Capital Structure and

Leverage
Chapter 15

Objectives
At the end of the chapter, you will be able to:
explain why there may be differences in a firms
capital structure measured on a book-value basis,
market value basis or a target basis
distinguish between business risk and financial
risk
Explain the effects of debt financing on the firms
expected return and risk
discuss the framework used when determining the
optimal capital structure
discuss the capital structure theory and explain
why firms in different industries tend to have
different capital structures.

Capital Structure
Target capital structure is the
mix of debt, preferred stock and
common equity the firm wants to
have.
Optimal Capital Structure
maximizes a firms stock price.

Weighing investor-supplied
Capital
Book Value
Market Value
Target

Trade offs
Using more debt will raise the
risk borne by stockholders
Using more debt generally,
increases the expected return
on equity.

Factors Influencing Capital

Structure Decisions

Business Risk
Firms Tax Position
Financial Flexibility
Managerial Conservatism or
Aggressiveness
Operating Conditions e.g. when Stock
Price Intrinsic Value

Business Risk vs. Financial Risk

Business Risk riskiness of the firms
assets if no debt is used.
Financial Risk additional risk placed on
the common stockholders as a result of
using debt.

Business Risk Determinants

Competition
Demand Variability
Sales Price Variability
Input Cost Variability
Product Obsolescence
Foreign risk exposure
Regulatory risk and legal exposures
The extent to which costs are fixed: operating
leverage

Operating Leverage
Operating leverage is the extent to which
fixed costs are used in a firms operations.
If fixed costs are high, other things held
constant, the greater is the business risk.
High degree on operating leverage, other
factors held constant, implies that a
relatively small change in sales results in
large change in ROE.

Operating Leverage
= % /%

= ()/()
= /
Operating Break even : EBIT = 0
BEP = /

Effect of Operating Leverage

Rev.

Rev.

TC

Profit
TC
FC

FC
QBE

Sales

QBE

Sales

Using operating leverage

Low operating leverage

Probability

High operating leverage

EBITL

EBITH

Typical situation: Can use operating leverage

to get higher E(EBIT), but risk also increases.

Conclusion on Operating
Leverage
Holding other factors constant, the
higher the degree of operating
leverage, the greater the firms
business risk.

Financial Leverage and

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.

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).
Firm U
No debt
$20,000 in assets
40% tax rate

Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate

Firm U: Unleveraged

Prob.
EBIT
Interest
EBT
Taxes (40%)
NI

Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
0
0
$2,000
$3,000
800
1,200
$1,200
$1,800

Good
0.25
$4,000
0
$4,000
1,600
$2,400

Firm L: Leveraged

Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI
*Same as for Firm U.

Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
1,200
1,200
$ 800
$1,800
320
720
$ 480
$1,080

Good
0.25
$4,000
1,200
$2,800
1,120
$1,680

Ratio comparison between

leveraged and unleveraged firms
FIRM U
BEP
ROE
TIE

FIRM L
BEP
ROE
TIE

Bad

Avg

10.0%
6.0%

15.0%
9.0%

Bad

Avg

10.0%
4.8%
1.67x

15.0%
10.8%
2.50x

Good
20.0%
12.0%

Good
20.0%
16.8%
3.30x

Risk and return for leveraged

and unleveraged firms
Expected Values:
E(BEP)
E(ROE)
E(TIE)

Firm U
15.0%
9.0%

Firm L

Firm U
2.12%
0.24

Firm L

15.0%
10.8%
2.5x

Risk Measures:
ROE
CVROE

4.24%
0.39

ROE Probability
0% Debt

Probability

50%

ROEU

ROEL

Typical situation: Can use operating leverage

to get higher E(ROE), but risk also increases.

The effect of leverage on

profitability and debt coverage
For leverage to raise expected ROE, must
have BEP > rd.
Why? If rd > BEP, then the interest expense
will be higher than the operating income
produced by debt-financed assets, so
leverage will depress income.
As debt increases, TIE decreases because
EBIT is unaffected by debt, and interest
expense increases (Int Exp = rdD).

Conclusions
Basic earning power (BEP) is
unaffected by financial leverage.
L has higher expected ROE because
BEP > rd.
L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return is
accompanied by higher risk.

