CHAPTER 13
Capital Structure and Leverage
Master Study Guide
Verbatim Theory • Detailed Examples • Computational Logic
TOPICS COVERED
Business vs. Financial Risk | Optimal Capital Structure
Operating Leverage | Capital Structure Theory
SECTION A: Verbatim Theory & Definitions
A.1 Business Risk
Definition
Business risk is the uncertainty about future operating income (EBIT), i.e., how well can we predict
operating income?
⚠ Critical Note: Business risk does NOT include financing effects.
What Determines Business Risk?
• Uncertainty about demand (sales).
• Uncertainty about output prices.
• Uncertainty about costs.
• Product, other types of liability.
• Operating leverage.
A.2 Operating Leverage
Definition
Operating leverage is the use of fixed costs rather than variable costs.
If most costs are fixed, hence do not decline when demand falls, then the firm has high operating
leverage.
Effect of Operating Leverage
More operating leverage leads to more business risk, for then a small sales decline causes a big
profit decline.
Using Operating Leverage — Typical Situation
Can use operating leverage to get higher E(EBIT), but risk also increases.
Low operating leverage → narrower EBIT distribution (lower risk, lower expected return)
High operating leverage → wider EBIT distribution (higher risk, higher expected return)
A.3 Financial Leverage & Financial Risk
Definitions
Financial leverage is the use of debt and preferred stock.
Financial risk is the additional risk concentrated on common stockholders as a result of financial
leverage.
A.4 Business Risk vs. Financial Risk
Business Risk Financial Risk
Depends on business factors such as Depends only on the types of securities
competition, product liability, and operating issued.
leverage.
Reflects uncertainty in EBIT (operating More debt → more financial risk.
income).
Exists regardless of how the firm is financed. Concentrates business risk on stockholders.
A.5 Optimal Capital Structure
Definition (Verbatim)
Optimal Capital Structure: That capital structure (mix of debt, preferred, and common
equity) at which P₀ is maximized. Trades off higher E(ROE) and EPS against higher risk.
The tax-related benefits of leverage are exactly offset by the debt's risk-related costs.
Target Capital Structure: The mix of debt, preferred stock, and common equity with which the firm
intends to raise capital.
Two Methods to Determine Optimal Capital Structure
• Minimizes WACC
• Maximizes stock price
Both methods yield the same results.
A.6 Recapitalization — Sequence of Events
1. Campus Deli announces the recapitalization.
2. New debt is issued.
3. Proceeds are used to repurchase stock.
4. The number of shares repurchased is equal to the amount of debt issued divided by price
per share.
A.7 Effect of Leverage on Profitability & Debt Coverage
• For leverage to raise expected ROE, must have BEP > k_d.
• If k_d > BEP, then the interest expense will be higher than the operating income produced
by debt-financed assets, so leverage will depress income.
• As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense
increases (Int Exp = k_d × D).
Conclusions (Verbatim)
• Basic earning power (BEP) is unaffected by financial leverage.
• L has higher expected ROE because BEP > k_d.
• L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher
expected return is accompanied by higher risk.
A.8 Bond Rating and Cost of Debt
As the firm borrows more money, the firm increases its financial risk, causing the firm's
bond rating to decrease, and its cost of debt to increase.
A.9 Cost of Equity & The Hamada Equation
If the level of debt increases, the riskiness of the firm increases. However, the riskiness of the firm's
equity also increases, resulting in a higher k_s.
The Hamada Equation — Verbatim
• Because the increased use of debt causes both the costs of debt and equity to increase, we
need to estimate the new cost of equity.
• The Hamada equation attempts to quantify the increased cost of equity due to financial
leverage.
• Uses the unlevered beta of a firm, which represents the business risk of a firm as if it had
no debt.
HAMADA EQUATION
βL = βU × [ 1 + (1 – T)(D/E) ]
βL = Levered Beta | βU = Unlevered Beta | T = Tax Rate | D = Debt | E = Equity
A.10 Capital Structure Theories
Modigliani-Miller (MM) Irrelevance Theory
The MM graph shows MM's tax benefit vs. bankruptcy cost theory. Logical, but doesn't tell whole
capital structure story. Main problem—assumes investors have same information as managers.
Signaling Theory
• Signaling theory suggests firms should use less debt than MM suggest.
• This unused debt capacity helps avoid stock sales, which depress stock price because of
signaling effects.
What Managers Are Expected to Do (Signaling)
• Issue stock if they think stock is overvalued.
• Issue debt if they think stock is undervalued.
• As a result, investors view a common stock offering as a negative signal—managers think
stock is overvalued.
