197.capital structure lecture


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  • Note: for the sake of simplicity we ignore taxes
  • Disadvantage to debt Advantage to debt
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  • 197.capital structure lecture

    1. 1. EBIT/EPS Analysis The tax benefit of debt Trade-off theory Practical considerations in the determination of capital structure CAPITAL STRUCTUR E Lecture 2
    2. 2. Capital structure <ul><li>Issues: </li></ul><ul><li>EBIT-EPS analysis </li></ul><ul><li>The tax shield benefit of debt </li></ul><ul><li>The trade-off theory of capital structure </li></ul><ul><li>P ractical considerations that affect the capital structure decision </li></ul>
    3. 3. Business Risk vs Financial Risk <ul><li>Business risk is the variability of a firm’s E arnings B efore I nterest and T axes ( EBIT ) </li></ul><ul><li>Financial risk arises from the use of d ebt , which imposes a fixed cost in the form of interest payments = financial leverage . </li></ul>
    4. 4. EBIT/ EPS analysis <ul><li>Examine s how different capital structures affect earnings available to shareholders (EPS) and risk </li></ul><ul><li>Question : for different levels of EBIT , how does financial leverage affect EPS ? </li></ul>
    5. 5. Risk and the Income Statement <ul><li> Sales </li></ul><ul><li>Business – Variable costs </li></ul><ul><li>Risk – Fixed costs </li></ul><ul><li> EBIT </li></ul><ul><li>– Interest expense </li></ul><ul><li>Financial Earnings before taxes </li></ul><ul><li>Risk – Taxes </li></ul><ul><li> Net Income </li></ul><ul><li>EPS = Net Income / no. of shares </li></ul>
    6. 6. Current and Proposed Capital Structures <ul><li> CURRENT PROPOSED </li></ul><ul><li>Total assets $100 million $100 million </li></ul><ul><li>Debt 0 million 50 million </li></ul><ul><li>Equity 100 million 50 million </li></ul><ul><li>Share price $25 $25 </li></ul><ul><li>N o. of shares 4,000,000 2,000,000 </li></ul><ul><li>Interest rate 10% 10% </li></ul>Note : for the purpose of simplicity we ignore taxes in this example
    7. 7. CURRENT CAPITAL STRUCTURE No Debt, 4 Million Shares ( m illions o mitted) <ul><li> EBIT 50% EBIT 50% </li></ul><ul><li> BELOW ABOVE </li></ul><ul><li> EXPECTED EXPECTED EXPECTED </li></ul><ul><li>EBIT $6.00 $12.00 $18.00 </li></ul><ul><li>– Int 0.00 0.00 0.00 </li></ul><ul><li>NI $6.00 $12.00 $18.00 </li></ul><ul><li>EPS $ 1.50 $ 3.00 $ 4.50 </li></ul>
    8. 8. <ul><li> EBIT 50% EBIT 50% </li></ul><ul><li> BELOW ABOVE </li></ul><ul><li> EXPECTED EXPECTED EXPECTED </li></ul><ul><li>EBIT $6.00 $12.00 $18.00 </li></ul><ul><li>– Int 5 .00 5 .00 5 .00 </li></ul><ul><li>NI $ 1 .00 $ 7 .00 $1 3 .00 </li></ul><ul><li>EPS $ 0 .50 $ 3. 5 0 $ 6 .50 </li></ul>PROPOSED CAPITAL STRUCTURE 50% Debt (10% Coupon), 2 m illion Shares ( m illions o mitted)
    9. 9. EBIT/ EPS analysis Current versus Proposed Current (no debt) Proposed (with debt) EPS 8 6 4 2 0 -2 -4 3 6 9 10 12 15 18 EBIT For EBIT up to £ 10m, e quity financing is best For EBIT greater than £ 10m, debt financing is best
    10. 10. The impact of financial leverage <ul><li>If EBIT is > 10, the levered capital structure is preferable, ie EPS is higher </li></ul><ul><li>If EBIT is < 10, the unlevered capital structure is preferable </li></ul><ul><li>Conclusion : whether or not debt is beneficial is dependent upon the capacity of firms to generate EBIT </li></ul>
    11. 11. Indifference Level <ul><li>The break-even EBIT o ccurs where the lines cross </li></ul><ul><li>At that level of EBIT both capital structures have the same EPS </li></ul>
    12. 12. <ul><li>Set the two EPS values equal to each other and solve for EBIT: </li></ul><ul><li>Current (unlevered) Proposed (levered) </li></ul><ul><li>(EBIT-I nt )(1- T ) = (EBIT-I nt )(1- T ) </li></ul><ul><li>S S </li></ul><ul><li>Since we assume T=0 </li></ul><ul><li>(EBIT-I nt ) = (EBIT-I nt ) </li></ul><ul><li>S S </li></ul>Breakeven Point
    13. 13. Break-even EBIT ( m illions o mitted)
    14. 14. The impact of financial leverage EPS U 1.5 3.0 4.5 EPS L 0.5 3.5 6.5 Spread U 3.0 Spread L 6.0 … t hat’s RISK EBIT 50% EBIT 50% BELOW ABOVE EXPECTED EXPECTED EXPECTED
    15. 15. The impact of financial leverage <ul><li>Leverage increases EPS if EBIT is high enough. </li></ul><ul><li>At very low levels of EBIT, EPS can be negative – as interest on debt has priority over payments to shareholders. </li></ul><ul><li>Financial leverage produces a broader spread of EPS values, ie shareholders’ returns are less predictable. This represents added RISK . </li></ul>
