Financial management and policy chapter 9
-
Upload
winnerbdit -
Category
Documents
-
view
697 -
download
1
Transcript of Financial management and policy chapter 9
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 24
Chapter 9
Capital
Structure
Publi
shed
by w
ww
.lec
ture
shee
t. c
om
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 24
The Target Capital Structure
• Risk—greater risk means greater costs to raise funds
• Financial flexibility—a stronger financial position—that
is, stronger balance sheet—generally implies the firm
is better able to raise funds in the capital markets,
especially in slumping economies
• Managerial attitude (conservatism or
aggressiveness)—some financial managers are more
conservative than others when it comes to using debt,
thus they are inclined to use less debt, all else equal.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 24
The Business Risk
and Financial Risk
• Business Risk—Uncertainty inherent in
projections of future returns (ROE or ROA) if
the firm uses no debt.
• Financial Risk—Additional risk associated with
using debt or preferred stock.
• Beware: The use of debt intensifies the firm’s
business risk borne by the common
stockholders.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 24
The Optimal Capital Structure
EBIT/EPS Analysis
Example: A firm that has no debt and assets equal to
€400,000 can issue debt and repurchase shares of stock at
€10 per share based on the following schedule:
Amount Debt/Asset Cost of Shares of StockEquity of Debt Ratio Debt, kd Outstanding
€400,000 € 0 0.0% 0.0% 40,000
320,000 80,000 20.0 6.0 32,000
240,000 160,000 40.0 9.0 24,000
160,000 240,000 60.0 20.0 16,000
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 24
Determining the Optimal Capital
Structure—EBIT/EPS Analysis
Assuming that operating expenses, such as cost of goods
sold, depreciation, and so forth, are not affected by capital
structure decisions, the firm is expected to generate the
operating income, EBIT, as follows:
Boom 0.1 $200,000
Normal 0.6 120,000
Recession 0.3 40,000
Type of Economy Probability EBIT = NOI
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 24
Determining the Optimal Capital
Structure—EBIT/EPS Analysis
Debt/Assets = 0:Debt = €0 Equity = €400,000 Interest = €0 Shares of stock = €400,000/€10 = 40,000
EBIT €200,000 €120,000 €40,000Interest (_____0) ( 0) ( 0)
Taxable income, EBT 200,000 120,000 40,000
Taxes (40%) ( 80,000) ( 48,000) (16,000)
Net income €120,000 €72,000 €24,000
Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3
EPS = NI/(40,000 shrs) €3.00 €1.80 €0.60
Expected EPS €1.56
sEPS €0.72
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 24
Determining the Optimal Capital
Structure—EBIT/EPS Analysis
EBIT €200,000 €120,000 €40,000Interest ( 4,800) ( 4,800) ( 4,800)
Taxable income, EBT 195,200 115,200 35,200
Taxes (40%) ( 78,080) ( 46,080) (14,080)
Net income €117,120 €69,120 €21,120
Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3
EPS = NI/(32,000 shrs) €3.66 €2.16 €0.66
Expected EPS €1.86
sEPS €0.90
Debt/Assets = 20%:Debt = 0.2(€400,000) = €80,000 Equity = €400,000 - €80,000 = €320,000
Interest = 0.06(€80,000) = €4,800 Shares of stock = €320,000/€10 = 32,000
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 24
Determining the Optimal Capital
Structure—EBIT/EPS Analysis
EBIT €200,000 €120,000 €40,000Interest ( 14,400) ( 14,400) ( 14,400)
Taxable income, EBT 185,600 105,600 25,600
Taxes (40%) ( 74,240) ( 42,240) (10,240)
Net income €111,360 €63,360 €15,360
Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3
EPS = NI/(24,000 shrs) €4.64 €2.64 €0.64
Expected EPS €2.24
sEPS €1.20
Debt/Assets = 40%:Debt = 0.4(€400,000) = €160,000 Equity = €400,000 - €160,000 = €240,000
Interest = 0.09(€160,000) = €14,400 Shares of stock = €240,000/€10 = 24,000
