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Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
Chapter 13
Leverage and
Capital
Structure
© 2012 Pearson Prentice Hall. All rights reserved. 13-2
Learning Goals
LG1 Discuss leverage, capital structure, breakeven
analysis, the operating breakeven point, and the effect
of changing costs on the breakeven point.
LG2 Understand operating, financial, and total leverage
and the relationships among them.
LG3 Describe the types of capital, external assessment of
capital structure, the capital structure of non-U.S.
firms, and capital structure theory.
© 2012 Pearson Prentice Hall. All rights reserved. 13-3
Learning Goals (cont.)
LG4 Explain the optimal capital structure using a graphical
view of the firm’s cost of capital functions and a zero-
growth valuation model.
LG5 Discuss the EBIT-EPS approach to capital structure.
LG6 Review the return and risk of alternative capital
structures, their linkage to market value, and other
important capital structure considerations related to
capital structure.
© 2012 Pearson Prentice Hall. All rights reserved. 13-4
Leverage
• Leverage refers to the effects that fixed costs have on the
returns that shareholders earn; higher leverage generally
results in higher, but more volatile returns.
– Fixed costs are costs that do not rise and fall with changes in a
firm’s sales. Firms have to pay these fixed costs whether
business conditions are good or bad.
– Generally, leverage magnifies both returns and risks.
• Capital structure is the mix of long-term debt and equity
maintained by the firm.
© 2012 Pearson Prentice Hall. All rights reserved. 13-5
Leverage (cont.)
• Operating leverage is concerned with the relationship
between the firm’s sales revenue and its earnings before
interest and taxes (EBIT) or operating profits.
• Financial leverage is concerned with the relationship
between the firm’s EBIT and its common stock earnings
per share (EPS
• Total leverage is the combined effect of operating and
financial leverage. It is concerned with the relationship
between the firm’s sales revenue and EPS.
© 2012 Pearson Prentice Hall. All rights reserved. 13-6
Table 13.1 General Income Statement
Format and Types of Leverage
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Leverage: Breakeven Analysis
• Breakeven analysis is used to indicate the level of operations
necessary to cover all costs and to evaluate the profitability
associated with various levels of sales; also called cost-volume-
profit analysis.
• The operating breakeven point is the level of sales necessary to
cover all operating costs; the point at which EBIT = $0.
– The first step in finding the operating breakeven point is to divide the cost of
goods sold and operating expenses into fixed and variable operating costs.
– Fixed costs are costs that the firm must pay in a given period regardless of the
sales volume achieved during that period.
– Variable costs vary directly with sales volume.
© 2012 Pearson Prentice Hall. All rights reserved. 13-8
Table 13.2 Operating Leverage,
Costs, and Breakeven Analysis
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Leverage: Breakeven Analysis
(cont.)
Rewriting the algebraic calculations in Table 13.2 as a
formula for earnings before interest and taxes yields:
EBIT = (P  Q) – FC – (VC  Q)
Simplifying yields:
EBIT = Q  (P – VC) – FC
Setting EBIT equal to $0 and solving for Q (the firm’s
breakeven point) yields:
© 2012 Pearson Prentice Hall. All rights reserved. 13-10
Leverage: Breakeven Analysis
(cont.)
Assume that Cheryl’s Posters, a small poster retailer, has
fixed operating costs of $2,500. Its sale price is $10 per
poster, and its variable operating cost is $5 per poster. What
is the firm’s breakeven point?
© 2012 Pearson Prentice Hall. All rights reserved. 13-11
Figure 13.1
Breakeven Analysis
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Table 13.3 Sensitivity of Operating Breakeven
Point to Increases in Key Breakeven Variables
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Leverage: Breakeven Analysis
(cont.)
Assume that Cheryl’s Posters wishes to evaluate the impact of several
options: (1) increasing fixed operating costs to $3,000, (2) increasing
the sale price per unit to $12.50, (3) increasing the variable operating
cost per unit to $7.50, and (4) simultaneously implementing all three
of these changes.
1. Operating breakeven point = $3,000/($10 – $5) = 600 units
2. Operating breakeven point = $2,500/($12.50 – $5) = 333.33 units
3. Operating breakeven point = $2,500/($10 – $7.50) = 1,000 units
4. Operating breakeven point = $3,000/($12.50 – $7.50) = 600 units
© 2012 Pearson Prentice Hall. All rights reserved. 13-14
Personal Finance Example
Rick Polo is considering having a new fuel-saving device installed in
his car. The installed cost of the device is $240 paid up-front, plus a
monthly fee of $15. He can terminate use of the device any time
without penalty. Rick estimates that the device will reduce his average
monthly gas consumption by 20%, which, assuming no change in his
monthly mileage, translates into a savings of about $28 per month. He
is planning to keep the car for 2 more years and wishes to determine
whether he should have the device installed in his car.
Breakeven point = $240/($28 – $15) = $240/$13 = 18.5 months
© 2012 Pearson Prentice Hall. All rights reserved. 13-15
Leverage: Operating Leverage
Operating leverage is the use of fixed operating costs to
magnify the effects of changes in sales on the firm’s
earnings before interest and taxes.
The figure on the following slide uses the data for Cheryl’s
Posters (sale price, P = $10 per unit; variable operating cost,
VC = $5 per unit; fixed operating cost, FC = $2,500)
© 2012 Pearson Prentice Hall. All rights reserved. 13-16
Figure 13.2 Breakeven analysis
and operating leverage
© 2012 Pearson Prentice Hall. All rights reserved. 13-17
Table 13.4 The EBIT for Various
Sales Levels
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Leverage: Operating Leverage
(cont.)
The degree of operating leverage (DOL) is the numerical
measure of the firm’s operating leverage.
As long as DOL is greater than 1, there is operating
leverage.
© 2012 Pearson Prentice Hall. All rights reserved. 13-19
Leverage: Operating Leverage
(cont.)
Applying the degree of operating leverage equation
to cases 1 and 2 in Table 13.4 yields the following
results:
© 2012 Pearson Prentice Hall. All rights reserved. 13-20
Leverage: Operating Leverage
(cont.)
A more direct formula for calculating the degree of
operating leverage at a base sales level, Q, is the following:
Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500
into the above equation yields the following result:
© 2012 Pearson Prentice Hall. All rights reserved. 13-21
Focus on Practice
Adobe’s Leverage
– Adobe Systems, the second largest PC software company in the
United States, dominates the graphic design, imaging, dynamic media,
and authoring-tool software markets.
– As demonstrated in the following table, operating leverage magnified
Adobe’s increase in EBIT in 2007 while magnifying the decrease in
EBIT in 2009.
– A 22.6% increase in 2007 sales resulted in EBIT growth of 39.7%.
– In 2008, EBIT increased just a little faster than sales did, but in 2009
as the economy endured a severe recession, Adobe revenues plunged
17.7%. The effect of operating leverage was that EBIT declined even
faster, posting a –35.3% drop.
© 2012 Pearson Prentice Hall. All rights reserved. 13-22
Focus on Practice (cont.)
Adobe’s Leverage
© 2012 Pearson Prentice Hall. All rights reserved. 13-23
Leverage: Operating Leverage
(cont.)
Assume that Cheryl’s Posters exchanges a portion of its
variable operating costs for fixed operating costs by
eliminating sales commissions and increasing sales salaries.
This exchange results in a reduction in the variable
operating cost per unit from $5 to $4.50 and an increase in
the fixed operating costs from $2,500 to $3,000.
© 2012 Pearson Prentice Hall. All rights reserved. 13-24
Table 13.5 Operating Leverage
and Increased Fixed Costs
© 2012 Pearson Prentice Hall. All rights reserved. 13-25
Leverage: Financial Leverage
Financial leverage is the use of fixed financial costs to
magnify the effects of changes in earnings before interest
and taxes on the firm’s earnings per share.
The two most common fixed financial costs are (1) interest
on debt and (2) preferred stock dividends.
© 2012 Pearson Prentice Hall. All rights reserved. 13-26
Leverage: Financial Leverage
(cont.)
