AC 517

Chapter 14: Capital Structure and Leverage

Capital

- Refers to investor-supplied funds

- E.g. long-term and short term loans from individuals and institutions, preferred stock, common stock, retained
earnings
- Note: Accounts payable and accruals are not capital because they are results of normal operations, not investment

Capital Structure

- The mix of debt, preferred stock, and common equity that is used to finance the firm’s assets
- The percentage of each investor-supplied capital, with the total being 100%

Optimal Capital Structure

- The capital structure that maximizes a stock’s intrinsic value

- The capital that maximizes the intrinsic value also minimizes the Weighted Average Cost of Capital (WACC)
- Measuring the Capital Structure:
o Use book values as provided by accountants and shown on the balance sheet, or market values of debt,
preferred stock, and common equity?
 For capital structure purposes, no distinction is made between common equity raised by issuing
stock versus retained earnings
 According to most financial theorists, it is better to use market values than book values
 But stock prices are volatile
o If used, then weights used to calculate WACC will also be volatile  so some
analysts argue for the use of book values
 It is impossible to identify a precisely optimal structure given volatility of financial markets, so it
would be impossible to remain on target over time even if the optimal structure could be
identified
 As a result, most firms focus on a target debt ratio as opposed to a single number
 Generally, a firm’s CFO considers the capital structures of the firms against which it benchmarks
and performs an analysis
 The greater the difference between the stock’s book value and market value, the greater the
difference between alternative WACCw
𝑊𝐴𝐶𝐶 = 𝑊𝑑 (𝑟𝑑 )(1 − 𝑇) + 𝑊𝑐 (𝑟𝑐 )
o If the actual debt ratio were significantly below the target range  firm raise capital by issuing debt
o If the debt ratio were above the target range  equity would be used
- Capital structure changes over time
o Two reasons:
1. Deliberate actions – if a firm is not currently at its target, it may deliberately raise new money in a
manner that moves the actual structure toward the target
2. Market actions
 Firm could incur high profits or losses that lead to significant change in book value equity as shown
on its balance sheet and to a decline in its stock price
 Interest rate changes due to changes in the general level of rates or changes in the firm’s default
risk could cause changes in debt’s market value
o Debt ratio > Target  sell large stock issue  use proceeds to retire debt
o Stock price increases  Debt ratio < Target  Issue bonds  Use proceeds to repurchase stock
Factors Affecting Target Capital Structure:

1. Business risk 3. Financial flexibility – the ability to raise funds

2. Tax position 4. Managerial conservatism and aggressiveness

Business and Financial Risk

- Stand-alone risk – where an asset’s cash flows are analyzed by themselves

- Portfolio risk – where cash flows from a number of assets are combined and consolidated cash flows are analyzed
o 2 components:
a. Diversifiable risk – risk that can be diversified away
b. Market risk – measured by the beta coefficient and reflects broad market movements that cannot be
eliminated by diversification

- Business Risk
o The riskiness inherent in the firm’s operations if it uses no debt
o Common measure of business risk: Standard deviation of firm’s Return on Invested Capital (ROIC)
 Measures the underlying risk of the firm before considering the effect of debt financing
 ROIC – measures the after-tax return that the company provides for all its investors
 Does not vary with the changes in capital structure
𝐸𝐵𝐼𝑇 (1 − 𝑇)
𝑅𝑂𝐼𝐶 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟 𝑠𝑢𝑝𝑝𝑖𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
o Factors Affecting Business Risk:
1. Competition 4. Input cost variability
2. Demand variability 5. Product obsolescence
3. Sales price variability
6. Foreign risk exposure – firms generating high percentage of earnings overseas are subject to exchange
rate fluctuations and political risks
7. Regulatory risk and legal exposure – firms operating under high regulation (e.g. financial services,
utilities) are subject to changes in regulatory environment which can affect current and future
profitability; companies that face significant legal exposure are damaged when forced to pay large
settlements (e.g. when being sued for damages caused by products)
8. Extent to which costs are fixed: operating leverage – when a high percentage of costs are fixed and
does not decline when demand falls, business risk increases

