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Unit 4 Study Guide

Capital Structure and Leverage

The Big Picture..

What is business risk?

• Uncertainty about future operating income (EBIT), i.e., how well can we predict
operating income?
• Business risk does not include financing effects.

Business risk is affected primarily by:

• Uncertainty about demand (sales)

• Uncertainty about output prices.
• Uncertainty about costs.
• Product, other types of liability
• Operating leverage

What is operating leverage, and how does it affect a firm’s business risk?

• Operating leverage is the use of fixed costs rather than variable costs.
• If most costs are fixed, hence do not decline when demand falls, then the firm has high
operating leverage.

What is financial leverage? Financial risk?

• Financial leverage is the use of debt and preferred stock.

• Financial risk is the additional risk concentrated on common stockholders as a result of
financial leverage.

Business Risk Vs. Financial Risk

• Business risk depends on business factors such as competition, product liability, and
operating leverage.
• Financial risk depends only on the types of securities issued: more debt, more financial
risk concentrates business risk on stockholders.

Consider 2 Hypothetical Firms

Firm U Firm L
No debt $20,000 of 12% Debt
$40, 000 in Assets $40, 000 in Assets
40% Tax rate 40% Tax rate
Both firms have the same operating leverage, business risk, and probability distribution
of EBIT. Differ only in respect of debt (Capital Structure)

Firm U: Unleveraged
Bad Avg. Good
Prob. .025 .50 .25
EBIT $4,000 $6,000 $8,000
Interest __0__ __ 0__ __0__
EBT $4,000 $6,000 $8,000
Taxes (40%) 1,600 2,400 3,200
NI $2,400 $3,600 $4,800

Firm L: leveraged
Bad Avg. Good
Prob. .025 .50 .25
EBIT $4,000 $6,000 $8,000
Interest 2,400 2,400 2,400
EBT $1,600 $3,600 $5,600
Taxes (40%) 640 1,,440 2,240
NI $960 $2,160 $3,360

Firm U: Unleveraged
Bad Avg. Good
ROE 6% 9% 12%
TIE - - -

Firm L: leveraged
Bad Avg. Good
ROE 4.8% 10.8% 16.8%
TIE 1.67x 2.5x 3.3x

If debt increases, TIE falls.

EBIT is constant ( unaffected by use of debt). And since kdD as D increases, Tie must

Financing Choices across the life cycle

$ Revenues/



External funding High, but High, relative Moderate, relative Declining, as a

Low, as projects dry
needs constrained by to firm value. to firm value. percent of firm
infrastructure value

Internal financing Negative or Negative or Low, relative to High, relative to More than funding needs
low low funding needs funding needs

External Owner’s Equity Venture Capital Common stock Debt Retire debt
Financing Bank Debt Common Stock Warrants Repurchase stock

Growth stage Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Start-up Rapid Expansion High Growth Mature Growth Decline

Transitions Accessing private equity Inital Public offering Seasoned equity issue Bond issues

The Transitional Phases..
• The transitions that we see at firms – from fully owned private businesses to venture
capital, from private to public and subsequent seasoned offerings are all motivated
primarily by the need for capital.
• In each transition, though, there are costs incurred by the existing owners:
– When venture capitalists enter the firm, they will demand their fair share and
more of the ownership of the firm to provide equity.
– When a firm decides to go public, it has to trade off the greater access to capital
markets against the increased disclosure requirements (that emanate from being
publicly lists), loss of control and the transactions costs of going public.
– When making seasoned offerings, firms have to consider issuance costs while
managing their relations with equity research analysts and rating agencies.

As a firm goes through the lifecycle, there are usually three transition points worth watching…
Note, though, that whether and when these transition points occur can vary widely across firms.
For some firms like Google and Amazon, the transition from owner funded businesses to large
publicly traded companies was speedy. Other firms, may, never make the transition and stay
privately owned businesses as they grow, using internal funding to grow over time. Still others
never make it to the transitional phases and fade away, go bankrupt or are acquired.

Measuring a firm’s financing mix …

• The simplest measure of how much debt and equity a firm is using currently is to look at
the proportion of debt in the total financing. This ratio is called the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity)
• Debt includes all interest bearing liabilities, short term as well as long term. It should also
include other commitments that meet the criteria for debt: contractually pre-set payments
that have to be made, no matter what the firm’s financial standing.
• Equity can be defined either in accounting terms (as book value of equity) or in market
value terms (based upon the current price). The resulting debt ratios can be very different.

