Leverage & Capital Structure Chap 13 transcript

Hi, welcome to chapter 13. Leverage and capital structure. So in today's chapter our learning goals are going to be to discuss leverage in the capital structure, how the break-even analysis helps us to determine the risks of a company in in calculating operating break-even point and the effects of change on the break-even point. We're going to look at understanding operational, financial, and total leverage and the relationship among those three leveraging factors.

We're going to describe the types of capital, external assessment of capital structure, the capital structure of non-US firms, and the capital structure theory. We're also going to talk about optimal capital structure, how to obtain it, look at some graphs and charts, and some valuation models. We're going to talk about the EBITDA to earnings per share approach for capital structure, and we're going to review the risks and returns of alternate capital structures and linking them to the market value of the stock.

Okay. So first, let's talk about leverage. What is leverage? Well, think of a lever. And a lever is something that gives you additional power. If you think of a traditional lever. But leverage in a business is the effect that fixed costs have on the returns of what the shareholders earn. So the higher leverage generally results in higher but more volatile returns. So leverage basically refers to borrowing money to buy fixed costs to run a business.

So fixed costs, um, they don't rise and fall with the change of production. So think of the rent on a store, uh, monthly insurance, things that are going to be a fixed cost no matter the size of the operation. Now, fixed costs do have to be paid whether the business is is selling products or not selling products. So, just a continuous cost. So, leverage can magnify returns and risks. And the risk is not being able to pay back the leveraged money.

And the additional returns is being able to expand and being able to have a bigger business. The capital structure is a mix of long-term and equity maintained by the firm. So, the firm has multiple sources as we learned in chapter nine to fund their capital pool of the company. So, operating leverage is concerned with the relationship between sales and earnings before interest and tax or what we call operating profits.

So, financial leverage is concerned with the relationship between the operating profits, the EBIT, and the EPS, their earnings per share. And total leverage is the combined effect of operating and financial leverage together. So, looking at the full spectrum from sales to earnings per share. So, this would be the total leverage would be from revenues to earnings per share. And we can break that up into operating and financial leverage within the total leverage group.

Now, the break-even analysis is an important one where we look at the amount of products we need to sell to break even. So, it's looking to put a number on the level operations necessary to cover all the the costs um and evaluate the profitability of various levels of sales. Sometimes also called the cost-volume-profit analysis. So, the break-even point is at which the sales it gives us the sales necessary to cover all the operating cost which um is EBIT.

So, the first step in finding the operating break-even point is divide the cost of goods sold and operating expenses into fixed and variable costs. Fixed costs as we know are are going to be paid in a given period regardless of the amount of products you sell, and variable costs will be tied directly to the sales volume. And that could be the direct material and labor to make the each product. So, you can see how if you make more products, you incur more variable costs.

Okay. So, if we're doing the operating leverage cost and break-even analysis, we can assign these characters or variables to represent the different levels of the income statement. So, the sales revenue is going to be P * Q, which is price * quantity. Less the fixed cost, which is represented by FC, and less the variable cost, which we calculate by our variable costs per unit * units. And then, if we take the the P * Q - the fixed costs - the variable costs, we get the EBIT, or operating profits.

So, now if we want to rearrange this formula, we can rewrite it to solve for the quantity. So, we put fixed costs on top, and we divide by price - variable cost, we'll get the quantity at zero break-even point. So, this will tell us the amount of quantity we need to break even as a company, or the minimum amount we need to sell to not lose any money. So, in this one scenario, if we have 2,500 fixed costs, price of $10 per share, and $5 variable cost, then we wind up needing to sell 500 units to reach the break-even point.

In this chart, uh we can see that same that same formula here. We can kind of display the results here. So, here we have the um the two $2,500 fixed costs. Here are the 500 units in sales, and we can see that it it creates the break-even point. So, um if we just go back up here, and at 500 units, here is the fixed cost, variable cost, so with 500 units. So, now 500 units um is going to bring us to our break-even point.

So, now any say we go to 1,000 units, if we sell 1,000 units, our operating costs will increase, but so will our sales revenue. And you can see how with leverage the the distance between the operating costs and sales revenue uh starts to spread apart, meaning this is the earnings in between the EBIT, operating profits are in between. So, down here, here there's zero. We break even. As we escalate sales revenue by escalating units, we start increasing our EBITs.

And this this widening of costs to sales is showing leverage or increased, you know, earnings as we increase our sales. So, that would be a graphical break-even analysis. So, what's the effect of we increase the increase in variables? So, if fixed costs increase, then the break-even point will increase. And we don't want the break-even point to increase because it means we have to sell more units to break even. If the sales price increases, that's going to decrease the amount of products we need to sell to break even.

And if the variable cost increase, that means we're going to increase the break-even point. Now, the inverse is true if we were decreasing these variables, then it would be a decrease, increase, decrease. As noted here. Okay, so let's do a uh a breakdown on the leverage analysis. So, let's look at Charles Posters, um which is elevate the impact of several option. One, increasing fixed operating costs to 3,000. Well, if they increase the fixed costs to 3,000, then they have to sell 600 units at a price of 10 and a variable cost of five.

