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1. Foundations. 2. Financial Background: A Review of Accounting, Financial Statements, and Taxes. 3. Cash Flows and Financial Analysis. 4. Financial Planning. 5. The Financial System, Corporate Governance, and Interest. Part II: DISCOUNTED CASH FLOW AND THE VALUE OF SECURITIES. 6. Time Value of Money. 7. The Valuation and Characteristics of Bonds. 8. The Valuation and Characteristics of Stock. 9. Risk and Return. Part III: BUSINESS INVESTMENT DECISIONS--CAPITAL BUDGETING. 10. Capital Budgeting. 11. Cash Flow Estimation. 12. Risk Topics and Real Options in Capital Budgeting. 13. Cost of Capital. Part IV: LONG-TERM FINANCING ISSUES. 14. Capital Structure and Leverage. 15. Dividends. Part V: OPERATIONS ISSUES--WORKING CAPITAL MANAGEMENT AND PLANNING. 16. The Management of Working Capital. 17. Corporate Restructuring. 18. International Finance.
Chapter 14 Capital Structure and Leverage Background Capital structure - mix of a firm’s debt and equity – In this chapter preferred stock is considered debt Financial Leverage - using borrowed money to multiply the effectiveness of equity – Financial leverage of 10% means the capital structure is 10% debt and 90% equity The Central Issue Can the use of debt (leverage) increase the value of a firm’s equity? – Can it increase stock price? Under certain conditions changing leverage can increase stock price – But an increase in leverage also increases risk Risk in the Context of Leverage Leverage influences stock price Measures of overall performance – – EBIT (Earnings Before Interest and Taxes) – Earnings per Share (EPS) is Return on Equity (ROE) is ROE = EPS = NET Income equity NET Income number of shares Redefining Risk for Leverage-Related Issues Leverage-related risk is variation in ROE and EPS – – – Business risk — variation in EBIT Financial risk — additional variation in ROE and EPS due to financial leverage Total risk is total variation in ROE and EPS Figure 14-1 Business and Financial Risk Leverage and Risk Two Kinds of Each Financial Leverage Operating Leverage Associated with capital structure Associated with cost structure, the firm’s Causes financial risk mix of fixed and variable cost Influences a firm’s business risk => variation in EBIT Financial Leverage Financial leverage may increase stock price – – – Can improve financial performance, as measured by ROE and EPS May make performance worse Always increases risk Table 14-1 Effect of Increasing Financial Leverage when Return on Capital Exceeds After-Tax Cost of Debt Replacing equity with debt reduces Net Income due to interest expense But if profitability is good, it reduces equity and number of shares faster than the decline in Net Income Hence as debt increases, both EPS and ROE rise dramatically Effect Of Increased Leverage On Stock Price In Good Times Based on ROE and EPS performance in good times, investors bid stock price up as debt is increased from low levels Effect is eventually mitigated by the increasing financial risk from leverage Under what conditions will increasing leverage improve ROE and EPS? 10 Background The Value of the Firm Notation – – – Vd = market value of the firm’s debt Ve = market value of the firm’s stock or equity Vf = market value of the firm in total Vf = Vd + Ve Investors’ returns on the firm’s securities will be – – kd = return on an investment in debt ke = return on an investment in equity The average cost of capital is a weighted average of the costs of debt and equity – ka = average cost of capital 49 Background The Value of the Firm Value is based on cash flow, which comes from income – Dividends and interest payments are both perpetuities The firm’s market value is the sum of its present values Operating income = And Vf = Vd + Ve OI = I + D OI Vf = ka Returns drive value in an inverse relationship 50 Figure 14-10 Variation in Value and Average Return with Capital Structure The value of the firm and the firm’s stock price each reach maxima when the average cost of capital is minimized 51 The Early Theory by Modigliani and Miller (MM) Restrictive Assumptions in Original Model – The 1958 MM paper on capital structure included numerous restrictions such as – – – – No income taxes Securities trade in perfectly efficient capital markets with no transaction costs No costs to bankruptcy Investors and companies can borrow as much as they want at the same rate 52 The Early Theory by Modigliani and Miller (MM) The Assumptions and Reality – Income taxes exist – Bankruptcy costs are quite high – Individuals cannot borrow at the same rate as companies and – Interest rates usually rise as more money is borrowed 53 The Early Theory by Modigliani and Miller (MM) The result – The independence hypothesis: value is independent of capital structure – As cheaper debt is added, the cost of equity increases because of increased risk Arbitrage concept Interpreting the result 54 Figure 14-11 The Independence Hypothesis (a) 55 Figure 14-11 The Independence Hypothesis (b) 56 Relaxing the Assumptions— More Insights Financing and the U.S Tax System – Tax system favors debt financing over equity financing Including Corporate Taxes in the MM Theory – – – Interest provides a tax shield that reduces government’s share of the firm’s earnings Value is increased by the PV of the tax shield The benefit of debt is the tax rate times the debt amount The benefit of debt accrues entirely to stockholders since bond returns are fixed 57 Table 14-4 The Tax System Favors Debt Financing 58 Tax Shield Interest is tax deductible, so if there’s debt and an amount of interest, I, the government gets T(OI − I) = T(OI) − TI PV of tax shield is TI TBk d = = TB kd kd 59 Figure 14-12 MM Theory with Taxes In the MM model with taxes, value increases steadily as leverage is added Thus, the firm’s value is maximized with 100% debt Note that k d remains constant across all levels of debt 60 Including Bankruptcy Costs in the MM Theory As leverage increases past a certain point, concern about bankruptcy losses increases – – Debt and equity investors raise required returns ka passes its minimum as price and value peak Hence value and price are maximized at an optimal capital structure where the average cost of capital is a minimum 61 Figure 14-13 MM Theory with Taxes and Bankruptcy Costs 62 An Insight into Mergers and Acquisitions In many mergers, a firm buys the stock of a target company at a premium over its market price/value If the target was undervalued due to lack of debt, the increase in value from adding leverage may be more than the premium paid for the target’s stock 63 [...]... Connection Example 14- 1 Managing EPS through Leverage Will borrowing more money and retiring stock raise Albany’s EPC, and if so, what capital structure will achieve an EPS of $2? Concept Connection Example 14- 1 Managing EPS through Leverage Concept Connection Example 14- 1 Managing EPS through Leverage Managing Through Leverage Under certain conditions management may be able to manipulate financial results... from financial statements to solve for unknown values: algebraic approach EPS = ROE × Book Value per share ROE = Net Income ÷ Equity Net Income= [EBIT – Interest] (1 – tax rate) Interest = kd (Debt) – Net Income = [EBIT – (kd)(Debt)](1 – tax rate) Equity = Total Capital – Debt [EBIT − (k d )(Debt)(1 − T ) EPS = (Book valueper share) (Total capital- Debt) 17 Table 14- 3 Financial Leverage and Risk Financial. .. Financial Leverage Help? Return on Capital Employed – Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE ROCE = EBIT ( 1 - tax rate ) debt + equity When the ROCE > the after-tax cost of debt, more leverage improves ROE and EPS When ROCE < the after-tax cost of debt, more leverage makes ROE and EPS worse 11 Table 14- 2 Effect of Increasing Financial. .. concerns overwhelm benefit of enhanced performance thus additional leverage decreases stock price As leverage increases, its effect goes from positive to negative 20 Figure 14- 2 The Effect of Leverage on Stock Price 21 Finding the Optimum— A Practical Problem 1 A firm with good profit prospects and little or no debt is probably missing an opportunity by not using borrowed money if interest rates are reasonable... Repurchasing stock for retirement at prices other than book value will have the same general impact on ROE, but not necessarily for EPS EPS = ROE x (book value per share) 24 The Degree of Financial Leverage (DFL) A Measurement Financial leverage magnifies changes in EBIT into larger changes in ROE and EPS DFL quantifies the effectiveness of leverage by relating relative changes to EPS and EBIT EBIT DFL =... visual/graphic representation of effect of leverage on EPS Helps managers analyze and quantify the tradeoffs between risk and results when deciding on leverage policy 26 Figure 14- 3 EBIT – EPS Analysis for ABC Corp (from Table 14. 1, Columns 1 and 2) For the Arizona Balloon Corporation the It is important to determine the 50% Debt and No Leverage lines intersect At the point of intersection ABC is indifference... Determines the level of activity a firm must achieve to stay in business in the long run Shows the mix of fixed and variable costs and the volume required for zero profit/loss 30 Figure 14- 4 Fixed, Variable, and Total Cost 31 Figure 14- 5 The Breakeven Diagram Breakeven occurs at the intersection of revenue and total cost, Q B/E 32 Breakeven Analysis The Contribution Margin – Every sale makes a contribution... into terrible results 18 Putting the Ideas Together— The Effect on Stock Price During periods of good performance, leverage enhances results in terms of ROE and EPS Leverage adds variability (risk) to financial performance when operating results change These effects push stock prices in opposite directions 19 Real Investor Behavior and the Optimal Capital Structure When leverage is low, an increase... of the difference between price (P) and variable cost (V) Ct = P – V – – Can be expressed as a percentage of revenue Known as the contribution margin (CM) CM = (P – V) P 33 Concept Connection Example 14- 4 Contribution Suppose a company can make a unit of product for $7 in variable labor and materials, and sell it for $10 What are the contribution and contribution margin? The contribution per unit is... QB E FC = (P − V ) – Breakeven shows how many units must be sold to pay for (cover) fixed costs – Can be expressed in terms of dollar sales SB E FC FC = = (P − V ) C M P 35 Concept Connection Example 14- 5 Breakeven What is the breakeven sales level in units and dollars for a company that can make a unit of product for $7 in variable costs and sell it for $10, if the firm has fixed costs of $1,800 per ... risk — variation in EBIT Financial risk — additional variation in ROE and EPS due to financial leverage Total risk is total variation in ROE and EPS Figure 14- 1 Business and Financial Risk Leverage... EBIT Financial Leverage Financial leverage may increase stock price – – – Can improve financial performance, as measured by ROE and EPS May make performance worse Always increases risk Table 14- 1... firm’s debt and equity – In this chapter preferred stock is considered debt Financial Leverage - using borrowed money to multiply the effectiveness of equity – Financial leverage of 10% means