Chapter 4 Capital Structure Policy
Chapter 4 Capital Structure Policy
DOL= %ΔEBIT
%Output where, EBIT is earning before interest and tax
Or
=1+ F
EBIT where, F is fixed operating cost
Or
DOL at base sales level Q = Q(P-V)
Q(P-V)-F where, Q is quantity, P is price ,
V is variable cost and F is fixed cost
Example,
P= 10 birr
V= 4 birr
F= 30,000 birr
Level of out put (Q) is 8,000 and increase to 10,000 units.
Required:
Determine DOL?
1
Solution:
EBIT= Q (P-V)-F
=8000(10-4)-30,000 = 18,000
EBIT= 10,000(10-4)-30,000=30,000
Percentage change in EBIT= (30,000-18,000)/18,000=66.67%
Percentage change in out puts = (10,000-8,000)/8,000=25%
DOL= %ΔEBIT
%Output
66.67%/25%=2.67
Or
1+ F
EBIT
1+ 30,000/18,000=2.67
Or
= Q (P-V)
Q (P-V)-F
=8,000(10-4)
8,000(10-4)-30,000
=2.67
The coefficient of operating leverage of 2.67 is interpreted as a 1% change in out put
form the current base levels, there will be a 2.67% change in EBIT in the same direction
as the out put (sales) change. If out put (sales) increase by 10%, EBIT will increase by
26.7% (10x 2.67%). Similarly, if out put (sales) decrease by 10%, EBIT will decrease by
26.7%. Other things equal, the higher the fixed costs relative to variable costs, the higher
the operating leverage.
Example,
AA firm has a base level of 150,000 units of sales. The sales price per unit is $10.00 and
variable costs per unit are $6.50. Total annual operating fixed costs are $155,000, and the
annual interest expense is $90,000. What is this firm’s degree of operating leverage
(DOL)?
Solution
2
Example,
P = 10
V=4
FC = 90,000
Required: Determine operating break even in units and sales?
Q = FC
P-V
= 90,000/(10-4) = 15,000 units. Sales = 10x 15,000 =150,000
Note that the coefficient of operating leverage at operating break even has undefined
value.
Example,
Compute EBIT and coefficient of operating leverage when Q is 10,000 units?
Solution:
EBIT= Q (P-V)-F = 10,000 (10-4) - 90,000= (30,000)
DOL = Q (P-V) = 10,000(10-4)
Q (P-V)-F 10,000(10-4)-90,000
=2
Or
DOL =1+ F = 1 + 90,000
EBIT (30,000)
1-3= 2
Note: -Technically, the formula for DOL should include absolute value signs because it is
possible to get a negative DOL when the EBIT for the base sales level is negative. Since
we assume that the EBIT for the base level of sales is positive, the absolute value signs
are not included.
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operating fixed costs affect EBIT. The more fixed charge financing the firm uses, the
more financial leverage it will have.
Degree of Financial leverage:
Degree of financial leverage is defined as the percentage change in EPS divided by the
percentage change in EBIT.
DFL = %Δ in EPS
%Δ in EBIT
Where, EPS is earning per share
Or
DFL = EBIT
EBIT-I-L-D/(1-T)
Where, I is interest payment
L is lease payment
D is dividend payment
T is tax rate
Unlike interest and lease payments, preferred dividends are not tax deductible. Therefore,
dividend payment has to be adjusted by dividing with (1-T) to make it on equivalent
basis.
Example,
A firm has a base level of 500,000 units of sales and increase to 600,000 units. The sales
price per unit is $10.00 and variable costs per unit are $6.50. Total annual operating fixed
costs are $1,250,000, and the annual interest expense is $100,000. The firm paid 80,000
for preferred stock holders and has 60,000 outstanding shares of common stock. The firm
tax rate is 40%.