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 24
Determining the Optimal Capital
Structure—EBIT/EPS Analysis
EBIT €200,000 €120,000 €40,000Interest ( 48,000) ( 48,000) ( 48,000)
Taxable income, EBT 152,000 72,000 ( 8,000)
Taxes (40%) ( 60,800) ( 28,800) 3,200
Net income € 91,200 €43,200 ( €4,800)
Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3
EPS = NI/(16,000 shrs) €5.70 €2.70 €(0.30)
Expected EPS €2.10
sEPS €1.80
Debt/Assets = 60%:Debt = 0.6(€400,000) = €240,000 Equity = €400,000 - €240,000 = €160,000
Interest = 0.20(€240,000) = €48,000 Shares of stock = €160,000/€10 = 16,000
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 24
Determining the Optimal Capital
Structure—EBIT/EPS Analysis
Summarizing the results, we have:
0.0% $1.56 $0.72
20.0 1.86 0.90
40.0 2.24 1.20
60.0 2.10 1.80
Proportion Expected Standardof Debt EPS Deviation
0.0% $1.56 $0.72
20.0 1.86 0.90
40.0 2.24 1.20
60.0 2.10 1.80
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 24
EPS Indifference Analysis
0.20
0.40
0.60
0.80
1.00
-0.20
-0.40
2 2.1 2.2
EPS(€)
Sales (€ millions)0
Fixed operating costs = €600,000Variable cost ratio = 70%
100% StockFinancing
40% DebtFinancing
EPS Indifference€2.12 million
0.54
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 24
Capital Structure — Stock Price
• The optimal capital structure is the mix of debt and equity that maximizes the value of the firm—that is, its stock price—not the EPS.
• The proportion of debt in the optimal capital structure will be less than the proportion of debt needed to maximize EPS because the market valuation of the stock, P0, considers the risk associated with the firm’s operations expected well into the future and EPS is based only on the firm’s operations expected for the next few years.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 24
Capital Structure—Stock Price
and the Cost of Equity, ks
The relationship of the cost of equity, ks, and the amount of
debt the firm uses to finance its assets can be illustrated as
follows:
kRF
% Debt inCapital Structure
Required Return onEquity, ks (%)
Risk-free rate of return
ks = kRF + Risk Premium
Total RiskPremium
Premium for business risk at aparticular level of operations
Premium for financial risk
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 24
Capital Structure—Stock Price
and the Cost of Capital, WACC
The relationship of the after-tax cost of debt,
kdT, cost of equity, ks, and WACC might be:
% Debt inCapital Structure
Cost ofCapital, WACC (%) Cost of
equity, ks
After-tax cost of debt, kdT
WACC
MinimumWACC
Optimal Amountof Debt (30%)
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 24
Capital Structure - WACC
• If the firm uses only equity to finance its assets (that is, zero debt is used) then WACC = ks
• As the firm begins to use some debt for financing, WACC declines, primarily because the tax benefit offered by the debt more than offsets the increased cost of equity
• At some point the tax benefit associated with debt is more than offset by increases in the before-tax cost of debt and the cost of equity that result from increases in the risk associated with the additional debt and, at this point, WACC begins to increase
• The point where WACC is the lowest is the optimal capital structure—this is the point where the value of the firm is maximized
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 24
Operating Leverage
• All else equal, if a firm can reduce its operating leverage, it
can use more debt (that is, increase its financial leverage),
and vice versa, and maintain the same degree of risk.
• Degree of operating leverage (DOL) refers to the
percentage change in operating income—designated
either NOI or EBIT—that results from a particular
percentage change in sales.
