CHAPTER 13

Capital Structure and Leverage

COMPLETE STUDY GUIDE — Verbatim + Logic Connections

📚 TOPICS COVERED IN THIS CHAPTER:

Business Risk vs. Financial Risk | Operating Leverage | Optimal Capital Structure | Capital
Structure Theory (Modigliani-Miller) | Signaling Effects

📍 CHAPTER ROADMAP: How Everything Connects

Understanding capital structure begins with understanding RISK. Here is the logical flow of the entire chapter:

Step Concept Key Question

1 Business Risk How uncertain is our operating income (EBIT)?
2 Operating Leverage How does our cost structure amplify business risk?
3 Financial Risk How does debt add ADDITIONAL risk on top of business risk?
4 Financial Leverage Example What happens to ROE & EPS when we add debt?
5 Optimal Capital Structure What debt level maximizes stock price?
6 Capital Structure Theory What does theory say? What does reality say?
7 Signaling Effects What signals does a firm send by issuing debt vs. stock?

LOGIC: These steps are not random — they build on each other. You can't understand optimal
capital structure without understanding both business risk and financial risk first. The chapter forces
you to master risk before you can master capital decisions.

SECTION 1: Business Risk

1.1 Definition of Business Risk

 Business Risk Uncertainty about future operating income (EBIT), i.e., how well can we
predict operating income?
EBIT Earnings Before Interest and Taxes — the measure of operating
income used to gauge business risk
Key Distinction Business risk does NOT include financing effects — it is purely about
operations

LOGIC: WHY exclude financing effects? Because we want to measure the risk that comes from the
BUSINESS ITSELF — from sales, costs, competition — not from how the company chose to fund
itself. Keeping them separate lets us analyze each type of risk independently.

Visual Concept: Probability Distribution of EBIT

• A NARROW, TALL probability curve = LOW business risk (we can predict EBIT well)
• A WIDE, FLAT probability curve = HIGH business risk (EBIT is unpredictable)

1.2 What Determines Business Risk?

The five determinants of business risk:

• Uncertainty about demand (sales)
• Uncertainty about output prices
• Uncertainty about costs
• Product, other types of liability
• Operating leverage

LOGIC: Notice that 'operating leverage' is listed as a DETERMINANT of business risk — this is why
the next section on operating leverage is placed here. Operating leverage is the one determinant
managers can most directly control through their choice of cost structure.

SECTION 2: Operating Leverage

2.1 Definition

Operating Leverage The use of fixed costs rather than variable costs
High Operating Leverage If most costs are fixed, hence do not decline when demand falls, then
the firm has high operating leverage
Fixed Costs (FC) Costs that remain constant regardless of sales volume
Variable Costs (VC) Costs that rise and fall with sales volume
QBE Break-even quantity — the sales level at which total revenue equals
 total cost

2.2 Effect of Operating Leverage on Business Risk

KEY RULE:
More operating leverage leads to more business risk, for then a small sales decline causes a big
profit decline.

Understanding the graph (two-panel chart from the text):

• LEFT panel (Low Fixed Costs): FC line is LOW; TC line rises steeply (high variable costs); QBE is
reached earlier; profit triangle is small
• RIGHT panel (High Fixed Costs): FC line is HIGH; TC line rises more gradually (lower variable costs);
QBE is further right; profit triangle is LARGER once past break-even

LOGIC: The logic of operating leverage as a double-edged sword: High fixed costs mean you NEED
more sales to break even. But once you pass break-even, profits grow faster. The danger is on the
downside — if sales fall, you still pay those fixed costs, so losses mount quickly.

2.3 Using Operating Leverage — The Trade-Off

From the text's probability distribution diagram:

• Low operating leverage → Lower E(EBIT), narrower distribution (less risk)
• High operating leverage → Higher E(EBIT), wider distribution (more risk)

EXACT QUOTE FROM TEXT:

Typical situation: Can use operating leverage to get higher E(EBIT), but risk also increases.

LOGIC: This is the fundamental trade-off in ALL of finance: more expected return comes with more
risk. Operating leverage is just one specific example of this universal principle. Managers must
decide whether the higher expected EBIT is worth the wider range of possible outcomes.