What if they increase the sales price to 12.50? Well, if the fixed costs stay the same, they increase the sales price, then we have uh uh we 333 units for the break-even point. And three with the increased the variable cost per unit. So, if they increase the variable cost per unit from five to 7.50, now we need to sell 1,000 units. And four, simultaneously implementing all three of these changes. Increased fixed cost, increased sales price, increased variable cost.

And we wind up getting back to the 600 unit level. So, that's just a quick what-if analysis on different scenarios. Okay. So, you could you could also do this in a break-even analysis in personal finance. If you're looking at at this guy Rick here is considering having new fuel-saving device installed in his car. Such things do exist, uh but manufacturers warn against installing them. Okay. So, the So, installing cost of this device is $240 paid up front, a monthly fee for $15.

Uh he can terminate the use of the device at any time without penalty. So, he estimates the device will reduce his average monthly gas consumption by 20%, which assuming no change in his monthly mileage, we can translate to the savings about $28 per month. So, he's planning to keep the car for 2 more years, and wishes to determine whether he should have the device installed. Okay. So, if we take the the fixed cost of the device and we divide by the $28 a month in his savings per month month minus the monthly fee, we get the fixed the fixed cost of 240 divided by 13, which would be 18.5 months.

And since he's going to have the car for 2 years, which is 24 months, the break-even point would come in 18.5 months, so it would be a yes to doing this. Okay. Now, let's look at operating leverage. So, operating leverage, you know, used to fix operating costs to magnify the effects and changes on sales in the firm's EBIT, or earnings before earnings before interest and tax. So, we can go back to Cheryl's posters. We know that the price of her poster is $10 per unit.

The variable cost is $5 per unit and the fixed operating cost is 2,500. So, let's look at if we put this in a chart, we could say that we have two quantities, quantity one and quantity two. What if she sells 1,000 posters? So, if she sells 1,000 posters, we surpass we make enough to surpass the fixed costs, we make enough to surpass the variable costs uh at the the break-even point at 500. So, then we wind up getting a total operating cost of um this amount, which is 7,800 or so, I'm not sure.

And then we wind up having a sales revenue of 10,000. So, EBIT of 2,500. But, if she moves to selling 15,000 posters, fixed costs don't change. So, because the fixed costs aren't going to be any different from 1,000 to 1,500 the leverage uh because the leveraging effect, now the costs they do go up, but not as much as the sales. So, the sales actually go up to about 15,000 and she winds up netting uh EBIT of 5,000. So, doubling our EBIT when she increases sales by 50%.

So, 100% increase in EBIT and a 50% increase in quantity. So, that that denotes that there's operating leverage. As long as there's different if there's a different change in increase in earnings to the increase in costs, there's operating leverage. Okay, so look at it on more of a numbered scale here, we could see that case one she goes to 1,500 posters. Case two, she goes from 1,000 to 1,500 posters. So, we can see this is the 50% increase in posters.

This 50% increase in posters generates a 100% increase in EBIT. Now, she goes to selling 500 posters, a 50% decrease, we wind up making no earnings, so this becomes a 100% decrease. Okay. So, how do you calculate the degree of operating leverage? Well, it's a numerical measure of the firm's operating leverage. So, we can look at the percentage change in EBIT divided by the percentage change in sales. So, we know that the percentage change in EBIT was 100% and the percentage change in sales was 50%.

So, that would denote degree of operating leverage of two. And as long as the the DOL is greater than one, there's operating leverage. So, in both cases, if we go up five to 1,500 posters, it's an operating leverage of two. If we go down to 500 posters, it's an operating leverage of two for Cheryl's posters. Now, this can also be done using more direct formula to calculate using some of those variables we were you working with before.

We know that Q is quantity, P is price, VC is variable cost, FC is fixed cost. So, taking Cheryl's information on her poster company, we can do 1,000 posters times sell price minus variable divided by 1,000 posters times sales price minus variables minus fixed cost and we get the 5,000 over 25 hundred and that's the the two. So, you can calculate it either way using these variables or the percent percentage change. It's two different ways of calculating operating leverage.

So, uh if we talk about if you look at in the book, there's a vignette on Adobe leverage. So, Adobe Systems makes software. You might be familiar with PDF files, they're the the creator of that format and Adobe Acrobat is one of their programs as well as many other programs including um I think Dreamweaver, maybe Premiere for for editing movies, and Illustrator for illustrating uh pictures. So, it's a pretty big company as far as their their profit their products.

So, they're the second largest PC software company in the United States dominating graphic design imaging uh dynamic media and and tool software markets, authoring tool software markets. Okay, so as demonstrated in the following table, the operating leverage uh magnified by the increase in EBIT 2007, 2010, 2012, while magnifying the decrease in earnings EBIT in 2009. So, 22% increase in 2007 sales resulted in a growth of 39%, but in 2009, the revenues plummeted 17% and effective leveraging what an EBIT declined even faster at 35 uh posting a 35% drop.

Well, okay, so let's move on to the chart. So, this is basically just kind of showing their leverage, so we can see their sales for each of the years and the EBIT for each of the years, and then we can calculate the percentage of change in sales you know, um from a year to year. So, we can see in 2009, sales actually decreased by 17%. And then we can see the percent change in EBIT. So, we can see that the degree of operating leverage was the highest when the sales decreased, and that could be because, you know, fixed costs aren't changing, and a decrease is going to um exacerbate the leverage more than the increases.

