Professional Documents
Culture Documents
Capital Structure
Capital Structure
Capital Structure
Capital structure is one of the most complex areas of financial decision making because of the interrelationships among capital structure and various other financial decision variables.
rE, rD, rT rE rT rD
Optimal capital structure. Since the maximization of value is achieved when the overall cost of capital, rT, is at a minimum, the optimal capital structure is therefore that at which the overall cost of capital is minimized. The point labeled M in the figure represents the point of optimal financial leverage and hence capital structure of the firm, since it results in a minimum overall cost of capital. The lower the firms overall or weighted average cost of capital, the higher the expected returns to owners. Given a fixed capital budget, the less the firms money costs, the greater the difference between the return of a project and the cost of money, and the greater the profits from the project. Reinvesting these increased profits will increase the firms expected future earnings and therefore its value.
EXAMPLE: Assume that a firm has fixed operating costs of $2500, the sale price per unit of its product is $10, and its variable operating cost per unit is $5. $2500 At sales of 500 units ( ), or $5000 ($10 * 500 units), the firms EBIT should $10 $5 just equal zero. In the example, the firm will have positive EBIT for sales greater than 500 units and negative EBIT, or a loss, for sales less than 500 units. The following figure presents the operating breakeven chart for this data. It can be seen from the additional notations on the chart that as the firms sales increase from 1000 to 1500 units (X1 to X2), its EBIT increase from $2500 to $5000 (EBIT1 to EBIT2). In other words, a 50% increase in sales (1000 to 1500 units) results in a 100% increase in EBIT.
Using the 1000-unit sales level as a reference point, two cases can be illustrated. Case 1. A 50% increase in sales (from 1000 to 1500 units) results in a 100% increase in EBIT (from $2500 to $5000). Case 2. A 50% decrease in sales (from 1000 to 500 units) results in a 100% decrease in EBIT (from $2500 to $0).
When a firm has fixed operating costs, operating leverage is present. An increase in sales results in a more than proportional increase in EBIT; a decrease in sales results in a more than proportional decrease in EBIT. Fixed costs and operating leverage. Changes in fixed operating costs affect operating leverage significantly. This effect can be best illustrated by continuing with our example. EXAMPLE. Assume that the firm discussed earlier is able to exchange a portion of its variable operating costs for fixed operating costs. This exchange results in a reduction in the variable operating cost per unit from $5 to $4,5 and an increase in the fixed operating costs from $2500 to $3000. In this case we will have:
The higher the firms fixed operating costs relative to variable operating costs, the greater the degree of operating leverage.
Financial leverage is defined as the firms ability to use fixed financial charges to magnify the effects of changes in earnings before interest and taxes on the firms earnings per share (eps). Earnings per share are calculated by dividing the earnings available for common stockholders by the number of shares of common stock outstanding. Taxes, as well as the financial costs of interest and preferred stock dividends, are deducted from the firms income stream. However, these taxes do not represent a fixed cost, since they change with changes in the level of earnings before taxes (EBT). As a variable cost, they have no direct effect on the firms financial leverage. EXAMPLE. A firm expects earnings before interest and taxes of $10000 in the current year. It has a $20000 bond with a 10% coupon and an issue of 600 shares of $4 (dividend per share) preferred stock outstanding; it also has 1000 shares of common stock outstanding. The annual interest on the bond issue is $2000 (0,10 * 20000). The annual dividends on the preferred stock are $2400 ($4/share * 600 shares). The table below presents the levels of earnings per share resulting from levels of earnings before interest and taxes of $6000, $10000, and $14000 assuming the firm is in the 40% tax bracket. Two situations are illustrated in the table.
Case 1. A 40% increase in EBIT (from $10000 to $14000) results in a 100% increase in earnings per share (from $2,4 to $4,8). Case 2. A 40% decrease in EBIT (from $10000 to $6000) results in a 100% decrease in earnings per share (from $2,4 to $0). The effect of financial leverage is such that an increase in the firms EBIT results in a greater than proportional increase in the firms earnings per share, while a decrease in the firms EBIT results in a more than proportional decrease in eps.
