Fundamental of financial management 13th ed brigham houston chapter 014

Chapter 14

Capital Structure and Leverage
Business vs. Financial Risk
Optimal Capital Structure
Operating Leverage
Capital Structure Theory
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What is business risk?

•

The riskiness inherent in the firm’s operations if it
uses no debt.
Probability

Low risk

High risk
0

•

E(ROIC)

EBIT

A commonly used measure of business risk is σROIC.

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What determines business risk?

•
•
•
•
•
•
•
•

Competition
Uncertainty about demand (sales)
Uncertainty about output prices
Uncertainty about costs
Product obsolescence
Foreign risk exposure
Regulatory risk and legal exposure
Operating leverage
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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.

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Effect of Operating Leverage

•

More operating leverage leads to more business risk,
for then a small sales decline causes a big profit
decline.
Rev.

$

Rev.

$
TC

} Profit
TC
FC

FC
QBE

•

Sales

QBE

Sales

What happens if variable costs change?
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Using Operating Leverage

•

Typical situation: Can use operating leverage to get
higher ROIC, but risk also increases.

Probability

Low operating leverage
High operating leverage

ROICL

ROICH
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Return on Invested Capital (ROIC)

•

ROIC measures the after-tax return that the
company provides for all its investors.

•

ROIC doesn’t vary with changes in capital structure.
EBIT(1 − T)
Investor -supplied capital
($400,000)(0.6)
=
$2,000,000
= 12%

ROIC =

14-7
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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.

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Business Risk vs. Financial Risk

•

Business risk depends on business factors such as
competition, product obsolescence, and operating

leverage.

•

Financial risk depends only on the types of
securities issued.

– More debt, more financial risk.
– Concentrates business risk on stockholders.

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An Example:
Illustrating Effects of Financial Leverage

•

Two firms with the same operating leverage, business risk, and
probability distribution of EBIT.

•

Only differ with respect to their use of debt (capital structure).

Firm U
No debt
$20,000 invested capital
40% tax rate

Firm L
$10,000 of 12% debt
$20,000 invested capital
40% tax rate

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Firm U: Unleveraged

Probability
EBIT
Interest
EBT
Taxes (40 %)
NI

Bad
0.25

Economy
Average
0.50

Good
0.25

$2,000

0
$2,000
800
$1,200

$3,000
0
$3,000
1,200
$1,800

$4,000
0
$4,000
1,600
$2,400

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Firm L: Leveraged

Probability*

Bad
0.25

Economy
Average

0.50

Good
0.25

EBIT *
Interest
EBT
Taxes (40%)
NI

$2,000
1,200
$ 800
320
$ 480

$3,000
1,200
$1,800
720
$1,080

$4,000
1,200
$2,800
1,120
$1,680

*Same as for Firm U.

14-12
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Ratio Comparison Between Leveraged and
Unleveraged Firms
Firm U
ROIC
ROE
TIE

Bad
6.0%
6.0
∞

Average
9.0%
9.0
∞

Good
12.0%
12.0
∞

Firm L
ROIC
ROE
TIE

Bad
6.0%
4.8
1.7x

Average
9.0%
10.8
2.5x

Good
12.0%
16.8
3.3x

14-13
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Risk and Return for Leveraged and Unleveraged
Firms
Expected values:
E(ROIC)
E(ROE)
E(TIE)

Firm U
9.0%
9.0 %

∞

Firm L
9.0%
10.8 %
2.5×

Firm U
2.12%
2.12%
0

Firm L
2.12%
4.24%
0.6×

Risk measures:
σ
ROIC
σ
ROE
σ
TIE

14-14

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The Effect of Leverage on Profitability and Debt
Coverage

•

For leverage to raise expected ROE, must have ROIC
> rd(1 – T).

•

Why? If rd(1 – T) > ROIC, then after-tax interest
expense will be higher than the after-tax operating
income produced by debt-financed assets, so
leverage will depress income.

•

As debt increases, TIE decreases because EBIT is
unaffected by debt, but interest expense increases
(Int Exp = rdD).

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Conclusions

•

Return on invested capital (ROIC) is unaffected by

financial leverage.

•
•

L has higher expected ROE because ROIC > rd(1 – T).
L has much wider ROE (and EPS) swings because of
fixed interest charges. Its higher expected return is
accompanied by higher risk.

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Optimal Capital Structure

•

The 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.

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Why do the bond rating and cost of debt depend
upon the amount of debt borrowed?

•

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

14-18
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Sequence of Events in a Recapitalization

•
•
•

Firm announces the recapitalization.
New debt is issued.
Proceeds are used to repurchase stock.

– The number of shares repurchased is equal to the
amount of debt issued divided by price per share.

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Cost of Debt at Different Debt Ratios
Amount
Borrowed

D/Cap.
Ratio

D/E
Ratio

Bond
Rating

rd

0

0

--

--

250

0.125

0.143

AA

8.0%

500

0.250

0.333

A

9.0%

750

0.375

0.600

BBB

11.5%

1,000

0.500

1.000

BB

14.0%

$

0

14-20
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Analyze the Recapitalization at Various Debt Levels
and Determine the EPS and TIE at Each Level
D = $0

(EBIT − rdD)(1 − T)
EPS =
Shares outstandin g
($400,000)(0.6)
=
80,000
= $3.00

14-21
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Determining EPS and TIE at Different Levels of
Debt (D = $250,000 and rd = 8%)
$250,000
Shares repurchase d =
= 10,000
$25
(EBIT − rdD)(1 − T)
EPS =
Shares outstandin g
[$400,000 − (0.08)($250,000)](0.6)
=
80,000 − 10,000
= $3.26
EBIT
$400,000
TIE =
=
= 20x
Int. Exp. $20,000
14-22
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Determining EPS and TIE at Different Levels of
Debt (D = $500,000 and rd = 9%)
$500,000

Shares repurchase d =
= 20,000
$25
(EBIT − rdD)(1 − T)
EPS =
Shares outstandin g
[$400,000 − (0.09)($500,000)](0.6)
=
80,000 − 20,000
= $3.55
EBIT
$400,000
TIE =
=
= 8.9x
Int. Exp. $45,000
14-23
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Determining EPS and TIE at Different Levels of
Debt (D = $750,000 and rd = 11.5%)
$750,000
Shares repurchase d =
= 30,000
$25
(EBIT − rdD)(1 − T)
EPS =
Shares outstandin g
[$400,000 − (0.115)($750,000)](0.6)

=
80,000 − 30,000
= $3.77
EBIT
$400,000
TIE =
=
= 4.6x
Int. Exp. $86,250
14-24
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Determining EPS and TIE at Different Levels of
Debt (D = $1,000,000 and rd = 14%)
$1,000,000
Shares repurchase d =
= 40,000
$25
(EBIT − rdD)(1 − T)
EPS =
Shares outstandin g
[$400,000 − (0.14)($1,000,000)](0.6)
=
80,000 − 40,000
= $3.90
EBIT
$400,000
TIE =
=

= 2.9x
Int. Exp. $140,000
14-25
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