16 Chapter Capital Structure and Leverage Slides Developed by: Terry Fegarty Seneca College.

1616Chapt

er

Chapt

er Capital Structure and

LeverageCapital Structure and

Leverage

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 16 – Outline (1)

• Background Capital Structure and Financial Leverage The Central Issue Risk in the Context of Leverage

• Financial Leverage Financial Leverage and Financial Risk Putting the Ideas Together—The Effect on Share

Price Real Investor Behavior and the Optimal Capital

Structure


Chapter 16 – Outline (2) Finding the Optimum—A Practical Problem The Target Capital Structure The Degree of Financial Leverage (DFL)—A

Measurement• EBIT-EPS Analysis• Operating Leverage

Breakeven Analysis The Effect of Operating Leverage The Degree of Operating Leverage (DOL)—A

Measurement Comparing Operating and Financial Leverage The Compounding Effect of Operating and Financial

Leverage


Chapter 16 – Outline (3)

• Capital Structure Theory Background—The Value of the Firm The Early Theory by Modigliani and Miller Relaxing the Assumptions—MM Theory with Taxes Relaxing the Assumptions—MM Theory with Taxes

and Bankruptcy Costs Other Considerations


Capital Structure and Financial Leverage

• Capital structure: mix of firm’s debt and common equity Preferred shares treated as part of firm’s debt

• Financial leverage: using borrowed money to enhance effectiveness of invested equity Financial leverage of 10% means firm’s capital

structure contains 10% debt and 90% equity


The Central Issue

• Can use of debt increase value of firm’s equity? Specifically, firm’s share price?

• Under certain conditions, changing leverage increases share price An optimal capital structure maximizes share price

• Relationship between capital structure and share price not precise nor fully understood


Risk in the Context of Leverage

• Leverage influences share price Alters risk/return relationship in equity investment

• Measures of performance Earnings Before Interest and Taxes (EBIT)

• Unaffected by leverage because calculated prior to deduction for interest

Return on Equity (ROE) • Net Income Shareholders’ Equity

Earnings per Share (EPS) • Net Income number of shares• Investors regard EPS as important indicator of future

profitability


Risk in the Context of Leverage

• Leverage-related risk is variation in ROE and EPS

• Two components Business risk—variation in EBIT

• Influenced by operating leverage—presence of fixed costs

Financial risk—additional variation in ROE and EPS from using financial leverage (debt)


Figure 16.1: Business and Financial Risk


Financial Leverage

• Under certain conditions, financial leverage can improve firm’s EPS and ROE If shares are replaced with debt, number of

shares and equity are reduced, increasing EPS and ROE

May increase share price

• However, at other times it may worsen EPS and ROE

• Financial leverage increases risk


Table 16.1: Effect of Increasing Financial Leverage When the Return on Capital Employed Exceeds the Cost of Debt

As the firm’s debt ratio rises, both EPS and ROE

rise dramatically. While NI falls, the number of shares outstanding falls at a faster rate as

debt replaces equity.


Financial Leverage

• Return on Capital Employed (ROCE) Measures profitability of operations before financing charges,

but after taxes, on basis comparable to ROE

EBIT 1 - tax rateROCE =

debt + equity

When ROCE more than after-tax cost of debt, more leverage improves ROE and EPS Increase borrowing?

When ROCE less than after-tax cost of debt, more leverage makes ROE and EPS worse Avoid borrowing?


Table 16.2: Effect of Increasing Financial Leverage When the Cost of Debt

Exceeds the Return on Capital Employed

ABC is now doing rather

poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE

decrease.


Example 16.1: Financial Leverage

Q: Financial information for the Scanterbury Corporation follows:

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Share price = $10 ROE = NI equity = $13,500 $90,000 = 15%EPS = Ni number of shares = $13,500 9,000,000 = $1.50

$13,500NI

9,000,000Number of shares=9,000Tax (@40%)

$100,000Capital$22,500EBT

90,000Equity1,200Interest (@12%)

$10,000Debt $23,700EBIT

Scanterbury Corporation at $10M Debt($000 except for per-share amounts)

Will borrowing more money and retiring shares raise EPS, and if so what capital structure will achieve an EPS of $2.00?


Example 16.1: Financial LeverageE

xam

ple

The after-tax cost of debt is 12% x (1 – 0.4), or 7.2%. Since 7.2% < 14.2%, trading equity for debt will increase EPS.

Using trial and error, we can determine that $45 million of debt is the approximate amount of debt that makes the firm’s EPS equal $2.00.

A: EPS will rise if ROCE exceeds the after-tax cost of debt.

