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H 1/31/2007

Tool Kit for Capital Structure Decisions: The Basics

In Chapter 6, we introduced the idea that risk has two principal components, market risk and stand-alone risk. Market risk is measured by beta, while stand-alone risk consists of both market risk plus an element of risk that can be eliminated through diversification. In this chapter, we introduce two new dimensions of risk, business risk and financial risk. Business risk is the risk inherent in the firm's operations, and it would be there even if used no debt. Financial risk is the additional risk borne by the stockholders as a result of the use of debt.

BUSINESS RISK AND FINANCIAL RISK (Section 16.2)

Operating Leverage reflects amount of fixed costs embedded in a firm's operations. Thus, if a high percentage of a firm's costs are fixed, hence continue even if sales decline, then the firm is said to have high operating leverage. High operating leverage produces a situation where a small change in sales can result in a large change in operating income. The following example compares two operational plans with different degrees of operating leverage. Using the input data given below, we examine the firm's profitability under two operating plans, in different states of the economy. The probabilities of the economic states are also given in the example. Input Data Price Variable costs Fixed costs Capital Tax Rate Plan A Low FC $2.00 $1.50 $20,000 $200,000 40%

Plan B High FC $2.00 Product sells at same price regardless of how it is produ $1.00 A has high variable costs; it doesn't use labor-saving equip $60,000 Plan B has high fixed costs (depreciation) due to the use of $200,000 saving equipment. 40%

Operating Performance
Data Applicable to Both Plans Units Dollar Demand Probability Sold Sales Terrible 0.05 0 $0 Poor 0.2 40,000 $80,000 Average 0.5 100,000 $200,000 Good 0.2 160,000 $320,000 Wonderful 0.05 200,000 $400,000 Expected Values: 100,000 $200,000 Standard Deviation (SD): $49,396 $98,793 Coefficient of Variation (CV): 0.49 0.49 A's breakeven units = 40,000. See table. Plan A: Low Fixed, High Variable Costs Pre-tax Net Op Profit Return on Units Operating Operating After Taxes Invested Sold Costs Profit (EBIT) (NOPAT) Capital 0 $20,000 ($20,000) ($12,000) -6.0% 40,000 $80,000 $0 $0 0.0% 100,000 $170,000 $30,000 $18,000 9.0% 160,000 $260,000 $60,000 $36,000 18.0% 200,000 $320,000 $80,000 $48,000 24.0% Exp. Values: $170,000 $30,000 $18,000 9.0% Std. Dev.: $24,698 7.4% Coef. of Var.: 0.82 0.82 B's breakeven units = 60,000. See calculation below. Plan B: High Fixed, Low Variable Costs Pre-tax Net Op Profit Return on Operating Operating After Taxes Invested Costs Profit (EBIT) (NOPAT) Capital $60,000 ($60,000) ($36,000) -18.0% $100,000 ($20,000) ($12,000) -6.0% $160,000 $40,000 $24,000 12.0% $220,000 $100,000 $60,000 30.0% $260,000 $140,000 $84,000 42.0% $160,000 $40,000 $24,000 12.0% $49,396 14.8% 1.23 1.23

Which plan is better? Based on expected profits and the return on invested capital, Plan B looks better. However, Plan B is also riskier as measured by the standard deviation (SD) and the coefficient of variation (CV). So, we face a tradeoff between risk and return--B is more profitable, but A is less risky. Someone will have to choose between the two plans, but at this point we have no basis for making the choice.

A 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114

Note also that Plan A will break even at sales as low as 40,000 units, while Plan B would have a $20,000 loss at that level. B's breakeven point is 50% higher, at 60,000 units. The results generated above are graphed below

Plan A: Low Fixed Costs, Low Operating Leverage

$200,000

Plan B: High Fixed Costs, High Operating Leverage

$200,000

Revenues and costs

Revenues and costs

$150,000

Revenues VC

$150,000

Revenues VC

$100,000

FC

$100,000

FC

$50,000

$50,000

$0

$0

50000 Sales (units)

100000

Sales (units)

50000

100000

B has a much higher breakeven point, (2) that B has more leverage in the sense that a given change in sales leads to a larger change in profits than for A. We can see from the table that A's breakeven point is at 40,000 units. We can see from the table and also from the graph that B's breakeven point is between 40,000 and 100,000 units, but we cannot tell the exact point. However, we can use the following formula to find the exact breakeven point: Q BE Plan A Q BE = Q BE = Q BE = Plan B BE B = BE B = BE B = =
FC

/ (P - VC)

In words, the quantity at which a firm breaks even is found as the Fixed Costs divided by the difference between Price and Variable costs. (P $2.00 VC) $1.50

FC $20,000 40,000 Units.

