CHAPTER 14
CAPITAL STRUCTURE AND LEVERAGE
FOCUS Capital structure can influence influence the the value value of a firm. Our focus is on understanding understanding why that's that's true true and what we can and can't do with the knowledge. The ideas are developed through a detailed illustration illustration that shows the performance and risk implications implications of financial leverage. Later in the chapter we explore the theoretical approach to the same issue and see that the conclusions conclusions reached are similar. Along the way we examine the concept of operating leverage and see how it interacts with financial leverage. PEDAGOGY The ideas behind capital capital structure and leverage leverage are taught taught on two levels the practical and the theoretical. A practical practical understanding is developed using an example illustrating how leverage helps recorded financial performance if the firm is doing well but hurts it if operating operating results are poor. !e then describe how this effect influences risk"averse investors in their #uest for returns. The pedagogical challenge of capital structure is presenting the $$ theory in a way the average person can understand. understand. The theory's math math is difficult and its its notation is unusual unusual creating two factors that combine to bewilder most students students immediately. immediately. %evertheless the theory is an important pillar pillar in the structure of finance and should be at least appreciated by anyone seriously in the field. The presentation of the the sub&ect sub&ect is one of of the defining features of this this book. book. The ideas are developed slowly slowly beginning with notation. notation. tudents are brought to an appreciation of what $$ accomplished accomplished and why it's important without without advanced mathematics. At the end they can hold their own in a discussion discussion of the independence theory theory arbitrage and the effects of taxes and bankruptcy costs. costs. Their understanding understanding is graphic and intuitive rather than mathematically rigorous but it's all they'll ever need. TEACHING OBJECTIVES tudents should gain an understanding understanding of the interrelations among capital structure financial results stock market prices and risk. They should also be able to #uantify and roughly measure measure the risk and performance implications implications of policy decisions regarding capital and cost structure. OUTLINE
(
)AC*+,O-% Terms Terms are defined and the idea that capital structure can influence financial performance is introduced. A. The The Cen Centr tral al (ssu (ssuee Can capital structure influence stock price and the market value of the firm/ 0urther is there an optimal structure that maximi1es value/ ). ,isk ,isk in the the Conte Context xt of of Levera Leverage ge ,edefining risk as variation in 2)(T and 23. C. Leverage Leverage and ,isk " Two Two *inds *inds of 2ach Operating and financial leverage business business and financial risk. -nderstanding the natu nature re of each.
((. ((. 0(%A 0(%A%C %C(A (AL L L242, L242,A+ A+2 2 A. The 2ffec 2ffectt of 0inanci 0inancial al Levera Leverage ge 5ow financial leverage amplifies performance as measured by ,O2 and 23 " developed through a detailed illustration. illustration. !hen leverage helps and when it hurts. ). 0inancial 0inancial Leverage Leverage and 0inancial 0inancial ,isk Tying Tying leverage to the notion of risk as variation in performance. C. 3utting 3utting the (deas (deas Tog Togethe etherr " The 2ffect 2ffect on on tock 3rice 3rice 5ow investors react to performance variations variations and the effect on stock prices. The practical 667
66<
Capital tructure and Leverage difficulty of finding an optimal capital structure. . The egree egree of 0inancial 0inancial Leverage Leverage 80L9 " A $easurement $easurement The 0L concept. concept. -sing 0L to predict results and measure risk. 2. 2)(T 2)(T""23 23 Analy nalysi siss -sing leverage concepts to determine an appropriate capital structure given management's expectations about 2)(T.
(((. O32,AT O32,AT(%+ L242,A+2 L242,A+2 A. Termino Terminology logy and efinition efinitionss Cost structure " fixed and variable defining operating leverage as the use of fixed costs. ). )rea )reake keve ven n Analy nalysi siss The breakeven techni#ue graphically and algebraically C. The 2ff 2ffect ect of of Operat Operating ing Leve Leverag ragee -sing breakeven concepts to understand how operating leverage affects 2)(T when volume changes. . The egree egree of Operating Operating Leverage Leverage 8OL9 8OL9 " A $easurement $easurement The OL concept. -sing OL to to predict results and measure risk. 2. Comparing Comparing Operating Operating and 0inancial 0inancial Leverage Leverage A detailed comparison of the concepts showing similarities and differences. 0. The Compound Compounding ing 2ffect 2ffect of Operating Operating and 0inancial 0inancial Leverage Leverage The effect of the two leverages is multiplicative multiplicative and acting together can make a company very risky. The egree of Total Total Leverage 8TL9 concept. (4. CA3(TAL CA3(TAL T,-CT-,2 T,-CT -,2 T52O,: T52O ,: 0ormal financial theory approaches the capital structure issue differently but arrives at basically the same result. A. )ackground )ackground " The 4alue of the 0irm -nderstanding the theory's notation ). The 2arly Theory Theory by $odiglia $odigliani ni and $iller $iller The basic $$ model its restrictive assumptions assumptions and its results. C. ,elaxing ,elaxing the the Ass Assumpt umptions ions " $ore $ore (nsight (nsightss The effect of including taxes and bankruptcy costs. The $$ approach arrives at the same result as the intuitive approach for somewhat different reasons. . An (nsight (nsight into $ergers $ergers and Ac#uisi Ac#uisition tionss The value added by financial leverage as a &ustification for paying premiums in ac#uisitions.
QUESTIONS
7. The user user of levera leverage ge might might be though thoughtt of of as as taki taking ng advant advantage age of the provid provider er.. )etwee )etween n stockholders and bondholders bondholders who is the user and who is the provider/ +ive a word explanation or illustration that might might support this view. view. !hat does the used party get in return/ bondholders. The stockholders through through ANSWER: tockholders use leverage provided by bondholders. management undertake pro&ects using their own and bondholders; money. money. The rewards of success accrue mainly to stockholders while the penalty penalty for total failure is shared by both. This seeming unfairness is the sense in which the user of leverage takes advantage of the provider. 5owever bondholders bondholders are protected against moderate failure failure which mainly hurts stockholders. stockholders. This is because interest payments must be made regardless of profitability. profitability.
666
Capital tructure and Leverage
This safety under a wide range of poor performance short of disaster is what bondholders get in return for providing leverage. <. The central issue underlying the study of leverage is whether or not it influences stock price and whether there's an optimal structure. )ut the whole idea seems kind of fu11y and uncertain. !hy are people so interested/ 8 Hint = Think of management's goals and of the world of mergers.9 ANSWER: A great deal of money can be made very #uickly if a change in leverage can have an immediate and substantial impact on stock price. (n merger situations ac#uiring firms often borrow the money to purchase firms being ac#uired. (f the resulting increase in leverage of the combined organi1ation has a positive effect on stock price the stockholders of both companies can get rich virtually overnight.
