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Leverage
and Capital
Structure
Chapter
Across the Disciplines
Why This Chapter Matters To You
Accounting: You need to understand how to calculate and analyze operating and financial leverage and to be familiar with the tax effects of various capital structures.
Information systems: You need to under- stand the types of capital and what capital structure is, because you will provide much of the information needed in man- agement’s determination of the best capi- tal structure for the firm.
Management: You need to understand leverage so that you can magnify returns for the firm’s owners and to understand capital structure theory so that you can make decisions about the firm’s optimal capital structure.
Marketing: You need to understand breakeven analysis, which you will use in pricing and product feasibility decisions.
Operations: You need to understand the impact of fixed and variable operating costs on the firm’s breakeven point and its operating leverage, because these costs will have a major impact on the firm’s risk and return.
LEARNING GOALS
Discuss the role of breakeven analysis, the operating breakeven point, and the effect of changing costs on it.
Understand operating, financial, and total leverage and the relationships among them.
Describe the types of capital, external assessment of capital structure, the capital structure of non-U.S. firms, and capital structure theory.
Explain the optimal capital structure using a graphical view of the firm’s cost-of-capital functions and a zero- growth valuation model.
Discuss the EBIT–EPS approach to capital structure.
Review the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital structure.
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422 PART 4 Long-Term Financial Decisions
capital structure The mix of long-term debt and equity maintained by the firm.
leverage Results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners.
Leverage
Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners. Generally, increases in leverage result in increased return and risk, whereas decreases in leverage result in decreased return and risk. The amount of leverage in the firm’s capital structure —the mix of long-term debt and equity maintained by the firm—can significantly affect its value by affecting return and risk. Unlike some causes of risk, management has almost complete control over the risk introduced through the use of leverage. Because of its effect on value, the financial manager must understand how to measure and evaluate leverage, particularly when making capital structure decisions. The three basic types of leverage can best be defined with reference to the firm’s income statement, as shown in the general income statement format in Table 11.1.
- Operating leverage is concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes, or EBIT. (EBIT is a descriptive label for operating profits. )
- Financial leverage is concerned with the relationship between the firm’s EBIT and its common stock earnings per share (EPS).
- Total leverage is concerned with the relationship between the firm’s sales rev- enue and EPS.
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everage involves the use of fixed costs to magnify returns. Its use in the capital structure of the firm has the potential to increase its return and risk. Leverage and capital structure are closely related concepts that are linked to capital budget- ing decisions through the cost of capital. These concepts can be used to minimize the firm’s cost of capital and maximize its owners’ wealth. This chapter discusses leverage and capital-structure concepts and techniques and how the firm can use them to create the best capital structure.
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T A B L E 1 1. 1 General Income Statement Format and Types of Leverage Sales revenue L e s s : C o s t o f g o o d s s o l d Operating leverage Gross profits L e s s : O p e r a t i n g e x p e n s e s Earnings before interest and taxes (EBIT) L e s s : I n t e r e s t Net profits before taxes Total leverage L e s s : T a x e s Financial leverage Net profits after taxes L e s s : P r e f e r r e d s t o c k d i v i d e n d s Earnings available for common stockholders
Earnings per share (EPS)
424 PART 4 Long-Term Financial Decisions
Simplifying Equation 11.1 yields
EBIT Q ( P VC ) FC (11.2)
As noted above, the operating breakeven point is the level of sales at which all fixed and variable operating costs are covered—the level at which EBIT equals $0. Setting EBIT equal to $0 and solving Equation 11.2 for Q yield
Q (11.3)
Q is the firm’s operating breakeven point.
E X A M P L E Assume that Cheryl’s Posters, a small poster retailer, has fixed operating costs of $2,500, its sale price per unit (poster) is $10, and its variable operating cost per unit is $5. Applying Equation 11.3 to these data yields
Q 500 units
At sales of 500 units, the firm’s EBIT should just equal $0. The firm will have positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for sales less than 500 units. We can confirm this by substituting values above and below 500 units, along with the other values given, into Equation 11.1.
The Graphical Approach
Figure 11.1 presents in graphical form the breakeven analysis of the data in the preceding example. The firm’s operating breakeven point is the point at which its total operating cost —the sum of its fixed and variable operating costs—equals sales revenue. At this point, EBIT equals $0. The figure shows that for sales below 500 units, total operating cost exceeds sales revenue, and EBIT is less than $0 (a loss). For sales above the breakeven point of 500 units, sales revenue exceeds total operating cost, and EBIT is greater than $0.
