Chapter 6 The Firms Capital Structure

Capital structure is one of the most complex areas of financial decision making because of the interrelationships among capital structure and various other financial decision variables.

6.1. Basic theory of the capital structure

The theory of capital structure is closely related to the firms cost of capital. Many debates over whether an optimal capital structure exists are found in the financial literature. The debate began in the late 1950s, and there is as yet no resolution of the conflict. Theorists who assert the existence of an optimal capital structure are said to take a traditional approach, while those who believe such a structure does not exists are called supporters of the M&M approach, named for its initial proponents, Franco Modigliani and Merton H. Miller. To provide some insight into what is meant by an optimal capital structure, we will examine the traditional approach. In the traditional approach to capital structure, the value of the firm is maximized when the cost of capital is minimized. Cost functions. It can be seen from the figure below that three cost functions the cost of debt, rD; the cost of equity, rE; and the overall cost of capital, rT are plotted as a function of financial leverage measured by the debt ratio (debt-to-total-assets). The cost of debt, rD, remains constant as financial leverage increases, until a point is reached at which lenders feel the firm is becoming financially risky. At this point, the cost of debt will increase. The cost of equity, rE, also increases with increasing financial leverage, but much more rapidly than the cost of debt. The faster increase in the cost of equity occurs because market participants recognize that the earnings of the firm must be discounted at a higher rate as leverage increases in order to compensate for the higher degree of financial risk. The overall cost of capital, rT, results from the weighted average of the firms debt and equity capital. At a debt ratio of zero, the firm is 100 percent equity-financed. As debt is substituted for equity and the debt ratio increases, the overall cost of capital declines because the debt cost is less than the equity cost. As the debt ratio continues to increase, the increased debt cost eventually causes the overall cost of capital to rise.

rE, rD, rT rE rT rD

Optimal capital structure. Since the maximization of value is achieved when the overall cost of capital, rT, is at a minimum, the optimal capital structure is therefore that at which the overall cost of capital is minimized. The point labeled M in the figure represents the point of optimal financial leverage and hence capital structure of the firm, since it results in a minimum overall cost of capital. The lower the firms overall or weighted average cost of capital, the higher the expected returns to owners. Given a fixed capital budget, the less the firms money costs, the greater the difference between the return of a project and the cost of money, and the greater the profits from the project. Reinvesting these increased profits will increase the firms expected future earnings and therefore its value.

6.2. Operating leverage

The firms cost of goods sold and its operating expenses contain fixed and variable operating-cost components. Fixed operating costs are a function of time, not sales, and are typically contractual (for example: rent is a fixed operating cost). Variable operating costs vary directly with sales. They are a function of volume, not time. Production and delivery costs are variable operating costs. In some cases, semi variable operating costs partly fixed and partly variable operating costs result. One example of semi variable operating costs might be sales commissions. These commissions may be fixed over a certain range of volume and increase to higher levels for higher volumes. Operating leverage can be defined as the ability to use fixed operating costs to magnify the effects of changes in sales on earnings before interest and taxes.

EXAMPLE: Assume that a firm has fixed operating costs of $2500, the sale price per unit of its product is $10, and its variable operating cost per unit is $5. $2500 At sales of 500 units ( ), or $5000 ($10 * 500 units), the firms EBIT should $10 $5 just equal zero. In the example, the firm will have positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for sales less than 500 units. The following figure presents the operating breakeven chart for this data. It can be seen from the additional notations on the chart that as the firms sales increase from 1000 to 1500 units (X1 to X2), its EBIT increase from $2500 to $5000 (EBIT1 to EBIT2). In other words, a 50% increase in sales (1000 to 1500 units) results in a 100% increase in EBIT.

Using the 1000-unit sales level as a reference point, two cases can be illustrated. Case 1. A 50% increase in sales (from 1000 to 1500 units) results in a 100% increase in EBIT (from $2500 to $5000). Case 2. A 50% decrease in sales (from 1000 to 500 units) results in a 100% decrease in EBIT (from $2500 to $0).