Chen Foods, a small Asian food company, expects EBIT of
$10,000 in the current year. It has a $20,000 bond with a
10% (annual) coupon rate of interest and an issue of 600
shares of $4 (annual dividend per share) preferred stock
outstanding. It also has 1,000 shares of common stock
outstanding. The annual interest on the bond issue is $2,000
(0.10  $20,000). The annual dividends on the preferred
stock are $2,400 ($4.00/share  600 shares).
© 2012 Pearson Prentice Hall. All rights reserved. 13-27
Table 13.6 The EPS for Various
EBIT Levels
© 2012 Pearson Prentice Hall. All rights reserved. 13-28
Leverage: Financial Leverage
(cont.)
The degree of financial leverage (DFL) is the numerical
measure of the firm’s financial leverage.
Whenever DFL is greater than 1, there is financial leverage.
© 2012 Pearson Prentice Hall. All rights reserved. 13-29
Leverage: Financial Leverage
(cont.)
Applying the degree of financial leverage equation to cases
1 and 2 in Table 13.6 yields the following results:
© 2012 Pearson Prentice Hall. All rights reserved. 13-30
Personal Finance Example
Shanta and Ravi Shandra wish to assess the impact of additional long-
term borrowing on their degree of financial leverage (DFL). The
Shandras currently have $4,200 available after meeting all of their
monthly living (operating) expenses, before making monthly loan
payments. They currently have monthly loan payment obligations of
$1,700 and are considering the purchase of a new car, which would
result in a $500 per month increase (to $2,200) in their total monthly
loan payments. Because a large portion of Ravi’s monthly income
represents commissions, the Shandras feel that the $4,200 per month
currently available for making loan payments could vary by 20%
above or below that amount.
© 2012 Pearson Prentice Hall. All rights reserved. 13-31
Personal Finance Example
(cont.)
© 2012 Pearson Prentice Hall. All rights reserved. 13-32
Leverage: Financial Leverage
(cont.)
A more direct formula for calculating the degree of financial
leverage at a base level of EBIT is the following:
Note that in the denominator, the term 1/(1 – T) converts the
after-tax preferred stock dividend to a before-tax amount for
consistency with the other terms in the equation.
© 2012 Pearson Prentice Hall. All rights reserved. 13-33
Leverage: Financial Leverage
(cont.)
Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and
the tax rate (T = 0.40) into the previous equation yields:
© 2012 Pearson Prentice Hall. All rights reserved. 13-34
Leverage: Total Leverage
Total leverage is the use of fixed costs, both
operating and financial, to magnify the effects of
changes in sales on the firm’s earnings per share.
© 2012 Pearson Prentice Hall. All rights reserved. 13-35
Leverage: Total Leverage
(cont.)
Cables Inc., a computer cable manufacturer, expects sales of
20,000 units at $5 per unit in the coming year and must meet
the following obligations: variable operating costs of $2 per
unit, fixed operating costs of $10,000, interest of $20,000,
and preferred stock dividends of $12,000. The firm is in the
40% tax bracket and has 5,000 shares of common stock
outstanding.
© 2012 Pearson Prentice Hall. All rights reserved. 13-36
Table 13.7
The Total Leverage Effect
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Leverage: Total Leverage
(cont.)
The degree of total leverage (DTL) is the numerical
measure of the firm’s total leverage.
As long as the DTL is greater than 1, there is total leverage.
© 2012 Pearson Prentice Hall. All rights reserved. 13-38
Leverage: Total Leverage
(cont.)
Applying the degree of total leverage equation to the
data in Table 13.7 yields the following:
© 2012 Pearson Prentice Hall. All rights reserved. 13-39
Leverage: Total Leverage
(cont.)
A more direct formula for calculating the degree of total
leverage at a given base level of sales, Q, is given by the
following equation:
© 2012 Pearson Prentice Hall. All rights reserved. 13-40
Leverage: Total Leverage
(cont.)
Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000,
I = $20,000, PD = $12,000, and the tax rate (T = 0.40) into
the previous equation yields:
© 2012 Pearson Prentice Hall. All rights reserved. 13-41
Leverage: Relationship of Operating,
Financial, and Total Leverage
Total leverage reflects the combined impact of operating and
financial leverage on the firm.
High operating leverage and high financial leverage will
cause total leverage to be high. The opposite will also be
true.
The relationship between operating leverage and financial
leverage is multiplicative rather than additive.
DTL = DOL  DFL
© 2012 Pearson Prentice Hall. All rights reserved. 13-42
Leverage: Relationship of Operating,
Financial, and Total Leverage (cont.)
Substituting the values calculated for DOL and DFL, shown
on the right-hand side of Table 13.7, into the previous
equation yields
DTL = 1.2  5.0 = 6.0
© 2012 Pearson Prentice Hall. All rights reserved. 13-43
Focus on Ethics
Repo 105
– By early 2008, Lehman Brothers had $32 in debt for each $1 in equity.
– Lehman used off-balance sheet transactions hide the extent of its
indebtednesses.
– Repo 105 transactions enabled Lehman to reduce both total liabilities and
total assets and allowed the firm to report lower leverage ratios. With the start
of a new quarter, Lehman would unwind the transactions and restore the
liabilities to their balance sheet.
– Assume that Lehman’s Repo 105 transactions fall within the limits allowed
by Generally Accepted Accounting Principles as Lehman’s management has
argued. What are the ethical implications of undertaking transactions
expressly to temporarily hide how much money a firm has borrowed?
© 2012 Pearson Prentice Hall. All rights reserved. 13-44
The Firm’s Capital Structure:
Types of Capital
All of the items on the right-hand side of the firm’s balance sheet,
excluding current liabilities, are sources of capital. The following
simplified balance sheet illustrates the basic breakdown of total capital
into its two components, debt capital and equity capital.
© 2012 Pearson Prentice Hall. All rights reserved. 13-45
The Firm’s Capital Structure:
Types of Capital (cont.)
• The cost of debt is lower than the cost of other forms of financing.
• Lenders demand relatively lower returns because they take the least
risk of any contributors of long-term capital.
• Lenders have a higher priority of claim against any earnings or
assets available for payment, and they can exert far greater legal
pressure against the company to make payment than can owners of
preferred or common stock.
• The tax deductibility of interest payments also lowers the debt cost
to the firm substantially.
© 2012 Pearson Prentice Hall. All rights reserved. 13-46
The Firm’s Capital Structure:
Types of Capital (cont.)
• Unlike debt capital, which the firm must eventually repay, equity
capital remains invested in the firm indefinitely—it has no maturity
date.
• The two basic sources of equity capital are (1) preferred stock and
(2) common stock equity, which includes common stock and
retained earnings.
• Common stock is typically the most expensive form of equity,
followed by retained earnings and then preferred stock.
• Whether the firm borrows very little or a great deal, it is always true
that the claims of common stockholders are riskier than those of
lenders, so the cost of equity always exceeds the cost of debt.
© 2012 Pearson Prentice Hall. All rights reserved. 13-47
The Firm’s Capital Structure:
External Assessment of Capital Structure
• A direct measure of the degree of indebtedness is the debt ratio
(total liabilities ÷ total assets).
– The higher this ratio is, the greater the relative amount of debt (or financial
leverage) in the firm’s capital structure.
• Measures of the firm’s ability to meet contractual payments
associated with debt include the times interest earned ratio
(EBIT ÷ interest) and the fixed-payment coverage ratio.
• The level of debt (financial leverage) that is acceptable for one
industry or line of business can be highly risky in another, because
different industries and lines of business have different operating
characteristics.
© 2012 Pearson Prentice Hall. All rights reserved. 13-48
Table 13.8 Debt Ratios for Selected
Industries and Lines of Business
© 2012 Pearson Prentice Hall. All rights reserved. 13-49
Personal Finance Example
Assume that the Loo family is applying for a mortgage loan.
The family’s monthly gross (before-tax) income is $5,380,
and they currently have monthly installment loan obligations
that total $560. The $200,000 mortgage loan they are
applying for will require monthly payments of $1,400.
