CHAPTER 13
13.1 Leverage
Leverage: Refers to the effects that fixed costs have on the returns that shareholders earn;
higher leverage generally results in higher but more volatile returns.
These fixed costs may be operating costs, or they may be financial costs. Leverage increases
both returns and risks, enabling a company to achieve higher profits but also causing greater
profit volatility. Managers can limit the impact of leverage by adopting strategies that rely
more heavily on variable costs than on fixed costs.
Capital structure: The mix of long-term debt and equity maintained by the firm.
Table 13.1 uses an income statement to highlight where different sources of leverage come
from.
Operating leverage is concerned with the relationship between the firm’s sales revenue and
its EBIT or operating profits.
Financial leverage is concerned with the relationship between the firm’s EBIT and its
common stock EPS.
Total leverage is the combined effect of operating and financial leverage.
❖ Three types of leverage concepts (Operating Leverage, Financial Leverage,
Total Leverage)
First, breakeven analysis, which lays the foundation for leverage concepts by demonstrating
the effects of fixed costs on the firm’s operations.
*Breakeven Analysis (cost-volume-profit analysis): Used to indicate the level of operations
necessary to cover all costs and to evaluate the profitability associated with various levels of
sales. The firm’s operating breakeven point is the level of sales necessary to cover all
operating costs.
The first step in finding the operating breakeven point is to divide the cost of goods sold and
operating expenses into fixed and variable operating costs. Fixed costs are costs that the firm
must pay in a given period regardless of the sales volume achieved during that period.
Variable costs vary directly with sales volume.
Simplifying Equation: EBIT = Q * (P - VC) - FC
P = sale price per unit
FC = fixed operating cost per period
Q = sales quantity in units
VC = variable operating cost per unit
The operating breakeven point is the level of sales at which all fixed and variable operating
costs are covered—the level at which EBIT equals $0.
Q is the firm’s operating breakeven point.
Graphical Approach:
Figure 13.1 presents in graphical
form the breakeven analysis of
the data. At this point, EBIT
equals $0. The figure shows that
for sales below 500 units, total
operating cost exceeds sales
revenue, and EBIT is less than $0
(a loss). For sales above the
breakeven point of 500 units,
sales revenue exceeds total
operating cost, and EBIT is
greater than $0.
Changing Costs and the Operating Breakeven Point
A firm’s operating breakeven point is sensitive to a number of variables: fixed operating cost
(FC), the sale price per unit (P), and the variable operating cost per unit (VC).
An increase in cost (FC or VC)
tends to increase the operating
breakeven point, whereas an
increase in the sale price per unit
(P) decreases the operating
breakeven point.
1. Operating Leverage: The use of fixed operating costs to magnify the effects of changes
in sales on the firm’s earnings before interest and taxes.
Measuring the Degree of Operating Leverage (DOL): The numerical measure of the
firm’s operating leverage.
*As long as DOL is greater than 1,
there is operating leverage.
Fixed Costs and Operating Leverage:
Changes in fixed operating costs affect operating leverage significantly. Firms sometimes can
alter the mix of fixed and variable costs in their operations.
2. Financial Leverage: The use of fixed financial costs to magnify the effects of changes
in earnings before interest and taxes on the firm’s earnings per share. The two most common
fixed financial costs are (1) interest on debt and (2) preferred stock dividends.
Measuring the Degree of Financial Leverage (DFL): The numerical measure of the firm’s
financial leverage.
*Whenever DFL is greater than 1,
there is financial leverage.
A more direct formula for calculating the degree of financial leverage at a base level of EBIT:
3. Total Leverage: The use of fixed costs, both operating and financial, to magnify the
effects of changes in sales on the firm’s earnings per share.
Measuring the Degree of Total Leverage (DTL): The numerical measure of the firm’s total
leverage.
*As long as the DTL is greater than 1,
there is total leverage.
Relationship of Operating, Financial, and Total Leverage
Total leverage reflects the combined impact of operating and financial leverage on the firm.
The relationship between operating leverage and financial leverage is multiplicative
13.2 The Firm’s Capital Structure
Capital structure decisions are critical as they influence the cost of capital, project NPVs, and
the firm's value. Poor decisions raise costs and reduce viable projects, while effective
decisions lower costs, increase NPVs, and enhance firm value.
Types of Capital
All of the items on the right-
hand side of the firm’s balance
sheet, excluding current
liabilities, are sources of capital.
