Firms generally consider the following factors when making capital structure decisions:
1. Sales stability. A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with unstable sales. Utility companies, because of their stable demand, have historically been able to use more financial leverage than industrial firms.
2. Asset structure. Firms whose assets are suitable as security for loans tend to use debt rather heavily. General-purpose assets that can be used by many businesses make good collateral, whereas special-purpose assets do not. Thus, real estate companies are usually highly leveraged, whereas companies involved in technological research are not.
3. Operating leverage. Other things the same, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk.
4. Growth rate. Other things the same, faster-growing firms must rely more heavily on external capital (see Chapter 11). Further, the flotation costs involved in selling common stock exceed those incurred when selling debt, which encourages rapidly growing firms to rely more heavily on debt. At the same time, however, these firms often face greater uncertainty, which tends to reduce their willingness to use debt.
5. Profitability. One often observes that firms with very high rates of return on investment use relatively little debt. Although there is no theoretical justification for this fact, one practical explanation is that very profitable firms such as Intel, Microsoft, and Coca-Cola simply do not need to do much debt financing. Their high rates of return enable them to do most of their financing with internally generated funds.
6. Taxes. Interest is a deductible expense, and deductions are most valuable to firms with high tax rates. Therefore, the higher a firm's tax rate, the greater the advantage of debt.
7. Control. The effect of debt versus stock on a management's control position can influence capital structure. If management currently has voting control (over 50 percent of the stock) but is not in a position to buy any more stock, it may choose debt for new financings. On the other hand, 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, because if the firm goes into default, the managers will almost surely lose their jobs. However, if too little debt is used, management runs the risk of a takeover. Thus, control considerations could lead to the use of either debt or equity, because the type of capital that best protects management will vary from situation to situation. In any event, if management is at all insecure, it will consider the control situation.
8. Management attitudes. Because no one can prove that one capital structure will lead to higher stock prices than another, management can exercise its own judgment about the proper capital structure. Some managements tend to be more conservative than others, and thus use less debt than the average firm in their industry, whereas aggressive managements use more debt in the quest for higher profits.
9. Lender and rating agency attitudes. Regardless of managers' own analyses of the proper leverage factors for their firms, lenders' and rating agencies' attitudes frequently influence financial structure decisions. In the majority of cases, the corporation discusses its capital structure with lenders and rating agencies and gives much weight to their advice. For example, one large utility was recently told by Moody's and Standard & Poor's that its bonds would be downgraded if it issued more debt. This influenced its decision to finance its expansion with common equity.
10. Market conditions. Conditions in the stock and bond markets undergo both long- and short-run changes that can have an important bearing on a firm's optimal capital structure. For example, during a recent credit crunch, the junk bond market dried up, and there was simply no market at a "reasonable" interest rate for any new long-term bonds rated below triple B. Therefore, low-rated companies in need of capital were forced to go to the stock market or to the short-term debt market, regardless of their target capital structures. When conditions eased, however, these companies sold bonds to get their capital structures back on target.
11. The firm's internal condition. A firm's own internal condition can also have a bearing on its target capital structure. For example, suppose a firm has just successfully completed an R&D program, and it forecasts higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reflected in the stock price. This company would not want to issue stock—it would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price. Then it could sell an issue of common stock, retire the debt, and return to its target capital structure. This point was discussed earlier in connection with asymmetric information and signaling.
12. Financial flexibility. Firms with profitable investment opportunities need to be able to fund them. An astute corporate treasurer made this statement to the authors:
Our company can earn a lot more money from good capital budgeting and operating decisions than from good financing decisions. Indeed, we are not sure exactly how financing decisions affect our stock price, but we know for sure that having to turn down a promising venture because funds are not available will reduce our long-run profitability. For this reason, my primary goal as treasurer is to always be in a position to raise the capital needed to support operations.
We also know that when times are good, we can raise capital with either stocks or bonds, but when times are bad, suppliers of capital are much more willing to make funds available if we give them a secured position, and this means debt. Further, when we sell a new issue of stock, this sends a negative "signal" to investors, so stock sales by a mature company such as ours are not desirable.
