CHAPTER 13

Capital Structure and

Leverage

Business vs. financial risk

Optimal capital structure
Operating leverage
Capital structure theory
13-1

What is business risk?

Uncertainty about future operating income (EBIT),

i.e., how well can we predict operating income?
Low risk

Probability

High risk
0

E(EBIT)

EBIT

Note that business risk does not include financing

effects.
13-2

What determines business

risk?

Uncertainty about demand (sales).

Uncertainty about output prices.
Uncertainty about costs.
Product, other types of liability.
Operating leverage.

13-3

What is operating leverage, and

how does it affect a firms
business risk?

Operating leverage is the use of

fixed costs rather than variable
costs.
If most costs are fixed, hence do
not decline when demand falls,
then the firm has high operating
leverage.

13-4

Effect of operating
leverage

More operating leverage leads to

more business risk, for then a
small sales decline causes a big
profit
decline.
Rev.
Rev.
$
$

TC

Profit
TC
FC

FC
QBE

Sales

QBE

Sales
13-5

What is financial leverage?

Financial risk?

Financial leverage is the use of

debt and preferred stock.
Financial risk is the additional
risk concentrated on common
stockholders as a result of
financial leverage.

13-6

Business risk vs. Financial

risk

Business risk depends on

business factors such as
competition, product liability, and
operating leverage.
Financial risk depends only on the
types of securities issued.

More debt, more financial risk.

13-7

An example:
Illustrating effects of financial
leverage

Two firms with the same operating

leverage, business risk, and probability
distribution of EBIT.
Only differ with respect to their use of
debt (capital structure).
Firm U
No debt
$20,000
40% tax

Firm L
$10,000 of 12% debt
in assets
$20,000 in assets
rate 40% tax rate
13-8

Firm U: Unleveraged
Prob.
EBIT
Interest
EBT
Taxes (40%)
NI

Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
0
0
$2,000
$3,000
800
1,200
$1,200
$1,800

Good
0.25
$4,000
0
$4,000
1,600
$2,400

13-9

Firm L: Leveraged
Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI

Economy
Bad
Avg.
0.25
0.50
$2,000
$3,000
1,200
1,200
$ 800
$1,800
320
720
$ 480
$1,080

Good
0.25
$4,000
1,200
$2,800
1,120
$1,680

*Same as for Firm U.

13-10

Ratio comparison between

leveraged and unleveraged
firms
FIRM U

Bad Avg Good

ROE
TIE

6.0%

FIRM L

Bad Avg Good

ROE
TIE

4.8%
1.67x

9.0%

12.0%

10.8%
2.50x

16.8%
3.30x

13-11

Optimal Capital Structure

That capital structure (mix of

debt, preferred, and common
equity) at which P0 is maximized.
The target capital structure is the
mix of debt, preferred stock, and
common equity with which the
firm intends to raise capital.
13-12

Optimal Capital Structure

EBIT X (1 T)
V=
WACC
Where,

EBIT = Earnings before interest and taxes

T = Tax rate
WACC = Weighted Average Cost of Capital

13-13

Graphical View of Optimal Capital

Structure
Figure: Cost Functions and Value: Capital costs and the optimal capital structure
V*
Value

value of the firm

Cost of equity

Cost of Debt
Annual Cost (%)

WACC

M* = Optimal Capital Structure

Gearing Level
Source: (Gitman & Hennessey, 2004)

Finding Optimal Capital

Structure

The firms optimal capital

structure can be determined two
ways:

Minimizes WACC.
Maximizes EPS.

13-15

Table for calculating WACC

and determining the
minimum WACC
Amount D/A ratio
borrowed
0.00%
$
0
12.50
250
25.00
500
37.50
750
50.00
1,000

E/A
ratio

ks

kd (1 T) WACC

100.00% 12.00% 0.00%

12.00%

87.50

12.51

4.80

11.55

75.00

13.20

5.40

11.25

62.50

14.16

6.90

11.44

50.00

15.60

8.40

12.00

* Amount borrowed expressed in terms of thousands of

dollars
13-16