Corporate Finance Lecture 11 Capital Structure and Leverage

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Corporate FinanceLecture 11 Capital Structure
and Leverage

• Selcuk Caner
• Bilkent University

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Chapter 14 Outline

• Business vs. financial risk
• Optimal capital structure
• Operating leverage
• Capital structure theory

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What is business risk?

• Uncertainty about future operating income (EBIT),
  i.e., how well can we predict operating income?
• Note that business risk does not include
  financing effects.

Probability
Low risk
High risk
EBIT
E(EBIT)
0
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Business risk is affected primarily by

• Uncertainty about demand (sales).
• Uncertainty about output prices.
• Uncertainty about costs.
• Product, other types of liability.
• Operating leverage.

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What is operating leverage, and how does it
affect a firms 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.

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• More operating leverage leads to more business
  risk, for then a small sales decline causes a big
  profit decline.

• What happens if variable costs change?

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Probability
Low operating leverage
High operating leverage
EBITL
EBITH
Typical situation Can use operating leverage to
get higher E(EBIT), but risk increases.
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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.

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Business Risk vs. Financial Risk

• Business risk depends on business factors 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 on stockholders.

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Consider 2 Hypothetical Firms
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
Both firms have same operating leverage, business
risk, and probability distribution of EBIT.
Differ only with respect to use of debt (capital
structure).
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Firm U Unleveraged
Economy
Bad Avg. Good

Prob. 0.25 0.50 0.25 EBIT 2,000 3,000 4,000 Int
erest 0 0
0 EBT 2,000 3,000 4,000 Taxes (40) 800
1,200 1,600 NI 1,200 1,800 2,400
12
Firm L Leveraged
Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25 EBIT 2,000 3,000 4,000 I
nterest 1,200 1,200 1,200 EBT
800 1,800 2,800 Taxes (40) 320 720
1,120 NI 480 1,080 1,680 Same as for Firm
U.
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Firm U Bad Avg. Good
BEP 10.0 15.0 20.0 ROE(NI/Equity) 6.0 9.0 12
.0 TIE (EBIT/Interest)
Firm L Bad Avg. Good
BEP 10.0 15.0 20.0 ROE 4.8 10.8 16.8 TIE 1.
67x 2.5x 3.3x BEP (Basic Earning Power
EBIT/Assets) same for Firms U and L.
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Expected Values E(BEP) 15.0 15.0 E(ROE) 9.0
10.8 E(TIE) 2.5x Risk Measures sROE 2.12 4
.24 CVROE 0.24 0.39
U L
8
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• For leverage to raise expected ROE, must have BEP
  gt kd.
• Why? If kd gt BEP, then the interest expense will
  be higher than the operating income produced by
  debt-financed assets, so leverage will depress
  income.

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Conclusions

• Basic earning power BEP EBIT/Total assets is
  unaffected by financial leverage.
• L has higher expected ROE because BEP gt kd.
• L has much wider ROE (and EPS) swings because of
  fixed interest charges. Its higher expected
  return is accompanied by higher risk.

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If debt increases, TIE falls.
TIE
EBIT I
EBIT is constant (unaffected by use of debt), and
since I kdD, as D increases, TIE must fall.
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Optimal Capital Structure

• 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
  exactly offset by the debts 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.

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Describe the sequence of events in a
recapitalization.

• Campus Deli announces the recapitalization.
• New debt is issued.
• Proceeds are used to repurchase stock.

Debt issued Price per share
Shares bought .
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Cost of debt at different debt levels after
recapitalization
Amount D/A D/E
Bond borrowed ratio ratio
rating kd
0 0 0 -- --
250 0.125 0.1429 AA 8
500 0.250 0.3333 A 9
750 0.375 0.6000 BBB 11.5
1,000 0.500 1.0000 BB 14
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Why does the bond rating and cost of debt depend
upon the amount borrowed?
As the firm borrows more money, the firm
increases its risk causing the firms bond rating
to decrease, and its cost of debt to increase.
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What would the earnings per share (EPS) be if
Campus Deli recapitalized and used these amounts
of debt 0, 250,000, 500,000, 750,000?
Assume EBIT 400,000, T 40, and shares can
be repurchased at P0 25.
D 0
EPS0
3.00.
(400,000)(0.6) 80,000
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D 250, kd 8.
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D 500, kd 9.
25
D 750, kd 11.5.
400 86.25
EBIT I
TIE 4.6.
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D 1,000, kd 14.
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Stock Price (Zero Growth)
D1ks g
EPSks
DPSks
P0 .
If payout 100, then EPS DPS and E(g) 0.
We just calculated EPS DPS. To find the
expected stock price (P0), we must find the
appropriate ks at each of the debt levels
discussed.
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What effect would increasing debt have on the
cost of equity for the firm?

