Chapter 13: Capital Structure Basics

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Capital StructureBasics

Break-even level of sales. Operating and financial leverage

and risk. Risks and returns of leveraged

buy-outs (LBOs). Effect of capital structure on value.

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Steps to Solution Construct a chart to find the sales break-

even point = level of sales necessary to cover operating (not financial) costs.

This requires that you calculate EBIT for different unit sales amounts.

The point at which EBIT = 0 is the break-even level of sales.

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Assumptions◦ Fixed costs remain constant as quantity changes. ◦ Variable costs vary as quantity of output changes.

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Fixed Costs

Variable Costs

Fixed costs may include salaries, depreciation, rent.

Variable costs may include commissions, materials, labor.

This is a generalization. For example, some salaries may be considered fixed and others variable. In the long-run all costs are variable.

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Calculation of Break-even Quantity

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EBIT = Sales – Variable Costs - Fixed Costs

Find Quantity which results in EBIT = $0


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Where:Where:Unit Salesbe = Break-even quantity

FC = Total fixed costsp = Sales price per unit

vc = Variable costs per unit

Unit Salesbe = FC

p – vc


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Unit Salesbe = FC

p – vcExample:Example:Fixed Costs = $1,000,000/yearPrice = $800/unitVariable Costs = $400/unit


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$1,000,000 $800 – $400

=

= 2,500 units

Unit Salesbe = FC p – vc

Example:Example:Fixed Costs = $1,000,000/yearPrice = $800/unitVariable Costs = $400/unit

Now calculate total revenue.

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p = Sales price per unitQ = unit sales

TR = p x Q

Calculate total revenue for different levels of sales.

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Unit sales (Q) x Price (p) = Total Revenue (TR) 0 x $800 = $ 0

500 x $800 = $ 400,0001,000 x $800 = $ 800,0002,000 x $800 = $1,600,0002,500 x $800 = $2,000,000

TR = p x Q

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You cannot easily move a large boulderYou cannot easily move a large boulder.

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However, with the aid of a lever you can However, with the aid of a lever you can move an object many times your size.move an object many times your size.

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The longer the lever, the bigger theThe longer the lever, the bigger therock you can move.rock you can move.

In a financial context, the magnifying power of leverage can be used to help (or hurt) a firm’s financial performance.

Operating leverage occurs due to fixed costs in the production process.

With high fixed operating costs, a small change in sales will trigger a large change in operating income (EBIT).

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Measurement of Operating Leverage◦ Degree of Operating Leverage (DOL)

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DOL = % Change in EBIT % Change in Sales

DOL > 1 means the firm has operating leverage.

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Example:Example: S1 = 3,750 units S2 = 5,000 unitsFC = $1mil and VC = $400/unit P = $800/unit

Sales of 3,750 units = (3,750 * $800) = $3milEBIT = $3mil - $1mil – $1.5mil= $.5milSales of 5,000 units = (5,000 * $800) = $4mil EBIT = $4mil - $1mil - $2mil = $1mil

DOL=($1 - $.5) / $.5

($4 - $3) / $3=

100

33.33= 3.0

DOL = % Change in EBIT % Change in Sales

Measurement of DOL◦ Calculation using alternate formula:

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DOL = Sales - Total VC Sales -Total VC - FC

Measurement of DOL◦ Calculation using alternate formula:

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DOL = ($3 - $1.5) / ($3 - $1.5 - $1)

= 1.5 / .5

= 3


Measurement of DOL◦ Calculation using per unit information:

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Q = 3,750 unitsP = $800 per unit

VC = $400 per unit FC = $1,000,000 per year.

Example:Example:


Measurement of DOL◦ Calculation using per unit information:

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= 3Interpretation: If sales change 1%,

then EBIT will change 3% (same direction).

