197.Capital Structure Lecture Gdansk 2006 Lecture 2

EBIT/EPS Analysis The tax benefit of debt

Trade-off theory Practical considerations in the

determination of capital structure

CAPITAL STRUCTURELecture 2

Kevin Campbell, University of Stirling, October 2006 22

Capital structure

Issues:

EBIT-EPS analysis The tax shield benefit of debt The trade-off theory of capital structure Practical considerations that affect the

capital structure decision


Business Risk vs Financial Risk

Business risk is the variability of a firm’s Earnings Before Interest and Taxes (EBIT)

Financial risk arises from the use of debt, which imposes a fixed cost in the form of interest payments = financial leverage.


EBIT/EPS analysis

Examines how different capital structures affect earnings available to shareholders (EPS) and risk

Question: for different levels of EBIT, how does financial leverage affect EPS?


Risk and the Income Statement

SalesBusiness – Variable costsRisk – Fixed costs

EBIT – Interest expense

Financial Earnings before taxesRisk – Taxes

Net Income

EPS = Net Income / no. of shares


Current and Proposed Capital Structures

CURRENT PROPOSED

Total assets $100 million $100 millionDebt 0 million 50 millionEquity 100 million 50 millionShare price $25 $25No. of shares 4,000,000 2,000,000Interest rate 10% 10%

Note: for the purpose of simplicity we ignore taxes in this example


CURRENT CAPITAL STRUCTURE No Debt, 4 Million Shares (millions omitted)

EBIT 50%EBIT 50% EBIT 50%EBIT 50%

BELOWBELOW ABOVE ABOVE EXPECTEDEXPECTED EXPECTEDEXPECTED

EXPECTEDEXPECTED

EBIT $6.00 $12.00 $18.00– Int 0.00 0.00 0.00NI $6.00 $12.00 $18.00EPS $ 1.50 $ 3.00 $ 4.50



BELOWBELOW ABOVE ABOVE EXPECTEDEXPECTED EXPECTEDEXPECTED

EXPECTEDEXPECTED

EBIT $6.00 $12.00 $18.00– Int 5.00 5.00 5.00NI $1.00 $ 7.00 $13.00EPS $ 0.50 $ 3.50 $ 6.50

PROPOSED CAPITAL STRUCTURE 50% Debt (10% Coupon), 2 million Shares (millions omitted)


EBIT/EPS analysisCurrent versus Proposed

Current (no debt)

Proposed (with debt)

EPS8

6

4

2

0

-2

-43 6 9 10 12 15 18

EBIT

For EBIT up to £10m, equity financing is best

For EBIT greater than £10m, debt financing is best


The impact of financial leverage

If EBIT is > 10, the levered capital structure is preferable, ie EPS is higher

If EBIT is < 10, the unlevered capital structure is preferable

Conclusion: whether or not debt is beneficial is dependent upon the capacity of firms to generate EBIT


Indifference Level

The break-even EBIT occurs where the lines cross

At that level of EBIT both capital structures have the same EPS


Set the two EPS values equal to each other and solve for EBIT:

Current (unlevered) Proposed (levered)

(EBIT-Int)(1-T) = (EBIT-Int)(1-T) S S

Since we assume T=0

(EBIT-Int) = (EBIT-Int) S S

Breakeven Point


Break-even EBIT (millions omitted)

10$

20$2

)5($4422

)1.50($

4

EBIT

EBIT

EBITEBIT

EBITEBIT

EPSEPS LU


EPSU 1.5 3.0 4.5

EPSL 0.5 3.5 6.5

SpreadU 3.0

SpreadL 6.0 … that’s RISK



BELOWBELOW ABOVE ABOVE EXPECTEDEXPECTED EXPECTEDEXPECTED EXPECTEDEXPECTED



Leverage increases EPS if EBIT is high enough.

At very low levels of EBIT, EPS can be negative – as interest on debt has priority over payments to shareholders.

Financial leverage produces a broader spread of EPS values, ie shareholders’ returns are less predictable. This represents added RISK.


Summary: EBIT/EPS analysis

Indicates EBIT values when one capital structure may be preferred over another

Analysis of expected EBIT can focus on the likelihood of actual EBIT exceeding the indifference point


Because interest on debt is deducted from EBIT before the amount of tax paid is calculated, there is a benefit to debt … in the form of lower corporate taxes

Consider an example …

The tax benefit of debt


Firm Unlevered Firm Levered

No debt $10,000 of 12% Debt$20,000 Equity $10,000 in Equity40% tax rate 40% tax rate


Both firms have same business risk and EBIT of $3,000.

They differ only with respect to use of debt.

