L09s CF Estimation

Lecture 10 Capital Structure and Leverage
Learning Objectives
Understand the risk-return trade-off associated with the
use of operating leverage and financial leverage.
Distinguish between business risk and financial risk.
Finding the optimal capital structure through
maximising stock price and minimising WACC.
Distinguish between levered beta and unlevered beta
Apply the Hamada Equation
Understand the impact of increasing debt on EPS, cost of equity,
cost of debt, and WACC
Discuss capital structure theories and use them to
explain the capital structure of firms.
MMs irrelevance theory
Trade-off theory: Trades off tax benefit of debt vs. the
bankruptcy costs of debt
Signalling theory
Using debt to constrain managers
1
AB1201: Financial
Management
Lecture 10 Capital Structure and Leverage
By: Angie Low

Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Capital Structure
There are two main sources of capital:

Debt: A firm promises to make fixed payments (interest and
principal) regularly. However, when the firm defaults on
payment, bankruptcy may occur.
Equity: Equity holders receive whatever cash flows that is
left over in the firm after paying the debtholders.
Debt Hybrid financing Common equity

e.g. bank debt, e.g. convertible bonds, e.g. common stock,
bonds preferred stock, lease retained earnings
3
Capital Structure
Capital structure refers to the percentage of debt,
preferred stock, and common equity that is used to
finance a firms assets. Ratio commonly used:
Debt to capital ratio = Debt/(Debt+Equity+Preferred Stock)
TODAY
Is there an optimal capital structure that maximises

shareholders wealth?
What kind of trade-offs are we faced with?
What are the benefits and costs of debt versus equity?
4
Outline of Lecture
Business vs. Financial Risk
Operating Leverage and Financial Leverage
Finding Optimal Capital Structure
Capital Structure Theories
5
Business Risk and Financial Risk

Income Statement
Sales Business Risk
- Total operating costs Operations
EBIT (Operating Income)
- Interest expense
EBT
- Taxes (40%) Financial Risk

Financing
Net income
Earnings per share (EPS)
= Net Income/Shares outstanding
Return on Equity (ROE)
= Net Income/Common Equity
6
What is Business Risk?

The risk inherent in a firms operations.
Uncertainty about future operating income (EBIT).
Measured using standard deviation of EBIT.
Note that business
Probability Low risk risk does not include
financing effects
High risk
0 E(EBIT) EBIT
7
What Determines Business Risk?

EBIT = Sales Operating Cost
= Quantity*Price Operating Cost
Uncertainty about demand (sales)

Uncertainty about output prices
Uncertainty about costs
Product, other types of liability
Operating leverage
8
Effects of Operating Leverage on

Business Risk
Operating leverage is the use of fixed costs
rather than variable costs.
EBIT = Sales Operating Cost
In general, more fixed cost more operating

leverage more business risk
A small sales decline causes a big EBIT decline.
9
Operating Leverage Example
You are going to start a durian cake-

making business. Which of the following
involves higher operating leverage and
thus have higher business risk?
Rent machine for $30/month to shell durians and
make cake
Hire worker to shell durians and make cake for
$0.50 per piece
10
Operating Leverage Example

Best (120 cakes) Normal (60 cakes) Worst (20 cakes)
11
The Trade-off When Using Operating

Leverage
Trade-off: Although operating leverage comes
with higher business risk, it is also accompanied
by higher E(EBIT).
High
High E(EBIT)
OL
High risk
Low E(EBIT)
Low Low risk
OL
12
What is Financial Leverage and

Financial Risk?
Financial leverage is the use of debt and preferred
stock which incurs fixed financial charges.
Financial risk is the additional risk concentrated on
common stockholders as a result of financial
leverage.
More debt, more financial risk
13
14
15
Optimal Capital Structure

The capital structure (mix of debt, preferred, and
common equity) at which stock price is maximised.
Trades off higher expected profitability against higher risk

when we increase debt.
Goal: Find the stock price at each level of debt.