6.
,elate business and financial risk as defined in this chapter to the risks described in Chapter >.
ANSWER: The risks discussed in this chapter relate to variations in a firm's financial results. )usiness risk is variation in 2)(T. 0inancial risk is the increase in variation found between 2)(T and 23 and ,O2 if financial leverage is present. (n other words these risks are found within the firm's financial statements. The concepts in Chapter > were broader in that they addressed an investor's return. That return can be influenced by recorded financial results as well as by other things that don't show up on a company's books. 0or example an economic recession depresses stock prices and therefore investor returns but may not influence profitability as seen in 2)(T ,O2 or 23. The risks in Chapter > include the risks discussed here.
?.
!hy are ,O2 and 23 such important measures of performance to investors/
ANSWER: ,O2 is an indication of the total performance of a company including both operating and financing issues. ince people invest only for money the return on what's invested is of fundamental importance. 23 taken along with stock price gives an indication of the same thing &ust how much is a firm making relative to the price of a share/ 23 is also important because it tends to drive stock price through the 3@2 ratio. 5ence it can be an indication of future price appreciation.
. )oth business risk and financial risk would exist with or without either type of leverage. Leverage &ust makes them more significant. Are these statements true or false/ 2xplain. ANSWER: 0alse. )usiness risk is variation in 2)(T. (t is increased but not caused by operating leverage. ome business risk exists in virtually all companies even in the complete absence of leverage. 5owever financial risk is the additional variation in 23 over that of 2)(T that comes as a result of debt 8financial leverage9. !ithout financial leverage there is no financial risk.
B. )riefly explain the pros and cons of financial leverage. (n other words what are its benefits and what are the costs that come along with those benefits/ ANSWER: 0inancial leverage makes good results measured in terms of 23 and ,O2 better. 5ence in good times it can enhance financial performance and thereby tends to increase stock price. 5owever it can also exaggerate poor performance making a moderately poor showing in bad times much worse. Leverage adds to the variability of financial performance which is the essence of risk. 5ence financial leverage adds risk which tends to depress stock price. This increased risk is the cost of leverage.
. 2xplain in words the ,OC2 test for the advisability of adding leverage. That is what is the test really telling us/ !hen will it indicate a company is doing the wrong thing/
66?
Chapter 7?
ANSWER: The ,OC2 test measures the firm's operating ability to earn a return on invested money against the cost of borrowing. (f the ,OC2 is higher than the cost of borrowed funds 8both after tax9 the firm will profit to the extent of the difference on whatever money it borrows. 5owever leverage adds risk and the ,OC2 doesn't test for that. 5ence if borrowing is already high it may be unwise to borrow more even if the ,OC2 is above the cost of debt.
D. The risk added by financing is small and insignificant relative to the inherent risk in most businesses. (s that statement true or false/ iscuss. ANSWER: The statement is generally true in good times if in addition the use of leverage is low or moderate. 5owever it is false when debt levels are high. Then debt can create financial risk that exceeds business risk several times over.
>. escribe generally how leverage affects stock prices. !hat forces are at work driven by what effects/ ANSWER: (f business is good and the ,OC2 exceeds the after"tax cost of capital additional leverage enhances ,O2 and 23. These measures are watched by investors and the improvement can have a positive effect on stock price. At the same time however increased leverage makes those measures more volatile in response to changes in the business's operating results. That implies a riskier business. ,isk levels are also watched by investors and have a negative impact on price. !hich effect dominates depends on how much leverage exists and the current business climate.
7E. 2xplain the difference between a fixed and a variable cost. 5ow do these concepts change as the time hori1on lengthens/ (n other words are the same things fixed over a "year planning period that are fixed in a typical 7"year period/ !hat about a 7E"year period/ !hat's the relevant period when we're talking about operating leverage/ ANSWER: A fixed cost remains constant when production levels change. A variable cost increases or decreases in direct proportion to changes in production. The longer the planning period the more things are variable. 0or example the costs associated with a factory are fixed in the 7"year time frame. Over a 7E"year period however a new factory can be built so the costs associated with it can be considered variable. The discussion of operating leverage is made in the context of a relatively short period of time. 5ence only direct inputs are variable.
77. !hy do labor"intensive processes involve less operating leverage than automated processes/ !hat fixed costs are associated with automation/ !hy can't those costs be eliminated by &ust selling the machinery/ ANSWER: 5igh operating leverage implies a preponderance of fixed cost. Labor isn't a fixed cost because people can be fired if business turns down. The main fixed cost associated with automation is depreciation associated with the e#uipment. (f the e#uipment is leased the payments can be fixed if the lease can't be broken. (f the e#uipment is ac#uired with borrowed money the interest on the loan is a fixed cost. (dle machinery can be sold but generally at a big loss. (f the e#uipment is highly speciali1ed there may be no market for it.
7<.
2xplain the idea of breakeven analysis in a brief paragraph.
ANSWER: )reakeven analysis finds the production and sales level re#uired for the company to &ust survive. At the breakeven volume all costs are covered by revenue but nothing is left over for profit. The firm &ust Fbreaks evenF in terms of profit and loss.
66
Capital tructure and Leverage
76. escribe the concept of the breakeven point in words by using the concept of contribution and fixed costs. 8hort answer.9 ANSWER: 2ach unit sold contributes the difference between price and variable cost to profit and overhead. This amount is called the FcontributionF. At the breakeven point the total contribution from all units sold &ust e#uals the firm's fixed costs.
7?.
ummari1e the effect of operating leverage on 2)(T.
ANSWER: $ore operating leverage enhances 2)(T at points above breakeven but makes it worse when operating below breakeven. 5ence it makes 2)(T more volatile with changes in volume.
7. The )raithwaite Tool Co. is considering a ma&or moderni1ation and automation of its plant using borrowed funds. 0ully discuss a serious financial negative that could result from the pro&ect. ANSWER: The automation of the plant will make )raithwaite more capital intensive add fixed costs and increase operating leverage. This will increase the volatility of 2)(T as the level of sales changes. )y financing the pro&ect with borrowed money the firm will add debt to its capital structure increasing financial leverage. This makes 23 and ,O2 more volatile as 2)(T changes. The net result of these effects is multiplicative. Therefore changes in sales may produce very large changes in 23 and ,O2 after the pro&ect is implemented. This is likely to make the company more risky in the eyes of investors and may have a detrimental effect on its stock price.
