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Principles of Business Finance Fin 510. Dr. Lawrence P. Shao Marshall University Spring 2002. CHAPTER 12 Capital Structure and Leverage. Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory. What is business risk?.

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slide1

Principles of Business FinanceFin 510

Dr. Lawrence P. Shao

Marshall University

Spring 2002

chapter 12 capital structure and leverage
CHAPTER 12Capital Structure and Leverage
  • Business vs. financial risk
  • Optimal capital structure
  • Operating leverage
  • Capital structure theory
what is business risk
What is business risk?
  • Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?
  • Note that business risk does not include financing effects.

Probability

Low risk

High risk

0

E(EBIT)

EBIT

business risk is affected primarily by
Business risk is affected primarily by:
  • Uncertainty about demand (sales).
  • Uncertainty about output prices.
  • Uncertainty about costs.
  • Product, other types of liability.
  • Operating leverage.
what is operating leverage and how does it affect a firm s business risk
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.
slide6

Probability

Low operating leverage

High operating leverage

EBITL

EBITH

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

what is financial leverage financial risk
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.
business risk vs financial risk
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: More debt, more financial risk. Concentrates business risk on stockholders.
slide9

Consider 2 Hypothetical Firms

Firm UFirm L

No debt $10,000 of 12% debt

$20,000 in assets $20,000 in assets

40% tax rate 40% tax rate

Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt (capital structure).

slide10

Firm U: Unleveraged

Economy

Bad Avg. Good

Prob. 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000

Interest 0 0 0

EBT $2,000 $3,000 $4,000

Taxes (40%) 800 1,200 1,600

NI $1,200 $1,800 $2,400

slide11

Firm L: Leveraged

Economy

Bad Avg. Good

Prob.* 0.25 0.50 0.25

EBIT* $2,000 $3,000 $4,000

Interest 1,200 1,200 1,200

EBT $ 800 $1,800 $2,800

Taxes (40%) 320 720 1,120

NI $ 480 $1,080 $1,680

*Same as for Firm U.

slide12

8

8

8

Firm U Bad Avg. Good

BEP* 10.0% 15.0% 20.0%

ROE 6.0% 9.0% 12.0%

TIE

Firm L Bad Avg. Good

BEP* 10.0% 15.0% 20.0%

ROE 4.8% 10.8% 16.8%

TIE 1.67x 2.5x 3.3x

*BEP same for U and L.

slide13

Expected Values:

E(BEP) 15.0% 15.0%

E(ROE) 9.0% 10.8%

E(TIE) 2.5x

Risk Measures:

sROE 2.12% 4.24%

CVROE 0.24% 0.39%

U L

8

conclusions
Conclusions
  • Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage.
  • BEP indicates the ability of the firm’s assets to generate (operating) income.
  • L has much wider ROE (EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.
optimal capital structure
Optimal Capital Structure

That capital structure (mix of debt, preferred, and common equity) at which P0 is maximized. Trades off higher E(ROE) and EPS against higher risk.

what are signaling effects in capital structure
What are “signaling” effects in capital structure?
  • Managers have better information about a firm’s long-run value than outside investors.
  • Managers act in the best interests of current stockholders.

Assumptions:

therefore managers can be expected to
Therefore, managers can be expected to:
  • 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.

estimated costs of debt and equity for campus deli see p 1
Estimated costs of debt and equity for Campus Deli (see p. 1):

Amt. borrowed

kd

ks

$0

10.0%

15.0%

250

10.0

15.5

500

11.0

16.5

750

13.0

18.0

1,000

16.0

20.0

what s wacc at d 0 d 500 d 1 000 assets 2 000 000
What’s WACC at D = 0, D = $500, D = $1,000? (Assets = $2,000,000)

WACC = wdkd(1 - T) + wcks

D = 0:

WACC = 0 + 1.0(15%) = 15.0%.

D = $500:

WACC = .25(11%)(.6) + .75(16.5%) = 14.0%.

D = $1,000:

WACC = .50(16%)(.6) + .50(20.0%) = 14.8%.

slide20

%

ks

15

WACC

kd(1-T)

D/A

0

.25

.50

.75

$

P0

EPS

D/A

.25

.50

slide21

Value of Stock

MM result

Actual

No leverage

D/A

0

D1

D2

slide22
The graph shows MM’s tax benefit vs. bankruptcy cost theory.
  • Signaling theory suggests firms should use less debt than MM suggest.
  • This unused debt capacity helps avoid stock sales, which depress P0 because of signaling effects.