DOL3,750 units = 3,750(800) – 3,750(400) 3,750(800) –3,750(400) – 1,000,000

Degree of Operating Leverage falls as sales rise

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Quantity DOL2,500 (Qbe) Undefined3,250 4.333,750 35,000 2

Degree of Operating Leverage falls as sales rise

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If FC = $0, DOL = 1

Quantity DOL2,500 (Qbe) Undefined3,250 4.333,750 35,000 2

The higher the sales level above break-even, the less the percent change in EBIT for a given percent change in sales

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LeverageLeverageTable Number 1

Degree of Financial Leverage◦ Finance a portion of the firm’s assets with

securities that have fixed financial costs Debt Preferred Stock

◦ Financial Leverage measures changes in earnings per share as EBIT changes.

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DFLEBIT = % Change in NI

% Change in EBIT

Base Level of EBIT

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Financial LeverageFinancial LeverageExample:Example: EBIT1 = $500,000

EBIT2 = $1,000,000

NI1 = $180,000NI2 = $480,600

DFL=(480.6 - 180) / 180

($1 - $.5) / $.5=

167

100= 1.67

DFL = % Change in NI % Change in EBIT

Measurement of DFL (Alternate formula)

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DFLEBIT = EBIT

EBIT – I

If DFL > 1, the firm has financial leverage. A given percent change in EBIT will result in a larger percent change in NI.

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EBIT = $500,000Interest Charges = $200,000

Example:Example:

= 1.67 times

Interpretation: When EBIT changes 1% (from an Interpretation: When EBIT changes 1% (from an existing level of $50,000) Net Income will change existing level of $50,000) Net Income will change 1.67% in the same direction.1.67% in the same direction.

DFLEBIT=500,000 =500,000

500,000 – 200,000

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Degree of Combined Leverage◦Measures changes in Net Income given

changes in Sales◦Combines both Operating and Financial

Leverage◦Computed for a specific level of sales

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DCLS = % Change in NI % Change in Sales

Base Level of Sales

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Combined LeverageCombined LeverageExample:Example: SALES1 = $3,000,000

SALES2 = $4,000,000

NI1 = $180,000NI2 = $480,600

DCL=(480.6 - 180) / .180

($4 - $3) / $3=

166.7

33.3= 5.0

DCL = % Change in NI % Change in Sales

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DCLS = DOLS x DFLEBIT

= 5.0 timesDCL3,750 = 3.0 x 1.67

Example:Example:

DFLEBIT = 1.67DOLS = 3.0

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Example:Example:

= 1,500,000 300,000 = 5

DCL3,750 = 3,750(800) – 3,750(400) 3,750(800) – 3,750(400) – 1,000,000 - $200,000

3 mil – 1.5 mil3 mil – 1.5 mil – 1 mil - .2 mil=

Sales – VCSales - VC - FC - I

DCLS =

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Interpretation: When sales change 1%, Net Income will change 5.0% in the same direction

DCLS = DOLS x DFLEBIT DCLS = DOLS x DFLEBIT

= 5.0 times

DCL3,750 = 3.0 x 1.67

Example:Example:

DFLEBIT = 1.67DOLS = 3.0

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Leverage can help the firm or hurt it. If EBIT increases, financial leverage will

magnify the increase in net income. If EBIT decreases, financial leverage will

magnify the decrease in net income.

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Capital Structure is the mixture of sources of funds a firm uses.◦ Debt◦ Preferred Stock◦ Common Stock

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A benefit of debt financing is that interest is tax deductible to the paying firm whereas payments to equity providers are not.

Firms must trade-off this benefit against the increased financial risk associated with higher debt levels.

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M&M wrote an important paper in 1958 in which they proved that with certain assumptions there is no optimal capital structure. One is as good as any other.

M&M’s Assumptions: No transaction costs, no taxes, everyone has same information and borrowing rates, debt is riskless, debt does not affect operations.

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In a later paper, M&M showed that when the tax deductibility of interest is considered, their model indicates that a capital structure of 100% debt is optimal.

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Firms attempt to balance the costs and benefits of debt to reach the optimal mix that maximizes the value of the firm.

Affect on costs of capital:◦ Since debt is cheaper than equity, use of debt

will initially lower the WACC.◦ At high levels of debt, the WACC will increase

as investors perceive the risk of the firm to be increasing substantially.

