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CAPITAL STRUCTURE Lecture 2

EBIT/EPS Analysis The tax benefit of debt Trade-off theory Practical considerations in the determination of capital structure

Capital structure
Issues:
   

EBIT-EPS analysis The tax shield benefit of debt The trade-off theory of capital structure Practical considerations that affect the capital structure decision

Kevin Campbell, University of Stirling, October 2006

Business Risk vs Financial Risk




Business risk is the variability of a firms Earnings Before Interest and Taxes (EBIT) Financial risk arises from the use of debt, which imposes a fixed cost in the form of interest payments = financial leverage.

Kevin Campbell, University of Stirling, October 2006

EBIT/EPS analysis


Examines how different capital structures affect earnings available to shareholders (EPS) and risk Question: for different levels of EBIT, how does financial leverage affect EPS?

Kevin Campbell, University of Stirling, October 2006

Risk and the Income Statement


Business Risk Sales Variable costs Fixed costs EBIT Interest expense Earnings before taxes Taxes Net Income Net Income / no. of shares
Kevin Campbell, University of Stirling, October 2006

Financial Risk

EPS =

Current and Proposed Capital Structures


CURRENT Total assets Debt Equity Share price No. of shares Interest rate $100 million 0 million 100 million $25 4,000,000 10% PROPOSED $100 million 50 million 50 million $25 2,000,000 10%

Note: for the purpose of simplicity we ignore taxes in this example


Kevin Campbell, University of Stirling, October 2006

CURRENT CAPITAL STRUCTURE


No Debt, 4 Million Shares (millions omitted)
EBIT 50% 50% BELOW EXPECTED EBIT 50% 50% ABOVE EXPECTED

EXPECTED

EBIT Int NI EPS

$6.00 0.00 $6.00 $ 1.50

$12.00 0.00 $12.00 $ 3.00

$18.00 0.00 $18.00 $ 4.50


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Kevin Campbell, University of Stirling, October 2006

PROPOSED CAPITAL STRUCTURE


50% Debt (10% Coupon), 2 million Shares
(millions omitted)
EBIT 50% 50% BELOW EXPECTED EBIT 50% 50% ABOVE EXPECTED

EXPECTED

EBIT Int NI EPS

$6.00 5.00 $1.00 $ 0.50

$12.00 5.00 $ 7.00 $ 3.50

$18.00 5.00 $13.00 $ 6.50


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Kevin Campbell, University of Stirling, October 2006

EBIT/EPS analysis
Current versus Proposed
8 6 4 2 0 -2 -4 3 6 9 10 12 15 18
For EBIT up to 10m, equity financing is best

EPS

Proposed (with debt)

Current (no debt)


For EBIT greater than 10m, debt financing is best

EBIT
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Kevin Campbell, University of Stirling, October 2006

The impact of financial leverage




If EBIT is > 10, the levered capital structure is preferable, ie EPS is higher If EBIT is < 10, the unlevered capital structure is preferable Conclusion: whether or not debt is beneficial is dependent upon the capacity of firms to generate EBIT
Kevin Campbell, University of Stirling, October 2006

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Indifference Level


The break-even EBIT occurs where the lines cross At that level of EBIT both capital structures have the same EPS

Kevin Campbell, University of Stirling, October 2006

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Breakeven Point


Set the two EPS values equal to each other and solve for EBIT: Current (unlevered) (EBIT-Int)(1-T) S Since we assume T=0 (EBIT-Int) S = (EBIT-Int) S
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Proposed (levered) = (EBIT-Int)(1-T) S

Kevin Campbell, University of Stirling, October 2006

Break-even EBIT (millions


EPSU ! EPS L EBIT 4 2 EBIT 2 EBIT EBIT EBIT  ($50 v .1) ! 2 ! 4 EBIT  4($5) ! $20 ! $10

omitted)

Kevin Campbell, University of Stirling, October 2006

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The impact of financial leverage


EBIT 50% 50% BELOW EXPECTED EBIT 50% 50% ABOVE EXPECTED

EXPECTED

EPSU EPSL SpreadU SpreadL

1.5 0.5 3.0

3.0 3.5

4.5 6.5

6.0 thats RISK


Kevin Campbell, University of Stirling, October 2006

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The impact of financial leverage




Leverage increases EPS if EBIT is high enough. At very low levels of EBIT, EPS can be negative as interest on debt has priority over payments to shareholders. Financial leverage produces a broader spread of EPS values, ie shareholders returns are less predictable. This represents added RISK.
Kevin Campbell, University of Stirling, October 2006

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Summary: EBIT/EPS analysis




Indicates EBIT values when one capital structure may be preferred over another Analysis of expected EBIT can focus on the likelihood of actual EBIT exceeding the indifference point

Kevin Campbell, University of Stirling, October 2006

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The tax benefit of debt




Because interest on debt is deducted from EBIT before the amount of tax paid is calculated, there is a benefit to debt in the form of lower corporate taxes Consider an example

Kevin Campbell, University of Stirling, October 2006

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The tax benefit of debt


Firm Unlevered
No debt $20,000 Equity 40% tax rate

Firm Levered
$10,000 of 12% Debt $10,000 in Equity 40% tax rate

U has $20K in Equity & L has $10K in Equity Both firms have same business risk and EBIT of $3,000. They differ only with respect to use of debt.
Kevin Campbell, University of Stirling, October 2006

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The tax benefit of debt


Firm U
EBIT Interest EBT Taxes (40%) NI ROE $3,000 0 $3,000 1 ,200 $1,800 9.0%

Firm L
$3,000 1,200 $1,800 720 $1,080 10.8%

U; 1.8/20K = 9%

L; 1.08 / 10K = 10.8%


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Kevin Campbell, University of Stirling, October 2006

Why does financial leverage increase the overall return to investors?




