FINA 427- Corporate Finance Capital structure, Leverage and Divisional Cost of Capital

DCL Formula

% change in EPS/% change in Sales = DOL * DFL

What constitutes a debt liability?

The debt component in a company's capitalization is imply a balance sheet's long-term debt; or where the debt component of a company's capitalization should consist of short-term borrowings (Notes payable), the current portion of long-term debt, long-term debt, and two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock.

Financial Leverage

The degree to which a company uses fixed-income securities such as debt and preferred equity The more debt financing a company uses, the higher its financial leverage A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line EPS

Corporate Finance

The division of finance that deals with financing, capital structuring, and investment decisions Primarily concerned with maximizing shareholder value through long and short-term financial planning and the implementation of various strategies

Net Operating Income

The income remaining after fixed-cost payments are made by a company, irrespective of sales. If DOL of a company is high, this means a relatively small increase in sales can have a large effect on net operating income Calculating DOL can help in decision-making, which may prevent large losses to a company based on smaller changes in sales

Comparing Both Theories

The main difference between them is the potential benefit from debt in a capital, which comes from the tax benefit of the interest payments. Since the MM capital structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes, and thus the tax benefit of interest payments, are recognized. The MM I theory without corporate taxes says that a firm's relative proportions of debt and equity don't matter; MM I with corporate taxes says that the firm with the greater proportion of debt is more valuable because of the interest tax shield MM II deals with the WACC. It says that as the proportion of debt in the company's capital structure increases, its return on equity to shareholders increases in a linear fashion. The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company's stock. However, because the company's capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction and thus concludes that changes in the debt-equity ratio do affect WACC. Therefore, a greater proportion of debt lowers the company's WACC

Capital Structure

The particular combination of debt and equity used by a company to finance its overall operations and growth A company's ratio of short-term debt and long-term debt should be considered when examining its capital structure Referred to as a firm's debt-to-equity ratio Matters because of the different tax implications of debt vs. equity and the impact of corporate taxes on a firm's profitability

Cost of Capital

The required return necessary to make a capital budgeting project; typically means the weighted average of a firm's cost of debt and cost of equity blended together Used by companies internally to judge whether a capital project is worth the expenditure of resources Used by investors to determine whether an investment is worth the risk compared to the return

Financial Risk

The risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure As a company increases debt and preferred equities, interest payments increase, reducing EPS which, as a result, increases risk to stockholder return

Funded Debt

The technical term applied to the Triton of a company's long-term debt that is made up of bonds and other similar long-term, fixed-maturity types of borrowings; No matter how problematic a company's financial condition may be, the holders of these obligations cannot demand immediate and full repayment as long as the company pays the interest on its funded debt

Probability of negative EBIT

z = Loss level EBIT - Expected EBIT/Standard deviation of EBIT Loss level of EBIT is the amount of EBIT needed to cover interest charges and preferred dividends

Raising Capital

Cane be done with either debt or equity; most companies use a mixture of both debt and equity Debt usually costs less than equity due to tax advantages, especially when rates are low. Debt, however, obligates the company to pay out a portion of future earnings, even when earnings are declining Equity does not need to be paid back Equity, however, comes with an exchange of ownership

Capital Structure types of Debt

Comes in the forms of bond issues or loans

Debt ratio

Compares total liabilities to total assets More of this ratio means less equity and, therefore, indicates a more leverage position. An issue with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities (the same is said as to the debt/equity ratio)

Debt/Equity Ratio

Compares total liabilities to total stockholders' equity. Current and non-current operational liabilities, particularly the latter, represent the obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principle or interest attacked to operational liabilities.

Three ratios to assess the financial strength of a company's capitalization structure

Debt Ratio, Debt/equity ratios, and Capitalization ratio

Company's Tax Exposure

Debt payment's are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes

Company's Capitalization

Describes a company's composition of permanent or long-term capital, which consists of a combination of debt and equity. A healthy capital structure that reflects a low level of debt and a corresponding high level of equity is a very positive sign of financial fitness.

With Newco's current production, its sales are $7 million annually. The company's variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annual interest expense is $100,000. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?

EBIT = $7,000,000 - $2,800,000 - $2,400,000 ($1,800,000) EBIT - Interest = $7,000,000 - $2,800,000 - $2,400,000 - $100,000 ($1,700,000) DFL = $1,800,000/$1,700,000 = 1.059 EPS Increase = 1.059 * .2 = .2118 The company's EPS will increase by 21.2% given the company's 20% increase in EBIT

Financial Flexibility

Essentially the firm's ability to raise capital in bad times. Companies should make an effort to be prudent when raising capital in good times and avoid stretching their capabilities too far The lower a company's debt level, the more financial flexibility a company has

Business Risk

Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.