FC $60,000 60,000

Units.

(P $2.00

VC) $1.00

At this point, we know that Plan B has a higher expected rate of return, but it is also more risky. Our analysis is on stand-alone risk. However, given a positive correlation between the firm's returns and that on the market, Plan B's higher risk will result in a higher "unlevered beta." We do not calculate unlevered betas here, but in the next section we assume that B's beta is 1.5, and we also assume that management believes that the choosing Plan B would lead to a higher stock price than Plan A.

115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158

FINANCIAL RISK AND LEVERAGE

Financial Leverage refers to the use of fixed-income securities (preferred stock and debt) in the capital structure. The firm has a certain amount of business risk as discussed above in connection with operating leverage. This business risk is measured by the firm's "unleveraged beta," which is the beta it would have if it had no debt. If the firm uses no financial leverage, i.e., no debt or preferred stock, then each stockholder would bear that business risk in proportion to his or her share of the stock. However, if the firm uses debt, then the business risk will be concentrated on its stockholders, and each will have to bear more of that risk than if the firm had remained debt-free. The risk of the stock is reflected in the stock's beta coefficient, and, as we discuss below, beta rises with the use of debt-- the more debt, the higher the beta. The lowest beta is the one that would exist if no debt were used--this is the "unleveraged beta," and it reflects the firm's business risk as discussed above. In the following example we illustrate all this, continuing with the situation described in our operating leverage example. We assume that the company decided on Plan B and thus requires $200,000 of capital. We also assume that the firm must increase its precentage financed with debt by 10% at at time, and that its debt ratio cannot exceed 60% due to restrictions in it's corporate charter. Further, we assume that Strasburg Inc currently has 10,000 shares of common stock outstanding. Current data for Strasburg Assets Debt Market value of equity Shares outstanding Tax rate

$200,000 $0 $200,000 10,000 40%

Table 16-1 Effects of Financial Leverage: Strasburg Electronics Financed with Zero Debt or $100,000 Debt Section I. Zero Debt Debt Book equity Interest rate Demand for product Probability (1) (2) Terrible 0.05 Poor 0.2 Normal 0.5 Good 0.2 Wonderful 0.05 Expected value: Standard deviation: Coefficient of variation:

$0 $200,000 n.a. Pre-tax income (5) ($60,000) (20,000) 40,000 100,000 140,000 $40,000 Taxes (40%) (6) ($24,000) (8,000) 16,000 40,000 56,000 $16,000 Net income (7) ($36,000) (12,000) 24,000 60,000 84,000 $24,000

EBIT (3) ($60,000) (20,000) 40,000 100,000 140,000 $40,000

Interest (4) $0 0 0 0 0 $0

ROE (8) -18.0% -6.0% 12.0% 30.0% 42.0% 12.0% 14.8% 1.23

A 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212

C $100,000 $100,000 10%

Section II. $100,000 of Debt Debt Book equity Interest rate Demand for product Probability (1) (2) Terrible 0.05 Poor 0.2 Normal 0.5 Good 0.2 Wonderful 0.05 Expected value: Standard deviation: Coefficient of variation:

EBIT (3) ($60,000) (20,000) 40,000 100,000 140,000 $40,000

Interest (4) $10,000 10,000 10,000 10,000 10,000 $10,000

Pre-tax income (5) ($70,000) (30,000) 30,000 90,000 130,000 $30,000

Taxes (40%) (6) ($28,000) (12,000) 12,000 36,000 52,000 $12,000

Net income (7) ($42,000) (18,000) 18,000 54,000 78,000 $18,000

ROE (8) -42.0% -18.0% 18.0% 54.0% 78.0% 18.0% 29.6% 1.65

Typically, financial leverage increases the expected rate of return on equity. In this case, the return on equity rises from 12% to 18.0%. However, this higher return comes at a price--the higher the debt ratio, the greater the risk as indicated by the standard deviation and the coefficient of variation, which rises from 1.23 to 1.65.

ESTIMATING THE OPTIMAL CAPITAL STRUCTURE (Section 16.5)

OL NG CTV T I U The optimal capital structure is the one that maximizes the value of the company. Also, that same capital structure minimizes the WACC. To find--or, really, estimate--the optimal capital structure, we need information on how capital structure affects the costs of debt and equity. The effects on debt are usually estimated by talking with bankers and investment bankers--Strasburg's debt cost schedule as shown above was determined in this way. The effects on the cost of equity are determined in various ways, but one logical starting point is the Hamada Equation, which is explained below. Discussions with its bankers indicate that Strasburg can borrow different amounts, but the more it borrows, the higher the cost of its debt. Note: the percentages are based on market values.

