} Profit. What is business risk? TOPIC 10 Capital Structure and Leverage. Effect of operating leverage. Using operating leverage

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1 TOPIC 10 Capital Structure and Leverage What i buine rik? Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income? Probability Low rik Buine v. financial rik Optimal capital tructure Operating leverage Capital tructure theory E(EBIT) High rik EBIT Note that buine rik doe not include financing effect What determine buine rik? Uncertainty about demand (ale). Uncertainty about output price. Uncertainty about cot. Product, other type of liability. Operating leverage. What i operating leverage, and how doe it affect a firm buine rik? Operating leverage i the ue of fixed cot rather than variable cot. If mot cot are fixed, hence do not decline when demand fall, then the firm ha high operating leverage Effect of operating leverage More operating leverage lead to more buine rik, for then a mall ale decline caue a big profit decline. $ Rev. $ Rev. TC } Profit TC FC FC Q BE Sale Q BE Sale What happen if variable cot change? 10-5 Uing operating leverage Probability EBIT L Low operating leverage High operating leverage EBIT H Typical ituation: Can ue operating leverage to get higher E(EBIT), but rik alo increae. 10-6

2 What i financial leverage? Financial rik? Financial leverage i the ue of debt and preferred tock. Financial rik i the additional rik concentrated on common tockholder a a reult of financial leverage. Buine rik v. Financial rik Buine rik depend on buine factor uch a competition, product liability, and operating leverage. Financial rik depend only on the type of ecuritie iued. More debt, more financial rik. Concentrate buine rik on tockholder An example: Illutrating effect of financial leverage Two firm with the ame operating leverage, buine rik, and probability ditribution of EBIT. Only differ with repect to their ue of debt (capital tructure). Firm U Firm L No debt $10,000 of 12% debt $20,000 in aet $20,000 in aet 40% tax rate 40% tax rate 10-9 Firm U: Unleveraged Economy Bad Avg. Good Prob EBIT $2,000 $3,000 $4,000 Interet EBT $2,000 $3,000 $4,000 Taxe (40%) 800 1,200 1,600 NI $1,200 $1,800 $2, Firm L: Leveraged Economy Bad Avg. Good Prob.* EBIT* $2,000 $3,000 $4,000 Interet 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxe (40%) ,120 NI $ 480 $1,080 $1,680 *Same a for Firm U Ratio comparion between leveraged and unleveraged firm FIRM U Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 6.0% 9.0% 12.0% TIE FIRM L Bad Avg Good BEP 10.0% 15.0% 20.0% ROE 4.8% 10.8% 16.8% TIE 1.67x 2.50x 3.30x 10-12

3 Rik and return for leveraged and unleveraged firm Expected Value: Firm U Firm L E(BEP) 15.0% 15.0% E(ROE) 9.0% 10.8% E(TIE) 2.5x Rik Meaure: Firm U Firm L σ ROE 2.12% 4.24% CV ROE The effect of leverage on profitability and debt coverage For leverage to raie expected ROE, mut have BEP > r d. Why? If r d > BEP, then the interet expene will be higher than the operating income produced by debt-financed aet, o leverage will depre income. A debt increae, TIE decreae becaue EBIT i unaffected by debt, and interet expene increae (Int Exp = r d D) Concluion Baic earning power (BEP) i unaffected by financial leverage. L ha higher expected ROE becaue BEP > r d. L ha much wider ROE (and EPS) wing becaue of fixed interet charge. It higher expected return i accompanied by higher rik. Optimal Capital Structure That capital tructure (mix of debt, preferred, and common equity) at which P 0 i maximized. Trade off higher E(ROE) and EPS againt higher rik. The taxrelated benefit of leverage are exactly offet by the debt rik-related cot. The target capital tructure i the mix of debt, preferred tock, and common equity with which the firm intend to raie capital Stock Price, with zero growth D1 EPS DPS P0 r - g r r If all earning are paid out a dividend, E(g) = 0. EPS = DPS To find the expected tock price (P 0 ), we mut find the appropriate k at each of the debt level dicued What effect doe increaing debt have on the cot of equity for the firm? If the level of debt increae, the rikine of the firm increae. We have already oberved the increae in the cot of debt. However, the rikine of the firm equity alo increae, reulting in a higher r

4 Finding Optimal Capital Structure The firm optimal capital tructure can be determined two way: Minimize WACC. Maximize tock price. Both method yield the ame reult. WACC WACC or weighted average cot of capital Table for calculating WACC and determining the minimum WACC Amount borrowed D/A ratio $ , % E/A ratio % r 12.00% r d (1 T) 0.00% WACC 12.00% * Amount borrowed expreed in term of thouand of dollar Table for determining the tock price maximizing capital tructure Amount Borrowed DPS r P 0 $ 0 $ % $ , , , ,000, What debt ratio maximize EPS? Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%. (Remember DPS = EPS becaue payout = 100%.) Rik i too high at D/A = 50%. What if there were more/le buine rik than originally etimated, how would the analyi be affected? If there were higher buine rik, then the probability of financial ditre would be greater at any debt level, and the optimal capital tructure would be one that had le debt. On the other hand, lower buine rik would lead to an optimal capital tructure with more debt

5 Other factor to conider when etablihing the firm target capital tructure 1. Indutry average debt ratio 2. TIE ratio under different cenario 3. Lender/rating agency attitude 4. Reerve borrowing capacity 5. Effect of financing on control 6. Aet tructure 7. Expected tax rate How would thee factor affect the target capital tructure? 1. Sale tability? 2. High operating leverage? 3. Increae in the corporate tax rate? 4. Increae in the peronal tax rate? 5. Increae in bankruptcy cot? 6. Management pending lot of money on lavih perk? What can manager be expected to do? Iue tock if they think tock i overvalued. Iue debt if they think tock i undervalued. A a reult, invetor view a common tock offering a a negative ignal-- manager think tock i overvalued Concluion on Capital Structure Need to make calculation a we did, but hould alo recognize input are guetimate. A a reult of imprecie number, capital tructure deciion have a large judgmental content. We end up with capital tructure varying widely among firm, even imilar one in ame indutry Problem Q13-5, Q13-8 P13-7 P13-11 P13-12 Key Term Buine rik, operating rik, financial rik Operating leverage, financial leverage Capital tructure Optimal capital tructure WACC