Leverage and Optimal Capital Structure

1. Leverage and Optimal Capital Structure Business vs. financial risk Operating leverage Optimal capital structure Capital structure theory

2. Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Note that business risk does not include financing effects. What is business risk?

3. What determines business risk? Uncertainty about demand (sales) Uncertainty about output prices Uncertainty about costs Product, other types of liability Operating leverage

4. What is operating leverage, and how does it affect a firm�s business risk? Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

5. Effect of operating leverage More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. What happens if variable costs change?

6. Operating Break Even � trade-off of fixed vs. variable costs QP � QV � F = 0 Q(P � V) � F = 0 Q(P � V) = F Qbe = F / (P � V) Qbe = Operating break even (units) P-V = fixed contribution margin F = fixed costs

7. Financial break-even Similar process to that of finding the bid price What OCF (or payment) makes NPV = 0? CF0 = 5,00,0000 N = 5; WACC = 18% CPT PMT = 1,598,889 = OCF Q = (FC + OCF) / (P-VC) Q = (1,000,000 + 1,598,889) / (25,000 � 15,000) = 259.888 units = 260 units @ 260 units Sales 6,500,000 (260 x 25,000) VC -3,900,000 (260 x 15,000) FC -1,000,000 OCF 1,600,000 The question now becomes: Can we sell at least 260 units per year to generate an OCF of 1,600,000?

8. Three Types of Leverage:Operating, Financial, Combined Sales Less: Cost of goods Sold Gross Profits Less: Operating Expenses Earnings Before Interest and Taxes (EBIT) Earnings Before Interest and Taxes (EBIT) Less: Interest Net Profits Before Taxes Less: Taxes Net Profits After Taxes Less: Preferred Stock Dividends Earnings Available for Common Stockholders Earnings Per Share (EPS)

9. Operating Leverage Operating leverage is the relationship between sales and operating cash flow Degree of operating leverage measures this relationship The higher the DOL, the greater the variability in operating cash flow The higher the fixed costs, the higher the DOL DOL depends on the sales level you are starting from DOL = 1 + (FC / OCF) or DOL = [Q(P-V)] / [Q(P-V) � F]

10. Example: DOL Consider the previous example Suppose sales are 300 units This meets all three break-even measures What is the DOL at this sales level? OCF = (25,000 � 15,000)*300 � 1,000,000 = 2,000,000 DOL = 1 + (1,000,000 / 2,000,000) = 1.5 What will happen to OCF if unit sales increases by 20%? Percentage change in OCF = DOL* Percentage change in Q Percentage change in OCF = 1.5(.20) = .3 or 30% OCF would increase to 2,000,000(1.3) = 2,600,000

11. Using operating leverage Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.

12. What is financial leverage?Financial risk? Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage � more interest expense (fixed expense)

13. Business risk vs. Financial risk Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued to finance the business. More debt, more financial risk. Concentrates business risk on stockholders.

14. An example:Illustrating effects of financial leverage Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure). Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate

15. Firm U: Unleveraged

16. Firm L: Leveraged

17. Ratio comparison between leveraged and unleveraged firms FIRM U Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 6.0% 9.0% 12.0% TIE 8 8 8 FIRM L Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 4.8% 10.8% 16.8% TIE 1.67x 2.50x 3.30x BEP = EBIT/A; ROE= NI/Equity; TIE = EBIT/I

18. Risk and return for leveraged and unleveraged firms Expected Values: Firm U Firm L E(BEP) 15.0% 15.0% E(ROE) 9.0% 10.8% E(TIE) 8 2.5x Risk Measures based on Bad, Avg, Good Firm U Firm L sROE 2.12% 4.24% CVROE 0.24 0.39

19. The effect of leverage on profitability and debt coverage For leverage to raise expected ROE, must have BEP > rd. Why? If rd > BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income. As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense increases (Int Exp = rdD).

20. Conclusions Basic earning power (BEP) is unaffected by financial leverage. L has higher expected ROE because BEP > rd. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

21. Optimal Capital Structure The capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. Trades off higher E(ROE) and EPS against higher risk. The tax-related benefits of leverage are exactly offset by the debt�s risk-related costs. The target capital structure is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.