7B. 2xplain the idea of bankruptcy costs. !hy are they important to investors/ !hen do investors start to worry about them/ ANSWER: )ankruptcy costs are the expenses incurred as a result of the administration of a firm's failure. They are not losses associated with the business deterioration that causes the bankruptcy. ,ather they're the costs of the legal and administrative system and the loss incurred if assets need to be sold cheaply. )ankruptcy costs are important to investors because they represent potential investment losses. !hen times are good and the firm's debt level is relatively low investors don't think much about bankruptcy costs. They start to worry however when failure looks possible. They become especially concerned when debt levels are high due to financial risk.
7. )riefly describe the result of $$'s original restrictive model. !hy was it important in spite of its serious restrictions/ ANSWER: $$'s original model implied that the firm's value is independent of capital structure. Although this view was already held by many others $$ described a logical way in which the behavior of investors could make it happen. The theory showed that the effect of capital structure on price and value is due to market imperfections like taxes and bankruptcy costs rather than to the basic interaction between investors and companies.
7D. )riefly summari1e the operating income argument that was supported by the original $$ result. ANSWER: A firm's value is nothing more than the present value of its expected future income stream. (f expected income doesn't change a rational market will hold the firm's total value constant regardless of how the income is divided between debt and e#uity investors. 2ssentially the argument says that you can't make something out of nothing. (.e. you can't create additional value out of a fixed income stream by changing the way it's divided between debt and e#uity.
66B
Chapter 7?
7>. Outline the arbitrage process proposed by $$ that supports the operating income argument. !hat is the arbitrage between/ ANSWER: (f increasing a firm's use of leverage created value stockholders could profit by selling its appreciated shares borrowing money and buying the unappreciated shares of a similar but unleveraged firm. This would put downward pressure on the price of the leveraged firm and upward pressure on the price of the unleveraged firm driving the two together. 8Actually keeping them from being different.9 The arbitrage is between stocks of leveraged and unleveraged firms.
2xplain in words how the tax system favors debt financing.
ANSWER: 3ayments to investors are either interest on debt or dividends on e#uity. (nterest payments are tax deductible while dividends are not. To the extent income is paid in interest rather than as a dividend it generates a tax savings. That savings is kept by the company without affecting investors. 5ence it's cheaper to pay a debt investor than to pay the same amount to an e#uity investor. The government effectively splits the bill for debt funds.
<7.
(n a short paragraph describe the result of adding taxes to the $$ model.
ANSWER: !hen taxes are added to the $$ model an annual tax savings e#ual to the tax rate times the firm's total debt is created. The present value of the perpetuity of that stream of savings is an addition to the value of the firm. This value increment increases steadily as more debt is added. (t belongs entirely to stockholders since bondholder returns are fixed. Therefore in the absence of other refinements the $$ model with taxes implies that the firm should borrow as much as possible right up to 7EEG of capital.
<<. (n another short paragraph describe the effect of adding bankruptcy costs to the $$ model with taxes. ANSWER: (ncluding bankruptcy costs in the $$ model mitigates the value enhancing effect of taxes by recogni1ing that more leverage increases risk. ince risk lowers value through its effect on the re#uired returns of e#uity investors it offsets the benefit of the tax shield associated with more debt. The two effects taken together mean that as leverage is added value increases reaches a maximum and then decreases
<6. Compare the implications of the $$ model with taxes and bankruptcy costs to the things we discovered by studying the Ari1ona 5ot Air )alloon Corporation. ANSWER: The bottom line is about the same. Adding debt to an unleveraged firm can initially increase value and stock price but eventually detracts from both. This means an optimal point must exist for every firm with respect to the amount of leverage it uses. %either approach tells us how to find the optimum. The reasons for the model's conclusions are somewhat different. The $$ model bases the beneficial effect of leverage on the favorable tax treatment of interest. The intuitive approach on the other hand is based on the idea that a profit is available if a firm can earn more using borrowed money than it pays for that use. )oth approaches conclude that a little leverage is good but a lot is generally bad.
66
Capital tructure and Leverage
BUSINESS ANALYSIS
7. The Armageddon Corp is in big trouble. ales are down and profits are off. On top of that the firm's credit rating has been reduced so it's facing very high interest rates on anything it borrows in the future. Current long"term borrowing represents BEG of capital but at fixed interest rates so it won't be affected. The firm's ma&or stockholder the Apocalypse +roup has scheduled a conference with management to discuss the company's problems. 2veryone is very nervous about this conference and the executive team is meeting to decide what to tell Apocalypse. Charlie +ladhand the director of marketing came into the meeting wearing a wide grin. 5e explained that he'd read an article about leverage that contained the solution to the company's problem. The article told of several successful firms that had to the delight of their owners become more successful by borrowing money. Charlie suggests that Armageddon da11le the Apocalypse +roup by borrowing heavily in the next few days before the conference. Criti#ue Charlie's idea. ANSWER: Charlie doesn't understand what he read. (ncreasing leverage only helps when 879 times are good and 8<9 when there isn't much debt to begin with. Armageddon is doing poorly so more debt would make returns worse. )ut it would also add risk. !ith the existing debt level at BEG an addition would be dangerously risky even in the best of times. (n this situation it would probably be a disaster.
<. :ou're interested in investing in the 3eters Company which has shown a remarkable increase in 23 over the last three years. :ou investigate and find that the company's debt"to"e#uity ratio has increased dramatically over the same period and is now four to one. 5ow does this information affect your feelings about 3eters as an investment/ ANSWER: 3eters; high 23 is based partly on its use of leverage which seems to have become excessive. This situation implies high risk in that a modest business downturn is likely to cause a precipitous drop in 23 and probably stock price. This should dampen investor interest somewhat.
