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Financial Leverage and

Capital Structure Policy

The Effect of Leverage

How does leverage affect the EPS and ROE?

• When we increase the amount of debt financing, we increase

the fixed interest expense
• If we have a really good year, then we pay our fixed cost and
we have more left over for our stockholders
• If we have a really bad year, we still have to pay our fixed costs
and we have less left over for our stockholders

Leverage amplifies the variation in both EPS and ROE

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Business and Financial Risk

• Business Risk - Uncertainty inherent in the firm’s
operations if it used no debt.

• Major Factors Affecting Business Risk:

– Total sales variability
– Total fixed operating expenses

• Financial Risk – Additional risk incurred through

the use of debt financing.

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• Firms with low business risk can take on more

financial risk.
• Firms with high business risk usually minimize
financial risk in order to keep total risk at
acceptable levels.

Impact of Operating Leverage on Profits

ABC PQR
Sales $10 $10
Operating Costs
Fixed 7 2
Variable 2 7
Operating Profit 1 2

Now, subject each firm to a 100% increase

in sales for next year. Which firm is
risky?

OL= (EBITt - EBIT t-1) / EBIT t-1

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Break-Even Point

ABC wants to determine break-even points

when:
Fixed costs: $100,000
SP: $43.75 each
Variable costs: $18.75 per UNIT

Break-Even Chart
Total Revenues

Profits
REVENUES AND COSTS

250

Total Costs
175

Fixed Costs
100
Losses
Variable Costs
50

0 1,000 2,000 3,000 4,000 5,000 6,000 7,000

QUANTITY PRODUCED AND SOLD

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Degree of Operating Leverage (DOL)

The % change in a firm’s operating profit (EBIT)

resulting from a 1 percent change in output.

DOL at Q %  in EBIT
DOL =
units of %  in Sales
Q( P − V ) S − VC
output = =
Q( P − V ) − F S − VC − F
(or sales) S − VC
=
EBIT

DFL and DCL

%  in EPS %  in EBIT
DFL = DOL =
%  in EBIT %  in Sales
EBIT Q( P − V ) S − VC
= = =
EBIT - I Q( P − V ) − F S − VC − F
S − VC
%  in=EPS
DCL = EBIT
%  in Sales
Q( P − V )
=
Q( P − V ) − F − I
S − VC S − VC
= =
S − VC − F − I EBT
 %  in EBIT  %  in EPS 
=  
 %  in Sales  %  in EBIT 
= (DOL)(DFL)

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Workout
New Old
Sales (33,000 units @ $25) $ 825,000 $ 750,000
- Variable costs ($7 per unit) (231,000) (210,000)
- Fixed costs (270,000) (270,000)
EBIT $ 324,000 $ 270,000
- Interest expense (170,000) (170,000)
EBT $ 154,000 $ 100,000
- Taxes ( 52,360) (34,000)
EAT $ 101,640 $ 66,000

EPS = $101,640/20,000 = $5.08 EPS = $3.30

%  in EPS %  in EBIT
DFL = DOL =
%  in EBIT %  in Sales
EBIT Q( P − V ) S − VC
= = =
11 EBIT - I Q( P − V ) − F S − VC − F
S − VC
=
EBIT

Capital Structure Theory

• Modigliani and Miller (M&M)Theory of
Capital Structure
– Proposition I – firm value
– Proposition II – WACC
• The value of the firm is determined by the
cash flows to the firm and the risk of the
assets
• Changing firm value
– Change the risk of the cash flows
– Change the cash flows

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A company has 200 mn cash flows. Expected growth

is 3% p.a. Calculate firm value for each case. Graph.

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Figure

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EBIT-EPS Break-Even,
or Indifference, Analysis
EBIT-EPS Break-Even Analysis -- Analysis of
the effect of financing alternatives on earnings
per share. The break-even point is the EBIT
level where EPS is the same for two (or more)
alternatives.

Calculate EPS for a given level of EBIT at a

given financing structure.
(EBIT - I) (1 - t) - Pref. Div.
EPS =
# of Common Shares

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EBIT-EPS Chart

BMW has $2 million in LT financing (100%

common stock equity).
• Current common equity shares = 50,000
• $1 million in new financing of either:
– All C.S. sold at $20/share (50,000 shares)
– All debt with a coupon rate of 10%
• Expected EBIT = $500,000
• Income tax rate is 30%

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EBIT-EPS Calculation with

New Equity Financing
Common Stock Equity Alternative
EBIT $500,000 $150,000*
Interest 0 0
EBT $500,000 $150,000
Taxes (30% x EBT) 150,000 45,000
EAT $350,000 $105,000
EACS $350,000 $105,000
# of Shares 100,000 100,000
EPS $3.50 $1.05

* Assume $150,000 EBIT

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EBIT-EPS Chart

6
Earnings per Share ($)

4 Common
3

0
0 100 200 300 400 500 600 700

EBIT ($ thousands)

