Description
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.
13-1
CHAPTER 13
Capital Structure and
Leverage
?
Business vs. fnancial risk
?
Optimal capital structure
?
Operating leverage
?
Capital structure theory
13-2
?
Uncertainty about future operating income (B!"#$
i.e.$ ho% %ell can %e predict operating income&
?
'ote that business risk does not include fnancing
e(ects.
)hat is business risk&
Probability
EBIT E(EBIT) 0
Low risk
High risk
13-3
)hat determines business
risk&
?
Uncertainty about demand (sales#.
?
Uncertainty about output prices.
?
Uncertainty about costs.
?
*roduct$ other types of liability.
?
Operating leverage.
13-4
)hat is operating leverage$ and
ho% does it a(ect a frm+s
business risk&
?
Operating leverage is the use of
f,ed costs rather than variable
costs.
?
!f most costs are f,ed$ hence do
not decline %hen demand falls$
then the frm has high operating
leverage.
13-5
(ect of operating
leverage
?
-ore operating leverage leads to more
business risk$ for then a small sales
decline causes a big proft decline.
?
)hat happens if variable costs change&
Sales
$
Rev.
TC
C
!
BE
Sales
$
Rev.
TC
C
!
BE
}
Pro"it
13-6
Using operating leverage
?
"ypical situation. Can use operating leverage
to get higher (B!"#$ but risk also increases.
Probability
EBIT
L
Low o#erati$g leverage
High o#erati$g leverage
EBIT
H
13-7
)hat is fnancial leverage&
/inancial risk&
?
/inancial leverage is the use of
debt and preferred stock.
?
/inancial risk is the additional
risk concentrated on common
stockholders as a result of
fnancial leverage.
13-8
Business risk vs. /inancial
risk
?
Business risk depends on business
factors such as competition$
product liability$ and operating
leverage.
?
/inancial risk depends only on the
types of securities issued.
?
-ore debt$ more fnancial risk.
?
Concentrates business risk on
stockholders.
13-9
0n e,ample.
!llustrating e(ects of fnancial
leverage
?
"%o frms %ith the same operating
leverage$ business risk$ and probability
distribution of B!".
?
Only di(er %ith respect to their use of
debt (capital structure#.
/irm U /irm L
'o debt 123$333 of 245 debt
143$333 in assets 143$333 in assets
635 ta, rate 635 ta, rate
13-10
/irm U. Unleveraged
E%o$o&y
Ba' (vg. )oo'
Prob. 0.*+ 0.+0 0.*+
EBIT $*,000 $-,000 $.,000
I$terest 0 0 0
EBT $*,000 $-,000 $.,000
Ta/es (.00) 100 2,*00 2,300
4I $2,*00 $2,100 $*,.00
13-11
/irm L. Leveraged
E%o$o&y
Ba' (vg. )oo'
Prob.5 0.*+ 0.+0 0.*+
EBIT5 $*,000 $-,000 $.,000
I$terest 2,*00 2,*00 2,*00
EBT $ 100 $2,100 $*,100
Ta/es (.00) -*0 6*0 2,2*0
4I $ .10 $2,010 $2,310
5Sa&e as "or ir& 7.
13-12
7atio comparison bet%een
leveraged and unleveraged
frms
/!7- U Bad 0vg 8ood
B* 23.35 29.35 43.35
7O :.35 ;.35 24.35
"! < < <
/!7- L Bad 0vg 8ood
B* 23.35 29.35 43.35
7O 6.=5 23.=5 2:.=5
"! 2.:>, 4.93, ?.?3,
13-13
7isk and return for leveraged
and unleveraged frms
,pected @alues.
/irm U /irm L
(B*# 29.35 29.35
(7O# ;.3523.=5
("!# < 4.9,
7isk -easures.
/irm U /irm L
A
7O
4.245 6.465
C@
7O
3.46 3.?;
13-14
"he e(ect of leverage on
proftability and debt
coverage
?
/or leverage to raise e,pected 7O$ must
have B* B k
d
.
?
)hy& !f k
d
B B*$ then the interest
e,pense %ill be higher than the operating
income produced by debtCfnanced assets$
so leverage %ill depress income.
?
0s debt increases$ "! decreases because
B!" is una(ected by debt$ and interest
e,pense increases (!nt ,p D k
d
E#.
13-15
Conclusions
?
Basic earning po%er (B*# is
una(ected by fnancial leverage.
?
L has higher e,pected 7O
because B* B k
d
.
?
L has much %ider 7O (and *S#
s%ings because of f,ed interest
charges. !ts higher e,pected
return is accompanied by higher
risk.
13-16
Optimal Capital Structure
?
"hat capital structure (mi, of debt$
preferred$ and common eFuity# at %hich
*
3
is ma,imiGed. "rades o( higher (7O#
and *S against higher risk. "he ta,C
related benefts of leverage are e,actly
o(set by the debt+s riskCrelated costs.
?
"he target capital structure is the mi, of
debt$ preferred stock$ and common eFuity
%ith %hich the frm intends to raise
capital.
13-17
Eescribe the seFuence of
events in a
recapitaliGation.
?
Campus Eeli announces the
recapitaliGation.
?
'e% debt is issued.
?
*roceeds are used to repurchase
stock.
?
"he number of shares repurchased
is eFual to the amount of debt
issued divided by price per share.
13-18
Cost of debt at di(erent levels of
debt$ after the proposed
recapitaliGation
Amount D/A D/E Bond
borrowed ratio ratio rating k
d
$ 0 0 0 -- --
250 0.125 0.1429 AA 8.0
500 0.250 0.!!!! A 9.0
"50 0.!"5 0.#000 BBB 11.5
1$000 0.500 1.0000 BB 14.0
13-19
)hy do the bond rating and cost of
debt depend upon the amount
borro%ed&
?
0s the frm borro%s more
money$ the frm increases its
fnancial risk causing the frm+s
bond rating to decrease$ and its
cost of debt to increase.
13-20
0nalyGe the proposed
recapitaliGation at various levels of
debt. Eetermine the *S and "!
at each level of debt.
1?.33
=3$333
(3.:# (1633$333#
g outstandin Shares
# " C 2 #( E k C B!" (
*S
13 E
d
=
=
=
=
13-21
Eetermining *S and "! at di(erent
levels of debt.
(E D 1493$333 and k
d
D =5#
43,
143$333
1633$333
,p !nt
B!"
"!
1?.4:
23$333 C =3$333
333##(3.:# 3.3=(1493$ C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
23$333
149
1493$333
d repurchase Shares
d
= = =
=
=
=
= =
13-22
Eetermining *S and "! at di(erent
levels of debt.
(E D 1933$333 and k
d
D ;5#
=.;,
169$333
1633$333
,p !nt
B!"
"!
1?.99
43$333 C =3$333
333##(3.:# 3.3;(1933$ C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
43$333
149
1933$333
d repurchase Shares
d
= = =
=
=
=
= =
13-23
Eetermining *S and "! at di(erent
levels of debt.
(E D 1>93$333 and k
d
D 22.95#
6.:,
1=:$493
1633$333
,p !nt
B!"
"!
1?.>>
?3$333 C =3$333
# $333##(3.: 3.229(1>93 C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
?3$333
149
1>93$333
d repurchase Shares
d
= = =
=
=
=
= =
13-24
Eetermining *S and "! at di(erent
levels of debt.
(E D 12$333$333 and k
d
D 265#
4.;,
1263$333
1633$333
,p !nt
B!"
"!
1?.;3
63$333 C =3$333
:# 3$333##(3. 3.26(12$33 C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
63$333
149
12$333$333
d repurchase Shares
d
= = =
=
=
=
= =
13-25
Stock *rice$ %ith Gero
gro%th
?