1. What is the firm’ earning per share?
2. What is the firm’s degree of financial leverage (DFL)?
Solution:
1. EPS = (EBIT-I) (1-T)-D
N
EBIT = 500,000(10-6.50)-1,250,000=500,000
EPS = (500,000-100,000) (1-0.4)-80,000
60,000
=2.67
If sales increases from 500,000 to 600,000 units the resulting EBIT and EPS is:
EBIT = 600,000(10-6.50)-1,250,000=850,000
EPS = (850,000-100,000) (1-0.4)-80,000
60,000
= 6.16
4
DFL = %Δ in EPS
%Δ in EBIT
= (6.16-2.67)/2.67
(850,000-500,000)/500,000
=1.307/0.7= 1.87
Or
DFL = EBIT
EBIT-I-L-D/(1-T)
= . 500,000 .
500,000-100,000- 80,000/(1-0.4)
= 1.87
Financial break even
It is defined as the value of EBIT that makes EPS equal to zero. At financial break even,
the firm’s EBIT is just sufficient to cover its fixed financing costs (interest and preferred
Stock dividends) on a before tax basis leaving no earnings for common shareholders.
(EBIT-I)(1-T)-D= EPS
N
(EBIT-I)(1-T)-D= 0
N
(EBIT-I)(1-T)-D = 0
EBIT-I = D
(1-T)
EBIT= D +I
(1-T)
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Example,
A firm has a base level of 15,000 units of sales and increase to 16,500 units. The sales
price per unit is $50.00 and variable costs per unit are $30. Total annual operating fixed
costs are $150,000, and the annual interest expense is $40,000. The firm paid 20,000 for
preferred stock holders and has 10,000 outstanding shares of common stock. The firm tax
rate is 40%.
1. What is the firm’ earning per share at an output level of 15,000 and 16,500 units?
2. What is the firm’s EBIT, Degree of operating leverage (DOL) and degree of financial
leverage at output level of 15,000 (DFL)?
3. What is the firm’s Degree of combined leverage (DCL)?
Solution:
. EPS = (EBIT-I) (1-T)-D
N
EBIT = 15,000(50-30)-150,000=150,000
EPS = (150,000-40,000) (1-0.4)-20,000
10,000
=4.6
If output increased to 16,500 units, EPS increase to:
EPS = (EBIT-I) (1-T)-D
N
EBIT = 16,500(50-30)-150,000=180,000
EPS = (180,000-40,000) (1-0.4)-20,000
10,000
=6.4
DCL = %Δ in EPS
%Δ in output
= (6.4-4.6)/4.6
(16,500-15,000)/15,000
=3.91
DOL =1+ F = 1 + 150,000
EBIT 150,000
1+1= 2
DFL = EBIT
EBIT-I-L-D/ (1-T)
= . 150,000 .
150,000-40,000- 20,000/(1-0.4)
=1.957
Therefore, DCL = DOL X DFL
=2 x 1.957
=3.91
Note: the firm’s DCL describes the effect that sales changes will have on EPS. However,
we must be careful to realize the approximate nature of this calculation. If the anticipated
sales change is beyond the relevant range of sales describe earlier, the variable cost ratio
may change, and if the time period is too long, fixed costs may change.
Overall breakeven
It is defined as the level of output that makes EPS equal to zero.
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EPS = (EBIT-I) (1-T)-D
N
0 =[Q(P-V)-F – I)] (1-T)- D
N
Q = I + F+ D/ (1-T)
P- V
Example,
A firm has a base level of 15,000 units of sales. The sales price per unit is $50.00 and
variable costs per unit are $30. Total annual operating fixed costs are $150,000, and the
annual interest expense is $40,000. The firm paid 20,000 for preferred stock holders and
has 10,000 outstanding shares of common stock. The firm tax rate is 40%.
1. What is the overall breakeven unit?
Solution:
Q = I + F+ D/ (1-T)
P- V
= 40,000 + 150,000 + 20,000/(1-0.4)
(50-30)
= 11,167 units
Financial leverage and Capital structure
Optimal capital structure is the capital structure that minimizes the firm’s weighted
average cost of capital and maximizes the value of the firm to its investors. If the firm
currently has an optimal capital structure, it will finance new investments by a financing
mix approximately like the current mix. If the current capital structure is not optima, the
firm should finance new asset in such a manner that the capital structure will be moved
toward the optimal position.