• DOL can be computed as follows:
EBIT
profit Gross
FVCS
VCS
FV)Q(P
V)Q(P
sales in change%
NOI in change %DOL
Q = number of products (units) the firm currently sellsP = sales price per unitV = variable cost per unitF = fixed operating costsS = current sales stated in dollars such that S = Q PVC = total variable costs of operations such that VC = Q V
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 24
Operating Leverage
Expected Sales = –5%
Outcomeof Expectations % Δ
SalesVariable operating costs (60%)Gross profitFixed operating costsNet operating income = EBIT
Sales $250,000Variable operating costs (60%)Gross profitFixed operating costsNet operating income = EBIT
Sales $250,000Variable operating costs (60%) (150,000)Gross profitFixed operating costsNet operating income = EBIT
Sales $250,000Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costsNet operating income = EBIT
Sales $250,000Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT
Sales $250,000 $237,500Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000
4.0x$25,000
$100,000
EBIT
profit Gross DOL
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000Fixed operating costs (75,000)Net operating income = EBIT 25,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000)Net operating income = EBIT 25,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000)Net operating income = EBIT 25,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0
Sales $250,000Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000
Risk = variability
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 24
Financial Leverage
• Degree of financial leverage refers to the percentage
change in EPS that results from a particular
percentage change in earnings before interest and
taxes, EBIT.
• DFL is computed as follows:
IFVCS
FVCS
IEBIT
EBIT
EBIT in change %
EPS in change %DFL
I = interest paid on debt
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 24
Financial Leverage
Expected Sales = –5%
Outcomeof Expectations % Δ
Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0
InterestEarnings Before TaxesTaxes (40%)Net Income
Interest (12,500)Earnings Before TaxesTaxes (40%)Net Income
Interest (12,500)Earnings Before Taxes 12,500Taxes (40%)Net Income
Interest (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income
Interest (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500
Interest (12,500) (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500
Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500
Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500Taxes (40%) (5,000)Net Income 7,500
Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000)Net Income 7,500
Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000)Net Income 7,500
Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500
Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500
Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500 -40.0
2.0x$12,500
$25,000
$12,500-$25,000
$25,000
I-EBIT
EBIT DFL Risk = variability
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 24
Total Leverage• Degree of total leverage (DTL) refers to the
percentage change in EPS that results from a
particular percentage change in sales.
• DTL combines DOL and DFL, and it is computed
as follows:
IEBIT
profit Gross
IFVCS
VCS
IFV)Q(P
V)Q(P
DFLDOLsales in change %
EPS in change %DTL
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 24
Total Leverage
Expected Sales = –5%
Outcomeof Expectations % ΔSales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500 -40.0
8.0x$12,500
$100,000
$12,500-$25,000
$100,000
I-EBIT
profit Gross DTL
Risk = variability; thus the greater the degree of leverage (operating, financial, or both), the greater the risk associated with the firm
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 24
Liquidity and Capital Structure
A firm might not operate at the optimal capital structure because:
It might be difficult, if not impossible, to determine the optimal capital structure.
Managers might be reluctant to take on the amount of debt necessary to achieve the optimal capital structure—that is, a conservative attitude toward debt might exist.
The firm provides important, needed services, and operating at the optimal mix of capital might endanger the firm’s ability to survive.
Financial liquidity is important to such firms.
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 23 of 24
Capital Structure—Trade-Off Theory• The value of a firm increases as it uses more
and more debt.
• Ignores the costs associated with bankruptcy,
which can be considerable
• If bankruptcy costs are considered, there is a
point where the benefit of the tax deductibility of
debt is more than offset by increases in the cost
of debt and the cost of equity that result from
the risk associated with the firm’s heavy use of
debt
Essentials of Managerial Finance by S. Besley & E. Brigham Slide 24 of 24
Capital Structure—Signaling Theory
• Studies have shown that when firms issue new
common stock to raise funds the per share
value of the stock decreases.
– Perhaps this occurs because managers would only
issue new common stock if they felt that the firm’s
future prospects were unfavorable.
– When debt is issued, only the contracted costs need
to be paid—that is, fixed interest and the repayment
of the debt—and the remaining gains from the
favorable projects accrue to the stockholders.
– Age of a firm—younger firms generally do not have
the same access to financial markets as older, more
established firms