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K*K*

We minimize We minimize KK** at at 50% debt 50% debt

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Homework Problems

1. You are given the following information for Firm XYZ:Fixed operating costs = $500,000Variable operating costs per unit = $40/unitSales price per unit = $50/unit

Calculate the break-even point in units for: (treat each scenario independently)a. fixed costs decrease to $450,000b. variable cost decreases to $37 per unitc. sales price increases to $55/unitd. changes for a, b, c, occur simultaneously

2. Company X has a sales price of $4.00 per unit and a variable cost of $3.40 per unit; fixed costs are $13,000, no debt, and sales of 250,000 units per year. Company Y has a sales price of $10.00 per unit and a variable cost of $7.00 per unit with fixed costs of $135,000 and sales of 200,000 units per year. Company Y also has interest payments of $60,000 annually. Both companies are in the 40% tax bracket.

a. compute DOL, DFL, and DCL for Company Xb. compute DOL, DFL, and DCL for Company Yc. compare the relative risk of both companies

3. Why is the Modigliani and Miller theory of capital structure not really practical for firms in the real world?

4. Debt financing is often called a two-edged sword. What does this mean?

5. Given a net income of $50,000, sales of $2,000,000, variable costs of $25,000, fixed operating costs of $175,000, price per unit of $5.00, interest expense of $20,000, and EBIT of $1,800,000:

a. calculate DOL b. calculate DFL c. calculate DCL

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Corporate Bonds,Preferred Stock,

and Leasing

Bond contract terms Differences among types of bonds Features of preferred stock Lease versus purchase Balance sheet treatment of leases

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Bondholders are lending the corporation funds for some stated period of time.

The corporation promises to make certain payments to the owner of the bond.

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Indenture◦ Definition: the contract between the

corporation and the investor Provisions included in the indenture:

◦ par value◦ coupon rate and payment dates◦ maturity date◦ any special features

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Par Value◦ (e.g. $1,000) also called Face Value

Coupon Interest Rate◦ The stated rate of interest. The rate that is

multiplied by the par value to determine the annual dollar interest paid.

Maturity◦ Time at which the original principal (Par

Value) is repaid to the bondholder.

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Collateral ◦ If the debt is secured by specific assets, the

lender is entitled to take the assets in the event of default.

Plan for repayment at maturity◦ Staggered maturities makes it easier for the firm

to raise the necessary funds.

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Sinking funds allow the firm to set aside the funds over time to ensure the ability to repay the loan.

Provisions for early repayment◦ Call provisions allow the issuer to refinance the

debt, usually done if interest rates fall.◦ Issuing new bonds to replace old bonds is known

as refunding.

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Special Features of Bond Indentures

Original issue: 12% coupon Coupon currently required for similar risk

bonds: 10% coupon Refinancing will save $20 per year on

each $1,000 bond. Interest savings offset by the expenses

of calling the original issue and issuing the new bonds. In addition, the call price the issuer must pay is usually greater than the face value.

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Restrictions on company operations that are designed to reduce risk to bondholders.◦ Restrictions on additional debt◦ Restrictions on payment of dividends◦ Minimum working capital required

Name of independent trustee to oversee the bond issue

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Special Features of Bond Indentures

Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt

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Moody’s and Standard & Poor’s regularly monitor issuer’s financial condition and assign a rating to the debt

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Investment Grade

Below Investment

Grade (Junk)

AAA Best QualityAA High QualityA Upper Medium GradeBBB Medium GradeBB SpeculativeB Very SpeculativeCCC Very Very SpeculativeCCC No Interest Being PaidD Currently in Default

Debenture Subordinated Debenture

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DebentureDebenture Subordinated DebentureSubordinated Debenture

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A debenture is an unsecured bond.

A subordinated debenture is a debenture that has lower priority for payment than other debenturesdesignated as senior.

DebentureDebenture Subordinated DebentureSubordinated Debenture

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A mortgage bond is secured by realassets such as airplanes, railroad cars,or real estate.

Mortgage Bond

DebentureDebenture Subordinated DebentureSubordinated Debenture Mortgage BondMortgage Bond Convertible Bond

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A convertible bond is a bond that gives the investor the right to convert the bond into a given number of shares of stock on or aftera given future date.The conversion ratio is the number of sharesthe investor will get for each bond converted.