A.11 Factors in Establishing Target Capital Structure
5. Industry average debt ratio
6. TIE ratios under different scenarios
7. Lender/rating agency attitudes
8. Reserve borrowing capacity
9. Effects of financing on control
10. Asset structure
11. Expected tax rate
Conclusions on Capital Structure (Verbatim)
• Need to make calculations as we did, but should also recognize inputs are "guesstimates."
• As a result of imprecise numbers, capital structure decisions have a large judgmental content.
• We end up with capital structures varying widely among firms, even similar ones in same
industry.
SECTION B: Comprehensive Examples & Case Details
B.1 Case Study: Firm U (Unleveraged) vs. Firm L (Leveraged)
Setup — Two Firms, Same Operating Risk
Two firms with the same operating leverage, business risk, and probability distribution of EBIT. Only
differ with respect to their use of debt (capital structure).
Firm U (Unleveraged) Firm L (Leveraged)
Debt No debt $10,000 of 12% debt
Total Assets $20,000 $20,000
Tax Rate 40% 40%
Firm U: Income Statement Under Three Economies
Bad (Prob 0.25) Average (Prob 0.50) Good (Prob 0.25)
EBIT $2,000 $3,000 $4,000
Interest $0 $0 $0
EBT $2,000 $3,000 $4,000
Taxes (40%) $800 $1,200 $1,600
Net Income $1,200 $1,800 $2,400
Firm L: Income Statement Under Three Economies
Bad (Prob 0.25) Average (Prob 0.50) Good (Prob 0.25)
EBIT $2,000 $3,000 $4,000
Interest $1,200 $1,200 $1,200
EBT $800 $1,800 $2,800
Taxes (40%) $320 $720 $1,120
Net Income $480 $1,080 $1,680
*Interest = 12% × $10,000 = $1,200 in all scenarios
Ratio Comparison: Leveraged vs. Unleveraged
Ratio Firm U — Firm U — Firm U — Firm L — Firm L — Firm L —
Bad Avg Good Bad Avg Good
BEP 10.0% 15.0% 20.0% 10.0% 15.0% 20.0%
ROE 6.0% 9.0% 12.0% 4.8% 10.8% 16.8%
TIE ∞ ∞ ∞ 1.67× 2.50× 3.30×
Risk & Return Summary
Metric Firm U Firm L
E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) ∞ 2.5×
σ(ROE) 2.12% 4.24%
CV(ROE) 0.24 0.39
B.2 Campus Deli Recapitalization — Full Case
Cost of Debt at Different Levels of Debt
Amount D/A Ratio D/E Ratio Bond Rating k_d
Borrowed
$0 0% 0% — —
$250,000 12.5% 14.29% AA 8.0%
$500,000 25.0% 33.33% A 9.0%
$750,000 37.5% 60.00% BBB 11.5%
$1,000,000 50.0% 100.00% BB 14.0%
Levered Betas and Costs of Equity
Given: Risk-free rate = 6%, Market risk premium = 6%, Unlevered beta = 1.0, Total assets =
$2,000,000
Amount D/A Ratio D/E Ratio Levered Beta k_s
Borrowed
$0 0.00% 0.00% 1.00 12.00%
$250,000 12.50% 14.29% 1.09 12.51%
$500,000 25.00% 33.33% 1.20 13.20%
$750,000 37.50% 60.00% 1.36 14.16%
$1,000,000 50.00% 100.00% 1.60 15.60%
WACC at Each Debt Level
Amount D/A E/A k_d(1–T) k_s WACC
Borrowed
$0 0.00% 100.00% 0.00% 12.00% 12.00%
$250,000 12.50% 87.50% 4.80% 12.51% 11.55%
$500,000 25.00% 75.00% 5.40% 13.20% 11.25%
$750,000 37.50% 62.50% 6.90% 14.16% 11.44%
$1,000,000 50.00% 50.00% 8.40% 15.60% 12.00%
EPS, DPS, and Stock Price at Each Debt Level
Amount Borrowed EPS / DPS k_s Stock Price P₀
$0 $3.00 12.00% $25.00
$250,000 $3.26 12.51% $26.03
$500,000 $3.55 13.20% $26.89 ← MAX
$750,000 $3.77 14.16% $26.59
$1,000,000 $3.90 15.60% $25.00
KEY CONCLUSION: P₀ is maximized ($26.89) at D/A = $500,000/$2,000,000 = 25%, so
optimal D/A = 25%.
EPS is maximized at 50%, but primary interest is stock price, not E(EPS).
