Stock and Debt
Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage generally has no effect on EBIT—it only affects EPS, given EBIT.
Because Firm A has higher fixed operating costs, its operating income will change by a greater percentage than Firm B’s operating income if sales change. Firm A has a higher degree of operating leverage than Firm B.
If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges also will 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.
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.
Carson does have leverage because its EPS increases by a greater multiple than its sales when sales change. According to the information that is given, Carson’s DTL is 4 = 20/5. Because we have no information about either the firm’s operating fixed costs or its fixed financing costs, we cannot state whether the firm has operating leverage, financial leverage, or both.
EBIT depends on sales and operating costs that generally are not affected by the firm’s use of financial leverage because 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.
Expected EPS generally is 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.
A firm can change the proportion of debt it uses in its capital structure. If the firm has too much (little) debt, it can reduce (increase) the proportion of debt in its capital structure. Such as change should decrease the firm’s WACC, and thus increase its value.
Absolute’s optimal capital structure is 40 percent debt (= $20,000,000/$50,000,000), because the market price of the company’s stock ($130. 75) is maximized at this point. 12-10With 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 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 the 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 saw from the actual debt ratios of the Bell companies. The Bell companies and the new AT&T lowered their debt ratios, for reasons along these lines.
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 might 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 also should keep in mind that this project, and R&D in general, are extremely risky and debt financing might not be available except at extremely high rates. For this reason, many R&D companies have low debt ratios, instead of paying low dividends and using retained earnings for financing projects. 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%. (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, but the risk is noticeably greater, equity financing should be recommended.
ANSWER: Business risk is the uncertainty associated with a firm’s projection of its future operating income.
It also is defined as the risk faced by a firm’s stockholders if the company uses no debt.
A firm’s business risk is affected by many factors, including:
variability in the demand for its output
variability in the price at which its output can be sold
variability in the prices of its inputs
the firm’s ability to adjust output prices as input prices change
the amount of operating leverage used by the firm
special risk factors (such as potential product liability for a drug company or the potential cost of a nuclear accident for a utility with nuclear plants).
ANSWER: Operating leverage is the extent to which fixed operating costs are used in a firm’s operations. If a high percentage of the firm’s total operating costs are fixed, and hence do not decline when demand falls, then the firm is said to have high operating leverage. Other things held constant, the greater a firm’s operating leverage, the greater its business risk.
ANSWER: Financial leverage refers to the firm’s decision to finance with fixed-charge securities, such as debt and preferred stock. Financial risk is the additional risk, over and above the company’s inherent business risk, or by the stockholders as a result of the firm’s decision to finance with debt.
ANSWER: As we discussed above, business risk depends on a number of factors such as sales and cost variability, and operating leverage. Financial risk, on the other hand, depends on only one factor—the amount of fixed-charge capital (financing) the company uses.
ANSWER: Here are the fully completed statements: The expected TIE would be larger than 2. 5x if less debt were used, but smaller if leverage were increased.
ANSWER: The optimal capital structure is the capital structure at which the tax-related benefits of leverage are exactly offset by debt’s risk-related costs. At the optimal capital structure, (1) the total value of the firm is maximized, (2) the WACC is minimized, and the price per share is maximized.
ANSWER: Here is the sequence of events:
1. CDSS must first announce its recapitalization plans.
2. The company’s stock would have some market price before the announcement, in this case, $20 per share. The company would have to estimate
(a) the price it would have to pay for the repurchased shares.
(b) the method to be used for the repurchase (open market purchases, or a tender offer).
3. For simplicity, we assume that the firm could repurchase stock at its current price, $20, which also happens to be its book value per share. In actuality, investors would probably reassess their views about the firm’s profitability and risk under the new capital structure, and the stock price probably would rise. No current shareholder would be willing to sell at a price very far below the expected new price, although some would be afraid the recap plan might not go through, and those stockholders would sell out at a lower-than-expected price. Therefore, the stock price would adjust quickly to a new equilibrium that reflects the recapitalization.
4. CDSS would purchase stock, then issue debt and use the proceeds to pay for the repurchased stock. After the recapitalization, the company would have more debt but fewer common shares outstanding. A new EPS could be calculated, and the price would settle into its new level.
ANSWER: The analysis for the debt levels being considered (in thousands of dollars and shares) is shown below: At Debt = $0. At Debt = $250,000: Shares repurchased = $250,000/$20 = 12,500. Remaining shares outstanding = 100,000 – 12,500 = 87,500.
Note: EPS and TIE calculations are in thousands of dollars. At Debt = $500,000: Shares repurchased = $500,000/$20 = 25,000. Remaining shares outstanding = 100,000 – 25,000 = 75,000.
(Note: EPS and TIE calculations are in thousands of dollars. )
At Debt = $750,000: Shares repurchased = $750,000/$20 = 37,500. Remaining shares outstanding = 100,000 – 37,500 = 62,500. (Note: EPS and TIE calculations are in thousands of dollars. ) At Debt = $1,000,000: Shares repurchased = $1,000,000/$20 = 50,000. Remaining shares outstanding = 100,000 – 50,000 = 50,000.
Note: EPS and TIE calculations are in thousands of dollars.
ANSWER: We can calculate the price of a constant growth stock as DPS divided by rs minus g, where g is the expected growth rate in dividends: Because in this case all earnings are paid out to the stockholders, DPS = EPS. Further, because no earnings are plowed back, the firm’s EBIT is not expected to grow, sog = 0.
Here are the results: Debt Level DPS rs Stock Price $ 0 $3. 00 15. 0% $20. 00 250,000 3. 26 15. 5 21. 03 500,000 3. 56 16. 5 21. 58* 750,000 3. 86 18. 0 21. 44 1,000,000 4. 8 20. 0 20. 40 * maximum.
ANSWER: A capital structure with $500,000 of debt produces the highest stock price, $21. 58, hence it is the best of those considered. ANSWER: We have seen that EPS continues to increase beyond the $500,000 optimal level of debt. Therefore, focusing on EPS when making capital structure decisions is not correct—while the EPS does take account of the differential cost of debt, it does not account for the increased risk that must be borne by the equity holders.
ANSWER: Currently, Debt/Total assets = 0%, so total assets = initial equity = $20 x 100,000 shares = $2,000,000.
WACC = ($500,000/$2,000,000)[(11%)(0. 60)] + ($1,500,000/$2,000,000)(16. 5%) = 1. 65% + 12. 38% = 14. 03%.
NOTE: If we had (1) used the equilibrium price for repurchasing shares and (2) used market value weights to calculate WACC, then we could be sure that the WACC at the price-maximizing capital structure would be the minimum. Using a constant $20 purchase price, and book value weights, inconsistencies might creep in.
ANSWER: If the firm had higher business risk, then, at any debt level, its probability of financial distress would be higher. Investors would recognize this, and both rd and rs would be higher than originally estimated. It is not shown in this analysis, but the end result would be an optimal capital structure with less debt. Conversely, the lower business risk would lead to an optimal capital structure that included more debt. ANSWER: The three degrees of leverage are calculated below: S = $1,350,000 New debt = $500,000 @ 11% VC = 0. 6S F = $40,000
(Note: Calculations are in thousands of dollars. )
DTL = DOL x DFL = 1. 08 x 1. 12 = 1. 21. The degree of operating leverage is defined as the percentage change in operating income (EBIT) associated with a given percentage change in sales. Because our company’s degree of operating leverage is 1. 08, this means that a given percentage increase in sales will lead to an 8 percent greater increase in EBIT. For example, if sales increased by 100 percent, then EBIT would increase by 108 percent. The degree of financial leverage is defined as the percentage change in EPS associated with a given percentage change in EBIT. Because CDSS’s degree of financial leverage is 1. 12, this means that if EBIT increased by 100 percent, then EPS would increase by 112 percent.
The degree of total leverage shows the combined effects of operating and financial leverage on the firm’s earnings per share. It is defined as the percentage change in EPS brought about by a given percentage change in sales, and it is calculated as DOL x DFL. Because CDSS’s DTL is 1. 21, a 100 percent increase in sales would produce a 121 percent increase in EPS. The degree of leverage concept is useful for planning purposes, as it gives an idea of what will happen to earnings as sales vary. Investors can use the concept to consider firms with different leverages if they expect sales to rise or fall.
ANSWER: Because it is difficult to quantify the capital structure decision, managers consider the following judgmental factors when making capital structure decisions:
The average debt ratio for firms in their industry.
Pro forma tie ratios at different capital structures under different scenarios.
Lender/rating agency attitudes.
Reserve borrowing capacity.
Effects of financing on control.
Expected tax rate.
ANSWER: The following figure presents a graph of the situation: The use of debt permits a firm to obtain tax savings from the deductibility of interest.
So the use of some debt is good; however, the possibility of bankruptcy increases the cost of using debt. At higher and higher levels of debt, the risk of bankruptcy increases, bringing with it costs associated with potential financial distress. Customers reduce purchases, key employees leave, and so on. There is some point, generally well below a debt ratio of 100 percent, at which problems associated with potential bankruptcy more than offset the tax savings from debt. Theoretically, the optimal capital structure is found at the point where the marginal tax savings just equal the marginal bankruptcy-related costs. However, analysts cannot identify this point with precision for any given firm, or for firms in general. Analysts can help managers determine an optimal range for their firm’s debt ratios, but the capital structure decision still is more judgmental than based on precise calculations.
ANSWER: The asymmetric information concept is based on the premise that management’s choice of financing gives signals to investors. Firms with good investment opportunities will not want to share the benefits with new stockholders, so they will tend to finance with debt. Firms with poor prospects, on the other hand, will want to finance with stock. Investors know this, so when a large, mature firm announces a stock offering, investors take this as a signal of bad news, and the stock price declines. Firms know this, so they try to avoid having to sell new common stock. This means maintaining a reserve of borrowing capacity so that when good investments come along, they can be financed with debt. 12-17Computer-Related Problem a. If the outstanding debt has to be refunded at the new higher interest rate, expected EPS would decline under either financing plan. However, EPS would decline more if debt financing were used. Therefore, debt financing has become relatively less attractive than stock financing.
The output generated by the model is given below:
ETHICAL DILEMMA A BOND IS A BOND … IS A STOCK … IS A BOONDOCK?
Ethical dilemma: Wally is evaluating whether to use a new (to the United States) financial instrument to raise funds to finance Ohio Rubber & Tire’s (ORT) expansion plans. The new instrument, which is called a boondock, has some characteristics of traditional debt and some characteristics that are similar to common equity. The cost of capital associated with boondocks is slightly higher than traditional debt but significantly lower than common equity. If ORT’s expansion plans are successful, both its bondholders and its stockholders will receive handsome returns. However, if the expansion plans are not successful, then it appears that stockholders can still benefit but at the expense of bondholders. ORT’s executives are some of the company’s major stockholders, so it appears that they would be in favor of issuing boondocks.
Discussion questions: Is there an ethical problem? If so, what is it? The question here is whether it is appropriate to use a new financial instrument called a boondock to raise funds needed for expansion. Because the cost of capital associated with a boondock is slightly higher than the cost of debt but significantly lower than the cost of equity, management thinks that it might be appropriate to use this medium to raise funds to invest in risky ventures. If the expansion investment is successful, both the bondholders and the stockholders will benefit. Of course, the benefit to stockholders will be greater than the benefit of bondholders. On the other hand, if the expansion investment is unsuccessful, both bondholders and stockholders will suffer financial losses.
But, because the market values of the boondocks will decline significantly, the firm could benefit by repurchasing these financing instruments in the capital markets. In this case, stockholders would benefit at the expense of bondholders. As a result, the ethical question is whether ORT should raise funds using boondocks knowing that there is a possibility that its stockholders will gain at the expense of its bondholders. ?Is it appropriate for ORT to use boondocks to raise funds that are needed for expansion? Is there an ethical dilemma here? Maybe not. Remember that investors take risks when purchasing the stocks and bonds of firms. In this case, ORT would be wise to use boondocks if the purpose is to raise funds for expansion while trying to lower the cost of capital associated with “going to” the financial markets. It might be argued that it is unethical for ORT to use boondocks if the intent is to benefit executives who receive bonuses and incentives in the form of the company’s stock. It also might be argued that it is unethical if the intent is to harm the position of bondholders.
However, if the primary objective is to increase the value of the firm, then it is difficult to argue that issuing this new financial instrument is unethical. What would you do if you were Wally? It seems that the best solution is for Wally to try to get more information about the new financial instrument called a boondock. Because little is known about boondocks and they appear to be rather complex financial instruments, Wally should gather more information about the risks as well as the benefits to ORT associated with using this medium to raise funds for expansion. Once he has performed his due diligence, Wally should determine whether using boondocks will benefit the firm and its investors in general. If the answer is “no,” then boondocks should not be used.
The following articles might be assigned for background material: Emily Thornton, “Gluttons at the Gate,” BusinessWeek, October 30, 2006, pp. 58-66.
David Henry, “Cross-Dressing Securities,” BusinessWeek, March 13, 2006, pp. 58-59