Um and in this particular for this particular company for what how their earnings um EBIT works. And we don't know specifically what their fixed to variable costs are, so they both play a factor in calculating this. But this is something that we would want to to take a real company and apply this degree of operating leverage. So, the higher the number, the more operating leverage they have. So, you know, it's interesting as they move forward in time, they start making more sales, if you may you know making more sales and making more EBIT, however, the percent change in sales uh to the percent change in EBIT, you see that there isn't uh as big of a spread between So, when there's a big spread between say 22 and 39, and a smaller spread such as 11 and 10, let's actually go on the walk.

It's a smaller spread. Even 13 to 15, we have a lower percentage. Okay, so just math basic math there. Uh So, we'll go back to Cheryl's posters here. So, if the What is pretty much the same here. Degree of operating leverage is again Now, what if this is a scenario here, the the reduction in variable cost from 5 to 450, and an increase in in fixed costs from 25 to 3,000. So, this is sort of what if scenario. So, what if this does change?

Well, again, we put the numbers that we're just changing the variable and the fixed costs, and we get a lower leverage here due to actually a higher leverage here uh 2.2, because now EBIT is going up to 550, but this the EBIT is still 2,500. So, we have even higher leverage. So, what we can say is, you know, variable costs and fixed costs, depending on their amounts, are going to change the percentage of leverage. So, if we look at this case again, a 50% increase, a 50% decrease when looking at um operating costs here.

So, if we get a 50% decrease in our posters from 1,000 to 500, our EBIT goes from 2,500 to -250, which is a 110% decline. And if we increase our posters by 500, we get a fifth fifth 52 $5,250 increase or 110%. All right. Just looking at these numbers here a little bit. Okay, so this would be the degree uh the percentage degree of operating leverage. All right, so let's move into financial leverage. Okay, so financial leverage.

So, we're looking at the fixed costs and how they're magnified by changes in earnings before interest and tax to earnings per share. So, we're looking at the other side of the income statement. So, two most common fixed financial costs are interest on the debt and preferred stock dividends. So, we'll look at this Chen Foods as an example. They expect the EBIT of 10,000 the current year and has $20,000 bond at 10% annual coupon and a rate of interest as a rate of interest and 600 shares of preferred stock at a $4 dividend.

Now, it also has 10,000 shares of common stock outstanding. The annual interest on the bond is 2,000 and the annual dividends in the preferred stock are 2,400. Okay, so let's look at a change. So, we're starting at this $10,000 EBIT. What happens if we go up 40% and we go down 40%? So, if we go down 40%, the net effect is um earnings per share of zero. And if we have just a $10,000 EBIT, then we have our earnings per share of 240.

And we have cuz we have 1,000 shares. These represents the shares outstanding. And if we go up 40% to 14,000, we're going to have a earnings per share of um earnings available to common shareholders of 4,800 divided by 1,000 shares give us earnings per share of 1480. So, we can see that we're going from 12 $2.40 to 1480 is a 100% increase. And going to zero is a 100% decrease in their financial leverage. So, we could use the percentage change in EPS divided by a percentage change in EBIT.

So, what is the percentage change in earnings per share? Earnings per share went up 100% here. And if we look at EBIT, that went up 40%. So, it would be 100% divided by 40%. So, 100% divided by 40% gives shows us a financial leverage in either direction increasing earnings EBIT or decreasing EBIT, we get a 2.5 percent degree of financial leverage. Now, you can also calculate this using uh other variables. So, we could take uh more you know, more direct formula.

We can take the EBIT divided by EBIT minus interest times the preferred uh dividend. I'm um I'm sorry. Minus the preferred dividend times 1 divided by 1 minus T. So, the in the term 1 divided by 1 minus T converts the after-tax preferred stock dividend to a before-tax amount to make it consistent with the other terms in the equation. So, we just have to do a little tax conversion on the preferred stock dividend. Okay.

So, if we take that example, we know it's 10,000 EBIT. So, we're going to divide by 10,000 EBIT minus the interest minus the uh converted preferred dividend after accounting for tax. So, what we wind up with is 10,000 divided by 4,000 or a leverage of 2.5. So, there's two different ways of calculating a financial leverage. Now, total leverage is going to look at both operating and financial leverage together. So, let's look at Cables Incorporated, a computer cable manufacturer.

Expected sales of 20,000 units at $5 per unit um at $5 per unit coming in the coming year. And must meet the following obligations. It has a variable cost per unit of $2 and a fixed operating cost of 10,000, interest of 20,000, preferred stock dividend of 12,000. And the firm is in the 40% tax bracket and has 5,000 shares of common stock outstanding. So, here's all the variables we need to calculate total leverage. So, we're looking at a 50% What if a 50% increase in sales to 30,000?

Okay? So, EBIT would go from 50 to 80,000, a 60% increase. And if we look at the uh earnings per share, we'd go from 120 to 480, a 300% increase. So, the degree of of operating leverage is we have a 60% increase in EBIT divided by a 50% increase in sales or 1.2. And we have a 300% increase in our earnings per share divided by a 60% increase in EBIT or a degree of financial leverage of five. Now, if you take the 300% increase in earnings per share and divide it by the 50% increase in sales, we get the total leverage.