U has $20K in Equity & L has $10K in Equity


EBIT $3,000 $3,000Interest 0 1,200EBT $3,000 $1,800Taxes (40%) 1 ,200 720NI $1,800 $1,080ROE 9.0% 10.8%

Firm U Firm L

U; 1.8/20K = 9% L; 1.08 / 10K = 10.8%



Why does financial leverage increase the overall return to investors? Investors include both:

Debtholders (banks & bondholders) Shareholders

Total return to investors: U: NI = $1,800. L: NI + Interest = $1,080 + $1,200 = $2,280.

Taxes paid: U: $1,200 L: $720 Difference = $480

More EBIT goes to investors in Firm L


Because the Government subsidizes debt, and the tax savings go to the investors.

The tax savings are called the “tax shield” and grows proportionally with the increase of debt.

Why does financial leverage increase the overall return to investors?


Debt versus Equity

Basic point. A firm’s cost of debt is always less than its cost of equity. Why? debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible.

It may appear a firm should use as much debt and as little equity as possible due to the cost difference … but this ignores the potential problems associated with debt.

A Basic Capital Structure Theory



There is a trade-off between the benefits of using debt and the costs of using debt.

The use of debt creates a tax shield benefit from the interest on debt.

The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.


The costs of financial distress associated with debt

Bankruptcy costs including legal and accounting fees and a likely decline in the value of the firm’s assets

Financial distress may also cause customers, suppliers, and management to take actions harmful to firm value.



Agency costs arise from conflicts between shareholders and bondholders

When you lend money to a business, you are allowing the shareholders to use that money in the course of running that business.

Shareholders interests are different from your interests, because

You (as lender) are interested in getting your money back

Shareholders are interested in maximizing their wealth



Agency costs associated with debt:

Restrictive covenants meant to protect creditors can reduce firm efficiency.

Monitoring costs may be expended to insure the firm abides by the restrictive covenants.

As the level of debt financing increases, the contractual and monitoring costs are expected to increase.



Capital structure: practical considerations

In addition to the variables described by the trade-off theory of capital structure, a variety of practical considerations also affect a firm’s capital structure decisions:

Industry standards Creditor and rating agency requirements Maintaining excess borrowing capacity Profitability and the need for funds Managerial risk aversion Corporate control


Industry standards

It is natural to compare a firm’s capital structure to other firms in the same industry.

Business risk is a significant factor impacting a firm’s capital structure and is heavily influenced by a firm’s industry.

Evidence indicate firms’ capital structures tend toward an industry average.

Practical considerations


Creditor and Rating Agency Requirements

Firms need to abide by restrictive covenants, which may include restrictions on the amount of future debt.

Firms typically desire to appear financially strong to potential creditors in order to maintain borrowing capacity and low interest rates.

Using less debt in capital structure helps to maintain this appearance.



Maintaining Excess Borrowing Capacity

Successful firms typically maintain excess borrowing capacity.

This provides financial flexibility to react to investment opportunities.

The maintenance of excess borrowing capacity causes firms to use less debt in their capital structure than otherwise.



Profitability and the Need for Funds

Profits can be paid out as dividends to shareholders or reinvested in the firm.

If a firm generates high profits and reinvests a large proportion back into the firm, then it has a continuous source of internal funding.

This will reduce the use of debt in the firm’s capital structure.



Practical considerations Managerial Risk Aversion

Well-diversified shareholders are likely to welcome the use of financial leverage.

Management wealth is typically much more dependent upon the success of the company acting as their employer.

To the extent management can act on their own desires, the firm is likely to have less debt in its capital structure than is desired by shareholders.


Practical considerations Corporate Control

Controlling owners may desire to issue debt instead of ordinary shares since debt does not grant ownership rights.

Firms with little financial leverage are often considered excellent takeover targets.

Issuing more debt may help to avoid a corporate takeover.


Summary

EBIT/EPS analysis may be used to help determine whether it would be better to finance a project with debt or equity.

Firms must trade-off the tax advantage to debt financing against the effect of debt on firm risk.

Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure.


KONIEC

DZIĘKUJĘ ZA UWAGĘ


Homework…EBIT/EPS Analysis

A company is considering the following two capital structures:

Plan A: sell 1,200,000 shares at £10 per share (£12 million total)

Plan B: issue £3.5 million in debt (9% coupon) and sell 850,000 shares at £10 per share (£12 million total)

Assume a corporate tax rate of 50%

REQUIRED:

(a) What is the break-even value of EBIT?(b) At this break-even value, what is the income statement for each

capital structure plan and the EPS?(c) Draw a diagram to illustrate the trade-off between EBIT and EPS

Documents

197.Capital Structure Lecture Gdansk 2006 Lecture 2