DebentureDebenture Subordinated DebentureSubordinated Debenture Mortgage BondMortgage Bond Convertible Bond

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The The conversion valueconversion value is the market price per is the market price per share times the conversion ratio.share times the conversion ratio.

e.g. If the stock price = $20 and the conversione.g. If the stock price = $20 and the conversionratio = 45, the conversion value = $20 x 45 = $900.ratio = 45, the conversion value = $20 x 45 = $900.

DebentureDebenture Subordinated DebentureSubordinated Debenture Mortgage BondMortgage Bond Convertible BondConvertible Bond Variable Rate Bond

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A variable rate bond pays investors interest thatis adjusted according to an established time table and a market rate index.e.g. Coupon rate is LIBOR + 300 basis points

Debenture Subordinated Debenture Mortgage Bond Convertible Bond Variable Rate Bond Putable Bond

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A putable bond can be cashed inbefore maturity at the option ofthe bond’s owner.

Debenture Subordinated Debenture Mortgage Bond Convertible Bond Variable Rate Bond Putable Bond Junk Bond

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A junk bond is a bond that is rated belowinvestment grade.

Debenture Subordinated Debenture Mortgage Bond Convertible Bond Variable Rate Bond Putable Bond Junk Bond International Bond

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International bonds are bonds thatare sold in countries other thanwhere the issuer is domiciled.

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1st Mortgage Bonds2nd Mortgage Bonds

Senior Debentures

Subordinated Debentures

Preferred StockCommon StockMore

Risk

LessRisk

Priority of Claim Higher Lower

A hybrid security with both debt and equity characteristics.

Has priority over common stock in receipt of dividends and in liquidation.

Dividends are fixed as a percentage of par value.

Only participating preferred stock (which is rare) shares in the residual income with the common stockholders.

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Corporations can generally exclude from taxable income 70% of dividend income received on preferred stock issued by another corporation.

e.g. Company X owns Company Y preferred stock that pays 4% dividends. If Company X’s marginal tax rate = 40%, the after tax yield on this investment AT yield = 4%[1-(.3x.4)] = 3.52%

Compare to 4% on fully taxable investment: AT yield = 4%(1-.4) = 2.4%

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A lease is a contractual arrangement where a party who needs an asset (lessee) contracts with another party who owns the asset (lessor) to use that asset for a specified period of time, without conveyance of title.

A long-term non-cancelable lease contract is very similar financially to a debt obligation from the perspective of the lessee.

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Flexibility and convenience Few restrictions Avoid the risk of obsolescence 100 percent financing Tax savings Ease of obtaining credit

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Lease payments for operating leases are fully deductible to businesses but only interest portions of debt payments are deductible.

The IRS strictly examines lease arrangements to ensure that they are genuine lease agreements and not installment sales in disguise.

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An operating lease has a term that is substantially shorter than the useful life of the asset and is cancelable by the lessee (e.g. car rental for a business trip).

A capital lease is long term and non-cancelable. The economic value is mostly depleted by the end of the lease (e.g. a ten year lease of a truck.)

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Both operating and capital leases appear on the income statement.◦ Payments on operating leases are tax-

deductible expenses.◦ Depreciation for the leased asset and imputed

interest from capital lease payments are deductible.

Capital leases also appear on the balance sheet because they are the functional equivalent of a purchase financed with debt.

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Homework Problems

1.Four years ago, you purchased a convertible bond at par with a ten year maturity with an 8% coupon. The conversion ratio of the bond is 25. The current market price of the stock is $50. Calculate the conversion value.

2.Using the information in the previous question, if the current market interest rate is 9.5% on similar non-convertible bonds, should you convert? Explain.

3.You purchased a fifteen-year 10% coupon bond at par five years ago. The bond can be redeemed for $900 after five years. The current required rate of return on similar non-convertible bonds is 9%. Should you redeem the bond? Explain.

4.Why are junk bonds called high-yield bonds?

5.Explain why preferred stock is known as a hybrid security.

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Common Common StockStock

Characteristics of common stock. Advantages and disadvantages of equity

financing. Process of issuing common stock. Understand rights and warrants.