Effect of Financial leverage on EPS
Example,
Suppose, a new firm, ABC Company, is just now considering financing plans. The firm
needs birr 100,000 of long term capital to begin operations and has narrowed the choice
to two financing plans:
Alternative 1: sell 1,000 shares of common stock at birr 100 per share.
Alternative 2: sell 500 shares of common stock at birr 100 per share and borrow birr
50,000 from the bank at 5% interest.
Alternative 1 is an all equity plan. The company’s long term debt to equity ratio would be
zero. Alternative 2 involves the sales of equal amounts of debt and equity, and the firm’s
long-term debt to equity ratio to be one. What effect would these plans have on ABC
EPS? It depends on the relationship between the before tax cost of debt and the rate of
return on assets before interest and taxes. Most firm’s EBIT influenced by general
economic conditions. If the economy is strong, EBIT will be favorable, and if the
economy is weak, EBIT will be unfavorable. ABC estimates that if the economy is weak,
EBIT will be 4,000; if the economy is about average, EBIT will be birr 6,000; and if the
economy is strong, EBIT will be birr 8,000. Theses estimates imply that ABC’s return on
asset before interest and tax (EBIT/ Total asset) will be 4 %( 4,000/100,000) in weak
economy, 6 percent in an average economy, and 8 percent in a strong economy. In
comparison, the before tax cost of debt is 5%.
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Economic conditions:
Weak Average strong
Alternative 1: all equity financing (debt: equity ration=0)
EBIT 4,000 6,000 8,000
INTEREST 0 0 0
EBT 4,000 6,000 8,000
TAX (50%) 2,000 3,000 4,000
NI 2,000 3,000 4,000
NO OF SHARES COMMON 1,000 1,000 1,000
EPS 2 3 4
Alternative 2
5
EPS 4 Alternative 1
3
2
1
0 1 2 3 4 5 6 7 8
EBIT (birr 000)
Figure 2.1
We can also algebraically solve for EBIT at the indifference point. By definition:
EPS = (EBIT-I) (1-T)-D
N
Alternative 1: EPS 1 = (EBIT-0) (1-0.5)-0 = 0.0005EBIT
1,000
Alternative 2: EPS 2 = (EBIT-2,500) (1-0.5)-0 = 0.0001EBIT-2.5
500
The indifference point is where the two EPS’ are equal.
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0.0005EBIT = 0.0001EBIT-2.5
EBIT= 5,000birr
Effect of financial leverage on financial risk and expected EPS
In this section we relate expected EPS and financial risk to stock price. Let us assume
ABC’s EBIT outcomes are equally likely, and then the probability of each is one third.
EPS
EBIT Probability Alternative 1 Alternative 2
4,000 1/3 2 1.50
6,000 1/3 3 3.50
8,000 1/3 4 5.50
Required: compute expected EPS and standard deviation of each alternative.
Expected EPS = EPS x Probability
Alternative 1: expected EPS= 1/3 x 2 + 1/3x 3 + 1/3x 4 =3
Standard deviation= 1/3(2-3)2 + 1/3(3-3)2 + 1/3(4-3)2
=0.82
Alternative 2: expected EPS= 1/3 x 1.5 + 1/3x 3.50 + 1/3x 5.5 =3.50
Standard deviation= 1/3(1.5-3.5)2 + 1/3(3.5-3.5)2 + 1/3(5.5-3.5)2
=1.63
When we see the two alternatives, note that there are two effects of financing with debt.
That is there are two effects of financial leverage:
1. Expected earnings per share increases
2. The standard deviation of earnings per share increases. These two conclusions
have important valuation implications. The firm’s ability to pay dividend is
directly related to its expected EPS. The greater the expected EPS, the greater the
firm’s future expected dividends will be.
Remark: increased financial leverage= increase expected EPS= increase standard
deviation= increase stock riskiness.
