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# Leverage and Capital Structure

Ch 13

by

Tweet## NATALY GARCIA

on 5 April 2013#### Transcript of Leverage and Capital Structure

Leverage and Capital Structure Effects that fixed costs have on the returns that shareholders earn:

+ leverage = + returns + volatility Leverage What are fixed costs? Costs that the firm must pay in a given period regardless of the sales volume achieved during that period. Mix of long term debt and capital of a company. Capital Structure http://www.youtube.com/watch?v=eutMZD8i6ys. Financial Leverage Operating Leverage Relationship between the firm’s sales revenue and its earnings before interest and taxes (EBIT) or operating profits Total Leverage Combined effect of operating and financial leverage.

Relationship between the firm’s sales revenue and EPS. Relationship between the firm’s EBIT and its common stock earnings per share (EPS) Leverage Indicates the level of operations necessary to cover all costs and to evaluate the profitability associated with various levels of sales. (cost-volume-profit analysis).

Operating breakeven point is the level of sales necessary to cover all operating costs (EBIT = $0)

Divide COS and operating expenses into fixed and variable operating costs.

Fixed: no change with sales volume.

Variable: vary directly with sales volume. Laura 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?

1) Op BEP = $3,000/($10 – $5) = 600 units.

2) Op BEP = $2,500/($12.50 – $5) = 333.33 units.

3) Op BEP = $2,500/($10 – $7.50) = 1,000 units.

4) Op BEP = $3,000/($12.50 – $7.50) = 600 units. Breakeven analysis Laura wishes to evaluate the impact of:

1. increasing fixed operating costs to $3,000

2. increasing the sale price per unit to $12.50

3. increasing the VC per unit to $7.50

4. simultaneously implementing all three. Operating Leverage Use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes. Laura Posters (price, P = $10 per unit; variable operating cost, VC = $5 per unit; fixed operating cost, FC = $2,500) Degree of operating leverage (DOL) is the numerical measure of the firm’s operating leverage. As DOL is + than 1 = exist operating leverage. Doing DOL on both Laura cases. Other formula: Solving with the new formula:

Q = 1,000, P = $10,

VC = $5, and FC = $2,500 : Laura exchanges a portion of its VC for FC by eliminating commissions and increasing salaries. This results in a reduction in VC from $5 to $4.50 and an increase in FC from $2,500 to $3,000. Fixed Costs and Operating Leverage Changing the mix of fixed and variable costs in the operation to maximize the benefits of the leverage. More DOL Financial Leverage Total Leverage Is the use of fixed financial costs to magnify the effects of changes in EBIT on the firm’s EPS. Note: 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. A restaurant 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. Taxes are 40%.

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). The degree of financial leverage (DFL) is the numerical measure of the firm’s financial leverage. Applying DDL in the restaurant: and...

EBIT = $10,000, I = $2,000,

PD = $2,400, y taxes = 40% : The two most common fixed financial costs are:

1. interest on debt

2. preferred stock dividends. Whenever DFL is + than 1, there is financial leverage. Other formula is: 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. A cable manufacturer, expects sales of 20,000 units at $5 per unit in the coming year and must meet the following obligations: operating VC of $2 per unit, operating FC 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. The degree of total leverage (DTL) is the numerical measure of the firm’s total leverage. A more direct formula: As long as the DTL is + than 1, there is total leverage. Applying DTL in the cable co.: and...

Q = 20,000, P = $5, VC = $2, FC = $10,000, I=$20,000, PD=$12,000 e impuestos de 40%: Leverage Relations Total leverage reflects the combined impact of operating and financial leverage on the firm.

The relationship between operating leverage and financial leverage is multiplicative rather than additive.

DTL = DOL * DFL Using last DOL and DFL we have: DTL = 1.2 * 5.0 = 6.0 Capital Structure Types of Capital Capital sources are:

DEBT CAPITAL

- Only long term.

- The cost of debt is lower than the cost (less risk)

- The tax deductibility of interest payments also lowers the debt cost.

EQUITY CAPITAL

- Remains invested in the firm indefinitely.

- Preferred stock and common stock equity (common stock & retained earnings).

- Common stock is typically the most expensive form of equity, followed by retained earnings and then preferred stock. 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.

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. 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. How leveraged are they and how much would be if they take it? Capital Structure of Non-U.S. Firms DIFFERENCES

- Non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts.

- 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. SIMILARITIES

- The same industry patterns of capital structure tend to be found in all the world.

- The capital structures of the largest non U.S.-based multinational companies, which have access to capital markets around the world, typically resemble the capital structures of multinational U.S. companies.

