Sesi 10-Capital Structure and Leverage

Chapter 15
CAPITAL STRUCTURE AND

LEVERAGE
Business vs. Financial Risk

Optimal Capital Structure
Operating Leverage
Capital Structure Theory
15
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orin part.
TARGET C APITAL STRUCTURE
• Optimal capital structure

• The capital structure that maximizes a firm’s stock price
• Target capital structure
• The mix of debt, preferred stock, and common equity the firm wants
to have
• Setting the capital structure involves a trade-off between risk and
return, as using more debts:
• raise the risk borne by stockholders
• increases the expected return on equity
15-2
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C APITAL STRUCTURE DECISION
• Factors influence capital structure decisions:

• Business risk
• The greater the firm’s business risk, the lower its optimal debt ratio
• Tax position – tax incentives of using debt
• Financial flexibility
• When a firm is experiencing operating difficulties, it is easier to raise
debt than equity capital
• Managerial conservatism or aggressiveness
• More aggressive managers are more willing to use debt
15-3
WHAT IS BUSINESS RISK?
• The riskiness inherent in the firm’s operations if it uses no debt.
Probability Low risk
High risk
0 E(ROIC) EBIT
• A commonly used measure of business risk is ROIC.

15-4
WHAT DETERMINES BUSINESS
RISK?
• Competition
• Uncertainty about demand (sales)
• Uncertainty about output prices
• Uncertainty about costs
• Product obsolescence
• Foreign risk exposure
• Regulatory risk and legal exposure
• Operating leverage
15-5
WHAT IS OPERATING LEVERAGE, AND HOW DOES
IT AFFECT A FIRM’S BUSINESS RISK?
• Operating leverage is the use of fixed costs rather than

variable costs.
• If most costs are fixed, hence do not decline when
demand falls, then the firm has high operating leverage.
15-6
EFFECT OF OPERATING LEVERAGE
• More operating leverage leads to more business risk, for then a small
sales decline causes a big profit decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales
• What happens if variable costs change?

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15-8
15-9
USING OPERATING LEVERAGE
• Typical situation: Can use operating leverage to get

higher ROIC, but risk also increases.
Probability Low operating leverage
High operating leverage
ROICL ROICH
15-10
15-11
WHAT IS FINANCIAL LEVERAGE?
FINANCIAL RISK?
• Financial leverage is the use of debt and preferred stock.

• Financial risk is the additional risk concentrated on
common stockholders as a result of financial leverage.
15-12
BUSINESS RISK VS. FINANCIAL RISK
• Business risk depends on business factors such as

competition, product obsolescence, and operating
leverage.
• Financial risk depends only on the types of securities
issued.
– More debt, more financial risk.
– Concentrates business risk on stockholders.
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15-14
15-15
15-16
15-17
OPTIMAL C APITAL STRUCTURE
• The capital structure (mix of debt, preferred, and common

equity) at which P0 is maximized.
• Trades off higher E(ROE) and EPS against higher risk. The tax-
related benefits of leverage are exactly offset by the debt’s
risk-related costs.
• The target capital structure is the mix of debt, preferred
stock, and common equity with which the firm intends to
raise capital.
WACC AND C APITAL STRUCTURE CHANGES
• How to set the debt-equity mix that maximizes the firm’s

stock price?
• It is difficult to determine
• Rather easier to predict how a capital structure change will
affect the WACC than the stock price
• Hence, it is more beneficial to use the estimated relationship
between capital structure and the WACC to guide the capital
structure decisions
15-20
WHAT EFFECT DOES MORE DEBT HAVE ON A
FIRM’S COST OF EQUITY?
• If the level of debt increases, the firm’s risk increases.