6. :ou're the C0O of Axelrod Trucking a privately held firm whose owner Hoe Axelrod is interested in selling the company and retiring. 5e therefore wants to pump up its value by any means possible. Hoe read an article about leverage in a business maga1ine the other day and has sent you a memo directing that you restructure the firm's capital to the FoptimumF in order to maximi1e the company's value. 3repare a brief response to Hoe's memo. ANSWER: Hoe= Optimi1ing a company's value by borrowing is a good idea in theory but it's hard to put it into practice with any precision. (f a firm is doing well more debt enhances financial results in terms of ,O2 and 23. 5owever if the company is doing poorly it makes results worse. That means increasing the use of debt 8known as leverage9 makes results more volatile or risky. )etter results tend to enhance value but riskiness tends to detract from it. The problem is that no one knows exactly how to balance these two effects to maximi1e value. (n general we can say that if business performance looks good for the foreseeable future and the firm doesn't have much debt a little more will probably help. On the other hand a heavily leveraged firm will probably do well to reduce its debt especially if business looks shaky ahead. (n our case we can't optimi1e any better than to estimate that a debt level of about 6EG or 6G is appropriate if times are good. That should be reduced to less than
?. The ,evere Company currently has good earnings and a capital structure that's
66D
Chapter 7?
great deal of attention to 23 when buying and selling. 5e also understands that leverage can magnify 23. 5owever he knows little more than that about finance. 5arry has strongly suggested to the treasurer that ,evere restructure its capital to BG debt in order to enhance 23 and increase stock price. :ou're an analyst in the firm's treasury department. The treasurer has asked you to prepare an analysis of 5arry's proposal to help him talk the boss out of the idea. :ou've calculated the company's current 0L at <.< and pro&ected that it would be .D at the proposed leverage level. raft a memo from the treasurer to 5arry tactfully explaining why his idea ma y not work and might actually have a result opposite to what he wants to achieve. ANSWER: 5arry= Our operating results are currently very good so an increase in leverage will favorably impact 23 which will tend to have a favorable impact on stock price. 5owever that's only part of the picture. )ecause leverage magnifies 23 it makes the measure more volatile when operating results change. (n stock market terms that makes the company more risky which tends to negatively influence stock price. -nfortunately the market's response to increased risk is a little vague. (f there isn't much leverage in the first place a little extra is more or less ignored. 5owever if the absolute level of leverage is high adding more can have a dramatically negative effect. This is true even when operating results are good. The perennial #uestion with respect to leverage is which effect will dominate. (n other words on balance will price go up or down if a certain amount more leverage is added/ That #uestion can rarely be answered with certainty but a certain financial ratio may be able to give us some insights into what's likely to happen. The egree of 0inancial Leverage 80L9 measures the risk associated with leverage. (t relates percentage changes in 23 to percentage changes in 2)(T as a function of debt. (n other words it tells how big a change in 23 will occur as a result of any change in 2)(T given our debt level. (n this way it measures the financial risk associated with leverage. Currently our 0L is <.<. That means a 7G change in 2)(T will bring about a <.
. The Appleridge Company is a large manufacturer of capital goods. 8The demand for capital goods typically swings up and down a great deal between good and bad economic times.9 )usiness has been good lately and is expected to remain so in the foreseeable future. The firm is currently relatively labor intensive in its processes. The chief engineer $ike Iuickwrench has suggested a ma&or pro&ect to moderni1e and automate the plant. At the output level planned for next year the pro&ect will reduce total cost by 7EG. $ike has presented the idea to the management team in a totally positive light. The other executives are caught up in $ike's enthusiasm and are ready to proceed. :ou're Appleridge's C0O and feel that all sides of an issue should be discussed before it is approved. !hat concerns do you have/ 5ow would you present them in a way that keeps you from appearing to be overly negative/ ANSWER: The problem is the additional risk that the pro&ect adds to the company's performance. (n the capital goods industries it's virtually assured that significant downturns will be experienced in the future as the economy goes through booms and recessions. (n some businesses the downturns are manageable say
66>
Capital tructure and Leverage
sub&ective probabilities attached. Let the team evaluate which way to go. (t's possible that a modified plan can achieve most of the benefits of the automation but avoid some of the risk. B. The !ycombe Company is doing well and is interested in diversifying so it's been looking around for an ac#uisition target. The Albe Company has been found with the help of an investment banker. Albe is #uite profitable and about half the si1e of !ycombe. This si1e relationship is reflected in their market values. )oth firms are financed entirely by e#uity. The investment banker has advised that it will be necessary to pay a premium of about 6EG over market price to ac#uire Albe. !ycombe's president is having a hard time with this news and has asked you for advice. Construct and explain an approach to the ac#uisition that might make the premium easier to rationali1e. !ould it affect your argument if neither Albe nor !ycombe were particularly profitable/ (f so how/ ANSWER: The president is struggling with the following problem= (f Albe's market value truly represents the firm's worth the premium represents a payment of extra value from !ycombe's shareholders to Albe's at the time of the ac#uisition. -nless there are remarkable benefits to operating the two firms together that money is lost to !ycombe's shareholders forever. Leverage may provide some relief. 0irst notice that neither firm has any debt at present and that they are both en&oying good profitability. That means an increase in leverage might increase value. Assume the si1e relationships of the market values of the two firms are roughly as follows 8J7EE is an arbitrary figure for !ycombe it's the relationships that are important9=
!ycombe $arket 4alue J7EE 4alue of Albe $arket 4alue JE 3remium 86EG9 7 B J7B (f !ycombe ac#uires Albe by borrowing JE the market value of the capital structure of the resulting firm may be approximately as follows. ebt 2#uity Total
J E 6EG 77 EG J7B 7EEG
This is a reasonable level of leverage that may cause an increase in the value of the e#uity. To the extent that such an increase occurs it will mitigate the loss to !ycombe's stockholders from the premium payment. (f the firms weren't profitable increasing leverage would be likely to make their financial results worse rather than better. That means an increase in stock price and value is unlikely to come from the idea.
PROBLEMS
Basic C!c"#$s a!% Ca&c'&a$i!s: Ta(&"s 14)1* 14)+* a!% E,'a$i! 14-1 .#a/"s 0* 01* a!% 0+2 7.
The Connecticut Computer Company has the following selected financial results. 7EG ebt ebt 2#uity Total Capital
J 7EEEE >EEEE J7EEEEE
?EG ebt
G ebt
6?E
Chapter 7?
hares K J
7DEEE
2)(T (nterest 8 7G9 2)T Tax 8?EG9 2AT
J7DEEE 7EE J7BEE BBEE J >>EE
,O2 23 The company is considering a capital restructuring to increase leverage from its present level of 7EG of capital. a. Calculate Connecticut;s ,O2 and 23 under its current capital structure. b. ,estate the financial statement line items shown the number of shares outstanding ,O2 and 23 if Connecticut borrows money and uses it to retire stock until its capital structure is ?EG debt assuming 2)(T remains unchanged and the stock continues to sell at its book value. 8evelop the second column of the chart shown.9 c. ,ecalculate same figures assuming Connecticut continues to restructure until its capital structure is G debt. 8evelop the third column of the chart.9 d. 5ow is increasing leverage affecting financial performance/ !hat overall effect might the changes have on the market price of Connecticut;s stock/ !hy/ 8!ords only. 5int= consider the move from 7EG to ?EG and that from ?EG to G separately.9 SOLUTION: a-* (-* c-
7EG ebt
?EG ebt
G ebt
ebt 2#uity Total Capital
J 7EEEE >EEEE J7EEEEE
J ?EEEE BEEEE J7EEEEE
J EEE <EEE J7EEEEE
hares K J
7DEEE
7<EEE
EEE
2)(T (nterest 8 7G9 2)T Tax 8?EG9 2AT
J7DEEE 7EE J7BEE BBEE J >>EE
J7DEEE BEEE J7<EEE ?DEE J
J7DEEE 77<E J BE <EE J ?EE
,O2 23
77.EG J.