Changing Costs and the
Operating Breakeven Point
A firm’s operating breakeven point is sensitive to a number of variables: fixed operating cost ( FC ), the sale price per unit ( P ), and the variable operating cost per unit ( VC ). The effects of increases or decreases in these variables can be readily seen by referring to Equation 11.3. The sensitivity of the breakeven sales volume ( Q ) to an increase in each of these variables is summarized in Table 11.3. As might be expected, an increase in cost ( FC or VC ) tends to increase the operating breakeven point, whereas an increase in the sale price per unit ( P ) decreases the operating breakeven point.
E X A M P L E Assume that Cheryl’s Posters wishes to evaluate the impact of several options: (1) increasing fixed operating costs to $3,000, (2) increasing the sale price per unit to
$2, $
$2, $10 $
FC P VC
CHAPTER 11 Leverage and Capital Structure 425
$12.50, (3) increasing the variable operating cost per unit to $7.50, and (4) simultaneously implementing all three of these changes. Substituting the appro- priate data into Equation 11.3 yields the following results:
(1) Operating breakeven point 600 units
(2) Operating breakeven point 333 1 ⁄3 units $2, $12.50 $
$3, $10 $
Sales Revenue
Total Operating Cost
Operating Breakeven Point
EBIT
Fixed Operating Cost
0 500 1,000 1,500 2,000 2,500 3,
Loss
12,
10,
8,
6,
4,
2,
Costs/Revenues ($)
Sales (units)
F I G U R E 1 1. 1
Breakeven Analysis Graphical operating breakeven analysis
T A B L E 1 1. 3 Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables
Effect on operating Increase in variable breakeven point
Fixed operating cost (FC) Increase Sale price per unit ( P ) Decrease Variable operating cost per unit (VC) Increase Note: Decreases in each of the variables shown would have the oppo- site effect from their effect on operating breakeven point.
CHAPTER 11 Leverage and Capital Structure 427
Figure 11.2 as well as relevant data for a 500-unit sales level. We can illustrate two cases using the 1,000-unit sales level as a reference point.
Case 1 A 50% increase in sales (from 1,000 to 1,500 units) results in a 100% increase in EBIT (from $2,500 to $5,000). Case 2 A 50% decrease in sales (from 1,000 to 500 units) results in a 100% decrease in EBIT (from $2,500 to $0).
From the preceding example, we see that operating leverage works in both directions. When a firm has fixed operating costs, operating leverage is present. An increase in sales results in a more-than-proportional increase in EBIT; a decrease in sales results in a more-than-proportional decrease in EBIT.
Measuring the Degree of Operating Leverage (DOL)
The degree of operating leverage (DOL) is the numerical measure of the firm’s operating leverage. It can be derived using the following equation:^3
DOL (11.4) Percentage change in EBIT Percentage change in sales
degree of operating leverage (DOL) The numerical measure of the firm’s operating leverage.
2,
4,
6,
8,
10,
12,
14,
16,
0 500 1,000 1,500 2,000 2,500 3, Q 1 Q 2 Sales (units)
Costs/Revenues ($)
EBIT 1 ($2,500)
EBIT 2 ($5,000)
Loss
EBIT
Fixed Operating Cost
Total Operating Cost
Sales Revenue
F I G U R E 1 1. 2
Operating Leverage Breakeven analysis and operating leverage
- The degree of operating leverage also depends on the base level of sales used as a point of reference. The closer the base sales level used is to the operating breakeven point, the greater the operating leverage. Comparison of the degree of operating leverage of two firms is valid only when the same base level of sales is used for both firms.
428 PART 4 Long-Term Financial Decisions
Whenever the percentage change in EBIT resulting from a given percentage change in sales is greater than the percentage change in sales, operating leverage exists. This means that as long as DOL is greater than 1, there is operating leverage.
E X A M P L E Applying Equation 11.4 to cases 1 and 2 in Table 11.4 yields the following results: 4
Case 1: 2.
Case 2: 2.
Because the result is greater than 1, operating leverage exists. For a given base level of sales, the higher the value resulting from applying Equation 11.4, the greater the degree of operating leverage.
A more direct formula for calculating the degree of operating leverage at a base sales level, Q , is shown in Equation 11.5.
DOL at base sales level Q (11.5)
E X A M P L E Substituting Q 1,000, P $10, VC $5, and FC $2,500 into Equation 11. yields the following result:
DOL at 1,000 units 2.
The use of the formula results in the same value for DOL (2.0) as that found by using Table 11.4 and Equation 11.4.^5
Fixed Costs and Operating Leverage
Changes in fixed operating costs affect operating leverage significantly. Firms sometimes can incur fixed operating costs rather than variable operating costs and at other times may be able to substitute one type of cost for the other. For example, a firm could make fixed-dollar lease payments rather than payments equal to a specified percentage of sales. Or it could compensate sales representa- tives with a fixed salary and bonus rather than on a pure percent-of-sales com-
$5, $2,
1,000 ($10 $5) 1,000 ($10 $5) $2,
Q ( P VC ) Q ( P VC ) FC
100% 50%
100% 50%
- Because the concept of leverage is linear, positive and negative changes of equal magnitude will always result in equal degrees of leverage when the same base sales level is used as a point of reference. This relationship holds for all types of leverage discussed in this chapter.
- When total sales in dollars—instead of unit sales—are available, the following equation, in which TR dollar level of base sales and TVC total variable operating costs in dollars, can be used. DOL at base dollar sales TR This formula is especially useful for finding the DOL for multiproduct firms. It should be clear that because in the case of a single-product firm, TR P Q and TVC VC Q, substitution of these values into Equation 11. results in the equation given here.
^ TR^ ^ TVC TR (^) TVC (^) F C
430 PART 4 Long-Term Financial Decisions
are (1) interest on debt and (2) preferred stock dividends. These charges must be paid regardless of the amount of EBIT available to pay them. 6
E X A M P L E Chen Foods, a small Oriental food company, expects EBIT of $10,000 in the cur- rent year. It has a $20,000 bond with a 10% (annual) coupon rate of interest and an issue of 600 shares of $4 (annual dividend per share) preferred stock outstand- ing. It also has 1,000 shares of common stock outstanding. The annual interest on the bond issue is $2,000 (0.10 $20,000). The annual dividends on the pre- ferred stock are $2,400 ($4.00/share 600 shares). Table 11.6 presents the EPS corresponding to levels of EBIT of $6,000, $10,000, and $14,000, assuming that the firm is in the 40% tax bracket. Two situations are shown: Case 1 A 40% increase in EBIT (from $10,000 to $14,000) results in a 100% increase in earnings per share (from $2.40 to $4.80). Case 2 A 40% decrease in EBIT (from $10,000 to $6,000) results in a 100% decrease in earnings per share (from $2.40 to $0).
The effect of financial leverage is such that an increase in the firm’s EBIT results in a more-than-proportional increase in the firm’s earnings per share, whereas a decrease in the firm’s EBIT results in a more-than-proportional decrease in EPS.
- As noted in Chapter 7, although preferred stock dividends can be “passed” (not paid) at the option of the firm’s directors, it is generally believed that payment of such dividends is necessary. This text treats the preferred stock div- idend as a contractual obligation, not only to be paid as a fixed amount, but also to be paid as scheduled. Although failure to pay preferred dividends cannot force the firm into bankruptcy, it increases the common stockholders’ risk because they cannot be paid dividends until the claims of preferred stockholders are satisfied.
T A B L E 1 1. 6 The EPS for Various EBIT Levels a
Case 2 Case 1
40% 40%
EBIT $6,000 $10,000 $14, Less: Interest ( I ) (^) (^2) , (^0) (^0) (^0) (^2) , (^0) (^0) (^0) (^2) , (^0) (^0) (^0) Net profits before taxes $4,000 $ 8,000 $12, Less: Taxes ( T 0.40) (^) (^1) , (^6) (^0) (^0) (^3) , (^2) (^0) (^0) (^4) , (^8) (^0) (^0) Net profits after taxes $2,400 $ 4,800 $ 7, Less: Preferred stock dividends ( PD ) (^) (^2) , (^4) (^0) (^0) (^2) , (^4) (^0) (^0) (^2) , (^4) (^0) (^0) Earnings available for common (EAC) $ 0 $ 2,400 $ 4,
Earnings per share (EPS) $0 $2.40 $4.
100% 100% a As noted in Chapter 1, for accounting and tax purposes, interest is a tax-deductible expense, whereas divi- dends must be paid from after-tax cash flows.
