ISBN: 0-03-028931-9
Chapter 14 Financial Planning and Forecasting
In this chapter, we examined the effects of financial leverage on stock prices, earnings per share, and the cost of capital. The key concepts covered are summarized below.
A firm's optimal capital structure is that mix of debt and equity which maximizes the stock price and also minimizes the WACC. At any point in time, management has a specific target capital structure in mind, presumably the optimal one, although this target may change over time.
Several factors influence a firm's capital structure. These include the firm's (1) business risk, (2) tax position, (3) need for financial flexibility, and (4) managerial conservatism or aggressiveness.
Business risk is the riskiness of the firm's assets if it uses no debt. A firm will have little business risk if the demand for its products is stable, if the prices of its inputs and products remain relatively constant, if it can adjust its prices freely if costs increase, and if a high percentage of its costs are variable and hence will decrease if sales decrease. The extent to which fixed costs are used in a firm’s operations is called the operating leverage. Other things the same, the lower a firm's business risk, the higher its optimal debt ratio.
Business risk is dependant upon several factors, including: (1) demand variability, (2) sales price variability, (3) input cost variability, (4) ability to adjust output prices for changes in input costs, (5) ability to develop new products in a timely, cost-effective manner, (6) foreign risk exposure, and (7) operating leverage.
The operating breakeven point is the quantity of goods sold at which ROE=0, EBIT=0, and the firm’s operations break even. The greater the degree of operating leverage, the greater required sales to break even.
Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure. Financial risk is the added risk borne by stockholders as a result of financial leverage.
The Hamada equation is a method by which a firm’s beta and required return can be extrapolated under different capital structure arrangements. Based upon the firm’s current beta and current debt level, you can determine an estimate of the expected beta of the firm if it carried no debt. This beta is called the unlevered beta. This process is called the "unlevering of the beta". The process can be reversed, and the beta "relevered" under a series of possible capital structure arrangements. Once the expected betas are determined, you can estimate the firm cost of capital and determine the optimal capital structure. This process revolves around the following equation, where T is the tax rate, D/E is the firm’s debt-to-equity ratio, bU is the firm’s unlevered beta, and bL,% represents the firm’s levered beta at a particular debt ratio:
Modigliani and Miller developed a trade-off theory of capital structure. They showed that debt is useful because interest is tax deductible, but also that debt brings with it costs associated with actual or potential bankruptcy. Under MM's theory, the optimal capital structure strikes a balance between the tax benefits of debt and the costs associated with bankruptcy.
An alternative (or, really, complementary) theory of capital structure relates to the signals given to investors by a firm's decision to use debt versus stock to raise new capital. A stock issue sets off a negative signal, while using debt is a positive, or at least a neutral, signal. As a result, companies try to avoid having to issue stock by maintaining a reserve borrowing capacity, and this means using less debt in "normal" times than the MM trade-off theory would suggest. Asymmetric information is a situation in which managers have better information about a firm’s prospects than investors do, whereas symmetric information is a situation where the two groups have the same level of information.
A firm's owners may have to use a relatively large amount of debt to constrain the managers. A high debt ratio raises the threat of bankruptcy, which carries a cost, but which also forces managers to be more careful and less wasteful with shareholders' money. Many corporate takeovers and leveraged buyouts in recent years were designed to improve efficiency by reducing the free cash flow available to managers.
Although it is theoretically possible to determine a firm's optimal capital structure, as a practical matter we cannot estimate it with precision. Accordingly, financial executives generally treat the optimal capital structure as a range--for example, 40 to 50 percent debt--rather than as a precise point, such as 45 percent. The concepts discussed in this chapter help managers understand the factors they should consider when they set the target capital structure ranges for their firms.
Copyright © Harcourt College Publishers, A Harcourt
Higher Learning Company. All rights reserved.