Putting all these thoughts together gives rise to the goal of maintaining financial flexibility, which, from an operational viewpoint, means maintaining adequate reserve borrowing capacity. Determining an "adequate" reserve borrowing capacity is judgmental, but it clearly depends on the factors discussed in the chapter, including the firm's forecasted need for funds, predicted capital market conditions, management's confidence in its forecasts, and the consequences of a capital shortage.
How does sales stability affect the target capital structure? How do the types of assets used affect a firm's capital structure? How do taxes affect the target capital structure? How do lender and rating agency attitudes affect capital structure? How does the firm's internal condition affect its actual capital structure? What is "financial flexibility," and is it increased or decreased by a high debt ratio?
This chapter examined the effects of financial leverage on stock prices, earnings per share, and the cost of capital. The key concepts covered are listed below:
• A firm's optimal capital structure is that mix of debt and equity that maximizes the stock price.At any point in time, management has a specific target capital structure in mind, presumably the optimal one, although this target may change over time.
• Several factors influence a firm's capital structure. These include its (1) business risk, (2) tax position, (3) need for financial flexibility, (4) managerial conservatism or aggressiveness, and (5) growth opportunities.
• Business risk is the riskiness inherent in the firm's operations if it uses no debt. A firm will have little business risk if the demand for its products is stable, if the prices of its inputs and products remain relatively constant, if it can adjust its prices freely if costs increase, and if a high percentage of its costs are variable and hence will decrease if sales decrease. Other things the same, the lower a firm's business risk, the higher its optimal debt ratio.
• Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure. Financial risk is the added risk borne by stockholders as a result of financial leverage.
• Operating leverage is the extent to which fixed costs are used in a firm's operations. In business terminology, a high degree of operating leverage, other factors held constant, implies that a relatively small change in sales results in a large change in ROIC.
• Robert Hamada used the underlying assumptions of the CAPM, along with the Modigliani and Miller model, to develop the Hamada equation, which shows the effect of financial leverage on beta as follows:
Firms can take their current beta, tax rate, and debt/equity ratio to arrive at their unlevered beta, bU, as follows:
• Modigliani and Miller and their followers developed a trade-off theory of capital structure. They showed that debt is useful because interest is tax deductible, but also that debt brings with it costs associated with actual or potential bankruptcy. The optimal capital structure strikes a balance between the tax benefits of debt and the costs associated with bankruptcy.
• An alternative (or, really, complementary) theory of capital structure relates to the signals given to investors by a firm's decision to use debt versus stock to raise new capital. A stock issue sets off a negative signal, while using debt is a positive, or at least a neutral, signal. As a result, companies try to avoid having to issue stock by maintaining a reserve borrowing capacity, and this means using less debt in "normal" times than the MM trade-off theory would suggest.
• A firm's owners may decide to use a relatively large amount of debt to constrain the managers. A high debt ratio raises the threat of bankruptcy, which carries a cost but which also forces managers to be more careful and less wasteful with shareholders' money. Many of the corporate takeovers and leveraged buyouts in recent years were designed to improve efficiency by reducing the cash flow available to managers.
Although each firm has a theoretically optimal capital structure, as a practical matter we cannot estimate it with precision. Accordingly, financial executives generally treat the optimal capital structure as a range—for example, 40 to 50 percent debt—rather than as a precise point, such as 45 percent. The concepts discussed in this chapter help managers understand the factors they should consider when they set the target capital structure ranges for their firms.
13-1 Define each of the following terms:
a. Capital structure; business risk; financial risk b. Operating leverage; financial leverage; breakeven point c. Reserve borrowing capacity
13-2 What term refers to the uncertainty inherent in projections of future ROIC?
13-3 Firms with relatively high nonfinancial fixed costs are said to have a high degree of what?
13-4 "One type of leverage affects both EBIT and EPS. The other type affects only EPS." Explain this statement.
13-5 Why is the following statement true? "Other things being the same, firms with relatively stable sales are able to carry relatively high debt ratios."
13-6 Why do public utility companies usually have capital structures that are different from those of retail firms?
13-7 Why is EBIT generally considered to be independent of financial leverage? Why might EBIT actually be influenced by financial leverage at high debt levels?
13-8 If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?