Table 16-2 Interest Rates for Strasburg with Different Capital Structures
Percent financed with debt (wd) 0% 10% 20% 30% 40% 50% 60% Debt Cost Schedule Percent financed with equity Cost of debt (wce) (rd) 100% 8.0% 90% 8.0% 80% 8.1% 70% 8.5% 60% 9.0% 50% 11.0% 40% 14.0%

THE HAMADA EQUATION

Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation:

A 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267
f

b = bU x [1 + (1-T) x (D/S)]
Here bL is the leveraged beta, b U is the beta that the firm would have if it used no debt, T is the marginal tax rate, D is the market value of the debt, and S is the market value of the equity. In the table below, we apply the Hamada equation to Strasburg Electronics, given its unlevered beta and tax rate. bU Tax rate 1 40% wd 0% 10% 20% 30% 40% 50% 60% D/S 0.00 0.11 0.25 0.43 0.67 1.00 1.50 BL 1.00 1.07 1.15 1.26 1.40 1.60 1.90

As the table shows, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity and then on the WACC. Here we assume that the risk-free rate is 6% and the market risk premium is 6% We also assume that Strasburg pays out all of its earnings as dividends, hence its earnings and dividends are not expected to grow. Therefore, its stock price can be found by using the perpetuity equation, Price = Dividend/rs. Risk-free rate, rRF: Market risk premium, RP M Free Cash Flow, FCF: 6% 6% $24,000

Table 16-3 Strasburg's Optimal Capital Structure

Percent Market After-tax financed Debt/Equity, cost of debt, with debt, wd D/S (1-T) rd (1) (2) (3) 0% 0.00% 4.80% 10% 11.11% 4.80% 20% 25.00% 4.86% 30% 42.86% 5.10% 40% 66.67% 5.40% 50% 100.00% 6.60% 60% 150.00% 8.40% Estimated beta, b (4) 1.00 1.07 1.15 1.26 1.40 1.60 1.90 Cost of equity, rs (5) 12.0% 12.4% 12.9% 13.5% 14.4% 15.6% 17.4% Value of operations, Vop (7) $200,000 $206,186 $212,540 $217,984 $222,222 $216,216 $200,000

WACC (6) 12.00% 11.64% 11.29% 11.01% 10.80% 11.10% 12.00%

Notes:

The D/S ratio is calculated as: D/S = w / (1-wd). d The interest rates are shown in Table 16-2, and the tax rate is 40%. c The beta is estimated using Hamadas formula in Equation 16-8. d The cost of equity is estimated using the CAPM formula: sr= rRF + (RPM)b, where the risk free rate is 6 percent and the market risk premium is 6 percent. e The weighted average cost of capital is calculated using Equation 16-2: WACC = wce rs + wd rd (1-T), where wce = (1-wd).
b

268 269 270 271 272 We see that the stock price is maximized, and the WACC is minimized, if the firm finances with 40% debt and 60% equity. This 273 is the optimal capital structure. 274 275 We can graph the key data in the table above. 276 277 20% 278 279 Cost of 280 281 282 15% 283 WACC 284 285 286 10% 287 288 289 After-Tax 290 Cost of 5% 291 292

The value of the firm's operations is calculated using the free cash flow valuation formula in Equation 16-1, modified to reflect the fact that Strasburg has zero growth: V op = FCF / WACC. Since Strasburg has zero growth, it requires no investment in capital, and its FCF is equal to its NOPAT. Using the EBIT shown in Table 16-1: FCF = NOPAT + Investment in capital = EBIT(1-T) + 0 = $40,000 (1-0.4) = $24,000.

A 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323 324 325 326 327 328 329 330 331 332 333 334 335
0%

0%

10%

20%

30%

40%

50%

60%

Percent Financed with Debt

Value of Firm

$250,000

$200,000

$150,000

$100,000

$50,000

$0 0% 10% 20% 30% 40% 50% 60% Percent Financed with Debt

ANATOMY OF A RECAPITALIZATION
Strasburg will issue debt and use the proceeds to repurchase stock. This is a recapitalization, often called a "recap." When Strasburg announces its planned recapitalization, investors realize that the company will be worth more after the recap. Therefore, the stock price will increase when the plans are announced, even though the actual repurchase has not yet occurred. If the stock price did not increase until after the actual repurchase, it would be possible for an investor to buy the stock immediately prior to the repurchase, and then reap a reward the next day when the repurchase ocurred. Curent stockholders realize this, and refuse to sell the stock unless they are paid the price that is expected immediately after the repurchase occurrs.

Table 16-4

336 337 338 339 340 341 342 343 344 345 346

Anatomy of a Recapitalization After Debt Issue, But Before Debt After Before Issue Repurchase Repurchase (1) (2) (3) Vop $200,000 $222,222 $222,222 + ST 0 88,889 0 investments VTotal $200,000 $311,111 $222,222 Debt 0 88,889 88,889 Value of equity (S) $200,000 $222,222 $133,333 Number of shares 10,000 10,000 $6,000.00 P $20.00 $22.22 $22.22 $200,000 0 $200,000 $222,222 0 $222,222 $133,333 88,889 $222,222

347 348 349 350 351 Table 16-5 352 353 Percent 354 financed 355 with debt, wd 356 (1) 357 0% 358 10% 359 20% 360 30% 361 40% 362 50% 363 60% 364 365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 380 381 382 383 384 385 386 387

Value of stock + Cash distributed in repurchase Wealth of shareholders

Value of operations, Vop (2) $200,000 206,186 212,540 217,984 222,222 216,216 200,000

Market value of debt, D (3) $0 20,619 42,508 65,395 88,889 108,108 120,000

Market value of equity, S (4) $200,000 185,567 170,032 152,589 133,333 108,108 80,000

Number of Stock shares after Net income, price, P repurchase, n NI (5) (6) (7) $20.00 $10,000 $24,000 $20.62 9,000 23,010 $21.25 8,000 21,934 $21.80 7,000 20,665 $22.22 6,000 19,200 $21.62 5,000 16,865 $20.00 4,000 13,920

Earnings per share, EPS (8) $2.40 $2.56 $2.74 $2.95 $3.20 $3.37 $3.48

Stock Price $25

Price

EPS $6

$20 $4 $15 $10 $5 $0 0% 10% 20% 30% 40% 50% $0 60%

EPS

$2

Percent Financed with Debt

J 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62

J 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114

Further discussion of Operating Leverage (Beyond the scope of the textbook, but interesting) 1. The beta of the i th asset can be found using this equation: b i = V i,M ( Wi / WM ) Here ViM is the correlation coefficient between the asset and the market and the

J 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 2.

3. 4.

5.

K L M N O P Q Ws are the standard deviations of the asset and the market. We could estimate the W of the market, based on historical data. The approximate W for large company stocks is 27.9%, and 25.76% for small company stocks. Assume W Market = 25% We could calculate the historical V between some traded assets and the market, and make an educated guess about r for non-traded assets, like Strasburg's project. Assume that Strasburg's management estimates the project correlation with the market to be 0.75. So, the returns move up and down with the market, which V = 0.75 is typical. We calculated above the SD for A and B as follows:

WA = 7.41% WB = 14.82% 6. We can now apply the formula to find betas for Plans A and B: A's beta = 0.22

B's beta = 0.44 These betas could be used in the Hamada equation as described below to bring in financial risk and thus to get an idea of total risk with different operating and financial plans. 7. This type analysis is not commonly applied because of the difficulty of obtaining sufficiently accurate data. However, it is useful as a framework for thinking about the issues. Moreover, as market and operating data become increasingly available, the framework will become increasingly operational.

SECTION 16.2
SOLUTIONS TO SELF-TEST 6 A firm has fixed operating costs of $100,000 and variable costs of $4 per unit. If it sells the product for $6 per unit, what is the breakeven quantity? F= V= P= QBE $100,000 $4 $6 50,000

SECTION 16.5
SOLUTIONS TO SELF-TEST

5 Use the Hamada equation to calculate the unlevered beta for JAB Industries, assuming the following data: b L = 1.4; T = 40%; wd = 0.45. bL Tax rate wd Equity ratio bU 1.4 40% 0.45 0.55 0.9390

6 Suppose rRF = 6% and RPM = 5%. What would the cost of equity be for JAB Industries if it has no debt? If w d is 0.45? rRF RPM No debt: From 5, bu = rs,U 6% 5%

0.9390 10.70%

Debt From 5, bL = rs,L

1.00 1.40 13.00%

7 A firms value of operations is equal to $800 million after a recapitalization (the firm had no debt before the recap). It raised $200 million in new debt and used this to buy back stock. The firm had no short-term investments before or after the recap. After the recap, wd = 0.25. The firm had 10 million shares before the recap. What is S (the value of equity after the recap)? What is P (the stock price) after the recap? What is n (the number of remaining shares) after the recap? Vop D wd n0 S= P= n= $800 $200 0.25 10 $600 $80.00 7.5