- The worldwide trend is away from reliance on banks for financing and toward greater reliance on security issuance. LEVERAGE AROUND THE WORLD

- Firms in Argentina used more long-term debt than firms in any other country.

- Argentina used almost 60% more long-term debt than did U.S. companies. Capital Structure Theory Optimal capital structure 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. Financial theory does offer help in understanding how a firm’s capital structure affects the firm’s value. - 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. Many researchers 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.

The cost of debt financing results from:

1. The increased probability of bankruptcy caused by debt obligations

2. Agency costs of the lender’s constraining the firm’s actions

3. The costs associated with managers having more information about the firm’s prospects than do investors. Allowing firms to deduct interest payments on debt.

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. The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due. Agency Costs Probability of Bankruptcy A soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates:

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:

Which is the estimated EBIT? FINANCIAL RISK

- Risk that the company can't meet its financial obligations.

- The penalty of not meeting those obligations is bankruptcy.

- The higher the financial FC (debts and preferred stock) the more DFL and risk. BUSINESS RISK

- Risk to the firm of being unable to cover its operating costs.

- The greater the firm’s operating leverage—the use of operating FC—the higher its business risk.

- Revenue stability and cost stability also affect it.

- Firms with high business risk therefore tend toward less highly leveraged capital structures & vs. TOTAL RISK

- Is the combined risk of business and financial risk and determinates the bankruptcy probability. Tax Benefits Imposed by lenders.

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 extends 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. Is the situation in which managers of a firm have more information than do investors.

SIGNAL

Is a financing action by management that is believed to reflect its view of the firm’s stock value;

Debt financing is viewed as a positive signal that management believes the stock is “undervalued,”

Stock issue is viewed as a negative signal that management believes the stock is “overvalued.” Asymmetric Information Even if it exists (so far) only in theory... 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).

We can plot coordinates on the EBIT–EPS graph by assuming specific EBIT values and calculating the EPS associated with them. 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 DFL 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 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. Choosing the Optimal Capital Structure EBIT-EPS Approach to Capital Structure 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. 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. Simulate the following capital structures: debt ratios of 0%, 30%, and 60%. For EBIT values of $100,000 and $200,000, the associated EPS values calculations. Basic Shortcoming Considering Risk in EBIT-EPS Analysis Estimating Value

Full transcript+ leverage = + returns + volatility Leverage What are fixed costs? Costs that the firm must pay in a given period regardless of the sales volume achieved during that period. Mix of long term debt and capital of a company. Capital Structure http://www.youtube.com/watch?v=eutMZD8i6ys. Financial Leverage Operating Leverage Relationship between the firm’s sales revenue and its earnings before interest and taxes (EBIT) or operating profits Total Leverage Combined effect of operating and financial leverage.

Relationship between the firm’s sales revenue and EPS. Relationship between the firm’s EBIT and its common stock earnings per share (EPS) Leverage Indicates the level of operations necessary to cover all costs and to evaluate the profitability associated with various levels of sales. (cost-volume-profit analysis).

Operating breakeven point is the level of sales necessary to cover all operating costs (EBIT = $0)

Divide COS and operating expenses into fixed and variable operating costs.

Fixed: no change with sales volume.

Variable: vary directly with sales volume. Laura 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?

1) Op BEP = $3,000/($10 – $5) = 600 units.

2) Op BEP = $2,500/($12.50 – $5) = 333.33 units.

3) Op BEP = $2,500/($10 – $7.50) = 1,000 units.

4) Op BEP = $3,000/($12.50 – $7.50) = 600 units. Breakeven analysis Laura wishes to evaluate the impact of:

1. increasing fixed operating costs to $3,000

2. increasing the sale price per unit to $12.50

3. increasing the VC per unit to $7.50

4. simultaneously implementing all three. Operating Leverage Use of fixed operating costs to magnify the effects of changes in sales on the firm’s earnings before interest and taxes. Laura Posters (price, P = $10 per unit; variable operating cost, VC = $5 per unit; fixed operating cost, FC = $2,500) Degree of operating leverage (DOL) is the numerical measure of the firm’s operating leverage. As DOL is + than 1 = exist operating leverage. Doing DOL on both Laura cases. Other formula: Solving with the new formula:

Q = 1,000, P = $10,

VC = $5, and FC = $2,500 : Laura exchanges a portion of its VC for FC by eliminating commissions and increasing salaries. This results in a reduction in VC from $5 to $4.50 and an increase in FC from $2,500 to $3,000. Fixed Costs and Operating Leverage Changing the mix of fixed and variable costs in the operation to maximize the benefits of the leverage. More DOL Financial Leverage Total Leverage Is the use of fixed financial costs to magnify the effects of changes in EBIT on the firm’s EPS. Note: 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. A restaurant 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. Taxes are 40%.