The following simplified
balance sheet illustrates the
basic breakdown of total capital
into its two components, debt
capital and equity capital:
External Assessment of Capital Structure
Financial leverage results from the use of fixed-cost financing. The amount of leverage in the
firm’s capital structure can affect its value by affecting return and risk. Those outside the firm
can make a rough assessment of capital structure by using measures found in the firm’s
financial statements. For example, a direct measure of the degree of indebtedness is the debt
ratio. The higher this ratio is, the greater the relative amount of debt (or financial leverage) in
the firm’s capital structure. Measures of the firm’s ability to meet contractual payments
associated with debt include the times interest earned ratio (EBIT : interest) and the fixed
payment coverage ratio. These ratios provide indirect information on financial leverage.
Generally, the smaller these ratios, the greater the firm’s financial leverage and the less able it
is to meet payments as they come due.
Capital Structure of Non-US Firms
In general, non–U.S. companies have much higher degrees of indebtedness than their U.S.
counterparts.
Reason: U.S. capital markets are more developed than those elsewhere and have played a
greater role in corporate financing than has been the case in other countries.
In Europe, Japan, and Pacific Rim nations, commercial banks are more involved in corporate
financing and can make equity investments in nonfinancial firms, unlike in the U.S. Tighter
ownership structures in these regions allow better financial oversight, enabling higher
tolerance for corporate indebtedness.
Despite differences, U.S. corporations share similarities with global firms in capital structure
patterns. Industries worldwide exhibit similar debt usage, with high-growth firms relying less
on debt due to intangible assets, unlike asset-heavy industries. Large multinational
corporations often have similar capital structures globally, borrowing more than smaller
firms. Riskier or highly profitable firms tend to borrow less. Additionally, there is a global
shift from bank financing to security issuance, likely reducing capital structure differences
over time.
Capital Structure Theory
Research suggests there is an optimal capital structure, but no precise method for determining
it. Modigliani and Miller's theory in 1958 argued that, in perfect markets, capital structure
doesn’t affect a firm's value. However, under less restrictive assumptions, an optimal capital
structure emerges by balancing the benefits and costs of debt. The benefits include the tax
shield from deductible interest payments, while the costs stem from increased bankruptcy
risk, agency costs from lender constraints, and information asymmetry between managers and
investors.
*Tax Benefits
Allowing firms to deduct interest payments on debt when calculating taxable income reduces
the amount of the firm’s earnings paid in taxes, thereby making more earnings available for
bondholders and stockholders.
ri = cost of debt
rd = before-tax cost of debt
T = tax rate
*Profitablity of Bankruptcy
Depending largely on its levels of both business risk and financial risk.
Business Risk: the risk to the firm of being unable to cover its operating costs. In general, the
greater the firm’s operating leverage—the use of fixed operating costs—the higher its
business risk. The higher a firm’s business risk, the more cautious the firm must be in
establishing its capital structure. Firms with high business risk there fore tend toward less
highly leveraged capital structures, and firms with low business risk tend toward more highly
leveraged capital structures.
Financial Risk: the risk to the firm of being unable to cover required financial obligations.
The penalty for not meeting financial obligations is bankruptcy. The more fixed-cost
financing (debt and preferred stock) a firm uses, the higher its financial leverage and risk.
Financial risk is influenced by the firm's capital structure, which is in turn shaped by the
business risks it faces.
Total Risk: The total risk of a firm—business and financial risk combined—determines its
probability of bankruptcy.
Agency Costs Imposed by Lenders
The agency problem arises when the interests of owners and lenders diverge. Lenders face
the risk that managers, acting on behalf of shareholders, might pursue risky strategies that
benefit shareholders at the expense of lenders. To mitigate this risk, lenders often impose
restrictions on borrowers, such as limiting the firm's ability to take on additional debt or
invest in risky projects. These restrictions, while necessary to protect lenders, can increase the
cost of borrowing for the firm. Thus, there's a delicate balance between protecting lenders
and ensuring that the firm can access capital at a reasonable cost.
Asymmetric Information: The situation in which managers of a firm have more information
about operations and future prospects than do investors.