ROCE $23.7M(1 0.4)

14.2%100.0M


Example 16.1: Financial Leverage— An Alternate Approach

A: If we set EPS to $2 we can solve for the value of Debt

0$45,156,25 Debt

10$Debt - $100.0M

.4) - )(1(.12)(Debt - $23.7M 2$

Exa

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Financial Leverage and Financial Risk• Financial leverage is a two-edged sword

Multiplies good results into great results Multiples bad results into terrible results

• Leverage magnifies changes in EBIT into larger changes in ROE and EPS

• Financial risk is increased variability in financial results that comes from additional leverage


Table 16.3: Financial Leverage and Risk


Putting the Ideas Together—The Effect on Share Price

• Leverage enhances performance while it adds risk, pushing share prices in opposite directions Enhanced performance makes expected

return on shares higher, driving up share’s price

Increased risk drives down share’s price• Which effect dominates, and when?


Real Investor Behavior and the Optimal Capital Structure• When leverage is low, increase in debt

has positive effect on investors• At high debt levels, concerns about risk

dominate and adding more debt decreases share’s price

• As leverage increases, effect goes from positive to negative, which results in an optimal capital structure


Figure 16.2: The Effect of Leverage on Share Price


Finding the Optimum—A Practical Problem

• No way to determine exact optimum amount of leverage for particular company at particular time Appropriate level tends to vary according to

• Nature of company’s business• If firm has high business risk it should use less leverage

• Economic climate• If outlook is poor investors are likely to be more sensitive

to risk


Finding the Optimum—A Practical Problem• General guidelines

1. Profitable firm with little or no debt should probably increase borrowing if interest rates are reasonable

2. For most businesses, optimal capital structure is somewhere between 30% and 50% debt

3. Debt levels above 60% create excessive risk and should be avoided unless cash flows are very stable (for example, those of a public utility)


The Target Capital Structure

• Firm’s target capital structure is management’s estimate of optimal capital structure An approximation as to amount of debt that

will maximize firm’s share price


The Degree of Financial Leverage (DFL)—A Measurement• Financial leverage magnifies changes in EBIT

into larger changes in ROE and EPS The degree of financial leverage (DFL) relates

relative changes in EBIT to relative changes in EPS

% EPSDFL = or % EPS = DFL % EBIT

% EBIT

Somewhat

tedious

Easier method of calculating DFL is:

EBITDFL =

EBIT - Interest


Example 16.2: The Degree of Financial Leverage (DFL)—A Measurement

Q: Selected income statement and capital information for the Mallaig Manufacturing Company follow ($000):

Currently 700,000 common shares are outstanding. The firm pays 15% interest on its debt.. The income tax rate is 40%

Management is considering restructuring capital to 50% debt in the hope that the increased EPS will have increase the price of its shares. Mallaig’s shares sell for their book value of $10 per share.

Estimate the effect of the proposed restructuring on EPS. Then use the degree of financial leverage to assess the increase in risk involved.

$8,000Total$1,380EBIT

7,000 Equity4,200Cost/expense

$1,000 Debt$5,580Revenue

Capital

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A:

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400,000700,000Shares outstanding

ProposedCurrent

$8,000$8,000Total

4,0007,000 Equity

$4,000$1,000 Debt

Capital

$1.170$1.054EPS

$468$738NI

ProposedCurrent

312492Tax (@40%)

$780$1,230EBT

600150Interest (15% of debt)

$1,380$1,380EBIT

If business conditions remain unchanged, more debt will result

in a higher EPS



A: Next, calculate DFL:

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Current

Proposed

$1,380DFL = 1.12

$1,380 - $150

$1,380DFL = 1.77

$1,380 - $600

EPS will be much more volatile under the proposed plan. EPS will change by a factor of 1.77 vs. 1.12.


EBIT-EPS Analysis

• Managers need way to quantify and analyze tradeoffs between risk and results when changing leverage levels

• Analysis provides graphical portrayal of the trade-off Involves graphing EPS as function of EBIT for each

leverage level

• Portrays results of leverage and helps to decide how much to use


Graphical Analysis of EBIT - EPS

EPS

EBIT

Debt Financing

EquityFinancing

IndifferencePoint

Advantage toequity financing

Advantage todebt financing


Figure 16.3: EBIT – EPS Analysis for ABC Corporation

The indifference point occurs

when the two plans offer the

same EBIT

The 50% Debt and No Leverage lines intersect. At the

point of intersection ABC is indifferent between the two

plans. To the left of the intersection the 50% Debt plan is preferable. To the

right of the point the No Leverage plan

is preferable.

