Chapter 13 Capital Structure

Foundations of Finance
Tenth Edition, Global Edition
Chapter 12
Determining the Financing Mix
Copyright © 2020 Pearson Education Ltd. All Rights Reserved

Learning Objectives
12.1 Distinguish between business and financial risk.
12.2 Use break-even analysis.
12.3 Understand the relationship between operating,
financial, and combined leverage.
12.4 Discuss the concept of an optimal capital structure.
12.5 Use the basic tools of capital structure management.

Figure 12.1 The Cost of Capital as a
Link Between a Firm’s Asset
Structure and Capital Structure

Understanding the Difference
Between Business and Financial
Risk

Risk
• Risk is variability associated with expected revenue or
income streams. Such variability may arise due to three
sources:
– Choice of business line (business risk)
– Choice of an operating cost structure (operating risk)
– Choice of a capital structure (financial risk)

Business Risk
• Business risk is the variation in the firm’s expected
earnings attributable to the industry in which the firm
operates. There are four determinants of business risk:
– The stability of the domestic economy
– The exposure to, and stability of, foreign economies
– Sensitivity to the business cycle
– Competitive pressures in the firm’s industry

Operating Risk
• Operating risk is the variation in the firm’s operating
earnings that results from firm’s cost structure (mix of fixed
and variable operating costs).
• Earnings of firms with higher proportion of fixed operating
costs are more vulnerable to change in revenues.

Financial Risk
• Financial risk is the variation in earnings as a result of
firm’s financing mix or proportion of financing that requires
a fixed return.

Break-Even Analysis

Break-Even Analysis
• Break-even analysis is used to determine the break-even quantity
of a firm’s output by examining the relationships among the firm’s
cost structure, volume of output, and profit.
• Break-even quantity may be calculated in units or sales dollars.
• Break-even point indicates the point of sales or units at which
earnings before interest and taxes (EBIT) is equal to zero.
• Use of break-even model enables the financial manager to
– Determine the quantity of output that must be sold to cover all
operating costs, as distinct from financial costs
– Calculate the EBIT that will be achieved at various output
levels

Essential Elements of the Break-Even Model
• Break-even analysis requires information on the following:
– Fixed costs
– Variable costs
– Total revenue
– Total volume
• Break-even analysis requires classification of costs into two
categories:
– Fixed costs
– Variable costs
• Because all costs are variable in the long run, break-even analysis is
a short-run concept.

Fixed Costs
• These costs do not vary in total amount as sales volume or the
quantity of output changes.
– As production volume increases, fixed costs per unit of product
falls, as fixed costs are spread over a larger and larger quantity
of output (but total remains the same).
– Fixed costs vary per unit but remain fixed in total.
– The total fixed costs are generally fixed for a specific range of
output.
Fixed Costs Examples

1. Administrative salaries
2. Depreciation
3. Insurance
4. Lump sums spent on intermittent advertising programs
5. Property taxes
6. Rent

Variable Costs
• Variable costs vary as output changes. Thus if production is
increased by 10 percent, total variable costs will also increase by 10
percent.
Variable Costs Examples

1. Direct labor
2. Direct materials
3. Energy costs (fuel, electricity, natural gas) associated with the
production
4. Freight costs
5. Packaging
6. Sales commissions

Figure 12.2 The Behavior of Total,
Fixed, and Variable Costs over a
Relevant Range of Output

Revenue
• Total revenue is the total sales dollars.
• Total revenue = P × Q
P = selling price per unit
Q = quantity sold
Volume
• The volume of output refers to the firm’s level of operations and may
be indicated either as a unit quantity or as sales dollars.
Break-Even Point (BEP)

• BEP = Point at which EBIT equals zero (sales price per unit) × (units
sold) − [(variable cost per unit) ×(units sold) + (total fixed cost)] =
EBIT = $0

Example
1. Fixed costs = $100,000
2. Sales price per unit = $10
3. Variable cost per unit = $6
• BEP (units) =
$100, 000
 $10  $6 
$100, 000
=
 $4 
= 25, 000 units
• If the firm sells 25,000 units, EBIT will be equal to zero dollars.

Table 12.1 Income Statement for Pierce
Grain Company
Sales $300,000
Less: Total variable costs 180,000
Revenue before fixed costs $120,000
Less: Total fixed costs 100,000
EBIT $ 20,000

Example in Dollars
total fixed costs
Break - even level of revenues =
 variable costs 
1  revenues 
 
$100, 000
Break-even level of revenues = = $250, 000
 $180, 000 
1  $300, 000 
 

Sources of Operating Leverage

Operating Leverage (1 of 2)
• Operating leverage measures the sensitivity of the firm’s EBIT to
fluctuation in sales when a firm has fixed operating costs.
• If the firm has no fixed operating costs, EBIT will change in proportion
to the change in sales.
% change in EBIT
• Operating Leverage (OL) =
% change in sales
• Thus % change in EBIT = OL × % change in sales
Where:
EBITt
% change in EBIT = EBITt1 
EBITt
% change in sales Sales t

= Sales t1 
Sales t
Operating Leverage (1 of 2)
Example:
If a company has an operating leverage (OL) of 6, then what is the
change in EBIT if sales increase by 5 percent?
% change in EBIT = OL × % change in sales

= 6 × 5% = 30%
• Thus, if the firm increases sales by 5 percent, EBIT will increase by 30
percent
• Operating leverage is present when

% change in EBIT
is > 1.00
% change in sales
• The greater the firm’s degree of operating leverage, the more the
profits will vary in response to change in sales.

Financial Leverage
• Financial leverage means financing a portion of the firm’s assets with
securities bearing a fixed (limited) rate of return in hopes of increasing
the return to the common stockholders.
• Thus the decision to use preferred stock or debt exposes the
common stockholders to financial risk.
• Variability of EBIT is magnified by the firm’s use of financial leverage.

Table 12.4 Possible Capital Structures for
Pierce Grain Company
a 2,000 common shares outstanding. b 1,500 common shares outstanding. c 1,200 common shares outstanding.

Three Capital Structure Plans
• Plan A: 0% debt—no financial risk
• Plan B: 25% debt—moderate financial risk
• Plan C: 40% debt—higher financial risk
• See Table 12.5 for impact of financial leverage on earnings per
share (EPS). The use of financial leverage magnifies the
impact of changes in EBIT on earnings per share.

Table 12.5 An Analysis of Financial Leverage at
Different EBIT Levels: Pierce Grain Company
a The negative tax bill recognizes the credit arising from the carryback and carryforward provision of the tax code.
Capital Structure Plans
• A firm employing financial leverage is exposing its owners to financial
risk when percentage change in EPS divided by percentage change
in EBIT is greater than 1.00.
Combined Leverage
• Operating leverage causes changes in sales revenues to cause even
greater changes in EBIT. Furthermore, changes in EBIT due to
financial leverage create large variations in both EPS and total
earnings available to common shareholders.
• Not surprisingly, combining operating and financial leverage causes
rather large variations in EPS.
Percentage Change in EPS
• Combined Leverage =
Percentage Change in Sales
• Or Combined Leverage = Operating Leverage × Financial Leverage

Capital Structure Theory

Financial and Capital Structure
• Financial Structure
– Mix of all items that appear on the right-hand side of
the company’s balance sheet (see Table 12.7).
• Capital Structure
– Mix of the long-term sources of funds used by the firm
– Capital Structure = Financial Structure − Non-interest-
bearing liabilities (accounts payable, accrued
expenses)

Table 12.7 Distinguishing Between a Firm’s
Financial Structure and Its Capital Structure

Designing a Capital Structure
• Designing a prudent capital structure requires answers
to the following:
• Debt maturity composition: How should a firm best
divide its total fund sources between short-term and
long-term debt components?
• Debt-equity composition: What mix of debt and equity
should the firm use?

Capital Structure Management
• A firm should mix the permanent sources of funds in a
manner that will maximize the company’s stock price, or
minimize the cost of capital.
• A proper mix of fund sources is called the “optimal
capital structure.”

A Quick Look at Capital Structure
Theory
• Theory focuses on the effect of financial leverage on the
overall cost of capital to the enterprise.
• In other words, can the firm affect its overall cost of
funds, either favorably or unfavorably, by varying the
mixture of financing used?
• Firms strive to minimize the cost of using financial capital
so as to maximize shareholder’s wealth.

Independence Position
• According to Modigliani and Miller, the total value of the
firm is not influenced by the firm’s capital structure. In
other words, the financing decision is irrelevant!
• Their conclusions were based on restrictive assumptions
(such as no taxes, capital structure consisting of only
stocks and bonds, perfect or efficient markets).

Financing Mix (1 of 2)
• Figure 12.5 shows that the firm’s value remains the same, despite
the differences in financing mix.
• Figure 12.6 shows that the firm’s cost of capital remains constant,
although cost of equity rises with increased leverage.

Financing Mix (2 of 2)
• The implication of these figures for financial managers is that
one capital structure is just as good as any other.
• However, the above conclusion is possible only under strict
assumptions.
• We next turn to a market and legal environment that relaxes
these restrictive assumptions.

Extensions to Independence Hypothesis:
The Moderate Position
• The moderate position considers how the capital structure
decision is affected when we consider the following:
– Interest expense is tax deductible (a benefit of debt)
– Debt financing increases the risk of default (a disadvantage
of debt)
• Combining the above (benefit and drawback) provides a
conceptual basis for designing a prudent capital structure.

