CAPITAL STRUCTURE AND LEVERAGE Chapter 7

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CAPITAL STRUCTURE AND LEVERAGE Chapter 7
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• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

Capital Structure
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2 concepts that enhance our understanding of
risk...

• 1) Operating Leverage - affects a firms business
  risk.
• 2) Financial Leverage - affects a firms
  financial risk.

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Implications

• If there is a high degree of business risk
  inherent in the line of commerce,
• It calls for a low degree of financial risk.
• If there is a low degree of business risk,
• Use a higher level of financial leverage.

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Why is Capital Structure Important?

• 1) Leverage higher financial leverage means
  higher returns to stockholders, but higher risk
  due to interest payments.
• 2) Cost of Capital Each source of financing
  has a different cost. Capital structure affects
  the cost of capital.
• 3) The Optimal Capital Structure is the one that
  minimizes the firms cost of capital and
  maximizes firm value.

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CAPITAL STRUCTURE - Traditional Approach Models

• Times Interest Earned EBIT/Interest
• Times Burden Earned EBIT/Interest Sinking
  Fund
• Times Debt Charges Earned EBITDA/Interest
  S.F. Capital Expend.
• Important What does you Banker look for??

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CAPITAL STRUCTURE - Traditional Approach

• The idea behind the traditional approach is that
  if a firm has Interest coverage greater than
  some norm - or average for an industry - then
  their Capital Structure is acceptable. If their
  coverage ratios were less than the average the
  conclusion would be that the company had too much
  debt.

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CAPITAL STRUCTURE Traditional Approach

• When this approach was first invented, bonded
  indebtedness was all quite alike in its terms
  the difference in interest rates was not much and
  there was no required SINKING FUND.
• A sinking fund is an actual cash fund in which
  the company deposits cash (or the security itself
  - which takes cash) so that there would be
  sufficient money to pay off the bond when it
  matured.
• Bonds were essentially HOMOGENEOUS

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CAPITAL STRUCTURE - Theoretical Approach

• In 1958, Modigliani and Miller argued that in a
  world of no taxes, and certain other assumptions,
  changes in the firms capital structure have no
  effect on the valuation of the firm.
• Thus, if the value of the firm is V, then
• V S D
• Then if you increase debt - and thus the risk
  of the firm - S declines leaving V unchanged.
  
  

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CAPITAL STRUCTURE - Theoretical Approach

• Essentially, MM argue that capital structure
  does not really matter, that the Market will
  adjust to whatever capital structure there is.
  When it comes to optimal capital structure, the
  argument is based on two things
• 1) the tax savings associated with interest and
• 2) the costs of bankruptcy.

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CAPITAL STRUCTURE - Cash Flow Approach

• The amount of debt that you can have (max.) is
  the amount of debt you can service!
• This is why the HETEROGENEITY of debt is so
  important.
• The problem then is How do you determine how
  much money is available to service debt. The
  answer is
• Maximum amount of debt NOCF/I SF
• Where NOCF NOCF - necessary Discretionary
• and the Sinking Fund is expressed as a percentage
  of principal
• and i is the interest rate.

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CAPITAL STRUCTURE - Cash Flow Approach

• In short, NOCF is the amount of money a firm
  has to service its debt.
• But remember, today debt may be quite
  HETEROGENEOUS, that is, it may have a wide array
  of interest rates and debt repayment requirements.

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CAPITAL STRUCTURE - Cash Flow Approach

• Illustration of the heterogeneity of debt
• 1) 1,000,000 / .10 10,000,000 Face amount of
  debt
• 2) 1,000,000 / .15 6,666,666
• 3) 1,000,000 / .10 .15 4,000,000
• 4) 1,000,000 / .12 .33 2,222,222
• Where S.F. of debt paid off each year.
• SO A FIRM WITH THE SAME NOCF WOULD HAVE THE
  SAME ABILITY TO SERVICE DEBT THAT RANGED FROM
  10 MILLION TO 2.2 MILLION.

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CAPITAL STRUCTURE - Cash Flow Approach

• When discussing whether a firm has too much
  debt - and one should be referring to the
  debts Servicing requirements - the usual
  assumption is What would happen in a recession?
• The following graph illustrates this scenario.