7<.EG J.BE
7B.
d. (ncreasing leverage is improving financial performance as measured by ,O2 and 23. As debt increases earnings e#uity and the number of shares outstanding all decrease. 5owever since e#uity decreases fastest the ratios ,O2 82AT@2#uity9 and 23 82AT@hares9 get larger. The increase in debt from 7EG to ?EG of capital is likely to increase stock price because investors will react favorably to the improvement in ratios. (n this leverage range debt is not excessively high so the positive effect of the improving ratios will probably overcome the negative effect of increasing risk.
6?7
Capital tructure and Leverage
The move from ?EG to G debt on the other hand is likely to be perceived by investors as making the company uncomfortably risky. At higher leverage levels the negative effect on investors of increased risk usually overwhelms the positive effect of improving performance ratios and the net result is a decline in stock price.
<. ,econsider the Connecticut Computer Company of the previous problem assuming the firm has experienced some difficulties and its 2)(T has fallen to JDEEE. a- ,econstruct the three"column chart developed in problem 7 assuming Connecticut;s 2)(T remains at JDEEE. (- (nterpret the result in terms of stock price and the advisability of restructuring capital under these conditions. c- Could these results have been predicted more easily/ -se the ,OC2 concept to come to the same conclusion. SOLUTION: a-
7EG ebt
?EG ebt
G ebt
ebt 2#uity Total Capital
J 7EEEE >EEEE J7EEEEE
J ?EEEE BEEEE J7EEEEE
J EEE <EEE J7EEEEE
hares K J
7DEEE
7<EEE
EEE
2)(T (nterest 8 7G9 2)T Tax 8?EG9 2AT
JDEEE 7EE JBEE <BEE J 6>EE
JDEEE BEEE J<EEE DEE J7
J DEEE 77<E 8J 6<E9 " 8J 6<E9
,O2 23
?.6G J.<<
<.EG J.7E
876.EG9 8J.B9
b. tock price would almost certainly decline as a result of restructuring. (ncreased debt is causing a deterioration of financial performance measured by ,O2 and 23 as well as increasing risk. )oth of these have negative effects on investors; attitudes. -nder these conditions 8a low 2)(T9 it would virtually never be advisable to exchange e#uity for debt. c. Leverage is not advisable if the return on capital employed ,OC2 is less than the after tax cost of debt. Currently Connecticut;s ,OC2 is ,OC2 2)(T87 − T9 @ 8ebt M 2#uity9 JDEEE87 − .?9 @ J7EEEEE J?DEE @ J7EEEEE ?.DG (ts after tax cost of debt is 7G87 N T9 7G87 − .?9 >G 5ence at an 2)(T of JDEEE Connecticut;s ,OC2 is less than its after tax cost of debt and we would not expect adding leverage to do the firm any good.
6?<
Chapter 7?
6. Assume Connecticut Computer Company of the last two problems is earning an 2)(T of J7EEE. Once again calculate the chart showing the implication of adding more leverage. 4erbally rationali1e the result. SOLUTION=
7EG ebt
?EG ebt
G ebt
ebt 2#uity Total Capital
J 7EEEE >EEEE J7EEEEE
J ?EEEE BEEEE J7EEEEE
J EEE <EEE J7EEEEE
hares K J
7DEEE
7<EEE
EEE
2)(T (nterest 8 7G9 2)T Tax 8?EG9 2AT
J7EEE 7EE J76EE ?EE J D7EE
J7EEE BEEE J>EEE 6BEE J ?EE
J7EEE 77<E J 6E 7EE J <<E
>.EG J.?
>.EG J.?
>.EG J.?
,O2 23
Leverage has no effect on financial performance but it still adds risk hence the effect on stock price would probably be negative. At an 2)(T of J7EEE the ,OC2 and the after tax cost of debt are both >G. Trading e#uity for debt or vice versa makes no difference on performance because the firm is earning on capital exactly what it pays for the use of additional debt funds. (.e. there;s no leverage.P The risk effect however is still there because as the firm adds more debt it must pay more interest making its profit margin narrower. This will probably drive the stock;s price down in the absence of a counteracting favorable change in ratios.
?. !atson !aterbed !orks (nc. has an 2)(T of J<. million can borrow at 7G interest and pays combined state and federal income taxes of ?EG. (t currently has no debt and is capitali1ed by e#uity of J7< million. The firm has 7. million shares of common stock outstanding that trade at book value. a. Calculate !atson's 2AT ,O2 and 23 currently and at capital structures that have
E >B J 7?6?
?EG ebt J <E
BEG ebt J <E 7EDE J 7BE BBD J 7EE<
DEG ebt J <E 7??E J 767E
6?6
Capital tructure and Leverage
)ALA%C2 522T ebt 2#uity Capital
" J7<EEE J7<EEE
J <?EE >BEE J7<EEE
J ?DEE
J
J >BEE <?EE J7<EEE
7.$
7.<$
.>$
.B$
.6$
76.DG J7.7E
7?.>G J7.
7B.>G J7.6
G J7.B
6<.DG J<.B<
hrs K JD ,O2 23
b. The effect of leverage accelerates as more leverage is added. That is the same increment of debt brings larger changes in ,O2 and 23 as leverage increases.
Ma!a/i!/ EPS T3'/3 L"5"a/": E6a7#&" 14)1 .#a/" 0+2 . The Tanenbaum Tea Company wants to show the stock market an 23 of J6 per share but doesn't expect to be able to improve profitability over what is reflected in the financial plan for next year. The plan is partially reproduced as follows. Ta!"!(a'7 T"a C7#a!8 Fi!a!cia& P9"c$i! + .;2
2)(T (nterest 8K7
J7DE 7BE J77>E B6< J7EBD
ebt J 76EEE 2#uity >EEE Capital J77EEEE Rshares 6EEEEE
Tanenbaum's stock sells at book value. !ill trading e#uity for debt help the firm achieve its 23 goal and if so what debt level will produce the desired 23/ SOLUTION: (n 8JEEE9
,OC2 =
2)(T87 − T9 ebt + 2#uity
=
J7DAE8.B <9 J77EEEE
=
7E.BG
After"tax cost of debt k d87−T9 7$@6.$ shares JD6> Change in e#uity J>$ − JDB$ hares retired at book value J77EEEEEE @ JDD
6??
