13: Capital StructureTABLE 13.4 EXPECTED CASH FLOWS TO SHAREHOLDERS AND BONDHOLDERS UNDER THE CURRENT
AND PROPOSED CAPITAL STRUCTURES FOR HTMC FOR THREE EQUALLY LIKELY OUTCOMESRecession Normal growth Boom
$500,000 $1,000,000 $1,500,000EBIT
All-equity
financing50% debt,
50% equityAll-equity
financing50% debt,
50% equityAll-equity
financing50% debt:
50% equity- Interest (6.0%) $0 $(300,000) $ 0 $(300,000) $0 $(300,000)
Net income $500, 000 $200,000 $1,000,000 $700,000 $1,500,000 $1,200,00
Shares outstanding 200,000 100,000 200,000 100,000 200,000 100,000
Earnings per share (EPS) $2.50 $2.00 $5.00 $7.00 $7.50 $12.00
Return on shares (%)
(P 0 = $50.00/share)
5.0% 4.0% 10.0% 14.0% 15.0% 24.0%
So, what’s the catch? What could possibly argue against HTMC adopting the recapitalisation plan
and increasing EPS and ROE? The answer is that the economy may well fall into a recession next year,
in which case High-Tech’s EBIT will only be $500,000. With the existing all-equity capital structure,
the company would achieve an EPS of $2.50, yielding a 5.0% ROE for shareholders. However, if
HTMC recapitalises and the economy falls into a recession, net income will only be $200,000, after
paying $300,000 in interest. Thus, EPS will be $2.00 and ROE only 4.0%. In other words, whether the
recapitalisation plan increases or decreases returns for shareholders depends on the state of the economy.
Recall that Ms Kelly believes that each of the three economic scenarios is equally likely. Based on
that view, we already calculated the expected level of EBIT. But what about expected EPS and expected
ROE? As HTMC’s major shareholder claimed, the expected return to shareholders rises if HTMC adds
debt to its capital structure.Expected EPS(no debt) =
1
3
$7.50 +
1
3
$5 +
1
3
$2.50 = $5
Expected EPS(with debt) =
1
3
$12 +
1
3
$7 +
1
3
$2 = $7
Expected ROE(no debt) =
1
3
15% +
1
3
10% +
1
3
5% = 10%
Expected ROE(with debt) =
1
3
24% +
1
3
14% +
1
3
4% = 14%
13 -1a HOW LEVERAGE INCREASES THE RISK OF EXPECTED
EARNINGS PER SHAREFigure 13.1 illustrates how High-Tech’s capital structure affects the relationship between EBIT and
EPS. In good economic times, the company enjoys higher EPS with the 50% debt/50% equity capital
structure than with the all-equity capital structure. However, in a recession, HTMC’s shareholders
earn more under the old all-equity capital structure. Now you can see how the term leverage applies to
the decision to borrow money: relative to the all-equity capital structure, borrowing money makes
shareholders better off when times are good and worse off when times are bad. Leverage magnifies both
the good outcomes and the bad ones.LO 13.1