!f all earnings are paid out as
dividends$ (g# D 3.
?
*S D E*S
?
"o fnd the e,pected stock price (*
3
#$
%e must fnd the appropriate k
s
at
each of the debt levels discussed.
s s s
2
3
k
E*S
k
*S
g C k
E
* = = =
13-26
)hat e(ect does increasing debt
have on the cost of eFuity for the
frm&
?
!f the level of debt increases$ the
riskiness of the frm increases.
?
)e have already observed the
increase in the cost of debt.
?
Ho%ever$ the riskiness of the frm+s
eFuity also increases$ resulting in a
higher k
s.
13-27
"he Hamada Fuation
?
Because the increased use of debt causes
both the costs of debt and eFuity to
increase$ %e need to estimate the ne% cost
of eFuity.
?
"he Hamada eFuation attempts to Fuantify
the increased cost of eFuity due to fnancial
leverage.
?
Uses the unlevered beta of a frm$ %hich
represents the business risk of a frm as if it
had no debt.
13-28
"he Hamada Fuation
I
L
D I
U
J 2 K (2 C "# (EL#M
?
Suppose$ the riskCfree rate is :5$
as is the market risk premium.
"he unlevered beta of the frm is
2.3. )e %ere previously told that
total assets %ere 14$333$333.
13-29
Calculating levered betas and
costs of eFuity
!f E D 1493$
I
L
D 2.3 J 2 K (3.:#(1493L12$>93# M
I
L
D 2.3=9>
k
s
D k
7/
K (k
-
N k
7/
# I
L
k
s
D :.35 K
.35# 2.3=9>
k
s
D 24.925
13-30
"able for calculating levered
betas and costs of eFuity
(&o8$t
borrowe'
$ 0
*+0
+00
6+0
2,000
9
ratio
0.000
2*.+0
*+.00
-6.+0
+0.00
Levere'
Beta
2.00
2.0;
2.*0
2.-3
2.30
9:E
ratio
0.000
2..*;
--.--
30.00
200.00
k
s
2*.000
2*.+2
2-.*0
2..23
2+.30
13-31
/inding Optimal Capital
Structure
?
"he frm+s optimal capital
structure can be determined t%o
%ays.
?
-inimiGes )0CC.
?
-a,imiGes stock price.
?
Both methods yield the same
results.
13-32
"able for calculating )0CC
and determining the
minimum )0CC
9 ratio
0.000
2*.+0
*+.00
-6.+0
+0.00
al8e o" Sto%k
0 9
2
9
*
9
?? res8lt
(%t8al
4o leverage
13-40
-odiglianiC-iller !rrelevance
"heory
?
"he graph sho%s --+s ta, beneft
vs. bankruptcy cost theory.
?
Logical$ but doesn+t tell %hole
capital structure story. -ain
problemCCassumes investors have
same information as managers.
13-41
!ncorporating signaling
e(ects
?
Signaling theory suggests frms
should use less debt than --
suggest.
?
"his unused debt capacity helps
avoid stock sales$ %hich depress
stock price because of signaling
e(ects.
13-42
)hat are PsignalingQ e(ects
in capital structure&
?
0ssume.
?
-anagers have better information
about a frm+s longCrun value than
outside investors.
?
-anagers act in the best interests of
current stockholders.
13-43
)hat can managers be
e,pected to do&
?
!ssue stock if they think stock is
overvalued.
?
!ssue debt if they think stock is
undervalued.
?
0s a result$ investors vie% a
common stock o(ering as a
negative signalCCmanagers think
stock is overvalued.
13-44
Conclusions on Capital
Structure
?
'eed to make calculations as %e did$
but should also recogniGe inputs are
Pguesstimates.Q
?
0s a result of imprecise numbers$ capital
structure decisions have a large
Rudgmental content.
?
)e end up %ith capital structures
varying %idely among frms$ even
similar ones in same industry.
doc_203609850.ppt
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.