Impact of Taxes on Capital Structure
(1 of 2)
• Interest expense is tax deductible.
• Because interest is deductible, the use of debt financing
should result in higher total market value for firms
outstanding securities.
Tax shield benefit  rd (m)(t )
• r = rate, m = principal, t = marginal tax rate

Table 12.8 Skip’s Camper Cash Flows to All
Investors—The Case of Taxes
Unleveraged Leveraged
Blank
Capital Structure Capital Structure
Expected level of net operating
income $2,000,000 $2,000,000
Interest expense 0 480,000
Earnings before taxes (EBT) $2,000,000 $1,520,000
Taxes (21%) 420,000 319,200
Earnings available to common
stockholders $1,580,000 $1,200,800
Interest paid to creditors 0 480,000
Expected payments to all
security holders $1,580,000 $1,680,800

Impact of Taxes on Capital Structure (2 of 2)
• Because interest on debt is tax deductible, the higher the
interest expense, the lower the taxes.
• Thus, one could suggest that firms should maximize debt
… indeed, firms should go for 100 percent debt to
maximize tax shield benefits!!
• But we generally do not see 100 percent debt in the real
world … why not?
• One possible explanation
– Bankruptcy costs

Firm Value and Agency Costs
• To ensure that agent-managers act in shareholders best
interest, firms must
1. Have proper incentives
2. Monitor decisions
– Bonding the managers
– Auditing financial statements
– Structuring the organization in unique ways that limit
useful managerial decisions
– Reviewing the costs and benefits of management
perquisites
• The costs of the incentives and monitoring must be borne by
the stockholders.

Impact of Agency Costs on Capital Structure
(1 of 2)
• Capital structure management also gives rise to agency costs.
Bondholders are principals because essentially they have given a loan
to the corporation, which is owned by shareholders.
• Agency problems stem from conflicts of interest between stockholders
and bondholders. For example, pursuing risky projects may benefit
stockholders but may not be appreciated by bondholders.
• Bondholders’ greatest fear is default by corporation or misuse of funds
leading to financial distress.
• Agency costs may be minimized by agreeing to include several
protective covenants in the bond contract.
• Bond covenants impose costs (such as periodic disclosure) and
impose constraints (on type of project that management can
undertake, collateral, distribution of dividends, limits on further
borrowing).
Impact of Agency Costs on Capital Structure
(2 of 2)
• Agency costs depend on the level of debt. At lower levels of debt,
creditors may not insist on a long list of bond covenants to monitor.
Thus, agency cost and cost of financing are reduced at lower levels of
debt.
• Figure 12.8 indicates the trade-offs. For example, increasing the
protective covenants will reduce the interest cost but increase the
monitoring cost (which is eventually borne by the shareholders).

Managerial Implications
• Determining the firm’s financing mix is critically important for the
manager.
• We observe that the decision to maximize the market value of
leveraged firm is influenced primarily by the present value of tax
shield benefits, present value of bankruptcy costs, and present
value of agency costs.

The Basic Tools of Capital Structure
Management

Basic Tools
• Two basic tools are used to evaluate capital structure
decisions:
– EBIT-EPS analysis
– Financial leverage ratios

EBIT-EPS Analysis
• Managers care about EPS because it sends an important
signal to the market about future prospects and will affect
the stock prices
• The EBIT-EPS chart provides a way to visualize the
effects of alternative capital structure on both the level and
volatility of the firm’s earning per share (EPS).

Figure 12.9 EBIT-EPS Analysis Chart for
Pierce Grain Company

EBIT-EPS Chart
• The chart shows that at a specific level of EBIT, stock and
bond plan produce different EPS (except at the
intersection point with EBIT = $21,000 where EPS is
equal to $6.72 under both plans).
• Above the intersection point, EPS will be higher for plan
with greater leverage (and vice versa).
• For example, at EBIT of $30,000
– EPS using bond plan = $11.46
– EPS using stock plan = $10.27

Finding the Intersection or EBIT-
EPS Indifference Point (1 of 2)
• Compare EPS-stock plan versus EPS-bond plan
and solve for EBIT in the following two equations:
EPS : STOCK PLAN EPS : BOND PLAN
 EBIT  I s 1  Tc   P =
 EBIT  I b 1  Tc   P
Ss Sb
SS = # of common shares
I = interest expense
P = preferred dividends
T = tax rate

Finding the Intersection or EBIT-
EPS Indifference Point (2 of 2)
• EPS-EBIT chart is simply a tool to analyze capital
structure decision.
• Thus, achieving a high EPS based on high leverage may
not be the right decision.
• The final decision will be made after weighing all factors.

Table 12.9 Analyzing Pierce Grain
Company’s Financing Choices

Comparative Leverage Ratios
• Two types of ratios (as covered in Chapter 4), balance
sheet leverage ratios and coverage ratios, can be
computed and compared to industry norms.
• If the ratios are significantly different from industry
average, the managers must analyze further.

Financial Analysis
• To assess a firm’s financial leverage, analysts will
generally use the net debt ratio.
• Companies who are able to pay some or all of their debt
with excess cash have less risk exposure.

Chapter 13 Capital Structure

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Foundations of Finance

Tenth Edition, Global Edition

Copyright © 2020 Pearson Education Ltd. All Rights Reserved

Copyright © 2020 Pearson Education Ltd. All Rights Reserved

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Fixed Costs Examples

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Variable Costs Examples

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Break-Even Point (BEP)

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% change in sales Sales t

% change in EBIT = OL × % change in sales

• Operating leverage is present when

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• Or Combined Leverage = Operating Leverage × Financial Leverage

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