$4, 1, $2, 1, $ 1,
Measuring the Degree of Financial Leverage (DFL)
The degree of financial leverage (DFL) is the numerical measure of the firm’s financial leverage. Computing it is much like computing the degree of operating leverage. The following equation presents one approach for obtaining the DFL.^7
DFL (11.6)
Whenever the percentage change in EPS resulting from a given percentage change in EBIT is greater than the percentage change in EBIT, financial leverage exists. This means that whenever DFL is greater than 1, there is financial leverage.
E X A M P L E Applying Equation 11.6 to cases 1 and 2 in Table 11.6 yields
Case 1: 2.
Case 2: 2.
In both cases, the quotient is greater than 1, so financial leverage exists. The higher this value, the greater the degree of financial leverage.
A more direct formula for calculating the degree of financial leverage at a base level of EBIT is given by Equation 11.7, where the notation from Table 11. is used. Note that in the denominator, the term 1/(1 T ) converts the after-tax preferred stock dividend to a before-tax amount for consistency with the other terms in the equation.
EBIT DFL at base level EBIT (11.7) EBIT I (^) PD (^)
E X A M P L E Substituting EBIT $10,000, I $2,000, PD $2,400, and the tax rate ( T 0.40) into Equation 11.7 yields the following result:
$10, DFL at $10,000 EBIT $10,000 $2,000 (^) $2,400 (^)
2.
Note that the formula given in Equation 11.7 provides a more direct method for calculating the degree of financial leverage than the approach illustrated using Table 11.6 and Equation 11.6.
$10, $4,
1 1 0.
1 1 T
100% 40%
100% 40%
Percentage change in EPS Percentage change in EBIT
CHAPTER 11 Leverage and Capital Structure 431
degree of financial leverage (DFL) The numerical measure of the firm’s financial leverage.
- This approach is valid only when the same base level of EBIT is used to calculate and compare these values. In other words, the base level of EBIT must be held constant to compare the financial leverage associated with different levels of fixed financial costs.
CHAPTER 11 Leverage and Capital Structure 433
sales changes of equal magnitude in opposite directions result in EPS changes of equal magnitude in the corresponding direction. At this point, it should be clear that whenever a firm has fixed costs—operating or financial—in its structure, total leverage will exist.
Measuring the Degree of Total Leverage (DTL)
The degree of total leverage (DTL) is the numerical measure of the firm’s total leverage. It can be computed much as operating and financial leverage are com- puted. The following equation presents one approach for measuring DTL:^8
DTL (11.8)
Whenever the percentage change in EPS resulting from a given percentage change in sales is greater than the percentage change in sales, total leverage exists. This means that as long as the DTL is greater than 1, there is total leverage.
E X A M P L E Applying Equation 11.8 to the data in Table 11.7 yields
DTL 6.
Because this result is greater than 1, total leverage exists. The higher the value, the greater the degree of total leverage.
A more direct formula for calculating the degree of total leverage at a given base level of sales, Q, is given by Equation 11.9, which uses the same notation that was presented earlier: Q ( P VC ) DTL at base sales level Q (11.9) Q ( P VC ) FC I (^) PD (^)
E X A M P L E Substituting Q 20,000, P $5, VC $2, FC $10,000, I $20,000, PD $12,000, and the tax rate ( T 0.40) into Equation 11.9 yields DTL at 20,000 units 20,000 ($5 $2) 20,000 ($5 $2) $10,000 $20,000 (^) $12,000 (^)
6.
Clearly, the formula used in Equation 11.9 provides a more direct method for calculating the degree of total leverage than the approach illustrated using Table 11.7 and Equation 11.8.
$60, $10,
1 1 0.
1 1 T
300% 50%
Percentage change in EPS Percentage change in sales
degree of total leverage (DTL) The numerical measure of the firm’s total leverage.
- This approach is valid only when the same base level of sales is used to calculate and compare these values. In other words, the base level of sales must be held constant if we are to compare the total leverage associated with dif- ferent levels of fixed costs.