The example shows that we can push up E(EPS) by using more debt, but the risk
resulting from increased leverage more than offsets the benefit of higher E(EPS).
SECTION C: Computational Logic & Step-by-Step "Why"
Guide
C.1 EPS Calculation — Detailed Logic
EPS FORMULA
EPS = [ (EBIT – k_d × D) × (1 – T) ] ÷ Shares Outstanding
k_d = cost of debt | D = total debt | T = tax rate
Variable Identification
Variable Meaning
EBIT Earnings Before Interest and Taxes =
$400,000 (given operating income)
k_d Cost of debt — varies by amount borrowed
(e.g., 8% at D=$250K)
D Total debt outstanding (e.g., $250,000;
$500,000; etc.)
k_d × D Annual interest expense in dollars
(1 – T) After-tax multiplier; T = 40%, so (1 – 0.40) =
0.60
Shares Outstanding 80,000 – shares repurchased (repurchased =
D ÷ $25)
Calculation 1: D = $0 (No Debt)
Identify shares outstanding
STEP
No shares repurchased → Shares = 80,000
1
→ 80,000 shares
Calculate interest expense
STEP
k_d × D = 0% × $0 = $0
2
→ $0 interest
Calculate after-tax income
STEP
(EBIT – Interest) × (1 – T) = ($400,000 – $0) × 0.60 = $240,000
3
→ $240,000
STEP Divide by shares outstanding
$240,000 ÷ 80,000
4
→ EPS = $3.00
Calculation 2: D = $250,000; k_d = 8%
Shares repurchased
STEP
$250,000 ÷ $25 per share = 10,000 shares repurchased
1
→ 10,000 shares
Remaining shares outstanding
STEP
80,000 – 10,000
2
→ 70,000 shares
Interest expense
STEP
8% × $250,000 = $20,000
3
→ $20,000
After-tax income
STEP
($400,000 – $20,000) × 0.60 = $380,000 × 0.60
4
→ $228,000
EPS
STEP
$228,000 ÷ 70,000
5
→ EPS = $3.26
Calculation 3: D = $500,000; k_d = 9%
Shares repurchased
STEP
$500,000 ÷ $25 = 20,000 shares
1
→ 20,000 shares
Remaining shares
STEP
80,000 – 20,000
2
→ 60,000 shares
Interest expense
STEP
9% × $500,000 = $45,000
3
→ $45,000
After-tax income
STEP
($400,000 – $45,000) × 0.60 = $355,000 × 0.60
4
→ $213,000
STEP EPS
$213,000 ÷ 60,000
5
→ EPS = $3.55
Calculation 4: D = $750,000; k_d = 11.5%
Shares repurchased
STEP
$750,000 ÷ $25 = 30,000 shares
1
→ 30,000 shares
Remaining shares
STEP
80,000 – 30,000
2
→ 50,000 shares
Interest expense
STEP
11.5% × $750,000 = $86,250
3
→ $86,250
After-tax income
STEP
($400,000 – $86,250) × 0.60 = $313,750 × 0.60
4
→ $188,250
EPS
STEP
$188,250 ÷ 50,000
5
→ EPS = $3.77
Calculation 5: D = $1,000,000; k_d = 14%
Shares repurchased
STEP
$1,000,000 ÷ $25 = 40,000 shares
1
→ 40,000 shares
Remaining shares
STEP
80,000 – 40,000
2
→ 40,000 shares
Interest expense
STEP
14% × $1,000,000 = $140,000
3
→ $140,000
After-tax income
STEP
($400,000 – $140,000) × 0.60 = $260,000 × 0.60
4
→ $156,000
STEP EPS
$156,000 ÷ 40,000
5
→ EPS = $3.90
C.2 TIE (Times Interest Earned)
TIE FORMULA
TIE = EBIT ÷ Interest Expense
Higher TIE = safer | Lower TIE = more default risk
Debt Level TIE Calculation
D = $0 No interest → TIE = ∞
D = $250,000 $400,000 ÷ $20,000 = 20×
D = $500,000 $400,000 ÷ $45,000 = 8.9×
D = $750,000 $400,000 ÷ $86,250 = 4.6×
D = $1,000,000 $400,000 ÷ $140,000 = 2.9×
WHY TIE falls: EBIT stays constant at $400,000 in all scenarios. As D increases, interest
expense (k_d × D) rises, shrinking the safety cushion.
C.3 Hamada Equation — Step-by-Step
HAMADA EQUATION
βL = βU × [ 1 + (1 – T)(D/E) ]
Given: βU = 1.0 | T = 40% | k_RF = 6% | Market Risk Premium = 6% | Total Assets = $2,000,000
Example: D = $250,000 → E = $2,000,000 – $250,000 = $1,750,000
Compute (1 – T)
STEP
(1 – 0.40) = 0.60
1
→ 0.60
Compute D/E ratio
STEP
$250,000 ÷ $1,750,000 = 0.1429
2
→ D/E = 0.1429
STEP Compute the bracket
3 1 + (0.60 × 0.1429) = 1 + 0.0857 = 1.0857
→ 1.0857
Compute βL
STEP
βL = 1.0 × 1.0857
4
→ βL = 1.0857 ≈ 1.09
Compute k_s via CAPM
STEP
k_s = 6.0% + (6.0% × 1.0857) = 6.0% + 6.51%
5
→ k_s = 12.51%
"WHY" Analysis — Hamada Logic
WHY does βL increase with more debt? Adding debt forces common stockholders to
bear more risk (financial risk piles on top of business risk). The Hamada equation precisely
quantifies this amplification: the D/E ratio scales the additional risk, and (1–T) reflects the
tax shield that partially offsets it.
WHY multiply by (1–T) instead of 1? Debt carries a tax deduction on interest payments.
The government effectively absorbs part of the risk, so the full D/E ratio overstates the
added burden. Multiplying by (1–T) = 0.60 discounts it to the after-tax effect.
C.4 Stock Price — Zero Growth Model
ZERO GROWTH STOCK PRICE
P₀ = DPS ÷ k_s = EPS ÷ k_s
Valid when E(g) = 0 (all earnings paid as dividends → EPS = DPS)
Debt Level P₀ Calculation
D = $0 $3.00 ÷ 0.1200 = $25.00
D = $250,000 $3.26 ÷ 0.1251 = $26.03
D = $500,000 $3.55 ÷ 0.1320 = $26.89 ← MAXIMUM
D = $750,000 $3.77 ÷ 0.1416 = $26.59
D = $1,000,000 $3.90 ÷ 0.1560 = $25.00
WHY does P₀ peak at D=$500K then decline? Initially, EPS rises faster than k_s (the
risk premium), so the numerator's growth outpaces the denominator. Beyond D=$500K,
k_s rises sharply due to the higher levered beta, making the denominator grow faster than
EPS, pulling P₀ back down.
C.5 WACC — Weighted Average Cost of Capital
WACC FORMULA
WACC = (D/A) × k_d(1–T) + (E/A) × k_s
k_d(1–T) = after-tax cost of debt | E/A = equity weight | D/A = debt weight
Example: D = $500,000
Calculate weights
STEP
D/A = 25% = 0.25 | E/A = 75% = 0.75
1
→ D/A=0.25, E/A=0.75
After-tax cost of debt
STEP
k_d(1–T) = 9% × (1–0.40) = 9% × 0.60 = 5.40%
2
→ 5.40%
Cost of equity
STEP
k_s = 13.20% (from Hamada/CAPM)
3
→ 13.20%
WACC
STEP
(0.25 × 5.40%) + (0.75 × 13.20%) = 1.35% + 9.90%
4
→ WACC = 11.25% ← MINIMUM
WHY WACC is minimized at D/A = 25%: This is the same point where P₀ is maximized.
Both methods confirm the optimal capital structure. At this point, the tax-related benefits of
leverage exactly offset the debt's risk-related costs.
C.6 Mental Maps for Exam Pressure
QUICK FORMULA CHAIN: EPS → k_s → P₀
Step 1: Shares repurchased = D ÷ $25
Step 2: New shares = 80,000 – repurchased
Step 3: Interest = k_d × D
Step 4: EPS = (EBIT – Interest) × 0.60 ÷ New shares
Step 5: D/E = D ÷ (Assets – D)
Step 6: βL = βU × [1 + 0.60 × (D/E)]
Step 7: k_s = 6% + 6% × βL
Step 8: P₀ = EPS ÷ k_s
Step 9: WACC = (D/A)(k_d × 0.60) + (E/A)(k_s)
OPTIMAL = Minimum WACC = Maximum P₀ (both occur at the SAME debt level)
Risk Concept Quick Mental Anchor
Business Risk EBIT uncertainty → No financing effects
Operating Leverage More fixed costs → bigger profit swings →
higher business risk
Financial Risk Debt → concentrated risk on stockholders
BEP > k_d Required for leverage to HELP ROE, not hurt
it
MM Theory gap Assumes investors = managers in
information
Stock offering signal Negative → managers think stock is
OVERVALUED
Debt issuance signal Positive → managers think stock is
UNDERVALUED