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Company Issuing the StockCompany Issuing the Stock

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Description of Preferred StockDescription of Preferred Stock(Class B Preferred and Class C Preferred)

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Ticker Symbol

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Annual Dividend per Share in dollarsAnnual Dividend per Share in dollarsp = Initial Dividend

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Volume of TradingThe number of shares changing hands.

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Daily Trading RangeDaily Trading Range6½ = $6.50

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Closing PriceClosing Price

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Price Change from Close on Previous Trading Day

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Trading Range over the Past YearTrading Range over the Past Years = stock split = new 52 week high achieved

on this day

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Dividend YieldDividend Yield

Dividend Closing Price

=

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Price to Earnings (PE) Ratio

Closing Price Earnings per Share =

Dividends◦ Vary over time◦ Not guaranteed

Residual Claim Voting Rights Sometimes Preemptive Right to buy

New Stock

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Shareholders elect a group of individuals called the Board of Directors who oversee the management of the corporation.

The Board of Directors selects the managers who are responsible for day-to-day operations of the firm.

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Majority voting◦ For each seat open, one vote can be cast per

share. Each position on the board is voted for separately.

Cumulative voting◦ Each shareholder gets one vote per share

times the number of seats open. Votes may be spread out among candidates as desired. The top X vote getters are elected to the X seats to be filled.

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Excalibur Corporation has 3 seats open on its 9 member Board of Directors. There are 100,000 shares outstanding. The minority interest owns 40,000 shares.

Does the minority have a chance of electing one Director if all shares are voted?

The minority has 40,000 x 3 = 120,000 votes. Number they can elect =

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(40,000-1)(3+1)100,000

= 1.61.6 = 1 director (always round down)

Number of Directors Electable

Excalibur Corporation has 5 seats open on its 9 member Board of Directors. There are 100,000 shares outstanding.

How many shares does the minority need to control to elect 2 directors?

Number of shares needed =

90

= 33,334.33= 33,334.33

Number of Shares Needed for X Directors

2 X 100,0005+1 +1

Disadvantages of Equity Financing Dilution of ownership and power. Flotation costs

◦ Fees paid to investment bankers, lawyers, and accountants

◦ Usually higher than for debt issues.

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Signaling Effects◦ Investors may think that managers would

not issue stock unless it were overvalued in the market.

◦ Therefore, a stock issue is seen as a negative signal and investors will respond by selling the stock.

◦ Selling pressure causes the stock price to fall.

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Disadvantages of Equity Financing (cont.)

Advantages of Equity Financing No interest to pay. No obligation to pay dividends. Reduces financial risk.

◦ This may be a more important advantage to firms that already are relatively risky due to the kind of business they do (e.g. high tech)

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Sell to existing shareholders or to new shareholders?

Initial Public Offering (IPO) Role of Investment Bankers

◦ Underwriting◦ Best efforts

Pricing the issue

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Securities issued by a corporation that allow investors to buy new stock at a given price.

Preemptive Right◦ Allows a shareholder the right to maintain their

% ownership by buying a proportional share of any new issue.

◦ The rights can also be sold in the open market.

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There are 60,000 shares outstanding and another 20,000 will be issued.

Each shareholder will receive one right for for each share held, a total of 60,000 rights.

To buy one share of the new issue, you will need to pay the subscription price plus 60,000/20,000 = 3 rights.

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A warrant is a security giving the owner the option to buy shares of common stock at a certain exercise price for a set period of time.

Like rights except that they are sold to investors rather than given away.

Each warrant allows you to buy a particular number of shares.

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Homework Problems

1. Describe the difference between a preemptive right and a warrant.

2. Company XYZ has 30 million shares of common stock outstanding. It wishes to issue another 1,500,000 shares. The current market price per share is $25 and the rights offering subscription price is $20 per share.

a. How many rights will current stockholders receive?b. How many rights are needed to buy one additional share?

3. The Whitcomb Bank has 10 directors on its board and 1,000,000 voting shares of common stock outstanding. The company uses cumulative voting rules and is planning to elect four new directors. How many shares of common stock would a group of shareholders need to insure that they could elect at least two directors at the next election?

