Financial management and policy chapter 9

Published by www.lecturesheet. com
Chapter 9

Capital
Structure

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

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 Risk
and 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 Stock
Equity of Debt Ratio Debt, kd Outstanding
€400,000 € 0 0.0% 0.0% 40,000
320,000 80,000 20.0 6.0 32,000
240,000 160,000 40.0 9.0 24,000
160,000 240,000 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:

Type of Economy Probability EBIT = NOI
Boom 0.1 $200,000
Normal 0.6 120,000
Recession 0.3 40,000


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

Type of Economy Boom Normal Recession
Probability 0.1 0.6 0.3
EBIT €200,000 €120,000 €40,000
Interest (_____0) ( 0) ( 0)
Taxable income, EBT 200,000 120,000 40,000
Taxes (40%) ( 80,000) ( 48,000) (16,000)
Net income €120,000 €72,000 €24,000
EPS = NI/(40,000 shrs) €3.00 €1.80 €0.60
Expected EPS €1.56
sEPS €0.72

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

EBIT €200,000 €120,000 €40,000
Interest ( 4,800) ( 4,800) ( 4,800)
Taxes (40%) ( 78,080) ( 46,080) (14,080)
Net income €117,120 €69,120 €21,120
EPS = NI/(32,000 shrs) €3.66 €2.16 €0.66
sEPS €0.90

Debt/Assets = 40%:
Debt = 0.4(€400,000) = €160,000 Equity = €400,000 - €160,000 = €240,000

EBIT €200,000 €120,000 €40,000
Interest ( 14,400) ( 14,400) ( 14,400)
Taxes (40%) ( 74,240) ( 42,240) (10,240)
Net income €111,360 €63,360 €15,360
EPS = NI/(24,000 shrs) €4.64 €2.64 €0.64
sEPS €1.20

Debt/Assets = 60%:
Debt = 0.6(€400,000) = €240,000 Equity = €400,000 - €240,000 = €160,000

EBIT €200,000 €120,000 €40,000
Interest ( 48,000) ( 48,000) ( 48,000)
Taxable income, EBT 152,000 72,000 ( 8,000)
Taxes (40%) ( 60,800) ( 28,800) 3,200
Net income € 91,200 €43,200 ( €4,800)
EPS = NI/(16,000 shrs) €5.70 €2.70 €(0.30)
sEPS €1.80

Summarizing the results, we have:

Proportion Expected Standard
of Debt EPS Deviation
0.0% $1.56 $0.72
20.0 1.86 0.90
40.0 2.24 1.20
60.0 2.10 1.80


EPS Indifference Analysis

EPS(€)
Fixed operating costs = €600,000
1.00
Variable cost ratio = 70%

0.80 40% Debt
Financing
0.60
100% Stock
0.54 Financing
0.40

0.20

Sales
0 (€ millions)

2 2.1 2.2
-0.20
EPS Indifference
-0.40 €2.12 million


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: Required Return on
Equity, ks (%)

ks = kRF + Risk Premium

Premium for
financial risk Total Risk
Premium
Premium for business risk at a
particular level of operations
kRF

Risk-free rate of return

% Debt in
Capital Structure


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:
Cost of
Capital, WACC (%) Cost of
equity, ks

WACC

After-tax cost
Minimum of debt, kdT
WACC

% Debt in
Optimal Amount Capital Structure
of 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:
% change in NOI Q(P  V) S  VC Gross profit
DOL    
% change in sales Q(P  V)  F S  VC  F EBIT
Q = number of products (units) the firm currently sells
P = sales price per unit
V = variable cost per unit
F = fixed operating costs
S = current sales stated in dollars such that S = Q  P
VC = total variable costs of operations such that VC = Q  V

Operating Leverage
Expected Sales = –5%
Outcomeof Expectations % Δ
Sales $250,000 $237,500 -5.0%
Variable operating costs (60%) (150,000) (142,500) -5.0
Gross profit 100,000 95,000 -5.0
Fixed operating costs (75,000) (75,000) 0.0
Net operating income = EBIT 25,000 20,000 -20.0

Gross profit $100,000
DOL    4.0x Risk = variability
EBIT $25,000


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:

% change in EPS EBIT S  VC  F
DFL   
% change in EBIT EBIT  I S  VC  F  I

I = interest paid on debt


Financial Leverage
Outcome of Expectations % Δ
Sales $250,000 $237,500 -5.0%
Gross profit 100,000 95,000 -5.0
Interest (12,500) (12,500) 0.0
Earnings Before Taxes 12,500 7,500 -40.0
Taxes (40%) (5,000) (3,000) -40.0
Net Income 7,500 4,500 -40.0
EBIT $25,000 $25,000
DFL     2.0x Risk = variability
EBIT - I $25,000 - $12,500 $12,500

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:
% change in EPS
DTL   DOL  DFL
% change in sales

Q(P  V) S  VC Gross profit
  
Q(P  V)  F  I S  VC  F  I EBIT  I


Total Leverage
Gross profit $100,000 $100,000
DTL     8.0x
EBIT - I $25,000 - $12,500 $12,500

Outcome of Expectations % Δ
Sales $250,000 $237,500 -5.0%
Gross profit 100,000 95,000 -5.0
Interest (12,500) (12,500) 0.0
Earnings Before Taxes 12,500 7,500 -40.0
Taxes (40%) (5,000) (3,000) -40.0
Net Income 7,500 4,500 -40.0
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

Financial management and policy chapter 9

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