Businessvs.FinancialRisk
Chapter13
CapitalStructureand
Leverage
OptimalCapitalStructure
OperatingLeverage
CapitalStructureTheory
131
Whatisoperatingleverage,andhowdoesit
affectafirmsbusinessrisk?
Operatingleverageistheuseoffixedcosts
ratherthanvariablecosts.
Ifmostcostsarefixed,hencedonotdecline
whendemandfalls,thenthefirmhashigh
operatingleverage.
132
EffectofOperatingLeverage
Moreoperatingleverageleadstomore
businessrisk,forthenasmallsalesdecline
causesabigprofitdecline.
Rev.
Rev.
$
TC
$
}
FC
QBE
Sales
QBE
Profit
TC
FC
Sales
Whathappensifvariablecostschange?
133
Whatisfinancialleverage?
Financialrisk?
Financialleverageistheuseofdebtand
preferredstock.
Financialriskistheadditionalrisk
concentratedoncommonstockholdersasa
resultoffinancialleverage.
134
AnExample:
IllustratingEffectsofFinancialLeverage
Twofirmswiththesameoperatingleverage,
businessrisk,andprobabilitydistributionof
EBIT.
Onlydifferwithrespecttotheiruseofdebt
(capitalstructure).
FirmU
Nodebt
$20,000inassets
40%taxrate
FirmL
$10,000of12%debt
$20,000inassets
40% taxrate
135
FirmU:Unleveraged
Probability
EBIT
Interest
EBT
Taxes(40%)
NI
Bad
0.25
$2,000
0
$2,000
800
$1,200
Economy
Average
0.50
$3,000
0
$3,000
1,200
$1,800
Good
0.25
$4,000
0
$4,000
1,600
$2,400
136
FirmL:Leveraged
Probability*
EBIT*
Interest
EBT
Taxes(40%)
NI
Bad
0.25
$2,000
1,200
$ 800
320
$ 480
Economy
Average
0.50
$3,000
1,200
$1,800
720
$1,080
Good
0.25
$4,000
1,200
$2,800
1,120
$1,680
* SameasforFirmU.
137
RatioComparisonBetweenLeveraged
andUnleveragedFirms
ROE = NI/Total Equity
ROE
Bad
Average
Good
FirmU
6.0%
9.0%
12.0%
FirmL
4.8%
10.8%
16.8%
Firm equity Us equals assets because no debt ($20,000)
Firm Ls equity equals assets minus debt ($10,000)
138
OptimalCapitalStructure
Thecapitalstructure(mixofdebt,preferred,
andcommonequity)atwhichP0is
maximized.
139
SequenceofEventsinaRecapitalization
Weareincreasingthe%ofdebtcomparedto
equity
Firmannouncestherecapitalization.
Newdebtisissued.
Proceedsareusedtorepurchasestock.
Thenumberofsharesrepurchasedisequalto
theamountofdebtissueddividedbypriceper
share.
1310
CostofDebtatDifferentDebtRatios
Amount
Borrowed
$0
D/A
Ratio
0
D/E
Ratio
0
Bond
Rating
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%
rd
1311
Whydothebondratingandcostofdebt
dependupontheamountofdebtborrowed?
Asthefirmborrowsmoremoney,thefirm
increasesitsfinancialriskcausingthefirms
bondratingtodecrease,anditscostofdebt
toincrease.
1312
Whateffectdoesmoredebthaveona
firmscostofequity?
Ifthelevelofdebtincreases,thefirmsrisk
increases.
Wehavealreadyobservedtheincreaseinthe
costofdebt.
However,theriskofthefirmsequityalso
increases,resultinginahigherrs.
1313
Whataresignalingeffectsincapital
structure?
Assumptions:
Managershavebetterinformationaboutafirms
longrunvaluethanoutsideinvestors.
Managersactinthebestinterestsofcurrent
stockholders.
Whatcanmanagersbeexpectedtodo?
Issuestockiftheythinkstockisovervalued.
Issuedebtiftheythinkstockisundervalued.
Asaresult,investorsviewastockoffering
negativelymanagersthinkstockisovervalued.
1314
Breakeven
QBE=Fixedcosts/(salespricevariable
costs)
Salespricevariablecostisalsoknownas
contributionmargin
1315