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) – Return on Equity (ROE) is NET Income ROE = equity NET Income – Earnings EPSper = Share (EPS) is 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 Associated with capital structure Causes financial risk Operating Leverage Associated with cost structure, the firm’s 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 kd 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 [...]... capital - Debt ) 17 Table 14-3 Financial Leverage and Risk Financial leverage is a two-edged sword – Multiplies good results into great results – Multiplies bad results 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... 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, QB/E 32 Breakeven Analysis The Contribution Margin – Every sale makes a contribution of the difference between price (P) and variable cost (V) Ct = P – V – Can be expressed as a... 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... reasons (sales, costs, management) 28 Operating Leverage Fixed and Variable Costs and Cost Structure Fixed Costs Variable Costs – Don’t change with the level of sales – Change with the level of sales – Include rent, depreciation, utilities, salaries – Include direct labor, direct materials, sales commissions Cost Structure – the mix of fixed and variable costs in a firm’s operations 29 Breakeven Analysis... 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. .. 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 month? The breakeven point in units... < the after-tax cost of debt, more leverage makes ROE and EPS worse 11 Table 14-2 Effect of Increasing Financial Leverage when After-Tax Cost of Debt Exceeds Return on Capital When ROCE is less than the after tax cost of debt, increasing leverage reduces EPS and ROE That, along with increasing risk, has a very negative effect on investors and stock price falls 12 Concept Connection Example 14-1 Managing... EPS through Leverage Managing Through Leverage Under certain conditions management may be able to manipulate financial results and stock price by changing the firm’s capital structure This is true, but must be done cautiously 16 An Alternate Approach (Optional) Using ratios and information from financial statements to solve for unknown values: algebraic approach EPS = ROE × Book Value per share ROE =... 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 =... breakeven point in units is $1,800 ÷ ($10 - $7) = 600 units The breakeven point in dollars is $10 per unit times 600 units, or $6,000, which could also be calculated as $1,800 / 0.30 Thus, the firm must sell 600 units per month to cover fixed costs 36