Capital Structure And Leverage, Lecture Notes - Financial Management, Study notes of Financial Management

Download Capital Structure And Leverage, Lecture Notes - Financial Management and more Study notes Financial Management in PDF only on Docsity! 13-1 CHAPTER 13 Capital Structure and Leverage  Business vs. financial risk  Optimal capital structure  Operating leverage  Capital structure theory 13-2 Target Capital Structure  Preferred, Optimal mix of D, E and P/S to: a) Max value of firm and b) Raise capital and finance expansion  Tradeoffs: More debt increases risk, which lowers stock P; but more debt leads to higher expected return on equity (ROE), which raises stock P.  Optimal capital structure: Max stock P. 13-5 What determines business risk? (Variability of EBIT) TR (Sales Revenue) = P x Q  Uncertainty about demand (Sales): Q  Uncertainty about output prices: P  Uncertainty about costs (Input P)  Elasticity of Demand – Price sensitivity  Currency Risk Exposure – Foreign sales?  Product and other types of legal liability  Operating leverage (FC vs. VC) 13-6  Firms can control business risk:  Negotiate long-term contracts for labor, supplies, inputs, leases, etc.  Marketing strategies to stabilize units sales and prices  Hedging with commodity and financial futures to stabilize revenues and costs  General Rule: The greater the business risk, the lower the optimal debt ratio. 13-7 What is operating leverage, and how does it affect a firm’s business risk?  Operating leverage is the use of fixed costs rather than variable costs.  If most costs are fixed, and therefore do not decline when demand falls, then the firm has high operating leverage.  Examples: Nuclear plant, UM-Flint, GM and Ford, Automated Equipment vs. Low-Tech Equipment  General Rule: Higher the operating leverage, the greater the business risk, lower optimal debt 13-10 Illustration of Operating Leverage  See Example Fig 13-2 in Book, p. 428 and graph p. 430  Breakeven Formula:  QBE = FC / (P – VC)  $20,000 / ($2 – 1.50) = 40,000 units  $60,000 / ($2 – 1.00) = 60,000 units 13-11 What is financial leverage? Financial risk?  Financial leverage is the use of debt and preferred stock  Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage (Debt).  Remember: Business Risk is the risk with no debt. 13-12 Business risk vs. Financial risk  Example: Income from sales commissions and Adjustable-rate Mortgage (ARM)  Business risk depends on business factors such as competition, product liability, and operating leverage.  Financial risk depends only on the types of securities issued.  More debt, more financial risk – see p. 431.  Concentrates business risk on stockholders. 13-15 Firm L: Leveraged, E = $10,000 Economy Bad Avg. Good Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NIAT $ 480 $1,080 $1,680 *Same as for Firm U. 13-16 Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg Good BEP (EBIT/TA) 10.0% 15.0% 20.0% ROE (NIAT/E) 6.0% 9.0% 12.0% TIE (EBIT/INT) ∞ ∞ ∞ FIRM L Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 4.8% 10.8% 16.8% TIE 1.67x 2.50x 3.30x 13-17 Risk and return for leveraged and unleveraged firms Expected Values: Firm U Firm L E(BEP) 15.0% 15.0% E(ROE) 9.0% 10.8% E(TIE) ∞ 2.5x Risk Measures: Firm U Firm L σROE 2.12% 4.24% CVROE 0.24 0.39 13-20 Optimal Capital Structure  The capital structure (mix of debt, preferred, and common equity) at which share price (P0) is maximized.  Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debt’s risk- related costs.  The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital. 13-21 Sequence of events in a recapitalization.  Firm announces the recapitalization.  New debt is issued.  Proceeds are used to repurchase stock.  The number of shares repurchased is equal to the amount of debt issued divided by price per share. 