Investors include both:





Debtholders (banks & bondholders) Shareholders U: NI = $1,800. L: NI + Interest = $1,080 + $1,200 = $2,280.

Total return to investors:


 

Taxes paid:
 

U: $1,200 L: $720

Difference = $480
Kevin Campbell, University of Stirling, October 2006

More EBIT goes to investors in Firm L


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Why does financial leverage increase the overall return to investors?


 Because the Government subsidizes debt, and the tax savings go to the investors.  The tax savings are called the tax shield and grows proportionally with the increase of debt.

Kevin Campbell, University of Stirling, October 2006

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A Basic Capital Structure Theory




Debt versus Equity




Basic point. A firms cost of debt is always less than its cost of equity. Why?
  

debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible.

It may appear a firm should use as much debt and as little equity as possible due to the cost difference but this ignores the potential problems associated with debt.
Kevin Campbell, University of Stirling, October 2006

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A Basic Capital Structure Theory




There is a trade-off between the benefits of using debt and the costs of using debt.


The use of debt creates a tax shield benefit from the interest on debt. The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.
Kevin Campbell, University of Stirling, October 2006

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A Basic Capital Structure Theory




The costs of financial distress associated with debt




Bankruptcy costs including legal and accounting fees and a likely decline in the value of the firms assets Financial distress may also cause customers, suppliers, and management to take actions harmful to firm value.
Kevin Campbell, University of Stirling, October 2006

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A Basic Capital Structure Theory




Agency costs arise from conflicts between shareholders and bondholders




When you lend money to a business, you are allowing the shareholders to use that money in the course of running that business. Shareholders interests are different from your interests, because You (as lender) are interested in getting your money back Shareholders are interested in maximizing their wealth
Kevin Campbell, University of Stirling, October 2006

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A Basic Capital Structure Theory




Agency costs associated with debt:




Restrictive covenants meant to protect creditors can reduce firm efficiency. Monitoring costs may be expended to insure the firm abides by the restrictive covenants. As the level of debt financing increases, the contractual and monitoring costs are expected to increase.
Kevin Campbell, University of Stirling, October 2006

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Capital structure: practical considerations




In addition to the variables described by the trade-off theory of capital structure, a variety of practical considerations also affect a firms capital structure decisions:
Industry standards Creditor and rating agency requirements Maintaining excess borrowing capacity Profitability and the need for funds Managerial risk aversion Corporate control
Kevin Campbell, University of Stirling, October 2006

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Practical considerations
Industry standards


It is natural to compare a firms capital structure to other firms in the same industry. Business risk is a significant factor impacting a firms capital structure and is heavily influenced by a firms industry. Evidence indicate firms capital structures tend toward an industry average.
Kevin Campbell, University of Stirling, October 2006

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Practical considerations
Creditor and Rating Agency Requirements


Firms need to abide by restrictive covenants, which may include restrictions on the amount of future debt. Firms typically desire to appear financially strong to potential creditors in order to maintain borrowing capacity and low interest rates. Using less debt in capital structure helps to maintain this appearance.
Kevin Campbell, University of Stirling, October 2006

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Practical considerations
Maintaining Excess Borrowing Capacity


Successful firms typically maintain excess borrowing capacity. This provides financial flexibility to react to investment opportunities. The maintenance of excess borrowing capacity causes firms to use less debt in their capital structure than otherwise.
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Kevin Campbell, University of Stirling, October 2006

Practical considerations
Profitability and the Need for Funds


Profits can be paid out as dividends to shareholders or reinvested in the firm. If a firm generates high profits and reinvests a large proportion back into the firm, then it has a continuous source of internal funding. This will reduce the use of debt in the firms capital structure.
Kevin Campbell, University of Stirling, October 2006

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Practical considerations
Managerial Risk Aversion


Well-diversified shareholders are likely to welcome the use of financial leverage. Management wealth is typically much more dependent upon the success of the company acting as their employer. To the extent management can act on their own desires, the firm is likely to have less debt in its capital structure than is desired by shareholders.
Kevin Campbell, University of Stirling, October 2006

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Practical considerations
Corporate Control


Controlling owners may desire to issue debt instead of ordinary shares since debt does not grant ownership rights. Firms with little financial leverage are often considered excellent takeover targets. Issuing more debt may help to avoid a corporate takeover.

Kevin Campbell, University of Stirling, October 2006

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Summary


EBIT/EPS analysis may be used to help determine whether it would be better to finance a project with debt or equity. Firms must trade-off the tax advantage to debt financing against the effect of debt on firm risk. Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure.

Kevin Campbell, University of Stirling, October 2006

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KONIEC DZI KUJ ZA UWAG

Kevin Campbell, University of Stirling, October 2006

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Homework
EBIT/EPS Analysis


A company is considering the following two capital structures:


 

Plan A: sell 1,200,000 shares at 10 per share (12 million total) Plan B: issue 3.5 million in debt (9% coupon) and sell 850,000 shares at 10 per share (12 million total)

Assume a corporate tax rate of 50% REQUIRED: (a) What is the break-even value of EBIT? (b) At this break-even value, what is the income statement for each capital structure plan and the EPS? (c) Draw a diagram to illustrate the trade-off between EBIT and EPS
Kevin Campbell, University of Stirling, October 2006

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