Self-Test Problems (Solutions Appear in Appendix A)
ST-1 The Rogers Company is currently in this situation: (1) EBIT = $4.7 million; (2) tax rate, OPTIMAL CAPITAL STRUCTURE T = 40%; (3) value of debt, D = $2 million; (4) rd = 10%; (5) rs = 15%; (6) shares of stock outstanding, n0 = 600,000; and stock price, P0 = $30. The firm's market is stable, and it expects no growth, so all earnings are paid out as dividends. The debt consists of perpetual bonds.
a. What is the total market value of the firm's stock, S, and the firm's total market value, V?
b. What is the firm's weighted average cost of capital?
c. Suppose the firm can increase its debt so that its capital structure has 50 percent debt, based on market values (it will issue debt and buy back stock). At this level of debt, its cost of equity rises to 18.5 percent. Its interest rate on all debt will rise to 12 percent (it will have to call and refund the old debt). What is the WACC under this capital structure? What is the total value? How much debt will it issue, and what is the stock price after the repurchase? How many shares will remain outstanding after the repurchase?
ST-2 Lighter Industrial Corporation (LIC) is considering a large-scale recapitalization. Currently, HAMADA EQUATION LIC is financed with 25 percent debt and 75 percent equity. LIC is considering increasing its level of debt until it is financed with 60 percent debt and 40 percent equity. The beta on its common stock at the current level of debt is 1.5, the risk free rate is 6 percent, the market risk premium is 4 percent, and LIC faces a 40 percent federal-plus-state tax rate.
a. What is LIC's current cost of equity?
b. What is LIC's unlevered beta?
c. What will be the new beta and new cost of equity if LIC recapitalizes?
13-1 Schweser Satellites Inc. produces satellite earth stations that sell for $100,000 each. The firm's OpERATING LEVERAGE fixed costs, F, are $2 million; 50 earth stations are produced and sold each year; profits total AND BREAKEVEN $500,000; and the firm's assets (all equity financed) are $5 million. The firm estimates that it can change its production process, adding $4 million to investment and $500,000 to fixed operating costs. This change will (1) reduce variable costs per unit by $10,000 and (2) increase output by
20 units, but (3) the sales price on all units will have to be lowered to $95,000 to permit sales of the additional output. The firm has tax loss carry-forwards that cause its tax rate to be zero, its cost of equity is 15 percent, and it uses no debt.
a. Should the firm make the change?
b. Would the firm's operating leverage increase or decrease if it made the change? What about its breakeven point?
c. Would the new situation expose the firm to more or less business risk than the old one? Here are the estimated ROE distributions for Firms A, B, and C:
Firm A: ROEA
Firm B: ROEB
Firm C: ROEC
CAPITAL STRUCTURE ANALYSIS
a. Calculate the expected value and standard deviation for Firm C's ROE. ROEA = 10.0%, cta = 5.5%; ROEb = 12.0%, CTb = 7.7%.
b. Discuss the relative riskiness of the three firms' returns. (Assume that these distributions are expected to remain constant over time.)
c. Now suppose all three firms have the same standard deviation of basic earning power (EBIT/ Total assets), cta = ctb = aC = 5.5%. What can we tell about the financial risk of each firm?
The Rivoli Company has no debt outstanding, and its financial position is given by the following data:
Cost of equity, rs 10%
Stock price, P0 $15
Shares outstanding, n0 200,000
Tax rate, T (federal-plus-state) 40%
The firm is considering selling bonds and simultaneously repurchasing some of its stock. If it moves to capital structure with 30 percent debt based on market values, its cost of equity, rs, will increase to 11 percent to reflect the increased risk. Bonds can be sold at a cost, rd, of 7 percent. Rivoli is a no-growth firm. Hence, all its earnings are paid out as dividends, and earnings are expectationally constant over time.
a. What effect would this use of leverage have on the value of the firm?
b. What would be the price of Rivoli's stock?
c. What happens to the firm's earnings per share after the recapitalization?
d. The $500,000 EBIT given previously is actually the expected value from the following probability distribution:
100,000) 200,000 500,000 800,000 1,100,000
CAPITAL STRUCTURE ANALYSIS
e. Determine the times-interest-earned ratio for each probability. What is the probability of not covering the interest payment at the 30 percent debt level?