22. Sequence in an additional debt recapitalization. Firm announces the recapitalization. New debt is issued. Proceeds are used to repurchase stock. The number of shares repurchased is equal to the amount of debt issued divided by price per share. Result is to increase debt, lower equity proportions

23. Cost of debt at different debt ratiosD + E = TA

24. Analyze the recapitalization at various debt levels and determine the EPS and TIE at each level.

25. Determining EPS and TIE at different levels of debt.(D = $250,000 and rd = 8%, P=25)

26. Determining EPS and TIE at different levels of debt.(D = $500,000 and rd = 9%, P=25)

27. Determining EPS and TIE at different levels of debt.(D = $750,000 and rd = 11.5%, P=25)

28. Determining EPS and TIE at different levels of debt.(D = $1,000,000 and rd = 14%, P=25)

29. Stock Price, with zero growth If all earnings are paid out as dividends, E(g) = 0. EPS = DPS To find the expected stock price (P0), we must find the appropriate rs at each of the debt levels discussed.

30. What effect does more debt have on a firm�s cost of equity? If the level of debt increases, the riskiness of the firm increases. We have already observed the increase in the cost of debt. However, the riskiness of the firm�s equity also increases, resulting in a higher rs.

31. Finding Rs Find Beta FirstThe Hamada Equation Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity. The Hamada equation attempts to quantify the increased cost of equity due to financial leverage. Uses the unlevered beta of a firm, which represents the business risk of a firm as if it had no debt.

32. Finding Rs - Find Beta firstThe Hamada Equation bL = bU[ 1 + (1 � T) (D/E)] Suppose, the risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is 1.0. We were previously told that total assets were $2,000,000.

33. Calculating levered betas and costs of equity at 250,000 If D = $250 bL = 1.0 [ 1 + (0.6)($250/$1,750) ] bL = 1.0857 rs = rRF + (rM � rRF) bL rs = 6.0% + (6.0%) 1.0857 rs = 12.51%

34. Table for calculating levered betas and costs of equity

35. Hamada equation - example A Company is trying to estimate its optimal capital structure. Right now, it has a capital structure that consists of 15% debt and 85% equity. (Its D/E ratio is 0.1765) The risk-free rate is 5% and the market risk premium is 7%. Currently the company's cost of equity is 14% and its tax rate is 40%. What would be the estimated cost of equity if it were to change its capital structure to 50% debt and 50% equity? Facts given: rs = 14%; D/E = 0.1765; rRF = 5%; RPM = 7%; T = 40%.

36. Solution � steps Step 1: Find the firm's current levered beta using the CAPM: �rs�= rRF + RPM(b) 14%�= 5% + 7%(b) b�= 1.286 Step 2: Find the firm's unlevered beta using the Hamada equation: b�= b U[1 + (1 - T)(D/E)] 1.286� = b U[1 + (0.6)(0.1765)] �1.286= 1.1059bU �1.1628= bU

37. Solution - continued Step 3: Find the new levered beta given the new capital structure using the Hamada equation: b = bU[1 + (1 - T)(D/E)] b = 1.1628[1 + (0.6)(1)] b = 1.8604 Step 4: Find the firm's new cost of equity given its new beta and the CAPM: �rs = rRF + RPM(b) �rs = 5% + 7%(1.8604) �rs = 18.048%.

38. Finding Optimal Capital Structure The firm�s optimal capital structure can be determined two ways: Minimizes WACC. Maximizes stock price. Both methods yield the same results.

39. Table for calculating levered betas and costs of equity

40. Determining the stock price for each capital structure

41. What debt ratio maximizes EPS? Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%. (Remember DPS = EPS because payout = 100%.) Risk is too high at D/A = 50%.

42. What is the firm�s optimal capital structure? P0 is maximized ($26.89) at D/A = $500,000/$2,000,000 = 25%, so optimal D/A = 25%. EPS is maximized at 50%, but primary interest is stock price, not E(EPS). The example shows that we can push up E(EPS) by using more debt, but the risk resulting from increased leverage more than offsets the benefit of higher E(EPS).