Capital Structure and Leverage
After reading this chapter, students should be able to:
• Explain why capital structure policy involves a trade-off between risk and return, and list the four primary factors that influence capital structure decisions.
• Distinguish between a firm’s business risk and its financial risk.
• Explain how operating leverage contributes to a firm’s business risk and conduct a breakeven analysis, complete with a breakeven chart.
• Define financial leverage and explain its effect on expected ROE, expected EPS, and the risk borne by stockholders.
• Briefly explain what is meant by a firm’s optimal capital structure.
• Specify the effect of financial leverage on beta using the Hamada equation, and transform this equation to calculate a firm’s unlevered beta, bU.
• Illustrate through a graph the premiums for financial risk and business risk at different debt levels.
• List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure.
• List a number of factors or practical considerations firms generally consider when making capital structure decisions.
• Briefly explain the extent that capital structure varies across industries, individual firms in each industry, and different countries.
This chapter is rather long, but it is also modular, hence sections can be omitted without loss of continuity. Therefore, if you are experiencing a time crunch, you could skip selected sections. Assuming you are going to cover the entire chapter, the details of what we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 12. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes.
DAYS ON CHAPTER: 4 OF 58 DAYS (50-minute periods)
ANSWERS TO END-OF-CHAPTER QUESTIONS
If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations.
Current liabilities. Retail firms place more emphasis on current liabilities because they have greater inventories and receivables.
Long-term debt. Public utilities place greater emphasis on long-term debt because they have more stable sales and profits as well as more fixed assets.
Retained earnings. Retail firms also use retained earnings to a greater extent, probably because they are generally smaller and, hence have less access to capital markets. Public utilities have lower retained earnings because they have high dividend payout ratios and a set of stockholders who want dividends. This is discussed further in Chapter 14.
EBIT depends on sales and operating costs that generally are not affected by the firm’s use of financial leverage, since interest is deducted from EBIT. At high debt levels, however, firms lose business, employees worry, and operations are not continuous because of financing difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive leverage causes investors, customers, and employees to be concerned about the firm’s future.
The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value and stock price. However, bankruptcy-related costs begin to be felt after some amount of debt has been employed, and these costs offset the benefits of debt. See Figure 12-8 in the textbook.
Expected EPS is generally measured as EPS for the...
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