Mort. pay./Gross income = $1,400/$5,380 = 26%
Tot. instal. pay./Gross income = ($560 + $1,400)/$5,380
= $1,960/$5,380 = 36.4%
© 2012 Pearson Prentice Hall. All rights reserved. 13-50
The Firm’s Capital Structure:
Capital Structure of Non-U.S. Firms
In general, non-U.S. companies have much higher degrees
of indebtedness than their U.S. counterparts.
– Most of the reasons relate to the fact that U.S. capital markets
are more developed than those elsewhere and have played a
greater role in corporate financing than has been the case in
other countries.
© 2012 Pearson Prentice Hall. All rights reserved. 13-51
The Firm’s Capital Structure:
Capital Structure of Non-U.S. Firms
On the other hand, similarities do exist between U.S.
corporations and corporations in other countries.
– First, the same industry patterns of capital structure tend to be
found all around the world.
– Second, the capital structures of the largest U.S.-based
multinational companies, which have access to capital markets
around the world, typically resemble the capital structures of
multinational companies from other countries more than they
resemble those of smaller U.S. companies.
– Finally, the worldwide trend is away from reliance on banks for
financing and toward greater reliance on security issuance.
© 2012 Pearson Prentice Hall. All rights reserved. 13-52
Matter of Fact
Leverage Around the World
– A recent study of the use of long-term debt in 42 countries found
that firms in Argentina used more long-term debt than firms in
any other country.
– Relative to their assets, firms in Argentina used almost 60%
more long-term debt than did U.S. companies.
– Indian firms were heavy users of long-term debt as well. At the
other end of the spectrum, companies from Italy, Greece, and
Poland used very little long-term debt. In those countries, firms
used only about 40% as much long-term debt as did their U.S.
counterparts.
© 2012 Pearson Prentice Hall. All rights reserved. 13-53
The Firm’s Capital Structure:
Capital Structure Theory
• Research suggests that there is an optimal capital structure
range.
• It is not yet possible to provide financial managers with a
precise methodology for determining a firm’s optimal
capital structure.
• Nevertheless, financial theory does offer help in
understanding how a firm’s capital structure affects the
firm’s value.
© 2012 Pearson Prentice Hall. All rights reserved. 13-54
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
In 1958, Franco Modigliani and Merton H. Miller
(commonly known as “M and M”) demonstrated
algebraically that, assuming perfect markets, the capital
structure that a firm chooses does not affect its value.
© 2012 Pearson Prentice Hall. All rights reserved. 13-55
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Many researchers, including M and M, have examined the
effects of less restrictive assumptions on the relationship
between capital structure and the firm’s value.
– The result is a theoretical optimal capital structure based on balancing
the benefits and costs of debt financing.
– The major benefit of debt financing is the tax shield, which allows
interest payments to be deducted in calculating taxable income.
– The cost of debt financing results from (1) the increased probability of
bankruptcy caused by debt obligations, (2) the agency costs of the
lender’s constraining the firm’s actions, and (3) the costs associated
with managers having more information about the firm’s prospects
than do investors.
© 2012 Pearson Prentice Hall. All rights reserved. 13-56
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Tax Benefits
– Allowing firms to deduct interest payments on debt when
calculating taxable income reduces the amount of the firm’s
earnings paid in taxes, thereby making more earnings available
for bondholders and stockholders.
– The deductibility of interest means the cost of debt, ri, to the
firm is subsidized by the government.
– Letting rd equal the before-tax cost of debt and letting T equal
the tax rate, from Chapter 9, we have ri = rd  (1 – T).
© 2012 Pearson Prentice Hall. All rights reserved. 13-57
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Probability of Bankruptcy
– The chance that a firm will become bankrupt because of an inability to meet
its obligations as they come due depends largely on its level of both business
risk and financial risk.
– Business risk is the risk to the firm of being unable to cover its operating
costs.
– In general, the greater the firm’s operating leverage—the use of fixed
operating costs—the higher its business risk.
– Although operating leverage is an important factor affecting business risk,
two other factors—revenue stability and cost stability—also affect it.
– Firms with high business risk therefore tend toward less highly leveraged
capital structures, and firms with low business risk tend toward more highly
leveraged capital structures.
© 2012 Pearson Prentice Hall. All rights reserved. 13-58
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Cooke Company, a soft drink manufacturer, is preparing to make a
capital structure decision. It has obtained estimates of sales and the
associated levels of earnings before interest and taxes (EBIT) from its
forecasting group: There is a 25% chance that sales will total
$400,000, a 50% chance that sales will total $600,000, and a 25%
chance that sales will total $800,000. Fixed operating costs total
$200,000, and variable operating costs equal 50% of sales. These data
are summarized, and the resulting EBIT calculated, in the following
table:
© 2012 Pearson Prentice Hall. All rights reserved. 13-59
Table 13.9 Sales and Associated EBIT
Calculations for Cooke Company ($000)
© 2012 Pearson Prentice Hall. All rights reserved. 13-60
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Probability of Bankruptcy
– The firm’s capital structure directly affects its financial risk,
which is the risk to the firm of being unable to cover required
financial obligations.
– The penalty for not meeting financial obligations is bankruptcy.
– The more fixed-cost financing—debt (including financial leases)
and preferred stock—a firm has in its capital structure, the
greater its financial leverage and risk.
– The total risk of a firm—business and financial risk combined—
determines its probability of bankruptcy.
© 2012 Pearson Prentice Hall. All rights reserved. 13-61
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Cooke Company’s current capital structure is as
follows:
© 2012 Pearson Prentice Hall. All rights reserved. 13-62
Table 13.10 Capital Structures Associated with
Alternative Debt Ratios for Cooke Company
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Table 13.11 Level of Debt, Interest Rate, and Dollar
Amount of Annual Interest Associated with Cooke
Company’s Alternative Capital Structures
© 2012 Pearson Prentice Hall. All rights reserved. 13-64
Table 13.12a Calculation of EPS for Selected
Debt Ratios ($000) for Cooke Company
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Table 13.12b Calculation of EPS for Selected
Debt Ratios ($000) for Cooke Company
© 2012 Pearson Prentice Hall. All rights reserved. 13-66
Table 13.12c Calculation of EPS for Selected
Debt Ratios ($000) for Cooke Company
© 2012 Pearson Prentice Hall. All rights reserved. 13-67
Table 13.13 Expected EPS, Standard Deviation,
and Coefficient of Variation for Alternative
Capital Structures for Cooke Company
© 2012 Pearson Prentice Hall. All rights reserved. 13-68
Figure 13.3
Probability Distributions
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Figure 13.4 Expected EPS and
Coefficient of Variation of EPS
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The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Agency Costs Imposed by Lenders
– As noted in Chapter 1, the managers of firms typically act as
agents of the owners (stockholders).
– The owners give the managers the authority to manage the firm
for the owners’ benefit.
– The agency problem created by this relationship extends not
only to the relationship between owners and managers but also
to the relationship between owners and lenders.
– To avoid this situation, lenders impose certain monitoring
techniques on borrowers, who as a result incur agency costs.
© 2012 Pearson Prentice Hall. All rights reserved. 13-71
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
Asymmetric Information
– Asymmetric information is the situation in which managers of
a firm have more information about operations and future
prospects than do investors.
– A pecking order is a hierarchy of financing that begins with
retained earnings, which is followed by debt financing and
finally external equity financing.
– A signal is a financing action by management that is believed to
reflect its view of the firm’s stock value; generally, debt
financing is viewed as a positive signal that management
believes the stock is “undervalued,” and a stock issue is viewed
as a negative signal that management believes the stock is
“overvalued.”
© 2012 Pearson Prentice Hall. All rights reserved. 13-72
The Firm’s Capital Structure:
Capital Structure Theory (cont.)
What, then, is the optimal capital structure, even if it exists (so far)
only in theory?
