Capital Structure and Leverage. Chapter 13. © 2003 South-Western/Thomson Learning. Background. Capital structure refers to the mix of a firm’s debt and equity Preferred stock is assumed to be part of a firm’s debt
© 2003 South-Western/Thomson Learning
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.
ABC is now doing rather poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE decrease.
Albany Corporation at $10M Debt
($000 except for per-share amounts)
Number of shares=
Stock price = $10 per share
ROE = EAT equity = $13,500 $90,000 = 15%
EPS = EAT number of shares = $13,500 9,000,000 = $1.50
The treasurer feels debt can be traded for equity without immediately affecting the price of the stock or the rate at which the firm can borrow. Management believes it is in the best interest of the company and its stockholders to move the firm’s EPS from its current level up to $2.00 per share. However, no opportunities are available to increase operating profit (EBIT) above the current level of $23.7 million. Will borrow more money and retiring stock raise Albany’s EPS, and if so what capital structure will achieve an EPS of $2.00?Financial Leverage—Example
A: EPS will rise if ROCE exceeds the after-tax cost of debt. ROCE is currently:
The after-tax cost of debt is 12% x (1 – 0.4), or 7.2%. Since 7.2% < 14.2%, trading equity for debt will increase EPS.
Using trial and error, you can determine that $45 million of debt is the approximate amount of debt that makes the firm’s EPS equal $2.00.
Q: Selected income statement and capital information for the Moberly Moped Manufacturing Company follow ($000):
Currently 700,000 shares of common stock are outstanding. The firm pays 15% interest on its debt and anticipates that it can borrow as much as it reasonably needs at that rate. The income tax rate is 40%
Moberly is interested in boosting the price of its stock. To do that management is considering restructuring capital to 50% debt in the hope that the increased EPS will have a positive effect on price. However, the economic outlook is shaky, and the company’s CFO thinks there’s a good chance that a deterioration in business conditions will reduce EBIT next year. At the moment Moberly’s stock sells for its book value of $10 per share.
Estimate the effect of the proposed restructuring on EPS. Then use the degree of financial leverage to assess the increase in risk that will come along with it.
ExampleThe Degree of Financial Leverage (DFL)—A Measurement—Example
A: Since the equity is trading at book value, this is a relatively simple example.
Interest (15% of debt)
If business conditions remain unchanged, a higher EPS will result with the addition of debt.
$1.170The Degree of Financial Leverage (DFL)—A Measurement (Example)
It is important to determine the indifference point, which occurs when the two plans offer the same EBIT.
When examining the ABC Corporation you can see that the 50% Debt and No Leverage lines intersect. At the point of intersection ABC is indifferent between the two plans. However, to the left of the intersection the 50% Debt plan is preferable, but to the right of the point the No Leverage plan is preferable.
Q: Suppose a company can make a unit of product for $7 in variable labor and materials, and sell it for $10. What are the contribution and contribution margin?
A: The contribution per unit is $3, or $10 - $7, while the contribution margin is $3 $10, or 30%.
Q: What is the breakeven sales level in units and dollars for a company that can make a unit of product for $7 in variable costs and sell it for $10, if the firm has fixed costs of $1,800 per month?
A: The breakeven point in units is $1,800 ($10 - $7) = 600 units. The breakeven point in dollars is $10 per unit times 600 units, or $6,000, which could also be calculated as $1,800 0.30. Thus, the firm must sell 600 units per month to cover fixed costs.
Q: Suppose Firm A has fixed costs of $1,000 per period, sells its product for $10, and has variable costs of $8 per unit. Further, suppose Firm B has fixed costs of $1,500 and also sells its product for $10 a unit. Both firms are at the same breakeven point. What variable cost must Firm B have if it is to achieve the same breakeven point as Firm A? State the trade-off at the breakeven point. Which structure is preferred if there’s a choice?
A: Both firms have a breakeven point of 500 units (Firm A: $1,000 $2). We need to solve the breakeven formula for Firm B’s variable costs per unit:
QB/EFirm B = FC (P – VB)
500 units = $1,500 ($10 – VB)
VB = $7
The preferred structure depends on volatility—if sales are expected to be highly volatile, the lower fixed cost structure might be better in the long run.
Thus, at breakeven, a $1
differential in contribution
makes up for a $500
difference in fixed cost.The Effect of Operating Leverage—Example
Q: The Albergetti Corp. sells its product at an average price of $10. Variable costs are $7 per unit and fixed costs are $600 per month. Evaluate the degree of operating leverage when sales are 5% and then 50% above the breakeven level.
A: First, compute the breakeven volume: $600 ($10 - $7) = 200 units. Breakeven plus 5% is 200 x 1.05 or 210 units, while breakeven plus 50% is 200 x 1.50 or 300 units. DOL at 210 units is:
DOL at 300 units is:
Note that DOL decreases
as the output level
breakeven.The Degree of Operating Leverage (DOL)—A Measurement
Q: The Allegheny Company is considering replacing a manual production process with a machine. The money to buy the machine will be borrowed. The replacement of people with a machine will alter the firm’s cost structure in favor of fixed costs, while the loan will move the capital structure in the direction of more debt. The firm’s leverage positions at expected output levels with and without the project are summarized as follows:
The economic outlook is uncertain and some managers fear a decline in sales of as much as 10% in the coming year. Evaluate the effect of the proposed project on risk in financial performance.
A: The firm’s current DTL is 2 x 1.5, or 3, meaning a 10% decline in sales could result in a 30% decline in EPS. Under the proposal, the DTL will be much higher: 8.75, or 3.5 x 2.5, meaning a 10% drop in sales could lead to a 87.5% drop in EPS.
2.5The Compounding Effect of Operating and Financial Leverage—Example
Returns drive value in an inverse relationship.
The value of the firm and the firm’s stock price reach a maximum when the average cost of capital is minimized.Figure 13.10: Variation in Value and Average Return with Capital Structure
The All Equity firm pays more taxes because it receives no interest expense deduction.
Total payments to investors are higher for the leveraged company.Table 13.4
In the MM model with taxes value increases steadily as leverage is added. Thus, the firm’s value is maximized with 100% debt. Note that kd remains constant across all levels of debt.Figure 13.12: MM Theory with Taxes