• If the level of debt increases, the riskiness of
  the firm increases.
• We have already observed the increase in the cost
  of debt.
• However, the riskiness of the firms equity also
  increases, resulting in a higher ks.

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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 unlevered beta of a firm, which
  represents the business risk of a firm as if it
  had no debt.

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The Hamada Equation (contd)
bL bU 1 (1 T)(D/E).
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 total assets were
2,000,000.
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Calculating Levered Betas
D 250
ks kRF (kM kRF)bL
bL bU1 (1 T)(D/E)
bL 1.01 (1 0.4)(250/1,750)
bL 1.01 (0.6)(0.1429)
bL 1.0857.
ks kRF (kM kRF)bL
ks 6.0 (6.0)1.0857 12.51.
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Table for Calculating Levered Betas
ks 12.00 12.51 13.20 14.16 15.60
Amount borrowed 0 250 500
750 1,000
D/A ratio 0.00 12.50 25.00 37.50 50.00
Levered Beta 1.00 1.09 1.20 1.36 1.60
D/E ratio 0.00 14.29 33.33 60.00 100.00
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Minimizing the WACC
ks 12.00 12.51 13.20 14.16
15.60
kd (1 T) 0.00 4.80 5.40 6.90
8.40
Amount borrowed 0 250 500
750 1,000
D/A ratio 0.00 12.50 25.00 37.50 50.00
E/A ratio 100.00 87.50 75.00 62.50 50.00
WACC 12.00 11.55 11.25 11.44
12.00
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P0 DPS/ks
Amount Borrowed
DPS
k
P
s
0
0
3.00
25.00
12.00
3.26
26.03
250,000
12.51
3.55
26.89
500,000
13.20
3.77
26.59
750,000
14.16
15.60
3.90
25.00
1,000,000
Maximum Since D 500,000 and assets
2,000,000, optimal D/A 25.
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What debt ratio maximizes EPS?
See preceding slide. Maximum EPS 3.90 at D
1,000,000, and D/A 50. Risk is too high at
D/A 50.
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What is Campus Delis optimal capital structure?
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
interest is stock price, not E(EPS).
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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).
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ks
15
WACC
kd(1 T)
D/A
0
.25
.75
.50

P0
EPS
D/A
.25
.50
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If it were discovered that the firm had 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. On the other hand, lower business risk
would lead to an optimal capital structure of
more debt.
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Other factors to consider when establishing the
firms target capital structure?
1. Industry average debt ratio 2. TIE ratios
under different scenarios 3. Lender/rating agency
attitudes 4. Reserve borrowing capacity 5.
Effects of financing on control 6. Asset
structure 7. Expected tax rate
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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?
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Long-term Debt Ratios for Selected Industries
Industry Long-Term Debt
Ratio Pharmaceuticals 20.00 Computers 25.93 Ste
el 39.76 Aerospace 43.18 Airlines 56.33 Utiliti
es 56.52
Source Dow Jones News Retrieval. Data
collected through December 17, 1999.
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Value of Stock
MM result
Actual
No leverage
D/A
0
D1
D2
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• The graph shows MMs tax benefit vs. bankruptcy
  cost theory.
• Logical, but doesnt tell whole capital structure
  story. Main problem--assumes investors have same
  information as managers.

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Signaling theory, discussed earlier, suggests
firms should use less debt than MM suggest. This
unused debt capacity helps avoid stock sales,
which depress P0 because of signaling effects.
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What are signaling effects in capital structure?
Assumptions

• Managers have better information about a firms
  long-run value than outside investors.
• Managers act in the best interests of current
  stockholders.

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Therefore, managers can be expected to

• issue stock if they think stock is overvalued.
• issue debt if they think stock is undervalued.
• As a result, investors view a common stock
  offering as a negative signal--managers think
  stock is overvalued.

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Conclusions on Capital Structure
1. Need to make calculations as we did, but
should also recognize inputs are
guesstimates. 2. As a result of imprecise
numbers, capital structure decisions have a large
judgmental content. 3. We end up with capital
structures varying widely among firms, even
similar ones in same industry.
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