– Because the value of a firm equals the present value of its future cash flows,
it follows that the value of the firm is maximized when the cost of capital is
minimized.
where
EBIT = earnings before interest and taxes
T = tax rate
NOPAT = net operating profits after taxes, which is the after-tax operating
earnings available to the debt and equity holders, EBIT  (1 – T)
ra = weighted average cost of capital
© 2012 Pearson Prentice Hall. All rights reserved. 13-73
Figure 13.5
Cost Functions and Value
© 2012 Pearson Prentice Hall. All rights reserved. 13-74
EBIT-EPS Approach to Capital
Structure
The EBIT–EPS approach is an approach for selecting the
capital structure that maximizes earnings per share (EPS)
over the expected range of earnings before interest and taxes
(EBIT).
© 2012 Pearson Prentice Hall. All rights reserved. 13-75
EBIT-EPS Approach to Capital
Structure (cont.)
We can plot coordinates on the EBIT–EPS graph by
assuming specific EBIT values and calculating the EPS
associated with them. Such calculations for three capital
structures—debt ratios of 0%, 30%, and 60%—for Cooke
Company were presented in Table 13.12. For EBIT values
of $100,000 and $200,000, the associated EPS values
calculated there are summarized in the table below the graph
in Figure 13.6.
© 2012 Pearson Prentice Hall. All rights reserved. 13-76
Figure 13.6
EBIT–EPS Approach
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EBIT-EPS Approach to Capital Structure:
Considering Risk in EBIT-EPS Analysis
• When interpreting EBIT–EPS analysis, it is important to consider
the risk of each capital structure alternative.
• Graphically, the risk of each capital structure can be viewed in light
of two measures:
1. the financial breakeven point (EBIT-axis intercept)
2. the degree of financial leverage reflected in the slope of the capital
structure line: The higher the financial breakeven point and the steeper the
slope of the capital structure line, the greater the financial risk.
© 2012 Pearson Prentice Hall. All rights reserved. 13-78
EBIT-EPS Approach to Capital Structure:
Basic Shortcoming of EBIT-EPS Analysis
• The most important point to recognize when using EBIT–EPS
analysis is that this technique tends to concentrate on maximizing
earnings rather than maximizing owner wealth as reflected in the
firm’s stock price.
• The use of an EPS-maximizing approach generally ignores risk.
• Because risk premiums increase with increases in financial
leverage, the maximization of EPS does not ensure owner wealth
maximization.
© 2012 Pearson Prentice Hall. All rights reserved. 13-79
Choosing the Optimal Capital
Structure: Linkage
• To determine the firm’s value under alternative capital structures,
the firm must find the level of return that it must earn to
compensate owners for the risk being incurred.
• The required return associated with a given level of financial risk
can be estimated in a number of ways.
– Theoretically, the preferred approach would be first to estimate the beta
associated with each alternative capital structure and then to use the CAPM
framework to calculate the required return, rs.
– A more operational approach involves linking the financial risk associated
with each capital structure alternative directly to the required return.
© 2012 Pearson Prentice Hall. All rights reserved. 13-80
Table 13.14 Required Returns for Cooke
Company’s Alternative Capital Structures
© 2012 Pearson Prentice Hall. All rights reserved. 13-81
Choosing the Optimal Capital
Structure: Estimating Value
• The value of the firm associated with alternative capital structures
can be estimated by using one of the standard valuation models,
such as the zero-growth model.
• Although some relationship exists between expected profit and
value, there is no reason to believe that profit-maximizing strategies
necessarily result in wealth maximization.
• It is therefore the wealth of the owners as reflected in the estimated
share value that should serve as the criterion for selecting the best
capital structure.
© 2012 Pearson Prentice Hall. All rights reserved. 13-82
Table 13.15 Calculation of Share Value
Estimates Associated with Alternative Capital
Structures for Cooke Company
© 2012 Pearson Prentice Hall. All rights reserved. 13-83
Figure 13.7 Estimated share value and EPS for
alternative capital structures for Cooke
Company
© 2012 Pearson Prentice Hall. All rights reserved. 13-84
Table 13.16a Important Factors to Consider in
Making Capital Structure Decisions
© 2012 Pearson Prentice Hall. All rights reserved. 13-85
Table 13.16b Important Factors to Consider in
Making Capital Structure Decisions
© 2012 Pearson Prentice Hall. All rights reserved. 13-86
Review of Learning Goals
LG1 Discuss leverage, capital structure, breakeven
analysis, the operating breakeven point, and the effect
of changing costs on it.
– Leverage results from the use of fixed costs to magnify
returns to a firm’s owners. Capital structure, the firm’s mix
of long-term debt and equity, affects leverage and therefore
the firm’s value. Breakeven analysis measures the level of
sales necessary to cover total operating costs. The operating
breakeven point increases with increased fixed and variable
operating costs and decreases with an increase in sale price,
and vice versa.
© 2012 Pearson Prentice Hall. All rights reserved. 13-87
Review of Learning Goals
(cont.)
LG2 Understand operating, financial, and total leverage and the
relationships among them.
– Operating leverage is the use of fixed operating costs by the firm to
magnify the effects of changes in sales on EBIT. The higher the fixed
operating costs, the greater the operating leverage. Financial leverage is
the use of fixed financial costs by the firm to magnify the effects of
changes in EBIT on EPS. The higher the fixed financial costs, the
greater the financial leverage. The total leverage of the firm is the use of
fixed costs—both operating and financial—to magnify the effects of
changes in sales on EPS.
© 2012 Pearson Prentice Hall. All rights reserved. 13-88
Review of Learning Goals
(cont.)
LG3 Describe the types of capital, external assessment of capital
structure, the capital structure of non-U.S. firms, and capital
structure theory.
– Debt capital and equity capital make up a firm’s capital structure.
Capital structure can be externally assessed by using financial ratios—
debt ratio, times interest earned ratio, and fixed-payment coverage ratio.
Non-U.S. companies tend to have much higher degrees of indebtedness
than do their U.S. counterparts, primarily because U.S. capital markets
are more developed.
– Research suggests that there is an optimal capital structure that balances
the firm’s benefits and costs of debt financing. The major benefit of debt
financing is the tax shield. The costs of debt financing include the
probability of bankruptcy, agency costs imposed by lenders, and
asymmetric information.
© 2012 Pearson Prentice Hall. All rights reserved. 13-89
Review of Learning Goals
(cont.)
LG4 Explain the optimal capital structure using a graphical view of
the firm’s cost-of-capital functions and a zero-growth valuation
model.
– The zero-growth valuation model defines the firm’s value as its net
operating profits after taxes (NOPAT), or after-tax EBIT, divided by its
weighted average cost of capital. Assuming that NOPAT is constant, the
value of the firm is maximized by minimizing its weighted average cost
of capital (WACC). The optimal capital structure minimizes the WACC.
Graphically, the firm’s WACC exhibits a U-shape, whose minimum
value defines the optimal capital structure that maximizes owner
wealth.
© 2012 Pearson Prentice Hall. All rights reserved. 13-90
Review of Learning Goals
(cont.)
LG5 Discuss the EBIT–EPS approach to capital structure.
– The EBIT–EPS approach evaluates capital structures in
light of the returns they provide the firm’s owners and their
degree of financial risk. Under the EBIT–EPS approach,
the preferred capital structure is the one that is expected to
provide maximum EPS over the firm’s expected range of
EBIT. Graphically, this approach reflects risk in terms of
the financial breakeven point and the slope of the capital
structure line. The major shortcoming of EBIT–EPS
analysis is that it concentrates on maximizing earnings
(returns) rather than owners’ wealth, which considers risk as
well as return.
© 2012 Pearson Prentice Hall. All rights reserved. 13-91
Review of Learning Goals
(cont.)
LG6 Review the return and risk of alternative capital structures,
their linkage to market value, and other important
considerations related to capital structure.
– The best capital structure can be selected by using a valuation model to
link return and risk factors. The preferred capital structure is the one
that results in the highest estimated share value, not the highest EPS.
Other important nonquantitative factors must also be considered when
making capital structure decisions.
© 2012 Pearson Prentice Hall. All rights reserved. 13-92
Chapter Resources on
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capital structure and leverage.pdf

  • 1. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 13 Leverage and Capital Structure
  • 2. © 2012 Pearson Prentice Hall. All rights reserved. 13-2 Learning Goals LG1 Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on the breakeven point. LG2 Understand operating, financial, and total leverage and the relationships among them. LG3 Describe the types of capital, external assessment of capital structure, the capital structure of non-U.S. firms, and capital structure theory.