Chapter 7?
%ew number of shares outstanding 6EEEEE − ?7>DD 6D6>EEE @ 6
Basics P&'s DFL: A##&8 E,'a$i! 14-< .#a/" 0112 B. The Canterbury Coach Corporation has 2)(T of J6.B< million and total capital of J
,OC2 =
2)(T87 − T9 ebt + 2#uity
=
J6B
=
7E.DBG
After"tax cost of debt k d87−T9 7
3roposals
7G ebt J 6BB
6EG ebt J 6BEE 77BE J 7?E
?G ebt J 6B
BEG ebt J 6B
G ebt J 6B<
J 6EEE J7EEE J
J BEEE 7?EEE J
J >EEE 77EEE J
J7<EEE DEEE J
J7EEE EEE J
hares )ook 4alue
?<EEE J?E
6EEEE J?E
<EEE J?E
7<EEE J?E
,O2 23
77.G J?.BE
7<.?G J?.>
76.>G J.?
7B.?G JB.?
<7.DG JD.?
7.<
7.?6
7.BB
7.>>
2)(T (nterest 2)T Tax 2AT )ALA%C2 522T ebt 2#uity Capital
0L 2)(T @82)(T −(9 0L 7.77
6?
Capital tructure and Leverage
c. As performance accelerates so does the risk implied by the increasing 0L. The highest level of leverage yields financial risk that almost doubles business risk. That intuitively seems unacceptable. The ?G level seems reasonable. (f 2)(T is stable however there is less reason to be concerned about more leverage.
F"cas$i!/ R"s'&$s T3'/3 $3" DFL: E6a7#&" 14)+ .#a/" 0112 .
)alfour Corp has the following operating results and capital structure 8JEEE9. ,evenue Cost@2xpense 2)(T
JBEEE ?EE J7EE
ebt 2#uity Total
J 7
The firm is contemplating a capital restructuring to BEG debt. (ts stock is currently selling for book value at J< per share. The interest rate is >G and combined state and federal taxes are ?G9 7ED 2)T J76>< Tax 8?
3roposed J7EE ?E J >BE ?E6 J
)ALA%C2 522T ebt 2#uity Capital
J 7
J BEEE ?EEE J7EEEE
Rhares 2#@)4 per share JDDEEEEE@J< 6<EEE J?EEEEEE@J<
7BEEEE
a. 23 2AT @ R hrs Current= JDE@6< J<.<> 3roposed= J@7BE
J6.?D
b. 0L 2)(T @ 2)T Current= J7EE@J76>< 7.ED 3roposed= J7EE@J>BE
7.B
c. G ∆23 0L 8G ∆2)(T9 0cst 23 23 87 − G ∆2)(T9
6?B
Chapter 7?
G ∆ 2)(T G 7EG <G
Current G ∆23 0cst 23 .?G J<.7 7E.DG J<.E? <.EG J7.B
3roposed G ∆23 0cst 23 .DG J6.<7 7.BG J<.>? 6>.EG J<.7<
d. 23 is higher but more variable under the proposed structure. 5owever at a <G reduction in 2)(T 23 is still better under the proposal than under the old structure. 5ence if operating profitability isn't expected to vary much the proposal may be a good idea. e. !e can't say for sure because the ultimate impact on stock price depends on investors' sub&ective feelings about risk and return trade"off. 5owever it looks likely that the impact would be favorable if 2)(T isn't expected to vary more than <G.
D. Algebraically derive 23 ,O2 × )ook value per shareU. 8 Hint = !rite the definitions of ,O2 23 and book value and then start substituting.9 SOLUTION: !rite the definition of 23 and solve for 2AT 23 2AT @ R hrs 2AT 23 8R hrs9 !rite the definition of ,O2 and substitute for 2AT ,O2 2AT@2#uity 23 8R hrs9@2#uity olve for 23 23 ,O2 2#uity@R hrsU. )ut since 2#uity@R hrsU is )ook value per share 23 ,O2 8)ook 4alue per hare9.
EBIT)EPS A!a&8sis: E6a7#&" 14-< .#a/" 01<2 >. :ou're a financial analyst at 3inkerton (nteractive +raphic ystems 83(+9 a successful entrant in a new and rapidly growing field. As in most new fields however rapid growth is anything but assured and 3(+'s future performance is uncertain. The firm expects to earn operating profits of J? million next year up from J7 million last year. To support this enormous growth the firm plans to raise J7 million in new capital. (t already has capital of J million which is ?EG debt. 3(+ can raise the new money in any proportion of debt and e#uity management chooses. The C0O is considering three possibilities= all e#uity JD million debt and J million e#uity and all debt. (nterest on the current debt as well as on new borrowing is expected to be 7EG and the company pays state and federal income taxes at a combined rate of ?EG. 2#uity will be raised by selling stock at the current market price of J7E which is e#ual to its book value. The C0O has asked you to prepare an analysis to aid management in making the debt@e#uity decision. :ou are also to provide a recommendation of your own. a. 3repare an 2)(T"23 analysis of the situation showing a line for the capital structure that results from each of the three options. Calculate 23 under each new capital structure at 2)(T levels of J7 million J< million and J? million. Then graph 2)(T versus 23 for each option. ,efer to 0igure 7?" 6. how last year's 23 on the graph. b. iscuss the effect the options might have on stock price. c. $ake a sub&ective recommendation under each of the following assumptions about the J? million forecast. upport your position with words and references to your 2)(T"23 analysis.
6?
Capital tructure and Leverage
7. The J? million Operating 3rofit pro&ection is a best"case scenario. Anything from 8J< million9 to J? million has an e#ual probability of occurring. <. The J? million is a fair estimate with about a BEG probability. 5owever performance better than J? million is unlikely. 2)(T results could range anywhere from 1ero to J? million. 6. J? million is an easy target. There's an even chance of anything between J? million and JD million. SOLUTION: a.
