15 - 1

CHAPTER 15
Capital Structure Decisions:
The Basics
 Impact of leverage on returns
 Business versus financial risk
 Capital structure theory
 Perpetual cash flow example
 Setting the optimal capital structure
in practice
 15 - 2

Consider Two 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 EBIT of
$3,000. They differ only with respect to
use of debt.
 15 - 3

Impact of Leverage on Returns

Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080

ROE 9.0% 10.8%

 15 - 4

Why does leveraging increase return?

 Total dollar return to investors:

U: NI = $1,800.
L: NI + Int= $1,080 + $1,200 = $2,280.
Difference= $480.
 Taxes paid:
U: $1,200; L: $720.
Difference = $480.
 More EBIT goes to investors in Firm L.
 Equity $ proportionally lower than NI.
 15 - 5

What is business risk?

Uncertainty about future operating income

(EBIT). Probability
Low risk

High risk

0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects.
 15 - 6

Factors That Influence Business Risk

 Uncertainty about demand (unit

sales).
 Uncertainty about output prices.
 Uncertainty about input costs.
 Product and other types of liability.
 Degree of operating leverage (DOL).
 15 - 7

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.
 The higher the proportion of fixed
costs within a firm’s overall cost
structure, the greater the operating
leverage.
(More...)
 15 - 8
 Higher operating leverage leads to
more business risk, because a small
sales decline causes a larger profit
decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC

QBE Sales QBE Sales

(More...)
 15 - 9

Probability Low operating leverage

High operating leverage

EBITL EBITH

 In the typical situation, higher

operating leverage leads to higher
expected EBIT, but also increases risk.
 15 - 10

Business Risk versus Financial Risk

 Business risk:
Uncertainty in future EBIT.
Depends on business factors such as
competition, operating leverage, etc.
 Financial risk:
Additional business risk concentrated on
common stockholders when financial
leverage is used.
Depends on the amount of debt and
preferred stock financing.
 15 - 11

From a shareholder’s perspective, how

are financial and business risk
measured in the stand-alone sense?

Stand-alone Business Financial

risk = risk + risk .

Stand-alone risk = σ ROE .

Business risk = σ ROE(U) .

Financial risk = σ ROE -σ ROE(U) .

 15 - 12

Now consider the fact that EBIT is not

known with certainty. What is the
impact of uncertainty on stockholder
profitability and risk for Firm U and
Firm L?
 15 - 13

Firm U: Unleveraged

Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
 15 - 14

Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 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.
 15 - 15

Firm U Bad Avg. Good

BEP 10.0% 15.0% 20.0%
ROI* 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE

8
8

8
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 8.4% 11.4% 14.4%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
*ROI = (NI + Interest)/Total financing.
 15 - 16

Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROI) 9.0% 11.4%
E(ROE) 9.0% 10.8%

Risk Measures:
σ ROE 2.12% 4.24%
CVROE 0.24 0.39
8

E(TIE) 2.5x
 15 - 17

Conclusions
 Basic earning power = BEP = EBIT/Total
assets is unaffected by financial
leverage.
 L has higher expected ROI and ROE
because of tax savings.
 L has much wider ROE (and EPS) swings
because of fixed interest charges. Its
higher expected return is accompanied
by higher risk.
(More...)
 15 - 18

 In a stand-alone risk sense, Firm L’s

stockholders see much more risk
than Firm U’s.
U and L: σ ROE(U) = 2.12%.
U: σ ROE = 2.12%.
L: σ ROE = 4.24%.

L’s financial risk is σ ROE - σ ROE(U) =

4.24% - 2.12% = 2.12%. (U’s is zero.)
(More...)
 15 - 19

 For leverage to be positive (increase

expected ROE), BEP must be > kd.
 If kd > BEP, the cost of leveraging will
be higher than the inherent
profitability of the assets, so the use
of financial leverage will depress net
income and ROE.
 In the example, E(BEP) = 15% while
interest rate = 12%, so leveraging
“works.”
 15 - 20

Capital Structure Theory

 MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
 Trade-off theory
 Signaling theory
 Debt financing as a managerial constraint
 15 - 21

MM Theory: Zero Taxes

 MM prove, under a very restrictive set

of assumptions, that a firm’s value is
unaffected by its financing mix.
 Therefore, capital structure is
irrelevant.
 Any increase in ROE resulting from
financial leverage is exactly offset by
the increase in risk.
 15 - 22

MM Theory: Corporate Taxes

 Corporate tax laws favor debt

financing over equity financing.
 With corporate taxes, the benefits of
financial leverage exceed the risks:
More EBIT goes to investors and less
to taxes when leverage is used.
 Firms should use almost 100% debt
financing to maximize value.
 15 - 23

MM Theory: Corporate and

Personal Taxes

 Personal taxes lessen the advantage

of corporate debt:
Corporate taxes favor debt financing.
Personal taxes favor equity financing.
 Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.
 Firms should still use 100% debt.
 15 - 24

Trade-off Theory

 MM theory ignores bankruptcy (financial

distress) costs, which increase as more
leverage is used.
 At low leverage levels, tax benefits
outweigh bankruptcy costs.
 At high levels, bankruptcy costs outweigh
tax benefits.
 An optimal capital structure exists that
balances these costs and benefits.
 15 - 25