The debt level that maximises stock price is the optimal capital
structure.
16
How do we determine the impact of

changing capital structure on stock
price? EPS D1 DPS
P0
rs g rs rs
If all earnings are paid out as dividends, growth
rate, g = 0.
EPS = DPS.
To find the expected stock price ( P0 ) at each
debt level, we must find the EPS and appropriate
rs at each debt level.
17
Finding the Optimal Capital Structure:

Sequence of events in a recapitalisation
A firm announces the recapitalisation.
New debt is issued.
Proceeds from debt issuance are used to
repurchase stock.
Total capital does not change.
The number of shares repurchased is equal to the amount
of debt issued divided by price per share.
Repurchase Issue debt

shares
Shareholders Firm Debtholders
$$ $$
18
Case Study: Finding the Optimal Capital

Structure for Cheetah Caf Company*
Key facts:
Cheetah Caf company is currently an all-equity
firm with no debt, no preferred stock.
It has total capital of $2 million.
Shares outstanding = 80,000
EBIT = $400,000.
Tax rate = 40%.
Shares can be repurchased at the
current market price of $25.
* This case study is a modification of the integrated case in Essentials

of Financial Management (p. 542), by Brigham, Houston, Hsu, Kong,
and Bany-Ariffin, 2013, Singapore: Cengage Learning.
19
Cost of Debt at Different Debt Ratios

Amount Debt/ Debt/ Bond Rating
Borrowed Capital Equity rd
(000)
$ 0 0 0 -- --
250 0.125 0.143 AA 8.0%
500 0.250 0.333 A 9.0%
750 0.375 0.600 BBB 11.5%
1,000 0.500 1.000 BB 14.0%
1,250 0.625 1.667 B 17.0%
20
Analyse the recapitalisation at

various debt levels and determine
EPS at each level
When D $0, EPS
P0
(EBIT rd D)(1 T) rs
EPS
Shares outstanding
($400,000)(0.6)

80,000
$3.00
21
Determine EPS at Different Levels of

Debt (D = $250,000, D/C = 0.125, and
rd = 8%)
$250,000
Shares repurchase d 10,000
$25
(EBIT rd D)(1 T)
EPS
Shares outstanding
($400,000 0.08($250,000))(0.6)

80,000 10,000
$3.26
22
Determine EPS at Different Levels of Debt

Debt/Capital Shares EPS
rd repurchased
0.000 -- -- $3.00
0.125 8.0% 10,000 $3.26
0.250 9.0%
0.375 11.5%
0.500 14.0%
0.625 17.0%
23
What should be the optimal capital

structure?
Should we set the optimal capital structure at the
debt/capital ratio where the EPS is maximised?
Yes
No
High
debt
High E(EPS)
High risk
Low E(EPS)
Low risk
Low
debt
24
What effect does more debt have on

a firms cost of equity and EPS?
Higher EPS (Generally)
Higher financial
leverage
Higher Higher
financial risk required Higher cost of
faced by return by equity, rs
shareholders shareholders
Hamada Equation
EPS
P0 CAPM: rs= rRF + (rM rRF)b
rs
25
The Hamada Equation

Unlevered beta: Sometimes referred
Determined by to as asset beta
business risk only.
bL = bU[1 + (1 T)(D/E)]
Levered beta: Determined by Beta used in CAPM.

both business risk and Sometimes referred to as
financial risk. equity beta.
26
Calculating Levered Betas and

Costs of Equity
Suppose the risk-free rate is 6% as is the market risk
premium. The current levered beta (when debt = 0)
for Cheetah Caf is 1.0. When debt = 0, the unlevered
beta = levered beta. Therefore,
If D = $250 unlevered beta = 1.0
bL = 1.0[1 + (0.6)($250/$1,750)]
= 1.0857
rs = rRF + (rM rRF)bL

= 6.0% + (6.0%)1.0857
= 12.51%
27
Table for Calculating Levered Betas

and Costs of Equity
Amount Debt/ Debt/ Levered
Borrowed Capital Equity Beta rs
$ 0 0% 0% 1.00 12.00%
250 12.50 14.29 1.09 12.51
500 25.00 33.33
750 37.50 60.00
1,000 50.00 100.00
28
Determining the Stock Price

