Post on 12-Jul-2016
description
16-1
CHAPTER 16Capital Structure and Leverage
Business vs. Financial Risk
Operating & Financial Leverage
Optimal Capital Structure
Capital Structure theory
Capital Structure Example
16-2
Preview of Capital Structure
WACC = wd(rd)(1-T) + ws(rs)
Debt Increases Equity Cost (rs)
Debt Reduces Taxes
Debt Increases Risk of Bankruptcy
Increased Bankruptcy Reduces FCFs
Increased Bankruptcy Increases Agency Costs
Issuing Equity is Negative Market Signal
16-3
Business Risk is “Uncertainty” about future Operating Income (EBIT)
Note: Business Risk DOES NOT include financing risks
Business Risk
Probability
EBITE(EBIT)0
Low risk
High risk
16-4
Major Determinants of Business Risk
Demand Variability (Unit Sales)
Sales Price Variability
Input Cost variability
Ability to adjust output prices
Ability to develop new products
Foreign Risk Exposure
Operating Leverage (% Fixed Ops Costs)
16-5
Operating Leverage & Business Risk
Operating Leverage is relationship between Fixed Operating costs & Variable Operating costs
If most costs “Fixed”, Operating Leverage High & Business Risk Higher
Breakeven Analysis
EBIT = PQ – VQ – F = 0
QBE = F/(P – V)
16-6
Effect of Operating Leverage
More Operating Leverage leads to more Business Risk: Small Sales decline causes a Big Profit decline (and vice versa)
Sales
$ Rev.
TC
FC
QBE Sales
$ Rev.
TC
FC
QBE
} Profit
16-7
Using Operating Leverage
Can use Operating Leverage to get higher EBIT, but risk also increases
Probability
EBITL
Low operating leverage
High operating leverage
EBITH
16-8
Financial Leverage &Financial Risk
Financial Leverage is the use of debt and preferred stock (fixed financial costs)
Financial Risk is the “additional risk” concentrated on common stockholders as a result of Financial Leverage
16-9
Business Risk vs. Financial Risk
Business Risk depends on business factors: Economy, Competitiveness & Operating Leverage
Financial Risk depends on Debt vs Equity decisions More Debt, more financial risk
Increases risk to Common Stockholders
16-10
Financial Leverage Example
Two firms with same Operating Leverage, Business Risk, and probability distribution of EBIT
Only differ in use of debt (capital structure)
Firm U Firm L
No debt $10,000 of 12% debt (50%)
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
16-11
Financial Leverage ExampleUnleveraged Economy
Bad Avg. GoodProb. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400
Leveraged EconomyBad Avg. Good
Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200 1,200 1,200EBT $ 800 $1,800 $2,800Taxes (40%) 320 720 1,120NI $ 480 $1,080 $1,680
16-12
Ratio Comparison between Leveraged & Unleveraged firms
FIRM U Bad Avg GoodBEP 10.0% 15.0% 20.0%
ROE 6.0% 9.0% 12.0%
TIE ∞ ∞ ∞
FIRM L Bad Avg GoodBEP 10.0% 15.0% 20.0%
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.50x 3.30x
16-13
Risk & Return between Leveraged & Unleveraged firms
Expected Values:
Firm U Firm L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) ∞ 2.5x
Risk Measures:
Firm U Firm L
σROE 2.12% 4.24%
CVROE 0.24 0.39
16-14
Financial Leverage Conclusions
Basic Earning Power (BEP) is unaffected by Financial Leverage
For leverage to increase ROE: BEP > rd
“Leveraged” firm has higher expected ROE because BEP > rd & higher risk (σROE & CV)
Higher Expected Return is accompanied by Higher Risk
16-15
Optimal Capital Structure
Mix of debt, preferred, & common equity at which Ps (Value) is maximized & WACC is minimized
Target (Optimal) Capital Structure Mix of debt, preferred stock, & common
equity at which firm should raise capital
Use of Debt reduces Taxes
16-16
MM vs. Trade-off Theory