434 PART 4 Long-Term Financial Decisions
The Relationship of Operating, Financial, and Total Leverage
Total leverage reflects the combined impact of operating and financial leverage on the firm. High operating leverage and high financial leverage will cause total leverage to be high. The opposite will also be true. The relationship between oper- ating leverage and financial leverage is multiplicative rather than additive. The relationship between the degree of total leverage (DTL) and the degrees of operat- ing leverage (DOL) and financial leverage (DFL) is given by Equation 11.10. DTL DOL DFL (11.10)
E X A M P L E Substituting the values calculated for DOL and DFL, shown on the right-hand side of Table 11.7, into Equation 11.10 yields DTL 1.2 5.0 6. The resulting degree of total leverage is the same value that we calculated directly in the preceding examples.
Review Questions
11–1 What is meant by the term leverage? How are operating leverage, financial leverage, and total leverage related to the income statement? 11–2 What is the operating breakeven point? How do changes in fixed operat- ing costs, the sale price per unit, and the variable operating cost per unit affect it? 11–3 What is operating leverage? What causes it? How is the degree of operat- ing leverage (DOL) measured? 11–4 What is financial leverage? What causes it? How is the degree of financial leverage (DFL) measured? 11–5 What is the general relationship among operating leverage, financial lever- age, and the total leverage of the firm? Do these types of leverage comple- ment each other? Why or why not?
The Firm’s Capital Structure
Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables.^9 Poor cap- ital structure decisions can result in a high cost of capital, thereby lowering the NPVs of projects and making more of them unacceptable. Effective capital struc- ture decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects—and thereby increasing the value of the firm. This section links together many of the concepts presented in Chapters 4, 5, 6, 7, and 10 and the discussion of leverage in this chapter.
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- Of course, although capital structure is financially important, it, like many business decisions, is generally not so important as the firm’s products or services. In a practical sense, a firm can probably more readily increase its value by improving quality and reducing costs than by fine-tuning its capital structure.
436 PART 4 Long-Term Financial Decisions
indebtedness is the debt ratio. The higher this ratio, the greater the relative amount of debt (or financial leverage) in the firm’s capital structure. Measures of the firm’s ability to meet contractual payments associated with debt include the times interest earned ratio and the fixed-payment coverage ratio. These ratios provide indirect information on financial leverage. Generally, the smaller these ratios, the greater the firm’s financial leverage and the less able it is to meet pay- ments as they come due. The level of debt (financial leverage) that is acceptable for one industry or line of business can be highly risky in another, because different industries and lines of business have different operating characteristics. Table 11.8 presents the debt and times interest earned ratios for selected industries and lines of business. Significant industry differences can be seen in these data. Differences in debt posi- tions are also likely to exist within an industry or line of business.
T A B L E 1 1. 8 Debt Ratios for Selected Industries and Lines of Business (Fiscal Years Ended 4/1/00 Through 3/31/01)
Times interest Industry or line of business Debt ratio earned ratio
Manufacturing industries Books 65.2% 3. Dairy products 74.6 3. Electronic computers 55.4 3. Iron and steel forgings 62.7 2. Machine tools, metal cutting types 60.4 2. Wines & distilled alcoholic beverages 69.7 4. Women’s, misses’ & juniors’ dresses 53.5 2. Wholesaling industries Furniture 69.4 3. General groceries 66.8 2. Men’s and boys’ clothing 60.8 2. Retailing industries Autos, new and used 76.1 1. Department stores 52.8 2. Restaurants 92.5 2. Service industries Accounting, auditing, bookkeeping 68.4 5. Advertising agencies 81.3 4. Auto repair—general 75.9 2. Insurance agents and brokers 94.1 4. Source: RMA Annual Statement Studies, 2001–2002 (fiscal years ended 4/1/00 through 3/31/01) (Philadelphia: Robert Morris Associates, 2001). Copyright © 2001 by Robert Morris Associates. Note: Robert Morris Associates recommends that these ratios be regarded only as general guidelines and not as absolute industry norms. No claim is made as to the representativeness of these figures.