Managers often face challenges in raising funds for profitable investment opportunities due to
information asymmetry. Investors may be skeptical about management's claims, leading to a
discount in the stock price. To avoid this, managers may prefer to use retained earnings
(financial slack) to finance investments. When financial slack is insufficient, debt financing is
often favored over equity financing. Debt provides a fixed return to lenders, allowing
shareholders to capture the upside potential of successful investments without diluting their
ownership.
Pecking order: A hierarchy of financing that begins with retained earnings, which is followed
by debt financing and finally external equity financing. The pecking order theory explains
that firms primarily fund new investments with retained earnings, raising external financing
infrequently. When external financing is needed, firms tend to raise debt more often than
equity. Additionally, profitable firms, with ample financial slack, typically borrow less than
unprofitable firms.
Signal: A financing action by management that is believed to reflect its view of the firm’s
stock value; generally, debt financing is viewed as a positive signal that management believes
the stock is “undervalued,” and a stock issue is viewed as a negative signal that management
believes the stock is “overvalued”.
Optimal Capital Structure
Thethe present value of future cash flows is at its highest when the discount rate (the cost of
capital) is at its lowest.
If we assume that NOPAT (and
therefore EBIT) is constant, the value of
the firm, V, is maximized by
minimizing the weighted average cost
of capital, ra.
Cost Function
Figure 13.5(a) plots three
cost functions—the cost of
debt, the cost of equity, and
the weighted average cost
of capital (WACC)—as a
function of financial leverage
measured by the debt ratio
(debt to total assets).
The cost of debt remains low due to the tax shield but rises gradually with higher leverage to
compensate for increased risk.
The cost of equity is higher than debt and increases more rapidly as leverage rises, as
stockholders demand a higher return to offset the higher financial risk.
The weighted average cost of capital (WACC) initially decreases as debt is substituted for
equity because the after-tax cost of debt is lower than equity. The tax benefits of additional
debt outweigh the borrowing costs at lower debt ratios. However, as the debt ratio continues
to rise, the increased debt and equity costs eventually cause the WACC to rise due to
bankruptcy, agency, and other costs. This results in a U-shaped WACC curve.
Graphical View of Optimal Structure
Optimal capital structure: The capital structure at which the weighted average cost of capital
is minimized, thereby maximizing the firm’s value.
In Figure 13.5(a), point M
represents the minimum
WACC, indicating the optimal
financial leverage and capital
structure for the firm. Figure
13.5(b) shows that at this
optimal capital structure
(point M), the firm's value is
maximized at V*.
Minimizing the WACC
allows firms to undertake more profitable projects, increasing their value. However, since the
precise optimal capital structure is difficult to calculate and maintain, firms typically aim to
operate within a range close to their target capital structure.
13.3 EBIT–EPS Approach to Capital Structure
- The EBIT–EPS approach to capital structure involves selecting the capital structure that
maximizes EPS over the expected range of earnings before interest and taxes (EBIT).
PRESENTING A FINANCING PLAN GRAPHICALLY
- To analyze the effects of a firm’s capital structure on the owners’ returns, we consider the
relationship between earnings before interest and taxes (EBIT) and earnings per share (EPS).
In other words, we want to see how changes in EBIT lead to changes in EPS under different
capital structures.
- We will assume that business risk remains constant. That is, the firm’s basic operational risks
remain constant, and only financial risk varies as capital structures change. EPS is used to
measure the owners’ returns, which are expected to be closely related to share price.
Data Required
To draw a graph illustrating how changes in EBIT lead to changes in EPS, we
simply need to find two coordinates and plot a straight line between them. On
our graph, we will plot EBIT on the horizontal axis and EPS on the vertical axis.
CONSIDERING RISK IN EBIT–EPS ANALYSIS
- When interpreting EBIT–EPS analysis, it is important to consider the risk of each
capital structure alternative. Graphically, the risk of each capital structure can be
viewed in light of two measures: (1) the financial breakeven point (EBIT-axis
intercept) and (2) the degree of financial leverage reflected in the slope of the cap-
ital structure line: The higher the financial breakeven point and the steeper the
slope of the capital structure line, the greater the financial risk.
- Further assessment of risk can be performed by using ratios. As financial leverage (measured
by the debt ratio) increases, we expect a corresponding decline in the firm’s ability to make
scheduled interest payments (measured by the times interest earned ratio).
BASIC SHORTCOMING OF EBIT–EPS ANALYSIS
- The most important point to recognize when using EBIT–EPS analysis is that this technique
tends to concentrate on maximizing earnings rather than maximizing owner wealth as
reflected in the firm’s stock price.
