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Capital Structure Decisions

Ch 16 and 17

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Issues

Business risk and operating leverage Business risk and financial risk Financial risk and financial leverage Determining optimal capital structure Capital structure theories

MM Theory Trade-off theory Signaling theory Pecking order theory

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Leverage for Ford and Johnson & Johnson

Ford Motor

Johnson

&

Johnson

from yahoo.marketguide.com

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Optimal Capital Structure

Capital Structure policy involves a risk-return trade-off. An increase in debt raises the risk to

shareholders But an increase in debt generally leads to

higher return on equity (ROE). Higher risk has a negative impact on stock

prices but a higher ROE has a positive impact. There must be an optimal trade-off

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Primary factors affecting capital structures Business Risk

Higher Business Risk Lower Optimal Debt Ratio

Tax Position High Marginal Tax Rate Higher Optimal Debt

Ratio Financial Flexibility

Greater Need for Future Funds Lower Optimal Debt Ratio now

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Uncertainty about future operating income (EBIT).

Note that business risk focuses on operating income, so it ignores financing effects.

What is business risk?

Probability

EBITE(EBIT)0

Low risk

High risk

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Factors That Influence Business Risk

Uncertainty about demand (unit sales).

Uncertainty about output prices.

Uncertainty about input costs.

Product and other types of liability.

Degree of operating leverage (DOL).

And many others

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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. The higher the proportion of fixed costs within

a firm’s overall cost structure, the greater the operating leverage.

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Example: Operating Leverage

Conduct sensitivity (or scenario) analyses and measure expected ROE and standard deviations of ROEs

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Higher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline.

Sales

$ Rev.TC

FC

QBE Sales

$ Rev.

TC

FC

QBE

Profit}

Example: Operating Leverage

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Operating Leverage In the typical situation, higher operating leverage leads

to higher expected EBIT, but also increases risk.

P ro b a b ility

E B IT L

L o w o p e ra tin g le v e ra g e

H ig h o p e ra tin g le v e ra g e

E B IT H

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Business Risk versus Financial Risk

Business risk: Uncertainty in future EBIT. Usually refers to riskiness inherent in the firm’s

normal operating activities if it used no debt. Depends on business factors such as

competition, demand variability, sales price variability, operating leverage, etc.

Financial risk: Additional business risk concentrated on

common stockholders as a result of using debt (or financial leverage) is used.

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Stand-alone risk

Stand-alone Business Financialrisk risk risk= + .

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Financial Risk Financial Leverage

Additional risk placed on the stockholders as a result of the decision to finance with debt

We will look at the impact of financial risk on ROE and NI for different levels of debt.

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Financial Risk

Why some firms carry a low debt? The higher the percentage of debt, the riskier the

debt, hence the higher the interest rate lenders will charge.

Why some firms carry a high debt? The debt is tax-deductible, so the firm can

achieve a high ROE.

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Example: Financial LeverageAssume the tax rate, t is 30%. The firm B’s long-term debt

carries an interest rate of 8%.

Firm A Firm B $0 Debt $50 Debt $100 Equity $50 Equity

$100 $100 $100 $100

Assume 3 possible outcomesEBIT

Poor $0 Average $10

Excellent $20

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Example: Financial Leverage (Continued)1. Calculate Return on Equity (ROE) for each of

the three economics conditions for Firm A and Firm B.

2. Graph your results.

3. At what level of EBIT would these two firms’ stockholders be equally well off?

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Financial Leverage and the Impact on ROE

Disadvantage to debt

RO

E

Debt

No Debt

Break-even point

Advantage to debt

EBIT

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Financial Leverage and the Impact on ROE

Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage.

A levered firm has higher expected ROI and ROE because of tax savings.

A levered firm has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.

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Determining Optimal Capital Structure Capital structures vary considerably across

and within industries. Managers should choose the capital

structure that maximizes the firm’s stock price, not profit.

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Determining Optimal Capital Structure Table 16-3 Figure 16-8 The Hamada Equation

Beta changes with leverage. b= bu[1+(1-T)(D/E)] An increase debt ratio tends to increase in

beta. As a result, it will eventually increase cost of equity.

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Determining Optimal Capital Structure WACC

In this example, the WACC is minimized at D/A = 40%, the same debt level that maximizes stock price.

Since the value of a firm is the present value of future operating income, the lowest discount rate (WACC) leads to the highest value.

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Capital Structure Theories MM theory

Zero taxes Corporate taxes Corporate and personal taxes

Trade-off theory

Signaling theory

Pecking order Theory

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Capital Structure Theory

MM (Modigliani and Miller) No Taxes

Capital structure is irrelevant. (Pie Theory) Any increase in ROE resulting from financial

leverage is exactly offset by the increase in risk. Does not consider tax effects.

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Capital Structure Theory

MM (Modigliani and Miller) Corporate Taxes

Corporate tax laws favor debt financing over equity financing

Firms should use almost 100% debt financing to maximize value.

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Capital Structure Theory

MM (Modigliani and Miller) Corporate and Personal Taxes

Personal taxes lessen the advantage of corporate debt.

Corporate taxes favor debt financing. Personal taxes favor equity financing.

Income proceeds from bonds are taxed at personal income tax rates going up to 39.6 percent.

Long-term capital gains are taxed at a lower rate.

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Capital Structure Theory

Trade-Off Theory (Figure 16-9) MM theory ignores bankruptcy costs, which

increase as more leverage is used. At low leverage levels, tax benefits outweigh

bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits.

An optimal capital structure exists that balances these costs and benefits.

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Capital Structure Theory Signaling Theory

MM assumed that investors and managers have the same information.

But, managers often have better information (Information Asymmetry). Thus, they would:

Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales

as a negative signal.

In addition, investors may fear earning dilutions when additional stocks are issued, so they re-evaluate stocks negatively.

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Capital Structure Theory Pecking-Order Theory

Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

Rule 1 Use internal financing first.

Rule 2 Issue debt next, equity last.

The pecking-order Theory is at odds with the trade-off theory:

There is no target D/E ratio. Profitable firms use less debt. Companies like “financial slack” (or internal finance)

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Optimal Capital Structure and Cost of Capital: George Pacific Co.“On a market-value basis, our debt-to-capital ratio

was 47 percent. By employing this capital structure, we believe that our weighted average cost of capital is nearly optimized – at approximately 10 percent …..”

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WACC Estimates for Some Large U. S. Corporations

Company WACCIntel 12.9%General Electric 11.9Motorola 11.3Coca-Cola 11.2Walt Disney 10.0 AT&T 9.8Wal-Mart 9.8Exxon 8.8H. J. Heinz 8.5BellSouth 8.2

Common Size Balance SheetFor S&P Composite Index Firms during 2005

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Common Size Income StatementFor S&P Composite Index Firms during 2005

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Financial Ratios

2005 Ratios for selected firms

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