We can also get the total leverage by taking degree of operating leverage 1.2 and multiplying it by the degree of financial leverage five, which will also give us six. So, the degree of total leverage percent change in earnings per share divided by the percent change in sales, and that would be This is percent change in earnings per share, three 3,000 a 300% and this is the percent change in sales, 50%. So, 300 divided by 50% is the 6%.

Uh and we can also use the the variables. Uh in some problems it may not be able to give you all the full information need, but it might give you variables. Quantity, price, uh variable cost, fixed cost, and interest. And preferred dividend and tax rate. So, if we have these variables, which they gave us earlier, here's a summary of the variables from this company that they listed earlier. If we put that in that formula, we we will also be able to calculate degree of total leverage at six.

Now, like I said before, the degree of total leverage can also be calculated by taking degree of operational leverage and multiplying by degree of financial leverage. So, in this case, the 1.2 * 5 is the degree of total leverage of six. And just moving back here on that chart, that's why I said the 1.2 * the five gives us the six. Okay. So, you see there are there are many ways that you can calculate um this degree of total leverage.

Okay, if we're looking at um focusing on ethics here for a second, uh Lehman Brothers was is an investment bank or was an investment bank before the Great Recession, and they were a major player in the subprime mortgage market. So, in 2008, Lehman Brothers had $32 in debt for each dollar in equity. So, they were highly leveraged, and they used off-balance sheet transactions to hide the extent of this indebtedness to its shareholders.

So, the transactions enabled Lehman to both reduce total liabilities and total assets, allowing the firm to report lower leverage ratios and look even safer um with the start of of of each new quarter. So, Lehman would unwind the transactions and restore the liabilities to their balance sheet. So, um assuming that Lehm- Lehman's uh repo 105 transactions, as they call them, fell within the limits allowed by GAAP, then Lehman's management had That's what Lehman's manager argued.

But what is ethically implication of taking transactions you know, expressively to temporarily hide how much a firm has borrowed? Well, obviously it's unethical. They were making their company look less less risky than they were, and those risks eventually um exploded during the the Great Recession as the subprime market really imploded and thereby ending Lehman Brothers as a company. Um Okay, so let's look at the firm's capital structure and types of capital.

Okay, so all the items to the right-hand side of the firm's balance sheet excluding current liabilities are sources of capital. So, sources of capital, long-term debt, debt capital, and then stock equity, preferred stock, common stock, and retained earnings are equity capital for total capital. So, allowing a following simplified balance sheet um illustrates a basic breakdown of total capital with the two components, debt capital and equity capital.

Okay, so the cost of debt is lower because uh it's generally the lowest cost of financing with some limitations. So, lenders demand relatively low returns because um they take the risk that any um they take the least risk in any contributions to long-term capital. So, lenders are basically uh paid back first. So, they since they're less risky uh in the order of who gets paid first, they have lower rates of return demanded when they lend money to companies.

So, lenders have a higher priority claim against the assets. So, if you're if you're a bondholder, you go before stockholders or equity holders on the assets of the company to get paid back in case the company goes into bankruptcy. Um and they can also have can exert far more legal pressure against a company to make payments than can the owners of common stock. So, they have a they have a tighter control over the company.

And the tax deductibility of interest payments also lowers the the the debt cost to the firm substantially. So, the interest on bonds is tax deductible, which helps to also make them lower cost. Now, unlike debt capital, a firm must eventually repay um or you know, eventually firm has to repay the debt. Depending the bond can be 1 year, 10 years, 30 years, but equity capital remains invested in the firm indefinitely, so that you never have to pay that back.

So, the two basic sources of equity capital would be preferred stock and common stock, which includes uh common stock and retained earnings. And both of these were covered in previous chapters. And preferred stock is preferred cuz it pays a dividend, a guaranteed rate of a dividend. So, common stock is typically the most expensive form of equity cuz it uh followed by retained earnings and then preferred stock. So, preferred stock is cheapest cuz it guarantees a dividend, retained earnings is uh cheaper cuz you don't have to pay dividends on them, and then um but still more expensive than preferred stock, and then the common stock equity is the most expensive.

Now, so, a firm borrowing a very little or a great deal, it's always true that the the claims of the common um stockholders are riskier than the lenders cuz they're the lower on the order of who gets paid back if there's a bankruptcy. So, So, cost of equity always exceeds the cost of debt. And that's why most firms prefer to borrow with debt first before they really go to capital. Now, a direct measure of the degree of indebtment indebtedness of a company would be the the debit ratio.

Or the debt ratio. Uh total liabilities divided by total assets. And the higher the ratio, the greater amount of of financial leverage a company's holding. So, a firm So, when measuring a firm's ability to meet these payments, we can use the times interest earned ratio, which shows us their ability to cover their their interest payments. So, the level of debt financial leverage is acceptable between industries are different for different industries, depending on how risky they are.

Riskier companies aren't able to borrow as much debt compared to less risky companies, which could borrow more debt. So, in the industry, we have we can show you the the average debt ratio or the median debt ratio for the industry, uh and then also the times interest earned ratio for each of the industries. And you can see that educational services are, you know, have a very high times interest earned ratio compared to, say, real estate.