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CAPITAL STRUCTURE -Cash Flow Approach

• Illustration of Debt Servicing Ability

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CAPITAL STRUCTURE -Cash Flow Approach

• The preceding scenario illustrates that the firm
  in question should have no problem servicing its
  debt with the kind of recession simulated.

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CAPITAL STRUCTURE - Cash Flow Approach

• Effect of over-leveraging

Sales

NOCF
Priority Outflows
Time
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CAPITAL STRUCTURE - Cash Flow Approach

• What would happen to the firms cash account in
  the preceding scenario?
• If Priority Outflows are too high (close) to
  NOCF, then in a recession, the firm may
  experience a severe cash shortage.
• Whenever NOCF drops below Priority Outflows,
  the Cash Account goes down.

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CAPITAL STRUCTURE - Cash Flow Approach

• While it is intuitive to assume that a recession
  would be a bad scenario for a firm, remember that
  it is possible for a firm to emerge from a
  recession with more cash than it had at the
  beginning of the recession. How?
• If it keeps its NOCF above its Priority
  Outflows and doesnt overspend on Discretionary
  Outflows.

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CAPITAL STRUCTURE - Cash Flow Approach

• In a steady sales scenario, if NOCF exceeds
  the debt servicing requirements - the Priority
  Outflows - then the firm would not have too much
  debt.
• But is there an OPTIMAL CAPITAL STRUCTURE?
• Probably not as the problem is complicated by two
  very important considerations 1) the scenario
  assumed (later this is called the probability
  density function of Sales) and 2) the
  heterogeneity of the debt. Optimal to what?

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CAPITAL STRUCTURE - Cash Flow Approach

• In other scenarios, there may be different
  effects on NOCF. For example, in a growth
  scenario, there may be so much downward pressure
  on NOCF that there would be NO money available
  to service any debt. (This is assuming that the
  debt is not Zero coupon or Payment in kind -
  PIK- debt.)

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LEVERAGE

• What is leverage?
• Leverage is the inclusion of a fixed charge in
  the Income Statement - or Cash Flow Statement -
  which results in a magnification in the change in
  Net Income - or Cash - for a given change in
  Sales.
• There are two financial statements for which we
  can observe the effects of leverage 1)An Income
  Statement and 2) A Cash Flow Statement.

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TYPES OF LEVERAGE

• There are also two types of leverage
  1)Financial leverage and 2) Operating leverage.
• Debt, and its resulting interest payments - and
  Sinking Fund requirements - causes Financial
  Leverage.
• Depreciation and any other fixed charge, such as
  rent,produces what is called Operating Leverage.

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ILLUSTRATION OF LEVERAGE

• Consider these two Income Statements with
  Financial Leverage included

A
B
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ILLUSTRATION OF LEVERAGE

• If depreciation is added to these Income
  Statements, leverage would be increased.
• A
  B

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ILLUSTRATION OF LEVERAGE

• By adding Operating leverage to an Income
  Statement that already has Financial leverage,
  the Net Income Before Tax increased 33.3
  compared with an increase of 28with only
  Financial Leverage - for an increase in Sales of
  20.
• But remember, leverage is a two edged sword If
  Sales decline and there is leverage, the decline
  in Net Income Before Tax will be greater than the
  decline in Sales.

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LEVERAGE AND THE CASH FLOW STATEMENT

• How does leverage affect NOCF and the Cash
  Balance?
• Because NOCF includes changes in the Working
  Capital items (A/R, Inv. A/P), which the Income
  Statement does not, the effect on NOCF for a
  given change in Sales is not as clear as the
  change in EBIT for a given change in Sales. For
  example, would A/Rs increase proportionately as
  Sales increase?
• But the general magnification principal would
  apply.

