🗃️Corporate Finance Unit 8 – Leverage and Capital Structure

Key Concepts and Definitions

• Leverage refers to the use of borrowed funds to finance a firm's operations and investments
• Financial leverage involves using debt to finance assets and operations, while operating leverage relates to the proportion of fixed costs in a firm's cost structure
• Capital structure is the mix of debt and equity a firm uses to finance its operations and investments
• Debt includes loans, bonds, and other borrowings that must be repaid with interest
• Equity represents ownership in the firm and includes common stock, preferred stock, and retained earnings
• Cost of capital is the weighted average of the costs of debt and equity financing
  • Calculated using the weighted average cost of capital (WACC) formula: $WACC = (E/V) * Re + (D/V) * Rd * (1-Tc)$
  • Where E is the market value of equity, D is the market value of debt, V is the total value of the firm (E + D), Re is the cost of equity, Rd is the cost of debt, and Tc is the corporate tax rate

Types of Leverage

• Operating leverage refers to the proportion of fixed costs in a firm's cost structure
  • High operating leverage means a larger proportion of fixed costs, leading to greater sensitivity of operating income to changes in sales
  • Low operating leverage implies a smaller proportion of fixed costs and less sensitivity to changes in sales
• Financial leverage involves the use of debt to finance assets and operations
  • Measured by the debt-to-equity ratio, which compares the amount of debt to the amount of equity financing
  • Higher financial leverage increases the potential return on equity but also increases financial risk
• Combined leverage is the product of operating leverage and financial leverage
  • Measures the total impact of both types of leverage on a firm's earnings per share (EPS)
• Degree of operating leverage (DOL) measures the percentage change in operating income for a given percentage change in sales
  • Calculated as: $DOL = (Percentage change in operating income) / (Percentage change in sales)$
• Degree of financial leverage (DFL) measures the percentage change in EPS for a given percentage change in operating income
  • Calculated as: $DFL = (Percentage change in EPS) / (Percentage change in operating income)$

Capital Structure Basics

• Capital structure refers to the mix of debt and equity a firm uses to finance its operations and investments
• Debt financing includes loans, bonds, and other borrowings that must be repaid with interest
  • Advantages of debt include tax deductibility of interest payments and lower cost compared to equity
  • Disadvantages include fixed repayment obligations and increased financial risk
• Equity financing represents ownership in the firm and includes common stock, preferred stock, and retained earnings
  • Advantages of equity include no fixed repayment obligations and greater flexibility
  • Disadvantages include higher cost compared to debt and dilution of ownership and control
• A firm's capital structure decision involves balancing the costs and benefits of debt and equity financing
• The optimal capital structure maximizes firm value by minimizing the weighted average cost of capital (WACC)
• Factors influencing capital structure decisions include industry norms, firm size, growth opportunities, profitability, and risk

Theories of Capital Structure

• Modigliani and Miller (MM) proposition I states that in a perfect capital market, a firm's value is independent of its capital structure
  • Assumes no taxes, no transaction costs, no bankruptcy costs, and complete information
• MM proposition II introduces corporate taxes and states that firm value increases with the use of debt due to the tax deductibility of interest payments
  • Implies a 100% debt financing is optimal, which is unrealistic in practice
• Trade-off theory suggests an optimal capital structure balances the tax benefits of debt against the costs of financial distress
  • Firms should borrow up to the point where the marginal tax benefit equals the marginal cost of financial distress
• Pecking order theory argues that firms prefer internal financing (retained earnings) over external financing and debt over equity when external financing is necessary
  • Based on the idea that asymmetric information between managers and investors leads to a preference hierarchy
• Agency theory considers the conflicts of interest between shareholders and managers (agency costs of equity) and between shareholders and debtholders (agency costs of debt)
  • Suggests that an optimal capital structure minimizes total agency costs

Impact of Leverage on Firm Value

• Leverage affects firm value through its impact on the weighted average cost of capital (WACC)
  • Higher debt levels generally lower the WACC up to a certain point, as debt is typically cheaper than equity
  • Beyond the optimal level, increased debt raises the WACC due to higher financial risk and costs of financial distress
• Leverage also influences firm value through its effect on return on equity (ROE)
  • Higher debt levels can increase ROE by magnifying the impact of operating returns, but this comes at the cost of increased financial risk
• The effect of leverage on firm value depends on the firm's ability to generate returns above the cost of debt
  • If the return on invested capital (ROIC) exceeds the cost of debt, leverage can enhance firm value
  • If ROIC is lower than the cost of debt, leverage destroys value
• The impact of leverage on firm value is not constant and can change over time as market conditions, interest rates, and firm performance vary

Risk and Return Trade-offs

• Leverage increases the potential return on equity (ROE) but also increases the financial risk of the firm
  • Higher debt levels magnify the impact of operating returns on ROE, both positive and negative
  • Increased financial risk raises the cost of equity and the overall cost of capital
• The risk-return trade-off associated with leverage depends on the firm's business risk and financial risk
  • Business risk refers to the uncertainty of a firm's operating income and is influenced by factors such as industry, competition, and operating leverage
  • Financial risk is the additional risk to shareholders caused by the use of debt financing
• Firms with high business risk should generally have lower financial leverage to maintain a manageable total risk level
• Firms with low business risk can afford higher financial leverage without excessive total risk
• The optimal capital structure balances the risk-return trade-off by maximizing firm value while keeping the total risk at an acceptable level

Optimal Capital Structure

• The optimal capital structure maximizes firm value by minimizing the weighted average cost of capital (WACC)
  • Occurs at the point where the marginal benefit of debt (tax shield) equals the marginal cost of debt (financial distress)
• Factors influencing the optimal capital structure include industry norms, firm size, growth opportunities, profitability, and risk
  • Industry norms provide a benchmark for appropriate leverage levels, as firms in the same industry often face similar business risks and capital requirements
  • Larger, more mature firms generally have higher debt capacities due to stable cash flows and lower default risk
  • High-growth firms often rely more on equity financing to preserve financial flexibility and avoid underinvestment problems
  • Highly profitable firms may prefer internal financing (retained earnings) and have lower debt ratios, consistent with the pecking order theory
• The optimal capital structure is not a fixed target but a dynamic range that can vary over time as firm and market conditions change
• Firms should periodically review and adjust their capital structure to ensure it remains appropriate for their current situation and future goals

Real-World Applications and Case Studies

• Apple Inc. (AAPL) has maintained a relatively low debt-to-equity ratio, relying primarily on internal financing and equity to fund its operations and growth
  • Reflects the company's high profitability, substantial cash reserves, and strong market position
  • Allows flexibility to invest in research and development, acquisitions, and share repurchases
• General Electric (GE) historically maintained a high debt-to-equity ratio, leveraging its strong cash flows and credit rating to finance operations and acquisitions
  • Allowed the company to expand into various industries and generate high returns on equity
  • However, high leverage also contributed to financial difficulties during the 2008 financial crisis and subsequent years
• Tesla, Inc. (TSLA) has relied on a mix of debt and equity financing to fund its rapid growth and capital-intensive operations
  • Issued convertible bonds and traditional debt to finance factory construction and product development
  • Raised equity through public offerings and private placements to support expansion plans
  • High leverage and negative cash flows have led to concerns about the company's financial stability and ability to meet its obligations
• Berkshire Hathaway Inc. (BRK.A, BRK.B) has maintained a conservative capital structure with minimal debt and a focus on equity financing
  • Reflects the investment philosophy of CEO Warren Buffett, who emphasizes the importance of financial stability and long-term value creation
  • Allows the company to make opportunistic investments and acquisitions without the constraints of debt obligations