Financial management and policy chapter 9

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 24

Chapter 9

Capital

Structure

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Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 24

The Target Capital Structure

• Risk—greater risk means greater costs to raise funds

• Financial flexibility—a stronger financial position—that

is, stronger balance sheet—generally implies the firm

is better able to raise funds in the capital markets,

especially in slumping economies

• Managerial attitude (conservatism or

aggressiveness)—some financial managers are more

conservative than others when it comes to using debt,

thus they are inclined to use less debt, all else equal.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 24

The Business Risk

and Financial Risk

• Business Risk—Uncertainty inherent in

projections of future returns (ROE or ROA) if

the firm uses no debt.

• Financial Risk—Additional risk associated with

using debt or preferred stock.

• Beware: The use of debt intensifies the firm’s

business risk borne by the common

stockholders.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 24

The Optimal Capital Structure

EBIT/EPS Analysis

Example: A firm that has no debt and assets equal to

€400,000 can issue debt and repurchase shares of stock at

€10 per share based on the following schedule:

Amount Debt/Asset Cost of Shares of StockEquity of Debt Ratio Debt, kd Outstanding

€400,000 € 0 0.0% 0.0% 40,000

320,000 80,000 20.0 6.0 32,000

240,000 160,000 40.0 9.0 24,000

160,000 240,000 60.0 20.0 16,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 24

Determining the Optimal Capital

Structure—EBIT/EPS Analysis

Assuming that operating expenses, such as cost of goods

sold, depreciation, and so forth, are not affected by capital

structure decisions, the firm is expected to generate the

operating income, EBIT, as follows:

Boom 0.1 $200,000

Normal 0.6 120,000

Recession 0.3 40,000

Type of Economy Probability EBIT = NOI

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 24

Determining the Optimal Capital

Structure—EBIT/EPS Analysis

Debt/Assets = 0:Debt = €0 Equity = €400,000 Interest = €0 Shares of stock = €400,000/€10 = 40,000

EBIT €200,000 €120,000 €40,000Interest (_____0) ( 0) ( 0)

Taxable income, EBT 200,000 120,000 40,000

Taxes (40%) ( 80,000) ( 48,000) (16,000)

Net income €120,000 €72,000 €24,000

Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3

EPS = NI/(40,000 shrs) €3.00 €1.80 €0.60

Expected EPS €1.56

sEPS €0.72

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 24

Determining the Optimal Capital

Structure—EBIT/EPS Analysis

EBIT €200,000 €120,000 €40,000Interest ( 4,800) ( 4,800) ( 4,800)

Taxable income, EBT 195,200 115,200 35,200

Taxes (40%) ( 78,080) ( 46,080) (14,080)

Net income €117,120 €69,120 €21,120

Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3

EPS = NI/(32,000 shrs) €3.66 €2.16 €0.66

Expected EPS €1.86

sEPS €0.90

Debt/Assets = 20%:Debt = 0.2(€400,000) = €80,000 Equity = €400,000 - €80,000 = €320,000

Interest = 0.06(€80,000) = €4,800 Shares of stock = €320,000/€10 = 32,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 24

Determining the Optimal Capital

Structure—EBIT/EPS Analysis

EBIT €200,000 €120,000 €40,000Interest ( 14,400) ( 14,400) ( 14,400)

Taxable income, EBT 185,600 105,600 25,600

Taxes (40%) ( 74,240) ( 42,240) (10,240)

Net income €111,360 €63,360 €15,360

Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3

EPS = NI/(24,000 shrs) €4.64 €2.64 €0.64

Expected EPS €2.24

sEPS €1.20

Debt/Assets = 40%:Debt = 0.4(€400,000) = €160,000 Equity = €400,000 - €160,000 = €240,000

Interest = 0.09(€160,000) = €14,400 Shares of stock = €240,000/€10 = 24,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 24

Determining the Optimal Capital

Structure—EBIT/EPS Analysis

EBIT €200,000 €120,000 €40,000Interest ( 48,000) ( 48,000) ( 48,000)