(from Table 13.1, Columns 1 and 2)


EBIT-EPS Analysis

• Comparing two capital structures, indifference point is level of EBIT where EPS is same under both

(EBIT- )(1- )EPS=

Number of shares

I T

Capital Structure A Capital Structure B

(EBIT- )(1- )

Number of shares

I T (EBIT- )(1- )=

Number of shares

I T

Solve for EBIT


EBIT-EPS Analysis

For ABC Corporation:

No Leverage 50% Debt

(EBIT-$0)(1-0.4)

100,000(EBIT-$50,000)(1-0.4)

= 50,000

EBIT = $100,000

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Operating Leverage

• Terminology and Definitions Business Risk—Risk in Operations

• Defined as variation in EBIT• Most is caused by changes in sales level

Fixed and Variable Costs and Cost Structure•Fixed costs don’t change with level of sales,

while variable costs do• Fixed costs include rent, amortization, utilities, salaries• Variable costs include direct labour, direct materials,

sales commissions

• Mix of fixed and variable costs in a firm’s operations is its cost structure


Figure 16.4: Fixed, Variable, and Total Cost


Operating Leverage

• Terminology and Definitions Operating Leverage

• Refers to amount of fixed costs in the cost structure

• Increases business risk• May combine with financial leverage for very

volatile ROE and EPS


Breakeven Analysis

• Used to determine level of activity firm must achieve to stay in business in long run

• Shows mix of fixed and variable cost and volume required for zero profit/loss Profit/loss generally measured by EBIT


Breakeven Analysis

• Breakeven Diagrams Breakeven occurs at intersection of revenue

and total cost • Represents level of sales at which revenue equals

cost


Figure 16.5: The Breakeven Diagram


Breakeven Analysis

• The Contribution Margin Every sale makes contribution (Ct) of

difference between price (P) and variable cost (V)• Ct = P – V

Can be expressed as percentage of revenue• Known as contribution margin (CM)

M

(P-V)C =

P


Example 16.3: Breakeven Analysis

Q: Suppose a company can make a unit of product for $7 in variable labour and materials, and sell it for $10. What are the contribution and contribution margin?

A: The contribution per unit is $3, or $10 - $7, while the contribution margin is $3 $10, or 30%.

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Breakeven Analysis

• Calculating Breakeven Sales Level EBIT is revenue minus cost, or

• EBIT = PQ – VQ – FC

Breakeven occurs when revenue (PQ) equals total cost (VQ + FC), or

Breakeven tells us how many units have to be sold to contribute

enough money to pay for fixed costs

Can also be expressed in terms of dollar sales

CBE

FQ =

(P-V)

C CBE

M

P(F ) FS = =

(P-V) C


Example 16.4: Breakeven Analysis

Q: 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?

A: The 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.

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The Effect of Operating Leverage

• As sales volume moves away from breakeven, profit or loss increases faster with more operating leverage

• The Risk Effect More operating leverage leads to larger variations in

EBIT, or business risk

• The Effect on Expected EBIT Above breakeven, more operating leverage implies

higher operating profit• If firm is relatively sure of sales level, should trade

variable costs for fixed cost


Breakeven at Low Operating Leverage

Revenue

Total Cost

Fixed Cost

Quantity

Dollars

Breakeven Quantity

Low Fixed Costs with High Variable Costs

Low Breakeven; Profits/Losses Increase Slowly

Variable Cost

Profit


Breakeven at High Operating Leverage

Revenue

Total Cost

Fixed Cost

Quantity

Dollars

Breakeven Quantity

High Fixed Costs with Low Variable Costs

High Breakeven; Profits/Losses Increase Quickly

Variable Cost

Profit


Example 16.5: The Effect of Operating Leverage

Q: Suppose Firm A has fixed costs of $1,000 per period, sells its product for $10, and has variable costs of $8 per unit. Further, suppose Firm B has fixed costs of $1,500 and also sells its product for $10 a unit. Both firms are at the same breakeven point. What variable cost must Firm B have if it is to achieve the same breakeven point as Firm A? State the trade-off at the breakeven point. Which structure is preferred if there’s a choice?

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Example 16.5: The Effect of Operating Leverage

A: Both firms have a breakeven point of 500 units (Firm A: $1,000 $2). We need to solve the breakeven formula for Firm B’s variable costs per unit:

QB/E = FC (P – V)500 units = $1,500 ($10 – V)V = $7Change in V = $8 - $7 = $1

The preferred structure depends on volatility—if sales are expected to be highly volatile, the lower fixed cost structure might be better in the long run.

Thus, at breakeven, a $1differential in contribution

makes up for a $500difference in fixed cost.