CHAPTER 11 Leverage and Capital Structure 437
Capital Structure of Non-U.S. Firms
In general, non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts. Most of the reasons for this are related to the fact that U.S. capital markets are much more developed than those elsewhere and have played a greater role in corporate financing than has been the case in other countries. In most European countries and especially in Japan and other Pacific Rim nations, large commercial banks are more actively involved in the financing of corporate activity than has been true in the United States. Furthermore, in many of these countries, banks are allowed to make large equity investments in nonfinancial corporations—a practice that is prohibited for U.S. banks. Finally, share ownership tends to be more tightly controlled among founding-family, institutional, and even public investors in Europe and Asia than it is for most large U.S. corporations. Tight ownership enables owners to understand the firm’s financial condition better, resulting in their willingness to tolerate a higher degree of indebtedness. On the other hand, similarities do exist between U.S. corporations and cor- porations in other countries. First, the same industry patterns of capital structure tend to be found all around the world. For example, in nearly all countries, phar- maceutical and other high-growth industrial firms tend to have lower debt ratios
In Practice
Enron Corp. ’s December 31, 2000, balance sheet showed long-term debt of $10. 2 billion and $300 mil- lion in other financial obligations. These figures gave the company a 41 percent ratio of total obliga- tions to total capitalization. That didn’t seem out of line for a com- pany in the capital-intensive energy industry. Yet as the company’s finan- cial condition fell apart in the fall of 2001, investors and lenders discov- ered that Enron’s true debt load was far beyond what its balance sheet indicated. By selling assets to perfectly legal special-purpose entities (SPEs), Enron had moved billions of dollars of debt off its bal- ance sheet into subsidiaries, trusts, partnerships, and other cre- ative financing arrangements. For- mer CFO Andrew Fastow claimed that these complex arrangements were disclosed in footnotes and
that Enron was not liable for repay- ment of the debts of these SPEs. Enron’s required filing of Form 10-Q with the SEC, on November 19, 2001, told a different story: If its debt were to fall below investment grade, Enron would have to repay those off-balance-sheet partner- ship obligations. Ironically, its dis- closure of about $4 billion in off- balance-sheet liabilities triggered the downgrade of its debt to “junk” status and accelerated debt repayment. Enron’s secrecy about its off-balance-sheet ventures led to its loss of credibility in the investment community. Its stock and bond prices slid downward; its market value plunged $35 billion in about a month; and on December 2, 2001, Enron became the largest U.S. company ever to have filed for bankruptcy. Enron is not alone in its use of off-balance-sheet debt. Most air-
lines have large aircraft leases structured through off-balance- sheet vehicles, although analysts and investors are aware that the true leverage is higher. Pacific Gas & Electric , Southern California Edison , and Xerox have also run into problems from off-balance- sheet debt obligations. Don’t expect the Enron debacle to elimi- nate special-purpose entities, although the SEC has been calling for tighter consolidation rules. Companies like the flexibility that off-balance-sheet financing sources provide, not to mention that such financing makes debt ratios and returns look better.
Sources: Peter Behr, “Cause of Death: Mis- trust,” Washington Pos t (December 13, 2001), p. E1; Ronald Fink, “What Andrew Fastow Knew,” CFO (January 1, 2002); and David Henry, “Who Else Is Hiding Debt?” Business Week (January 28, 2002).
FOCUS ON PRACTICE Enron Plays Hide and Seek with Debt
CHAPTER 11 Leverage and Capital Structure 439
Business Risk In Chapter 10, we defined business risk as the risk to the firm of being unable to cover its operating costs. In general, the greater the firm’s operating leverage —the use of fixed operating costs—the higher its business risk. Although operating leverage is an important factor affecting business risk, two other factors—revenue stability and cost stability—also affect it. Revenue stabil- ity reflects the relative variability of the firm’s sales revenues. Firms with reason- ably stable levels of demand and with products that have stable prices have stable revenues. The result is low levels of business risk. Firms with highly volatile prod- uct demand and prices have unstable revenues that result in high levels of busi- ness risk. Cost stability reflects the relative predictability of input prices such as those for labor and materials. The more predictable and stable these input prices are, the lower the business risk; the less predictable and stable they are, the higher the business risk. Business risk varies among firms, regardless of their lines of business, and is not affected by capital structure decisions. The level of business risk must be taken as a “given.” The higher a firm’s business risk, the more cautious the firm must be in establishing its capital structure. Firms with high business risk there- fore tend toward less highly leveraged capital structures, and firms with low busi- ness risk tend toward more highly leveraged capital structures. We will hold business risk constant throughout the discussions that follow.
Financial Risk The firm’s capital structure directly affects its financial risk, which is the risk to the firm of being unable to cover required financial obligations. The penalty for not meeting financial obligations is bankruptcy. The more fixed-cost financing—debt (including financial leases) and preferred stock—a firm has in its capital structure, the greater its financial leverage and risk. Financial risk depends on the capital structure decision made by the man- agement, and that decision is affected by the business risk the firm faces. The total risk of a firm—business and financial risk combined—determines its prob- ability of bankruptcy.