Growth Rate

Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to grow faster. With this method, the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate More stable and mature firms typically need less debt to finance growth as their revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise

WACC & Optimal Capital Structure

Minimizing the Weighted Average Cost of Capital (WACC) maximizes the firm's value. This means that the optimal structure for a firm is the one that minimizes WACC

Modigliani and Miller's Assumptions

No Taxes No Transaction Costs No Bankruptcy Costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same information No effect of debt on a company's earnings before interest and taxes

Debt Financing

Occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors; Generally offers the lowest cost of capital due to its tax deductibility; Rarely the optimal structure since a company's risk generally increases as debt increases

Impacts on the Optimal Capital Structure

Personal tax effects- If capital gains and income taxes differ, this may alter the required return on a security by investors Industry effects- How stable is the Industry? More stability= larger debt capacity How profitable is the Industry? Higher profits = More debt capacity Signaling Effects- asymmetric information New equity gives a negative signal to a higher cost of equity and repurchases of equity have a positive signal leading to lower equity costs Managerial preferences- Pecking order and financial slack

Agency Costs: Stockholder-Bondholder relationship

Projects with high risk and high returns can shift wealth from bondholders to stockholder Stockholders may forgo profitable investments in the presence of debt Stockholders may issue high quantities of new debt, diminishing protection afforded to earlier bondholders Bondholders will shift monitoring and bonding costs back to stockholders by charging higher interest rates

Management Style

Ranges from aggressive to conservative The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's EPS

Long-term debt

Should be considered when examining a company's capital structure; Debt that matures in more than one year

Optimal Capital Structure

The best debt-to-equity ratio for a firm that maximizes its value; One that offers a balance between the ideal debt-to-equity range and minimizes the firm's cost of capital This leads to the lowest WACC and should be the target structure

How can a company change its capital structure?

By issuing debt back to buy back outstanding equities or by issuing new stock and using the proceeds to repay debt

Operating Leverage

A cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections Operating Leverage = Contribution Margin / Profit This involves using a large proportion of fixed costs to variable costs in the operations of the company The higher the degree of operating leverage, the more valatile and unpredicatble the EBIT figure is

Degree of Combined Leverage (DCL)

A leverage ratio that summarizes the combined effects that the degree of operating leverage (DOL) and the degree of financial leverage have on Earnings Per Share (EPS), given a particular change in sales Can be used to help determine the most optimal level of financial and operating leverage to use in any firm This ratio summarizes the effects of combining financial and operating leverage, and what effect this combination, or variations of this combination, has on the corporation's earnings A firm with a relatively high level of combined leverage is seen as riskier than a firm with less combined leverage, as the high leverage means more fixed costs to the firm

Degree of Operating Leverage (DOL)

A leverage ratio that summarizes the effect a particular amount of operating leverage has on a company's earnings before interest and taxes (EBIT) over a period of time DOL = % Change in EBIT / % Change in Sales

Balance Sheet

An important consideration for investing in a company's stock for stock investors that favor companies with good fundamentals The strength of a company' balance sheet can be evaluated by three broad categories of investment-quality measurements: 1. Working capital adequacy, 2. Asset performance, and 3. Capital Structure A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength

Modigliani and Miller's Tradeoff Theory of Leverage (MM II)

Assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. Recognizes the tax benefit from interest payments - that is, because interest paid on debt is tax deductible, issuing bonds effectively reduces a company's tax liability Paying dividends on equity, however, doe snot The actual rate of interest companies pay on bonds they issue is less than the nominal rate of interest because of the tax savings

Modigliani and Miller's Capital-Structure Irrelevance Proposition (MM I)

Assumes there are no taxes and no bankruptcy costs WACC should remain constant with changes in the company's capital structure Since there are no changes or benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price

Factors that influences a company's capital-structure decision

Business Risk Company's Tax Exposure Financial Flexibility Management Style Growth Rate Market Conditions

What is the Optimal Capital Structure

First, Optimal capital structure varies by industry because some industries are more asset intensive than others. The greater the investment in fixed assets (Plant, Property, and Equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Typically, industries that require a great deal of plan investment generally use more long-term debt. Second, capital structure tends to track with the company's growth cycle. Rapidly growing startups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments in favor of future price returns. These companies are considered growth stocks. High-growth companies do not need to give these shareholders cash today; however lenders would expect semi-annual or quarterly interest payments In summary, the optimal capital structure is the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this optimal capital structure