4. How do you value a stock that is not publicly traded?

5. What are the advantages and disadvantages of equity financing?

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Dividend Policy

Factors that influence dividend policy How to pay dividends Major dividend theories Alternatives to cash dividends

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Need for funds Management expectations for the firm’s

future prospects Stockholders’ preferences Restrictions on dividend payments Availability of cash

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On August 25, 2006 Southside Bankshares On August 25, 2006 Southside Bankshares announced a quarterly dividend of $1 per share announced a quarterly dividend of $1 per share to be paid to share holders of record September 9, to be paid to share holders of record September 9, 2006, payable September 15, 20062006, payable September 15, 2006

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Date that dividend is Date that dividend is announcedannounced


25 31 1 5 915AugustAugust SeptemberSeptember

Declaration Date

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All owners of record will All owners of record will receive the dividend.receive the dividend.



Declaration Date Date of Record

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4 days4 days




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To allow time for the official list of stockholders to be updated, stockholders must buy stock before the ex-dividend date which is 2 days prior to date of record.




Ex-Dividend Date

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Declaration DateEx-Dividend Date

Date of Record

Date that the dividend is paid out to the stockholders.

Payment Date

A dividend reinvestment plan (DRIP) is a plan in which stockholders are allowed to reinvest their dividends in additional shares of stock instead of receiving them in cash.

Popular with investors because they can avoid commission costs.

Dividends paid and reinvested are still taxable income to the investor.

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Residual Theory of Dividends◦ Hypothesizes that dividends should be

determined only after the firm has first examined their need for retained earnings to finance the equity portion of funds needed for their capital budget.

◦ Thus, dividends arise from the “residual” or left-over earnings.

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Example: Net Income = $150 million Total Amount of Funds Needed to Finance Positive

NPV Projects = $100 million Optimal Capital Structure: 60%D, 40%E Equity Funds Needed = $100 million x .4

= $40,000,000

Dividend to be Paid = $110 million ($150 million NI - $40,000,000 Equity Funds Needed)

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Residual Theory of DividendsResidual Theory of Dividends

Clientele Dividend Theory◦ Hypothesizes that different firms have different

types of investors. ◦ Some investors, such as elderly people on fixed

incomes, tend to prefer to receive dividend income.

◦ Others, such as young investors often prefer growth, and tend to like their income in the form of capital gains rather than as dividend income.

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Signaling Dividend Theory◦ Hypothesizes that since management is better

informed about the firm’s prospects, dividend announcements are seen as signals of future performance.

◦ Since investors usually respond negatively to dividend decreases, managers tend not to increase dividends unless the increase is expected to be sustainable.

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Bird in the Hand Theory◦ Hypothesizes that stockholders prefer to

receive dividends instead of having earnings reinvested.

◦ The dividend payment is more certain than the unknown future capital gain.

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Modigliani and Miller Dividend Theory◦ M&M originally argued in 1961 that,

without taxes or transactions costs, the way that the firm’s earnings are distributed (capital gains versus dividends) is irrelevant to firm value.

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Stock Dividends ◦ Existing shareholders receive additional

shares of stock instead of cash dividends. ◦ Payment is expressed as a percentage of

current stock holdings.

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e.g. if there is a 10% stock dividend, you would receive one additional share for

every 10 that you currently own.

Stock Splits◦ If total shares will increase by more than

25%, the company will usually declare a stock split.

◦ Purpose is usually to bring the stock price into a more popular trading range.

◦ Expressed as a ratio to original shares.

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e.g. a 2-1 split means that each investor e.g. a 2-1 split means that each investor will end up with twice as many shares.will end up with twice as many shares.

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Homework Problems and Questions

1. Explain the difference between a stock dividend and a stock split.

2. Net income is $2,500,000; dividends declared are $500,000. What is the dividend payout ratio?

3. Why is it important for a firm to understand the makeup of its stockholders before it determines a dividend policy?

4. Would it be a common practice for a high-growth firm to have a 100% dividend payout ratio? Explain.

5. What is the rationale of managers who view a stock split as a way to increase the total value of their firm’s stock?

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Chapter 13: Capital Structure Basics

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