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Capital Structure Decisions:
Impact of leverage on returns
Business versus financial risk
Capital structure theory
Perpetual cash flow example
Setting the optimal capital
structure in practice
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Consider Two Hypothetical Firms
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Both firms have same operating leverage,
business risk, and EBIT of $3,000. They
differ only with respect to use of debt.
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Impact of Leverage on Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROE 9.0% 10.8%
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Why does leveraging increase return?
Total dollar return to investors:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Difference = $480.
U: $1,200; L: $720.
Difference = $480.
More EBIT goes to investors in Firm L.
Equity $ proportionally lower than NI.
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What is business risk?
Uncertainty about future operating income
0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects.
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Factors That Influence Business Risk
Uncertainty about demand (unit
Uncertainty about output prices.
Uncertainty about input costs.
Product and other types of liability.
Degree of operating leverage (DOL).
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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
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Higher operating leverage leads to
more business risk, because a small
sales decline causes a larger profit
$ Rev. $ Rev.
TC } Profit
QBE Sales QBE Sales
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Probability Low operating leverage
High operating leverage
In the typical situation, higher
operating leverage leads to higher
expected EBIT, but also increases risk.
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Business Risk versus Financial Risk
Uncertainty in future EBIT.
Depends on business factors such as
competition, operating leverage, etc.
Additional business risk concentrated
on common stockholders when financial
leverage is used.
Depends on the amount of debt and
preferred stock financing.
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From a shareholder’s perspective, how
are financial and business risk
measured in the stand-alone sense?
Stand-alone Business Financial
risk = risk + risk .
Stand-alone risk = sROE.
Business risk = sROE(U).
Financial risk = sROE - sROE(U).
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Now consider the fact that EBIT is not
known with certainty. What is the
impact of uncertainty on stockholder
profitability and risk for Firm U and
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Firm U: Unleveraged
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
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Firm L: Leveraged
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
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Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 8.4% 11.4% 14.4%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
*ROI = (NI + Interest)/Total financing.
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E(BEP) 15.0% 15.0%
E(ROI) 9.0% 11.4%
E(ROE) 9.0% 10.8%
sROE 2.12% 4.24%
CVROE 0.24 0.39
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Basic earning power = BEP =
EBIT/Total assets is unaffected by
L has higher expected ROI and ROE
because of tax savings.
L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return
is accompanied by higher risk. (More...)
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In a stand-alone risk sense, Firm L’s
stockholders see much more risk
than Firm U’s.
U and L: sROE(U) = 2.12%.
U: sROE = 2.12%.
L: sROE = 4.24%.
L’s financial risk is sROE - sROE(U) =
4.24% - 2.12% = 2.12%. (U’s is zero.)
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For leverage to be positive (increase
expected ROE), BEP must be > kd.
If kd > BEP, the cost of leveraging will
be higher than the inherent
profitability of the assets, so the use
of financial leverage will depress net
income and ROE.
In the example, E(BEP) = 15% while
interest rate = 12%, so leveraging
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Capital Structure Theory
Corporate and personal taxes
Debt financing as a managerial
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MM Theory: Zero Taxes
MM prove, under a very restrictive
set of assumptions, that a firm’s
value is unaffected by its financing
Therefore, capital structure is
Any increase in ROE resulting from
financial leverage is exactly offset by
the increase in risk.
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MM Theory: Corporate Taxes
Corporate tax laws favor debt
financing over equity financing.
With corporate taxes, the benefits of
financial leverage exceed the risks:
More EBIT goes to investors and less
to taxes when leverage is used.
Firms should use almost 100% debt
financing to maximize value.
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MM Theory: Corporate and
Personal taxes lessen the advantage
of corporate debt:
Corporate taxes favor debt financing.
Personal taxes favor equity financing.
Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.
Firms should still use 100% debt.
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MM theory ignores bankruptcy
(financial distress) 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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MM assumed that investors and
managers have the same information.
But, managers often have better
information. 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.
Implications for managers?