  • 3. © 2012 Pearson Prentice Hall. All rights reserved. 13-3 Learning Goals (cont.) LG4 Explain the optimal capital structure using a graphical view of the firm’s cost of capital functions and a zero- growth valuation model. LG5 Discuss the EBIT-EPS approach to capital structure. LG6 Review the return and risk of alternative capital structures, their linkage to market value, and other important capital structure considerations related to capital structure.
  • 4. © 2012 Pearson Prentice Hall. All rights reserved. 13-4 Leverage • Leverage refers to the effects that fixed costs have on the returns that shareholders earn; higher leverage generally results in higher, but more volatile returns. – Fixed costs are costs that do not rise and fall with changes in a firm’s sales. Firms have to pay these fixed costs whether business conditions are good or bad. – Generally, leverage magnifies both returns and risks. • Capital structure is the mix of long-term debt and equity maintained by the firm.
  • 5. © 2012 Pearson Prentice Hall. All rights reserved. 13-5 Leverage (cont.) • Operating leverage is concerned with the relationship between the firm’s sales revenue and its earnings before interest and taxes (EBIT) or operating profits. • Financial leverage is concerned with the relationship between the firm’s EBIT and its common stock earnings per share (EPS • Total leverage is the combined effect of operating and financial leverage. It is concerned with the relationship between the firm’s sales revenue and EPS.
  • 6. © 2012 Pearson Prentice Hall. All rights reserved. 13-6 Table 13.1 General Income Statement Format and Types of Leverage
  • 7. © 2012 Pearson Prentice Hall. All rights reserved. 13-7 Leverage: Breakeven Analysis • Breakeven analysis is used to indicate the level of operations necessary to cover all costs and to evaluate the profitability associated with various levels of sales; also called cost-volume- profit analysis. • The operating breakeven point is the level of sales necessary to cover all operating costs; the point at which EBIT = $0. – The first step in finding the operating breakeven point is to divide the cost of goods sold and operating expenses into fixed and variable operating costs. – Fixed costs are costs that the firm must pay in a given period regardless of the sales volume achieved during that period. – Variable costs vary directly with sales volume.
  • 8. © 2012 Pearson Prentice Hall. All rights reserved. 13-8 Table 13.2 Operating Leverage, Costs, and Breakeven Analysis
  • 9. © 2012 Pearson Prentice Hall. All rights reserved. 13-9 Leverage: Breakeven Analysis (cont.) Rewriting the algebraic calculations in Table 13.2 as a formula for earnings before interest and taxes yields: EBIT = (P  Q) – FC – (VC  Q) Simplifying yields: EBIT = Q  (P – VC) – FC Setting EBIT equal to $0 and solving for Q (the firm’s breakeven point) yields:
  • 10. © 2012 Pearson Prentice Hall. All rights reserved. 13-10 Leverage: Breakeven Analysis (cont.) Assume that Cheryl’s Posters, a small poster retailer, has fixed operating costs of $2,500. Its sale price is $10 per poster, and its variable operating cost is $5 per poster. What is the firm’s breakeven point?
  • 11. © 2012 Pearson Prentice Hall. All rights reserved. 13-11 Figure 13.1 Breakeven Analysis
  • 12. © 2012 Pearson Prentice Hall. All rights reserved. 13-12 Table 13.3 Sensitivity of Operating Breakeven Point to Increases in Key Breakeven Variables
  • 13. © 2012 Pearson Prentice Hall. All rights reserved. 13-13 Leverage: Breakeven Analysis (cont.) Assume that Cheryl’s Posters wishes to evaluate the impact of several options: (1) increasing fixed operating costs to $3,000, (2) increasing the sale price per unit to $12.50, (3) increasing the variable operating cost per unit to $7.50, and (4) simultaneously implementing all three of these changes. 1. Operating breakeven point = $3,000/($10 – $5) = 600 units 2. Operating breakeven point = $2,500/($12.50 – $5) = 333.33 units 3. Operating breakeven point = $2,500/($10 – $7.50) = 1,000 units 4. Operating breakeven point = $3,000/($12.50 – $7.50) = 600 units
  • 14. © 2012 Pearson Prentice Hall. All rights reserved. 13-14 Personal Finance Example Rick Polo is considering having a new fuel-saving device installed in his car. The installed cost of the device is $240 paid up-front, plus a monthly fee of $15. He can terminate use of the device any time without penalty. Rick estimates that the device will reduce his average monthly gas consumption by 20%, which, assuming no change in his monthly mileage, translates into a savings of about $28 per month. He is planning to keep the car for 2 more years and wishes to determine whether he should have the device installed in his car. Breakeven point = $240/($28 – $15) = $240/$13 = 18.5 months
  • 15. © 2012 Pearson Prentice Hall. All rights reserved. 13-15 Leverage: Operating Leverage Operating leverage is the use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes. The figure on the following slide uses the data for Cheryl’s Posters (sale price, P = $10 per unit; variable operating cost, VC = $5 per unit; fixed operating cost, FC = $2,500)
  • 16. © 2012 Pearson Prentice Hall. All rights reserved. 13-16 Figure 13.2 Breakeven analysis and operating leverage
  • 17. © 2012 Pearson Prentice Hall. All rights reserved. 13-17 Table 13.4 The EBIT for Various Sales Levels
  • 18. © 2012 Pearson Prentice Hall. All rights reserved. 13-18 Leverage: Operating Leverage (cont.) The degree of operating leverage (DOL) is the numerical measure of the firm’s operating leverage. As long as DOL is greater than 1, there is operating leverage.
  • 19. © 2012 Pearson Prentice Hall. All rights reserved. 13-19 Leverage: Operating Leverage (cont.) Applying the degree of operating leverage equation to cases 1 and 2 in Table 13.4 yields the following results:
  • 20. © 2012 Pearson Prentice Hall. All rights reserved. 13-20 Leverage: Operating Leverage (cont.) A more direct formula for calculating the degree of operating leverage at a base sales level, Q, is the following: Substituting Q = 1,000, P = $10, VC = $5, and FC = $2,500 into the above equation yields the following result:
  • 21. © 2012 Pearson Prentice Hall. All rights reserved. 13-21 Focus on Practice Adobe’s Leverage – Adobe Systems, the second largest PC software company in the United States, dominates the graphic design, imaging, dynamic media, and authoring-tool software markets. – As demonstrated in the following table, operating leverage magnified Adobe’s increase in EBIT in 2007 while magnifying the decrease in EBIT in 2009. – A 22.6% increase in 2007 sales resulted in EBIT growth of 39.7%. – In 2008, EBIT increased just a little faster than sales did, but in 2009 as the economy endured a severe recession, Adobe revenues plunged 17.7%. The effect of operating leverage was that EBIT declined even faster, posting a –35.3% drop.
  • 22. © 2012 Pearson Prentice Hall. All rights reserved. 13-22 Focus on Practice (cont.) Adobe’s Leverage
  • 23. © 2012 Pearson Prentice Hall. All rights reserved. 13-23 Leverage: Operating Leverage (cont.) Assume that Cheryl’s Posters exchanges a portion of its variable operating costs for fixed operating costs by eliminating sales commissions and increasing sales salaries. This exchange results in a reduction in the variable operating cost per unit from $5 to $4.50 and an increase in the fixed operating costs from $2,500 to $3,000.
  • 24. © 2012 Pearson Prentice Hall. All rights reserved. 13-24 Table 13.5 Operating Leverage and Increased Fixed Costs
  • 25. © 2012 Pearson Prentice Hall. All rights reserved. 13-25 Leverage: Financial Leverage Financial leverage is the use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes on the firm’s earnings per share. The two most common fixed financial costs are (1) interest on debt and (2) preferred stock dividends.