Determining Optimal Capital

Structure
Seek to maximize the price of the firms stock.
Changes in use of debt will cause changes in
earnings per share, and, thus, in the stock
price.
Cost of debt varies with capital structure.
Financial leverage increases risk.
The optimal capital structure always calls for a
debt/assets ratio that is lower than the one that
maximizes expected EPS.

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.

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
firms bond rating to decrease, and its
cost of debt to increase.

Cost of debt at different debt ratios

Amount
borrowed

D/A
ratio

D/E ratio

Bond
rating

rd

$0

--

--

250

0.125

0.143

AA

8.0%

500

0.250

0.333

9.0%

750

0.375

0.600

BBB

11.5%

1,000

0.500

1.000

BB

14.0%

Analyze the recapitalization at various

debt levels and determine the EPS and
TIE at each level.
D = $0
( EBIT - rdD )( 1 - T )
EPS =
Shares outstanding
($400,000)(0.6)
=
80,000
= $3.00

Determining EPS and TIE at different

levels of debt.
(D = $250,000 and rd = 8%)
$250,000
Shares repurchased =
= 10,000
$25
( EBIT - rdD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.08($250,000))(0.6)
=
80,000 - 10,000
= $3.26
EBIT
$400,000
TIE =
=
= 20x
Int Exp $20,000

Determining EPS and TIE at different

levels of debt.
(D = $500,000 and rd = 9%)
$500,000
Shares repurchased =
= 20,000
$25
( EBIT - rdD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.09($500,000))(0.6)
=
80,000 - 20,000
= $3.55
EBIT
$400,000
TIE =
=
= 8.9x
Int Exp $45,000

Determining EPS and TIE at different

levels of debt.
(D = $750,000 and rd = 11.5%)
$750,000
Shares repurchased =
= 30,000
$25
( EBIT - rdD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.115($750,000))(0.6)
=
80,000 - 30,000
= $3.77
EBIT
$400,000
TIE =
=
= 4.6x
Int Exp $86,250

Determining EPS and TIE at different

levels of debt.
(D = $1,000,000 and rd = 14%)
$1,000,000
Shares repurchased =
= 40,000
$25
( EBIT - rdD )( 1 - T )
EPS =
Shares outstanding
($400,000 - 0.14($1,000,000))(0.6)
=
80,000 - 40,000
= $3.90
TIE =

EBIT
$400,000
=
= 2.9x
Int Exp $140,000

Stock Price, with zero growth

D1
EPS DPS
P0 =
=
=
rs - g
rs
rs
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 rs at each of the
debt levels discussed.

What effect does more debt

have on a firms cost of equity?
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 rs.

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.

The Hamada Equation

bL = bU[ 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 total assets
were $2,000,000.

Calculating levered betas and costs

of equity
If D = $250,
bL = 1.0 [ 1 + (0.6)($250/$1,750) ]
bL = 1.0857
rs = rRF + (rM rRF) bL
rs = 6.0% + (6.0%) 1.0857
rs = 12.51%

Table for calculating levered betas

and costs of equity
Amount
borrowed

D/A
ratio

D/E ratio Levered

beta

rs

$0

0%

0%

1.00

12.00%

250

12.50

14.29

1.09

12.51

500

25.00

33.33

1.20

13.20

750

37.50

60.00

1.36

14.16

1,000

50.00

100.00

1.60

15.60

Finding Optimal Capital Structure

The firms 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 equity
Amount
borrowed

D/A
ratio

E/A ratio

rs

rd(1-T)

WACC

$0

0%

100%

12.00%

--

12.00%

250

12.50

87.50

12.51

4.80%

11.55

500

25.00

75.00

13.20

5.40%

11.25

750

37.50

62.50

14.16

6.90%

11.44

1,000

50.00

50.00

15.60

8.40%

12.00

Determining the stock price

maximizing capital structure
Amount
borrowed

DPS

rs

P0

$0

$3.00

250

3.26

12.51

26.03

500

3.55

13.20

26.89

750

3.77

14.16

26.59

1,000

3.90

15.60

25.00

12.00% $25.00

What debt ratio maximizes EPS?

Maximum EPS = $3.90 at D = $1,000,000,
and D/A = 50%. (Remember DPS = EPS
because payout = 100%.)
Risk is too high at D/A = 50%.

What is the firms 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).
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).