13-22 Cost of debt at different debt ratios Amount borrowed D/A ratio D/E ratio Bond rating rd $ 0 0 0 -- -- 250 0.125 0.143 AA 8.0% 500 0.250 0.333 A 9.0% 750 0.375 0.600 BBB 11.5% 1,000 0.500 1.000 BB 14.0% 13-25 Determining EPS and TIE at different levels of debt. (D = $250,000 and rd = 8%) 20x $20,000 $400,000 Exp Int EBIT TIE $3.26 10,000- 80,000 000))(0.6)0.08($250, - ($400,000 goutstandin Shares ) T - 1 )( Dr - EBIT ( EPS 10,000 $25 $250,000 drepurchase Shares d      13-26 Determining EPS and TIE at different levels of debt. (D = $500,000 and rd = 9%) 8.9x $45,000 $400,000 Exp Int EBIT TIE $3.55 20,000- 80,000 000))(0.6)0.09($500, - ($400,000 goutstandin Shares ) T - 1 )( Dr - EBIT ( EPS 20,000 $25 $500,000 drepurchase Shares d      13-27 Determining EPS and TIE at different levels of debt. (D = $750,000 and rd = 11.5%) 4.6x $86,250 $400,000 Exp Int EBIT TIE $3.77 30,000- 80,000 ),000))(0.60.115($750 - ($400,000 goutstandin Shares ) T - 1 )( Dr - EBIT ( EPS 30,000 $25 $750,000 drepurchase Shares d      13-30 What effect does more debt have on a firm’s cost of equity?  If the level of debt increases, the riskiness of the firm increases.  We have already observed the increase in the cost of debt.  However, the riskiness of the firm’s equity also increases, resulting in a higher rs. 13-31 The Hamada Equation  Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity.  The Hamada equation attempts to quantify the increased cost of equity due to financial leverage.  Uses the unlevered beta of a firm, which represents the business risk of a firm as if it had no debt. 13-32 The Hamada Equation bL = bU[ 1 + (1 – T) (D/E)]  Suppose, the risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is 1.0. We were previously told that total assets were $2,000,000. 13-35 Finding Optimal Capital Structure  The firm’s optimal capital structure can be determined two ways:  Minimizes WACC.  Maximizes stock price.  Both methods yield the same results. 13-36 Table for calculating levered betas and costs of equity Amount borrowed D/A ratio E/A ratio rs rd(1-T) WACC $ 0 0% 100% 12.00% -- 12.00% 250 12.50 87.50 12.51 4.80% 11.55 500 25.00 75.00 13.20 5.40% 11.25 750 37.50 62.50 14.16 6.90% 11.44 1,000 50.00 50.00 15.60 8.40% 12.00 13-37 Determining the stock price maximizing capital structure Amount borrowed DPS rs P0 $ 0 $3.00 12.00% $25.00 250 3.26 12.51 26.03 500 3.55 13.20 26.89 750 3.77 14.16 26.59 1,000 3.90 15.60 25.00 13-40 What if there were more/less business risk than originally estimated, how would the analysis be affected?  If there were higher business risk, then the probability of financial distress would be greater at any debt level, and the optimal capital structure would be one that had less debt.  However, lower business risk would lead to an optimal capital structure with more debt. 13-41 Other factors to consider when establishing the firm’s target capital structure 1. Industry average debt ratio 2. TIE ratios under different scenarios 3. Lender/rating agency attitudes 4. Reserve borrowing capacity 5. Effects of financing on control 6. Asset structure 7. Expected tax rate 13-42 How would these factors affect the target capital structure? 1. Increase in sales stability? D 2. High operating leverage? D 3. Increase in the corporate tax rate? D 4. Increase in the personal tax rate? D 5. Increase in bankruptcy costs? D 6. Management spending lots of money on lavish perks? D 13-45 Incorporating signaling effects  Signaling theory suggests firms should use less debt than MM suggest.  This unused debt capacity helps avoid stock sales, which depress stock price because of “signaling effects.” 13-46 What are “signaling effects” in capital structure?  Assumptions:  Managers have better information about a firm’s long- run value and firm’s prospects than outside investors.  Managers act in the best interests of current stockholders.  What can managers be expected to do?  Issue stock if they think stock is overvalued.  Issue debt if they think stock is undervalued.  As a result, investors view a stock offering negatively-- managers think stock is overvalued. 13-47 Favorable v. Unfavorable Prospects for a Firm  Favorable prospects, profitable new product, Issue Debt or Equity? Why?  Unfavorable prospect, pending losses, Issue Debt or Equity? Why? Conclusions:  1. Issuing stock is negative signal, depresses price  2. Firm should maintain reserve borrowing capacity, use more E, less D than suggested by trade-off theory