When a firm has fixed operating costs, operating leverage is present. An increase in sales results in a more than proportional increase in EBIT; a decrease in sales results in a more than proportional decrease in EBIT. Fixed costs and operating leverage. Changes in fixed operating costs affect operating leverage significantly. This effect can be best illustrated by continuing with our example. EXAMPLE. Assume that the firm discussed earlier is able to exchange a portion of its variable operating costs for fixed operating costs. This exchange results in a reduction in the variable operating cost per unit from $5 to $4,5 and an increase in the fixed operating costs from $2500 to $3000. In this case we will have:

The higher the firms fixed operating costs relative to variable operating costs, the greater the degree of operating leverage.

6.3. Financial leverage

Financial leverage results from the presence of fixed financial charges in the firms income stream. These fixed charges do not vary with the firms earnings before interest and taxes; they must be paid regardless of the amount of EBIT available to pay them. The two fixed financial charges normally found on the income statement are (1) interest on debt and (2) preferred stock dividends. Financial leverage is concerned with the effects of changes in earnings before interest and taxes on the earnings available for the common stockholders.

Financial leverage is defined as the firms ability to use fixed financial charges to magnify the effects of changes in earnings before interest and taxes on the firms earnings per share (eps). Earnings per share are calculated by dividing the earnings available for common stockholders by the number of shares of common stock outstanding. Taxes, as well as the financial costs of interest and preferred stock dividends, are deducted from the firms income stream. However, these taxes do not represent a fixed cost, since they change with changes in the level of earnings before taxes (EBT). As a variable cost, they have no direct effect on the firms financial leverage. EXAMPLE. A firm expects earnings before interest and taxes of $10000 in the current year. It has a $20000 bond with a 10% coupon and an issue of 600 shares of $4 (dividend per share) preferred stock outstanding; it also has 1000 shares of common stock outstanding. The annual interest on the bond issue is $2000 (0,10 * 20000). The annual dividends on the preferred stock are $2400 ($4/share * 600 shares). The table below presents the levels of earnings per share resulting from levels of earnings before interest and taxes of $6000, $10000, and $14000 assuming the firm is in the 40% tax bracket. Two situations are illustrated in the table.

Case 1. A 40% increase in EBIT (from $10000 to $14000) results in a 100% increase in earnings per share (from $2,4 to $4,8). Case 2. A 40% decrease in EBIT (from $10000 to $6000) results in a 100% decrease in earnings per share (from $2,4 to $0). The effect of financial leverage is such that an increase in the firms EBIT results in a greater than proportional increase in the firms earnings per share, while a decrease in the firms EBIT results in a more than proportional decrease in eps.

6.4. Risk and capital structure

Risk comes into play in two ways: (1) the capital structure must be consistent with the business risk, and (2) the capital structure results in a certain level of financial risk. In other words, the prevailing business risk tends to act as an input into the capital structure decision process, the output of which is a certain level of financial risk. Business risk. Business risk can be defined as the relationship between the firms sales and its earnings before interest and taxes (EBIT). In general, the greater the firms operating leverage the use of fixed operating cost the higher its business risk. Although operating leverage is an important factor affecting business risk, two other factors also affect it revenue stability and cost stability. Revenue stability refers to the relative variability of the firms sales

revenues. Cost stability is concerned with the relative predictability of input prices such as labor and materials. In general, firms with low operating leverage, stable revenues, and stable costs have low business risk, while firms with high operating leverage, volatile revenues, and volatile costs have high business risk. Firms with stable revenues and costs can accept greater operating leverage (fixed operating costs) than those with volatile patterns of revenues and costs. Business risk is not affected by capital structure decisions. The higher the business risk, the more cautions the firm must be in establishing its capital structure. Firms with high business risk therefore tend towards less highly levered capital structures, and vice versa. EXAMPLE. The JSG Company, in preparing to make a capital structure decision, has obtained estimates of sales and the associated levels of EBIT. The firms forecasting group feels there is a 25% chance sales will total $400000, a 50% chance sales will total $600000, and a 25% chance sales will total $800000. Variable operating costs equal 50% of sales and fixed operating costs total $200000. These data are summarized and the resulting earnings before interest and taxes (EBIT) calculated in Table 6.1. It can be seen that there is a 25% chance EBIT will be zero, a 50% chance it will be $100000, and a 25% chance it will equal $200000. The financial manager must accept as given these levels of EBIT and associated probabilities when developing the firms capital structure. These EBIT data effectively reflect a certain level of business risk that captures the firms sales variability, cost variability, and operating leverage. Table 6.1. Sales and associated EBIT calculation for JSG Company ($000) Probability of sales Sales - Variable operating costs (50% of sales) - Fixed operating costs EBIT 0,25 $400 200 200 $0 0,50 $600 300 200 $100 0,25 $800 400 200 $200