13-1
CHAPTER 13
Capital Structure and
Leverage
?
Business vs. fnancial risk
?
Optimal capital structure
?
Operating leverage
?
Capital structure theory
13-2
?
Uncertainty about future operating income (B!"#$
i.e.$ ho% %ell can %e predict operating income&
?
'ote that business risk does not include fnancing
e(ects.
)hat is business risk&
Probability
EBIT E(EBIT) 0
Low risk
High risk
13-3
)hat determines business
risk&
?
Uncertainty about demand (sales#.
?
Uncertainty about output prices.
?
Uncertainty about costs.
?
*roduct$ other types of liability.
?
Operating leverage.
13-4
)hat is operating leverage$ and
ho% does it a(ect a frm+s
business risk&
?
Operating leverage is the use of
f,ed costs rather than variable
costs.
?
!f most costs are f,ed$ hence do
not decline %hen demand falls$
then the frm has high operating
leverage.
13-5
(ect of operating
leverage
?
-ore operating leverage leads to more
business risk$ for then a small sales
decline causes a big proft decline.
?
)hat happens if variable costs change&
Sales
$
Rev.
TC
C
!
BE
Sales
$
Rev.
TC
C
!
BE
}
Pro"it
13-6
Using operating leverage
?
"ypical situation. Can use operating leverage
to get higher (B!"#$ but risk also increases.
Probability
EBIT
L
Low o#erati$g leverage
High o#erati$g leverage
EBIT
H
13-7
)hat is fnancial leverage&
/inancial risk&
?
/inancial leverage is the use of
debt and preferred stock.
?
/inancial risk is the additional
risk concentrated on common
stockholders as a result of
fnancial leverage.
13-8
Business risk vs. /inancial
risk
?
Business risk depends on business
factors such as competition$
product liability$ and operating
leverage.
?
/inancial risk depends only on the
types of securities issued.
?
-ore debt$ more fnancial risk.
?
Concentrates business risk on
stockholders.
13-9
0n e,ample.
!llustrating e(ects of fnancial
leverage
?
"%o frms %ith the same operating
leverage$ business risk$ and probability
distribution of B!".
?
Only di(er %ith respect to their use of
debt (capital structure#.
/irm U /irm L
'o debt 123$333 of 245 debt
143$333 in assets 143$333 in assets
635 ta, rate 635 ta, rate
13-10
/irm U. Unleveraged
E%o$o&y
Ba' (vg. )oo'
Prob. 0.*+ 0.+0 0.*+
EBIT $*,000 $-,000 $.,000
I$terest 0 0 0
EBT $*,000 $-,000 $.,000
Ta/es (.00) 100 2,*00 2,300
4I $2,*00 $2,100 $*,.00
13-11
/irm L. Leveraged
E%o$o&y
Ba' (vg. )oo'
Prob.5 0.*+ 0.+0 0.*+
EBIT5 $*,000 $-,000 $.,000
I$terest 2,*00 2,*00 2,*00
EBT $ 100 $2,100 $*,100
Ta/es (.00) -*0 6*0 2,2*0
4I $ .10 $2,010 $2,310
5Sa&e as "or ir& 7.
13-12
7atio comparison bet%een
leveraged and unleveraged
frms
/!7- U Bad 0vg 8ood
B* 23.35 29.35 43.35
7O :.35 ;.35 24.35
"! < < <
/!7- L Bad 0vg 8ood
B* 23.35 29.35 43.35
7O 6.=5 23.=5 2:.=5
"! 2.:>, 4.93, ?.?3,
13-13
7isk and return for leveraged
and unleveraged frms
,pected @alues.
/irm U /irm L
(B*# 29.35 29.35
(7O# ;.3523.=5
("!# < 4.9,
7isk -easures.
/irm U /irm L
A
7O
4.245 6.465
C@
7O
3.46 3.?;
13-14
"he e(ect of leverage on
proftability and debt
coverage
?