- Operating Leverage
o The extent to which fixed costs are used in a firm’s operations
 Higher fixed costs  higher business risk
 Higher fixed costs are generally associated with highly automated, capital-intensive firms
and industries, businesses employing highly skilled workers that must be retained and
paid even during recessions, firms with high product development costs (because
amortization of development cost is a fixed cost)
o Higher percentage of total costs are fixed  higher degree of operating leverage
 A higher degree of operating leverage, other factors held constant, implies that a relatively small
change in sales results in a large change in ROIC
 However a higher degree of operating leverage also entails a higher expected ROIC, but also
higher probability of losses
𝐶𝑀
𝐷𝑂𝐿 =
𝐸𝐵𝐼𝑇
Where DOL = degree of operating leverage CM = contribution margin EBIT = Earnings before interest and taxes
 - Financial Risk
o An increase in stockholders’ risk, over and above the firm’s basic business risk, resulting from the use of
financial leverage
o Financial leverage – the extent to which fixed-income securities (debt and preferred stock) are used in a
firm’s capital structure
o Changes in debt would not affect ROIC, but affect the proportion of risk borne by the firm’s stockholders
 Changes in use of debt  changes in EPS  changes in risk  affect stock price
 Typically, using debt increases the expected rate of return for an investment, but also increases
risk to the common stockholders (measured by coefficient of variation of ROE)
𝜎𝐸𝑃𝑆 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇
𝐶𝑂𝑉 = 𝐷𝐹𝐿 = 𝑇𝐼𝐸 =
𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐸𝑃𝑆 𝐸𝐵𝑇 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑪𝒐𝒎𝒃𝒊𝒏𝒆𝒅 𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 = 𝑫𝑭𝑳 × 𝑫𝑶𝑳

𝑬𝑩𝑰𝑻
𝑩𝒂𝒔𝒊𝒄 𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝑷𝒐𝒘𝒆𝒓 = If rd > BEP  ROE ↓ If rd < BEP  ROE ↑
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
Where COV = covariance DFL = Degree of financial leverage TIE = times interest earned
EBIT = Earnings before interest and taxes EBT = Earnings before taxes
DOL = Degree of operating leverage

Determining Optimal Capital Structure

- “The optimal capital structure is the one that maximizes the price of the firm’s stock, and this generally calls for
a debt/capital ratio that is lower than the one that maximizes expected EPS”
- Stock prices are positively related to expected earnings but negatively related to higher risk
o To the extent that higher debt levels raise expected EPS, financial leverage increases stock price
o Higher debt levels also increase the firm’s risk, which increases cost of equity and reduces stock price
- Rule: Minimize WACC, maximize stock price

- WACC and Capital Structure Changes

o Managers should set as the target capital structure the debt-equity mix that maximizes firm’s stock price
 Difficult to estimate how a given change in capital structure would affect stock price
 Easier to predict how capital structure change affects WACC
o Capital structure that maximizes stock price minimizes WACC
o Managers use estimated relationship between capital structure and WACC to guide capital structure
decisions
 An increase in the Debt/Capital ratio increases the costs of both debt and equity
- The Hamada Equation - theoretical formula that quantifies the effect of leverage on the cost of equity
𝐷
𝑏𝐿 = 𝑏𝑈 [1 + (1 − 𝑇) ( )]
𝐸
Where 𝑏𝐿  is the firm’s current beta 𝑏𝑈  is the firm’s unlevered beta
o Unlevered beta
 The firm’s beta coefficient if it has no debt
 If the firm was debt-free, its beta would depend entirely on its business risk and thus would be a
measure of the firm’s “basic business risk”
𝐷
𝑏𝑈 = 𝑏𝐿 / [ 1 + (1 − 𝑇) ( )]
𝐸
𝑟𝑠 = 𝑟𝑅𝐹 + 𝑅𝑃𝑀 (𝑏𝑖 )
𝑟𝑠 = 𝑟𝑅𝐹 + 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑓𝑜𝑟 𝑏𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑟𝑖𝑠𝑘 + 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑓𝑜𝑟 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑟𝑖𝑠𝑘
Capital Structure Theory

- Modern capital structure theory began in 1958 when Professors Franco Modigliani and Merton Miller published
the most influential finance article
o He proved that under a restrictive set of assumptions, that a firm’s value should be unaffected by its
capital structure
o Assumptions:
1. There are no brokerage costs
2. There are no taxes
3. There are no bankruptcy costs
4. Investors can borrow at the same rate as corporations
5. All investors have the same information as management about the firm’s future investment
opportunities
6. EBIT is not affected by the use of debt
o Some of these assumptions are unrealistic, but by indicating the conditions which capital structure is
irrelevant, MM provided clues about what is required to make capital structure relevant and, therefore,
to affect a firm’s value
- The Effect of Taxes
o Miller argued that investors are willing to accept relatively low before-tax returns on stocks than before-
tax returns on bonds
 Why?
 Interest in bonds is taxed as personal income at rates going up to 35%
 Income from stocks partly come from dividends and capital gains
o Most long-term capital gains are taxed at a maximum rate of 15% and this tax can
be deferred until the stock is sold and gain is realized
o Returns on common stock are taxed at lower effective rates than returns on debt
o Key concepts:
1. The deductibility of interest favors the use of debt in financing
2. The more favorable tax treatment of income from stocks lowers the required rates of return on stocks
and thus facors the use of equity
o Tax benefits associated with debt financing represent about 7% of the average firm’s value
 If a leverage-free firm decided to use an average amount of debt, its value would rise by 7%
o Subsequent reductions in tax rates on both dividends and capital gains have continued the benefits of
equity over debt financing which has continued the trend toward a greater reliance on equity financing