Plotting figures in Graphs

Debt/
kd
Expected Estimated ks = [kRF +
Estimated Resulting
Assets
EPS
Beta
Price
P/E Ratio
(kM kRF)s]
0% $2.40
1.50
12.0%
$20.00
8.33
10
8.0%
2.56
1.60
12.4
20.65
8.06
20
8.3
2.75
1.73
12.9
21.33
7.75
30
9.0
2.97
1.89
13.5
21.90
7.38
40
10.0
3.20
2.10
14.4
22.22
6.94
50
12.0
3.36
2.40
15.6
21.54
6.41
60
15.0
3.30
2.85
17.4
18.97
5.75

WACC
12.00%
11.64
11.32
11.10
11.04
11.40
12.36

Relationship Between
Capital Structure and EPS
Expected EPS ($)

Maximum EPS = $3.36

3.5
3
2.5
2
1.5
1
0.5
0

10

20

30

40

50

60

Debt/Assets (%)
44

Relationship Between
Capital Structure and Cost of Capital
Cost of Capital (%)
20

Cost of Equity, ks

15

10

WACC
Minimum = 11.04%

0
0

10

20

30

40

50

60

Debt/Assets (%)
45

Relationship Between
Capital Structure and Stock Price
Stock Price ($)
24

Maximum = $22.22

23
22
21
20
19
18
0

10

20

30

40

50

60

Debt/Assets (%)
46

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.

Degree of Financial Leverage

(DFL)
The percentage change in earnings available
to common stockholders associated with a
given percentage change in EBIT.

DFL =

Percentage change in EPS

Percentage change in EBIT

EPS
EPS
EBIT
EBIT

EBIT
= EBIT - Int

This equation assumes the firm has no

preferred stock.

Degree of Total Leverage (DTL)

The percentage change in EPS that results
from a given percentage change in sales.
DTL = DOL X DFL
DTL =

Q(P - V)
Q(P - V) - F - Int

DTL =

S - VC
S - VC - F - Int

Gross Profit
EBIT - Int

49

Capital Structure Theory

The Effect of Taxes
The Effect of Potential Bankruptcy
Trade-off Theory
Signaling Theory
50

Trade-Off Theory
(Modigliani and Miller)
1. Theory:
1. Interest is tax-deductible expense, therefore less expensive
than common or preferred stock.
2. So, 100% debt is the preferred capital structure.

2. Theory:
1. Interest rates rise as debt/asset ratio increases
2. Tax rates fall at high debt levels (lowers debt tax shield)
3. Probability of bankruptcy increases as debt/assets ratio
increases.

51

Trade-Off Theory (continued)

3. Two levels of debt:
1.

Threshold debt level (D/A1) = where bankruptcy costs

become material

2.

Optimal debt level (D/A2) = where marginal tax shelter

benefits = marginal bankruptcyrelated costs

3.

Between these two debt levels, the firms stock price rises,
but at a decreasing rate

4.

So, the optimal debt level = optimal capital structure

52

Trade-Off Theory (cont)

4. Theory and empirical evidence support these
ideas, but the points cannot be identified
precisely.
5. Many large, successful firms use much less
debt than the theory suggestsleading to
development of signaling theory.

53

Modigliani-Miller Irrelevance Theory

Value of Stock

MM result

Actual
No leverage
0

D1

D2

D/A

Signaling Theory
Symmetric Information
Investors and managers have identical information
about the firms prospects.

Asymmetric Information
Managers have better information about their firms
prospects than do outside investors.

55

Signaling Theory
Signal
An action taken by a firms management that
provides clues to investors about how
management views the firms prospects

Result: Reserve Borrowing Capacity

Ability to borrow money at a reasonable cost when
good investment opportunities arise
Firms often use less debt than optimal to ensure
that they can obtain debt capital later if needed.

56

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?
Assumptions:
Managers have better information about a firms longrun value than outside investors.
Managers act in the best interests of current
stockholders.

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.

Using Debt Financing to

Constrain Managers
Conflicts of interest among managers
especially if there is excess cash
Leveraged Buyout

Variations in Capital Structures

among Firms
Wide variations in use of financial leverage
among industries and firms within an industry
TIE (times interest earned ratio) measures how safe
the debt is:
percentage of debt
interest rate on debt
companys profitability

60

Closing Prayer
Numbers 6:24-26
The Lord bless you and keep you, the Lord
make his face shine upon you and be
gracious to you; the Lord turn His face
toward you and give you peace.