Capital Structure and Leverage

Chapter 12 Capital Structure and Leverage

LEARNING OBJECTIVES ANSWERS TO END-OF-CHAPTER QUESTIONS

12-1 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations.

12-2 Current liabilities. Retail firms place more emphasis on current liabilities because they have greater inventories and receivables.

Long-term debt. Public utilities place greater emphasis on long-term debt because they have more stable sales and profits as well as more fixed assets.

Retained earnings. Retail firms also use retained earnings to a greater extent, probably because they are generally smaller and, hence have less access to capital markets. Public utilities have lower retained earnings because they have high dividend payout ratios and a set of stockholders who want dividends. This is discussed further in Chapter 14.

12-3 EBIT depends on sales and operating costs that generally are not affected by the firm’s use of financial leverage, since interest is deducted from EBIT. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financing difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive leverage causes investors, customers, and employees to be concerned about the firm’s future.

12-4 The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value and stock price. However, bankruptcy- related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. See Figure 12-8 in the textbook.

12-5 Expected EPS is generally measured as EPS for the coming years, and we typically do not reflect in this calculation any bankruptcy-related costs. Also, EPS does not reflect (in a major way) the increase in risk

and ks that accompanies an increase in the debt ratio, whereas P0 does reflect these factors. Thus, the stock price will be maximized at a debt level that is lower than the EPS-maximizing debt level.

12-6 With increased competition after the breakup of AT&T, the new AT&T and the seven Bell operating companies’ business risk increased. With this component of total company risk increasing, the new companies probably

Integrated Case: 13 - 2 decided to reduce their financial risk, and use less debt, to compensate. With increased competition the chance of bankruptcy increases and lowering debt usage makes this less of a possibility. If we consider the tax issue alone, interest on debt is tax deductible; thus, the higher the firm’s tax rate the more beneficial the deductibility of interest is. However, competition and business risk have tended to outweigh the tax aspect as we can see from the actual debt ratios of the Bell companies. The Bell companies and AT&T have been lowering their debt ratios, for reasons along these lines.

12-7 The firm may want to assess the asset investment and financing decisions jointly. For instance, the highly automated process would require fancy, new equipment (capital intensive) so fixed costs would be high. A less automated production process, on the other hand, would be labor intensive, with high variable costs. If sales fell, the process that demands more fixed costs might be detrimental to the firm if it has much debt financing. The less automated process, however, would allow the firm to lay off workers and reduce variable costs if sales dropped; thus, debt financing would be more attractive. Operating leverage and financial leverage are interrelated. The highly automated process would increase the firm’s operating leverage; thus, its optimal capital structure would call for less debt. On the other hand, the less automated process would call for less operating leverage; thus, the firm’s optimal capital structure would call for more debt.

12-8 Several possibilities exist for the firm, but trying to match the length of the project with the maturity of the financing plan seems to be the best approach. The firm may want to finance the R&D with short- term debt and then, if the project’s results are successful, to raise the needed capital for production through long-term debt or equity. Another possibility would be to issue convertible bonds, which can be converted to common stock--a lower interest rate would be paid now, and in the future (presumably the stock price will increase with the new process) investors would trade in the bonds for stock. One should also keep in mind that this project, and R&D in general, is extremely risky and debt financing may not be available except at extremely high rates. For this reason, many R&D companies have low debt ratios, instead paying low dividends and using retained earnings for financing projects.

12-9 Operating leverage is the presence of fixed costs in the operation of a firm. Profits fluctuate when sales increase or decrease, because only the variable costs change with volume changes. The profits of a firm with a high percentage of fixed costs are magnified when sales increase, since costs increase only by the low percentage of variable costs.

12-10 The selling price per unit, the variable cost per unit, and total fixed costs are necessary to construct a breakeven analysis. The procedure can also be accomplished by using total sales dollars, total fixed costs, and total cost per unit.

Integrated Case: 13 - 3 12-11 a. The breakeven point will be lowered.

b. The breakeven point will be increased because fixed costs have increased.

c. The breakeven point will be lowered. 12-12 An increase in the personal tax rate makes both stocks and bonds less attractive to investors because it raises the tax paid on dividend and interest income. Changes in personal tax rates will have differing effects, depending on what portion of an investment’s total return is expected in the form of interest or dividends versus capital gains. For example, a high personal tax rate has a greater impact on bondholders because more of their return will be taxed at the new higher rate. An increase in the personal tax rate will cause some investors to shift from bonds to stocks. This raises the cost of debt relative to equity. In addition, a lower corporate tax rate reduces the advantage of debt by reducing the benefit of a corporation’s interest deduction that discourages the use of debt. Consequently, the net result would be for firms to use more equity and less debt in their capital structures.

