Chapter 3

Capital Structure and

Leverage
 Business vs. Financial Risk
 Optimal Capital Structure
 Operating Leverage
 Capital Structure Theory
 Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities
Advantages of Debt

 Interest is tax deductible (lowers the effective

cost of debt)
 Debt-holders are limited to a fixed return – so
stockholders do not have to share profits if
the business does exceptionally well
 Debt holders do not have voting rights
Disadvantages of Debt

 Higher debt ratios lead to greater risk and

higher required interest rates (to compensate
for the additional risk)
What is the optimal debt-equity ratio?

 Need to consider two kinds of risk:

 Business risk
 Financial risk
What is business risk?
 Uncertainty about future operating income
(EBIT), i.e., how well can we predict
operating income?
Probability Low risk

High risk

0 E(EBIT) EBIT

 Note that business risk does not include

financing effects.
What determines business risk?

 Uncertainty about demand (sales)

 Uncertainty about output prices
 Uncertainty about costs
 Product, other types of liability
 Operating leverage
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.
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
securiICRs issued.
 More debt, more financial risk.
 Concentrates business risk on stockholders.
Example of Business Risk
 Suppose 10 people decide to form a
corporation to manufacture disk drives.
 If the firm is capitalized only with common
stock – and if each person buys 10% -- each
investor shares equally in business risk
Example of Relationship Between
Financial and Business Risk

 If the same firm is now capitalized with 50%

debt and 50% equity – with five people
investing in debt and five investing in equity
 The 5 who put up the equity will have to bear
all the business risk, so the common stock will
be twice as risky as it would have been had
the firm been all-equity (unlevered).
Another 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: Unleveraged
Economy
Bad Average Good
Probability 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000

Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
Firm L: Leveraged
Ratio Comparison Between Leveraged and
Unleveraged Firms
Firm U Bad Average Good
BEP
ROA 10.0% 15.0% 20.0%
ROE 6.0 9.0 12.0
TIE
ICR   

Firm L Bad Average Good

BEP
ROA 10.0% 15.0% 20.0%
ROE 4.8 10.8 16.8
TIE
ICR 1.67× 2.50x 3.30x

ROA - Return on Asset ROE - Return on Equity ICR – Interest Cover Ratio
The difference between ROA
and ROE
The big factor that separates ROE and ROA is financial leverage, or debt. The
balance sheet's fundamental equation shows how this is true: assets = liabilities +
shareholders' equity. This equation tells us that if a company carries no debt, its
shareholders' equity and its total assets will be the same. It follows then that their
ROE and ROA would also be the same.

But if that company takes on financial leverage, ROE would rise above ROA. The
balance sheet equation - if expressed differently - can help us see the reason for
this: shareholders' equity = assets - liabilities. By taking on debt, a company
increases its assets thanks to the cash that comes in. But since equity equals
assets minus total debt, a company decreases its equity by increasing debt. In
other words, when debt increases, equity shrinks, and since equity is the ROE's
denominator, ROE, in turn, gets a boost. At the same time, when a company
takes on debt, the total assets - the denominator of ROA - increase. So, debt
amplifies ROE in relation to ROA.
Optimal Capital Structure
 The capital structure (mix of debt, preferred,
and common equity) at which P0 is
maximized.
 Trades off higher E(ROE) and EPS against
higher risk. The tax-related benefits of
leverage are exactly offset by the debt’s risk-
related costs.
 The target capital structure is the mix of
debt, preferred stock, and common equity
with which the firm intends to raise capital.
Cost of Debt at Different Debt Ratios

Amount D/A D/E Bond

Borrowed Ratio Ratio Rating rd
$ 0 0 0 -- --
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%
Why do the bond rating and cost of debt depend
upon the amount of debt borrowed?

 As the firm borrows more money, the firm

increases its financial risk causing the firm’s
bond rating to decrease, and its cost of debt
to increase.
What effect does more debt have on a firm’s
cost of equity?

 If the level of debt increases, the firm’s risk

increases.
 We have already observed the increase in the
cost of debt.
 However, the risk of the firm’s equity also
increases, resulting in a higher rs.
Finding Optimal Capital Structure

 The firm’s optimal capital structure can be

determined two ways:
 Minimizes WACC.
 Maximizes stock price.
 Both methods yield the same results.
 Table for Calculating Levered Betas and Costs of
Equity

Amount D/A E/A

Borrowed Ratio Ratio ke kd(1 – T) WACC
$ 0 0% 100% 12.00% -- 12.00%

250 12.50 87.50 12.51 4.80% 11.55

500 25.00 75.00 13.20 5.40% 11.25

750 37.50 62.50 14.16 6.90% 11.44

1,000 50.00 50.00 15.60 8.40% 12.00

Determining the Stock Price Maximizing Capital
Structure

Amount
Borrowed EPS ke P0
$ 0 $3.00 12.00% $25.00

250 3.26 12.51 26.03

500 3.55 13.20 26.89

750 3.77 14.16 26.59

1,000 3.90 15.60 25.00

What debt ratio maximizes
EPS?
 Maximum EPS = $3.90 at D = $1,000,000,
and D/A = 50
 Risk is too high at D/A = 50%.
What is Campus Deli’s optimal capital structure?

 P0 is maximized ($26.89) at D/A =

$500,000/$2,000,000 = 25%, so optimal D/A
= 25%.
 EPS is maximized at 50%, but primary
interest is stock price, not E(EPS).
 The example shows that we can push up
E(EPS) by using more debt, but the risk
resulting from increased leverage more than
offsets the benefit of higher E(EPS).
What if there were more/less business risk than originally
estimated, how would the analysis be affected?

 If there were higher business risk, then the

probability of financial distress would be
greater at any debt level, and the optimal
capital structure would be one that had less
debt.
 However, lower business risk would lead to
an optimal capital structure with more debt.
What are “signaling” effects in capital
structure?

 Assumptions:
 Managers have better information about a firm’s
long-run value than outside investors.
 Managers act in the best interests of current
stockholders.
 What can managers be expected to do?
 Issue stock if they think stock is overvalued.
 Issue debt if they think stock is undervalued.
 As a result, investors view a stock offering
negatively─managers think stock is overvalued.