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Debt Financing As
a Managerial Constraint
One agency problem is that
managers can use corporate funds
for non-value maximizing purposes.
The use of financial leverage:
Bonds “free cash flow.”
Forces discipline on managers.
However, it also increases risk of
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Perpetual Cash Flow Example
Expected EBIT = $500,000; will remain
constant over time.
Firm pays out all earnings as
dividends (zero growth).
Currently is all-equity financed.
100,000 shares outstanding.
P0 = $20; T = 40%.
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Component Cost Estimates
Borrowed (000) kd ks
$ 0 - 15.0%
250 10.0% 15.5
500 11.0 16.5
750 13.0 18.0
1,000 16.0 20.0
If company recapitalizes, debt would be
issued to repurchase stock.
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The MM and Miller models cannot
be applied here because several
assumptions are violated.
kd is not a constant.
Bankruptcy and agency costs
Theory provides some valuable
insights, but because of invalid
assumptions, direct real-world
application is questionable.
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Sequence of Events in a
Firm announces the recapitalization.
Investors reassess their views and
estimate a new equity value.
New debt is issued and proceeds are
used to repurchase stock at the new
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Shares Debt issued
Bought New price/share
After recapitalization firm would have
more debt but fewer common shares
An analysis of several debt levels is
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D = $250, kd = 10%, ks = 15.5%.
(EBIT - kdD)(1 - T)
S1 = ks
[$500 - 0.1($250)](0.6)
= 0.155 = $1,839.
V1 = S1 + D1 = $1,839 + $250 = $2,089.
P1 100 = $20.89.
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= = 11.97.
= n1 = 100 - 11.97 = 88.03.
Check on stock price:
P1 = n = = $20.89.
Other debt levels treated similarly.
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What is the firm’s optimal amount
Debt kd ks P
$250 10% 15.5% $20.89
500 11 16.5 21.18
750 13 18.0 20.92
$500,000 of debt produces the
highest stock price and thus is the
best of the debt levels considered.
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Calculate EPS at debt of $0, $250K,
$500K, and $750K, assuming that the
firm begins at zero debt and recap-
italizes to each level in a single step.
Net income = NI = [EBIT - kd D](1 - T).
EPS = NI/n.
D NI n EPS
$ 0 $300 100.00 $3.00
250 285 88.03 3.24
500 267 76.39 3.50
750 242 64.15 3.77
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EPS continues to increase beyond
the $500,000 optimal debt level.
Does this mean that the optimal
debt level is $750,000, or even
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Find the WACC at each debt level.
D S V kd ks WACC
$ 0 $2,000 $2,000 -- 15.0% 15.0%
250 1,839 2,089 10% 15.5 14.4
500 1,618 2,118 11.0 16.5 14.2
750 1,342 2,092 13.0 18.0 14.3
e.g. D = $250:
WACC = ($250/$2,089)(10%)(0.6)
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The WACC is minimized at D =
$500,000, 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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How would higher or lower
business risk affect
the optimal capital structure?
At any debt level, the firm’s probability
of financial distress would be higher.
Both kd and ks would rise faster than
before. The end result would be an
optimal capital structure with less debt.
Lower business risk would have the
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Is it possible to do an analysis exactly
like the one above for most firms?
No. The analysis above was based
on the assumption of zero growth,
and most firms do not fit this
Further, it would be very difficult, if
not impossible, to estimate ks with
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What type of analysis should firms
conduct to help find their optimal, or
target, capital structure?
Financial forecasting models can
help show how capital structure
changes are likely to affect stock
prices, coverage ratios, and so on.
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Forecasting models can generate
results under various scenarios, but
the financial manager must specify
appropriate input values, interpret
the output, and eventually decide on
a target capital structure.
In the end, capital structure decision
will be based on a combination of
analysis and judgment.
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What other factors would managers
consider when setting the target
Debt ratios of other firms in the
Pro forma coverage ratios at
different capital structures under
different economic scenarios.
Lender and rating agency attitudes
(impact on bond ratings).
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Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible,
and hence suitable as collateral?