12-13 a. An increase in the corporate tax rate would encourage a firm to increase the amount of debt in its capital structure because a higher tax rate increases the interest deductibility feature of debt.

b. An increase in the personal tax rate would cause investors to shift from bonds to stocks. This would raise the cost of debt relative to equity; thus, firms would be encouraged to use less debt in their capital structures.

c. Firms whose assets are illiquid and would have to be sold at “fire sale” prices should limit their use of debt financing. Consequently, this would discourage the firm from increasing the amount of debt in its capital structure.

d. If changes to the bankruptcy code made bankruptcy less costly, then firms would tend to increase the amount of debt in their capital structures.

e. Firms whose earnings are more volatile, all else equal, face a greater chance of bankruptcy and, therefore, should use less debt than more stable firms.

Integrated Case: 13 - 4 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

F 12-1 QBE = P  V $500,000 QBE = $4.00 - $3.00

QBE = 500,000 units.

12-2 The optimal capital structure is that capital structure where WACC is minimized and stock price is maximized. Since Jackson’s stock price is maximized at a 30 percent debt ratio, the firm’s optimal capital structure is 30 percent debt and 70 percent equity. This is also the debt level where the firm’s WACC is minimized.

12-3 From the Hamada Equation, b = bU[1 + (1 – T)(D/E)], we can calculate bU

as bU = b/[1 + (1 – T)(D/E)].

bU = 1.2/[1 + (1 – 0.4)($2,000,000/$8,000,000)]

bU = 1.2/[1 + 0.15]

bU = 1.0435.

12-4 skip this problem from your hw assignment a. 8,000 units 18,000 units Sales $200,000 $450,000 Fixed costs 140,000 140,000 Variable costs 120,000 270,000 Total costs $260,000 $410,000 Gain (loss) ($ 60,000) $ 40,000

F $140,000 b. QBE = = = 14,000 units. P - V $10

SBE = QBE(P) = (14,000)($25) = $350,000.

Integrated Case: 13 - 5 Dollars 800,000

600,000 Sales Costs 400,000

200,000 Fixed Costs

Units of Output 10 0 5 15 20 (Thousands)

c. If the selling price rises to $31, while the variable cost per unit remains fixed, P - V rises to $16. The end result is that the breakeven point is lowered.

F $140,000 QBE = = = 8,750 units. P - V $16

SBE = QBE(P) = (8,750)($31) = $271,250.

Dollars 800,000

Sales 600,000

Costs 400,000

200,000 Fixed Costs

The breakeven point drops to 8,750 units. The contribution margin per each unit sold has been increased; thus the variability in the firm’s profit stream has been increased, but the opportunity for magnified profits has also been increased.

d. If the selling price rises to $31 and the variable cost per unit rises to $23, P - V falls to $8. The end result is that the breakeven point increases.

F $140,000 QBE = = = 17,500 units. P - V $8

Integrated Case: 13 - 6 SBE = QBE(P) = (17,500)($31) = $542,500. The breakeven point increases to 17,500 units because the contribution margin per each unit sold has decreased.

Dollars 800,000

Sales Costs 600,000

400,000

200,000 Fixed Costs

12-6 Skip this problem a. LL: D/TA = 30%. EBIT $4,000,000 Interest ($6,000,000  0.10) 600,000 EBT $3,400,000 Tax (40%) 1,360,000 Net income $2,040,000

Return on equity = $2,040,000/$14,000,000 = 14.6%.

Integrated Case: 13 - 7 HL: D/TA = 50%. EBIT $4,000,000 Interest ($10,000,000  0.12) 1,200,000 EBT $2,800,000 Tax (40%) 1,120,000 Net income $1,680,000

Return on equity = $1,680,000/$10,000,000 = 16.8%.

b. LL: D/TA = 60%. EBIT $4,000,000 Interest ($12,000,000  0.15) 1,800,000 EBT $2,200,000 Tax (40%) 880,000 Net income $1,320,000

Return on equity = $1,320,000/$8,000,000 = 16.5%.

Although LL’s return on equity is higher than it was at the 30 percent leverage ratio, it is lower than the 16.8 percent return of HL. Initially, as leverage is increased, the return on equity also increases. But, the interest rate rises when leverage is increased. Therefore, the return on equity will reach a maximum and then decline.

12-8 skip this problem Facts as given: Current capital structure: 25%D,

75%E; kRF = 5%; kM – kRF = 6%; T = 40%; ks = 14%.

Step 1: Determine the firm’s current beta.

ks = kRF + (kM – kRF)b 14% = 5% + (6%)b 9% = 6%b 1.5 = b.

Step 2: Determine the firm’s unlevered beta, bU.

bU = bL/[1 + (1 – T)(D/E)]

bU = 1.5/[1 + (1 – 0.4)(0.25/0.75)]

bU = 1.5/1.20

bU = 1.25.

Integrated Case: 13 - 8 Step 3: Determine the firm’s beta under the new capital structure.

bL = bU(1 + (1 – T)(D/E))

bL = 1.25[1 + (1 – 0.4)(0.5/0.5)]

bL = 1.25(1.6)

bL = 2.

