Capital Structure and Leverage

Capital Structure and Leverage Rest of Chapter 14

Capital Structure • M&M (Modigliani and Miller)

Background skim • Capital structure refers to the mix of a firm’s debt and equity • In this context Preferred Stock is assumed to be part of a firm’s debt • Financial leverage refers to using borrowed money to enhance the effectiveness of invested equity • Financial leverage of 40% means the firm’s capital structure contains 40% debt and 60% equity

Small business (not the focus of this class) • Equity at a point in time is fixed • Add equity over time with retained earnings • Does not have easy access to equity capital market • Capital structure (amount of debt) a KEY business decision • Trade off of more risk as additional debt is taken off versus the additional return from adding the debt

skim The Central Issue for Corporations • Capital structure is independent (mostly) of the size of the company and its asset mix • The question is: can the use of debt increase the value of a firm’s equity? • Specifically, the firm’s stock price • Under certain conditions changing leverage increases stock price • An optimal capital structure maximizes stock price • The relationship between capital structure and stock price is not precise nor fully understood

skim Risk in the Context of Leverage • Leverage influences stock price • Alters the risk/return relationship in an equity investment • Measures of performance • Operating income (AKA: EBIT) • Unaffected by leverage because it is calculated prior to the deduction for interest • Leverage increases the EM and increases ROE if BEP>interest rate • Risk of ROE and EPS is very much effected by leverage

Financial Leverage • Borrowing money (leverage) is used because it is expected to increase average ROE and EPS • The use of borrowed money incurs interest, which is in essence a fixed cost, so risk is also increased • When returns are greater than the interest rate then financial leverage will improve a firm’s ROE and EPS • However, if returns are lower than the interest rate then borrowing money will worsen EPS and ROE

ROCE and BEP • Return on Capital Employed (ROCE) • Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE • When the ROCE exceeds the after-tax cost of debt, more leverage improves ROE and EPS • When ROCE is less than the after-tax cost of debt, more leverage makes ROE and EPS worse • BEP: Can compare to pre tax interest rate.

Table 13.1 As the firm’s debt ratio rises, both EPS and ROE rise dramatically. While EAT falls, the number of shares outstanding falls at a faster rate as debt replaces equity.

Table 13.2 ABC is now doing rather poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE decrease.

Financial Leverage and Financial Risk skim • Financial leverage is a two-edged sword • Multiplies good results into great results • Multiples bad results into terrible results • ROE and EPS for leveraged firms experience more variation • Financial risk is the increased variability in financial results that comes from additional leverage

Putting the Ideas Together—The Effect on Stock Price skim • Leverage enhances returns while it adds risk, pushing stock prices in opposite directions • Enhanced performance increases dividends, which increases the PV of dividends per share (driving up the stock’s price) • The increased risk increases the stocks beta and this decreases the PV of dividends per share (drives down the stock’s price) • Which effect dominates, and when? • Principle of increasing. Risk increases at an increasing rate as leverage increases. • At low leverage an increase in debt increases risk a little • At high leverage an increase in debt increases risk a lot

Real Investor Behavior and the Optimal Capital Structure skim • When leverage is low an increase in debt has a positive effect on investors • At high debt levels concerns about risk dominate and adding more debt decreases the stock’s price • As leverage increase its effect goes from positive to negative, which results in an optimum capital structure

Figure 13.2: The Effect of Leverage on Stock Price

Finding the Optimum—A Practical Problem skim • There is no way to determine the exact optimum amount of leverage for a particular company at a particular time • Appropriate level tends to vary according to • Nature of a company’s business • If firm has high business risk it should use less leverage • Economic climate • If the outlook is poor investors are likely to be more sensitive to risk • As a practical matter the optimum capital structure cannot be precisely located • The best we can usually do is compare to the industry average

The Target Capital Structure • A firm’s target capital structure is management’s estimate of the optimal capital structure • An approximation or best guess as to the amount of debt that will maximize the firm’s stock price

Modigliani and Miller (MM) Capital Structure Theory • Restrictive Assumptions in the Original Model • In 1958 MM published their first paper on capital structure • Included numerous restrictions such as • No income taxes • Securities trade in perfectly efficient capital markets with no transaction costs • No costs to bankruptcy • Investors and companies can borrow as much as they want at the same rate

The Early Theory by Modigliani and Miller (MM) • The Result • Under MM’s initial set of restrictions, value is independent of capital structure • As cheaper debt is added the cost of equity increases because of increased risk • However the weight of the more expensive equity is decreasing while the weight of the cheaper debt is increasing, leading to a constant weighted average cost of capital • Thus the PV of the firm does not change

The Theory by Modigliani and Miller (MM) • The Assumptions and Reality • Realistically income taxes exist • Realistically the 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

The Early Theory by Modigliani and Miller (MM) • The Arbitrage Concept • Arbitrage means making a profit by buying and selling the same thing at the same time in two different markets • MM proposed that arbitrage by equity investors would hold the value of the firm constant as debt levels changed • Equity investors could sell shares in a leveraged firm and buy shares in an unleveraged firm by borrowing money on their own • Interpreting the Result • The MM result implies that leverage affects value because of market imperfections • Such as taxes and transaction costs (including bankruptcy)

Relaxing the Assumptions—More Insights • Financing and the U.S. Tax System • Tax system favors debt financing over equity financing • Interest expense on debt is tax deductible while dividends on stock are not • Bankruptcy costs • Greater chance of incurring cost as more debt is used, thus causes value of stock to decline at some point as risk gets too high • Interest rate on debt rises as debt increases – causing stock price to decline at some point

Relaxing the Assumptions—More Insights • Corporate taxes and bankruptcy costs discussed in the text. • Relaxing MM assumptions suggests that an optimal amount of debt exists for a corporation, but doesn’t really help us find it.

Capital Structures Around the World $424$ Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995 Source: Essentials of Managerial Finance by Besley and Brigham

Capital Structure and Leverage