Pettit Printing Company has a total market value of $100 million, consisting of 1 million shares selling for $50 per share and $50 million of 10 percent perpetual bonds now selling at par. The
OPTIMAL CAPITAL STRUCTURE WITH HAMADA
WACC AND OPTIMAL CAPITAL STRUCTURE
company's EBIT is $13.24 million, and its tax rate is 15 percent. Pettit can change its capital structure by either increasing its debt to 70 percent (based on market values) or decreasing it to 30 percent. If it decides to increase its use of leverage, it must call its old bonds and issue new ones with a 12 percent coupon. If it decides to decrease its leverage, it will call in its old bonds and replace them with new 8 percent coupon bonds. The company will sell or repurchase stock at the new equilibrium price to complete the capital structure change.
The firm pays out all earnings as dividends; hence, its stock is a zero growth stock. Its current cost of equity, rs, is 14 percent. If it increases leverage, rs will be 16 percent. If it decreases leverage, rs will be 13 percent. What is the firm's WACC and total corporate value under each capital structure?
Beckman Engineering and Associates (BEA) is considering a change in its capital structure. BEA currently has $20 million in debt carrying a rate of 8 percent, and its stock price is $40 per share with 2 million shares outstanding. BEA is a zero growth firm and pays out all of its earnings as dividends. EBIT is $14.933 million, and BEA faces a 40 percent federal-plus-state tax rate. The market risk premium is 4 percent, and the risk free rate is 6 percent. BEA is considering increasing its debt level to a capital structure with 40 percent debt, based on market values, and repurchasing shares with the extra money that it borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on the new debt will be 9 percent. BEA has a beta of 1.0.
a. What is BEA's unlevered beta? Use market value D/S when unlevering.
b. What are BEA's new beta and cost of equity if it has 40 percent debt?
c. What are BEA's WACC and total value of the firm with 40 percent debt?
Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company's treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table:
Market Debt-to-Value Ratio (wd)
Market Equity-to-Value Ratio (wc)
Market Debt-to-Equity Ratio (D/S)
Before-Tax Cost of Debt (rd)
Elliott uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free rate is 5 percent, the market risk premium is 6 percent, and its tax rate is 40 percent. Elliott estimates that if it had no debt, its "unlevered" beta, bu, would be 1.2. Based on this information, what is the firm's optimal capital structure, and what would the weighted average cost of capital be at the optimal capital structure?
BUILD A MODEL: WACC AND OPTIMAL CAPITAL STRUCTURE
Start with the partial model in the file Ch 13 P7 Build a Model.xls from the textbook's web site. Rework Problem 13-6 using a spreadsheet model. After completing the problem as it appears, answer the following related questions.
a. Plot a graph of the after-tax cost of debt, the cost of equity, and the WACC versus the debt/ value ratio.
b. Would the optimal capital structure change if the unlevered beta changed? To answer this question, do a sensitivity analysis of WACC on bu for different levels of bu.
See Ch 13 Show.ppt and Ch 13 Mini Case.xls.
Assume you have just been hired as business manager of PizzaPalace, a pizza restaurant located adjacent to campus. The company's EBIT was $500,000 last year, and since the university's enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock, and the stock is traded in the over-the-counter market.
The firm is currently financed with all equity; it has 100,000 shares outstanding; and P0 = $25 per share. When you took your MBA corporate finance course, your instructor stated that most firms' owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:
Percent Financed with Debt, wd rd
If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6 percent.
a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows.
b. (1) What is business risk? What factors influence a firm's business risk?
(2) What is operating leverage, and how does it affect a firm's business risk? Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.
c. Now, to develop an example that can be presented to PizzaPalace's management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000.
(1) Construct partial income statements, which start with EBIT, for the two firms.
(2) Now calculate ROE for both firms.
(3) What does this example illustrate about the impact of financial leverage on ROE?
d. Explain the difference between financial risk and business risk.
e. Now consider the fact that EBIT is not known with certainty, but rather has the following probability distribution:
Economic State Probability EBIT
Average 0.50 3,000
Good 0.25 4,000
Redo the part a analysis for Firms U and L, but add basic earnings power (BEP), return on invested capital (ROIC, defined as NOPAT/Capital = EBIT (1 — T)/TA for this company), and the times-interest-earned (TIE) ratio to the outcome measures. Find the values for each firm in each state of the economy, and then calculate the expected values. Finally, calculate the standard deviations. What does this example illustrate about the impact of debt financing on risk and return?
