Corporate Finance Capital Structure, Leverage, and Dividend Policy, Lecture notes of Corporate Finance

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CHAPTER 13

Capital Structure and Leverage

Business vs. financial risk

Optimal capital structure

Operating leverage

Capital structure theory



Uncertainty about future operating income (EBIT),

i.e., how well can we predict operating income?



Note that business risk does not include financing

effects.

What is business risk?

Probability 0 E(EBIT) EBIT Low risk High risk

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.

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.

Problem # 1 (Breakeven

Analysis)

 A company’s fixed operating costs are $500,000, its variable costs are $3.00 per unit, and the product’s sales price is $4.00. What is the company’s breakeven point; that is, at what unit sales volume would its income equal its costs?  Given: SP = $4/unit; Var. Cost = $3/unit & Fixed =$500, Q BE = Fixed Costs / (Selling Price – Variable Cost) Q BE = $500,000 / ($4.00 - $3.00) Q BE = 500,000 units.

Problem #2 (Financial

Leverage Effects)

 Firms HL and LL are identical except for their leverage ratios and the interest rates they pay on debt. Each has $20 million in assets, $4 million of EBIT, and is in the 40 % federal-plus-state tax bracket. Firm HL, however, has a debt ratio (D/A) of 50 % and pays 12 % interest on its debt, whereas LL has a 30 % debt ratio and pays only 10 % interest on its debt.  Calculate the rate of return on equity (ROE) for each firm.  (^) Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt ratio from 30 to 60 %, even though that would increase LL’s interest rate on all debt to 15 %. Calculate the new ROE for LL.

The effect of leverage on profitability and debt coverage  For leverage to raise expected ROE, must have BEP > r d .  (^) Why? If r d

BEP, then the interest expense will be higher than the operating income produced by debt-financed assets, so leverage will depress income.  As debt increases, TIE decreases because EBIT is unaffected by debt, and interest

expense increases (Int Exp = r d D).

Conclusions



Basic earning power (BEP) is unaffected

by financial leverage.



L has higher expected ROE because BEP

> r

d



L has much wider ROE (and EPS) swings

because of fixed interest charges. Its

higher expected return is accompanied

by higher risk.

Problem #3 (Optimal Capital

Structure)

 Jackson Trucking Company is in the process of setting its tar- get capital structure. The CFO believes the optimal debt ratio is somewhere between 20 and 50 %, and her staff has compiled the following projections for EPS and the stock price at various debt levels:  Assuming that the firm uses only debt and common equity, what is Jackson’s optimal capital structure? At what debt ratio is the company’s WACC minimized?

Problem #3 (Optimal Capital

Structure)



The optimal capital structure is that capital

structure where WACC is minimized and stock

price is maximized. Because Jackson’s stock

price is maximized at a 30% debt ratio, the firm’s

optimal capital structure is 30% debt and 70%

equity. This is also the debt level where the

firm’s WACC is minimized.

The Hamada Equation

b

L

= b

U

[ 1 + (1 – T) (D/E)]

Suppose, the risk-free rate is 6%,

as is the market risk premium.

The unlevered beta of the firm is

1.0. We were previously told that

total assets were $2,000,000.

Calculating levered betas and costs of equity If D = $250, b L = 1.0 [ 1 + (0.6)($250/$1,750) ] b L = 1. r s = r RF

• (r M

• r RF ) b L r s = 6.0% + (6.0%) 1. r s = 12.51%

What is dividend policy?

The decision to pay out earnings

versus retaining and reinvesting

them.

Dividend policy includes



High or low dividend payout?



Stable or irregular dividends?



How frequent to pay dividends?



Announce the policy?

Dividend irrelevance theory



Investors are indifferent between dividends

and retention-generated capital gains.



Investors can create their own dividend

policy



If they want cash, they can sell stock.



If they don’t want cash, they can use

dividends to buy stock.



Proposed by Modigliani and Miller and

based on unrealistic assumptions (no taxes

or brokerage costs), hence may not be true.

Need an empirical test.