Practical financial management lasher 7th ed chapter 014

Chapter 14 Capital Structure and Leverage


Background
Capital structure - mix of a firm’s debt and
equity
– In this chapter preferred stock is considered
debt
Financial Leverage - using borrowed money to
multiply the effectiveness of equity
– Financial leverage of 10% means the capital
structure is 10% debt and 90% equity

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The Central Issue
Can the use of debt (leverage) increase
the value of a firm’s equity?
– Can it increase stock price?

Under certain conditions changing
leverage can increase stock price
– But an increase in leverage also increases
risk

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Risk in the Context of Leverage
Leverage influences stock price

Measures of overall performance
– EBIT (Earnings Before Interest and Taxes)
– Return on Equity (ROE) is
NET Income
ROE =
equity

NET Income
– Earnings
EPSper
= Share (EPS) is
number of shares

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Redefining Risk for
Leverage-Related Issues
Leverage-related risk is variation in ROE and EPS
– Business risk — variation in EBIT
– Financial risk — additional variation in ROE and
EPS due to financial leverage
– Total risk is total variation in ROE and EPS

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Figure 14-1 Business and Financial Risk

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Leverage and Risk
Two Kinds of Each
Financial Leverage
Associated with capital
structure
Causes financial risk.

Operating Leverage
Associated with cost
structure, the firm’s mix of
fixed and variable cost
Influences a firm’s
business risk => variation
in EBIT

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Financial Leverage
Financial leverage may increase stock price
– Can improve financial performance, as measured
by ROE and EPS
– May make performance worse
– Always increases risk

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Table 14-1 Effect of Increasing Financial Leverage when
Return on Capital Exceeds After-Tax Cost of Debt

Replacing equity
with debt reduces
Net Income due to
interest expense.
But if profitability
is good, it
reduces equity
and number of
shares faster than
the decline in Net
Income. Hence as
debt increases,
both EPS and
ROE rise
dramatically.
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Effect Of Increased Leverage On
Stock Price In Good Times
Based on ROE and EPS performance in good
times, investors bid stock price up as debt is
increased from low levels
Effect is eventually mitigated by the increasing
financial risk from leverage
Under what conditions will increasing leverage
improve ROE and EPS?

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When Might Financial Leverage Help?
Return on Capital Employed
– Measures the profitability of operations before financing charges but after
taxes on a basis comparable to ROE

ROCE =

EBIT ( 1 - tax rate )
debt + equity

When the ROCE > the after-tax cost of debt,
more leverage improves ROE and EPS
When ROCE < the after-tax cost of debt,
more leverage makes ROE and EPS worse
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Table 14-2 Effect of Increasing Financial Leverage when After-Tax Cost
of Debt Exceeds Return on Capital

When ROCE is less
than the after tax
cost of debt,
increasing
leverage reduces
EPS and ROE .

That, along with
increasing risk, has
a very negative
effect on investors
and stock price
falls.
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Concept Connection Example 14-1
Managing EPS through Leverage

Will borrowing more money and retiring stock raise Albany’s
EPC, and if so, what capital structure will achieve an EPS of $2?


Concept Connection Example 14-1
Managing EPS through Leverage


Concept Connection Example 14-1
Managing EPS through Leverage


Managing Through Leverage
Under certain conditions management
may be able to manipulate financial
results and stock price by changing the
firm’s capital structure.
This is true, but must be done cautiously

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An Alternate Approach (Optional)
Using ratios and information from financial statements to solve
for unknown values: algebraic approach
EPS = ROE × Book Value per share
ROE = Net Income ÷ Equity
Net Income= [EBIT – Interest] (1 – tax rate)
Interest = kd (Debt)
– Net Income = [EBIT – (kd)(Debt)](1 – tax rate)
Equity = Total Capital – Debt

[EBIT − (k d )(Debt)(1 − T )
EPS =
(Book value per share)
(Total capital - Debt )
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Table 14-3 Financial Leverage and Risk
Financial leverage is a two-edged sword
– Multiplies good results into great results
– Multiplies bad results into terrible results

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Putting the Ideas Together—

The Effect on Stock Price
During periods of good performance, leverage
enhances results in terms of ROE and EPS
Leverage adds variability (risk) to financial
performance when operating results change
These effects push stock prices in opposite directions

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Real Investor Behavior and
the Optimal Capital Structure
When leverage is low, an increase has a
positive effect on investors
At high debt levels, risk concerns overwhelm
benefit of enhanced performance thus
additional leverage decreases stock price
As leverage increases, its effect goes from
positive to negative

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Figure 14-2 The Effect of
Leverage on Stock Price

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Finding the Optimum—

A Practical Problem
1. A firm with good profit prospects and little or no
debt is probably missing an opportunity by not
using borrowed money if interest rates are
reasonable.
2. For most businesses, the optimal capital
structure is somewhere between 30% and 50%
debt.
3. Debt levels above 60% create excessive risk
and should be avoided.

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The Target Capital Structure
A firm’s target capital structure is
management’s estimate of the optimal capital
structure

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The Effect of Leverage When Stocks
Aren’t Trading at Book Value
Changes in leverage not involving the
purchase of equity at book value are more complex
Repurchasing stock for retirement at prices other
than book value will have the same general impact
on ROE, but not necessarily for EPS

EPS = ROE x (book value per share)
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The Degree of Financial Leverage (DFL)
A Measurement
Financial leverage magnifies changes in
EBIT into larger changes in ROE and EPS
DFL quantifies the effectiveness of leverage
by relating relative changes to EPS and
EBIT

EBIT
DFL =
EBIT - Interest

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