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rE
Rate of return rA
rD
D*
Figure 2.2 Debt as percentage of Total asset
Figure 2.2 illustrates the traditionalists’ view on the effect of leverage on the expected
return of both the debt holder and the equity holder. The line rD represents the cost of
debt, the line rA is the expected rate of return on assets, and the line rE is the cost of
equity. D* is debt capacity, the range of debt that minimizes the firm’s cost of capital and
maximizes the firm value. The modernists’ position on the use of debt and the value of
the firm was established by Franco Modigliani and Merton Miller in the late 1950s. The
modernist position states that, under ideal conditions, all capital structures produce the
same total cost of capital to the firm and the same total firm value. Modernists believe
that the financing decision is irrelevant.
rE
Rate of return
rA
rD
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structure in pie model. As we can see in figure 2.4, two possible ways of cutting up the
pie between equity slice and debt slice 40%-60% and 60%-40%. However, the size of the
pie is the same for both firms because the value of the assets is the same. This is what
M&M Proposition I states: The size of the pie doesn’t depend on how it is sliced.
Stock Stock
40% 60%
Bonds Bonds
60%
40%
Figure 2.4
B) M&M Proposition II: The Cost of Equity and Financial Leverage.
Although changing the capital structure of the firm may not change the firm’s total value,
it does cause important changes in the firm’s debt and equity. Let us see what happens to
a firm financed with debt and equity when the debt/equity ratio is changed.
M&M proposition II stated that weighted average cost of capital, WACC, is:
WACC= E/V x RE + D/V x RD
Where V= E + D
E= equity
D= debt
RE= cost of equity
RD= cost of debt
WACC is the required return on the firm’s overall assets and it is also labeled as RA
RA = E/V x RE + D/V x RD, if we arrange this to solve for the cost of equity capital
(RE):
RE = RA + (RA- RD) x (D/E)
M&M proposition stated that a firm’s cost of equity capital is a positive linear
function of its capital structure. The cost of equity depends on three things: the
required rate of return on the firm’s assets, RA, the firm’s cost of debt, RD, and the
firm’s debt/equity ration, D/E
RE
Cost of capital
WACC= RA
RD
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As shown M&M proposition II indicates that the cost of equity, RE, is given by the
straight line with a slope of (RA-RD). The y-intercept corresponds to a firm with a
debt/equity ratio of zero, so RA=RE. As the firm raises its debt/equity ratio, the
increase in leverage raises the risk of the equity and therefore the required return or
cost of equity (RE). Notice that the WACC doesn’t depend on the debt/equity ratio;
it’s the same no matter what the debt/equity ratio is. The firm’s overall cost of capital
is unaffected by its capital structure. As illustrated in figure 2.5, the fact that the cost
of debt is lower than the cost of equity is exactly offset by the increase in the cost of
equity form borrowing. In other words, the change in the capital structure weights
(E/V and D/V) is exactly offset by the change in the cost of equity (RE), so the
WACC stays the same.
Example,
The RRR Corporation has a weighted average cost of capital (unadjusted) of 12
percent. It can borrow at 8 percent. Assume that RRR has a target capital structure of
80 percent equity and 20 percent debt.
Required:
1. What is its cost of equity?
2. What is the cost of equity if the target capital structure is 50 percent equity?
3. Calculate the unadjusted WACC using your answers to verify that it is the same
Solution:
1. According to M&M proposition II,
RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.2/0.8)
=13%
2. RE = RA + (RA- RD) x (D/E)
=12% + (12%-8%) x (0.5/0.5)
=16%
3. The unadjusted WACC assuming that the percentage of equity financing is 80%
and the cost of equity is 13%:
WACC= E/V x RE + D/V x RD
= 0.8 x 13% + 0.2 x 8%
=12%
As we calculated, the WACC is 12 percent in both cases.
Exercise1
The FFF company, a major manufacturer of telephone switching equipment, has a
perpetual expected EBIT of birr 200. The interest rate is 12%.