Amount Debt/ DPS P0=
Borrowed Capital = EPS rs DPS/rs
$ 0 0% $3.00 12.00% $25.00
250 12.50 3.26 12.51 26.03
500 25.00 3.55
750 37.50 3.77
1,000 50.00 3.90
29
Two Methods to Find Optimal Capital

Structure
The firms optimal capital structure can be
determined two ways:
Maximises stock price
Minimises WACC
Both methods yield the same results.
15-30
Capital Structure in Reality

Need to make calculations as we did, but should
also recognise that 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.
31
Lessons Learnt: Steps to finding optimal

capital structure
Estimate the cost of debt at different debt levels
As debt default risk cost of debt
Estimate EPS at different debt levels
EPS = [(EBIT - rdD)(1 - T)] / Shares outstanding
As debt EPS up to a certain extent
Estimate rs = rRF + (rM rRF)bL at different debt levels
As debt financial risk bL rs
Hamada Equation: bL = bU[1 + (1 T)(D/E)]
Estimate P0= EPS/rs at different debt levels
Optimal capital structure is the debt level that maximises
stock price
Optimal capital structure is the debt level that minimises WACC.
32
A Hypothetical Scenario
Imagine a perfect world where
there are no taxes.
firms do not go bankrupt.
investors know as much as managers.
there are no agency costs.
there are no transaction costs.
investors can borrow at the same rate as corporations.
In this perfect world, do you think the stock price will
be affected by the capital structure?
Yes
No
33
Franco Modigliani Merton H. Miller

Copyright The Nobel Foundation 1985 Copyright The Nobel Foundation 1990
Franco Modigliani Biographical. (n.d.). Merton H. Miller Biographical. (n.d.).
Retrieved March 26, 2015, from Retrieved March 26, 2015, from
http://www.nobelprize.org/ http://www.nobelprize.org/
34
Modigliani-Miller Irrelevance Theory

Value of Stock
MM debt
irrelevance result -
1958
0 Debt/Capital
35
Relaxing Assumption 1: Tax benefit of debt

Tax benefits of debt: Interest expense is tax-
deductible Pay less taxes. But distributions to
shareholders, e.g. dividends, do not reduce taxes.
Value of Stock Incorporating tax:
MM result - 1963
MM debt
1958
0 Debt/Capital 36
Relaxing Assumption 2: Bankruptcy costs

Expected bankruptcy costs depends on:
Probability of bankruptcy: How volatile is your future cash
flow?
Actual costs incurred when in bankruptcy: Legal and
accounting fees, liquidation of assets at fire-sales, loss of
customers, suppliers, employees, etc.
Indirect costs due to the threat of bankruptcy: Customers
and suppliers refuse to do business with the firm because
they think that the firm may go bankrupt anytime.
37
Trade-off Theory: Tax benefits versus

bankruptcy costs
Trade-off Theory
Expected
Tax benefits of debt bankruptcy costs of
Firms trade off the debt
tax benefits of debt
against problems Interest expense is
caused by tax deductible but Probability of
dividends to equity bankruptcy
potential are not
bankruptcy.
Costs incurred
during bankruptcy
Indirect costs due

to the threat of
bankruptcy
38
Modigliani-Miller Irrelevance Theory and

Trade-off Theory
Value of Stock
Incorporating tax:
MM result - 1963
Trade-off
theory
MM debt
1958
0 D1 D2 Debt/Capital
Bankruptcy cost becomes Optimal capital structure 39

important
Relaxing Assumption 3: Signalling effects

Under MMs Irrelevance Theory, shareholders and
managers have the same information about a
firms prospects (Symmetric information).
But in reality, managers have more information
than outside shareholders.
Signalling theory suggests firms use less debt than
what trade-off theory suggests
This unused debt capacity helps avoid stock sales, which
depress stock price because of signalling effects.
40
Relaxing Assumption 3: Signalling effects