Current tructure ebt J<EEE 2#uity 6EEE Total JEEE R hrs 6EE
CA3(TAL Options for %ew Capital Additions 7 < 6 " JDEEE J7EEE J7EEE JEEE " 7EE
EE
"
3ossible %ew tructures 7 < 6 J <EEE J7EEEE J7EEE 7DEEE 7EEEE 6EEE J
%ote that the number of shares comes from dividing e#uity by J7E per share which is market price as well as book value. (%CO$2 TAT2$2%T AT 2)(T J?EEE Capital tructure Options 7 < 2)(T (nterest 2)T Tax 2AT 23
J?EEE
J?EEE 7EEE J6EEE 7
6 J?EEE 7EE J<6EE >
(%CO$2 TAT2$2%T AT 2)(T J<EEE Capital tructure Options 7 < 2)(T (nterest 2)T Tax 2AT 23
J<EEE
J<EEE 7EEE J7EEE ?EE J BEE JE.BE
6 J<EEE 7EE J 6EE 7
(%CO$2 TAT2$2%T AT 2)(T J7EEE
6?D
Chapter 7?
Capital tructure Options 7 < 2)(T (nterest 2)T Tax 2AT 23 •
J7EEE
J7EEE 7EEE J E E J E J E.EE
6 J7EEE 7EE 8J EE9 8
0or illustrative purposes assume a tax credit on losses.
%ote that last year's income tatement is identical to Column 7 in the last table except that there are 6EEEEE shares of stock outstanding which yields an 23 of J7.BE.
23 J.EE
"6"
J?.EE J6.EE "<" J<.EE "7" J7.EE
2)(T
J7EEE
J<EEE
J6EEE
J?EEE
b. The three options display a wide range of choices with respect to the trade"off between risk and performance. Option one is relatively conservative in that there's almost no loss at 23 until a loss is experienced at 2)(T. Option three on the other hand is very risky getting into negative 23s while operating profits are still good. (ntuitively option three seems risky enough to decrease stock price. The choice between options one and two is sub&ective. An important point however is a comparison with last year's 23 which can be calculated at J7.BE. Option one will result in a decline in 23 at the expected level of 2)(T. That fact is likely to make it unacceptable. c. 79 This is a high risk scenario in which most people would probably choose option one. 2ven that gives only about a <@6 probability of a positive 23. The others are worse. Option three looks like it could bankrupt the firm toward the bottom of the 2)(T range. <9This is a common business situation= A likely outcome has more downside risk than upside potential. 2ither of the first two options is supportable. 69 Option three is clearly the best choice if the outlook is really this good.
C!$i('$i! a!% B"a="5"!: E6a7#&"s 14)4 a!% 14)> .#a/"s 01? a!% 0+2
6?>
Capital tructure and Leverage
7E. Cranberry !ood 3roducts (nc. spends an average of J>.E in labor and J7<.?E in materials on every unit it sells. ales commissions and shipping amount to another J6.7E. All other costs are fixed and add up to J7?EEEE per month. The average unit sells for J6<.EE. a. !hat are Cranberry's contribution and contribution margin/ b. !hat is the firm's breakeven point in units/ c. Calculate the dollar breakeven point in two ways. d. ketch the )reakeven iagram. SOLUTION: 4ariable cost per unit 4 Labor M $aterial M CW 4 J>.E M J7<.?E M J6.7E J<.EE
a. b. c.
Ct 3 − 4 J6< − J< J.EE C$ 83 − 49@3 J@J6< .<7D> <7.>G I)@2 0C@Ct J7?EEEE@J
d. ,ev JB?EEEE
TC
0C
J7?EEEE
I
Fi6"%@Vaia(&" Cs$ Ta%" a!% DOL: E6a7#&"s 14-0 a!% 14- .#a/"s 0++ a!% 0+42 77.
,eferring to the Cranberry Company of the previous problem= a. Calculate the OL when sales are
OL = a. )@2M
I83 − 49 I83 − 49 − 0C I
=
I I − J7?EEEE OL B.E ?.6 6.
6E
Chapter 7?
b.
I)@2 0C@83−49 After automated 2#uipment installed 0C J7BEEEE I)@2
OL = )@2M
I83 − 49 I83 − 49 − 0C I
=
DI DI − J7BEEEE OL B.E ?.6 6.
The OL around a fixed breakeven point is a function of #uantity only as the mix of fixed and variable costs shifts.
P(&"7s 1+ 1> "" $ B'& W% P%'c$s .BWP2* a 7a!'ac$'" 3i/3 ,'a&i$8 '!i$'"7<.
)!3 pro&ects sales of 7EEEEE units next year at an average price of JE per unit. 4ariable costs are estimated at ?EG of revenue and fixed costs will be J<.? million. )!3 has J7 million in bonds outstanding on which it pays DG and its marginal tax rate is ?EG. There are 7EEEEE shares of stock outstanding which trade at their book value of J6E. Compute )!3;s contribution contribution margin 2AT OL and 23.
SOLUTION:8J $illions9 ,evenue 7EEEEE x JE 4ariable Cost K ?EG Contribution $argin 0ixed Costs 2)(T (nterest 2xpense J7.E x .ED 2)T Tax K ?EG 2AT
Contribution E N 8E x .?9 Contribution $argin 6E@E 2AT OL X7EEEE8E"
J.EE <.EE 6.EE <.?E .BE .EDE .
67 76.
Capital tructure and Leverage )!3 intends to purchase a machine that will result in a ma&or improvement in product #uality along with a small increase in manufacturing efficiency. The machine will cost J7 million which will be borrowed at >G. The #uality improvement is expected to have a significant impact on )!3;s competitive position. (ndeed management expects sales to increase by G in spite of a planned 7EG price increase. The efficiency improvement combined with the price increase will result in variable costs of 6BG of revenue. 0ixed cost however will rise by 7>G. a. Compute )!3;s new contribution contribution margin 2AT OL and 23 if it purchases the new machine. b. (f all of )!3;s pro&ections come to pass how will stock price be influenced/ !hat factors should be considered in estimating a stock price change/
SOLUTION: 8J $illions9 a. ,evenue 87EEEEE x JE x 7.7 x 7.E9 4ariable Cost K 6BG Contribution $argin 0ixed Costs 8J<.? x 7.7>9 2)(T (nterest 2xpense 8J7.E x .ED M J7.E x .E>9 2)T Tax K ?EG 2AT
Contribution 8J " .6Bx J9 Contribution $argin 8J6.
J. <.E> 6.B>B <.DB .D?E .7E .BE .
b.
An increase in 23 will have a positive effect on stock price. A doubling of debt however might have a negative effect especially if debt was already a significant percentage of capital. The decrease in OL means results will be less volatile which should have a positive effect. (t isn;t possible to say with certainty which effect will dominate.
7?.
Calculate )!3;s 0L and TL before and after the ac#uisition of the new machine.
SOLUTION:
0L 2)(T@82)(T N (9 TL OL x 0L
7.
!@O machine .B@.< 7.7 .E x 7.7 .
!@machine [email protected] 7.< ?.? x 7.< .
