Capital Structure Case Study

Financial Ratios

a) The free cash flow model implies that the value of the firm is the present value of the expected future free cash flows. Under this model, capital structure can affect firm value. The free cash flow model is as follows (Cherewyk, 2015):

FCF = EBIT (1-t) + depreciation -- CAPEX -- ? working capital -- ? other assets

In this portion of the model, the free cash flow is not affected by the capital structure. Interest on debt is not included in the free cash flow, nor is the tax effect of this interest. However, when the free cash flow is discounted, it is discounted using the weighted-average cost of capital, and that is affected by the level of debt and the cost of debt. By changing the WACC, the firm changes the rate at which the free cash flow is discounted, thereby affecting firm value. Generally, the cost of debt is lower than the cost of equity, which means that the discount rate will be lower, and the present value of the expected future free cash flows higher, when the firm carries more debt in its capital structure.

B1) Business risk is the risk that factors affecting the free cash flows (or revenues, or profits) will change in the future. Such risks should be specific to the nature of the business, but they can be either internal or external. They are not general market risks. Many factors affect business risk, including the cost of inputs, demand, regulations, competitors -- anything that can affect the stability of the profits or cash flows from the business.

B2) Operating leverage refers to the fixed costs in the operating structure. They contribute to business risk as the denominator. Basically, as revenues fluctuate, the ability of the company to scale up or down its costs in line with changes in revenue is the core principle of business risk. A business can have highly volatile cash flows, but if it can scale down or up in line with those flows, it is not as risky as a business with a high amount of fixed costs. Fixed costs increase business risk because the business can be more susceptible to negative effects of the fluctuations that it faces. As example, consider the unit breakeven point:

P -- V = $5 per unit

FC = $200, so 200 / 5 = 40 units sold is the breakeven point.

c) 1) 2)

Firm 1 (no leverage)

Firm 2 (leverage)

EBIT

EBIT

Interest

0

Interest

Tax

Tax

Net Income

Net Income

Equity

20000

Equity

10000

ROE

9.00%

ROE

10.80%

C3) This example illustrates the effect of leverage on ROE. The ROE is higher with leverage because the equity level is lower. The net income (numerator) is lower, but the denominator (equity) is lower, too, which means that the ROE ends up higher for the leveraged firm.

d) Financial risk is the risk that is associated with the firm's choice of financing vehicles, whereas business risk is the risk associated with the cash flows/revenues, in other words the running of the business. Financial risk exists specifically because of the financial choices that the firm has made, such as the choice of capital structure.

e) If EBIT falls to $2,000, the following occurs:

Firm 1 (no leverage)

Firm 2 (leverage)

EBIT

2000

EBIT

2000

Interest

0

Interest

Tax

Tax

Net Income

Net Income

Equity

20000

Equity

10000

ROE

6.00%

ROE

4.80%

This shows that leverage affects return. The risk is higher with respect to ROE because the net income is going to be lower with leverage, on account of the interest payments. The interest payments decrease the amount of earnings that can be returned to the shareholders. So while leverage is good when the company is making a lot of money, it also increases risk to the shareholders because of the fixed cost that the interest represents. Higher fixed costs = greater risk, and when those are interest payments, this is financial risk.

f) Capital theory attempts to determine what effects capital structure has on returns, and what the optimal capital structure for firms might be. The basic capital structure theory, Modigliani-Miller (MM) argues that in a perfect market, capital structure should have no impact on earnings. Most firms do not operate in such a market, so much of the work building on MM has focused on determining the impacts that the different variables have on earnings. So for example, in most countries there are differences in how debt and equity financing are taxed, so to determine the optimal capital structure, it is important for companies to understand how each of the different variables affects earnings, so that they can determine the optimal capital structure for their firm, and where the firm is taxed.

g) MM was based on evidence that capital structure does not matter in a perfect market. The application of MM shows that there is never really a perfect market, and that each variable can influence the optimal capital structure. Firms seeking to determine their optimal capital structure have to understand how their market deviates from the MM perfect market, and what those deviations mean. In particular, this is examine d through the eyes of the shareholder, as to how the company can structure its capital structure to optimize the amount of income that shareholders receive.

For managers -- financial managers, presumably -- the implication is with respect to how much debt the company should take on. This will depend on the prevailing characteristics of the market, and the respective costs of debt and equity. For operating managers, there are implications as well. A company with a high degree of leverage has a high rate of financial risk. For firms that have a high rate of financial risk, it is necessary that they have very stable cash flows, which falls to the operating manager to ensure. The operating managers need to be able to communicate effectively with the financial managers to ensure that there is a reasonable balance between operating risk and financial risk, because too much of both at the same time is not healthy. Firms with very stable cash flows can take on higher debt to return more to their shareholders; firms with volatile cash flows should have lower levels of financial risk in order to offset this higher operating risk.

h) 1) 2)

% Debt