• We have already observed the increase in the cost of debt.
• However, the risk of the firm’s equity also increases, resulting
in a higher rs.
15-21
THE HAMADA EQUATION
• Because the increased use of debt causes both the costs of

debt and equity to increase, we need to estimate the new cost
of equity.
• The Hamada equation attempts to quantify the increased cost
of equity due to financial leverage.
• Uses the firm’s unlevered beta, which represents the firm’s
business risk as if it had no debt.
15-22
15-
© 2013CengageLearning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole23
orin part.
FINDING OPTIMAL C APITAL STRUCTURE
• The firm’s optimal capital structure can be determined

two ways:
– Minimizes WACC.
– Maximizes stock price.
• Both methods yield the same results.
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EFFECT OF C APITAL STRUCTURE
ON EPS
15-25
ON COST OF C APITAL
15-26
ON STOCK PRICE
15-27
C APITAL STRUCTURE THEORY
• Modigliani-Miller Theory: a firm’s value should be unaffected by its

capital structure
• Under several assumptions, including:
• There are no brokerage costs
• There are no taxes
• There are no bankruptcy costs
• Investors can borrow at the same rate as corporations
• All investors have the same information as management
• EBIT is not affected by the use of debt
15-28
MODIGLIANI-MILLER
IRRELEVANCE THEORY
15-29
MODIGLIANI-MILLER IRRELEVANCE
THEORY
• The graph shows MM’s tax benefit vs. bankruptcy cost

theory.
• Logical, but doesn’t tell whole capital structure story.
Main problem: assumes investors have same information
as managers.
15-30
TRADE-OFF THEORY
• The capital structure theory that states that firms trade off the
tax benefits of debt financing against problems caused by
potential bankruptcy.
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15-32
INCORPORATING SIGNALING EFFECTS
• Signaling theory suggests firms should use less debt than

MM suggest.
• This unused debt capacity helps avoid stock sales, which
depress stock price because of signaling effects.
15-33
WHAT ARE “SIGNALING” EFFECTS IN
C APITAL STRUCTURE?
• Assumptions:
– Managers have better information about a firm’s long-run value than
outside investors.
– Managers act in the best interests of current stockholders.
• What can managers be expected to do?
– Issue stock if they think stock is overvalued.
– Issue debt if they think stock is undervalued.
– As a result, investors view a stock offering negatively; managers think
stock is overvalued.
15-34
CHECKLIST FOR C APITAL
STRUCTURE DECISIONS
• Sales stability • Management attitudes

• Asset structure • Lender and rating agency
• Operating leverage attitudes
• Growth rate • Market conditions
• Profitability • The firm’s internal condition
• Taxes • Financial flexibility
• Control
15-35
CONCLUSIONS ON C APITAL STRUCTURE
• Need to make calculations as we did, but should also

recognize inputs are “guesstimates.”
• As a result of imprecise numbers, capital structure decisions
have a large judgmental content.
• We end up with capital structures varying widely among firms,
even similar ones in same industry.
15-36

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Chapter 15

CAPITAL STRUCTURE AND

Business vs. Financial Risk

• Optimal capital structure

• Factors influence capital structure decisions:

• The riskiness inherent in the firm’s operations if it uses no debt.

Probability Low risk

• A commonly used measure of business risk is ROIC.

• Operating leverage is the use of fixed costs rather than

• What happens if variable costs change?

• Typical situation: Can use operating leverage to get

High operating leverage

• Financial leverage is the use of debt and preferred stock.

• Business risk depends on business factors such as

• The capital structure (mix of debt, preferred, and common

• How to set the debt-equity mix that maximizes the firm’s

• If the level of debt increases, the firm’s risk increases.

• Because the increased use of debt causes both the costs of

• The firm’s optimal capital structure can be determined

• Modigliani-Miller Theory: a firm’s value should be unaffected by its

• The graph shows MM’s tax benefit vs. bankruptcy cost

• Signaling theory suggests firms should use less debt than

• Sales stability • Management attitudes

• Profitability • The firm’s internal condition

• Taxes • Financial flexibility

• Need to make calculations as we did, but should also

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