And real estate can borrow, say, actually financial finance insurance can borrow a lot more than, say, educational services. So, these are between industries have different risks, so they're going to have different acceptable rates of debt and coverage. Now, non-US companies have a much higher degree of indebtedness than their US counterparts. So, US companies have typically have had a easier time going public using equity and engage and incorporating equity equity easily into the capital structure.

Foreign companies in other countries outside the US typically have a more traditionally developed commercial banking system, which is set up to lend capital directly to companies and play a larger role in the corporate financing than uh you would have in the United States. So, just a just a difference between the United States um uh a large percentage of our capital financing is equity than overseas, say Europe, a large percentage is debt.

So, now let's talk about some similarities. First, the same industry patterns of capital structure tend to be found around the world. So, the same patterns of industry norms are consistent around the world. Second, capital structures of the largest US-based multinational companies uh which have access to capital markets around the world typically resemble the capital structures of multinational companies from other countries rather than those of smaller US companies.

And finally, worldwide trend is always um is away from relying on banks for financing and towards greater um reliance on security issuance, which issuing their own bonds or issuing stock. Okay, so let's look at leverage around the world. A recent study um the use of long-term debt in 42 countries found that Argentina used more long-term debt more long-term debt than any other country. Relative to assets, firms in Argentina used about 60% more long-term debt than did US companies.

Indian firms were also heavy users of long-term debt as well. And the other end of the spectrum, uh companies from Italy, Greece, and Poland used very little long-term debt. And in those countries, firms paid only about 40% as much long-term debt as it did the US counterparts. So, there are differences around the world. Let's move over to capital structure and capital structure theory. So, there are some theories um that suggest there's an optimal capital structure range.

So, there's an optimal assortment of preferred stock, stock, and debt to make the companies max allow companies to maximize wealth. So, it's not possible to provide managers precise formula on how to do this for determining the optimal capital structure. However, it hasn't stopped finance from making theories that help offer understanding of how capital structures affect the firm's value. So, in 1958, um what we would commonly refer to as M&M, which is uh these um two people that wrote a lot of papers about finance, demonstrated algebraically that assuming perfect markets, which we know there are no perfect markets, the capital structure that a firm chooses does not affect its value.

So, what they were arguing in their paper is that it doesn't matter what the capital structure is. It's not going to really change the value of the stock price of a company. Now, if you look at the effects of restrictive assumptions on the relationship between capital structure and the firm, uh the firm's value, uh first we have to understand what are restrictive assumptions. So, you know, the result of the optimal capital structure based on the balance sheet, the benefits and costs of debt financing.

So, a major benefit of debt financing is a tax shield. So, we get to lower our taxes or not pay tax on the interest payments. Now, the cost of debt financing results in the increased a probability of a of bankruptcy caused by these debt obligations. The agency costs um of the lenders constraining the firm's actions. So, the costs associated with managers having And three, the costs associated with managers having more information about the firm than investors do.

So, here are three um you know, restrictive assumptions. Okay. So, let's just talk about the tax benefits. We know that um Okay. So, this is just to talk about the tax benefits. We know that the borrowing debt has a real big tax advantage. So, firms who are going to be making interest payments can have those interests tax de- deducted. So, basically, we reduce our income by the amount of interest and not have to pay tax on that, which makes us more profitable, as we saw in chapter nine.

Now, the probability of bankruptcy increases cuz the more debt you take on, the riskier company becomes, the risk the riskier it is that you will not be able to pay back your debt, and that can result in the um bankruptcy of the company. Now, if we look at this example, if we talk about the uh software manufacturer uh making capital budgeting decision, they they obtain estimates of sales associated with low levels of earnings before interest and tax from its forecasting group.

And so, there's a 25% chance that the sales will total 400,000, a 50% chance sales will be 600,000, and 25% chance and that sales will be 800,000. So, sort of a pessimistic, most likely, and optimistic scenarios. Pessimistic, most likely, and optimistic scenarios that we talked about in the last chapter, and these the data is summarized, resulting in EBIT calculations in this table. So, at each different revenue position, we wind up getting a different level of EBIT.

So, obviously, the most EBIT is when we sell the most rev- we have selling the most soda. So, the probability of bankruptcy. So, Okay. Now, what is the probability of bankruptcy? Well, it certainly goes up as the financial risk of a company goes up uh and you're just not able to cover. This sort of like if you went out and charged all your credit cards to the max and you owed $1,000 of interest a month, but you only made $800 a month, um you're going to go bankrupt personally.

So, the penalty for not meeting the financial obligation is bankruptcy, which pretty much means the company is done. So, the more fixed cost financing, uh then the more risk in the in the system, the greater financial leverage and risk. So, the total risk of a firm, the business and financial risk combined, is going to determine the probability of bankruptcy. So, uh financial risk is the risk of uh not being able to pay your debt and business risk is the risk that your business is not going to make money.

So, together, that's going to be the total risk of a firm, business and financial risk together. Now, if you look at the current capital structure, zero debt, all common equity. So, total capital and assets is 500,000. So, if we put it on the scale, we can have the scale here where we say percentage of debt ratio. So, right now, zero debt, if we look back here, zero to 500, cuz this is in the thousands. So, zero debt, 500 uh thousand in assets financed by equity gives us and then if we look at what our shares of outstanding stock would be, we would take uh column four divided by $20 a share to get outstanding shares.

