•Business Risk vs. Financial Risk•Operating Leverage•Capital Structure Theory
Business Risk, Operating LeverageFinancial Risk, Financial Leverage
Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Probability Low risk High risk 0 E(EBIT) EBIT Note that business risk does not include effect of financial leverage.
Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Competition. Operating leverage.
Operating Leverage is defined as (%change in EBIT)/(%change in sales). Operating leverage is high if the production requires higher fixed costs and low variable costs. High fixed cost can leverage small increase in sales into high increase in EBIT.
More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. $ Rev. $ Rev. TC } Profit TC FC FC QBE Sales QBE Sales
Low operating leverageProbability High operating leverage EBITL EBITH Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.
Business risk: ◦ Uncertainty in future EBIT. It is measured by the CV of EBIT or by the CV of ROE of a firm that does not use debt (or PS) financing. Financial risk: ◦ Additional risk placed on common stockholders when financial leverage is used. It is measured by the increase in the CV of ROE. ◦ Financial risk depends on the amount of debt (or preferred stock) financing the firm uses. 8
Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only differ with respect to their use of debt (capital structure). Firm U Firm L No debt $5,000 of 8% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate
Economic State Probability EBIT Bad 0.20 $500 Average 0.50 $600 Good 0.30 $700
E(EBIT) = Σ EBITi . Pi n 2 EBIT i E ( EBIT ) Pi i 1 CV = σ / E(EBIT) 11
Total risk is the risk born by the stockholders. It is measured by the volatility of ROE. Total Risk = Business Risk + Financial Risk Only firms that use financial leverage (e.g., debt or PS) would have financial risk. Firms that use no financial leverage would have only business risk. These firms’ total risk is equal to their business risk, i.e., the volatility of their ROE would be the same as the volatility of their EBIT. 13
Firm U has only business risk and no financial risk E (ROE) = (0.20)(6%) + (0.50)(9%) + (0.30)(12%) = 9.3% ROE = (6-9.3)2 (0.20) + (9-9.3)2 (0.50) (12-9.3)2 (0.30) = 2.1% CVROE = 2.1% / 9.3% = 0.226 (Total Risk ) 16
Firm L has financial risk in addition to business riskE (ROE) = (0.20)(6%) + (0.50)(12%) + (0.30)(18%) = 12.6% ROE = (6-12.6)2 (0.20) + (12-12.6)2(0.50) (18-12.6)2 (0.30) = 4.2% CVROE = 4.2% / 12.6% = 0.333 (Total Risk) Fin. Risk = Total Risk (0.333) - Bus. Risk (0.115) =0.218 17
CV(U)=0.226 CV(L)=0.333 Probability Firm U Firm L 6% 9% 12% 12% 18% ROEFirm L has a higher expected ROE but it also has morerisk because in addition to business risk it also hasfinancial risk. 18
MM theory ◦ Zero taxes ◦ Corporate taxes Trade-off theory Signaling theory Pecking order 19
MM assume: (1) no transactions costs; (2) individuals can borrow at the same rate as corporations. MM prove that there would be no difference between firms using leverage or investors borrowing and investing (home made leverage). The total values of Firm U and Firm L should be equal: VL = VU Therefore, capital structure is irrelevant. 20
Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms. MM show that the total CF to Firm L’s investors is equal to the total CF to Firm U’s investor plus an additional amount due to interest deductibility: VL = VU + TD If T=40%, then every dollar of debt adds 40 cents of extra value to firm. 22
Value of Firm VL = VU + TD TD VU 0 Financial Leverage Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.
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. 24
Tax ShieldValue of Firm Maximum Firm Value VU VL 0 Financial Leverage Optimal Capital Structure Distress Costs
Choosing the Optimal Capital Structure: A Numerical Example• Currently, the firm is all-equity financed.• Expected EBIT = $200,000.• The firm expects zero growth.• Currently the firm’s rs = 10%; b = 1.0; T = 40%; rRF = 4%; RPM = 6%. 26
Beta changes with leverage. bU is the beta of a firm when it has no debt (the unlevered beta). bL is the beta of a firm when it uses debt financing (leverage). Hamada’s Equation showing the relationship between bL and bU bL = bU [1 + (1 - T)(D/S)] 29
V = FCF / WACC Currently, with no debt: V = $120,000 / 0.10 = $1,200,000 20% debt: V = $120,000 / 0.0956 = $1,255,230 38
30% debt V = $120,000 / 0.0952 = $1,260,504 40% debt: V = $120,000 / 0.0984 = $1,219,512 50% debt V = $120,000 / 0.1055 = $1,137,441 39
wd WACC Corp. Value 0% 10.00% $1,200,00020% 9.56% $1,255,23030% 9.52% $1,260,504 Minimum Maximum40% 9.84% WACC $1,219,512 Value50% 10.55% $1,137,441 The corporation’s value is maximized when WACC is minimized. 40
wd = 30% gives: ◦ Lowest WACC ◦ Highest corporate value But wd = 20% is close. Optimal range is pretty flat between 20% and 30%. 41
Optimal Capital Structure 13.6% rsCost of 12.4%Capital 11.54% 10.90% WACC 10% 10.55% 9.56% 9.84% 9.52% rd(1-T) 7.5% 4.2% 4.8% 6% x 0% 20% 30% 40% 50% Debt/Assets Optimal 42
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? 43
Firms use internally generated funds first, because there are no flotation costs or negative signals. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals. If more funds are needed, firms then issue equity. 44