Agency Costs Imposed by Lenders
As noted in Chapter 1, the managers of firms typically act as agents of the owners (stockholders). The owners give the managers the authority to manage the firm for the owners’ benefit. The agency problem created by this relationship extends not only to the relationship between owners and managers but also to the rela- tionship between owners and lenders. When a lender provides funds to a firm, the interest rate charged is based on the lender’s assessment of the firm’s risk. The lender–borrower relationship, therefore, depends on the lender’s expectations for the firm’s subsequent behav- ior. The borrowing rates are, in effect, locked in when the loans are negotiated. After obtaining a loan at a certain rate, the firm could increase its risk by invest- ing in risky projects or by incurring additional debt. Such action could weaken the lender’s position in terms of its claim on the cash flow of the firm. From another point of view, if these risky investment strategies paid off, the stockhold- ers would benefit. Because payment obligations to the lender remain unchanged, the excess cash flows generated by a positive outcome from the riskier action would enhance the value of the firm to its owners. In other words, if the risky
440 PART 4 Long-Term Financial Decisions
investments pay off, the owners receive all the benefits; but if the risky invest- ments do not pay off, the lenders share in the costs. Clearly, an incentive exists for the managers acting on behalf of the stockhold- ers to “take advantage” of lenders. To avoid this situation, lenders impose certain monitoring techniques on borrowers, who as a result incur agency costs. The most obvious strategy is to deny subsequent loan requests or to increase the cost of future loans to the firm. Because this strategy is an after-the-fact approach, other controls must be included in the loan agreement. Lenders typically protect themselves by including provisions that limit the firm’s ability to alter significantly its business and financial risk. These loan provisions tend to center on issues such as the minimum level of liquidity, asset acquisitions, executive salaries, and dividend payments. By including appropriate provisions in the loan agreement, the lender can control the firm’s risk and thus protect itself against the adverse consequences of this agency problem. Of course, in exchange for incurring agency costs by agree- ing to the operating and financial constraints placed on it by the loan provisions, the firm should benefit by obtaining funds at a lower cost.
Asymmetric Information
Two surveys examined capital structure decisions.^12 Financial executives were asked which of two major criteria determined their financing decisions: (1) main- taining a target capital structure or (2) following a hierarchy of financing. This hierarchy, called a pecking order, begins with retained earnings, which is followed by debt financing and finally external equity financing. Respondents from 31 per- cent of Fortune 500 firms and from 11 percent of the (smaller) 500 largest over- the-counter firms answered target capital structure. Respondents from 69 percent of the Fortune 500 firms and 89 percent of the 500 largest OTC firms chose the pecking order. At first glance, on the basis of financial theory, this choice appears to be inconsistent with wealth maximization goals, but Stewart Myers has explained how “asymmetric information” could account for the pecking order financing preferences of financial managers.^13 Asymmetric information results when man- agers of a firm have more information about operations and future prospects than do investors. Assuming that managers make decisions with the goal of max- imizing the wealth of existing stockholders, then asymmetric information can affect the capital structure decisions that managers make. Suppose, for example, that management has found a valuable investment that will require additional financing. Management believes that the prospects for the firm’s future are very good and that the market, as indicated by the firm’s cur- rent stock price, does not fully appreciate the firm’s value. In this case, it would be advantageous to current stockholders if management raised the required funds using debt rather than issuing new stock. Using debt to raise funds is frequently
- The results of the survey of Fortune 500 firms are reported in J. Michael Pinegar and Lisa Wilbricht, “What Managers Think of Capital Structure Theory: A Survey,” Financial Management (Winter 1989), pp. 82–91, and the results of a similar survey of the 500 largest OTC firms are reported in Linda C. Hittle, Kamal Haddad, and Lawrence J. Gitman, “Over-the-Counter Firms, Asymmetric Information, and Financing Preferences,” Review of Financial Economics (Fall 1992), pp. 81–92.
- Stewart C. Myers, “The Capital Structure Puzzle,” Journal of Finance (July 1984), pp. 575–592.
pecking order A hierarchy of financing that begins with retained earnings, which is followed by debt financ- ing and finally external equity financing.
asymmetric information The situation in which managers of a firm have more information about operations and future prospects than do investors.