-se the information from the previous two problems. Calculate )!3;s breakeven point in units and dollars with and without the purchase of the new machine.
SOLUTION:
!ithout machine= !ith machine=
J<.? million@J6E DEEEE units DEEEE units x JE J?EEEEEE J<.DB million@J6.
6<
Chapter 7?
D"/"" T$a& L"5"a/" .DTL2: E6a7#&" 14- .#a/" 0+2 7B. The pitfire $odel Airplane Company has the following modified income statement 8JEEE9 at 7EEEEE units of production. ,evenue J7EEEE 4ariable Cost BEE 0ixed Cost <
C$
83−49@3 8J7EE − JB9@J7EE .6
)@2 0C@C$ J<
0L =
OL =
2)(T 2)(T − (
=
J76EE J76EE − JAEE
I83 − 49 I8 3 − 4 9 − 0C
=
=
7.B
7EEEEE8J6A9 7EEEEE8J6A9 − J<
TL OL × 0L <.B>< × 7.B< ?.6 c. A <G decline in sales implies 23 will decline by <G × TL <G × ?.6 7E>.?G 7E>.?G of J
JEEE ?D <
=
<.B><
66
Capital tructure and Leverage
Tax 8K ?EG9 2AT R shares
8 6E9 J 8 ?9
23 −J?EEE@
7. The ingleton $etal tamping Company is planning to buy a new computer controlled stamping machine for J7E million. The purchase will be financed entirely with borrowed money that will change ingleton's capital structure substantially. (t will also change operations by adding J7. million in fixed cost and eliminating J< million in variable cost at the current level of sales. The firm's current financial position is reflected in the following statement 8JEEE9. ,evenue 4ariable Cost 0ixed Cost 2)(T (nterest 8K 7EG9 2)T Tax 8K ?EG9 2AT
J7DEEE 7EEEE EEE J 6EEE EE J <EE 7EEE J 7EE
ebt J EEE 2#uity 7EEE Total J
J<.EE
a. ,estate the financial statements with the new machine and calculate the dollar breakeven points with and without it. b. Calculate the 0L with and without the new machine. c. Calculate the OL with and without the new machine. 8 Hint = :ou don't need I to use e#uation 87?"779 because 3I is revenue and 4I is total variable cost.9 d. Calculate the TL with and without the new machine. e. Comment on the variability of 23 with sales and the sources of that variability. f. (s it a good idea to buy the new machine if sales are expected to remain near current levels/ +ive two reasons why or why not. !hat has to be anticipated for the pro&ect to make sense/ SOLUTION: a.
0inancial tatements !ith %ew $achine ,evenue J7DEEE 4ariable Cost DEEE ebt J7EEE 0ixed Cost BEE 2#uity 7EEE 2)(T J 6EE Total J6EEEE (nterest 8K 7EG9 7EE Rshares EEEE 2)T J <EEE Tax 8K ?EG9 DEE 23 J7.BE 2AT J 7
%ew
)reakeven JDEEE
C$
J7DEEE
=
.????
J7EEEE J7DEEE
=
.AAAB
6?
Chapter 7? JAEEE )@2
.????
J6EEE J<AEE
JBAEE
=
J77
=
7.
J6AEE J<EEE
=
<.B
J7EEEE J6AEE
=
.AAAB
J77CE7
b. 0L
=
7.A
c. JDEEE
d.
OL
J6EEE
TL
7.
=
<.DB
7.8<.DB9 .E
e. 23 will vary substantially more 8.E@6.< −7 BG9 under the new plan. $ost of the variation will come from the increase in financial risk reflected in the 0L. f.
The new machine doesn't seem to be a good idea for two reasons= 7. At current production levels financial performance gets worse and <. 0inancial performance is considerably more variable 8risky9 with the machine. The pro&ect would make sense if a big increase in volume was expected.
7D.
choen (ndustries pays interest of J6 million each year on bonds with an average coupon rate of .G. The firm has ?. million shares of stock outstanding and pays out 7EEG of earnings in dividends. 2arnings per share 8239 is J6.E. choen;s cost of e#uity is 7
SOLUTION: 40 4d M 4e
40 [email protected] M J6.E x ?.$ [email protected]< J?E $M J767.<$ J77.<$
7>.
Assume choen (ndustries of the last problem is sub&ect to income tax at a rate of ?EG. a. ,ecalculate the value of the firm assuming there is no tax shield associated with debt and compare it to the value calculated in the last problem. That is assume interest is subtracted in calculating earnings but is not deductible in calculating taxes. 5ow much value has theoretically been lost to investors as a result of taxes/ !hich investors suffer the loss stockholders or bondholders/ b. !hat is the value of the tax shield associated with the firm;s debt/ !hat is the benefit of debt / Calculate the theoretical value of the firm including the benefit of debt and compare it with the value calculated in the last problem/ !ho gets the incremental value resulting from the tax shield/ c. -nder what conditions assuming bankruptcy costs are introduced are investors likely to receive the full benefit of debt calculated in part b/ 8!ords only.9 SOLUTION: a- 2arnings without tax were J6.E x ?.$ shares
J7.$
6
Capital tructure and Leverage Add interest payments Taxable income Less tax at ?EG Less interest 2arnings available for dividends
6.EE$ J7D.$ .E$ 6.EE$ J D.<$
4f 4d M 4e ( @ k d M @ k e J6$ @ .E M JD.< @ .7< J?E$ M JBD.$ J7ED.$ Loss in value due to taxes 3revious value 4alue with tax but no tax shield Loss in value to investors
J 77.<$ 87ED.$9 J B<.E$
tockholders suffer the entire loss because interest payments are fixed by choen;s bond contracts. (- The 8annual9 tax shield associated with debt is the tax saved by making deductible interest payments which is simply the payment times the tax rate. (n choen;s case that;s J6$ x .? J7.<$
The benefit of debt is the present value of the annual tax shield in perpetuity capitali1ed at the return on debt. J7.<$ @ .E J7B$ The benefit of debt is an addition to the value calculated earlier in this problem. 5ence the value with deductible taxes is 4alue with tax but no tax shield )enefit of debt
J7ED.$ 7B.EE$ J7
The benefit of debt accrues entirely to stockholders for the same reason they suffered the entire value loss from the imposition of taxes because interest payments are fixed by choen;s bond contracts. c- The introduction of bankruptcy costs causes the value of the firm to decline below the theoretical value with taxes because investors become concerned about risk as debt increases. ee 0igure 7?.76a. 0urther investor concern about risk is heightened if the company is facing difficult business conditions. 5ence the full benefit of debt is likely to be achieved only at low debt levels and when business is reasonably good.