/or leverage to raise e,pected 7O$ must
have B* B k
d
.
?
)hy& !f k
d
B B*$ then the interest
e,pense %ill be higher than the operating
income produced by debtCfnanced assets$
so leverage %ill depress income.
?
0s debt increases$ "! decreases because
B!" is una(ected by debt$ and interest
e,pense increases (!nt ,p D k
d
E#.
13-15
Conclusions
?
Basic earning po%er (B*# is
una(ected by fnancial leverage.
?
L has higher e,pected 7O
because B* B k
d
.
?
L has much %ider 7O (and *S#
s%ings because of f,ed interest
charges. !ts higher e,pected
return is accompanied by higher
risk.
13-16
Optimal Capital Structure
?
"hat capital structure (mi, of debt$
preferred$ and common eFuity# at %hich
*
3
is ma,imiGed. "rades o( higher (7O#
and *S against higher risk. "he ta,C
related benefts of leverage are e,actly
o(set by the debt+s riskCrelated costs.
?
"he target capital structure is the mi, of
debt$ preferred stock$ and common eFuity
%ith %hich the frm intends to raise
capital.
13-17
Eescribe the seFuence of
events in a
recapitaliGation.
?
Campus Eeli announces the
recapitaliGation.
?
'e% debt is issued.
?
*roceeds are used to repurchase
stock.
?
"he number of shares repurchased
is eFual to the amount of debt
issued divided by price per share.
13-18
Cost of debt at di(erent levels of
debt$ after the proposed
recapitaliGation
Amount D/A D/E Bond
borrowed ratio ratio rating k
d
$ 0 0 0 -- --
250 0.125 0.1429 AA 8.0
500 0.250 0.!!!! A 9.0
"50 0.!"5 0.#000 BBB 11.5
1$000 0.500 1.0000 BB 14.0
13-19
)hy do the bond rating and cost of
debt depend upon the amount
borro%ed&
?
0s the frm borro%s more
money$ the frm increases its
fnancial risk causing the frm+s
bond rating to decrease$ and its
cost of debt to increase.
13-20
0nalyGe the proposed
recapitaliGation at various levels of
debt. Eetermine the *S and "!
at each level of debt.
1?.33
=3$333
(3.:# (1633$333#
g outstandin Shares
# " C 2 #( E k C B!" (
*S
13 E
d
=
=
=
=
13-21
Eetermining *S and "! at di(erent
levels of debt.
(E D 1493$333 and k
d
D =5#
43,
143$333
1633$333
,p !nt
B!"
"!
1?.4:
23$333 C =3$333
333##(3.:# 3.3=(1493$ C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
23$333
149
1493$333
d repurchase Shares
d
= = =
=
=
=
= =
13-22
Eetermining *S and "! at di(erent
levels of debt.
(E D 1933$333 and k
d
D ;5#
=.;,
169$333
1633$333
,p !nt
B!"
"!
1?.99
43$333 C =3$333
333##(3.:# 3.3;(1933$ C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
43$333
149
1933$333
d repurchase Shares
d
= = =
=
=
=
= =
13-23
Eetermining *S and "! at di(erent
levels of debt.
(E D 1>93$333 and k
d
D 22.95#
6.:,
1=:$493
1633$333
,p !nt
B!"
"!
1?.>>
?3$333 C =3$333
# $333##(3.: 3.229(1>93 C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
?3$333
149
1>93$333
d repurchase Shares
d
= = =
=
=
=
= =
13-24
Eetermining *S and "! at di(erent
levels of debt.
(E D 12$333$333 and k
d
D 265#
4.;,
1263$333
1633$333
,p !nt
B!"
"!
1?.;3
63$333 C =3$333
:# 3$333##(3. 3.26(12$33 C (1633$333
g outstandin Shares
# " C 2 #( E k C B!" (
*S
63$333
149
12$333$333
d repurchase Shares
d
= = =
=
=
=
= =
13-25
Stock *rice$ %ith Gero
gro%th
?