- The Effect of Potential Bankruptcy

o Problems brought by threat of bankruptcy:
 Key employees start “jumping ship”
 Suppliers start refusing to grant credit
 Customers begin seeking more stable suppliers
 Lenders start demanding higher interest rates and imposing stricter loan covenants
o Bankruptcy-related problems are likely to increase the more debt a firm has in its capital structure.
 Bankruptcy costs discourage firms from pushing their debt to excessive levels
 Firms in bankruptcy have high legal and accounting expenses, and are forced to liquidate
their assets for less than they are worth
o Two Components of Bankruptcy-related costs:
1. Probability of occurrence
2. Costs that will be incurred if financial distress arises
o A firm whose earnings are relatively volatile, all else equal, face greater chance of bankruptcy and should
use less debt than a more stable firm
- Trade-Off Theory
o The capital structure theory that states that firms trade off the tax benefits of debt financing against
problems caused by potential bankruptcy
o A summary of the Trade-Off Theory is expressed graphically below. Here are some observations about the
figure:
1. The fact that interest paid is a deductible expense makes debt less expensive than common or
preferred stock. In effect, the government pays part of the cost of debt, or, to put it another way, debt
provides tax shelter benefits. As a result, using more debt reduces taxes and thus allows more of the
firm’s operating income (EBIT) to flow through to investors. This factor, on which MM focused, tends
to raise the stock’s price. Indeed, under the assumptions of their original paper, the stock price would
be maximized at 100 percent debt. The line labeled “MM Result Incorporating the Effects of Corporate
Taxation” in Figure 14-9 expresses the relationship between stock prices and debt under their
assumptions.
2. In the real world, firms have target debt ratios that call for less than 100 percent debt, and the reason
is to hold down the adverse effects of potential bankruptcy.
3. There is some threshold level of debt, labeled D1 in Figure 14-9, below which the probability of
bankruptcy is so low as to be immaterial. Beyond D1, however bankruptcy-related costs become
increasingly important, and they begin to offset the tax benefits of debt. In the range from D1 to D2,
bankruptcy-related costs reduce but do not completely offset the tax benefits of debt, so the firm’s
stock price continues to rise (but at a decreasing rate) as its debt ratio increases. However, beyond
D2, bankruptcy-related costs exceed the tax benefits, so from this point on increasing the debt ratio
lowers the stock price. Therefore, D2 is the optimal capital structure, the one where the stock price is
maximized. Of course, D1 and D2 vary from firm to firm, depending on their business risk and
bankruptcy costs.
4. While theoretical and empirical work supports the general shape of the curves in Figures 14-8 and 14-
9, these graphs must be taken as approximations, not as precisely defined functions. The numbers in
Figure 14-8 are shown out to two decimal places, but that is merely for illustrative purposes—the
numbers are not nearly that accurate in view of the fact that the graph is based on judgmental
estimates.
5. Another disturbing aspect of capital structure theory as expressed in Figure 14-9 is the fact that many
large, successful firms such as Intel and Microsoft use far less debt than the theory suggests. This point
led to the development of signaling theory, which is discussed next.
- Signaling Theory
o Signal – an action taken by a firm’s management that provides clues to investors about how management
views the firm’s prospects
o MM assumed that everyone – investors and managers alike – has the same information about a firm’s
prospects
 Symmetric information – the situation where investors and managers have identical information
about a firm’s prospects
 Asymmetric information – the situation where managers have different (better) information
about firm’s prospects than do investors
o Effect of Asymmetric information on optimal capital structure:
 We would expect a firm with very favorable prospects to avoid selling stock, and instead raise any
required new capital by using new debt, even if this moved its debt ratio beyond the target level
 A firm with unfavorable prospects would want to finance with stock, which would mean bringing
in new investors to share the losses
o From the Investor’s POV:
 In a nutshell, the announcement of stock offering is generally taken as a signal that the firm’s
prospects as seen by its management are not bright
 In effect, investors would lower their estimate of the firm’s value
o Implications:
 Issuing stock emits a negative signal and thus tends to depress the stock price, so even if the
company’s prospects are bright, a firm should, in normal times, maintain a reserve borrowing
capacity that can be used in the event that some especially good investment opportunity comes
along.
 Reserve borrowing capacity – the ability to borrow money at a reasonable cost when
good investment opportunities arise. Firms often use less debt than specified by the MM
capital structure in “normal” times to ensure that they can obtain debt capital later if
necessary
 Firms should, in normal times, use more equity and less debt than is suggested by the tax
benefit/bankruptcy cost trade-off model

