Principles Applied In This Chapter

Capital Structure policyChapter 15Principles Applied in This Chapter Principle 2: There is a Risk-Return Tradeoff Principle 3: Cash Flows Are the Source of Value Principle 5: Investors Respond to IncentivesLearning Objectives1.Describe a firm's capital structure.2.Explain why firms have different capital structures andhow capital structure influences a firm's weightedaverage cost of capital.3.Describe some fundamental differences in industriesthat drive differences in the way they finance theirinvestments.4.Use the basic tools of financial analysis to analyze afirm's financing decision.1

Capital Structure Choices in Practice The primary objective of capital structure management isto maximize the total value of the firm's outstanding debtand equity. The resulting financing mix that maximizes this combinedvalue is called the optimal capital structure.Defining a Firm's Capital Structure Capital structure owner's equity interest bearingdebtIt is also described using a firm's debt ratio.Defining the Firm's Capital StructureThe Debt to Enterprise Value ratio is also commonlyused to describe a firm's capital structure.Enterprise Value is what you would pay to own 100% of thefirm’s assetsBuy all of the equity and pay off all debtExcess cash offsets part of your cost2

Defining the Firm's Capital StructureThe book value of interest bearing debt includes: Short-term notes payable (e.g., bank loans),Current portion of long-term debt, andLong-term debt.Financial and Capital Structures for Selected Firms,Year-End 2015 BlankDefining the Firm's Capital StructureTable 15-1 shows that debt ratio is always higher than thedebt-to-enterprise value because: Debt ratio is based on book value and book value of equity isalways lower than its market value.Debt to value ratio excludes non-interest bearing debt in thenumerator resulting in a lower value.3

How Do Firms Finance Their Assets?Debt-to-Enterprise-Value Ratios for Selected IndustriesDefining the Firm's Capital StructureTable 15-1 also reports the Times Interest Earned Ratio,which measures the firm's ability to pay the interest on itsdebt out of operating earnings.Financial Leverage By borrowing a portion of firm's capital at a fixed rate ofinterest, firm can “leverage” the rate of return it earns on itstotal capital into an even higher rate of return on the firm'sequity. For example, if the firm is earning 17% on its investments andpaying only 8% on borrowed money, the 9% differential goesto the firm's owners. This is known as favorable financialleverage.If it earns less than 8%, it will be unfavorable financialleverage. 4

M&M Capital Structure TheoremM&M showed that, under ideal conditions, the level of debtin its capital structure does not matter.The theory relies on two basic assumptions:1.2.Firm’s cash flows are not affected by financing.Financial markets are perfect.M&M Capital Structure Theorem This is important because it tells us capital structure isdetermined by capital market imperfections TaxesCost of financial distress/bankruptcyAgency problems Shareholder-BondholderManager-ShareholderCorporate Taxes and Capital StructureSince interest payments are tax deductible (and dividendsare not), the after-tax cash flows will be higher if the firm'scapital structure includes more debt.5

Corporate Taxes and Capital Structure EBIT 20, Tax rate 40%Firm A: Debt 0, Equity 100Firm B: Debt 50 @ 10%, Equity 50Firm A Firm B EBITIntrEBTTaxNIDistr2002081212205156914Bankruptcy and Financial DistressCostsEven though debt provides valuable tax savings, a firmcannot keep on increasing debt.Increasing debt increases the riskiness of equity higherrequired return on equityIncreased risk of bankruptcy/financial distressThe Tradeoff Theory and the OptimalCapital StructureThus two factors can have material impact on the role ofcapital structure in determining firm value and firms musttradeoff the pluses and minuses of both these factors: Interest expense is tax deductible.Debt makes it more likely that firms will experience financialdistress costs.6

Figure 15.5 The Cost of Capital and theTradeoff TheoryCapital Structure Decisions and AgencyCostsDebt financing can help reduce agency costs.For example, debt financing by creating fixed dollar obligationswill reduce the firm's discretionary control over cash and thusreduce wasteful spending.Making Financing Choices When Managers areBetter Informed than ShareholdersWhen firms issue new shares, it is perceived that the firm'sstock is overpriced and accordingly share price generallyfalls.This provides an added incentive for firms to prefer debt.7

Making Financing Choices When Managers areBetter Informed than ShareholdersStewart Myers suggested that because of the information issuesthat arise when firms issue equity, firms tend to adhere to thefollowing pecking order when they raise capital: Internal sources of financing Marketable securities Debt Hybrid securities EquityManagerial Implications1.Higher levels of debt can benefit the firm due to taxsavings and potential to reduce agency costs.2.Higher levels of debt increase the probability of financialdistress costs and offset tax and agency cost benefits ofdebt.Figure 15.6 Capital Structure and Firm Value withTaxes, Agency Costs, and Financial Distress Costs8