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). The degree of financial leverage (DFL) is the numerical measure of the firm’s financial leverage. Applying DDL in the restaurant: and...

EBIT = $10,000, I = $2,000,

PD = $2,400, y taxes = 40% : The two most common fixed financial costs are:

1. interest on debt

2. preferred stock dividends. Whenever DFL is + than 1, there is financial leverage. Other formula is: 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. A cable manufacturer, expects sales of 20,000 units at $5 per unit in the coming year and must meet the following obligations: operating VC of $2 per unit, operating FC 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. The degree of total leverage (DTL) is the numerical measure of the firm’s total leverage. A more direct formula: As long as the DTL is + than 1, there is total leverage. Applying DTL in the cable co.: and...

Q = 20,000, P = $5, VC = $2, FC = $10,000, I=$20,000, PD=$12,000 e impuestos de 40%: Leverage Relations Total leverage reflects the combined impact of operating and financial leverage on the firm.

The relationship between operating leverage and financial leverage is multiplicative rather than additive.

DTL = DOL * DFL Using last DOL and DFL we have: DTL = 1.2 * 5.0 = 6.0 Capital Structure Types of Capital Capital sources are:

DEBT CAPITAL

- Only long term.

- The cost of debt is lower than the cost (less risk)

- The tax deductibility of interest payments also lowers the debt cost.

EQUITY CAPITAL

- Remains invested in the firm indefinitely.

- Preferred stock and common stock equity (common stock & retained earnings).

- Common stock is typically the most expensive form of equity, followed by retained earnings and then preferred stock. 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.

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. 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. How leveraged are they and how much would be if they take it? Capital Structure of Non-U.S. Firms DIFFERENCES

- Non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts.

- 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. SIMILARITIES

- The same industry patterns of capital structure tend to be found in all the world.

- The capital structures of the largest non U.S.-based multinational companies, which have access to capital markets around the world, typically resemble the capital structures of multinational U.S. companies.

- The worldwide trend is away from reliance on banks for financing and toward greater reliance on security issuance. LEVERAGE AROUND THE WORLD

- Firms in Argentina used more long-term debt than firms in any other country.

- Argentina used almost 60% more long-term debt than did U.S. companies. Capital Structure Theory Optimal capital structure 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. Financial theory does offer help in understanding how a firm’s capital structure affects the firm’s value. - 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. Many researchers 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.

The cost of debt financing results from:

1. The increased probability of bankruptcy caused by debt obligations

2. Agency costs of the lender’s constraining the firm’s actions

3. The costs associated with managers having more information about the firm’s prospects than do investors. Allowing firms to deduct interest payments on debt.

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. The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due. Agency Costs Probability of Bankruptcy A soft drink manufacturer, is preparing to make a capital structure decision. It has obtained estimates:

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:

Which is the estimated EBIT? FINANCIAL RISK

- Risk that the company can't meet its financial obligations.

- The penalty of not meeting those obligations is bankruptcy.

- The higher the financial FC (debts and preferred stock) the more DFL and risk. BUSINESS RISK

- Risk to the firm of being unable to cover its operating costs.

- The greater the firm’s operating leverage—the use of operating FC—the higher its business risk.

- Revenue stability and cost stability also affect it.

- Firms with high business risk therefore tend toward less highly leveraged capital structures & vs. TOTAL RISK

- Is the combined risk of business and financial risk and determinates the bankruptcy probability. Tax Benefits Imposed by lenders.

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 extends 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. Is the situation in which managers of a firm have more information than do investors.

SIGNAL

Is a financing action by management that is believed to reflect its view of the firm’s stock value;

Debt financing is viewed as a positive signal that management believes the stock is “undervalued,”

Stock issue is viewed as a negative signal that management believes the stock is “overvalued.” Asymmetric Information Even if it exists (so far) only in theory... 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).

We can plot coordinates on the EBIT–EPS graph by assuming specific EBIT values and calculating the EPS associated with them. 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 DFL 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 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. Choosing the Optimal Capital Structure EBIT-EPS Approach to Capital Structure 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. 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. Simulate the following capital structures: debt ratios of 0%, 30%, and 60%. For EBIT values of $100,000 and $200,000, the associated EPS values calculations. Basic Shortcoming Considering Risk in EBIT-EPS Analysis Estimating Value