- The use of an EPS-maximizing approach generally ignores risk. If investors did not require
risk premiums (additional returns) as the firm increased the proportion of debt in its capital
structure, a strategy involving maximizing EPS would also maximize stock price. But because
risk premiums increase with increases in financial leverage, the maximization of EPS does
not ensure owner wealth maximization.
- To select the best capital structure, firms must integrate both return (EPS) and risk (via the
required return, rs) into a valuation framework consistent with the capital structure theory
presented earlier.
13.4 Choosing the Optimal Capital Structure
- A wealth maximization framework for use in making capital structure decisions should
include the two key factors of return and risk. This section describes the procedures for
linking to market value the return and risk associated with alternative capital structures.
LINKAGE
- To determine the firm’s value under alternative capital structures, the firm must
find the level of return that it must earn to compensate owners for the risk being
Incurred.
- The required return associated with a given level of financial risk can be estimated in a
number of ways:
+ Theoretically, the preferred approach would be first
to estimate the beta associated with each alternative capital structure and then to use the CAPM
framework to calculate the required return, rs.
+ A more operational approach involves linking the financial risk associated with
each capital structure alternative directly to the required return. Here it involves
estimating the required return associated with each level of financial risk, as
measured by a statistic such as the coefficient of variation of EPS.
- Regardless of the approach used, one would expect the required return to increase as the
financial risk increases.
ESTIMATING VALUE
- The value of the firm associated with alternative capital structures can be estimated by using
one of the standard valuation models. If, for simplicity, we assume that all earnings are paid
out as dividends, we can use a zero-growth valuation model:
P0
MAXIMIZING VALUE VERSUS MAXIMIZING EPS
- Although some relationship exists between expected profit and value, there is no reason to
believe that profit-maximizing strategies necessarily result in wealth maximization. It is
therefore the wealth of the owners as reflected in the estimated share value that should serve
as the criterion for selecting the best capital structure.
SOME OTHER IMPORTANT CONSIDERATIONS
- Because there is really no practical way to calculate the optimal capital structure, any
quantitative analysis of capital structure must be tempered with other important
considerations.
Important Factors to Consider in Making Capital Structure Decisions
Concern Factor Description
Business risk Revenue stability Firms that have stable and
predictable revenues can more
safely undertake highly
leveraged capital structures
than can firms with volatile
patterns of sales revenue. Firms
with growing sales tend to
benefit from added debt; they
can reap the positive benefits of
financial leverage, which
magnifies the effect of these
increases.
Cash flow When considering a new
capital structure, the firm must
focus on
its ability to generate the cash
flows necessary to meet
obligations. Cash forecasts
reflecting an ability to service
debts (and preferred stock)
must support any shift in
capital structure.
Agency costs Contractual obligations A firm may be contractually
constrained with respect to the
type of funds that it can raise.
For example, a firm might be
prohibited from selling
additional debt except when the
claims of holders of such debt
are made subordinate to the
existing debt. Contractual
constraints on the sale of
additional stock, as well as on
the ability to distribute
dividends on stock, might also
exist.
Management preferences Occasionally, a firm will
impose an internal constraint
on the use
of debt to limit its risk
exposure to a level deemed
acceptable to
management. In other words,
because of risk aversion, the
firm’s management constrains
the firm’s capital structure at a
level that may or may not be
the true optimum.
Control A management group
concerned about control may
prefer to issue
debt rather than (voting)
common stock. Under
favorable market
conditions, a firm that wanted
to sell equity could make a
preemptive offering or issue
nonvoting shares, allowing
each
shareholder to maintain
proportionate ownership.
Generally, only
in closely held firms or firms
threatened by takeover does
control
become a major concern in the
capital structure decision.
Asymmetric information External risk assessment The firm’s ability to raise funds
quickly and at favorable rates
depends on the external risk
assessments of lenders and
bond
raters. The firm must consider
the impact of capital structure
decisions both on share value
and on published financial
statements from which lenders
and raters assess the firm’s
risk.
Timing At times when interest rates are
low, debt financing might be
more
attractive; when interest rates
are high, the sale of stock may
be
more appealing. Sometimes
both debt and equity capital
become
unavailable at reasonable
terms. General economic
conditions—
especially those of the capital
market—can thus significantly
affect
capital structure decisions.