SECTION 3: Financial Leverage & Financial Risk

3.1 Definitions

Financial Leverage The use of debt and preferred stock

Financial Risk The additional risk concentrated on common stockholders as a result of
financial leverage
 Key Point Financial risk is ADDITIONAL risk — it is layered ON TOP of business
risk

LOGIC: The word 'concentrated' in the definition of financial risk is critical. Debt holders get paid first
and have fixed claims. So when things go wrong, ALL of the additional volatility falls on common
stockholders. Financial leverage doesn't create new risk for the firm overall — it redistributes and
concentrates existing risk onto equity holders.

3.2 Business Risk vs. Financial Risk — Side-by-Side

Dimension Business Risk Financial Risk

Source Business factors: competition, product Types of securities issued (debt vs.
liability, operating leverage equity)
Driver How uncertain is EBIT? How much debt does the firm use?
Relationship More debt → more financial risk More debt → more financial risk
Effect on stockholders Stockholders bear business risk Debt concentrates business risk MORE
on stockholders

SECTION 4: Illustrating Effects of Financial Leverage —

Firm U vs. Firm L

4.1 Setup

Two firms with the same operating leverage, business risk, and probability distribution of EBIT. They 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%

4.2 Income Statement Results

Firm U — Firm U — Firm U — Firm L — Firm L — Firm L —

Bad Avg Good Bad Avg Good
Probability 0.25 0.50 0.25 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000 $2,000 $3,000 $4,000
Interest $0 $0 $0 $1,200 $1,200 $1,200
 EBT $2,000 $3,000 $4,000 $800 $1,800 $2,800
Taxes (40%) $800 $1,200 $1,600 $320 $720 $1,120
Net Income $1,200 $1,800 $2,400 $480 $1,080 $1,680

4.3 Ratio Comparison

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 ∞ ∞ ∞ 1.67x 2.50x 3.30x

4.4 Risk and Return Summary

Measure Firm U Firm L

E(BEP) 15.0% 15.0%
E(ROE) 9.0% 10.8%
E(TIE) ∞ 2.5x
σROE (Risk) 2.12% 4.24%
CVROE 0.24 0.39

4.5 Key Conclusions from the Example

• Basic earning power (BEP) is unaffected by financial leverage

• L has higher expected ROE because BEP > kd
• L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is
accompanied by higher risk

THE RULE for leverage to raise expected ROE:

For leverage to raise expected ROE, must have BEP > kd. If kd > BEP, then the interest expense will
be higher than the operating income produced by debt-financed assets, so leverage will depress
income.

Additionally: As debt increases, TIE decreases because EBIT is unaffected by debt, and interest expense
increases (Int Exp = kdD).

LOGIC: The leverage example perfectly captures the double-edged sword: Firm L has higher
expected ROE (10.8% vs 9.0%) — great! But it also has DOUBLE the risk (σROE 4.24% vs 2.12%)
and a CV of 0.39 vs 0.24. Is more return worth the extra risk? This is the central question of optimal
capital structure.
 SECTION 5: Optimal Capital Structure

5.1 Definition

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 Find It 1) Minimizes WACC 2) Maximizes stock price — Both methods yield
the same results

LOGIC: Why do minimizing WACC and maximizing stock price give the SAME result? Because
stock price = future cash flows / discount rate (WACC). If WACC goes down, the same cash flows
are worth more → stock price goes up. They are mathematically equivalent.

5.2 The Recapitalization Scenario (Campus Deli Example)

Sequence of events in a recapitalization:

• Campus Deli announces the recapitalization
• New debt is issued
• Proceeds are used to repurchase stock
• The number of shares repurchased is equal to the amount of debt issued divided by price per share

5.3 Cost of Debt at Different Debt Levels

Amount Borrowed D/A Ratio D/E Ratio Bond Rating kd

$0 0 0 — —
$250,000 0.125 0.1429 AA 8.0%
$500,000 0.250 0.3333 A 9.0%
$750,000 0.375 0.6000 BBB 11.5%
$1,000,000 0.500 1.0000 BB 14.0%

Why do bond rating and cost of debt depend upon the amount borrowed?

EXACT ANSWER:
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.