    16. 16. Summary: EBIT/ EPS analysis <ul><li>Indicates EBIT values when one capital structure may be preferred over another </li></ul><ul><li>Analysis of expected EBIT can focus on the likelihood of actual EBIT exceeding the indifference point </li></ul>
    17. 17. <ul><li>Because interest on debt is deducted from EBIT before the amount of tax paid is calculated, there is a benefit to debt … in the form of lower corporate taxes </li></ul><ul><li>Consider an example … </li></ul>The tax benefit of debt
    18. 18. Firm U nlevered Firm L evered No debt $10,000 of 12% Debt $20,000 Equity $10,000 in Equity 40% tax rate 40% tax rate The tax benefit of debt Both firms have same business risk and EBIT of $3,000. They differ only with respect to use of debt. U has $20K in Eq uity & L has $10K in Eq uity
    19. 19. 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 % Firm U Firm L U; 1.8/20K = 9 % L; 1.08 / 10K = 10.8 % The tax benefit of debt
    20. 20. Why does financial leverag e increase the overall return to investors? <ul><li>I nvestors include both : </li></ul><ul><ul><li>Debt h olders (banks & bondholders) </li></ul></ul><ul><ul><li>S hare holders </li></ul></ul><ul><li>Total return to investors : </li></ul><ul><ul><li>U: NI = $1,800. </li></ul></ul><ul><ul><li>L: NI + Int erest = $1,080 + $1,200 = $2,280. </li></ul></ul><ul><li>Taxes paid : </li></ul><ul><ul><li>U: $1,200 </li></ul></ul><ul><ul><li>L: $720 Difference = $480 </li></ul></ul><ul><li>More EBIT goes to investors in Firm L </li></ul>
    21. 21. <ul><li>Because the Government subsidizes debt, and the tax savings go to the investors. </li></ul><ul><li>The tax savings are called the “ tax shield ” and grows proportionally with the increase of debt . </li></ul>Why does financial leverag e increase the overall return to investors?
    22. 22. <ul><li>Debt v ersus Equity </li></ul><ul><ul><li>Basic point. A firm’s cost of debt is always less than its cost of equity . Why? </li></ul></ul><ul><ul><ul><li>debt has seniority over equity </li></ul></ul></ul><ul><ul><ul><li>debt has a fixed return </li></ul></ul></ul><ul><ul><ul><li>the interest paid on debt is tax-deductible . </li></ul></ul></ul><ul><ul><li>It may appear a firm should use as much debt and as little equity as possible due to the cost difference … but this ignores the potential problems associated with debt. </li></ul></ul>A Basic Capital Structure Theory
    23. 23. A Basic Capital Structure Theory <ul><li>There is a trade-off between the benefits of using debt and the costs of using debt. </li></ul><ul><ul><li>The use of debt creates a tax sh ield benefit from the interest on debt. </li></ul></ul><ul><ul><li>The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing. </li></ul></ul>
    24. 24. <ul><li>The costs of financial distress associated with debt </li></ul><ul><ul><li>Bankruptcy costs including legal and accounting fees and a likely decline in the value of the firm’s assets </li></ul></ul><ul><ul><li>Financial distress may also cause customers, suppliers, and management to take actions harmful to firm value. </li></ul></ul>A Basic Capital Structure Theory
    25. 25. <ul><li>Agency costs arise from conflicts between shareholders and bondholders </li></ul><ul><ul><li>When you lend money to a business, you are allowing the shareholders to use that money in the course of running that business. </li></ul></ul><ul><ul><li>Shareholders interests are different from your interests, because </li></ul></ul><ul><ul><li>You (as lender) are interested in getting your money back </li></ul></ul><ul><ul><li>Shareholders are interested in maximizing their wealth </li></ul></ul>A Basic Capital Structure Theory
    26. 26. <ul><li>Agency costs associated with debt: </li></ul><ul><ul><li>Restrictive covenants meant to protect creditors can reduce firm efficiency. </li></ul></ul><ul><ul><li>Monitoring costs may be expended to insure the firm abides by the restrictive covenants. </li></ul></ul><ul><ul><li>As the level of debt financing increases, the contractual and monitoring costs are expected to increase. </li></ul></ul>A Basic Capital Structure Theory
