Chapter 15
Capital Structure and Leverage
15-1
What is business risk?
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The riskiness inherent in the firm’s operations if it
uses no debt.
A commonly used measure of business risk is ROIC.
15-2
Determinants and measures of business risk
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There are many factors determining business risk:
– Competition
– Uncertainties about demand, output prices, costs
– Foreign risk exposure
– Regulatory risk and legal exposure, etc.
•
ROIC measures the after-tax return that the company
provides for all its investors.
– ROIC doesn’t vary with changes in capital structure.
15-3
What is financial leverage? Financial risk?
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Financial leverage is the use of debt and preferred
stock.
Financial risk is the additional risk concentrated on
common stockholders as a result of financial leverage.
Financial risk depends only on the types of securities
issued, while business risk depends on business
factors.
– More debt, more financial risk.
– Concentrates business risk on stockholders.
15-4
An Example:
Illustrating Effects of Financial Leverage
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Two firms with the same business risk, and
probability distribution of EBIT.
Only differ with respect to their use of debt (capital
structure).
Firm U
No debt
$20,000 invested capital
40% tax rate
Firm L
$10,000 of 12% debt
$20,000 invested capital
40% tax rate
15-5
Firm U: Unleveraged
Probability
EBIT
Interest
EBT
Taxes (40 %)
NI
Bad
0.25
Economy
Average
0.50
Good
0.25
$2,000
0
$2,000
800
$1,200
$3,000
0
$3,000
1,200
$1,800
$4,000
0
$4,000
1,600
$2,400
15-6
Firm L: Leveraged
Probability*
Bad
0.25
Economy
Average
0.50
Good
0.25
EBIT *
Interest
EBT
Taxes (40%)
NI
$2,000
1,200
$ 800
320
$ 480
$3,000
1,200
$1,800
720
$1,080
$4,000
1,200
$2,800
1,120
$1,680
* The same as for Firm U.
15-7
Ratio Comparison Between Leveraged and
Unleveraged Firms
Firm U
ROIC
ROE
Bad
6.0%
6.0
Average
9.0%
9.0
Good
12.0%
12.0
Firm L
ROIC
ROE
Bad
6.0%
4.8
Average
9.0%
10.8
Good
12.0%
16.8
14-8
Risk and Return for Leveraged and Unleveraged
Firms
Expected values:
E(ROIC)
E(ROE)
Firm U
9.0%
9.0 %
Firm L
9.0%
10.8 %
Firm U
2.12%
2.12%
Firm L
2.12%
4.24%
Risk measures:
ROIC
ROE
15-9
Conclusions
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Return on invested capital (ROIC) is unaffected by
financial leverage.
For leverage to raise expected ROE, ROIC > rd(1 – T).
– If rd(1 – T) > ROIC, then after-tax interest expense
will be higher than the after-tax operating income
produced by debt-financed assets, so leverage will
depress income.
– L has higher expected ROE because ROIC > rd(1 – T).
•
L has much wider ROE swings because of fixed interest
charges. Its higher expected return is accompanied by
higher risk.
15-10
Leverage and cost of capital
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As the firm borrows more money, the firm increases
its financial risk causing the firm’s bond rating to
decrease, and its cost of debt to increase.
The risk of the firm’s equity also increases, resulting in
a higher rs.
− The Hamada equation attempts to quantify the
increased cost of equity due to financial leverage.
bL = bU[1 + (1 – T)(D/E)]
− For example, if total invested capital is $20,000 and
D = $5,000, then E = $15,000. If T = 40% and bU is
1.0, bL = 1.0[1 + (0.6)($5,000/$15,000)] = 1.2.
15-11
Optimal Capital Structure and ModiglianiMiller Irrelevance Theory
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Optimal capital structure is the mix of debt, preferred
and common equity, at which P0 is maximized.
The starting point for analyzing capital structure is a
frictionless financial environment. In this environment
the value of the firm is not affected by its financing
mix. (Modigliani and Miller Irrelevance Theory)
– M&M’s frictionless environment: no income taxes; no
transaction costs of issuing debt or equity securities;
investors can borrow on the same terms as the firm.; the
various stakeholders of the firm are able to costlessly
resolve any conflicts of interest among themselves.
15-12
Example
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Firm U
•
Firm L
– No Debt. EBIT = dividends = $3,000
– 1,000 shares. PV = $3,000/0.15 = $20,000. P0 is $20.
– EBIT = $3,000
– Issued bonds that have a face value of $10,000 at 12%
– PV of bonds = $10,000 (riskless interest rate: 12%)
– Dividends = EBIT – $1,200 = $1,800
– PV of 500 shares is $10,000 according to M&M. P0 of Firm
L is the same as Firm U’s at $20.
13
Example (cont.)
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Since Firm L offers exactly the same future cash flows
as Firm U, the market value of Firm L should be
$20,000, which is the same as Firm U’s.
– Cash flows from Firm L and Firm U:
CFL  Dividends  Interest
 Net Earnings  Interest
 (EBIT  Interest) * (1  t)  Interest
 EBIT  Interest  Interest
CFU  CFL
– For example, suppose Firm L’s stock price is $19 per
share instead of $20. Then, one can replicate or
synthesize Firm U stock by buying proportional
amounts of the stock and bonds of Firm L.
14
Example (cont.)
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Merton Miller explained M-M theory in terms of a pie:
“Think of the firm as a gigantic pizza, divided into quarters.
If you cut each quarter in half into eighths, the M&M
proposition says that you will have more pieces, but not
more pizza.”
Although a share of stock in each of the companies has the
same price, Firm L’s stock has a higher expected return and
higher risk than Firm U’s stock.
− Future EBIT is a random variable. But the interest
payments will be the same regardless of the realized
value of EBIT.
− According to the Hamada equation, if bU is 1, bL is 2 and
rS of Firm L is 1.8. Therefore, P0 of Firm L is $20.
15
Creating Value through Financing Decisions
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In the real world, however, there are many frictions
that make capital structure matter very much. Finding
the optimal capital structure for a corporation involves
making trade-offs that depend on the particular legal
and tax environment.
Ways that management can add value through its
capital structure decisions:
– By its choice of capital structure the firm can reduce
its costs such as taxes or bankruptcy costs.
– By its choice of capital structure the firm can reduce
conflicts of interest among stakeholders in the firm.
16