Required:
1. Assuming that there are no taxes or other market imperfections, what is the value
of the company if its debt/equity ratio is 0.25 and its overall cost of capital is
16%? What is the value of the equity? What is the value of the debt?
2. What is the cost of equity capital for the company?
3. Suppose the corporate tax rate is 30%, there are no personal taxes or other
imperfections, and FFF Company has birr 400 in debt outstanding. If the
unlevered cost of equity is 20%, what is FFF’s value? What is the value of the
equity?
4. In question number 3, what is the overall cost of capital?
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Solution
1. If there are no taxes, then MM proposition I holds and FFF’s capital structure is
irrelevant, so the value of the firm is (birr 200/0.16)= birr 1250.
If the debt/equity ratio is 0.25, then for every birr 5 in capital, there is birr 4 in
equity. Thus, FFF is 80% equity, and the value of the equity is birr 1000. The value
of the debt is birr 250
2. the cost of equity capital can be computed using MM Proposition II as:
RE = RA + (RA- RD) x (D/E)
=16% + (16%-12%) x 0.25
=17%
Alternatively, we can compute the equity cash flow as (birr 200-0.12(250)) = birr
170, and divide by the value of equity. Since the equity is worth birr 1000, the cost of
capital is (birr 170/1000) =0.17 =17%
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The interest tax shield
To simplify things, assume that depreciation is zero and that there is no additional capital
expenditure and net working capital. In this case, cash flow from assets is equal to EBIT-
Taxes. For firms U and L the cash flow from assets would be birr (1000-300=700) and
(1000-276=724), respectively. See that the capital structure is now having some effect
because the cash flows from U and L are not the same even though the two firms have
identical assets. The total cash flow to L is birr 24 more. This is because an interest
deductible for tax purposes has generated a tax saving equal to the interest payment
multiplied by the tax rate: 80 x 30% = birr 24. This is interest tax shield, a tax saving
attainted by a firm from interest expense.
A. Taxes and M&M Proposition I
Since the debt is perpetual, the same birr 24 shield will be generated every year forever.
The after tax cash flow to L will thus be the same birr 700 that U earns plus the birr 24
tax shield. Since L’s cash flow is always birr 24 greater, firm L is worth more than Firm
U by the value of this birr 24 perpetuity. Because the tax shield is generated by paying
interest, it has the same risk as the debt, and 8 percent (the cost of debt) is therefore the
appropriate discount rate. The value of the tax shield is thus:
PV= birr 24/0.08 = 0.3 x 1,000 x 0.08
0.08
= 0.3(1000) = 300
The present value of the interest tax shield can be written as:
PV = ( Tc x RD x D)
RD
PV = Tc x D
Where, Tc is tax rate, RD is cost of debt and D is debt
We have now come up with another famous result, M&M Proposition I with taxes. We
have seen that the value of levered firm (V L) exceeds the value of unlevered firm (VU) by
the present value of the interest tax shield; Tc x D. M&M Proposition I with taxes
therefore states that:
VL = VU + TC x D
The effect of borrowing in this case is illustrated in figure 2.6. We have plotted the value
of the levered firm, VL, against the amount of debt, D. M&M relationship is given by a
straight line with a slope of TC and a y-intercept of V U. It is also drawn a horizontal line
representing VU. As indicated, the distance between the two lines is T c x D, the present
value of the tax shield.