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The Degree of Operating Leverage (DOL)—A Measurement• Operating leverage amplifies changes in

sales volume into larger changes in EBIT• DOL relates relative changes in volume

(Q) to relative changes in EBIT

C

% EBIT Q(P - V)DOL = or

% Q Q(P - V) - F

MCor

EBIT


Example 16.6: The Degree of Operating Leverage (DOL)—A Measurement

Q: The Cowichan Corp. sells its products at an average price of $10. Variable costs are $7 per unit and fixed costs are $600 per month. Evaluate the degree of operating leverage when sales are 5% and then 50% above the breakeven level.

A: Breakeven volume = $600 ($10 - $7) = 200 units. Breakeven plus 5% = 200 x 1.05 or 210 unitsBreakeven plus 50% = 200 x 1.50 or 300 units. DOL at 210 units is:

DOL at 300 units is: DOL decreases

as the output levelincreases above

breakeven.

Q=210

210($10 - $7)DOL = 21

210($10 - $7) - $600

Q=300

300($10 - $7)DOL = 3

300($10 - $7) - $600

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Comparing Operating and Financial Leverage

• Both operating and financial leverage can enhance results while increasing variation Operating leverage magnifies changes in

sales into larger changes in EBIT Financial leverage magnifies changes in EBIT

into larger changes in ROE and EPS


Comparing Operating and Financial Leverage

• Both methods substitute fixed cash outflows for variable cash outflows Operating leverage substitutes fixed costs for

variable costs in cost structure Financial leverage involves substitutes fixed

interest on debt for discretionary dividends on shares in capital structure


Comparing Operating and Financial Leverage• Both kinds of leverage increase risks as

the levels of leverage increase However, no financial risk if no debt Business risk would still exist even if no

operating leverage

• Financial leverage is more controllable than operating leverage Debt used at management’s discretion Technology may require fixed costs


Figure 16.7: The Similar Functions of Operating and Financial Leverage


The Compounding Effect of Operating and Financial Leverage• Effects of financial and operating leverage

compound one another• Changes in sales are amplified by operating

leverage into larger relative changes in EBIT Which in turn are amplified by financial leverage

into still larger relative changes in ROE and EPS Modest changes in sales can lead to dramatic

changes in ROE and EPS

• The combined effect can be measured using degree of total leverage (DTL) DTL = DOL × DFL


Figure 16.8: Risk and Cost Relationships Between Operating and Financial

Leverage


The Compounding Effect of Operating Leverage and Financial Leverage

Type of leverage

% Change in

Causes a bigger % change in

Operating Sales EBITFinancial EBIT EPS

Total Sales EPS


Degree of Total Leverage

%Change in Sales

%Change in EBIT

%Change in EPS

DOL DFL

DTL


Example 16.7: The Compounding Effect of Operating and Financial Leverage

Q: The Carragana Company is considering replacing a manual production process with a machine. The money to buy the machine will be borrowed. The firm’s cost structure will be altered in favour of fixed cost. The capital structure will include more debt. Leverage positions with and without the project are:

The economic outlook is uncertain and some managers fear a decline in sales of as much as 10% in the coming year. Evaluate the effect of the proposed project on risk in financial performance.

2.53.5Proposed

1.52.0Current

DFLDOL

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Example 16.7: The Compounding Effect of Operating and Financial Leverage

A: The firm’s current DTL is 2 x 1.5 = 3. A 10% decline in sales could result in a 30% decline in EPS. Under the proposal, the DTL will be 3.5 x 2.5 = 8.75. A 10% drop in sales could lead to a 87.5% drop in EPS.

87.5%8.75Proposed

30%3Current

EPSDTL ∆Exa

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Capital Structure Theory

• Studies the relationship between:

Capital structure• Mix of debt & equity securities in capital

Cost of capital• Return demanded by investors

• Impacts on value of firm


Capital Structure Theory

• Does capital structure affect share price and market value of firm?

• If so, is there optimal capital structure that: Minimizes firm’s weighted average cost of

capital (WACC)? Maximizes share price and value of firm? Or both?


Background—The Value of the Firm• Notation

Vd = market value of firm’s debt Ve = market value of firm’s shares or equity Vf = market value of firm in total

• Vf = Vd + Ve

• Investors’ returns on firm’s securities will be kd = return on investment in debt ke = return on investment in equity

• Theory begins by assuming a world without taxes or transaction costs Investors’ returns are exactly component capital costs ka = average cost of capital


Background—The Value of the Firm• Value (Vf) is based on cash flow which comes

from income (Operating income or OI) Earnings ultimately determine value because all cash

flows paid to investors come from earnings Consists of dividends (D) and interest payments (I)

(both assumed to be perpetuities)• The firm’s market value is the sum of their present values

Returns drive value in an inverse relationship.

fd e a

I D OIV = + =

k k k


Figure 16.10: Variation in Value and Average Return with Capital Structure

The value of the firm and the firm’s share

price reach a maximum when the

average cost of capital is minimized.