The difference between book value and market value debt ratios can give rise to problems. For
instance, most published debt ratios are book value debt ratios and many analysts talk about book
debt ratios when talking about financial leverage. When firms raise financing, though, they do so
in market value terms.

When “debt ratios” are used in analysis, it is best to define them up front. For the rest of this
analysis, we will debt ratio to mean market value, total debt ratios, with debt including the
present value of operating lease commitments.

The Financing Mix Question

• In deciding to raise financing for a business, is there an optimal mix of debt and equity?
– If yes, what is the trade off that lets us determine this optimal mix?
– What are the benefits of using debt instead of equity?
– What are the costs of using debt instead of equity?
– If not, why not?

Debt: Summarizing the trade off

Advantages of Debt Disadvantages of Debt

1. Tax Benefit: 1. Expected bankruptcy cost: The expected
Interest expenses on debt are tax deductible but cost of going bankrupt is a product of the
cash flows to equity are not. probability of going bankrupt and the cost
Implication: The higher the marginal tax rate, of going bankrupt. The latter includes both
the greater the benefits of debt. direct and indirect cost. The probability of
going bankrupt will be higher in business
with more volatile earnings and the cost of
bankruptcy will also vary across

1. Firms with more stable earnings should
borrow more, for any given level of
2. Firms with lower bankruptcy cost should
borrow more for any given level of
2.Added Discipline: Borrowing money mat 2. Agency Costs: Actions that benefit equity
force managers to think about consequences investors may hurt lenders. The greater the
of the investment decisions a little more potential for this conflict of interest, the
carefully and reduce bad investments. greater the cost borne by the borrower (as
higher interest rates or more covenants).
Implication: As the separation between
managers and stockholders increase, the Implication: Firms where lenders can
benefits to using debt will go up. monitor / control how money is being used
should be able to borrow more than firms
where that is difficult to do.
3. Loss of flexibility: Using up available debt
capacity today will mean that you cannot
draw on it in the future. This loss of
flexibility can be disastrous if funds are
needed and access to capital is shut off.

1. Firms that can forecast future funding
needs better should be able to borrow
2. Firms with better access to capital
markets should be more willing to
borrow more today.

Application Test:
Would you expect firm A to gain or lose from using a lot of debt?

• Considering, firm A,
– The potential tax benefits of borrowing
– The benefits of using debt as a disciplinary mechanism
– The potential for expected bankruptcy costs
– The potential for agency costs
– The need for financial flexibility
• Would you expect firm A to have a high debt ratio or a low debt ratio?
• Does firm A’s current debt ratio meet your expectations?

This is just a qualitative analysis. It will not give you a specific optimal debt ratio but provides
insight into why the firm may be using the financing mix that it is today.

Target Capital Structure

• The Mix of debt, preferred stock, and common equity with which the firm plans to raise

Optimal Capital Structure

A firm’s optimal capital structure is defined as the structure that would maximize its stock price.

• That capital structure (mix of debt, preferred and common equity) at which P0 is
maximized. Trades off higher E(ROE) and EPS against higher risk. The tax-related
benefits of leverage are exactly offset by the debt’s risk-related costs.
• The target capital structure is the mix of debt, preferred stock, and common equity with
which the firm intends to raise capital.

Four primary factors influence capital structure decisions:

1. Business risk, or the riskiness inherent in the firm’s operations if it used no debt. The
greater the firm’s business risk, the lower its optimal debt ratio.
2. The firm’s tax position. A major reason for using debt is that interest is tax deductible,
which lowers the effective cost of debt. However, if most of a firm’s income is already
sheltered from taxes by depreciation tax shields, interest on currently outstanding debt, or
tax loss carry-forwards, its tax rate will be low, hence additional debt would not be as
advantageous as it would be to a firm with a higher effective tax rate.
3. Financial flexibility, or the ability to raise capital on reasonable terms under adverse
conditions. A steady supply of capital is necessary for stable operations, which is vital for
long-run success. When money is tight in the economy, or when a firm is experiencing
operating difficulties, it is easier to raise debt than equity capital, and lenders are more
willing to accommodate companies with strong balance sheets. Therefore, the potential
future need for funds and the consequences of a funds shortage influence the target
capital structure—the greater the probability that capital will be needed, and the worse

the consequences of not being able to obtain it, the less debt the firm should have on its
balance sheet.
4. Managerial conservatism or aggressiveness. Some managers are more aggressive than
others, hence they are more willing to use debt in an effort to boost profits. This factor
does not affect the true optimal, or value-maximizing, capital structure, but it does
influence the firm’s target capital structure.