Financial Leverage and the Level of EPSFirms that use more debt financing will experience greaterswings in their earnings per share in response to changes infirm revenues and operating earnings.This is referred to as the financial leverage effect.Financial Leverage and the Volatility of EPSThe table below also illustrates the impact of financialleverage on the volatility of earnings per share.CapitalStructureWorst caseEBIT 10,000Best CaseEBIT 40,000 Changein EPS% Changein EPSPlan A2.5010.007.50300%Plan B2.0012.0010.00500%Plan C1.5014.0012.50833%Financial Leverage and the Volatility of EPSWe observe that when EBIT is high, a more levered firmwill realize higher EPS.If EBIT falls, a more levered firm larger drop in earnings pershare (EPS).9

Checkpoint 15.2: Check YourselfHouse of Toast has a new investment project. However, inthe weeks since the project was first analyzed, the firm haslearned that credit tightening in the financial markets hascaused the cost of debt financing for the debt financing planto increase to 10%.What level of EBIT produces zero EPS for the newborrowing rate?Using the EBIT-EPS Chart to Analyze theEffect of Capital Structure on EPSThe EBIT-EPS chart analyzes: Whether the debt plan produces a higher level of EPS for themost likely range of EBIT values. Possible swings in EPS that might occur under the capitalstructure alternatives.Table 15.4 Alternative Financial StructuresBeing Considered by the House of Toast, Inc.10

Table 15.5 Structure and the Level of EPSfor the House of Toast, Inc.Step 1: Picture the ProblemThe current and prospective capital structure alternativescan be described using pro forma balance sheets as given inthe next slide.Step 1: Picture the Problem (cont.)Current CapitalStructureLong-term debt at 8% 50,000Long-term debt at 10%With New DebtFinancing 50,000 50,000Common Stock 150,000 150,000Total Liabilities andEquity 200,000 250,0001,5001,500Common SharesOutstanding11

Step 2: Decide on a Solution StrategyA firm's capital structure will affect both the EPS for agiven level of operating earnings (EBIT) and the volatility ofchanges in EPS corresponding to changes in EBIT.We can use pro forma income statements for a range oflevels of EBIT that the firm believes is relevant to its futureperformance.Step 3: Solve50,000*.08 50,000*.10We calculate the EPS over a range of EBITs.EBIT/EPS AnalysisEBIT 5,000 9,000 9,000 9,000 9,000 9,000 9,000 9,000 (4,000) 0 11,000 16,000 21,000 26,000Less:InterestExpenseEBTTaxrate 50% 20,000 25,000 30,000 35,000Less:Taxes (2,000) 0 5,500 8,000 10,500 13,000NetIncome (2,000) 0 5,500 8,000 10,500 13,000 (1.33) 0 3.67 5.33 7.00 8.67EPSEPS Net income/1500Step 3: Solve (cont.)EBIT-EPS Chart forHouse of Toasts, Inc108EPS ( )6 9,0004200-2510152025303540EBIT( , thousands)12

Step 4: AnalyzeWe examine the EPS within the EBIT range of 5,000 to 35,000.The EPS ranges from a low of - 1.33 to a high of 8.67.At EBIT of 9,000, the EPS is equal to zero.Computing EPS Indifference Points forCapital Structure AlternativesThe point of intersection of the two capital structure linesfound in Figure 15-7 is called the EBIT-EPS indifferencepoint.The point identifies the level at which EPS will be the sameregardless of the financing plan chosen by the firm.Figure 15.7 EBIT-EPS Chart for the House ofToast, Inc.: Under New Financing13

Computing EPS Indifference Points for CapitalStructure Alternatives (cont.) At EBIT amounts in excess of the EBIT indifference level,the financing plan with more leverage will generate ahigher EPS. At EBIT amounts below the EBIT indifference level, thefinancing plan involving less leverage will generate a higherEPS.Computing EPS Indifference Points forCapital Structure Alternatives (cont.) Survey Evidence: FactorsThat Influence CFO Debt PolicyFigure 15.8 reports the survey results of 392 CFOs whowere asked about the potential determinants of capitalstructure choices on a scale of 0 to 4 (0 not important, 4 very important).14

Figure 15.8 CFO Opinions Regarding FactorsThat Influence Corporate Debt UseFigure 15.8 CFO Opinions Regarding FactorsThat Influence Corporate Debt Use15

changes in EPS corresponding to changes in EBIT. We can use pro forma income statements for a range of levels of EBIT that the firm believes is relevant to its future performance. Step 3: Solve We calculate the EPS over a range of EBITs. 50,000*.08 50,000*.10 EPS Net income/1500 EBIT/EPS Analysi