Financial risk. The firms capital structure directly affects its financial risk, which can be described as the risk resulting from the use of financial leverage. Since the level of this risk and the associated level of return (eps) are key inputs to the valuation process, the financial manager must estimate the potential impact of alternative capital structures on these factors and ultimately on value in order to select the best capital structure. EXAMPLE. For simplicity, let us assume that the JSG Company is considering 7 alternative capital structures. If we measure these structures using the debt ratio, they are associated with ratios of 0, 10, 20, 30, 40, 50, and 60 percent. If (1) the firm has no current liabilities, (2) its capital structure currently contains all equity as shown, and (3) the total amount of capital remains constant at $500000, the mix of debt and equity associated with the debt ratios just stated would be as noted in Table 6.2. Also shown in the table is the number of shares of common stock remaining outstanding under each alternative. Current capital structure Long-term debt $0 Common stock equity (25000 shares at $20) $500000 Total capital $500000

Associated with each of the debt levels in column 3 of the Table 6.2 would be an interest rate that is expected to increase with increases in financial leverage, as reflected in the debt ratio. The level of debt, the associated interest rate (assumed to apply to all debt), and the dollar amount of annual interest associated with each of the alternative capital structures is summarized in Table 6.3. Since both the level of debt and the interest rate increase with increasing financial leverage (debt ratios), the annual interest increases as well. Table 6.2 Capital structures associated with alternative debt ratios Capital structure ($000) Total assetsa Debt Equity Debt ratio (%) [(1) * (2)] [(2) - (3)] (1) (2) (3) (4) 0% 10 20 30 40 50 60
a

Shares of common stock outstanding (000) [(4) / $20]b (5) 25,00 22,50 20,00 17,50 15,00 12,50 10,00

$500 500 500 500 500 500 500

$0 50 100 150 200 250 300

$500 450 400 350 300 250 200

because the firm, for convenience, is assumed to have no current liabilities, its total assets equal its total capital of $500000. b the $20 value represents the book value per share of common stock equity noted earlier. Table 6.3 Level of debt, interest rate, and dollar amount of interest associated with JSG Companys alternative capital structures Capital structure debt ratio (%) 0% 10 20 30 40 50 60 Debt ($000) (1) $0 50 100 150 200 250 300 Interest rate on all debt (%) (2) 0,0% 9,0 9,5 10,0 11,0 13,5 16,5 Interest ($000) [(1) *(2)] (3) $0,00 4,50 9,50 15,00 22,00 33,75 49,50

Assuming a 40% tax rate, the calculation of the earnings per share (eps) for debt ratios of 0, 30%, and 60% is illustrated in Table 6.4. Also shown are the resulting expected eps, the standard deviation of eps, and the coefficient of variation of eps associated with each debt ratio.

Table 6.4 Calculation of eps for selected debt ratios ($000)

Debt ratio = 0% Probability EBIT - Interest Earnings before taxes - Taxes (40%) Earnings after taxes eps (25000 shares) expected eps standard deviation of eps coefficient of variation of eps 0,25 $0 0 $0 0 $0 $0 0,71 Debt ratio = 30% Probability EBIT - Interest Earnings before taxes - Taxes (40%) Earnings after taxes eps (25000 shares) expected eps standard deviation of eps coefficient of variation of eps 0,25 $0 15 -$15 -6 -$9 - $51 0,83 Debt ratio = 60% Probability EBIT - Interest Earnings before taxes - Taxes (40%) Earnings after taxes eps (25000 shares) expected eps standard deviation of eps coefficient of variation of eps 0,25 $0 49,50 -$49,50 -19,80 -$29,70 -$2,97 1,40 0,50 $100 49,50 $50,50 20,20 $30,30 $3,03 $3,03 $4,24 0,25 $200 49,50 $150,50 60,20 $90,30 $9,03 0,50 $100 15 $85 34 $ 51 $2,91 $2,91 $2,42 0,25 $200 15 $185 74 $111 $6,34 0,50 $100 0 $100 40 $ 60 $2,40 $2,40 $1,70 0,25 $200 0 $200 80 $120 $4,80

The resulting statistics from the calculations in Table 6.4, along with the same statistics for the other debt ratios (10, 20, 40, and 50 percent calculations not shown), are summarized for the 7 alternative capital structures in Table 6.5. Because the coefficient of variation measures the risk relative to the expected eps, it is the preferred risk measure for use in comparing capital structures. It should be clear that as the firms financial leverage increases, so does its coefficient of variation of eps. As expected, an increasing level of risk is associated with increased levels of financial leverage.