Mechanics of Cost of Capital Estimation

1. Estimate the Cost of Equity at different levels of debt:

 Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
 Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
 Default risk will go up and bond ratings will go down as debt goes up -> Cost of
Debt will increase.
 To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.

Basic inputs for computing cost of capital are cost of equity and cost of debt. This summarizes
the basic approach we will use to estimate each.

The Miller-Modigliani Theorem

• In an environment, where there are no taxes, default risk or agency costs, capital structure
is irrelevant.
• If the Miller Modigliani theorem holds:
– A firm's value will be determined the quality of its investments and not by its
financing mix.
– The cost of capital of the firm will not change with leverage. As a firm increases
its leverage, the cost of equity will increase just enough to offset any gains to the

With the above assumptions:
 The cost of capital will remain unchanged as the debt ratio changes
 The value of the firm will not be a function of leverage
 Investment decisions can be made independently of financing decisions
 Note that if we allow for tax benefits, and keep the other assumptions, the optimal
debt ratio will go to 100%.

What do firms look at in financing?

 There are some who argue that firms follow a financing hierarchy, with retained
earnings being the most preferred choice for financing, followed by debt and that
new equity is the least preferred choice. In particular,
o Managers value flexibility. Managers value being able to use capital (on
new investments or assets) without restrictions on that use or having to
explain its use to others.
o Managers value control. Managers like being able to maintain control of
their businesses.
 With flexibility and control being key factors:
o Would you rather use internal financing (retained earnings) or external
o With external financing, would you rather use debt or equity?
Firms have fairly strong preferences in terms of where they would like to raise capital. They
seem to prefer internal over external sources of capital and new debt over new equity.

Managers make financing decisions, not stockholders. The survey results indicate that what they
value will have consequences for what kind of financing gets used. And they seem to value
flexibility and control…

Application Test:

What type of financing gives you the most flexibility and the least need to answer to anyone?
- Internal financing or External financing (With internal financing, you do not have to file
with the SEC or explain to investors what you plan to do with the money… you may, in
hindsight, have to come up with a good story to tell your stockholders about why you
retained earnings…)
- New debt or new equity (If you do have to access external financing, it is a closer call.
While new debt may come with covenants (which restrict your operating flexibility) and
the need to explain your actions to ratings agencies or banks, issuing new equity requires
filings with the SEC and the possible loss of control.

Recapitalization involves restructuring a company's debt and equity mixture, with the aim of
increasing a firms optimal capital structure. The process essentially involves the exchange of
one form of financing for another, such as removing preferred shares from the company's capital
structure and replacing them with bonds.

Recapitalization can be beneficial to a company:
 defending the firm against a hostile takeover,
 minimizing taxes
 implement an exit strategy for venture capitalists.
 diversify a company’s debt-to-equity ratio to improve liquidity.

A good example is when a company issues stock in order to buy back debt securities, thus
increasing its proportion of equity capital as compared to its debt capital.

When a company's debt decreases in proportion to its equity, it has lower leverage and thus, all
things remaining constant, its EPS should decrease following the change, however its shares
would be incrementally less risky, since the company's shareholders have fewer debt obligations
which must be paid by the company before shareholders can see profits.

Getting to the Optimal

Condition of Firm Action to take

Under levered, Target of takeover Borrow money, buy back stock now
Under levered, Not target of a takeover, Good Borrow money, Take projects (now and over time)
Under levered, Not target of a takeover, Bad Borrow money, Buy back stock & pay dividends
projects over time
Over levered, threat of bankruptcy high Issue equity to retire debt or equity for debt swap,
Restructure debt
Over levered, no near-term threat of bankruptcy, Use retained earnings (equity) to take projects
Good projects over time
Over levered, no near-term threat of bankruptcy, Use retained earnings (equity) to retire debt over
Bad projects time

Describe the sequence of events in a recapitalization.

• Campus Deli announces the recapitalization.