Signaling Theory
 MM assumed that investors and managers
have the same information.
 But, managers often have better
information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
 Investors understand this, so view new
stock sales as a negative signal.
 Implications for managers?
 15 - 26

Debt Financing As
a Managerial Constraint

 One agency problem is that

managers can use corporate funds
for non-value maximizing purposes.
 The use of financial leverage:
Bonds “free cash flow.”
Forces discipline on managers.
 However, it also increases risk of
financial distress.
 15 - 27

Perpetual Cash Flow Example

Expected EBIT = $500,000; will remain

constant over time.
Firm pays out all earnings as
dividends (zero growth).
Currently is all-equity financed.
100,000 shares outstanding.
P0 = $20; T = 40%.
 15 - 28

Component Cost Estimates

Amount
Borrowed (000) kd ks
$ 0 - 15.0%
250 10.0% 15.5
500 11.0 16.5
750 13.0 18.0
1,000 16.0 20.0
If company recapitalizes, debt would be
issued to repurchase stock.
 15 - 29

 The MM and Miller models cannot

be applied here because several
assumptions are violated.
kd is not a constant.
Bankruptcy and agency costs
exist.
 Theory provides some valuable
insights, but because of invalid
assumptions, direct real-world
application is questionable.
 15 - 30

Sequence of Events in a
Recapitalization

 Firm announces the recapitalization.

 Investors reassess their views and
estimate a new equity value.
 New debt is issued and proceeds are
used to repurchase stock at the new
equilibrium price.
(More...)
 15 - 31

 Shares Debt issued

= .
Bought New price/share
 After recapitalization firm would have
more debt but fewer common shares
outstanding.
 An analysis of several debt levels is
given next.
 15 - 32

D = $250, kd = 10%, ks = 15.5%.

(EBIT - kdD)(1 - T)
S1 = ks
[$500 - 0.1($250)](0.6)
= 0.155 = $1,839.

V1 = S1 + D1 = $1,839 + $250 = $2,089.

$2,08
P1 9 = $20.89.
100
 15 - 33

Shares $250
= = 11.97.
repurchased $20.89

Shares
= n1 = 100 - 11.97 = 88.03.
remaining

Check on stock price:

S1 $1,839
P1 = = = $20.89.
n1 88.03
Other debt levels treated similarly.
 15 - 34

What is the firm’s optimal amount

of debt?
Debt kd ks P
$25010% 15.5% $20.89
50011 16.5 21.18
75013 18.0 20.92

$500,000 of debt produces the highest

stock price and thus is the best of the
debt levels considered.
 15 - 35

Calculate EPS at debt of $0, $250K,

$500K, and $750K, assuming that the
firm begins at zero debt and recap-
italizes to each level in a single step.

Net income = NI = [EBIT - kd D](1 - T).

EPS = NI/n.
D NI n EPS
$ 0 $300 100.00 $3.00
250 285 88.03 3.24
500 267 76.39 3.50
750 242 64.15 3.77
 15 - 36

 EPS continues to increase beyond

the $500,000 optimal debt level.
 Does this mean that the optimal
debt level is $750,000, or even
higher?
 15 - 37

Find the WACC at each debt level.

D S V kd ks WACC
$ 0 $2,000 $2,000 -- 15.0% 15.0%
250 1,839 2,089 10% 15.5 14.4
500 1,618 2,118 11.0 16.5 14.2
750 1,342 2,092 13.0 18.0 14.3
e.g. D = $250:
WACC = ($250/$2,089)(10%)(0.6)
+ ($1,839/$2,089)(15.5%)
= 14.4%.
 15 - 38

 The WACC is minimized at D =

$500,000, the same debt level that
maximizes stock price.
 Since the value of a firm is the
present value of future operating
income, the lowest discount rate
(WACC) leads to the highest value.
 15 - 39

How would higher or lower

business risk affect
the optimal capital structure?

 At any debt level, the firm’s probability

of financial distress would be higher.
Both kd and ks would rise faster than
before. The end result would be an
optimal capital structure with less debt.
 Lower business risk would have the
opposite effect.
 15 - 40

Is it possible to do an analysis exactly

like the one above for most firms?

 No. The analysis above was based on the

assumption of zero growth, and most
firms do not fit this category.
 Further, it would be very difficult, if not
impossible, to estimate ks with any
confidence.
 15 - 41

What type of analysis should firms

conduct to help find their optimal, or
target, capital structure?

 Financial forecasting models can

help show how capital structure
changes are likely to affect stock
prices, coverage ratios, and so on.

(More...)
 15 - 42

 Forecasting models can generate

results under various scenarios, but
the financial manager must specify
appropriate input values, interpret
the output, and eventually decide on
a target capital structure.
 In the end, capital structure decision
will be based on a combination of
analysis and judgment.
 15 - 43

What other factors would managers

consider when setting the target
capital structure?

 Debt ratios of other firms in the

industry.
 Pro forma coverage ratios at
different capital structures under
different economic scenarios.
 Lender and rating agency attitudes
(impact on bond ratings).
 15 - 44

 Reserve borrowing capacity.

 Effects on control.
 Type of assets: Are they tangible,
and hence suitable as collateral?
 Tax rates.