The Early Theory by Modigliani and Miller • Modigliani & Miller (MM) were the

pioneers in developing the theory of capital structure

• MM began by assuming perfect capital markets

• MM also recognized that debt will always cost less than equity because: Interest is tax deductible Debt securities are less risky than equity

securities


The Early Theory by Modigliani and Miller • Restrictive Assumptions in the Original

Model (1958) No income taxes Securities trade in perfectly efficient capital

markets with no transaction costs No bankruptcy costs

• No administrative costs • No losses on sale of assets

Investors and companies can borrow as much as they want at same interest rate


MM’s Two Propositions

• Under MM’s initial set of restrictions:• Proposition #1:

Market value of firm is independent of capital structure. Therefore, capital structure is irrelevant

• The independence hypothesis

• Proposition #2: The cost of capital remains constant as capital

structure changes. As quantity of debt rises, return demanded by shareholders increases because of increased risk, exactly offsetting benefit due to the lower cost of debt


Figure 16.11: The Independence Hypothesis


The Early Theory by Modigliani and Miller • The Arbitrage Concept

Arbitrage means making profit by buying and selling same thing at same time in two different markets

MM proposed that arbitrage by equity investors would hold value of firm constant as debt levels changed

• If adding leverage increased value of firm, equity investors could maximize returns by selling shares and borrowing to buy shares in unleveraged firm

• Would lower price of leveraged firm and raise price of unleveraged firm

• Value of firm should be constant as leverage increases


The Early Theory by Modigliani and Miller • The Assumptions and Reality

Realistically income taxes exist Realistically costs of bankruptcy are quite large Realistically individuals cannot borrow at the same

rate as companies and interest rates usually rise as more money is borrowed

• Interpreting MM Result Leverage does affect value because of market

imperfections• Such as taxes and transaction costs (including bankruptcy)


Relaxing the Assumptions—MM Theory with Taxes• Financing and the Tax System

Tax system favours debt financing over equity financing• Interest expense on debt is tax deductible while

dividends on shares are not


Table 16.4: The Tax System Favours Debt Financing

The All Equity firm pays more taxes

because it receives no interest expense

deduction.

Total payments to investors are higher

for the leveraged company.


Relaxing the Assumptions—MM Theory with Taxes• Including Corporate Taxes in the MM

Theory When taxes exist, operating income (OI) split

between investors and government• Reduces firm’s value

• Amount of reduction depends on firm’s use of leverage (debt)

• Interest on debt reduces taxable income which reduces taxes


Relaxing the Assumptions—MM Theory with Taxes• Interest provides tax shield that reduces

government’s share of firm’s earnings When firm uses debt financing, government’s take is

reduced by (corporate tax rate × interest expense) every year

• Present value of tax shield = (corporate tax rate × interest expense) kd

• Since interest expense is amount of debt (B) times interest rate on debt, equation can be written as

d

d

corporate tax rate x B x kPV of tax shield = = TB

k


Relaxing the Assumptions—MM Theory with Taxes• Having debt in capital structure increases

firm’s value by amount of debt times tax rate

• Benefit of debt accrues entirely to shareholders because bond returns are fixed

• In theory, firm can increase value of shares by replacing equity with debt


Figure 16.12: 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.


Relaxing the Assumptions—MM Theory with Taxes• If the value of firm increases with debt,

should conclusion be that all firms should be financed with 100% debt?

• Conclusion defies logic and is counter to customary practice

• What are we missing?


Relaxing the Assumptions—MM Theory with Taxes and Bankruptcy Costs• As leverage increases past a certain point,

probability of bankruptcy failure increases Investors raise required rates of return However, effect on cost of capital offset by growing

tax shield

• Eventually average cost of capital will be minimized and firm value will be maximized This is optimal capital structure Additional leverage beyond this point increases cost

of capital and reduces value


Figure 16.13: MM Theory with Taxes and Bankruptcy Costs


Other Considerations

• Industry effects Firms with stable cash flows tend to have

more debt More profitable firms tend to have less debt

ratios Market appears to reward firms with capital

structures appropriate to their industry

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16 Chapter Capital Structure and Leverage Slides Developed by: Terry Fegarty Seneca College.

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