• New debt is issued.
• Proceeds are used to repurchase stock.

Shares bought = Debt issued
Price Per share

Cost of debt at different debt levels after recapitalization

Amount D/A D/E Bond kd
borrowe ratio ratio Ratin
d g
$ 0 0 0 - --
250 0.125 0.1429 AA 9%
500 0.250 0.3333 A 9%
750 0.375 0.6000 BBB 11.5%

1,000 0.500 1.0000 BB 14%
Why does the bond rating and cost of debt depend upon the amount borrowed?

• As the firm borrows more money, the firm increases its risk causing the firm’s bond
rating to decrease, and its cost of debt to increase.

What would the earnings per share be if Campus Deli recapitalized and used these
amounts of debt: $0, $250,000, $500,000, $750,000? Assume EBIT = $400,000, T = 40%,
and shares can be repurchased at P0 = $25.

Stock Price (Zero Growth)

What effect would increasing debt have on the cost of equity for the firm?

 If the level of debt increases, the riskiness of the firm increases.

 We have already observed the increase in the cost of debt.
 However, the riskiness of the firm’s equity also increases, resulting in a higher ks.

Minimizing the WACC

What debt ratio maximizes EPS?

• Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%.

• Risk is too high at D/A = 50%.

What is Campus Deli’s optimal capital structure?

• P0 is maximized ($26.89) at D/A = $500,000/$2,000,000 = 25%, so optimal D/A = 25%.

• EPS is maximized at 50%, but primary interest is stock price, not E(EPS).
• The example shows that we can push up E(EPS) by using more debt, but the risk
resulting from
• increased leverage more than offsets the benefit of higher E(EPS).

Signalling Theory

• An action taken by a firm’s management that provides clues to investors about how
management views the firm’s prospects. e.g. a company announcement of an increase in
dividend payouts act as an indicator of the firm possessing strong future prospects. The
rationale behind dividend signaling models stems from game theory. A manager who has
good investment opportunities is more likely to "signal" than one who doesn't because it
is in his or her best interest to do so.

What are ‘signalling’ effects in capital structure?

• Managers have better information about a firm’s long-run value than outside investors
• Managers act in the best interests of current stockholders.

Unit 4:Tutorial Sheet (Lecturers Copy)

1. Why do public utilities pursue a different finance policy that retail firms?

2. Explain why the following statement is true: “other things the same, firms with relatively
stable sales are able to carry relatively high debt ratios”.

3. A company currently has assets of $5 million and it is 100 percent equity financed. The
company currently has net income of $1 million and it pays out 40 percent of its net income
as dividends. Both net income and dividends are expected to grow at a constant rate of 5
percent per year. There are 200,000 shares of stock outstanding, and it is estimated that the
current cost of capital is 13.4 percent. The company is considering a recapitalization exercise
where it will issue $1 million in debt and use the proceeds to repurchase stock. Investment
bankers have estimated that if the company goes ahead with the recapitalization, its before-
tax cost of debt will be 11 percent, and the cost of equity will rise to 14.5 percent. The
company has a 40 percent tax rate.

a. What is the current share price of the stock (i.e. before recapitalization)
b. Assume that the company maintains the same payout ratio, what will be the stock price
after recapitalization.

4. Two firms HL and LL are identical except for their leverage ratios and interest rates on debt.
Each has $20 million in assets, earned $4 million before interest and taxes in 2008 and has a
40 percent tax rate. Firm HL, however has a leverage ratio (D/TA) of 50 percent and pays 12
percent interest in its debt, whereas LL has a 30 percent leverage ratio and pays only 10
percent interest on its debt.

a. Calculate the rate of return on equity (net income/equity) for each firm.

b. Observing that HL has a higher rate of return on equity, LL’s treasurer decides to raise
the leverage ratio from 30 to 60 percent, which will increase LL’s interest rate on all
debt to 15 percent. Calculate the new rate of return on equity for LL.