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LEVERAGE AND BREAK-EVEN ANALYSIS

• Since leverage is a fixed charge, we can extend
  our discussion to what is known as Break-Even
  analysis.
• A firms Income Statement BREAK-EVEN point is
  found from the following
• B/E Fixed Charges/Contribution
• Where contribution Gross Profit / Sales

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LEVERAGE AND BREAK-EVEN ANALYSIS

• Consider the following Break-Even Chart

Profit
Profit/Loss

Break-Even
Total Costs
Loss
Variable Cost
Fixed Cost
Unit output or Sales
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LEVERAGE AND BREAK-EVEN ANALYSIS

• If we take the Total costs line (Yellow)and
  make it a horizontal line on the following chart,
  and then plot the Profit/Loss line, we get

s
We can now show the effects of leverage
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LEVERAGE AND BREAK-EVEN ANALYSIS

• If we increased the LEVERAGE - any kind of
  leverage - we would get the following

B/E
0
s
As leverage is increased, the B/E is
increased. For higher outputs profit increases
and vice versa.
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LEVERAGE AND BREAK-EVEN ANALYSIS

• The reason for the leverage increase might be the
  fact that we added to the equipment - we became
  more capital intensive. By so doing, we would
  realize higher profits IF we operated above the
  Break-Even level of output.
• Or, it could be that we added some debt. Again,
  the benefit is realized only if we operate above
  the break even point.

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LEVERAGE AND BREAK-EVEN ANALYSIS

• Conversely, what would happen if we sold off
  equipment and became more labor - variable cost -
  intensive?

The yellow line would be the new Profit/Loss
line.
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LEVERAGE AND BREAK-EVEN ANALYSIS

• As an aside, what would happen if we increased
  the firms variable costs? The Profit-Loss line
  rotates downward, thus

B/E
Sales
s
The yellow line would be the new Profit/Loss
line.
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LEVERAGE AND BREAK-EVEN ANALYSIS

• With less leverage, we would have lower losses at
  LOW levels of Sales and LOWER profit at higher
  levels of output.
• SO WHICH IS THE BETTER STRATEGY?

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LEVERAGE AND BREAK-EVEN ANALYSIS

• The better strategy depends on the probability
  density function of Sales. For example

B
A
Probability density functions of expected Sales
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LEVERAGE AND BREAK-EVEN ANALYSIS

• While the preceding chart shows what would happen
  to the firms Profit Loss on its Income
  Statement, the chart below shows what would
  happen to the firms Cash Flow Statement

A
B
Cash-Line
Cash Balance

Sales
s
-
Cash Flow Break-Even
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LEVERAGE AND BREAK-EVEN ANALYSIS

• From the preceding chart it can be seen that when
  the firms probability density function of Sales
  shifts upward this has the effect of rotating the
  NOCF line outward - just like it did when
  variable costs were increased. The effect of this
  shift is to raise the firms Cash Flow Break-Even
  point. It will take more Sales to have a
  Cash-Flow break-even.

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LEVERAGE AND BREAK-EVEN ANALYSIS

• If the firms management felt that it was facing
  a Sales probability similar to As density
  function, it would be better off with somewhat
  more leverage if management felt that it was
  facing a Sales probability of B, it would be
  better off with less leverage.
• THE TRICK IN MANAGEMENT IS TO FIGURE OUT WHAT
  PROBABILITY FUNCTION THE FIRM IS FACING.

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Leverage and the Probability Density Function of
Sales

• Returning to the NOCF model for how much debt a
  firm can support, we must remember that when we
  calculated NOCF we assumed a certain probability
  density function of expected sales, with NOCF
  being the mode of that distribution. Thus

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Leverage and the Probability Density Function of
Sales
Cash Flow Break Even Line

0
Sales
NOCF
-
In this case, the firm can feel quite
comfortable with the amount of leverage it has
undertaken.
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Leverage and the Probability Density Function of
Sales
Cash Flow Break Even Line

0
Sales
NOCF
-
In this case, there is less certainty in Sales
and, even though the firm should be able to
service its debt, it would be taking a large
chance - almost 50- of not being able to service
its debt!
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Leverage and the Probability Density Function of
Sales

• The previous slide is analogous to the prior
  slide showing a firm that over leveraged. If
  sales drop below what they were - or the modal
  estimate - then the firm will suffer a drop in
  cash.
• When deciding on committing a firm on a contract
  that involves leverage, e.g., a rent contract or
  taking out a loan, it is useful to have a rather
  good feel for the probability density function of
  sales it faces.

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LEVERAGE AND BREAK-EVEN ANALYSIS

• Guess wrong and the firm will either have lower
  profits - or less cash - than it might have OR it
  will have larger losses - perhaps even a cash
  insufficiency - than it would otherwise have.
• And that leads us back again to the question
• Is there an optimal capital structure?

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CAPITAL STRUCTUREandLEVERAGE
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