So, 25 outstanding shares for this if it's all equity. If we were 60% debt, our total uh we would have 30%, I'm sorry, 300,000, which is 60% of 500,000 in debt and 200,000 in equity, which is the 40% of the 50 500,000. Now, because we have a lot more debt than equity, we're going to have fewer shares outstanding because we have two 200 divided by 20. So, this would just look at the effect of escalating the debt ratio to the amount of outstanding shares.

And this is sort of how the capital structure would change depending on what uh structure would it take? Um 0 100 10% uh 90%. So, so debt to equity. So, I'm just taking what minus from 100. So, 10% minus 100 is 90. 20% minus 100 is 80% equity. So, to calculate that. Okay. Now, if we look at the level of debt and the interest we have to pay, if we're at 10% debt level, we have 50,000 in debt of the 500,000 assets and that's a 9% interest level.

Um so, the interest would be 4.5. If we go up to say 30%, now the interest goes to 10. We're going to 15. If we go to full 60% interest is going to be higher. Why is the interest rate higher? Because it has to compensate for the additional risks and the total interest paid is higher. So, that So, if we look at our debt percentage is zero, we wind up having earnings per share of 0 240 and 480. So, we could say the expected earnings per share is 240, standard deviation is 170, and the coefficient of variation is 71.

If we want to put the little statistics in on this information. So, what if we go up to 30% debt? So, with 30% debt, we now have interest. So, here we had no interest and now we have interest of 15. So, where does this 15 come from? This scale here. So, if we go to 30%, we have um 15 per $15 in interest. Um not percent. So, $15. So, that means that we wind up having a instead of having a zero break even at 25% at um probability at that 25% probability of those sales we mentioned earlier.

Now we have earnings per share of 51 cents negative, 290, and 634. And that changes the expected EPS goes up, standard deviation goes up, and so does the coefficient variation. Now, if the standard deviation and coefficient of variation increase from 170 from 170.71 to 242 and 0.83, that shows more variability, more risk. So even though the leverage did increase our earnings per share, so the leverage increased our earnings per share.

However, um because Why did it increase the earnings per share? Because we have less shares of stock. So when we have zero debt, we have more shares of stock. When we have less debt, see we have 25 shares of stock here with zero debt, only 17 shares of stock with zero with 30% debt. So even though the earnings went from 120 down to 1 11, we still have a higher earnings per share because we have fewer shares. But it's riskier.

If we go to 60% debt, now we only have 10 shares outstanding. So even though the earnings per share um earnings per share 120, 111, and now 90 at the 60 cuz we're paying more in interest. We're paying a lot more in interest. So our earnings are going down. We have a a big loss if our sales are at the lowest, $3 if our 50% percentage um chance up um most likely sales and $9 earnings per share in the most optimistic sales.

So that gives us uh expected EPS of $3.03, but a four a $4 standard deviation and 1.4 coefficient of variation. Very high, very risky. But you can see that, you know, does it pay going up 30% going from 30 to 60% debt, we move from expected EPS of 291 to 303. It's only 14 only a 12% increase for all this additional risk. Is it worth it? So, if we put this on a scale, we could say the earnings per share and this is in the most likely case earnings per share at each debt level.

You can see how it increases, but here it actually increases and then decreases. So, you would say this is more optimal because this is the highest earnings per share. But then we also have, you know, this is also an increased level of risk and standard deviation and coefficient of variation. Okay. So, we plot this on the scale. Here's a probability density. We see that the debt ratio at 0% has earnings has the highest earnings per share or the most most likely earnings per share at 240 at the 0% debt ratio.

At the 60% debt rate debt ratio, we go to $3.03. Uh but we have you see we have a smaller dispersion of likelihood. So, So, let's go see this 240. We had a 25% chance that it would be -51 cents. And a 25 sorry, 25% chance it was -51 cents and a 25% chance it was $6 and change. So, the tighter dispersion on the zero debt. If we go up to 60% debt, yeah, the expected earnings per share is higher, but the dispersion we could lose $4 per share all the way to make $9 per share.

So, there's more risk in the system with the higher debt. Now, as far as the expected earnings per share and the coefficient of variation of earnings per share at a 50% ratio, we have a maximum earnings per share to with the highest level earnings per share at 318, which I was pointing out back here. This 318 at 50% debt. So, If we that on the scale. We see that this is optimal. So, 60% debt give us our most amount of maximizing earnings per share.

So, at a 60% uh debt ratio, we have the highest amount of risk. So, financial risk and business risk. And then at 50%, we have a lower amount of risk. So, as debt decreases, our risk decrease cuz the debt is what gives us our financial risk. All right. Now, let's look at the the capital structure capital structure theory. So, agency costs imposed by the lender. So, we have to remember that managers are agents of a company.

They're agents for the owners. So, the owners give managers the authority to manage the firm firm in their best interests. Now, agency problems develop when the relationship extends not only to the relationship between owners and managers, but now the relationship between owners and lenders. So, to avoid the situation, lenders impose certain monitoring um techniques on borrowers who result to encourage agency who as a result incur agency costs.

