Capital Structure and Leverage
Capital Structure and Leverage
Learning Objectives
High risk
0 E(EBIT) EBIT
Note that business risk does not include
financing effects.
Business risk is affected primarily by:
EBITL EBITH
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Both firms have same operating
leverage, business risk, and probability
distribution of EBIT. Differ only with
respect to use of debt (capital structure).
Firm U: Unleveraged
Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
Firm U Bad Avg. Good
BEP* 10.0% 15.0% 20.0%
ROE6.0% 9.0% 12.0%
TIE
8
Firm L Bad Avg. Good
BEP* 10.0% 15.0% 20.0%
ROE4.8% 10.8% 16.8%
TIE 1.67x 2.5x 3.3x
*BEP same for Firms U and L.
Expected Values:
U L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) 2.5x
8
Risk Measures:
sROE 2.12% 4.24%
CVROE 0.24 0.39
For leverage to raise expected ROE,
must have BEP > kd.
Why? If kd > BEP, then the interest
expense will be higher than the
operating income produced by
debt-financed assets, so leverage
will depress income.
Conclusions
EBIT
TIE =
I
($400,000)(0.6)
= 80,000 = $3.00.
D = $250, kd = 8%.
Shares $250,000
repurchased = $25
= 10,000.
[$400 – 0.08($250)](0.6)
EPS1 =
80 – 10
= $3.26.
EBIT $400
TIE = = = 20×.
I $20
D = $500, kd = 9%.
Shares $500
repurchased = $25 = 20.
[$400 – 0.09($500)](0.6)
EPS2 =
80 – 20
= $3.55.
EBIT $400
TIE = = = 8.9×.
I $45
D = $750, kd = 11.5%.
Shares $750
repurchased = $25 = 30.
[$400 – 0.115($750)](0.6)
EPS3 =
80 – 30
= $3.77.
EBIT $400
TIE = = = 4.6×.
I $86.25
D = $1,000, kd = 14%.
Shares $1,000
repurchased = $25 = 40.
[$400 – 0.14($1,000)](0.6)
EPS4 =
80 – 40
= $3.90.
EBIT $400
TIE = = = 2.9×.
I $140
Stock Price (Zero Growth)
D1 EPS DPS
P0 = = = .
ks – g ks ks
bL = bU [1 + (1 – T)(D/E)].
15 ks
WACC
kd(1 – T)
P0
EPS
D/A
.25 .50
If is were discovered that the firm had
more/less business risk than originally
estimated, how would the analysis be
affected?
1. Sales stability?
2. High operating leverage?
3. Increase in the corporate tax rate?
4. Increase in the personal tax rate?
5. Increase in bankruptcy costs?
6. Management spending lots of
money on lavish perks?
Long-term Debt Ratios for
Selected Industries
Actual
No leverage
D/A
0 D1 D2
The graph shows MM’s tax benefit
vs. bankruptcy cost theory.
Logical, but doesn’t tell whole
capital structure story. Main
problem--assumes investors have
same information as managers.
Signaling theory, discussed earlier,
suggests firms should use less debt
than MM suggest.
This unused debt capacity helps
avoid stock sales, which depress P0
because of signaling effects.
What are “signaling” effects in capital
structure?
Assumptions: