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Capital Structure and Leverage

CHAPTER 14

CAPITAL STRUCTURE AND LEVERAGE

FOCUS

Capital structure can influence the value of a firm. Our focus is on understanding why that's true andwhat we can and can't do with the knowledge. The ideas are developed through a detailed illustrationthat shows the performance and risk implications of financial leverage. Later in the chapter we explorethe theoretical approach to the same issue and see that the conclusions reached are similar. Along theway we examine the concept of operating leverage and see how it interacts with financial leverage.

PEDAGOGY

The ideas ehind capital structure and leverage are taught on two levels! the practical and thetheoretical. A practical understanding is developed using an example illustrating how leverage helpsrecorded financial performance if the firm is doing well! ut hurts it if operating results are poor. "ethen descrie how this effect influences risk#averse investors in their $uest for returns.

The pedagogical challenge of capital structure is presenting the %% theory in a way the average

person can understand. The theory's math is difficult and its notation is unusual! creating two factorsthat comine to ewilder most students immediately. &evertheless! the theory is an important pillar inthe structure of finance! and should e at least appreciated y anyone seriously in the field. The presentation of the suect is one of the defining features of this ook. The ideas are developedslowly! eginning with notation. Students are rought to an appreciation of what %% accomplished andwhy it's important without advanced mathematics. At the end they can hold their own in a discussion of the independence theory! aritrage! and the effects of taxes and ankruptcy costs. Their understandingis graphic and intuitive rather than mathematically rigorous! ut it's all most will ever need.

TEACHING OBJECTIVES

Students should gain an understanding of the interrelations among capital structure! financial results!stock market prices and risk. They should also e ale to $uantify and roughly measure the risk and performance implications of policy decisions regarding capital and cost structure.

OUTLINE

( )AC*+,O-&Terms are defined and the idea that capital structure can influence financial performance isintroduced.A. The Central (ssue

Can capital structure influence stock price and the market value of the firm/ 0urther! is there anoptimal structure that maximi1es value/

). ,isk in the Context of Leverage,edefining risk as variation in 2)(T and 23S.

C. Leverage and ,isk # Two *inds of 2achOperating and financial leverage! usiness and financial risk. -nderstanding the nature of each.

((. 0(&A&C(AL L242,A+2A. The 2ffect of 0inancial Leverage

5ow financial leverage amplifies performance as measured y ,O2 and 23S # developedthrough a detailed illustration. "hen leverage helps and when it hurts.

). 0inancial Leverage and 0inancial ,iskTying leverage to the notion of risk as variation in performance.

C. 3utting the (deas Together # The 2ffect on Stock 3rice

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5ow investors react to performance variations and the effect on stock prices. The practicaldifficulty of finding an optimal capital structure.

. The egree of 0inancial Leverage :0L; # A %easurementThe 0L concept. -sing 0L to predict results and measure risk.

2. 2)(T#23S Analysis-sing leverage concepts to determine an appropriate capital structure given management's

expectations aout 2)(T.

(((. O32,AT(&+ L242,A+2A. Terminology and efinitions

Cost structure # fixed and variale! defining operating leverage as the use of fixed costs. ). )reakeven Analysis

The reakeven techni$ue graphically and algeraicallyC. The 2ffect of Operating Leverage

-sing reakeven concepts to understand how operating leverage affects 2)(T when volumechanges.

. The egree of Operating Leverage :OL; # A %easurementThe OL concept. -sing OL to predict results and measure risk.

2. Comparing Operating and 0inancial LeverageA detailed comparison of the concepts showing similarities and differences.

0. The Compounding 2ffect of Operating and 0inancial LeverageThe effect of the two leverages is multiplicative. Acting together they can make a companyvery risky.The egree of Total Leverage :TL; concept.

(4. CA3(TAL ST,-CT-,2 T52O,<0ormal financial theory approaches the capital structure issue differently ut arrives at asically thesame result.

A. )ackground # The 4alue of the 0irm-nderstanding the theory's notation

). The 2arly Theory y %odigliani and %iller The asic %% model! its restrictive assumptions! and its results.

C. ,elaxing the Assumptions # %ore (nsightsThe effect of including taxes and ankruptcy costs.The %% approach arrives at the same result as the intuitive approach for somewhat differentreasons.

. An (nsight into %ergers and Ac$uisitionsThe value added y financial leverage as a ustification for paying premiums in ac$uisitions.

QUESTIONS

8. The user of leverage might e thought of as taking advantage of the provider. )etweenstockholders and ondholders! who is the user and who is the provider/ +ive a word explanation orillustration that might support this view. "hat does the used party get in return/

ANSWER: Stockholders use leverage provided y ondholders. The stockholders! throughmanagement! undertake proects using oth their own and ondholder's money. The rewards of successaccrue mainly to stockholders! while the penalty for total failure is shared y oth. This seemingunfairness is the sense in which the user of leverage takes advantage of the provider.

5owever! ondholders are protected against moderate failure! which mainly hurts stockholders. Thisis ecause interest payments must e made regardless of profitaility.

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This safety under a wide range of poor performance short of disaster is what ondholders get in returnfor providing leverage.

=. The central issue underlying the study of leverage is whether or not it influences stock price andwhether there's an optimal structure. )ut the whole idea seems kind of fu11y and uncertain. "hy are people so interested/ : Hint > Think of management's goals and of the world of mergers.;

ANSWER: A great deal of money can e made very $uickly if a change in leverage can have animmediate and sustantial impact on stock price. (n merger situations! ac$uiring firms often orrow themoney to purchase firms eing ac$uired. (f the resulting increase in leverage of the cominedorgani1ation has a positive effect on stock price! the stockholders of oth companies can get richvirtually overnight.

7. ,elate usiness and financial risk as defined in this chapter to the risks descried in Chapter ?.

ANSWER: The risks discussed in this chapter relate to variations in a firm's financial results. )usinessrisk is variation in 2)(T. 0inancial risk is the increase in variation found etween 2)(T and 23S and,O2 if financial leverage is present. (n other words! these risks are found within the firm's financialstatements.

The concepts in Chapter ? were roader in that they addressed an investor's return. That return can e influenced y recorded financial results as well as y other things that don't show up on a company's ooks. 0or example! an economic recession depresses stock prices and therefore investor returns! utmay not influence profitaility as seen in 2)(T! ,O2 or 23S.

The risks in Chapter ? include the risks discussed here.

9. "hy are ,O2 and 23S such important measures of performance to investors/

ANSWER: ,O2 is an indication of the total performance of a company including oth operating andfinancing issues. Since people invest only for money! the return on what's invested is of fundamentalimportance. 23S taken along with stock price gives an indication of the same thing! ust how much is afirm making relative to the price of a share/ 23S is also important ecause it tends to drive stock pricethrough the 3@2 ratio. 5ence! it can e an indication of future price appreciation.

. )oth usiness risk and financial risk would exist with or without either type of leverage.Leverage ust makes them more significant. Are these statements true or false/ 2xplain.

ANSWER: 0alse. )usiness risk is variation in 2)(T. (t is increased ut not caused y operatingleverage. Some usiness risk exists in virtually all companies even in the complete asence of leverage.5owever! financial risk is the additional variation in 23S over that of 2)(T that comes as a result ofdet :financial leverage;. "ithout financial leverage there is no financial risk.

B. )riefly explain the pros and cons of financial leverage. (n other words! what are its enefits!and what are the costs that come along with those enefits/

ANSWER: 0inancial leverage makes good results measured in terms of 23S and ,O2 etter. 5ence ingood times it can enhance financial performance and therey tends to increase stock price. 5owever! itcan also exaggerate poor performance making a moderately poor showing in ad times much worse.Leverage adds to the variaility of financial performance! which is the essence of risk. 5ence financialleverage adds risk! which tends to depress stock price. This increased risk is the cost of leverage.

. 2xplain in words the ,OC2 test for the advisaility of adding leverage. That is! what is the testreally telling us/ "hen will it indicate a company is doing the wrong thing/

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ANSWER: The ,OC2 test measures the firm's operating aility to earn a return on invested moneyagainst the cost of orrowing. (f the ,OC2 is higher than the cost of orrowed funds :oth after tax; thefirm will profit to the extent of the difference on whatever money it orrows. 5owever! leverage addsrisk! and the ,OC2 doesn't test for that. 5ence if orrowing is already high! it may e unwise to orrowmore even if the ,OC2 is aove the cost of det.

6. The risk added y financing is small and insignificant relative to the inherent risk in most usinesses. (s that statement true or false/ iscuss.

ANSWER: The statement is generally true in good times if! in addition! the use of leverage is low ormoderate. 5owever! it is false when det levels are high. Then det can create financial risk thatexceeds usiness risk several times over.

?. escrie generally how leverage affects stock prices. "hat forces are at work! driven y whateffects/

ANSWER: (f usiness is good and the ,OC2 exceeds the after#tax cost of capital! additional leverageenhances ,O2 and 23S. These measures are watched y investors and the improvement can have a positive effect on stock price. At the same time! however! increased leverage makes those measuresmore volatile in response to changes in the usiness's operating results. That implies a riskier usiness.,isk levels are also watched y investors and have a negative impact on price. "hich effect dominatesdepends on how much leverage exists and the current usiness climate.

8D. 2xplain the difference etween a fixed and a variale cost. 5ow do these concepts change asthe time hori1on lengthens/ (n other words! are the same things fixed over a #year planning period thatare fixed in a typical 8#year period/ "hat aout a 8D#year period/ "hat's the relevant period whenwe're talking aout operating leverage/

ANSWER: A fixed cost remains constant when production levels change. A variale cost increases ordecreases in direct proportion to changes in production. The longer the planning period the more thingsare variale. 0or example the costs associated with a factory are fixed in the 8#year time frame. Over a8D#year period! however! a new factory can e uilt so the costs associated with it can e consideredvariale.

The discussion of operating leverage is made in the context of a relatively short period of time.5ence only direct inputs are variale.

88. "hy do laor#intensive processes involve less operating leverage than automated processes/"hat fixed costs are associated with automation/ "hy can't those costs e eliminated y ust sellingthe machinery/

ANSWER: 5igh operating leverage implies a preponderance of fixed cost. Laor isn't a fixed cost! ecause people can e fired if usiness turns down. The main fixed cost associated with automation isdepreciation associated with the e$uipment. (f the e$uipment is leased! the payments can e fixed if thelease can't e roken. (f the e$uipment is ac$uired with orrowed money! the interest on the loan is afixed cost. (dle machinery can e sold! ut generally at a ig loss. (f the e$uipment is highlyspeciali1ed! there may e no market for it.

8=. 2xplain the idea of reakeven analysis in a rief paragraph.

ANSWER: )reakeven analysis finds the production and sales level re$uired for the company to ustsurvive. At the reakeven volume! all costs are covered y revenue! ut nothing is left over for profit.The firm ust Ereaks evenE in terms of profit and loss.

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87. escrie the concept of the reakeven point in words y using the concept of contriution andfixed costs. :Short answer.;

ANSWER: 2ach unit sold contriutes the difference etween price and variale cost to profit andoverhead. This amount is called the EcontriutionE. At the reakeven point the total contriution fromall units sold ust e$uals the firm's fixed costs.

89. Summari1e the effect of operating leverage on 2)(T.

ANSWER: %ore operating leverage enhances 2)(T at points aove reakeven! ut makes it worsewhen operating elow reakeven. 5ence! it makes 2)(T more volatile with changes in volume.

8. The )raithwaite Tool Co. is considering a maor moderni1ation and automation of its plantusing orrowed funds. 0ully discuss a serious financial negative that could result from the proect.

ANSWER: The automation of the plant will make )raithwaite more capital intensive! add fixed costs!and increase operating leverage. This will increase the volatility of 2)(T as the level of sales changes.)y financing the proect with orrowed money! the firm will add det to its capital structure increasingfinancial leverage. This makes 23S and ,O2 more volatile as 2)(T changes.

The net result of these effects is multiplicative. Therefore! changes in sales may produce very largechanges in 23S and ,O2 after the proect is implemented. This is likely to make the company morerisky in the eyes of investors and may have a detrimental effect on its stock price.

8B. 2xplain the idea of ankruptcy costs. "hy are they important to investors/ "hen do investorsstart to worry aout them/

ANSWER: )ankruptcy costs are the expenses incurred as a result of the administration of a firm'sfailure. They are not losses associated with the usiness deterioration that causes the ankruptcy.,ather they're the costs of the legal and administrative system and the loss incurred if assets need to esold cheaply. )ankruptcy costs are important to investors ecause they represent potential investmentlosses. "hen times are good and the firm's det level is relatively low! investors don't think much aout ankruptcy costs. They start to worry! however! when failure looks possile. They ecome especiallyconcerned when det levels are high due to financial risk.

8. )riefly descrie the result of %%'s original restrictive model. "hy was it important in spite ofits serious restrictions/

ANSWER: %%'s original model implied that the firm's value is independent of capital structure.Although this view was already held y many others! %% descried a logical way in which the ehavior of investors could make it happen. The theory showed that the effect of capital structure on price and value is due to market imperfections like taxes and ankruptcy costs rather than to the asicinteraction etween investors and companies.

86. )riefly summari1e the operating income argument that was supported y the original %%result.

ANSWER: A firm's value is nothing more than the present value of its expected future income stream.(f expected income doesn't change! a rational market will hold the firm's total value constant regardlessof how the income is divided etween det and e$uity investors. 2ssentially the argument says that youcan't make something out of nothing. (.e.! you can't create additional value out of a fixed income stream y changing the way it's divided etween det and e$uity.

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8?. Outline the aritrage process proposed y %% that supports the operating income argument."hat is the aritrage etween/

ANSWER: (f increasing a firm's use of leverage created value! stockholders could profit y selling itsappreciated shares! orrowing money! and uying the unappreciated shares of a similar ut unleveragedfirm. This would put downward pressure on the price of the leveraged firm and upward pressure on the

price of the unleveraged firm driving the two together. :Actually! keeping them from eing different.;The aritrage is etween stocks of leveraged and unleveraged firms.

=D. 2xplain in words how the tax system favors det financing.

ANSWER: 3ayments to investors are either interest on det or dividends on e$uity. (nterest paymentsare tax deductile! while dividends are not. To the extent income is paid in interest rather than as adividend! it generates a tax savings. That savings is kept y the company without affecting investors.5ence it's cheaper to pay a det investor than to pay the same amount to an e$uity investor. Thegovernment effectively splits the ill for det funds.

=8. (n a short paragraph! descrie the result of adding taxes to the %% model.

ANSWER: "hen taxes are added to the %% model! an annual tax savings e$ual to the tax rate timesthe firm's total det is created. The present value of the perpetuity of that stream of savings is anaddition to the value of the firm. This value increment increases steadily as more det is added. (t elongs entirely to stockholders! since ondholder returns are fixed. Therefore! in the asence of otherrefinements! the %% model with taxes implies that the firm should orrow as much as possile right upto 8DDF of capital.

==. (n another short paragraph! descrie the effect of adding ankruptcy costs to the %% modelwith taxes.

ANSWER: (ncluding ankruptcy costs in the %% model mitigates the value enhancing effect of taxes y recogni1ing that more leverage increases risk. Since risk lowers value through its effect on there$uired returns of e$uity investors! it offsets the enefit of the tax shield associated with more det.The two effects taken together mean that as leverage is added! value increases! reaches a maximum! andthen decreases

=7. Compare the implications of the %% model with taxes and ankruptcy costs to the things wediscovered y studying the Ari1ona 5ot Air )alloon Corporation.

ANSWER: The ottom line is aout the same. Adding det to an unleveraged firm can initiallyincrease value and stock price! ut eventually detracts from oth. This means an optimal point mustexist for every firm with respect to the amount of leverage it uses. &either approach tells us how to findthe optimum.

The reasons for the model's conclusions are somewhat different. The %% model ases the eneficialeffect of leverage on the favorale tax treatment of interest. The intuitive approach! on the other hand!is ased on the idea that a profit is availale if a firm can earn more using orrowed money than it paysfor that use.

)oth approaches conclude that a little leverage is good! ut a lot is generally ad.

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BUSINESS ANALYSIS

8. The Armageddon Corp is in ig troule. Sales are down and profits are off. On top of that! thefirm's credit rating has een reduced so it's facing very high interest rates on anything it orrows in thefuture. Current long#term orrowing represents BDF of capital ut at fixed interest rates! so it won't eaffected.

The firm's maor stockholder! the Apocalypse +roup! has scheduled a conference with managementto discuss the company's prolems. 2veryone is very nervous aout this conference! and the executiveteam is meeting to decide what to tell Apocalypse.

Charlie +ladhand! the director of marketing! came into the meeting wearing a wide grin. 5eexplained that he'd read an article aout leverage that contained the solution to the company's prolem.The article told of several successful firms that had! to the delight of their owners! ecome moresuccessful y orrowing money. Charlie suggests that Armageddon da11le the Apocalypse +roup y orrowing heavily in the next few days efore the conference.

Criti$ue Charlie's idea.

ANSWER: Charlie doesn't understand what he read. (ncreasing leverage only helps when :8; times aregood! and :=; when there isn't much det to egin with. Armageddon is doing poorly! so more detwould make returns worse. )ut it would also add risk. "ith the existing det level at BDF! an additionwould e dangerously risky even in the est of times. (n this situation it would proaly e a disaster.

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great deal of attention to 23S when uying and selling. 5e also understands that leverage can magnify23S. 5owever! he knows little more than that aout finance. 5arry has strongly suggested to thetreasurer that ,evere restructure its capital to BF det in order to enhance 23S and increase stock price.

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suective proailities attached. Let the team evaluate which way to go. (t's possile that a modified plan can achieve most of the enefits of the automation! ut avoid some of the risk.

B. The "ycome Company is doing well and is interested in diversifying! so it's een lookingaround for an ac$uisition target. The Ale Company has een found with the help of an investment anker. Ale is $uite profitale! and aout half the si1e of "ycome. This si1e relationship is reflected

in their market values. )oth firms are financed entirely y e$uity. The investment anker has advisedthat it will e necessary to pay a premium of aout 7DF over market price to ac$uire Ale. "ycome's president is having a hard time with this news and has asked you for advice. Construct and explain anapproach to the ac$uisition that might make the premium easier to rationali1e. "ould it affect yourargument if neither Ale nor "ycome were particularly profitale/ (f so! how/

ANSWER: The president is struggling with the following prolem> (f Ale's market value trulyrepresents the firm's worth! the premium represents a payment of extra value from "ycome'sshareholders to Ale's at the time of the ac$uisition. -nless there are remarkale enefits to operatingthe two firms together! that money is lost to "ycome's shareholders forever.

Leverage may provide some relief. 0irst notice that neither firm has any det at present and that theyare oth enoying good profitaility. That means an increase in leverage might increase value.

Assume the si1e relationships of the market values of the two firms are roughly as follows :J8DD isan aritrary figure for "ycome! it's the relationships that are important;>

"ycome %arket 4alue J8DD 4alue of Ale

%arket 4alue JD3remium :7DF; 8 B

J8B

(f "ycome ac$uires Ale y orrowing JD! the market value of the capital structure of theresulting firm may e approximately as follows.

et J D 7DF 2$uity 88 DF Total J8B 8DDF

This is a reasonale level of leverage that may cause an increase in the value of the e$uity. To theextent that such an increase occurs! it will mitigate the loss to "ycome's stockholders from the premium payment.

(f the firms weren't profitale! increasing leverage would e likely to make their financial resultsworse rather than etter. That means an increase in stock price and value is unlikely to come from theidea.

PROBLEMS

Basic C!c"#$s a!% Ca&c'&a$i!s: Ta(&"s 14)1* 14)+* a!% E,'a$i! 14-1 .#a/"s 02* 03*

a!% 08. The Connecticut Computer Company has the following selected financial results.

8DF et 9DF et F et

et J 8D!DDD2$uity ?D!DDDTotal Capital J8DD!DDD

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Shares K J 86!DDD

2)(T J86!DDD(nterest : 8F; 8!DD2)T J8B!DD

Tax :9DF; B!BDD &et (ncome J ?!?DD

,O223S

The company is considering a capital restructuring to increase leverage from its present level of 8DF ofcapital.

a. Calculate ConnecticutGs ,O2 and 23S under its current capital structure. . ,estate the financial statement line items shown! the numer of shares outstanding! ,O2! and23S if Connecticut orrows money and uses it to retire stock until its capital structure is 9DFdet assuming 2)(T remains unchanged and the stock continues to sell at its ook value.:evelop the second column of the chart shown.;c. ,ecalculate same figures assuming Connecticut continues to restructure until its capitalstructure is F det. :evelop the third column of the chart.;d. 5ow is increasing leverage affecting financial performance/ "hat overall effect might thechanges have on the market price of ConnecticutGs stock/ "hy/ :"ords only. 5int> considerthe move from 8DF to 9DF and that from 9DF to F separately.;

SOLUTION: a-* (-* c-

8DF et 9DF et F et

et J 8D!DDD J 9D!DDD J !DDD

2$uity ?D!DDD BD!DDD =!DDDTotal Capital J8DD!DDD J8DD!DDD J8DD!DDD

Shares K J 86!DDD 8=!DDD !DDD

2)(T J86!DDD J86!DDD J86!DDD(nterest : 8F; 8!DD B!DDD 88!=D2)T J8B!DD J8=!DDD J B!DTax :9DF; B!BDD 9!6DD =!DD &et (ncome J ?!?DD J !=DD J 9!DD

,O2 88.DF 8=.DF 8B.=F

23S J. J.BD J.68

d. (ncreasing leverage is improving financial performance as measured y ,O2 and 23S. As detincreases! earnings! e$uity! and the numer of shares outstanding all decrease. 5owever! since e$uitydecreases fastest the ratios ,O2 :2AT@2$uity; and 23S :2AT@Shares; get larger.

The increase in det from 8DF to 9DF of capital is likely to increase stock price! ecauseinvestors will react favoraly to the improvement in ratios. (n this leverage range det is notexcessively high! so the positive effect of the improving ratios will proaly overcome the negativeeffect of increasing risk.

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The move from 9DF to F det! on the other hand! is likely to e perceived y investors asmaking the company uncomfortaly risky. At higher leverage levels the negative effect on investors ofincreased risk usually overwhelms the positive effect of improving performance ratios! and the net resultis a decline in stock price.

=. ,econsider the Connecticut Computer Company of the previous prolem assuming the firm hasexperienced some difficulties! and its 2)(T has fallen to J6!DDD.

a- ,econstruct the three#column chart developed in prolem 8 assuming ConnecticutGs 2)(Tremains at J6!DDD.(- (nterpret the result in terms of stock price and the advisaility of restructuring capital underthese conditions.c- Could these results have een predicted more easily/ -se the ,OC2 concept to come to thesame conclusion.

SOLUTION: a-

8DF et 9DF et F et

et J 8D!DDD J 9D!DDD J !DDD2$uity ?D!DDD BD!DDD =!DDDTotal Capital J8DD!DDD J8DD!DDD J8DD!DDD


2)(T J6!DDD J6!DDD J 6!DDD(nterest : 8F; 8!DD B!DDD 88!=D2)T JB!DD J=!DDD :J 7!=D;Tax :9DF; =!BDD 6DD # &et (ncome J 7!?DD J8!=DD :J 7!=D;

,O2 9.7F =.DF :87.DF;23S J.== J.8D :J.B;

. Stock price would almost certainly decline as a result of restructuring. (ncreased det is causing adeterioration of financial performance measured y ,O2 and 23S as well as increasing risk. )oth ofthese have negative effects on investorsG attitudes. -nder these conditions :a low 2)(T; it wouldvirtually never e advisale to exchange e$uity for det.

c. Leverage is not advisale if the return on capital employed! ,OC2! is less than the after tax cost ofdet. Currently ConnecticutGs ,OC2 is

,OC2 2)(T:8 − T; @ :et M 2$uity;

J6!DDD:8 − .9; @ J8DD!DDD

J9!6DD @ J8DD!DDD 9.6F

(ts after tax cost of det is

8F:8 N T; 8F:8 − .9; ?F

5ence at an 2)(T of J6!DDD! ConnecticutGs ,OC2 is less than its after tax cost of det and we would notexpect adding leverage to do the firm any good.

7. Assume Connecticut Computer Company of the last two prolems is earning an 2)(T ofJ8!DDD. Once again! calculate the chart showing the implication of adding more leverage. 4erallyrationali1e the result.

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SOLUTION>8DF et 9DF et F et

et J 8D!DDD J 9D!DDD J !DDD2$uity ?D!DDD BD!DDD =!DDDTotal Capital J8DD!DDD J8DD!DDD J8DD!DDD


2)(T J8!DDD J8!DDD J8!DDD(nterest : 8F; 8!DD B!DDD 88!=D2)T J87!DD J?!DDD J 7!DTax :9DF; !9DD 7!BDD 8!DD &et (ncome J 6!8DD J !9DD J =!=D

,O2 ?.DF ?.DF ?.DF23S J.9 J.9 J.9

Leverage has no effect on financial performance! ut it still adds risk hence the effect on stock price would proaly e negative.

At an 2)(T of J8!DDD the ,OC2 and the after tax cost of det are oth ?F. Trading e$uity for det or vice versa makes no difference on performance! ecause the firm is earning on capital exactlywhat it pays for the use of additional det funds. (.e.! thereGs no leverage.P The risk effect! however! isstill there ecause as the firm adds more det it must pay more interest making its profit marginnarrower. This will proaly drive the stockGs price down in the asence of a counteracting favoralechange in ratios.

9. "atson "atered "orks (nc. has an 2)(T of J=. million! can orrow at 8F interest! and pays comined state and federal income taxes of 9DF. (t currently has no det and is capitali1ed y

e$uity of J8= million. The firm has 8. million shares of common stock outstanding that trade at ookvalue.

a. Calculate "atson's &et (ncome! ,O2! and 23S currently and at capital structures that have =DF!9DF! BDF! and 6DF det. . Compare the 23S at the different leverage levels! and the amount of change etween levels asleverage increases. "hat happens to the effect of more det as leverage increases from a little to alot/

SOLUTION:

a.(&CO%2 STAT2%2&T

All =DF 9DF BDF 6DF

2$uity et et et et2)(T J =!D J =!D J =!D J =!D J =!D(nterest #QQ 7BD =D 8!D6D 8!99D2)T J =!D J =!7?D J =!D7D J 8!BD J 8!78DTax 8!8DD ?B 68= BB6 =9 &et (ncome J 8!BD J 8!979 J 8!=86 J 8!DD= J 6B

)ALA&C2 S522Tet # J =!9DD J 9!6DD J!=DD J ?!BDD2$uity J8=!DDD ?!BDD !=DD 9!6DD =!9DD

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Capital J8=!DDD J8=!DDD J8=!DDD J8=!DDD J8=!DDD

Shrs K J6 8.% 8.=% .?% .B% .7%

,O2 87.6F 89.?F 8B.?F =D.?F 7=.6F23S J8.8D J8.=D J8.7 J8.B J=.B=

. The effect of leverage accelerates as more leverage is added. That is! the same increment ofdet rings larger changes in ,O2 and 23S as leverage increases.

Ma!a/i!/ EPS T56'/5 L"7"6a/": E8a9#&" 14)1 .#a/" 03. The Tanenaum Tea Company wants to show the stock market an 23S of J7 per share! utdoesn't expect to e ale to improve profitaility over what is reflected in the financial plan for nextyear. The plan is partially reproduced as follows.

Ta!"!(a'9 T"a C9#a!

Fi!a!cia& P6;"c$i! +

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Chapter 89

Basics P&'s DFL: A##& E,'a$i! 14-? .#a/" 032B. The Canterury Coach Corporation has 2)(T of J7.B= million! and total capital of J=D million!which is 8F det. There are 9=!DDD shares of stock outstanding which sell at ook value. The firm pays 8=F interest on its det and is suect to a comined state and federal tax rate of 9DF. Canteruryis contemplating a capital restructuring to either 7DF! 9F! BDF! or F det.

a. At the current level of profitaility! will more det enhance results/ "hy/

. Calculate the net income! ,O2! 23S! and the 0L at the current and proposed structures! anddisplay your results in a systematic tale.c. (n a short paragraph referring to your tale! discuss the trade#off etween performance and

increased risk :reflected in the 0L; as leverage increases. o some levels seem to make more sensethan others/ "hat usiness characteristics would make the higher leverage levels less of a prolem/

SOLUTION:

a. (n :JDDD;

8D.6BFJ=D!DDD

J7!B=D:.B;

2$uityet

T;2)(T:8,OC2 ==

+

−=

After#tax cost of det k d:8−T; 8=F:.B; .=F

5ence!

,OC2 k d:8−T;which implies that more leverage will improve performance.

.(&CO%2 STAT2%2&T Current 3roposals

8F 7DF 9F BDF F et et et et et 2)(T J 7!B=D J 7!B=D J 7!B=D J 7!B=D J 7!B=D (nterest 7BD =D 8!D6D 8!99D 8!6DD 2)T J 7!=BD J =!?DD J =!9D J =!86D J 8!6=D

Tax 8!7D9 8!8BD 8!D8B 6= =6 &et (ncome J 8!?B J 8!9D J 8!=9 J 8!7D6 J 8!D?=

)ALA&C2 S522T et J 7!DDD J B!DDD J ?!DDD J8=!DDD J8!DDD 2$uity J8!DDD 89!DDD 88!DDD 6!DDD !DDD Capital J=D!DDD J=D!DDD J=D!DDD J=D!DDD J=D!DDD

Shares 9=!DDD 7D!DDD =!DDD =DD!DDD 8=!DDD )ook 4alue J9D J9D J9D J9D J9D

,O2 88.F 8=.9F 87.?F 8B.9F =8.6F

23S J9.BD J9.? J.9 JB.9 J6.9

0L 2)(T @:2)(T−(;

0L 8.88 8.= 8.97 8.BB 8.??

c. As ,O2 and 23S performance improves! so does the risk implied y the increasing 0L. Thehighest level of leverage yields financial risk that almost doules usiness risk. That intuitively seemsunacceptale. The 9F level seems reasonale. (f 2)(T is stale! however! there is less reason to econcerned aout more leverage.

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F6"cas$i!/ R"s'&$s T56'/5 $5" DFL: E8a9#&" 14)+ .#a/" 032. )alfour Corp has the following operating results and capital structure :JDDD;.

,evenue JB!DDD et J 8!=DD Cost@2xpense 9!DD 2$uity 6!6DD

2)(T J8!DD Total J8D!DDD

The firm is contemplating a capital restructuring to BDF det. (ts stock is currently selling for ookvalue at J= per share. The interest rate is ?F! and comined state and federal taxes are 9=F.

a. Calculate 23S under the current and proposed capital structures. . Calculate the 0L under oth structures.

c. -se the 0Ls to forecast the resulting 23S under each structure if operating profit falls off y F!8DF! or =F.

d. Comment on the desiraility of the proposed structure versus the current one as a function of thevolatility of the usiness.

e. (s stock price likely to e increased y a change to the proposed capital structure/ iscuss riefly.

SOLUTION: :JDDD; (&CO%2 STAT2%2&T Current 3roposed 2)(T J8!DD J8!DD(nterest :?F; 8D6 9D2)T J8!7?= J ?BDTax :9=F; 6 9D7

&et (ncome J 6D J

)ALA&C2 S522T et J 8!=DD J B!DDD2$uity 6!6DD 9!DDDCapital J8D!DDD J8D!DDD

RShares 2$@)4 per share J6!6DD!DDD@J= 7=!DDD J9!DDD!DDD@J= 8BD!DDD

a. 23S &et (ncome @ R Shrs Current> J6D@7= J=.=? 3roposed> J@8BD J7.96

. 0L 2)(T @ 2)TCurrent> J8!DD@J8!7?= 8.D63roposed> J8!DD@J?BD 8.B

c. F ∆23S 0L :F ∆2)(T;

0cst 23S 23S :8 − F ∆2)(T;

Current 3roposed

F ∆ 2)(T F ∆23S 0cst 23S F ∆23S 0cst 23S

F .9F J=.8 .6F J7.=8 8DF 8D.6F J=.D9 8.BF J=.?9

=F =.DF J8.B 7?.DF J=.8=

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Chapter 89

d. 23S is higher ut more variale under the proposed structure. 5owever! at a =F reduction in2)(T! 23S is still etter under the proposal than under the old structure. 5ence if operating profitailityisn't expected to vary much! the proposal may e a good idea.

e. "e can't say for sure ecause the ultimate impact on stock price depends on investors'

suective feelings aout risk and return trade#off. 5owever! it looks likely that the impact would efavorale if 2)(T isn't expected to vary more than =F.

6. Algeraically derive 23S ,O2 × )ook value per shareU.

: Hint > "rite the definitions of ,O2! 23S! and ook value! and then start sustituting.;

SOLUTION:

"rite the definition of 23S and solve for &et (ncome 23S &et (ncome @ R Shrs &et (ncome 23S :R Shrs; "rite the definition of ,O2 and sustitute for &et (ncome

,O2 &et (ncome @ 2$uity 23S :R Shrs; @ 2$uity Solve for 23S 23S ,O2 2$uity@R ShrsU. )ut since 2$uity@R ShrsU is )ook value per share! 23S ,O2 :)ook 4alue per Share;.

EBIT)EPS A!a&sis: E8a9#&" 14-? .#a/" @

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SOLUTION: a. CA3(TAL

Options for &ew Current Capital Additions 3ossile &ew Structures

Structure 8 = 7 8 = 7et J=!DDD # J6!DDD J8!DDD J =!DDD J8D!DDD J8!DDD

2$uity 7!DDD J8!DDD J!DDD # 86!DDD 8D!DDD 7!DDDTotal J!DDD J=D!DDD J=D!DDD J=D!DDDR Shrs 7DD 8!DD DD # 8!6DD 8!DDD 7DD

&ote that the numer of shares comes from dividing e$uity y J8D per share! which is market priceas well as ook value.

(&CO%2 STAT2%2&TS AT 2)(T J9!DDD

Capital Structure Options8 = 7

2)(T J9!DDD J9!DDD J9!DDD(nterest =DD 8!DDD 8!DD2)T J7!6DD J7!DDD J=!7DDTax 8!=D 8!=DD ?=D &et (ncome J=!=6D J8!6DD J8!76D23S J 8.= J 8.6D J 9.BD

(&CO%2 STAT2%2&TS AT 2)(T J=!DDD


2)(T J=!DDD J=!DDD J=!DDD(nterest =DD 8!DDD 8!DD2)T J8!6DD J8!DDD J 7DDTax =D 9DD 8=D &et (ncome J8!D6D J BDD J 86D23S JD.BD JD.BD JD.BD

(&CO%2 STAT2%2&TS AT 2)(T J8!DDD


2)(T J8!DDD J8!DDD J8!DDD(nterest =DD 8!DDD 8!DD2)T J 6DD J D :J DD;Tax 7=D D : =6D;V &et (ncome J 96D J D :J 9=D;23S J D.= J D.DD :J 8.9D;

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Chapter 89

• 0or illustrative purposes assume a tax credit on losses.

&ote that last year's income Statement is identical to Column 8 in the last tale except that there are7DD!DDD shares of stock outstanding! which yields an 23S of J8.BD.

23S

J.DD #7#

J9.DD

J7.DD#=#

J=.DD #8#

J8.DD

2)(T J8!DDD J=!DDD J7!DDD J9!DDD

. The three options display a wide range of choices with respect to the trade#off etween risk and performance. Option one is relatively conservative in that there's almost no loss at 23S until a loss isexperienced at 2)(T. Option three! on the other hand! is very risky getting into negative 23Ss whileoperating profits are still good. (ntuitively! option three seems risky enough to decrease stock price. The choice etween options one and two is suective. An important point! however! is a comparisonwith last year's 23S! which can e calculated at J8.BD. Option one will result in a decline in 23S at theexpected level of 2)(T. That fact is likely to make it unacceptale.c. 8; This is a high risk scenario in which most people would proaly choose option one. 2ven that

gives only aout a =@7 proaility of a positive 23S. The others are worse. Option three looks like itcould ankrupt the firm toward the ottom of the 2)(T range.=;This is a common usiness situation> A likely outcome has more downside risk than upside

potential. 2ither of the first two options is supportale.7; Option three is clearly the est choice if the outlook is really this good.

C!$6i('$i! a!% B6"a"7"!: E8a9#&"s 14)4 a!% 14)0 .#a/"s @

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. I)@2 0C@Ct J89D!DDD@J =D!DDD

c. S)@2 3:0C;@Ct :J7=;J89D!DDD@J JB9D!DDD S)@2 0C@C% J89D!DDD@.=86 JB9D!DDD

d.

=D!DDD -nits

Fi8"%Va6ia(&" Cs$ T6a%" a!% DOL: E8a9#&"s 14-@ a!% 14-2 .#a/"s @

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Chapter 89

DDD!8BDJI6

I6

0;43:I

;43:IOL

C −=

−−

−

=

)@2M I OL =DF =9!DDD B.D 7DF =B!DDD 9.7 9DF =6!DDD 7.

d. The OL around a fixed reakeven point is a function of $uantity only as the mix of fixed andvariale costs shifts.

P6(&"9s 1+ 10 6""6 $ B'6& W% P6%'c$s .BWP* a 9a!'ac$'6"6 5i/5 ,'a&i$

'6!i$'6"-

8=. )"3 proects sales of 8DD!DDD units next year at an average price of JD per unit. 4arialecosts are estimated at 9DF of revenue! and fixed costs will e J=.9 million. )"3 has J8 millionin onds outstanding on which it pays 6F! and its marginal tax rate is 9DF. There are 8DD!DDDshares of stock outstanding which trade at their ook value of J7D. Compute )"3Gs

contriution! contriution margin! &et (ncome! OL and 23S.

SOLUTION::J %illions;,evenue 8DD!DDD x JD J.DD4ariale Cost K 9DF =.DDContriution %argin 7.DD0ixed Costs =.9D2)(T .BD(nterest 2xpense J8.D x .D6 .D62)T .=Tax K 9DF .=D6 &et (ncome .78=

Contriution D N :D x .9; J7DContriution %argin 7D@D BDF &et (ncome J78=!DDDOL X8DD!DD:D#=D;@8DD!DDD:D#=D;#=9DDDDDUY 23S J78=!DDD@8DD!DDD J7.8=

87. )"3 intends to purchase a machine that will result in a maor improvement in product $ualityalong with a small increase in manufacturing efficiency. The machine will cost J8 million!which will e orrowed at ?F. The $uality improvement is expected to have a significantimpact on )"3Gs competitive position. (ndeed! management expects sales to increase y F in

spite of a planned 8DF price increase. The efficiency improvement comined with the priceincrease will result in variale costs of 7BF of revenue. 0ixed cost! however! will rise y 8?F.

a. Compute )"3Gs! new contriution! contriution margin! &et (ncome! OL! and 23Sif it purchases the new machine. . (f all of )"3Gs proections come to pass! how will stock price e influenced/ "hatfactors should e considered in estimating a stock price change/

SOLUTION: :J %illions;a. ,evenue :8DD!DDD x JD x 8.8 x 8.D; J.

4ariale Cost K 7BF =.D?

8D=

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Contriution %argin 7.B?B0ixed Costs :J=.9 x 8.8?; =.6B2)(T .69D(nterest 2xpense :J8.D x .D6 M J8.D x .D?; .8D2)T .BDTax K 9DF .=B6

&et (ncome .9D=

Contriution :J # .7Bx J; J7.=DContriution %argin :J7.=D@J; B9F &et (ncome J9D=!DDDOL X8D!DD:7.=D;@8D!DDD:7.=D;#=6BDDDUY 9.923S :J9D=!DDD@8DD!DDD; J9.D=

. An increase in 23S will have a positive effect on stock price. A douling of det! however!might have a negative effect! especially if det was already a significant percentage of capital.The decrease in OL means results will e less volatile which should have a positive effect. (tisnGt possile to say with certainty which effect will dominate.

89. Calculate )"3Gs 0L and TL efore and after the ac$uisition of the new machine.

SOLUTION:

"@O machine "@machine0L 2)(T@:2)(T N (; .B@.= 8.8 [email protected] 8.=TL OL x 0L .D x 8.8 . 9.9 x 8.= .

8. -se the information from the previous two prolems. Calculate )"3Gs reakeven point in unitsand dollars! with and without the purchase of the new machine.

SOLUTION:

"ithout machine> J=.9 million@J7D 6D!DDD units6D!DDD units x JD J9DDD!DDD

"ith machine> J=.6B million@J7.=D 68!87 units68!87 units x J J9!9B=!7

D"/6"" T$a& L"7"6a/" .DTL: E8a9#&" 14- .#a/" @1+8B. The Spitfire %odel Airplane Company has the following modified income statement :JDDD; at8DD!DDD units of production. ,evenue J8D!DDD 4ariale Cost B!DD 0ixed Cost =!=DD 2)(T J 8!7DD (nterest :K 8DF; DD 2)T J 6DD Tax :K 9DF; 7=D &et (ncome J 96D R shares =D!DDD

a. "hat are Spitfire's contriution margin and dollar reakeven point/

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Chapter 89

. Calculate Spitfire's current 0L! OL! and TL. c. Calculate the current 23S and estimate what it would ecome if sales declined y =F. -se theTL first and then recalculate the modified income statement. :Assume a negative 2)T generates anegative tax.;

SOLUTION:

a. 3 J8D%@8DD!DDD J8DD 4 JB.%@8DD!DDD JB

C% :3−4;@3 :J8DD − JB;@J8DD .7

S)@2 0C@C% [email protected] JB!=6!89

.

B=A.8ADDJ7DD!8J

7DD!8J

(2)(T

2)(T0L =

−

=

−

=

B?=.=DDD!=DD!=J;7A:JDDD!8DD

;7A:JDDD!8DD

0;43:I

;43:IOL

C

=

−

=

−−

−

=

TL OL × 0L =.B?= × 8.B= 9.7

c. A =F decline in sales implies 23S will decline y

=F × TL =F × 9.7 8D?.9F

8D?.9F of J=9 J=B.=B

J=9 − J=B.=B −J=.=B

,ecalculating the income statement>

,evenue J!DDD 4ariale Cost 9!6 0ixed Cost =!=DD 2)(T J 9= (nterest :K 8DF; DD 2)T J : ;

Tax :K 9DF; : 7D; &et (ncome J : 9; R shares =D!DDD

23S −J9!DDD@=D!DDD −J=.=

8. The Singleton %etal Stamping Company is planning to uy a new computer controlledstamping machine for J8D million. The purchase will e financed entirely with orrowed money thatwill change Singleton's capital structure sustantially. (t will also change operations y adding J8.million in fixed cost and eliminating J= million in variale cost at the current level of sales.The firm's current financial position is reflected in the following statement :JDDD;.

,evenue J86!DDD 4ariale Cost 8D!DDD et J !DDD 0ixed Cost !DDD 2$uity 8!DDD

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2)(T J 7!DDD Total J=D!DDD (nterest :K 8DF; DD Rshares D!DDD 2)T J =!DD Tax :K 9DF; 8!DDD 23S J=.DD &et (ncome J 8!DD

a. ,estate the financial statements with the new machine! and calculate the dollar reakeven pointswith and without it. . Calculate the 0L with and without the new machine.c. Calculate the OL with and without the new machine. : Hint > 8. At current production levels! financial performance gets worse! and

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Chapter 89

=. 0inancial performance is consideraly more variale :risky; with the machine.The proect would make sense if a ig increase in volume was expected.

86. Schoen (ndustries pays interest of J7 million each year on onds with an average coupon rateof .F. The firm has 9. million shares of stock outstanding and pays out 8DDF of earnings in

dividends. 2arnings per share :23S; is J7.D. SchoenGs cost of e$uity is 8=F. Calculate thefirmGs total value :the value of its det plus that of its e$uity; under the assumptions of%odigliani and %illerGs simplest model. (.e.! that there are no taxes and no transactions costs infinancial markets. : Hint: -se 2$uations 89.8 # 89.8.;

SOLUTION:

40 4d M 4e

40 J7.D%@.D M J7.D x 9.% [email protected]= J9D %M J878.=% J88.=%

8?. Assume Schoen (ndustries of the last prolem is suect to income tax at a rate of 9DF.a. ,ecalculate the value of the firm assuming there is no tax shield associated with det and

compare it to the value calculated in the last prolem. That is! assume interest is sutracted incalculating earnings! ut is not deductile in calculating taxes. 5ow much value has theoretically eenlost to investors as a result of taxes/ "hich investors suffer the loss! stockholders or ondholders/

. "hat is the value of the tax shield associated with the firmGs det. "hat is the benefit ofdebt / Calculate the theoretical value of the firm including the enefit of det and compare it with thevalue calculated in the last prolem/ "ho gets the incremental value resulting from the tax shield/

c. -nder what conditions! assuming ankruptcy costs are introduced! are investors likely toreceive the full enefit of det calculated in part / "ords only.

SOLUTION:

a- 2arnings without tax wereJ7.D x 9.% shares J8.%

Add interest payments 7.DD%Taxale income J86.%Less tax at 9DF .D%Less interest 7.DD%

2arnings availale for dividends J 6.=%

4f 4d M 4e ( @ k d M @ k e J7% @ .D M J6.= @ .8= J9D% M JB6.% J8D6.%

Loss in value due to taxes3revious value J 88.=%4alue with tax ut no tax shield :8D6.%;Loss in value to investors J B=.D%

Stockholders suffer the entire loss! ecause interest payments are fixed y SchoenGs ond contracts.

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(- The :annual; tax shield associated with det is the tax saved y making deductile interest payments!which is simply the payment times the tax rate. (n SchoenGs case thatGs

J7% x .9 J8.=%

The enefit of det is the present value of the annual tax shield in perpetuity capitali1ed at the return ondet.

J8.=% @ .D J8B%

The enefit of det is an addition to the value calculated earlier in this prolem. 5ence the value withdeductile taxes is

4alue with tax ut no tax shield J8D6.%)enefit of det 8B.DD%

J8=9.%

The enefit of det accrues entirely to stockholders for the same reason they suffered the entire valueloss from the imposition of taxes! ecause interest payments are fixed y SchoenGs ond contracts.

c- The introduction of ankruptcy costs causes the value of the firm to decline elow the theoreticalvalue with taxes ecause investors ecome concerned aout risk as det increases. See 0igure 89.87a.0urther! investor concern aout risk is heightened if the company is facing difficult usiness conditions.5ence the full enefit of det is likely to e achieved only at low det levels and when usiness isreasonaly good.

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IM Ch14-7e - WRL

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