Taxable income, EBT 152,000 72,000 ( 8,000)

Taxes (40%) ( 60,800) ( 28,800) 3,200

Net income € 91,200 €43,200 ( €4,800)

Type of Economy Boom Normal RecessionProbability 0.1 0.6 0.3

EPS = NI/(16,000 shrs) €5.70 €2.70 €(0.30)

Expected EPS €2.10

sEPS €1.80

Debt/Assets = 60%:Debt = 0.6(€400,000) = €240,000 Equity = €400,000 - €240,000 = €160,000

Interest = 0.20(€240,000) = €48,000 Shares of stock = €160,000/€10 = 16,000

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 24

Determining the Optimal Capital

Structure—EBIT/EPS Analysis

Summarizing the results, we have:

0.0% $1.56 $0.72

20.0 1.86 0.90

40.0 2.24 1.20

60.0 2.10 1.80

Proportion Expected Standardof Debt EPS Deviation

0.0% $1.56 $0.72

20.0 1.86 0.90

40.0 2.24 1.20

60.0 2.10 1.80

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 24

EPS Indifference Analysis

0.20

0.40

0.60

0.80

1.00

-0.20

-0.40

2 2.1 2.2

EPS(€)

Sales (€ millions)0

Fixed operating costs = €600,000Variable cost ratio = 70%

100% StockFinancing

40% DebtFinancing

EPS Indifference€2.12 million

0.54

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 24

Capital Structure — Stock Price

• The optimal capital structure is the mix of debt and equity that maximizes the value of the firm—that is, its stock price—not the EPS.

• The proportion of debt in the optimal capital structure will be less than the proportion of debt needed to maximize EPS because the market valuation of the stock, P0, considers the risk associated with the firm’s operations expected well into the future and EPS is based only on the firm’s operations expected for the next few years.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 24

Capital Structure—Stock Price

and the Cost of Equity, ks

The relationship of the cost of equity, ks, and the amount of

debt the firm uses to finance its assets can be illustrated as

follows:

kRF

% Debt inCapital Structure

Required Return onEquity, ks (%)

Risk-free rate of return

ks = kRF + Risk Premium

Total RiskPremium

Premium for business risk at aparticular level of operations

Premium for financial risk

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 24

Capital Structure—Stock Price

and the Cost of Capital, WACC

The relationship of the after-tax cost of debt,

kdT, cost of equity, ks, and WACC might be:

% Debt inCapital Structure

Cost ofCapital, WACC (%) Cost of

equity, ks

After-tax cost of debt, kdT

WACC

MinimumWACC

Optimal Amountof Debt (30%)

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 24

Capital Structure - WACC

• If the firm uses only equity to finance its assets (that is, zero debt is used) then WACC = ks

• As the firm begins to use some debt for financing, WACC declines, primarily because the tax benefit offered by the debt more than offsets the increased cost of equity

• At some point the tax benefit associated with debt is more than offset by increases in the before-tax cost of debt and the cost of equity that result from increases in the risk associated with the additional debt and, at this point, WACC begins to increase

• The point where WACC is the lowest is the optimal capital structure—this is the point where the value of the firm is maximized

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 24

Operating Leverage

• All else equal, if a firm can reduce its operating leverage, it

can use more debt (that is, increase its financial leverage),

and vice versa, and maintain the same degree of risk.

• Degree of operating leverage (DOL) refers to the

percentage change in operating income—designated

either NOI or EBIT—that results from a particular

percentage change in sales.