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Value
Of the
Firm VL = VU + TC x D
VL= 7300 TC x D
VU=7000 VU
VU
VU = EBIT x (1-TC)
RU
VU = 1000 x (1-0.3)
0.10
= 7,000
The value of the levered firm, VL, is:
VL = VU + TC x D
= 7,000 + 0.3 x 1,000
= 7,300
As indicated in figure 2.6, the value of the firm goes up by birr 0.30 for every 1 birr in
debt. It is difficult to imagine why any corporation would not borrow to the absolute
maximum under these circumstances. The result of the analysis in this section is that, if
tax is included, capital structure definitely matters. However, we reach the illogical
conclusion that the optimal capital structure is 100 percent debt
B. Taxes, the WACC, and Proposition II
The conclusion that the best capital structure is 100 percent debt also can be seen by
examining the weighted average cost of capital (WACC). If tax is considered, the WACC
is computed as:
WACC = E/V X RE + D/V X RD X (1-TC)
Where V = D + E
To calculate WACC, we need to know the cost of equity. M&M Proposition II with
corporate taxes states that the cost of equity is:
RE = RU + (RU – RD) X (D/E) X (1-TC)
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To illustrate, recall that firm L is worth birr 7,300 total (total asset of the firm). Since the
debt is worth birr 1,000, the equity must be worth 7,300-1,000 =6,300 birr. For firm L,
the cost of equity is thus:
RE = RU + (RU – RD) X (D/E) X (1-TC)
= 10% + (0.1-0.08) x (1,000/6,300) x (1-0.30)=10.22%
Therefore, the weighted average cost of capital is:
WACC = E/V X RE + D/V X RD X (1-TC)= 6,300/7,300 x 10.22% + 1,000/7,300 x 8% x
(1-0.3)= 9.6%
With out debt, the WACC is 10 percent, and, with debt, it is 9.6 percent. Therefore, the
firm is better off with debt. As the WACC decrease the value of the firm increase.
The following figure summarizes the discussion concerning the relationship between the
cost of equity, the after tax cost of debt, and the weighted average cost of capital. For
comparison, the cost of capital for unlevered firm (R U) is included. In the figure 2.7 the
horizontal axis is represented by debt/equity ratio and notice that how the WACC
declines as the debt/equity ratio rises. This illustrates again that the more debt the firm
uses, the lower is its WACC.
RE
RE = 10.22 %
RU = 10% RU
WACC = 9.6%
WACC
RD X (1-TC)
=8%X (1-0.3 RD X (1-TC)
=5.6%
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= 500 + 0.34 x 500= birr 670
Since the firm is worth birr 670 total and the debt is worth birr 500, the equity is worth
birr 170:
E = VL – D= 670- 500 = 170
Thus, from M&M Proposition II with taxes, the cost of equity is:
RE = RU + (RU – RD) X (D/E) X (1-TC)
= 0.20 + (0.20-0.10) x (500/170) x (1-0.34)= 39.4%
Finally, the WACC is:
WACC = E/V X RE + D/V X RD X (1-TC)
= (170/670) x 39.4% + (500/670) x 10% x (1-0.34)= 14.92%
Notice that this is substantially lower than the cost of capital for the firm with no debt
(RU = 20%), so debt financing is highly advantageous.
Modigliani and Miller Summary
I. The No tax case
A. Proposition I: The value of the firm levered (VL) is equal to the value of the firm
unlevered(VU):
VL=VU
Implication of Proposition I:
1. a firm’s capital structure is irrelevant
2. a firm’s weighted average cost of capital(WACC) is the same no matter what
mixture of debt and equity is used to finance the firm
B. Proposition II: The cost of equity, RE, is:
RE=RA+ (RA-RD) x D/E
Where RA is the WACC, RD is the cost of debt, and D/E is the debt/equity
Ratio.
Implication of Proposition II:
1. the cost of equity rises as the firm increases its use of debt financing
2. the risk of the equity depends on two things: the riskiness of the firm’s operations
( business risk) and the degree of financial leverage ( financial risk)
The tax case
A. Proposition I with taxes: The value of the firm levered (VL) is equal to the value
of the firm unlevered(VU) plus the present value of the interest tax shield:
VL= VU + Tc x D
Where Tc is the corporate tax rate and D is the amount of debt.
Implication of Proposition I:
1. Debt financing is highly advantageous, and, in the extreme, a firm’s optimal
capital structure is 100 percent debt.
2. a firm’s weighted average cost of capital (WACC) decreases as the firm relies
more heavily on debt financing
B. Proposition II with taxes: the cost of equity, RE, is
RE= RU + (RU-RD) x D/E x (1-Tc)
Where RU is the unlevered cost of capital, that is, the cost of capital for
the firm if it had no debt.
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