5. Olinde Electronics Inc. produces stereo components that sell at $100 per unit. Olinde’s fixed
costs are $200,000; variable costs are $50 per unit; 5,000 components are produced and sold
each year; EBIT is currently $50,000; and Olinde’s assets (all equity financed) are $500,000.
Olinde can change its production process by adding $400,000 to assets and $50,000 to fixed
operating costs. This change would (1) reduce variable costs per unit by $10 and (2) increase
output by 2,000 units, but (3) the sales price on all units would have to be lowered to $95 to
permit sales of the additional output. Olinde has tax loss carry-forwards that cause its tax rate
to be zero, it uses no debt, and its average cost of capital is 10 percent.

a. Should Olinde make the change?

b. Would Olinde’s breakeven point increase or decrease if it made the change?
c. Suppose Olinde were unable to raise additional equity financing and had to borrow the
$400,000 at an interest rate of 10 percent to make the investment. Use the Du Pont
equation to find the expected ROA of the investment. Should Olinde make the change if
debt financing must be used?

6. Financial leverage: Gentry Motors Inc., a producer of turbine generators, is in this situation:
EBIT = $4 million; tax rate = T = 35%; debt outstanding = D = $2 million; rd = 10%; rs =
15%; shares of stock outstanding = N0 = 600,000; and book value per share = $10. Because
Gentry’s product market is stable and the company expects no growth, all earnings are paid
out as dividends. The debt consists of perpetual bonds.

a. What are Gentry’s earnings per share (EPS) and its price per share (P0)?
b. What is Gentry’s weighted average cost of capital (WACC)?
c. Gentry can increase its debt by $8 million, to a total of $10 million, using the new debt to
buy back and retire some of its shares at the current price. Its interest rate on debt will be
12 percent (it will have to call and refund the old debt), and its cost of equity will rise
from 15 to 17 percent. EBIT will remain constant. Should Gentry change its capital
d. If Gentry did not have to refund the $2 million of old debt, how would this affect things?
Assume that the new and the still outstanding debt are equally risky, with rd =12%, but
that the coupon rate on the old debt is 10 percent.
e. What is Gentry’s TIE coverage ratio under the original situation and under the conditions
in part c of this question?

7. Currently, Bloom Flowers Inc. has a capital structure consisting of 20 percent debt and 80
percent equity. Bloom’s debt currently has an 8 percent yield to maturity. The risk-free rate
(rRF) is 5 percent, and the market risk premium (rM - rRF) is 6 percent. Using the CAPM,
Bloom estimates that its cost of equity is currently 12.5 percent. The company has a 40
percent tax rate.

a. What is Bloom’s current WACC?

b. What is the current beta on Bloom’s common stock?
c. What would Bloom’s beta be if the company had no debt in its capital structure? (That is,
what is Bloom’s unlevered beta, bU?) Bloom’s financial staff is considering changing its
capital structure to 40 percent debt and 60 percent equity. If the company went ahead
with the proposed change, the yield to maturity on the company’s bonds would rise to 9.5
percent. The proposed change will have no effect on the company’s tax rate.
d. What would be the company’s new cost of equity if it adopted the proposed change in
capital structure?
e. What would be the company’s new WACC if it adopted the proposed change in
capital structure?
f. Based on your answer to part e, would you advise Bloom to adopt the proposed
change in capital structure? Explain.

8. Optimal capital structure Jackson Trucking Company is in the process of setting its target
capital structure. The CFO believes the optimal debt ratio is somewhere between 20 and
50 percent, and her staff has compiled the following projections for EPS and the stock
price at various debt levels:

Debt Ratio Projected EPS Projected Stock Price

20% $3.20 $35.00
30 3.45 36.50
40 3.75 36.25
50 3.50 35.50

Assuming that the firm uses only debt and common equity, what is Jackson’s optimal
capital structure? At what debt ratio is the company’s WACC minimized?

9. What role do uncertainty and managerial flexibility play in real option analysis?

10. Describe the types of real options?

11. McKean Inc. is an all-equity firm with 200,000 shares outstanding. The company’s EBIT is
$2,000,000, and EBIT is expected to remain constant over time. The company pays out all of
its earnings each year, so its earnings per share (EPS) equals its dividends per shares (DPS).
The company’s tax rate is 40%.

The company is considering issuing $2 million worth of bonds (at par) and using the
proceeds for a stock repurchase. If issued, the bonds would have an estimated YTM of 10%.
The risk-free rate is 6.5%, and the market risk premium is 5.0%. The company’s beta is
currently 0.90, but investment bankers say the beta will rise to 1.10 if the recapitalization

Assume that the shares are repurchased at a price equal to the stock market price prior to the
recapitalization. What would be the company’s stock price following the recapitalization?