Assume Company X has $500,000 in sales in year one and $600,000 in sales in year two. For year one, the company's operating expenses were $150,000, while in year two, the operating expenses were $175,000. Calculate the DOL

First, calculate what EBIT was: Year one: $500,000-$150,000=$350,000 Year two: $600,000 -$175,000=$425,000 Next, calculate the percentage change in EBIT and sales: EBIT=$425,000/$300,000-1=.2143 or 21.43% Sales=$600,000/$500,000-1= .2 or 20% Finally, calculate the DOL: DOL=.2143/.2=1.0715 or 107.15%

Assume SpaceRocket had an EBIT of $50 million for the current fiscal year and an EBIT of $40 million for the previous fiscal year, or a 25% increase year over year (YOY). SpaceRocket reported sales of $80 million for the current fiscal year and sales of $65 million for the previous year, a 23.08% increase. Additionally, SpaceRocket reported an EPS of $2.50 for the current fiscal year and an EPS of $2.00 for the previous year, a 25% increase. Find the Degree of Combined Leverage

First: Find the Degree of Operating Leverage % Change in EBIT/% Change in Sales .25/.2308= 1.08 Second: Find the Degree of Financial Leverage Percentage Change in EPS or EBIT percentage Change in EBIT/EBIT - Interest Because there is no Interest, DFL is 1 Finally: Find the Degree of Combined Leverage DOL *DFL = 1.08 * 1 = 1.08 We can say that for every 1% change in sales, there will be a 1.08% increase in EPS

Optimal Capital Structure

For each company there is an optimal capital structure, including a percentage of debt and equity, and a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender

Financial slack

Having less than your max amount of debt provides slack in case an emergency or opportunity arises where you need to or want to issue debt

Modigliani and Miller's Capital Structure Theories

Hypothesized that in perfect markets, it odes not matter what capital structure a company uses to finance its operation Says the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends

Market Conditions

If the market is struggling, meaning that investors are limiting companies access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In this situation, it may be better for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plan.

Debt to Equity Ratio

Impacts the firm's borrowing costs and its value to shareholders A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity Indicates what proportion of equity and debt the company is using to finance its assets High debt to equity generally means that a company has been aggressive in financing its growth with debt Depends on the industry in which the company operates Increased by issuing new debt Lowered by issuing new equity

Equity part of debt-equity relationship

In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's capitalization

Debt Capacity

Influenced by the business cycle which is influence by three things: 1. Business Risk 2. Tax Structure 3. Financial Distress and Agency Costs

Pecking Order

Internal equity, debt, then external equity - basically in order required return

Market Value of Leverage Firm

Market value of unleveraged firm + PV of tax shield - PV of bankruptcy/financial distress costs - PV of agency costs

Capital Structure types of Equity

May come in the form of common stock, preferred stock, or retained earnings

Bankruptcy Cost

These costs can significantly affect a company's cost of capital. When a company invests in debt, the company is required to service that debt by making required interest payment. Interest payments alter a company's earnings as well as cash flow. MM II might make it sound as if it is always a good thing when a company increases its proportion of debt relative to equity, but that's not the case. Additional debt is good only up to a certain point because of bankruptcy costs The risk of bankruptcy increases with the increased debt load. Since the cost of debt becomes higher, the WACC is thus affected. With the additional debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increase debt load will then cause the WACC to increase significantly.

Formula for calculating a company's Degree of Financial Leverage (DFL)

This formula measures the percentage change in EPS over the percentage change in EBIT DFL = Percentage change in EPS or EBIT percentage change in EBIT / EBIT - Interest If the interest is 0, then the DLF will be equal to 1

Formula of DOL

This formula takes into account two variables. They are: The percent (%) change in EBIT from time period one to time period two The percent (%) change in sales from time period one to time period two EBIT can be calculated by taking the sales revenue and subtracting the operating expenses

Capitalization Ratio

Total debt/Total capitalization; Compares the debt component of a company's capital structure (the sum of obligations categorizes as debt plus the total shareholders' equity) to the equity component. Typically expresses as a percentage A low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt.

High Debt to Equity Ratio

When a lot of debt is used to finance increased operations, the company could potentially generate more earnings than it would have without the outside financing. If the financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders However, the cost of debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle.