Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 24 Chapter 12 Capital Structure

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 24

Chapter 12Chapter 12

Capital Structure


The Target Capital Structure• Risk—greater risk means greater costs to raise funds• Financial flexibility—a stronger financial position—that

is, stronger balance sheet—generally implies the firm is better able to raise funds in the capital markets, especially in slumping economies

• Managerial attitude (conservatism or aggressiveness)—some financial managers are more conservative than others when it comes to using debt, thus they are inclined to use less debt, all else equal.


The Business RiskThe Business Riskand Financial Riskand Financial Risk

• Business Risk—Uncertainty inherent in projections of future returns (ROE or ROA) if the firm uses no debt.

• Financial Risk—Additional risk associated with using debt or preferred stock.

• Beware: The use of debt intensifies the firm’s business risk borne by the common stockholders.


The Optimal Capital Structure EBIT/EPS Analysis

Example: A firm that has no debt and assets equal to €400,000 can issue debt and repurchase shares of stock at €10 per share based on the following schedule:

Amount Debt/Asset Cost of Shares of StockEquity of Debt Ratio Debt, kd Outstanding

€400,000€ 0 0.0% 0.0% 40,000320,000 80,000 20.0 6.0 32,000240,000 160,000 40.0 9.0 24,000160,000 240,000 60.0 20.0 16,000


Determining the Optimal Capital Structure—EBIT/EPS Analysis

Assuming that operating expenses, such as cost of goods sold, depreciation, and so forth, are not affected by capital structure decisions, the firm is expected to generate the operating income, EBIT, as follows:

Boom 0.1 $200,000Normal 0.6 120,000Recession 0.3 40,000

Type of Economy Probability EBIT = NOI



Debt/Assets = 0: Debt = €0 Equity = €400,000 Interest = €0 Shares of stock = €400,000/€10 = 40,000

EBIT €200,000 €120,000 €40,000Interest (_____0) ( 0) ( 0)Taxable income, EBT 200,000 120,000 40,000Taxes (40%) ( 80,000) ( 48,000) (16,000)Net income €120,000 €72,000 €24,000

Type of Economy Boom NormalRecessionProbability 0.1 0.6 0.3

EPS = NI/(40,000 shrs) €3.00 €1.80 €0.60Expected EPS €1.56EPS €0.72



EBIT €200,000 €120,000 €40,000Interest ( 4,800) ( 4,800) ( 4,800)Taxable income, EBT 195,200 115,200 35,200Taxes (40%) ( 78,080) ( 46,080) (14,080)Net income €117,120 €69,120 €21,120



Debt/Assets = 20%: Debt = 0.2(€400,000) = €80,000 Equity = €400,000 - €80,000 = €320,000Interest = 0.06(€80,000) = €4,800 Shares of stock = €320,000/€10 = 32,000



EBIT €200,000 €120,000 €40,000Interest ( 14,400) ( 14,400) ( 14,400)Taxable income, EBT 185,600 105,600 25,600Taxes (40%) ( 74,240) ( 42,240) (10,240)Net income €111,360 €63,360 €15,360






EBIT €200,000 €120,000 €40,000Interest ( 48,000) ( 48,000) ( 48,000)Taxable income, EBT 152,000 72,000 ( 8,000)Taxes (40%) ( 60,800) ( 28,800) 3,200Net income € 91,200 €43,200 ( €4,800)


EPS = NI/(16,000 shrs) €5.70 €2.70 €(0.30)Expected EPS €2.10EPS €1.80




Summarizing the results, we have:

0.0% $1.56 $0.7220.0 1.86 0.9040.0 2.24 1.20

60.0 2.10 1.80

Proportion Expected Standardof Debt EPS Deviation

0.0% $1.56 $0.7220.0 1.86 0.9040.0 2.24 1.20

60.0 2.10 1.80


EPS Indifference AnalysisEPS Indifference Analysis

0.20

0.40

0.60

0.80

1.00

-0.20

-0.40

2 2.1 2.2

EPS(€)

Sales (€ millions)0

Fixed operating costs = €600,000Variable cost ratio = 70%

100% StockFinancing

40% DebtFinancing

Advantage

of Debt

Advantage

of Equity

EPS Indifference€2.12 million

0.54


Capital Structure — Stock Price

• The optimal capital structure is the mix of debt and equity that maximizes the value of the firm—that is, its stock price—not the EPS.

• The proportion of debt in the optimal capital structure will be less than the proportion of debt needed to maximize EPS because the market valuation of the stock, P0, considers the risk associated with the firm’s operations expected well into the future and EPS is based only on the firm’s operations expected for the next few years.