• DOL can be computed as follows:

EBIT

profit Gross

FVCS

VCS

FV)Q(P

V)Q(P

sales in change%

NOI in change %DOL

Q = number of products (units) the firm currently sellsP = sales price per unitV = variable cost per unitF = fixed operating costsS = current sales stated in dollars such that S = Q PVC = total variable costs of operations such that VC = Q V

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 24

Operating Leverage

Expected Sales = –5%

Outcomeof Expectations % Δ

SalesVariable operating costs (60%)Gross profitFixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%)Gross profitFixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%) (150,000)Gross profitFixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costsNet operating income = EBIT

Sales $250,000Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT

Sales $250,000 $237,500Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

4.0x$25,000

$100,000

EBIT

profit Gross DOL

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000)Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0

Sales $250,000Variable operating costs (60%) (150,000)Gross profit 100,000Fixed operating costs (75,000)Net operating income = EBIT 25,000

Risk = variability

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 24

Financial Leverage

• Degree of financial leverage refers to the percentage

change in EPS that results from a particular

percentage change in earnings before interest and

taxes, EBIT.

• DFL is computed as follows:

IFVCS

FVCS

IEBIT

EBIT

EBIT in change %

EPS in change %DFL

I = interest paid on debt

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 24

Financial Leverage

Expected Sales = –5%

Outcomeof Expectations % Δ

Sales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0

InterestEarnings Before TaxesTaxes (40%)Net Income

Interest (12,500)Earnings Before TaxesTaxes (40%)Net Income

Interest (12,500)Earnings Before Taxes 12,500Taxes (40%)Net Income

Interest (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income

Interest (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500)Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000)Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500

Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500 -40.0

2.0x$12,500

$25,000

$12,500-$25,000

$25,000

I-EBIT

EBIT DFL Risk = variability

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 24

Total Leverage• Degree of total leverage (DTL) refers to the

percentage change in EPS that results from a

particular percentage change in sales.

• DTL combines DOL and DFL, and it is computed

as follows:

IEBIT

profit Gross

IFVCS

VCS

IFV)Q(P

V)Q(P

DFLDOLsales in change %

EPS in change %DTL

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 24

Total Leverage

Expected Sales = –5%

Outcomeof Expectations % ΔSales $250,000 $237,500 -5.0%Variable operating costs (60%) (150,000) (142,500) -5.0Gross profit 100,000 95,000 -5.0Fixed operating costs (75,000) (75,000) 0.0Net operating income = EBIT 25,000 20,000 -20.0Interest (12,500) (12,500) 0.0Earnings Before Taxes 12,500 7,500 -40.0Taxes (40%) (5,000) (3,000) -40.0Net Income 7,500 4,500 -40.0

8.0x$12,500

$100,000

$12,500-$25,000

$100,000

I-EBIT

profit Gross DTL

Risk = variability; thus the greater the degree of leverage (operating, financial, or both), the greater the risk associated with the firm

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 24

Liquidity and Capital Structure

A firm might not operate at the optimal capital structure because:

It might be difficult, if not impossible, to determine the optimal capital structure.

Managers might be reluctant to take on the amount of debt necessary to achieve the optimal capital structure—that is, a conservative attitude toward debt might exist.

The firm provides important, needed services, and operating at the optimal mix of capital might endanger the firm’s ability to survive.

Financial liquidity is important to such firms.

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 23 of 24

Capital Structure—Trade-Off Theory• The value of a firm increases as it uses more

and more debt.

• Ignores the costs associated with bankruptcy,

which can be considerable

• If bankruptcy costs are considered, there is a

point where the benefit of the tax deductibility of

debt is more than offset by increases in the cost

of debt and the cost of equity that result from

the risk associated with the firm’s heavy use of

debt

Essentials of Managerial Finance by S. Besley & E. Brigham Slide 24 of 24

Capital Structure—Signaling Theory

• Studies have shown that when firms issue new

common stock to raise funds the per share

value of the stock decreases.

– Perhaps this occurs because managers would only

issue new common stock if they felt that the firm’s

future prospects were unfavorable.

– When debt is issued, only the contracted costs need

to be paid—that is, fixed interest and the repayment

of the debt—and the remaining gains from the

favorable projects accrue to the stockholders.

– Age of a firm—younger firms generally do not have

the same access to financial markets as older, more

established firms