FIN340 Flashcards
chapter 15
Differentiating between operating leverage and financial leverage
The Operating Leverage measures the effect of fixed operating costs, whereas Financial Leverage measures the effect of interest expenses. Operating Leverage influences Sales and EBIT but Financial Leverage affects EBIT and EPS. Operating Leverage arises due to the company’s cost structure.
operating leverage
The extent to which fixed costs are used in a firm’s operations. If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high degree of operating leverage. Operating leverage is a measure of one element of business risk but does not include the second major element, sales variability.
financial leverage
Ratio of total assets to common equity. Shows the factor by which ROA is scaled up to determine ROE. Is the magnifying effect that debt has on ROE and shareholder risk.
interpreting variations in capital structure including optimal and target structure
Factors that the firm can control
Capital structure:
Other things held constant, an increase in the
target debt ratio tends to lower WACC because
the after-tax cost of debt is lower than the cost
of equity.
However, other things are not likely to remain
constant.
An increase in the use of debt will increase the
riskiness of both the debt and the equity, which
likely will offset the changes in the weights and
increase WACC
Dividend payout ratio
Capital budgeting decisions
The impact of capital structure on value depends upon the effect of debt on: WACC FCF
What is operating leverage, and how does it affect a firm’s business risk? Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs relative to variable costs, the greater the operating leverage.
calculating the effects of changing capital structure, levered and unlevered beta, cost of equity, and effects of the MM proposition.
Measures the after-tax return that the
company provides for ALL its investors (debt
+ equity).
Does not vary with changes in capital
structure
ROIC = EBIT*(1-T)/investor supplied capital
Investor-supplied capital = Long-term Debt + Total
Equity
Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
MM assume: (1) no transactions costs; (2) no
restrictions or costs to short sales; and (3)
individuals can borrow at the same rate as
corporations.
MM prove that if the total CF to investors of
Firm U and Firm L are equal, then arbitrage is
possible unless the total values of Firm U and
Firm L are equal:
VL = VU
.
Because FCF and values of firms L and U are
equal, their WACCs are equal.
Therefore, capital structure is irrelevant.
MM show that the total CF to Firm L’s investors is equal to the total CF to Firm U’s investor plus additional amount due to interest deductibility: CFL = CFU + rdDT. What is value of these cash flows? Value of CFU = VU MM show that the value of rdDT = TD Therefore, VL = VU + TD
Miller’s Theory: Corporate
and Personal Taxes
Personal taxes lessen the advantage of corporate debt: Corporate taxes favor debt financing since corporations can deduct interest expenses. Personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate.
Tc = corporate tax rate.
Td = personal tax rate on debt
income.
Ts = personal tax rate on stock income.
VL = VU + [1 − (1-Tc)(1-Ts)/(1-Td)]*D
Trade-off theory ( MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.)
Signaling theory ( MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. Implications for managers?)
Pecking order ( Firms use internally generated funds first, because there are no flotation costs or negative signals. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals. If more funds are needed, firms then issue equity.)
Debt financing as a managerial constraint ( One agency problem is that managers can use corporate funds for non-value maximizing purposes. The use of financial leverage: Bonds “free cash flow.” Forces discipline on managers to avoid perks and non-value adding acquisitions. A second agency problem is the potential for “underinvestment”. Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs. )
Firms with many investment opportunities should maintain reserve borrowing capacity, especially if they have problems with asymmetric information (which would cause equity issues to be costly).
Market Timing Theory
( Managers try to “time the market” when
issuing securities.
They issue equity when the market is
“high” and after big stock price run ups.
They issue debt when the stock market
is “low” and when interest rates are
“low.”
The issue short-term debt when the
term structure is upward sloping and
long-term debt when it is relatively flat)
Windows of opportunity (A window of opportunity is a short, often fleeting time period during which a rare and desired action can be taken. Once the window closes, the opportunity may never come again. In a competitive market with many participants seeking to maximize tangible or intangible value for their constituents—whether owners, other shareholders, employees, or perhaps their community—the window will shut fast as soon as a good deal is recognized.)