revenues. Cost stability is concerned with the relative predictability of input prices such as labor and materials. In general, firms with low operating leverage, stable revenues, and stable costs have low business risk, while firms with high operating leverage, volatile revenues, and volatile costs have high business risk. Firms with stable revenues and costs can accept greater operating leverage (fixed operating costs) than those with volatile patterns of revenues and costs. Business risk is not affected by capital structure decisions. The higher the business risk, the more cautions the firm must be in establishing its capital structure. Firms with high business risk therefore tend towards less highly levered capital structures, and vice versa. EXAMPLE. The JSG Company, in preparing to make a capital structure decision, has obtained estimates of sales and the associated levels of EBIT. The firms forecasting group feels there is a 25% chance sales will total $400000, a 50% chance sales will total $600000, and a 25% chance sales will total $800000. Variable operating costs equal 50% of sales and fixed operating costs total $200000. These data are summarized and the resulting earnings before interest and taxes (EBIT) calculated in Table 6.1. It can be seen that there is a 25% chance EBIT will be zero, a 50% chance it will be $100000, and a 25% chance it will equal $200000. The financial manager must accept as given these levels of EBIT and associated probabilities when developing the firms capital structure. These EBIT data effectively reflect a certain level of business risk that captures the firms sales variability, cost variability, and operating leverage. Table 6.1. Sales and associated EBIT calculation for JSG Company ($000) Probability of sales Sales - Variable operating costs (50% of sales) - Fixed operating costs EBIT 0,25 $400 200 200 $0 0,50 $600 300 200 $100 0,25 $800 400 200 $200
Financial risk. The firms capital structure directly affects its financial risk, which can be described as the risk resulting from the use of financial leverage. Since the level of this risk and the associated level of return (eps) are key inputs to the valuation process, the financial manager must estimate the potential impact of alternative capital structures on these factors and ultimately on value in order to select the best capital structure. EXAMPLE. For simplicity, let us assume that the JSG Company is considering 7 alternative capital structures. If we measure these structures using the debt ratio, they are associated with ratios of 0, 10, 20, 30, 40, 50, and 60 percent. If (1) the firm has no current liabilities, (2) its capital structure currently contains all equity as shown, and (3) the total amount of capital remains constant at $500000, the mix of debt and equity associated with the debt ratios just stated would be as noted in Table 6.2. Also shown in the table is the number of shares of common stock remaining outstanding under each alternative. Current capital structure Long-term debt $0 Common stock equity (25000 shares at $20) $500000 Total capital $500000
Associated with each of the debt levels in column 3 of the Table 6.2 would be an interest rate that is expected to increase with increases in financial leverage, as reflected in the debt ratio. The level of debt, the associated interest rate (assumed to apply to all debt), and the dollar amount of annual interest associated with each of the alternative capital structures is summarized in Table 6.3. Since both the level of debt and the interest rate increase with increasing financial leverage (debt ratios), the annual interest increases as well. Table 6.2 Capital structures associated with alternative debt ratios Capital structure ($000) Total assetsa Debt Equity Debt ratio (%) [(1) * (2)] [(2) - (3)] (1) (2) (3) (4) 0% 10 20 30 40 50 60
a
Shares of common stock outstanding (000) [(4) / $20]b (5) 25,00 22,50 20,00 17,50 15,00 12,50 10,00
because the firm, for convenience, is assumed to have no current liabilities, its total assets equal its total capital of $500000. b the $20 value represents the book value per share of common stock equity noted earlier. Table 6.3 Level of debt, interest rate, and dollar amount of interest associated with JSG Companys alternative capital structures Capital structure debt ratio (%) 0% 10 20 30 40 50 60 Debt ($000) (1) $0 50 100 150 200 250 300 Interest rate on all debt (%) (2) 0,0% 9,0 9,5 10,0 11,0 13,5 16,5 Interest ($000) [(1) *(2)] (3) $0,00 4,50 9,50 15,00 22,00 33,75 49,50
Assuming a 40% tax rate, the calculation of the earnings per share (eps) for debt ratios of 0, 30%, and 60% is illustrated in Table 6.4. Also shown are the resulting expected eps, the standard deviation of eps, and the coefficient of variation of eps associated with each debt ratio.