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EBIT-EPS Calculation with

New Debt Financing
Long-term Debt Alternative
EBIT $500,000 $150,000*
Interest 100,000 100,000
EBT $400,000 $ 50,000
Taxes (30% x EBT) 120,000 15,000
EAT $280,000 $ 35,000
EACS $280,000 $ 35,000
# of Shares 50,000 50,000
EPS $5.60 $0.70

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EBIT-EPS Chart

6 Debt
Earnings per Share ($)

5
Indifference point
between debt and
4
common stock
Common
3 financing

0
0 100 200 300 400 500 600 700
EBIT ($ thousands)

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Capital Structure Theory Under

Three Special Cases
• Case I – Assumptions
– No corporate or personal taxes
– No bankruptcy costs
• Case II – Assumptions
– Corporate taxes, but no personal taxes
– No bankruptcy costs
• Case III – Assumptions
– Corporate taxes, but no personal taxes
– Bankruptcy costs

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Case I – Propositions I and II

• Proposition I
– The value of the firm is NOT affected by
changes in the capital structure
– The cash flows of the firm do not
change; therefore, value doesn’t
change
• Proposition II
– The WACC of the firm is NOT affected
by capital structure

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Case I - Equations
• WACC = RA = (E/V)RE + (D/V)RD

• RE = RA + (RA – RD)(D/E)

– RA is the “cost” of the firm’s business risk, i.e.,

the risk of the firm’s assets
– (RA – RD)(D/E) is the “cost” of the firm’s
financial risk, i.e., the additional return required
by stockholders to compensate for the risk of
leverage

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Figure 16.3

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Case I - Example
• Data
– Required return on assets = 16%; cost of debt = 10%;
percent of debt = 45%
• What is the cost of equity?
– RE = 16 + (16 - 10)(.45/.55) = 20.91%
• Suppose instead that the cost of equity is 25%, what
is the debt-to-equity ratio?
– 25 = 16 + (16 - 10)(D/E)
– D/E = (25 - 16) / (16 - 10) = 1.5
• Based on this information, what is the percent of
equity in the firm?
– E/V = 1 / 2.5 = 40%

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The CAPM, the SML and

Proposition II
• How does financial leverage affect systematic
risk?
• CAPM: RA = Rf + A(RM – Rf)
– Where A is the firm’s asset beta and measures the
systematic risk of the firm’s assets
• Proposition II
– Replace RA with the CAPM and assume that the debt is
riskless (RD = Rf)
– RE = Rf + A(1+D/E)(RM – Rf)

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Business Risk and

Financial Risk
• RE = Rf + A(1+D/E)(RM – Rf)
• CAPM: RE = Rf + E(RM – Rf)
– E = A(1 + D/E)
• Therefore, the systematic risk of the stock
depends on:
– Systematic risk of the assets, A, (Business
risk)
– Level of leverage, D/E, (Financial risk)

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Case II – Cash Flow

• Interest is tax deductible
• Therefore, when a firm adds debt, it
reduces taxes, all else equal
• The reduction in taxes increases the
cash flow of the firm
• How should an increase in cash
flows affect the value of the firm?

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Case II - Example
Unlevered Firm Levered Firm

EBIT 5,000 5,000

Interest 0 500
Taxable 5,000 4,500
Income
Taxes (34%) 1,700 1,530
Net Income 3,300 2,970
CFFA 3,300 3,470

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Interest Tax Shield

• Annual interest tax shield
– Tax rate times interest payment
– 6,250 in 8% debt = 500 in interest expense
– Annual tax shield = .34(500) = 170
• Present value of annual interest tax shield
– Assume perpetual debt for simplicity
– PV = 170 / .08 = 2,125
– PV = D(RD)(TC) / RD = DTC = 6,250(.34) = 2,125

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Case II – Proposition I
• The value of the firm increases by the
present value of the annual interest tax
shield
– Value of a levered firm = value of an unlevered
firm + PV of interest tax shield
– Value of equity = Value of the firm – Value of
debt
• Assuming perpetual cash flows
– VU = EBIT(1-T) / RU
– VL = VU + DTC

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Example: Case II –
Proposition I
• Data
– EBIT = 25 million; Tax rate = 35%; Debt = $75
million; Cost of debt = 9%; Unlevered cost of
capital = 12%
• VU = 25(1-.35) / .12 = $135.42 million
• VL = 135.42 + 75(.35) = $161.67 million
• E = 161.67 – 75 = $86.67 million

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Case II – Proposition II
• The WACC decreases as D/E increases
because of the government subsidy on
interest payments
– RA = (E/V)RE + (D/V)(RD)(1-TC)
– RE = RU + (RU – RD)(D/E)(1-TC)
• Example
– RE = 12 + (12-9)(75/86.67)(1-.35) = 13.69%
– RA = (86.67/161.67)(13.69) + (75/161.67)(9)(1-
.35)
RA = 10.05%

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