    27. 27. <ul><li>In addition to the variables described by the trade-off theory of capital structure, a variety of practical considerations also affect a firm’s capital structure decisions: </li></ul><ul><ul><li>Industry standards </li></ul></ul><ul><ul><li>Creditor and rating agency requirements </li></ul></ul><ul><ul><li>Maintaining excess borrowing capacity </li></ul></ul><ul><ul><li>Profitability and the need for funds </li></ul></ul><ul><ul><li>Managerial risk aversion </li></ul></ul><ul><ul><li>Corporate control </li></ul></ul>Capital structure: practical considerations
    28. 28. <ul><li>Industry s tandards </li></ul><ul><ul><li>It is natural to compare a firm’s capital structure to other firms in the same industry. </li></ul></ul><ul><ul><li>Business risk is a significant factor impacting a firm’s capital structure and is heavily influenced by a firm’s industry. </li></ul></ul><ul><ul><li>Evidence indicate firms’ capital structures tend toward an industry average. </li></ul></ul>Practical c onsiderations
    29. 29. <ul><li>Creditor and Rating Agency Requirements </li></ul><ul><ul><li>Firms need to abide by restrictive covenants , which may include restrictions on the amount of future debt. </li></ul></ul><ul><ul><li>Firms typically desire to appear financially strong to potential creditors in order to maintain borrowing capacity and low interest rates. </li></ul></ul><ul><ul><li>Using less debt in capital structure helps to maintain this appearance. </li></ul></ul>Practical c onsiderations
    30. 30. <ul><li>Maintaining Excess Borrowing Capacity </li></ul><ul><ul><li>Successful firms typically maintain excess borrowing capacity. </li></ul></ul><ul><ul><li>This provides financial flexibility to react to investment opportunities. </li></ul></ul><ul><ul><li>The maintenance of excess borrowing capacity causes firms to use less debt in their capital structure than otherwise. </li></ul></ul>Practical c onsiderations
    31. 31. <ul><li>Profitability and the Need for Funds </li></ul><ul><ul><li>Profits can be paid out as dividends to sh areh olders or reinvested in the firm. </li></ul></ul><ul><ul><li>If a firm generates high profits and reinvests a large proportion back into the firm, then it has a continuous source of internal funding. </li></ul></ul><ul><ul><li>This will reduce the use of debt in the firm’s capital structure. </li></ul></ul>Practical c onsiderations
    32. 32. Practical c onsiderations <ul><li>Managerial Risk Aversion </li></ul><ul><ul><li>Well-diversified s hare holders are likely to welcome the use of financial leverage. </li></ul></ul><ul><ul><li>Management wealth is typically much more dependent upon the success of the company acting as their employer. </li></ul></ul><ul><ul><li>To the extent management can act on their own desires, the firm is likely to have less debt in its capital structure than is desired by s hare holders. </li></ul></ul>
    33. 33. Practical c onsiderations <ul><li>Corporate Control </li></ul><ul><ul><li>Controlling owners may desire to issue debt instead of ordinary shares since debt does not grant ownership rights. </li></ul></ul><ul><ul><li>Firms with little financial leverage are often considered excellent takeover targets. </li></ul></ul><ul><ul><li>Issuing more debt may help to avoid a corporate takeover. </li></ul></ul>
    34. 34. <ul><li>EBIT/EPS analysis may be used to help determine whether it would be better to finance a project with debt or equity. </li></ul><ul><li>Firms must trade-off the tax advantage to debt financing against the effect of debt on firm risk . </li></ul><ul><li>Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure . </li></ul>Summary
    35. 35. Homework… <ul><li>EBIT/EPS Analysis </li></ul><ul><li>A company is considering the following two capital structures: </li></ul><ul><ul><li>Plan A: sell 1,200,000 shares at £10 per share ( £ 12 million total) </li></ul></ul><ul><ul><li>Plan B: issue £3.5 million in debt ( 9% coupon) and sell 850,000 shares at £10 per share ( £ 12 million total) </li></ul></ul><ul><li>Assume a corporate tax rate of 50% </li></ul><ul><li>REQUIRED: </li></ul><ul><li>(a) What is the break-even value of EBIT? </li></ul><ul><li>(b) At this break-even value, what is the income statement for each capital structure plan and the EPS? </li></ul><ul><li>(c) Draw a diagram to illustrate the trade-off between EBIT and EPS </li></ul>