- Capital Structure Decisions: The Basics. - Capital structure is the manner in which a firm’s assets are financed. - Capital structure is normally expressed as the percentage of each type of capital used by the firm--debt, preferred stock, and common equity. - Business risk is the risk inherent in the operations of the firm, prior to the financing decision. - Thus, business risk is the uncertainty inherent in a total risk sense, future operating income, or earnings before interest and taxes (EBIT).. - Business risk is caused by many factors. - Two of the most important are sales variability and operating leverage. - Financial risk is the risk added by the use of debt financing. - Business risk plus financial risk equals total corporate risk.. - Operating leverage is the extent to which fixed costs are used in a firm’s operations.. - If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high degree of operating leverage. - Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure. - If a high percentage of a firm’s capital structure is in the form of debt and preferred stock, then the firm is said to have a high degree of financial leverage. - This allows the firm some flexibility to use debt in the future when additional capital is needed.. - 16-2 Business risk refers to the uncertainty inherent in projections of future ROE U. - 16-3 Firms with relatively high nonfinancial fixed costs are said to have a high degree of operating leverage.. - Financial leverage has no effect on EBIT--it only affects EPS, given EBIT.. - Such a firm is said to have high business risk. - Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges, and interest payments are fixed charges. - Thus, financial leverage can influence sales and costs, and hence EBIT, if excessive leverage is used.. - 16-8 The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value and stock price. - However, financial distress costs get higher and higher as more and more debt is employed, and these costs eventually offset and begin to outweigh the benefits of debt.. - Since the ROI exceeds the 15 percent cost of capital, this analysis suggests that the firm should go ahead with the change.. - It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one. - According to the standard deviations of ROE, Firm A is the least risky, while C is the most risky. - Firm A’s σ ROE = σ BEP = 5.5%. - Therefore, Firm A uses no financial leverage and has no financial risk. - However, Firm C’s stockholders also have the highest expected ROE.. - Original value of the firm (D = $0):. - With financial leverage (w d =30%):. - Because growth is zero, the value of the company is:. - Increasing the financial leverage by adding $900,000 of debt results in an increase in the firm’s value from to . - Using its target capital structure of 30% debt, the company must have debt of:. - With financial leverage:. - Thus, by adding debt, the firm increased its EPS by $0.342.. - The probability of this occurring is 0.10, or 10 percent.. - The firm’s optimal capital structure is that capital structure which minimizes the firm’s WACC. - Elliott’s WACC is minimized at a capital structure consisting of 40% debt and 60% equity. - At that capital structure, the firm’s WACC is 11.45%.. - The management group owns about 50 percent of the stock, and the stock is traded in the over-the-counter market.. - The firm is currently financed with all equity. - As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:. - PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6 percent.. - Provide a brief overview of capital structure effects. - Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.. - (5) W e And W d are percentages of the firm that are financed with stock and debt.. - The impact of capital structure on value depends upon the effect of debt on: WACC and/or FCF.. - Firm’s can deduct interest expenses. - This reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt. - It can cause reductions in agency costs, because debt “pre-commits,” or “bonds,” free cash flow for use in making interest payments. - Managers know the firm’s future prospects better than investors. - (1) What is business risk? What factors influence a firm's business risk?. - Factors that influence business risk include: uncertainty about demand (unit sales). - degree of operating leverage (DOL).. - (2) what is operating leverage, and how does it affect a firm's business risk? Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10.. - Answer: Operating leverage is the change in EBIT caused by a change in quantity sold. - The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage. - ROE 9.0% 10.8%. - What does this example illustrate about the impact of financial leverage on ROE?. - The firm’s basic earning power, BEP = EBIT/total assets, is unaffected by financial leverage.. - Firm L has the higher expected ROI because of the tax savings effect:. - Therefore, the use of financial leverage has increased the expected profitability to shareholders. - The higher roe results in part from the tax savings and also because the stock is riskier if the firm uses debt.. - The use of debt will increase roe only if ROA exceeds the after-tax cost of debt. - 7.2%, so the use of debt raises roe.. - Explain the difference between financial risk and business risk.. - Answer: Business risk increases the uncertainty in future EBIT. - Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used. - It depends on the amount of debt and preferred stock financing.. - What does this example illustrate about the impact of debt financing on risk and return?. - This example illustrates that financial leverage can increase the expected return to stockholders. - Thus, in a stand-alone risk sense, firm L is twice as risky as firm U--its business risk is 2.12 percent, but its stand-alone risk is 4.24 percent, so its financial risk is 4.24. - What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.. - MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix:. - Therefore, capital structure is irrelevant. - Any increase in roe resulting from financial leverage is exactly offset by the increase in risk (i.e., r s. - With corporate taxes, the benefits of financial leverage exceed the risks because more EBIT goes to investors and less to taxes when leverage is used. - If T=40%, then every dollar of debt adds 40 cents of extra value to firm.. - Miller’s conclusions with personal taxes are that the use of debt financing remains advantageous, but benefits are less than under only corporate taxes. - An optimal capital structure exists that balances these costs and benefits. - This is the trade-off theory.. - The use of financial leverage bonds “free cash flow,” and forces discipline on managers to avoid perks and non-value adding acquisitions.. - A second agency problem is the potential for “underinvestment”. - With the above points in mind, now consider the optimal capital structure for PizzaPalace.. - (1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.. - B u is the beta of a firm when it has no debt (the unlevered beta.) Hamada’s equation provides the beta of a levered firm: B L = B U [1 + (1 - T)(D/S. - (2) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity.. - As this shows, value is maximized at a capital structure with 30% debt.. - Answer: First, find the dollar value of debt and equity. - For example, for w d = 20%, the dollar value of debt is:. - Notice that the value of the equity declines as more debt is issued, because debt is used to repurchase stock. - But the total wealth of shareholders is the value of stock after the recap plus the cash received in repurchase, and this total goes up (it is equal to corporate value on earlier slide).. - The firm issues debt, which changes its WACC, which changes value. - The firm then uses debt proceeds to repurchase stock. - The stock price after debt is issued but before stock is repurchased reflects shareholder wealth, which is the sum of the stock and the cash paid in repurchase.. - S + (D - D 0 ) is the wealth of shareholders’ after the debt is issued but immediately before the repurchase. - Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure?. - Answer: The optimal capital structure is for w d = 30%. - What other factors should managers consider when setting the target capital structure?. - scenarios, lender and rating agency attitudes (i.e., the impact on bond ratings), reserve borrowing capacity, the effects on control (i.e., does the capital structure make it easier of harder for an outsider to take over the firm), the firm’s types of assets (i.e., are they tangible, and hence suitable as collateral?, and the firm’s projected tax rates.
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