CHAPTER 14Capital Structure and Leverage.ppt

CHAPTER 14Capital Structure and Leverage Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory What is business risk? Business risk is affected primarily by: Uncertainty about demand (sales). Uncertainty about output prices. Uncertainty about costs. Product, other types of liability. Operating leverage. What is operating leverage, and how does it affect a firm’s business risk? Operating leverage is the use of fixed costs rather than variable costs. If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage. More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline. What is financial leverage?Financial risk? Financial leverage is the use of debt and preferred stock. Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage. Business Risk vs. Financial Risk Business risk depends on business factors such as competition, product liability, and operating leverage. Financial risk depends only on the types of securities issued: More debt, more financial risk. Concentrates business risk on stockholders. Conclusions Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage. L has higher expected ROE because BEP kd. L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk. If debt increases, TIE falls. Optimal Capital Structure Describe the sequence of events in a recapitalization. Campus Deli announces the recapitalization. New debt is issued. Proceeds are used to repurchase stock. Cost of debt at different debt levels after recapitalization Why does the bond rating and cost of debt depend upon the amount borrowed? What would the earnings per share be if Campus Deli recapitalized and used these amounts of debt: $0, $250,000, $500,000, $750,000? Assume EBIT = $400,000, T = 40%, an