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CHAPTER 13 Capital Structure and Leverage

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CHAPTER 13 Capital Structure and Leverage

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    1. CHAPTER 13 Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage 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. 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.

    7. 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

    8. Firm U: Unleveraged

    9. Firm L: Leveraged

    10. 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

    11. 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: Firm U Firm L sROE 2.12% 4.24% CVROE 0.24 0.39

    12. 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.

    13. Cost of debt at different debt ratios

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

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

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

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

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

    19. 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.

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

    21. Calculating levered betas and costs of equity 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%

    22. Table for calculating levered betas and costs of equity

    23. Table for calculating levered betas and costs of equity

    24. Determining the stock price maximizing capital structure

    25. Other factors to consider when establishing the firm’s target capital structure Industry average debt ratio TIE ratios under different scenarios Lender/rating agency attitudes Reserve borrowing capacity Effects of financing on control Asset structure Expected tax rate

    26. How would these factors affect the target capital structure? Sales stability? High operating leverage? Increase in the corporate tax rate? Increase in the personal tax rate? Increase in bankruptcy costs? Management spending lots of money on lavish perks?

    27. Modigliani-Miller Irrelevance Theory

    28. Incorporating signaling effects Signaling theory suggests firms should use less debt than MM suggest. This unused debt capacity helps avoid stock sales, which depress stock price because of signaling effects.

    29. What are “signaling” effects in capital structure? Assumptions: Managers have better information about a firm’s long-run value than outside investors. Managers act in the best interests of current stockholders. What can managers be expected to do? Issue stock if they think stock is overvalued. Issue debt if they think stock is undervalued. As a result, investors view a stock offering negatively--managers think stock is overvalued.

    30. What can managers be expected to do? Issue stock if they think stock is overvalued. Issue debt if they think stock is undervalued. As a result, investors view a common stock offering as a negative signal--managers think stock is overvalued.

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