Step 4: Determine the firm’s new cost of equity under the changed capital structure.

ks = kRF + (kM – kRF)b

ks = 5% + (6%)2

ks = 17%.

12-12 Use of debt (millions of dollars):

Probability 0.3 0.4 0.3 Sales $2,250.0 $2,700.0 $3,150.0 EBIT (10%) 225.0 270.0 315.0 Interest* 77.4 77.4 77.4 EBT $ 147.6 $ 192.6 $ 237.6 Taxes (40%) 59.0 77.0 95.0 Net income $ 88.6 $ 115.6 $ 142.6

Earnings per share (20 million shares) $ 4.43 $ 5.78 $ 7.13

*Interest on debt = ($270  0.12) + Current interest expense = $32.4 + $45 = $77.4. Expected EPS = (0.30)($4.43) + (0.40)($5.78) + (0.30)($7.13) = $5.78 if debt is used.

2 2 2  Debt = (0.30)($4.43 - $5.78) + (0.40)($5.78 - $5.78) + (0.30)($7.13 - $5.78)2 = 1.094.

Debt = 1.094 = $1.05 = Standard deviation of EPS if debt financing is used.

$1.05 CV = = 0.18. $5.78

E(EBIT) $270 E(TIEDebt) = = = 3.49. I $77.4 Debt/Assets = ($652.50 + $300 + $270)/($1,350 + $270) = 75.5%.

Use of stock (millions of dollars):

Probability 0.3 0.4 0.3 Sales $2,250.0 $2,700.0 $3,150.0 EBIT 225.0 270.0 315.0 Interest 45.0 45.0 45.0 EBT $ 180.0 $ 225.0 $ 270.0 Taxes (40%) 72.0 90.0 108.0 Net income $ 108.0 $ 135.0 $ 162.0

Integrated Case: 13 - 9 Earnings per share (24.5 million shares)* $ 4.41 $ 5.51 $ 6.61

*Number of shares = ($270 million/$60) + 20 million = 4.5 million + 20 million = 24.5 million.

EPSEquity = (0.30)($4.41) + (0.40)($5.51) + (0.30)($6.61) = $5.51.

2 2 2  Equity = (0.30)($4.41 - $5.51) + (0.40)($5.51 - $5.51) + (0.30)($6.61 - $5.51)2 = 0.7260.

Equity = 0.7260 = $0.85.

$0.85 CV = = 0.15. $5.51

$270 E(TIE) = = 6.00. $45

Debt $652.50 + $300 = = 58.8%. Assets $1,350 + $270

Under debt financing the expected EPS is $5.78, the standard deviation is $1.05, the CV is 0.18, and the debt ratio increases to 75.5 percent. (The debt ratio had been 70.6 percent.) Under equity financing the expected EPS is $5.51, the standard deviation is $0.85, the CV is 0.15, and the debt ratio decreases to 58.8 percent. At this interest rate, debt financing provides a higher expected EPS than equity financing; however, the debt ratio is significantly higher under the debt financing situation as compared with the equity financing situation. Because EPS is not significantly greater under debt financing, while the risk is noticeably greater, equity financing should be recommended.

12-13 a. Firm A

1. Fixed costs = $80,000.

Breakeven sales - Fixed cost 2. Variable cost/unit = Breakeven units $200,000 - $80,000 $120,000 = = = $4.80/unit. 25,000 25,000

Breakeven sales $200,000 3. Selling price/unit = = = $8.00/unit. Breakeven units 25,000

Firm B

1. Fixed costs = $120,000.

Integrated Case: 13 - 10 Breakeven sales - Fixed costs 2. Variable cost/unit = Breakeven units $240,000 - $120,000 = = $4.00/unit. 30,000

Breakeven sales $240,000 3. Selling price/unit = = = $8.00/unit. Breakeven units 30,000 b. Firm B has the higher operating leverage due to its larger amount of fixed costs. c. Operating profit = (Selling price)(Units sold) - Fixed costs - (Variable costs/unit)(Units sold).

Firm A’s operating profit = $8X - $80,000 - $4.80X. Firm B’s operating profit = $8X - $120,000 - $4.00X.

Set the two equations equal to each other:

$8X - $80,000 - $4.80X = $8X - $120,000 - $4.00X -$0.8X = -$40,000 X = $40,000/$0.80 = 50,000 units.

Sales level = (Selling price)(Units) = $8(50,000) = $400,000.

At this sales level, both firms earn $80,000:

ProfitA = $8(50,000) - $80,000 - $4.80(50,000) = $400,000 - $80,000 - $240,000 = $80,000.

ProfitB = $8(50,000) - $120,000 - $4.00(50,000) = $400,000 - $120,000 - $200,000 = $80,000.

Integrated Case: 13 - 11