5.4 EPS and TIE Calculations at Each Debt Level

Formula used throughout:

EPS = (EBIT − kd × D)(1 − T) ÷ Shares Outstanding
TIE = EBIT ÷ Interest Expense

Base assumptions: EBIT = $400,000; Initial shares = 80,000; Stock price = $25; Tax rate = 40%

D kd Shares Repurchased Shares Remaining EPS TIE

$0 — 0 80,000 $3.00 ∞
$250,000 8% 10,000 70,000 $3.26 20x
$500,000 9% 20,000 60,000 $3.55 8.9x
$750,000 11.5% 30,000 50,000 $3.77 4.6x
$1,000,000 14% 40,000 40,000 $3.90 2.9x

CRITICAL INSIGHT:
What debt ratio maximizes EPS? Maximum EPS = $3.90 at D = $1,000,000, and D/A = 50%. Risk is
too high at D/A = 50%.

5.5 The Hamada Equation — Adjusting Cost of Equity for Leverage

Why do we need the Hamada Equation?

• If the level of debt increases, the riskiness of the firm increases
• The riskiness of the firm's equity also increases, resulting in a higher ks
• 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

βL = βU [ 1 + (1 − T)(D/E) ]

Given: Risk-free rate = 6%; Market risk premium = 6%; βU = 1.0; Total assets = $2,000,000

Example — if D = $250,000:
• βL = 1.0 [1 + (0.6)($250/$1,750)] = 1.0857
• ks = 6.0% + (6.0%)(1.0857) = 12.51%

Full Beta and Cost of Equity Table:

 Amount Borrowed D/A Ratio D/E Ratio Levered Beta ks
$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%

LOGIC: The Hamada Equation shows that as D/E rises, beta rises — making ks rise. This is the
mechanism by which financial risk translates into a higher required return on equity. More debt →
higher equity risk → shareholders demand higher returns → higher ks.

5.6 WACC at Different Debt Levels

Amount D/A Ratio E/A Ratio ks kd(1−T) WACC

Borrowed
$0 0.00% 100.00% 12.00% 0.00% 12.00%
$250,000 12.50% 87.50% 12.51% 4.80% 11.55%
$500,000 25.00% 75.00% 13.20% 5.40% 11.25%
$750,000 37.50% 62.50% 14.16% 6.90% 11.44%
$1,000,000 50.00% 50.00% 15.60% 8.40% 12.00%

5.7 Stock Price at Different Debt Levels

Using zero-growth stock pricing: P0 = EPS / ks = DPS / ks (since all earnings paid as dividends, E(g) = 0, and
EPS = DPS)

Amount Borrowed DPS (= EPS) ks P0 = DPS/ks

$0 $3.00 12.00% $25.00
$250,000 $3.26 12.51% $26.03
$500,000 $3.55 13.20% $26.89 ← MAXIMUM
$750,000 $3.77 14.16% $26.59
$1,000,000 $3.90 15.60% $25.00

OPTIMAL CAPITAL STRUCTURE ANSWER:

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).

LOGIC: EPS peaks at D/A = 50% but STOCK PRICE peaks at D/A = 25%. Why the difference?
 Because stock price accounts for RISK (through ks), but EPS does not. At 50% debt, EPS is highest
but ks is so high (15.6%) that investors discount those earnings heavily. The optimal point is where
the EPS benefit and the risk cost reach their best balance — and that's 25%, not 50%.

5.8 Business Risk and the Optimal Capital Structure

EXACT TEXT:
If there were higher business risk, then the probability of financial distress would be greater at any
debt level, and the optimal capital structure would be one that had less debt. On the other hand,
lower business risk would lead to an optimal capital structure with more debt.

LOGIC: This makes intuitive sense: if your business is already risky (uncertain EBIT), adding
financial risk on top would make things dangerous. A volatile firm should use less debt. A stable firm
(predictable EBIT) can safely carry more debt.

5.9 Other Factors in Setting Target Capital Structure

The text lists 7 factors to consider:

• 1. Industry average debt ratio
• 2. TIE ratios under different scenarios
• 3. Lender/rating agency attitudes
• 4. Reserve borrowing capacity
• 5. Effects of financing on control
• 6. Asset structure
• 7. Expected tax rate

How Specific Factors Affect Target Capital Structure:

Factor Direction of Effect on Debt Usage
Sales stability? More stable → can support MORE debt
High operating leverage? Already high business risk → should use LESS debt
Increase in corporate tax rate? Tax shield more valuable → MORE debt
Increase in personal tax rate? Makes equity relatively more attractive → LESS debt
Increase in bankruptcy costs? Risk of distress more costly → LESS debt
Management spending on lavish perks? Agency cost problem → lenders demand LESS debt be
available

SECTION 6: Capital Structure Theory — Modigliani-Miller

 6.1 MM Irrelevance Theory

WHAT MM SAID:
The 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.