Suppose you are the manager of FM Corp, and
you need capital to finance your project. You
know that the companys stock is currently
overvalued, what would you do?
Sell debt
Sell equity
Now suppose you know that the companys stock
is currently undervalued, would you sell debt or
equity to raise capital?
Sell debt
Sell equity
As a result, investors view a stock offering
negatively. They think that managers think the stock
is overvalued.
41
Relaxing Assumption 4: Agency costs

Conflicts may arise between managers and
shareholders agency problems.
When they have excess cash, managers tend to
spend the cash on their pet projects or
perquisites.
Debt can constrain managers because the
managers must now make sure they earn enough
to cover the regular interest payments. Failing to
do so, may force the firms to go into bankruptcy
and the managers will lose their jobs as a result.
42
Lessons Learnt: Capital structure theories

Modigliani and Miller (1958) proposed that debt is
irrelevant under a set of restrictive assumptions.
Trade-off theory trades off the tax benefits of debt
against the bankruptcy costs of debt.
Signalling theory posits that firms tend to hold less
debt than what the trade-off theory suggests
because firms want to maintain unused debt
capacity.
The regular interest payments due to debt financing
can be used to constrain financial managers.
43
Where Do We Stand?
Business risk: Uncertainty about EBIT.
Operating leverage increases E(EBIT) and EBIT
Financial risk: Additional risk concentrated on
common stockholders as a result of debt.
Financial leverage increases E(ROE) and ROE
Hamada equation: bL = bU[1 + (1 T)(D/E)]
Optimal capital structure: Trades off higher E(ROE)/
E(EPS) against higher risk
Maximise stock price
Minimise WACC
Capital structure theories begin with MMs debt
irrelevance theory
Trade-off theory: Trades off tax benefits vs. the bankruptcy
costs of debt
44

L09s CF Estimation

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Lecture 10 Capital Structure and Leverage

Lecture 10 Capital Structure and Leverage

By: Angie Low

There are two main sources of capital:

Debt Hybrid financing Common equity

Is there an optimal capital structure that maximises

Business Risk and Financial Risk

EBIT (Operating Income)

- Taxes (40%) Financial Risk

What is Business Risk?

What Determines Business Risk?

Uncertainty about demand (sales)

Effects of Operating Leverage on

In general, more fixed cost more operating

Operating Leverage Example

You are going to start a durian cake-

Operating Leverage Example

The Trade-off When Using Operating

What is Financial Leverage and

Optimal Capital Structure

Trades off higher expected profitability against higher risk

Goal: Find the stock price at each level of debt.

How do we determine the impact of

Finding the Optimal Capital Structure:

Repurchase Issue debt

Case Study: Finding the Optimal Capital

* This case study is a modification of the integrated case in Essentials

Cost of Debt at Different Debt Ratios

250 0.125 0.143 AA 8.0%

500 0.250 0.333 A 9.0%

750 0.375 0.600 BBB 11.5%

1,000 0.500 1.000 BB 14.0%

1,250 0.625 1.667 B 17.0%

Analyse the recapitalisation at

Determine EPS at Different Levels of

Determine EPS at Different Levels of Debt

0.125 8.0% 10,000 $3.26

What should be the optimal capital

What effect does more debt have on

Higher EPS (Generally)

The Hamada Equation

Levered beta: Determined by Beta used in CAPM.

Calculating Levered Betas and

rs = rRF + (rM rRF)bL

Table for Calculating Levered Betas

250 12.50 14.29 1.09 12.51

500 25.00 33.33

750 37.50 60.00

1,000 50.00 100.00

Determining the Stock Price

250 12.50 3.26 12.51 26.03

500 25.00 3.55

750 37.50 3.77

1,000 50.00 3.90

Two Methods to Find Optimal Capital

Capital Structure in Reality

Lessons Learnt: Steps to finding optimal

Franco Modigliani Merton H. Miller

Modigliani-Miller Irrelevance Theory

Relaxing Assumption 1: Tax benefit of debt

Relaxing Assumption 2: Bankruptcy costs

Trade-off Theory: Tax benefits versus

Indirect costs due

Modigliani-Miller Irrelevance Theory and