- Using Debt Financing to Constrain Managers

o Conflict of interest arise if managers and shareholders have different objectives
 Particularly likely when firm has more cash than needed to support its core operations
 Managers often use excess cash for wasteful expenditures
 Firms can reduce excess cash flows by:
1. Funnel some of it back to shareholders through higher dividends or stock repurchases
2. Tilt the target capital structure toward more debt in the hope that higher debt service
requirements will force managers to become more disciplined
3. Leverage buyout (LBO)
 Debt is used to finance the purchase of a higher percentage of the company’s shares
 Disadvantage of increasing debt and reducing free cash flow:
 Increases risk of bankruptcy

- Pecking Order Hypothesis

o The sequence in which firms prefer to raise capital:
1. Spontaneous credit 3. Debt
2. Retained earnings 4. Common stock
 - Windows of Opportunity
o The occasion where a company’s managers adjust its firm’s capital structure to take advantage of certain
market situations
o When a company’s stock is overvalued, its managers can take the opportunity to issue new equity at a
time when its market value is relatively high
o Managers may also choose to repurchase stock when the firm’s stock is undervalued

Checklist for Capital Structure Decisions

1. Sales Stability
o A frim whose sales are relatively stable can safely take on more debt and incur higher fixed charges than
a company with unstable sales
o E.g. Utility companies (has more stable demand and was able to use more financial leverage than
industrial firm
2. Asset Structure
o Other factors constant, a company is able to take on more debt if it has more cash on the balance sheet
o Net debt – equal to the total debt less cash and equivalents
 Companies often look at this measure when setting their target capital structure
 𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 – 𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠
o General-purpose assets that can be used by many businesses make good collateral, while special-purpose
assets do not
 Reason why real estate companies are usually high leveraged while companies involved in
technological research are not
3. Operating Leverage
o Other things constant, a firm with less operating leverage is better able to employ financial leverage
because it will have less business risk
4. Growth rate
o Other things the same, faster-growing firms must rely more heavily on external capital
 Flotation costs > Costs in issuing debt  these firms rely more heavily on debt
 However these firms often face higher uncertainty which tends to reduce their willingness
to use debt
5. Profitability
o Firms with higher rates of return on investment use relatively little debt
 Reason: Very profitable firms do not need to do much debt financing because high rates of return
enable them to do most of their financing with internally generated funds
6. Taxes
o Higher tax rate = Greater advantage of debt
 Interest is a deductible expense and deductions are most valuable to firms with high rate taxes
7. Control
o Control considerations can lead to the use of debt or equity because the type of capital that best protects
management varies from situation to situation
 If management currently has voting control but is not in a position to buy any more stock, it may
choose debt for new financings
 Management may decide to use equity if the firm’s financial situation is so weak that the use of
debt might subject it to serious risk of default
 If too little debt is used, management may run a risk of takeover
8. Management Attitudes
o Some managers tend to be relatively conservative and use less debt, whereas aggressive managers use a
relatively high percentage of debt to earn higher profits
 9. Lender and Rating Agency Attitudes
o Corporations often discuss their capital structures with lenders and rating agencies and give much weight
to their advice
10. Market Conditions
o Conditions in the stock and bond markets undergo long- and short-run changes that can have an
important bearing on a firm’s optimal capital structure
11. The Firm’s Internal Condition
o When firm forecasts higher earnings, it would prefer to finance with debt until higher earnings materialize
and are reflected in the stock price
 It could then sell an issue of common stock, use the proceeds to retire the debt, and return to its
target capital structure
12. Financial Flexibility
o A company should always be in a position to raise capital needed to support operations
 Having to turn down promising ventures due to lack of funds reduces long-term profitability
 When times are good, the firm can raise capital with either stocks or bonds
 When times are bad, investors are more willing to give funds when given a stronger position which
is debt
 When selling a new issue of stock, it sends out a negative “signal” to investors, so stock sales by a
mature company are not desirable
o Firms must maintain “adequate borrowing capacity”
 Determining what is “adequate” reserve is judgmental
 Depends on the firm’s forecasted need for funds, predicted capital market conditions,
management’s confidence in its forecasts, and consequences of capital shortage

Variations in Capital Structures

- Some observations:
o Petroleum, aerospace, biotechnology, and steel companies use relatively little debt because their
industries tend to be cyclical, oriented toward research, or subject to high product liability suits
o Grocery stores, utility companies, and airline use debt relatively heavy because their fixed assets make
good security for mortgage bonds and their relatively stable sales make it safe to carry more than average
debt
- Times-interest-earned (TIE) ratio
o Gives an indication on how vulnerable the company is to financial distress
o Depends on 3 factors:
1. Percentage of debt
2. Interest rate on debt
3. Company’s profitability
o Low leveraged companies have high coverage ratios, while highly leveraged companies have lower
coverage ratios
𝐸𝐵𝐼𝑇
𝑇𝐼𝐸 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