MM Graph Description: The graph shows stock value on the Y-axis and D/A ratio on the X-axis:
• 'No leverage' line: flat baseline
• 'MM result' curve: rises due to tax benefit of debt, then curves down due to bankruptcy costs
• 'Actual' curve: similar shape to MM result but reflects real-world imperfections
• D1 = point where tax benefits peak; D2 = point where bankruptcy costs dominate

LOGIC: MM's insight was revolutionary: without taxes and bankruptcy costs, capital structure is
IRRELEVANT. But reality includes both. The tax shield on debt is valuable (making debt attractive),
but at some point, the probability of bankruptcy makes additional debt too costly. The optimal point is
where marginal tax benefit = marginal bankruptcy cost.

SECTION 7: Signaling Theory

7.1 The Signaling Framework

Two key assumptions:

• Managers have better information about a firm's long-run value than outside investors
• Managers act in the best interests of current stockholders

7.2 What Managers Do — and What It Signals

Manager's Action Why They Do It Market's Interpretation

Issue stock They think stock is OVERVALUED NEGATIVE signal — stock is overpriced
Issue debt They think stock is UNDERVALUED POSITIVE signal — stock is underpriced

KEY QUOTE:
As a result, investors view a common stock offering as a negative signal — managers think stock is
overvalued.

7.3 Implications for Capital Structure

EXACT TEXT:
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.

LOGIC: Signaling theory explains why firms maintain 'reserve borrowing capacity.' If you've already
maxed out your debt, and you need new funding, you're FORCED to issue stock — which sends a
bad signal. By keeping some debt capacity in reserve, a firm retains the ability to raise money
through debt when needed, avoiding the stock-issuance penalty.

SECTION 8: Conclusions on Capital Structure

DIRECT QUOTES FROM TEXT:

1. Need to make calculations as we did, but should also recognize inputs are 'guesstimates.'
2. As a result of imprecise numbers, capital structure decisions have a large judgmental content.
3. We end up with capital structures varying widely among firms, even similar ones in same industry.

LOGIC: The final conclusion is intellectually honest: even with all the theory and math, capital
structure decisions involve significant judgment. The models give us a framework and direction, not a
precise answer. This is why two firms in the same industry can have very different debt ratios and
both be rational.

📊 MASTER SUMMARY: All Key Terms & Formulas

Business Risk Uncertainty about future operating income (EBIT); does NOT include
financing effects
Operating Leverage Use of fixed costs rather than variable costs
Financial Leverage Use of debt and preferred stock
Financial Risk Additional risk concentrated on common stockholders due to financial
leverage
Optimal Capital Structure Mix of debt/preferred/equity that MAXIMIZES P0 (= minimizes WACC)
Target Capital Structure The intended mix with which the firm will raise capital
BEP (Basic Earning EBIT / Total Assets — unaffected by financial leverage
Power)
TIE (Times Interest EBIT / Interest Expense — decreases as debt increases
Earned)
Hamada Equation βL = βU [1 + (1−T)(D/E)] — measures how leverage increases equity
beta
Recapitalization Issue debt → use proceeds to repurchase stock → changes capital
structure
MM Theory At optimal, tax benefits of debt = bankruptcy costs of debt
Signaling Theory Stock issuance = negative signal (stock overvalued); Debt issuance =
positive signal
Reserve Borrowing Keeping debt below maximum to avoid forced stock issuance
Capacity

🧠 LOGIC CHAIN: The Story of Chapter 13 in One Flow

St The Story
a
g
e
A Every firm faces BUSINESS RISK — uncertainty about EBIT from sales, costs, competition
B One key driver of business risk is OPERATING LEVERAGE — more fixed costs = more EBIT volatility
C Managers can layer on FINANCIAL RISK by adding debt — this concentrates risk on stockholders
D Adding debt raises ROE when BEP > kd, but it also raises the cost of equity (higher β via Hamada)
E The OPTIMAL capital structure balances these forces — max P0 where marginal benefit = marginal cost
F MM Theory formalizes this: tax shield benefit vs. bankruptcy cost tradeoff
G SIGNALING theory adds a real-world twist: keep reserve capacity so you never have to issue stock
H In practice: calculations guide us, but judgment dominates — no single answer works for all firms