  • 26. © 2012 Pearson Prentice Hall. All rights reserved. 13-26 Leverage: Financial Leverage (cont.) Chen Foods, a small Asian food company, expects EBIT of $10,000 in the current year. It has a $20,000 bond with a 10% (annual) coupon rate of interest and an issue of 600 shares of $4 (annual dividend per share) preferred stock outstanding. It also has 1,000 shares of common stock outstanding. The annual interest on the bond issue is $2,000 (0.10  $20,000). The annual dividends on the preferred stock are $2,400 ($4.00/share  600 shares).
  • 27. © 2012 Pearson Prentice Hall. All rights reserved. 13-27 Table 13.6 The EPS for Various EBIT Levels
  • 28. © 2012 Pearson Prentice Hall. All rights reserved. 13-28 Leverage: Financial Leverage (cont.) The degree of financial leverage (DFL) is the numerical measure of the firm’s financial leverage. Whenever DFL is greater than 1, there is financial leverage.
  • 29. © 2012 Pearson Prentice Hall. All rights reserved. 13-29 Leverage: Financial Leverage (cont.) Applying the degree of financial leverage equation to cases 1 and 2 in Table 13.6 yields the following results:
  • 30. © 2012 Pearson Prentice Hall. All rights reserved. 13-30 Personal Finance Example Shanta and Ravi Shandra wish to assess the impact of additional long- term borrowing on their degree of financial leverage (DFL). The Shandras currently have $4,200 available after meeting all of their monthly living (operating) expenses, before making monthly loan payments. They currently have monthly loan payment obligations of $1,700 and are considering the purchase of a new car, which would result in a $500 per month increase (to $2,200) in their total monthly loan payments. Because a large portion of Ravi’s monthly income represents commissions, the Shandras feel that the $4,200 per month currently available for making loan payments could vary by 20% above or below that amount.
  • 31. © 2012 Pearson Prentice Hall. All rights reserved. 13-31 Personal Finance Example (cont.)
  • 32. © 2012 Pearson Prentice Hall. All rights reserved. 13-32 Leverage: Financial Leverage (cont.) A more direct formula for calculating the degree of financial leverage at a base level of EBIT is the following: Note that in the denominator, the term 1/(1 – T) converts the after-tax preferred stock dividend to a before-tax amount for consistency with the other terms in the equation.
  • 33. © 2012 Pearson Prentice Hall. All rights reserved. 13-33 Leverage: Financial Leverage (cont.) Substituting EBIT = $10,000, I = $2,000, PD = $2,400, and the tax rate (T = 0.40) into the previous equation yields:
  • 34. © 2012 Pearson Prentice Hall. All rights reserved. 13-34 Leverage: Total Leverage Total leverage is the use of fixed costs, both operating and financial, to magnify the effects of changes in sales on the firm’s earnings per share.
  • 35. © 2012 Pearson Prentice Hall. All rights reserved. 13-35 Leverage: Total Leverage (cont.) Cables Inc., a computer cable manufacturer, expects sales of 20,000 units at $5 per unit in the coming year and must meet the following obligations: variable operating costs of $2 per unit, fixed operating costs of $10,000, interest of $20,000, and preferred stock dividends of $12,000. The firm is in the 40% tax bracket and has 5,000 shares of common stock outstanding.
  • 36. © 2012 Pearson Prentice Hall. All rights reserved. 13-36 Table 13.7 The Total Leverage Effect
  • 37. © 2012 Pearson Prentice Hall. All rights reserved. 13-37 Leverage: Total Leverage (cont.) The degree of total leverage (DTL) is the numerical measure of the firm’s total leverage. As long as the DTL is greater than 1, there is total leverage.
  • 38. © 2012 Pearson Prentice Hall. All rights reserved. 13-38 Leverage: Total Leverage (cont.) Applying the degree of total leverage equation to the data in Table 13.7 yields the following:
  • 39. © 2012 Pearson Prentice Hall. All rights reserved. 13-39 Leverage: Total Leverage (cont.) A more direct formula for calculating the degree of total leverage at a given base level of sales, Q, is given by the following equation:
  • 40. © 2012 Pearson Prentice Hall. All rights reserved. 13-40 Leverage: Total Leverage (cont.) Substituting Q = 20,000, P = $5, VC = $2, FC = $10,000, I = $20,000, PD = $12,000, and the tax rate (T = 0.40) into the previous equation yields:
  • 41. © 2012 Pearson Prentice Hall. All rights reserved. 13-41 Leverage: Relationship of Operating, Financial, and Total Leverage Total leverage reflects the combined impact of operating and financial leverage on the firm. High operating leverage and high financial leverage will cause total leverage to be high. The opposite will also be true. The relationship between operating leverage and financial leverage is multiplicative rather than additive. DTL = DOL  DFL
  • 42. © 2012 Pearson Prentice Hall. All rights reserved. 13-42 Leverage: Relationship of Operating, Financial, and Total Leverage (cont.) Substituting the values calculated for DOL and DFL, shown on the right-hand side of Table 13.7, into the previous equation yields DTL = 1.2  5.0 = 6.0
  • 43. © 2012 Pearson Prentice Hall. All rights reserved. 13-43 Focus on Ethics Repo 105 – By early 2008, Lehman Brothers had $32 in debt for each $1 in equity. – Lehman used off-balance sheet transactions hide the extent of its indebtednesses. – Repo 105 transactions enabled Lehman to reduce both total liabilities and total assets and allowed the firm to report lower leverage ratios. With the start of a new quarter, Lehman would unwind the transactions and restore the liabilities to their balance sheet. – Assume that Lehman’s Repo 105 transactions fall within the limits allowed by Generally Accepted Accounting Principles as Lehman’s management has argued. What are the ethical implications of undertaking transactions expressly to temporarily hide how much money a firm has borrowed?
  • 44. © 2012 Pearson Prentice Hall. All rights reserved. 13-44 The Firm’s Capital Structure: Types of Capital All of the items on the right-hand side of the firm’s balance sheet, excluding current liabilities, are sources of capital. The following simplified balance sheet illustrates the basic breakdown of total capital into its two components, debt capital and equity capital.
  • 45. © 2012 Pearson Prentice Hall. All rights reserved. 13-45 The Firm’s Capital Structure: Types of Capital (cont.) • The cost of debt is lower than the cost of other forms of financing. • Lenders demand relatively lower returns because they take the least risk of any contributors of long-term capital. • Lenders have a higher priority of claim against any earnings or assets available for payment, and they can exert far greater legal pressure against the company to make payment than can owners of preferred or common stock. • The tax deductibility of interest payments also lowers the debt cost to the firm substantially.
  • 46. © 2012 Pearson Prentice Hall. All rights reserved. 13-46 The Firm’s Capital Structure: Types of Capital (cont.) • Unlike debt capital, which the firm must eventually repay, equity capital remains invested in the firm indefinitely—it has no maturity date. • The two basic sources of equity capital are (1) preferred stock and (2) common stock equity, which includes common stock and retained earnings. • Common stock is typically the most expensive form of equity, followed by retained earnings and then preferred stock. • Whether the firm borrows very little or a great deal, it is always true that the claims of common stockholders are riskier than those of lenders, so the cost of equity always exceeds the cost of debt.
  • 47. © 2012 Pearson Prentice Hall. All rights reserved. 13-47 The Firm’s Capital Structure: External Assessment of Capital Structure • A direct measure of the degree of indebtedness is the debt ratio (total liabilities ÷ total assets). – The higher this ratio is, the greater the relative amount of debt (or financial leverage) in the firm’s capital structure. • Measures of the firm’s ability to meet contractual payments associated with debt include the times interest earned ratio (EBIT ÷ interest) and the fixed-payment coverage ratio. • The level of debt (financial leverage) that is acceptable for one industry or line of business can be highly risky in another, because different industries and lines of business have different operating characteristics.
