Chapter 13. Capital Structure and Leverage

Chapter 13 -- Capital Structure and Leverage



. Capital structure
. Business risk vs. financial risk
. Break-even analysis
. Determining the optimal capital structure
. Capital structure theories


Firms can use equity and debt as sources of finance. Capital structure theory is concerned with the decision relating to their proportion.



. Capital structure


Capital: investor-supplied funds, such as long- and short-term loans, preferred
stock, common stock, and retained earnings



Capital structure: the mix of debt, preferred stock, and common equity that is used
by a firm to finance its assets



The optimal capital structure: the capital structure that maximizes the company’s
stock price (or minimizes the company’s overall cost of capital, WACC)



Capital structure changes over time





. Business risk vs. financial risk


 Business risk: the riskiness inherent in the firm’s operations if it uses no debt

It is measured by the variability of expected ROE (ROA)



Business risk depends on:

Competition

Demand variability

Sales price variability

Input cost variability

Ability to develop new products

Operating leverage

Foreign risk

 Regulations



 Operating leverage: the extent to which the fixed costs are used, the higher the

fixed costs, the higher the operating leverage, the higher the business risk



 Financial risk: the additional risk placed on stockholders as a result of the firm’s
decision to use debt



 Financial leverage: the extend to which fixed income securities are used

. Break-even analysis


 Variable costs: vary with the output

 Fixed costs: not vary with the output



 Notation: V: variable cost per unit

 Q: the number of units sold

 P: price

 F: fixed costs

 F

 Break-even level of sales: QBE = ---------

 P - V





. Determining the optimal capital structure


WACC and capital structure change



WACC = wd(rd)(1-T) + wc(rs), assuming no preferred stock

 = (D/A)*(rd)*(1-T) + (E/A)*(rs)



where D/A is the debt-to-asset ratio (also called debt ratio) and E/A is the equity-
to-asset ratio (also called equity ratio) and D/A + E/A = 1



You are going to choose D/A or E/A to minimize WACC



Cost of debt increases with debt; cost of equity increases with debt; beta increases
with debt (since higher debt increases the risk of bankruptcy)

We observe , T, D/E ratio, therefore we can figure out . We then vary D/E to figure out at different capital structure. We apply CAPM to find the required rates of return and stock prices at different capital structure to find the optimal capital structure that maximizes the stock price (or minimizes the WACC) 

Note: EPS maximization is not the goal of a firm and usually the maximum EPS doesn’t occur at the same capital structure where the stock price is maximized or the WACC is minimized. 

. Capital structure theories 

 Assumptions: perfect capital markets with no taxes, homogeneous information, 

EBIT is not affected by using debt, and investors can borrow at the same rate as 

corporations 

 Irrelevance theory (Modigliani and Miller 1958): capital structure doesn’t matter; the capital structure 

does not affect stock price or the overall cost of capital 

The effect of taxes (MM 1963): if corporate taxes are considered, stock price and overall cost of capital will be affected by the capital structure. The higher the debt, the lower the overall cost of capital, the higher the stock price. 

 The trade-off model: corporate taxes are considered and firms may fail.

Costs of financial distress include bankruptcy-related costs 

Benefits from tax shields 

The greater the use of debt, the larger the fixed interest charges, the greater the probability that a firm will go bankruptcy. At the same time, the greater the use of debt, the larger the tax shields. 

 VL = VU + PV(tax shields) - PV(financial distress and agency costs) 

 Implication of trade-off model: 

Higher-risk firms should borrow less 

Firms with tangible assets can borrow more 

Firms in higher tax bracket can borrow more 

 Signaling theory: asymmetric information means that investors and management 

have different information. Any change in capital structure reveals insider 

information. For example, a firm issues new stock to raise money is viewed as a 

negative signal which causes stock price to drop.



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