Debt ratio = 0% Probability EBIT - Interest Earnings before taxes - Taxes (40%) Earnings after taxes eps (25000 shares) expected eps standard deviation of eps coefficient of variation of eps 0,25 $0 0 $0 0 $0 $0 0,71 Debt ratio = 30% Probability EBIT - Interest Earnings before taxes - Taxes (40%) Earnings after taxes eps (25000 shares) expected eps standard deviation of eps coefficient of variation of eps 0,25 $0 15 -$15 -6 -$9 - $51 0,83 Debt ratio = 60% Probability EBIT - Interest Earnings before taxes - Taxes (40%) Earnings after taxes eps (25000 shares) expected eps standard deviation of eps coefficient of variation of eps 0,25 $0 49,50 -$49,50 -19,80 -$29,70 -$2,97 1,40 0,50 $100 49,50 $50,50 20,20 $30,30 $3,03 $3,03 $4,24 0,25 $200 49,50 $150,50 60,20 $90,30 $9,03 0,50 $100 15 $85 34 $ 51 $2,91 $2,91 $2,42 0,25 $200 15 $185 74 $111 $6,34 0,50 $100 0 $100 40 $ 60 $2,40 $2,40 $1,70 0,25 $200 0 $200 80 $120 $4,80
The resulting statistics from the calculations in Table 6.4, along with the same statistics for the other debt ratios (10, 20, 40, and 50 percent calculations not shown), are summarized for the 7 alternative capital structures in Table 6.5. Because the coefficient of variation measures the risk relative to the expected eps, it is the preferred risk measure for use in comparing capital structures. It should be clear that as the firms financial leverage increases, so does its coefficient of variation of eps. As expected, an increasing level of risk is associated with increased levels of financial leverage.
Table 6.5 Expected eps, standard deviation, and coefficient of variation for alternative capital structures Capital structure debt ratio (%) 0% 10 20 30 40 50 60 Expected eps ($) (1) $2,40 2,55 2,72 2,91 3,12 3,18 3,03 Standard deviation of eps ($) (2) $1,70 1,88 2,13 2,42 2,83 3,39 4,24 Coefficient of variation of eps [(2) / (1)] (3) 0,71 0,74 0,78 0,83 0.91 1,07 1,40
The relative risk of two of the capital structures evaluated in Table 6.4 (debt ratio = 0% and 60%) can be illustrated by showing the probability distribution of eps associated with each of them. The figure below shows these two distributions. It can be seen that while the expected level of eps increases with increasing financial leverage, so does risk, as reflected in the relative dispersion of each of the distributions. Clearly, the uncertainty of the expected eps as well as the chance of experiencing negative eps is greater when higher degrees of leverage are employed.
The nature of the risk-return trade-off associated with the 7 capital structures under consideration can clearly be observed by plotting the eps and coefficient of variation relative to the debt ratio.
An analysis of the figure shows that as debt is substituted for equity (as the debt ratio increases), the level of earnings per share rises and then begins to fall (graph a). Based on the graph, it can be seen that the peak earnings per share occur at a debt ratio of 50%. The decline in earnings per share beyond that ratio results from the fact that the significant increases in interest are not fully compensated for by the reduction in the number of shares of common stock outstanding. If we look at the risk behavior as measured by the coefficient of variation, we can see that risk increases with increasing leverage (graph b). As noted, a portion of the risk can be attributed to business risk, while that portion changing in response to increasing financial leverage would be attributed to financial risk.
Table 6.6 Required returns for JSG Companys alternative capital structures Capital structure (%) 0% 10 20 30 40 50 60 Coefficient of variation of eps (1) 0,71 0,74 0,78 0,83 0,91 1,07 1,40 Estimated required return, rE (2) 11,5% 11,7 12,1 12,5 14,0 16,5 19,0
Calculation of share value estimates associated with alternative capital Expected eps ($) (1) $2,40 2,55 2,72 2,91 3,12 3,18 3,03 Estimated required rate of return, rE (2) 0,115 0,117 0,121 0,125 0,140 0,165 0,190 Estimated share value ($) [(1) /(2)] (3) $20,87 21,79 22,48 23,28 22,29 19,27 15,95
Plotting the resulting share values against the associated debt ratios, the figure clearly illustrates that the maximum share value occurs at the capital structure associated with a debt ratio of 30%; at that debt ratio, the share value is expected to equal $23,28. While the firms profits (eps) are maximized at a debt ratio of 50%, share price is maximized at a 30% debt ratio. In this case, the preferred capital structure would be the 30% debt ratio. The goal of the financial manager has been specified as maximizing owners wealth, not profit.
The procedures used to calculate the expected value, standard deviation, and coefficient of variation: Expected value of return: r = ri Pri
i =1 n
Where: ri = the return for the ith outcome Pri = the probability of occurrence of ith return n = the number of outcomes considered Standard deviation:
k =
(r
n i =1
r Pri
Coefficient of variation: CV = k r