  • 48. © 2012 Pearson Prentice Hall. All rights reserved. 13-48 Table 13.8 Debt Ratios for Selected Industries and Lines of Business
  • 49. © 2012 Pearson Prentice Hall. All rights reserved. 13-49 Personal Finance Example Assume that the Loo family is applying for a mortgage loan. The family’s monthly gross (before-tax) income is $5,380, and they currently have monthly installment loan obligations that total $560. The $200,000 mortgage loan they are applying for will require monthly payments of $1,400. Mort. pay./Gross income = $1,400/$5,380 = 26% Tot. instal. pay./Gross income = ($560 + $1,400)/$5,380 = $1,960/$5,380 = 36.4%
  • 50. © 2012 Pearson Prentice Hall. All rights reserved. 13-50 The Firm’s Capital Structure: Capital Structure of Non-U.S. Firms In general, non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts. – Most of the reasons relate to the fact that U.S. capital markets are more developed than those elsewhere and have played a greater role in corporate financing than has been the case in other countries.
  • 51. © 2012 Pearson Prentice Hall. All rights reserved. 13-51 The Firm’s Capital Structure: Capital Structure of Non-U.S. Firms On the other hand, similarities do exist between U.S. corporations and corporations in other countries. – First, the same industry patterns of capital structure tend to be found all around the world. – Second, the capital structures of the largest U.S.-based multinational companies, which have access to capital markets around the world, typically resemble the capital structures of multinational companies from other countries more than they resemble those of smaller U.S. companies. – Finally, the worldwide trend is away from reliance on banks for financing and toward greater reliance on security issuance.
  • 52. © 2012 Pearson Prentice Hall. All rights reserved. 13-52 Matter of Fact Leverage Around the World – A recent study of the use of long-term debt in 42 countries found that firms in Argentina used more long-term debt than firms in any other country. – Relative to their assets, firms in Argentina used almost 60% more long-term debt than did U.S. companies. – Indian firms were heavy users of long-term debt as well. At the other end of the spectrum, companies from Italy, Greece, and Poland used very little long-term debt. In those countries, firms used only about 40% as much long-term debt as did their U.S. counterparts.
  • 53. © 2012 Pearson Prentice Hall. All rights reserved. 13-53 The Firm’s Capital Structure: Capital Structure Theory • Research suggests that there is an optimal capital structure range. • It is not yet possible to provide financial managers with a precise methodology for determining a firm’s optimal capital structure. • Nevertheless, financial theory does offer help in understanding how a firm’s capital structure affects the firm’s value.
  • 54. © 2012 Pearson Prentice Hall. All rights reserved. 13-54 The Firm’s Capital Structure: Capital Structure Theory (cont.) In 1958, Franco Modigliani and Merton H. Miller (commonly known as “M and M”) demonstrated algebraically that, assuming perfect markets, the capital structure that a firm chooses does not affect its value.
  • 55. © 2012 Pearson Prentice Hall. All rights reserved. 13-55 The Firm’s Capital Structure: Capital Structure Theory (cont.) Many researchers, including M and M, have examined the effects of less restrictive assumptions on the relationship between capital structure and the firm’s value. – The result is a theoretical optimal capital structure based on balancing the benefits and costs of debt financing. – The major benefit of debt financing is the tax shield, which allows interest payments to be deducted in calculating taxable income. – The cost of debt financing results from (1) the increased probability of bankruptcy caused by debt obligations, (2) the agency costs of the lender’s constraining the firm’s actions, and (3) the costs associated with managers having more information about the firm’s prospects than do investors.
  • 56. © 2012 Pearson Prentice Hall. All rights reserved. 13-56 The Firm’s Capital Structure: Capital Structure Theory (cont.) Tax Benefits – Allowing firms to deduct interest payments on debt when calculating taxable income reduces the amount of the firm’s earnings paid in taxes, thereby making more earnings available for bondholders and stockholders. – The deductibility of interest means the cost of debt, ri, to the firm is subsidized by the government. – Letting rd equal the before-tax cost of debt and letting T equal the tax rate, from Chapter 9, we have ri = rd  (1 – T).
  • 57. © 2012 Pearson Prentice Hall. All rights reserved. 13-57 The Firm’s Capital Structure: Capital Structure Theory (cont.) Probability of Bankruptcy – The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends largely on its level of both business risk and financial risk. – Business risk is the risk to the firm of being unable to cover its operating costs. – In general, the greater the firm’s operating leverage—the use of fixed operating costs—the higher its business risk. – Although operating leverage is an important factor affecting business risk, two other factors—revenue stability and cost stability—also affect it. – Firms with high business risk therefore tend toward less highly leveraged capital structures, and firms with low business risk tend toward more highly leveraged capital structures.
  • 58. © 2012 Pearson Prentice Hall. All rights reserved. 13-58 The Firm’s Capital Structure: Capital Structure Theory (cont.) Cooke Company, a soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates of sales and the associated levels of earnings before interest and taxes (EBIT) from its forecasting group: There is a 25% chance that sales will total $400,000, a 50% chance that sales will total $600,000, and a 25% chance that sales will total $800,000. Fixed operating costs total $200,000, and variable operating costs equal 50% of sales. These data are summarized, and the resulting EBIT calculated, in the following table:
  • 59. © 2012 Pearson Prentice Hall. All rights reserved. 13-59 Table 13.9 Sales and Associated EBIT Calculations for Cooke Company ($000)
  • 60. © 2012 Pearson Prentice Hall. All rights reserved. 13-60 The Firm’s Capital Structure: Capital Structure Theory (cont.) Probability of Bankruptcy – The firm’s capital structure directly affects its financial risk, which is the risk to the firm of being unable to cover required financial obligations. – The penalty for not meeting financial obligations is bankruptcy. – The more fixed-cost financing—debt (including financial leases) and preferred stock—a firm has in its capital structure, the greater its financial leverage and risk. – The total risk of a firm—business and financial risk combined— determines its probability of bankruptcy.
  • 61. © 2012 Pearson Prentice Hall. All rights reserved. 13-61 The Firm’s Capital Structure: Capital Structure Theory (cont.) Cooke Company’s current capital structure is as follows:
  • 62. © 2012 Pearson Prentice Hall. All rights reserved. 13-62 Table 13.10 Capital Structures Associated with Alternative Debt Ratios for Cooke Company
  • 63. © 2012 Pearson Prentice Hall. All rights reserved. 13-63 Table 13.11 Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with Cooke Company’s Alternative Capital Structures
  • 64. © 2012 Pearson Prentice Hall. All rights reserved. 13-64 Table 13.12a Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company
  • 65. © 2012 Pearson Prentice Hall. All rights reserved. 13-65 Table 13.12b Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company
  • 66. © 2012 Pearson Prentice Hall. All rights reserved. 13-66 Table 13.12c Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company
  • 67. © 2012 Pearson Prentice Hall. All rights reserved. 13-67 Table 13.13 Expected EPS, Standard Deviation, and Coefficient of Variation for Alternative Capital Structures for Cooke Company
  • 68. © 2012 Pearson Prentice Hall. All rights reserved. 13-68 Figure 13.3 Probability Distributions
  • 69. © 2012 Pearson Prentice Hall. All rights reserved. 13-69 Figure 13.4 Expected EPS and Coefficient of Variation of EPS
  • 70. © 2012 Pearson Prentice Hall. All rights reserved. 13-70 The Firm’s Capital Structure: Capital Structure Theory (cont.) Agency Costs Imposed by Lenders – As noted in Chapter 1, the managers of firms typically act as agents of the owners (stockholders). – The owners give the managers the authority to manage the firm for the owners’ benefit. – The agency problem created by this relationship extends not only to the relationship between owners and managers but also to the relationship between owners and lenders. – To avoid this situation, lenders impose certain monitoring techniques on borrowers, who as a result incur agency costs.
  • 71. © 2012 Pearson Prentice Hall. All rights reserved. 13-71 The Firm’s Capital Structure: Capital Structure Theory (cont.) Asymmetric Information – Asymmetric information is the situation in which managers of a firm have more information about operations and future prospects than do investors. – A pecking order is a hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing. – A signal is a financing action by management that is believed to reflect its view of the firm’s stock value; generally, debt financing is viewed as a positive signal that management believes the stock is “undervalued,” and a stock issue is viewed as a negative signal that management believes the stock is “overvalued.”