So, that means that when you borrow a lot of money from a bank, they're going to want to monitor your company to to better monitor their risk and their investment in you. So, that's going to make an additional factor meaning that you can't do things that are 100% in the owner's best interest cuz you have to now also do things that are in the best interest of the people who lent you money. Okay. So, uh asymmetric information.

This is a situation where managers have more information about the operations and future prospects of the firm than investors do. So, this could be uh a problem in the capital structure. Now, pecking order theory, and I think we go Okay, that's all we talk about here. So, the pecking order theory is sort of putting uh borrowing on a hierarchy. So, it begins with retained earnings followed by debt financing followed by issuing new equity.

So, this would be putting The pecking order would say that the the cheapest form that we could use is the retained earnings um or the easiest form to borrow in would be retained earnings cuz that's money we have from being profitable that we can spend as a company. So, let's see. That would be the first position in the pecking order. Then we follow by debt financing, which is much which is a cheaper financing than equity.

So, equity would be the third. So, we could say that, you know, the capital structure is more based on the pecking order of the managers of the company, what they prefer to do and when raising equity. And that's what determines the the um the capital structure of a company. Now, a third structure theory could be signal. So, based on the actions managers take send a sends a signal to the marketplace. So, if um management were to uh issue a lot of new stock, it would say that it's pretty positive you know, issuing lot of stock is generally um a signal that they want to share the risks with other people.

So, if you issue stock, then you're you're selling some of the ownership in the company and spreading out the risks. Now, if you do a lot of debt financing, it's generally viewed as more positive signal that management believes the stock is undervalued and they're not going to issue new stock because they're not going to get um the value for the stock or that the chances of making money for where they're going to invest this money so good they're going to they really don't want to spread it out on the equity side, so they're going to borrow the money, which be the most optimal or the best effect for the company.

So, borrowing debt is a more positive signal than issuing equity. Sometimes issuing equity could be more of a desperate signal than uh for a company that's uh not able to raise any more debt equity. So, the signaling effect can uh determine the company's financial uh capital structure. So, what about an optimal capital structure? So, how do we calculate an optimal capital structure? So, right now there's only theory.

We don't have a concrete formula that says this is how you make an optimal structure, but we can use this formula here because the value of the firm equals the present values of its cash flow, we could we could take the EBIT times one minus the tax rate divided by R to the A, which is the weighted average cost of capital. So, this formula here EBIT times one minus tax rate is really NOPAT or not net operating profit after tax divided by the weighted average cost of capital will give us the value of the firm.

So, so this is a formula that is similar to the stock valuation formulas from chapter seven. Uh this would be like a zero growth formula, I believe. So, we just modified it here to put it into a a capital structure. So, optimal capital structure would equal whatever point V is at the highest. So, the value when NOPAT divided by the weighted average cost of capital, whatever uh values get us to the highest uh value for the company's valuation would be the optimal level M.

So, at the optimal level of value, we also would have the lowest level of cost for uh cost of capital, uh you know, the weighted average cost of capital and the cost of debt. So, if you take the cost of debt and the cost of equity, we would have the weighted average cost of capital as an average in the middle. So, the optimal capital structure is the point at which the weighted average cost of capital is the lowest would give us the highest valuation for the the firm, and that's mathematically true here.

So, whatever is lowest rate cuz, you know, NOPAT is not going to change in this scenario. What's changing is the rate. So, if the weighted average cost of capital where it's the lowest is going to generate the highest value for the company. Now, there's also this EBIT minus uh to EB uh earnings per share approach. So, this approach looks to select capital structure that maximizes earnings per share over the expected range of EBIT.

So, we can also plot the plot the coordinates um on a graph to assume specific EBIT values and calculate the earnings per share associated with them. So, for such calculations for three capital structures, debt ratio of zero, debt ratio of 30, and a debt ratio of 60% as we investigated before of this company is soda company presented in table 13-2 for EBIT values of 100,000 and 200,000. So, let's find let's look at those associated EPS values uh that are calculated in the graph.

So, here we have the three capital structures, orange, blue, and green, 30 0, 30, and 60%. Now, the earnings per share at 100,000 we'll get 240, 291, and 303. And at 200,000 we'll get 480, 634, and 903. So, if we plot that on a chart, we have our break-even point right here where um at 50 earnings EBIT, which is 50,000 cuz it's in the thousands, is a break-even point. Uh now, as we can see with we start with the orange line the break-even point is uh earnings per share at zero um which would be the debt ratio at zero.

Now, as we in as we increase earnings per share we wind up becoming um if we look in this line the earnings per share increase and um so, debt ratio at 0% we have would have um earnings per share at Let's see, at this point going from 100, so the 100 level, this would be the 240. And at 200 level, this would be the uh two the 480. So, 240 to 480. On the 30% we see that we're going from the 291 to the 634 as mentioned on the scale and on the 60% debt, we go from the at the 100,000 EBIT we go from 303 to 903.

So, you see this has the most amount of this is the has the highest slope here which would mean the most leverage. So, again, this is just looking at this is EBIT to earnings per share and the relationship between the two variables. Okay. So, when interpreting this analysis, it's important to consider the risk of each capital structure. So, graphically the risk of each capital structure can be viewed in two measures.