What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.
Selected Additional References and Cases g. With the above points in mind, now consider the optimal capital structure for PizzaPalace.
(1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC.
(2) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity.
(3) Calculate the resulting price per share, the number of shares repurchased, and the remaining shares.
h. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure?
i. What other factors should managers consider when setting the target capital structure?
For an article on signaling, see
Baskin, Jonathon, "An Empirical Investigation of the Pecking Order Hypothesis," Financial Management, Spring 1989, 26-35.
For an academic discussion of the issues, see
Caks, John, "Corporate Debt Decisions: A New Analytical Framework," Journal of Finance, December 1978, 12971315.
Masulis, Ronald W., "The Impact of Capital Structure Change on Firm Value: Some Estimates," Journal of Finance, March 1983, 107-126.
Piper, Thomas R., and Wolf A. Weinhold, "How Much Debt Is Right for Your Company?" Harvard Business Review, July-August 1982, 106-114.
Shalit, Sol S., "On the Mathematics of Financial Leverage," Financial Management, Spring 1975, 57-66.
For some insights into how practicing financial managers view the capital structure decision, see
Kamath, Ravindra R., "Long-Term Financing Decisions: Views and Practices of Financial Managers of NYSE Firms," Financial Review, May 1997, 331-356.
Norton, Edgar, "Factors Affecting Capital Structure Decisions," Financial Review, August 1991, 431-446.
Pinegar, J. Michael, and Lisa Wilbricht, "What Managers Think of Capital Structure Theory: A Survey," Financial Management, Winter 1989, 82-91.
Scott, David F., and Dana J. Johnson, "Financing Policies and Practices in Large Corporations," Financial Management, Summer 1982, 51-59.
To learn more about the link between market risk and operating and financial leverage, see
Callahan, Carolyn M., and Rosanne M. Mohr, "The Determinants of Systematic Risk: A Synthesis," The Financial Review, May 1989, 157-181.
Gahlon, James M., and James A. Gentry, "On the Relationship between Systematic Risk and the Degrees of Operating and Financial Leverage," Financial Management, Summer 1982, 15-23.
Prezas, Alexandras P., "Effects of Debt on the Degrees of Operating and Financial Leverage," Financial Management, Summer 1987, 39-44.
Here are some additional articles that relate to this chapter:
Easterwood, John C., and Palani-Rajan Kadapakkam, "The Role of Private and Public Debt in Corporate Capital Structures," Financial Management, Autumn 1991, 49-57.
Garvey, Gerald T., "Leveraging the Underinvestment Problem: How High Debt and Management Shareholdings Solve the Agency Costs of Free Cash Flow," Journal of Financial Research, Summer 1992, 149-166.
Harris, Milton, and Artur Raviv, "Capital Structure and the Informational Role of Debt," Journal of Finance, June 1990, 321-349.
Israel, Ronen, "Capital Structure and the Market for Corporate Control: The Defensive Role of Debt Financing," Journal of Finance, September 1991, 1391-1409.
See the following two articles for additional insights into the relationship between industry characteristics and financial leverage:
Bowen, Robert M., Lane A. Daley, and Charles C. Huber, Jr., "Evidence on the Existence and Determinants of Inter-Industry Differences in Leverage," Financial Management, Winter 1982, 10-20.
Long, Michael, and Ileen Malitz, "The Investment-Financing Nexus: Some Empirical Evidence," Midland Corporate Finance Journal, Fall 1985, 53-59.
For a discussion of the international implications of capital structure, see
Rutterford, Janette, "An International Perspective on the Capital Structure Puzzle," Midland Corporate Finance Journal, Fall 1985, 60-72.
The Cases in Financial Management series contains many of the concept we present in Chapter 13.
Case 9, "Home Security Systems, Inc.," Case 10, "Kleen Kar, Inc.," Case 10A, "Mountain Springs, Inc.," and Case 10B, "Greta Cosmetics, Inc.," which present a situation similar to the Strasburg example in the text.
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