  • 72. © 2012 Pearson Prentice Hall. All rights reserved. 13-72 The Firm’s Capital Structure: Capital Structure Theory (cont.) What, then, is the optimal capital structure, even if it exists (so far) only in theory? – Because the value of a firm equals the present value of its future cash flows, it follows that the value of the firm is maximized when the cost of capital is minimized. where EBIT = earnings before interest and taxes T = tax rate NOPAT = net operating profits after taxes, which is the after-tax operating earnings available to the debt and equity holders, EBIT  (1 – T) ra = weighted average cost of capital
  • 73. © 2012 Pearson Prentice Hall. All rights reserved. 13-73 Figure 13.5 Cost Functions and Value
  • 74. © 2012 Pearson Prentice Hall. All rights reserved. 13-74 EBIT-EPS Approach to Capital Structure The EBIT–EPS approach is an approach for selecting the capital structure that maximizes earnings per share (EPS) over the expected range of earnings before interest and taxes (EBIT).
  • 75. © 2012 Pearson Prentice Hall. All rights reserved. 13-75 EBIT-EPS Approach to Capital Structure (cont.) We can plot coordinates on the EBIT–EPS graph by assuming specific EBIT values and calculating the EPS associated with them. Such calculations for three capital structures—debt ratios of 0%, 30%, and 60%—for Cooke Company were presented in Table 13.12. For EBIT values of $100,000 and $200,000, the associated EPS values calculated there are summarized in the table below the graph in Figure 13.6.
  • 76. © 2012 Pearson Prentice Hall. All rights reserved. 13-76 Figure 13.6 EBIT–EPS Approach
  • 77. © 2012 Pearson Prentice Hall. All rights reserved. 13-77 EBIT-EPS Approach to Capital Structure: Considering Risk in EBIT-EPS Analysis • When interpreting EBIT–EPS analysis, it is important to consider the risk of each capital structure alternative. • Graphically, the risk of each capital structure can be viewed in light of two measures: 1. the financial breakeven point (EBIT-axis intercept) 2. the degree of financial leverage reflected in the slope of the capital structure line: The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk.
  • 78. © 2012 Pearson Prentice Hall. All rights reserved. 13-78 EBIT-EPS Approach to Capital Structure: Basic Shortcoming of EBIT-EPS Analysis • The most important point to recognize when using EBIT–EPS analysis is that this technique tends to concentrate on maximizing earnings rather than maximizing owner wealth as reflected in the firm’s stock price. • The use of an EPS-maximizing approach generally ignores risk. • Because risk premiums increase with increases in financial leverage, the maximization of EPS does not ensure owner wealth maximization.
  • 79. © 2012 Pearson Prentice Hall. All rights reserved. 13-79 Choosing the Optimal Capital Structure: Linkage • To determine the firm’s value under alternative capital structures, the firm must find the level of return that it must earn to compensate owners for the risk being incurred. • The required return associated with a given level of financial risk can be estimated in a number of ways. – Theoretically, the preferred approach would be first to estimate the beta associated with each alternative capital structure and then to use the CAPM framework to calculate the required return, rs. – A more operational approach involves linking the financial risk associated with each capital structure alternative directly to the required return.
  • 80. © 2012 Pearson Prentice Hall. All rights reserved. 13-80 Table 13.14 Required Returns for Cooke Company’s Alternative Capital Structures
  • 81. © 2012 Pearson Prentice Hall. All rights reserved. 13-81 Choosing the Optimal Capital Structure: Estimating Value • The value of the firm associated with alternative capital structures can be estimated by using one of the standard valuation models, such as the zero-growth model. • Although some relationship exists between expected profit and value, there is no reason to believe that profit-maximizing strategies necessarily result in wealth maximization. • It is therefore the wealth of the owners as reflected in the estimated share value that should serve as the criterion for selecting the best capital structure.
  • 82. © 2012 Pearson Prentice Hall. All rights reserved. 13-82 Table 13.15 Calculation of Share Value Estimates Associated with Alternative Capital Structures for Cooke Company
  • 83. © 2012 Pearson Prentice Hall. All rights reserved. 13-83 Figure 13.7 Estimated share value and EPS for alternative capital structures for Cooke Company
  • 84. © 2012 Pearson Prentice Hall. All rights reserved. 13-84 Table 13.16a Important Factors to Consider in Making Capital Structure Decisions
  • 85. © 2012 Pearson Prentice Hall. All rights reserved. 13-85 Table 13.16b Important Factors to Consider in Making Capital Structure Decisions
  • 86. © 2012 Pearson Prentice Hall. All rights reserved. 13-86 Review of Learning Goals LG1 Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect of changing costs on it. – Leverage results from the use of fixed costs to magnify returns to a firm’s owners. Capital structure, the firm’s mix of long-term debt and equity, affects leverage and therefore the firm’s value. Breakeven analysis measures the level of sales necessary to cover total operating costs. The operating breakeven point increases with increased fixed and variable operating costs and decreases with an increase in sale price, and vice versa.
  • 87. © 2012 Pearson Prentice Hall. All rights reserved. 13-87 Review of Learning Goals (cont.) LG2 Understand operating, financial, and total leverage and the relationships among them. – Operating leverage is the use of fixed operating costs by the firm to magnify the effects of changes in sales on EBIT. The higher the fixed operating costs, the greater the operating leverage. Financial leverage is the use of fixed financial costs by the firm to magnify the effects of changes in EBIT on EPS. The higher the fixed financial costs, the greater the financial leverage. The total leverage of the firm is the use of fixed costs—both operating and financial—to magnify the effects of changes in sales on EPS.
  • 88. © 2012 Pearson Prentice Hall. All rights reserved. 13-88 Review of Learning Goals (cont.) LG3 Describe the types of capital, external assessment of capital structure, the capital structure of non-U.S. firms, and capital structure theory. – Debt capital and equity capital make up a firm’s capital structure. Capital structure can be externally assessed by using financial ratios— debt ratio, times interest earned ratio, and fixed-payment coverage ratio. Non-U.S. companies tend to have much higher degrees of indebtedness than do their U.S. counterparts, primarily because U.S. capital markets are more developed. – Research suggests that there is an optimal capital structure that balances the firm’s benefits and costs of debt financing. The major benefit of debt financing is the tax shield. The costs of debt financing include the probability of bankruptcy, agency costs imposed by lenders, and asymmetric information.
  • 89. © 2012 Pearson Prentice Hall. All rights reserved. 13-89 Review of Learning Goals (cont.) LG4 Explain the optimal capital structure using a graphical view of the firm’s cost-of-capital functions and a zero-growth valuation model. – The zero-growth valuation model defines the firm’s value as its net operating profits after taxes (NOPAT), or after-tax EBIT, divided by its weighted average cost of capital. Assuming that NOPAT is constant, the value of the firm is maximized by minimizing its weighted average cost of capital (WACC). The optimal capital structure minimizes the WACC. Graphically, the firm’s WACC exhibits a U-shape, whose minimum value defines the optimal capital structure that maximizes owner wealth.
  • 90. © 2012 Pearson Prentice Hall. All rights reserved. 13-90 Review of Learning Goals (cont.) LG5 Discuss the EBIT–EPS approach to capital structure. – The EBIT–EPS approach evaluates capital structures in light of the returns they provide the firm’s owners and their degree of financial risk. Under the EBIT–EPS approach, the preferred capital structure is the one that is expected to provide maximum EPS over the firm’s expected range of EBIT. Graphically, this approach reflects risk in terms of the financial breakeven point and the slope of the capital structure line. The major shortcoming of EBIT–EPS analysis is that it concentrates on maximizing earnings (returns) rather than owners’ wealth, which considers risk as well as return.
  • 91. © 2012 Pearson Prentice Hall. All rights reserved. 13-91 Review of Learning Goals (cont.) LG6 Review the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital structure. – The best capital structure can be selected by using a valuation model to link return and risk factors. The preferred capital structure is the one that results in the highest estimated share value, not the highest EPS. Other important nonquantitative factors must also be considered when making capital structure decisions.
  • 92. © 2012 Pearson Prentice Hall. All rights reserved. 13-92 Chapter Resources on MyFinanceLab • Chapter Cases • Group Exercises • Critical Thinking Problems