Average Return with Capital

Structure

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The value of the firm and the firm’s stock price each reach maxima when the average cost of capital is minimized.

The Early Theory by Modigliani and Miller (MM)

Restrictive Assumptions in Original Model

– The 1958 MM paper on capital structure included numerous restrictions such as

The Early Theory by Modigliani and Miller (MM)

The Assumptions and Reality

– Income taxes exist

– Bankruptcy costs are quite high

– Individuals cannot borrow at the same rate as companies and

– Interest rates usually rise as more money is borrowed

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The Early Theory by Modigliani and Miller (MM)

The result

– The independence hypothesis: value is independent of capital structure

– As cheaper debt is added, the cost of equity increases because of increased risk

Arbitrage concept

Interpreting the result

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Figure 14-11 The Independence Hypothesis (a)

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Figure 14-11 The Independence Hypothesis (b)

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Relaxing the Assumptions—

More Insights

Financing and the U.S Tax System

Including Corporate Taxes in the MM Theory

– Interest provides a tax shield that reduces government’s share of the firm’s

Table 14-4 The Tax System Favors

Debt Financing

TBk k

Figure 14-12 MM Theory with Taxes

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In the MM model with taxes, value increases steadily as leverage is added Thus, the firm’s value is maximized with 100% debt Note that kd remains constant across all levels of debt.

Including Bankruptcy Costs in the

MM Theory

As leverage increases past a certain point, concern about bankruptcy losses increases

Hence value and price are maximized at an optimal capital structure where the average cost

of capital is a minimum

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Figure 14-13

MM Theory with Taxes and Bankruptcy

Costs

An Insight into Mergers and Acquisitions

In many mergers, a firm buys the stock of a target company at a premium over its market price/value

If the target was undervalued due to lack of debt, the increase in value from adding leverage may be more than the premium paid for the target’s stock

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