PPT:
What is business risk? The riskiness inherent in the firm’s operations if it uses no debt. Risk to a firm’s common stockholders. Single most important determinant of capital structure. A commonly used measure of business risk is variance of ROIC.
What determines business
risk?
Competition – less competition lowers business risk.
Demand variability for firm’s products/services -
more stability lowers business risk.
Sales price variability – volatility causes more
business risk exposure.
Input cost variability – uncertainty of input costs
results in higher business risk.
Product obsolescence – more business risk for
industries with products who have an accelerated
product life cycle and become obsolete faster.
Foreign risk exposure – currency exchange rate
fluctuations and country risk, such as political
and economic risk increases business risk.
Regulatory risk and legal exposure – industries
that are highly regulated and subject to higher
legal issues, tend to have higher business risk.
Operating leverage – the extent to which fixed
costs are used in a firm’s operations.
Operating Breakeven
Q is quantity sold, F is fixed cost, V
is variable cost, TC is total cost,
and P is price per unit.
Operating breakeven = QBE = F / (P – V)
Occurs when EBIT = 0 EBIT = P(Q) – V(Q) – F = 0 where P = average sales price per unit of output Q = units of output V = variable cost per unit F = fixed operating costs
Typical situation: Can use operating
leverage to get higher ROIC, but risk also
increases.
Business Risk versus Financial Risk
Business risk: Uncertainty in future EBIT, NOPAT, and ROIC. Depends on business factors such as competition, operating leverage, etc.
Financial risk: Additional business risk concentrated on common stockholders when financial leverage is used. Depends on the amount of debt and preferred stock financing. More debt, more financial risk
Optimal Capital 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
Finding Optimal Capital
Structure
The firm’s optimal capital structure can be determined two ways: Minimize WACC. Maximize stock price. Both methods yield the same results. • More difficult to determine effects on stock price from changes in capital structure. • Most companies focus on minimizing cost of capital
Determining WACC
Depends on several variables
Capital structure (% of each type of capital used)
Cost of each type of capital (use after tax cost of
debt)
Cost of Debt
YTM on existing bonds or market rate for new
bond issues
Cost of Equity
CAPM (capital asset pricing model) = rs = rRF + RPm(b)
rs is costs of stock
Hamada equation used to find b
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
The Cost of Equity at Different Levels of Debt: Hamada’s Formula: MM theory implies that beta changes with leverage. bU is the beta of a firm when it has no debt (the unlevered beta) b = bU * [1 + (1 - T)(wd/ws)]
The Repurchase: No Effect
on Stock Price
The announcement of an intended
repurchase might send a signal that affects
stock price, and the previous change in
capital structure affects stock price, but the
repurchase itself has no impact on stock
price.
If investors thought that the repurchase would
increase the stock price, they would all purchase
stock the day before, which would drive up its
price.
If investors thought that the repurchase would
decrease the stock price, they would all sell short
the stock the day before, which would drive down
the stock price
Remaining Number of
Shares After Repurchase
DOld is amount of debt the firm initially has, DNew is amount after issuing new debt. nPrior is number of shares before repurchase, nPost is number after. Total shares remaining:
nPost = nPrior – (DNew – DOld)/P
Calculating S, the Value of
Equity after the Recap
S = (1 – wd) Vop nPost = nPrior(VopNew−DNew)/(VopNew−DOld)
Equity as an Option on the
Firm’s Value
For highly levered firms there is a relatively high probability
of default.
Equity holders make the decision on whether or not to
make a required interest or principal payment on the debt.
If they do make the payment, they own the total value of
the firm minus the amount due to debtholders.
If they default because the total value of the firm is less
than the amount owed to debtholders, then they own
nothing.
The equity owners’ position looks like an option to buy the
firm with an exercise price equal to the value of the debt.
How do companies manage
the maturity structure of
their debt?
Maturity matching
Finance long-term assets with long-term debt
Finance short-term assets with short-term debt.
Information asymmetries: Firms with better future
prospects than expected by investors
Issuing long-term debt will lock in a higher interest rate
than warranted by company’s prospect.
So issue short-term debt (even though its rate is too
high) but refinance at appropriate rate when company’s
prospects are revealed.