One, the financial break-even point on the access which is denoted by this square. So, we have a financial break-even point here at 50. And then we have it here at a lower amount and then here we have at zero. Um and then with the degree of financial leverage reflected by the slope of the capital structure line the higher the financial break-even point the steeper the slope. So, the steeper the slope of the capital structure the greater the financial risk.

So, this has the 60% level has the steepest slope. Um it has the of the three, this is the steepest slope. So, this would be the most risky compared to these have much less slopes, the rise over the run. So, that'd be just another way of looking at. So, most important to point out recognize that when using this analysis, the technique tends to concentrate on maximizing earnings per share rather than shareholders wealth.

Um so, the use of EPS maximizing approach generally it risk Uh and because risk premiums increase um with increases in financial leverage, the maximum EPS does not ensure the owners wealth maximum maximization. So, it's really ignoring we're just looking at earnings per share generation here. We're ignoring the risks to get to this $9 earnings per share. We're ignoring the risk of having so much debt. So, it's just just another method to look at.

So, let's So, if you're going to choose an optimal capital structure, we have to determine the uh the firm's value under alternative capital structures. So, how does changing the capital structure change the value of the firms and the level of return it must return to compensate uh owners for the risk. And we have to look at the required return associated with given level of financial risk. Um And it can be estimated in a number of ways.

So, theoretically, the preferred approach would be to estimate a beta and be a beta represent the risk for all alternative capital structures and use the capital asset pricing pricing model to calculate the required rate of return. Uh more operational process involves linking the financial risk associated with each capital structure um alternatives directly to the required rate of return. So, here we have the different percentages of debt in the capital structure and we have the coefficients of earnings per share and the required rate of return.

So, the estimated required rate of return based on the debt ratio in relationship to the coefficient and this would be our using um the scale. This is going to become important later in the estimated returns. Okay. So, we could use Here's the zero growth model. We could use the zero growth model. Uh so, we could the value of the firms associated with alternative capital structure can be estimated using the standard valuation model.

So, we could use the zero growth model here. Earnings per share divided by required rate of return to get the stock price. So, although this relationship exists between profits and value, there's no reason to believe that profit maximization strategies necessarily will result in wealth wealth maximization. So, you know, what it means there is that, you know, you may maximize your earnings per share, but that doesn't always maximize someone's long-term wealth appreciation or maximization.

There is There is a a diff- There's a disconnect there depending on the risks. So, therefore, the wealth of the owners reflected as the estimated share value that uh should serve as a criteria for selecting the best capital. So, that's why we want to take earnings per share relationship to the weighted average cost to the required um return to get the stock price. So, in these cases, if we take the earnings per share and we're dividing by the estimated return, which was back from this table.

So, we put them in here and we can get the estimated stock price per share. So, whereas stock price maximized right here at the 30% level, we get a maximum stock price using that formula. So, if we graph it, the maximum share price here at 23.28 would be preferred. So, that's the maximum share value. Our maximum earnings per share is down here because we used more risk or we had a higher um required rate of return, which is going to uh lower the stock price.

So, this is the perfect representation of maximizing shareholders' wealth, which is maximizing the share price of the of the stock, is different than maximizing the earnings per share based on the risks of the level of debt. So, a 50% debt is riskier, which is going to lower the stock price. And then at 60% debt, we get the even lower estimated share price because the cost of capital is so high. Okay. So, let's look the important factors to consider when making capital structures decisions.

Well, one is the revenues stability. How stable is the revenue? So, utilities that have a very stable base of repetitive revenue can have very high debt levels because the revenue is just so stable and guaranteed. Other industries like say, if you're if you make movies, if you're a movie studio, your your revenue is not as stable. And cash flow, how stable is your cash flow? Again, a utility will have much more stable cash flow than a a seasonal business.

If we look at contractual um obligations as part of agency costs, having more contractual obligations is something to consider in your uh capital structure decision. And management preferences, so what does the management prefer to do in signaling? And uh what is the acceptable in their terms as far as their risk aversion? And what obligations would you have to take on uh by selling additional debt. So, these are all other considerations in formulating your capital structure.

It's not just the numbers that are going to equal the best results. Sometimes you have to also think about how does this affect my business? Yeah, this may be the optimal earnings per share or the optimal stock price, but if I have to really have a high amount of agency costs, then it may not be worth it. Or if I have a high amount of business risk, I don't want to really put myself in obligation to pay back a lot of interest when my revenue and cash flow is less uh stable.

Now, uh also um control of managers as part of this is part of the agency costs. If managers have to give up a lot of control by um raise raising capital in exchange for control of the business, then that's going to be a something that you have to think about also. So, sometimes issuing too much equity could lead to hostile takeovers or different you know, control of the board or voting shares and things of that nature.

So, these things managers have to think about when they're raising capital. And also asymmetric information about what the the the managers know versus what the investors know. And the timing of the interest rates, um when you know, times when interest rates are low, debt financing would be more attractive than when interest rates are high. So, right now we've had a low interest rate environment for a long time. So, companies that actually loaded up more on their debt percentages than in the past cuz debt has become so affordable.

Okay. So, that concludes the chapter and and take some time to review the learning goals that we discussed. They're summarized at the end of the PowerPoint here, um reviewing the learning goals that we just covered in this 1-hour lecture of chapter 13. Uh I hope you enjoyed the lecture and see you next time.