Table 6.5 Expected eps, standard deviation, and coefficient of variation for alternative capital structures Capital structure debt ratio (%) 0% 10 20 30 40 50 60 Expected eps ($) (1) $2,40 2,55 2,72 2,91 3,12 3,18 3,03 Standard deviation of eps ($) (2) $1,70 1,88 2,13 2,42 2,83 3,39 4,24 Coefficient of variation of eps [(2) / (1)] (3) 0,71 0,74 0,78 0,83 0.91 1,07 1,40

The relative risk of two of the capital structures evaluated in Table 6.4 (debt ratio = 0% and 60%) can be illustrated by showing the probability distribution of eps associated with each of them. The figure below shows these two distributions. It can be seen that while the expected level of eps increases with increasing financial leverage, so does risk, as reflected in the relative dispersion of each of the distributions. Clearly, the uncertainty of the expected eps as well as the chance of experiencing negative eps is greater when higher degrees of leverage are employed.

The nature of the risk-return trade-off associated with the 7 capital structures under consideration can clearly be observed by plotting the eps and coefficient of variation relative to the debt ratio.

An analysis of the figure shows that as debt is substituted for equity (as the debt ratio increases), the level of earnings per share rises and then begins to fall (graph a). Based on the graph, it can be seen that the peak earnings per share occur at a debt ratio of 50%. The decline in earnings per share beyond that ratio results from the fact that the significant increases in interest are not fully compensated for by the reduction in the number of shares of common stock outstanding. If we look at the risk behavior as measured by the coefficient of variation, we can see that risk increases with increasing leverage (graph b). As noted, a portion of the risk can be attributed to business risk, while that portion changing in response to increasing financial leverage would be attributed to financial risk.

6.5. Estimating value

The value of the firm associated with alternative capital structures can be estimated using the standard valuation model. If, for simplicity, we assume that all earnings are paid out as dividends, a zero growth valuation model such as developed in chapter 5 can be used. eps P0 = rE EXAMPLE. Returning again to the JSG Company, we can now estimate the value of its stock under each of the alternative capital structures.

Table 6.6 Required returns for JSG Companys alternative capital structures Capital structure (%) 0% 10 20 30 40 50 60 Coefficient of variation of eps (1) 0,71 0,74 0,78 0,83 0,91 1,07 1,40 Estimated required return, rE (2) 11,5% 11,7 12,1 12,5 14,0 16,5 19,0

Table 6.7 structures Capital structure debt ratio (%) 0% 10 20 30 40 50 60

Calculation of share value estimates associated with alternative capital Expected eps ($) (1) $2,40 2,55 2,72 2,91 3,12 3,18 3,03 Estimated required rate of return, rE (2) 0,115 0,117 0,121 0,125 0,140 0,165 0,190 Estimated share value ($) [(1) /(2)] (3) $20,87 21,79 22,48 23,28 22,29 19,27 15,95

Plotting the resulting share values against the associated debt ratios, the figure clearly illustrates that the maximum share value occurs at the capital structure associated with a debt ratio of 30%; at that debt ratio, the share value is expected to equal $23,28. While the firms profits (eps) are maximized at a debt ratio of 50%, share price is maximized at a 30% debt ratio. In this case, the preferred capital structure would be the 30% debt ratio. The goal of the financial manager has been specified as maximizing owners wealth, not profit.

The procedures used to calculate the expected value, standard deviation, and coefficient of variation: Expected value of return: r = ri Pri
i =1 n

Where: ri = the return for the ith outcome Pri = the probability of occurrence of ith return n = the number of outcomes considered Standard deviation:

k =

(r
n i =1

r Pri

Coefficient of variation: CV = k r