Capital Structure—Stock Price and the Cost of Equity, ks

The relationship of the cost of equity, ks, and the amount of

debt the firm uses to finance its assets can be illustrated as follows:

kRF

% Debt inCapital Structure

Required Return onEquity, ks (%)

Risk-free rate of return

ks = kRF + Risk Premium

Total RiskPremium

Premium for business risk at aparticular level of operations

Premium for financial risk


Capital Structure—Stock Price and the Cost of Capital, WACC

The relationship of the after-tax cost of debt, kdT, cost of equity, ks, and WACC might be:

% Debt inCapital Structure

Cost ofCapital, WACC (%) Cost of

equity, ks

After-tax cost of debt, kdT

WACC

MinimumWACC

Optimal Amountof Debt (30%)


Capital Structure - WACC• If the firm uses only equity to finance its assets (that is,

zero debt is used) then WACC = ks• As the firm begins to use some debt for financing, WACC

declines, primarily because the tax benefit offered by the debt more than offsets the increased cost of equity

• At some point the tax benefit associated with debt is more than offset by increases in the before-tax cost of debt and the cost of equity that result from increases in the risk associated with the additional debt and, at this point, WACC begins to increase

• The point where WACC is the lowest is the optimal capital structure—this is the point where the value of the firm is maximized


Operating Leverage• All else equal, if a firm can reduce its operating leverage, it can

use more debt (that is, increase its financial leverage), and vice versa, and maintain the same degree of risk.

• Degree of operating leverage (DOL) refers to the percentage change in operating income—designated either NOI or EBIT—that results from a particular percentage change in sales.

• DOL can be computed as follows:

EBITprofit Gross

FVCS

VCSFV)Q(P

V)Q(Psales in change%NOI in change %

DOL

Q = number of products (units) the firm currently sellsP = sales price per unitV = variable cost per unitF = fixed operating costsS = current sales stated in dollars such that S = Q PVC = total variable costs of operations such that VC = Q V


Operating Leverage

Expected Sales = –5%

Outcomeof Expectations % Δ

SalesVariable operating costs (60%)Gross profitFixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%)Gross profitFixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%)(150,000)Gross profitFixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%)(150,000)Gross profit 100,000Fixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%)(150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT

Sales $250,000 $237,500Variable operating costs (60%)(150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

4.0x$25,000$100,000

EBIT

profit Gross DOL

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000 95,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0

Sales $250,000Variable operating costs (60%)(150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Risk = variability


Financial Leverage

• Degree of financial leverage refers to the percentage change in EPS that results from a particular percentage change in earnings before interest and taxes, EBIT.

• DFL is computed as follows:

IFVCSFVCS

IEBITEBIT

EBIT in change %EPS in change %

DFL

I = interest paid on debt


Financial LeverageExpected Sales = –5%


Sales $250,000 $237,500 -5.0%Variable operating costs (60%)(150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0InterestEarnings Before TaxesTaxes (40%)Net Income

Interest (12,500)Earnings Before TaxesTaxes (40%)Net Income

Interest (12,500)Earnings Before Taxes 12,500Taxes (40%)Net Income

Interest (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income

Interest (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500 -40.0

2.0x$12,500$25,000

$12,500-$25,000$25,000

I-EBIT

EBIT DFL Risk = variability


Total Leverage• Degree of total leverage (DTL) refers to the percentage

change in EPS that results from a particular percentage change in sales.

• DTL combines DOL and DFL, and it is computed as follows:

IEBITprofit Gross

IFVCSVCS

IFV)Q(PV)Q(P

DFLDOLsales in change %EPS in change %

DTL


Total Leverage

Expected Sales = –5%


Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500 -40.0

8.0x$12,500$100,000

$12,500-$25,000$100,000

I-EBIT

profit Gross DTL

Risk = variability; thus the greater the degree of leverage (operating, financial, or both), the greater the risk associated with the firm


Liquidity and Capital Structure A firm might not operate at the optimal

capital structure because: It might be difficult, if not impossible, to

determine the optimal capital structure. Managers might be reluctant to take on the

amount of debt necessary to achieve the optimal capital structure—that is, a conservative attitude toward debt might exist.

The firm provides important, needed services, and operating at the optimal mix of capital might endanger the firm’s ability to survive.

Financial liquidity is important to such firms.


Capital Structure—Trade-Off Theory• The value of a firm increases as it uses more and

more debt. • Ignores the costs associated with bankruptcy, which

can be considerable• If bankruptcy costs are considered, there is a point

where the benefit of the tax deductibility of debt is more than offset by increases in the cost of debt and the cost of equity that result from the risk associated with the firm’s heavy use of debt


Capital Structure—Signaling Theory• Studies have shown that when firms issue new

common stock to raise funds the per share value of the stock decreases. – Perhaps this occurs because managers would only issue new

common stock if they felt that the firm’s future prospects were unfavorable.

– When debt is issued, only the contracted costs need to be paid—that is, fixed interest and the repayment of the debt—and the remaining gains from the favorable projects accrue to the stockholders.

– Age of a firm—younger firms generally do not have the same access to financial markets as older, more established firms

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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 24 Chapter 12 Capital Structure