!f all earnings are paid out as
dividends$ (g# D 3.
?
*S D E*S
?
"o fnd the e,pected stock price (*
3
#$
%e must fnd the appropriate k
s
at
each of the debt levels discussed.
s s s
2
3
k
E*S
k
*S
g C k
E
* = = =
13-26
)hat e(ect does increasing debt
have on the cost of eFuity for the
frm&
?
!f the level of debt increases$ the
riskiness of the frm increases.
?
)e have already observed the
increase in the cost of debt.
?
Ho%ever$ the riskiness of the frm+s
eFuity also increases$ resulting in a
higher k
s.
13-27
"he Hamada Fuation
?
Because the increased use of debt causes
both the costs of debt and eFuity to
increase$ %e need to estimate the ne% cost
of eFuity.
?
"he Hamada eFuation attempts to Fuantify
the increased cost of eFuity due to fnancial
leverage.
?
Uses the unlevered beta of a frm$ %hich
represents the business risk of a frm as if it
had no debt.
13-28
"he Hamada Fuation
I
L
D I
U
J 2 K (2 C "# (EL#M
?
Suppose$ the riskCfree rate is :5$
as is the market risk premium.
"he unlevered beta of the frm is
2.3. )e %ere previously told that
total assets %ere 14$333$333.
13-29
Calculating levered betas and
costs of eFuity
!f E D 1493$
I
L
D 2.3 J 2 K (3.:#(1493L12$>93# M
I
L
D 2.3=9>
k
s
D k
7/
K (k
-
N k
7/
# I
L
k
s
D :.35 K
.35# 2.3=9>k
s
D 24.925
13-30
"able for calculating levered
betas and costs of eFuity
(&o8$t
borrowe'
$ 0
*+0
+00
6+0
2,000
9
ratio
0.000
2*.+0
*+.00
-6.+0
+0.00
Levere'
Beta
2.00
2.0;
2.*0
2.-3
2.30
9:E
ratio
0.000
2..*;
--.--
30.00
200.00
k
s
2*.000
2*.+2
2-.*0
2..23
2+.30
13-31
/inding Optimal Capital
Structure
?
"he frm+s optimal capital
structure can be determined t%o
%ays.
?
-inimiGes )0CC.
?
-a,imiGes stock price.
?
Both methods yield the same
results.
13-32
"able for calculating )0CC
and determining the
minimum )0CC
9
ratio0.000
2*.+0
*+.00
-6.+0
+0.00
al8e o" Sto%k
0 9
2
9
*
9
?? res8lt
(%t8al
4o leverage
13-40
-odiglianiC-iller !rrelevance
"heory
?
"he graph sho%s --+s ta, beneft
vs. bankruptcy cost theory.
?
Logical$ but doesn+t tell %hole
capital structure story. -ain
problemCCassumes investors have
same information as managers.
13-41
!ncorporating signaling
e(ects
?
Signaling theory suggests frms
should use less debt than --
suggest.
?
"his unused debt capacity helps
avoid stock sales$ %hich depress
stock price because of signaling
e(ects.
13-42
)hat are PsignalingQ e(ects
in capital structure&
?
0ssume.
?
-anagers have better information
about a frm+s longCrun value than
outside investors.
?
-anagers act in the best interests of
current stockholders.
13-43
)hat can managers be
e,pected to do&
?
!ssue stock if they think stock is
overvalued.
?
!ssue debt if they think stock is
undervalued.
?
0s a result$ investors vie% a
common stock o(ering as a
negative signalCCmanagers think
stock is overvalued.
13-44
Conclusions on Capital
Structure
?
'eed to make calculations as %e did$
but should also recogniGe inputs are
Pguesstimates.Q
?
0s a result of imprecise numbers$ capital
structure decisions have a large
Rudgmental content.
?
)e end up %ith capital structures
varying %idely among frms$ even
similar ones in same industry.
doc_203609850.ppt