MM theory ignores Bankruptcy (financial distress) Costs, which increase as more Debt is used
VL = VU + TD
Trade-off Theory includes Bankruptcy
VL = VU + TD – (PV of Bankruptcy Costs)
An Optimal capital structure exists that balances costs and tax benefits
16-17
Trade-off Theory vs MM
Value of Stock
0 D1 D2
D/A
MM with no bankruptcy risk
Actual Value
No leverage
Value reduced by potential bankruptcy
Value added by Debt tax benefits
16-18
“Signaling” effects in Capital Structure
Managers (Insiders) have better information
Will sell new stock if stock is overvalued
Will sell bonds/buyback stock if stock is undervalued
New stock sales are “negative” signals & vice versa
Firms keep “Reserve Borrowing Capacity” Avoid new stock issues
Able to borrow for opportunities & emergencies
Signaling theory suggests firms should use less Debt than MM suggest
16-19
Other Capital Structure Issues
Use of Debt to Constrain Managers
Investment Opportunity Set (IOS)
High IOS: Lower Debt Levels
Low IOS: Higher Debt Levels
Higher Business Risk
Increases probability of Bankruptcy
Optimal capital structure has less debt
See “Checklist” at end of Chapter
16-20
Capital Structure Example
Example Sequence of Events
Firm decides to 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 current price per share (P0)
16-21
Initial Assumptions
Total Assets = $2,000,000
Debt = None (all Equity)
EBIT = $400,000
Price per Share (P0) = $25.00
rrf = 6%, rmkt = 6%
RPmkt = 6%
Beta (no debt) = 1.0
Payout = 100% Growth (g) = 0%
Shares Outstanding = 80,000
16-22
Cost of debt at different debt levels(Investment Banker Estimates)
Amount D/A D/E Bond
borrowed ratio ratio rating rd
$ 0 0 0 -- --
250 0.125 0.1429 AA 8.0%
500 0.250 0.3333 A 9.0%
750 0.375 0.6000 BBB 11.5%
1,000 0.500 1.0000 BB 14.0%
16-23
Determine the EPS and TIE at each level of debt
$3.00
80,000
(0.6)($400,000)
goutstandin Shares
) T - 1 )( Dr - EBIT ( EPS
$0 D
d
16-24
Determining EPS and TIE (D = $250,000 and rd = 8%)
20x $20,000
$400,000
Exp Int
EBIT TIE
$3.26
10,000- 80,000
000))(0.6)0.08($250, - ($400,000
goutstandin Shares
) T - 1 )( Dr - EBIT ( EPS
10,000 $25
$250,000 drepurchase Shares
d
16-25
Summary of EPS & TIE Ratios
Amount Borrowed
EPS TIE Ratio
0 $3.00 ∞
250 3.26 20x
500 3.55 8.89x
750 3.77 4.64x
1000 3.90 2.85
16-26
Stock Price, with zero growth
If all earnings are paid out as dividends, g = 0. Therefore: EPS = DPS
To find the expected stock price (P0), we must find the appropriate “Beta” & rs at each of the debt levels discussed
sss
10
r
DPS
r
EPS
g - r
D P
16-27
Calculating “Beta” & “rs” from Hamada Equation & CAPM
Hamada Equation: βL = βU[ 1 + (1 - T) (D/E)]
βL = 1.0 [ 1 + (0.6)($250/$1,750) ]
βL = 1.09
CAPM: rs = rRF + (rM – rRF) βL
rs = 6.0% + (6.0%) 1.0857
rs = 12.51%
16-28
Summary of “Betas” & “rs” at different levels of Debt
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
rs
12.00%
12.51
13.20
14.16
15.60
16-29
Summary of WACC at different levels of Debt
D/A (Wd)
ratio
0.00%
12.50
25.00
37.50
50.00
WACC
12.00%
11.55
11.25
11.44
12.00
E/A (Ws)
ratio
100.00%
87.50
75.00
62.50
50.00
rs
12.00%
12.51
13.20
14.16
15.60
rd (1 – T)
0.00%
4.80
5.40
6.90
8.40
Amount
borrowed
$ 0
250
500
750
1,000
* Amount borrowed expressed in terms of thousands of dollars
16-30
Summary of Stock Price at different levels of Debt
Amount
Borrowed EPS/DPS rs P0
$ 0 $3.00 12.00% $25.00
250,000 3.26 12.51
500,000 3.55 13.20
26.03
26.89
750,000 3.77 14.16 26.59
1,000,000 3.90 15.60 25.00
16-31
Optimal Capital Structure
The Optimal Capital structure Minimizes WACC (NOT EPS!)
The Optimal Capital structure Maximizes Stock Price. (NOT EPS!)
Both methods yield the same results