Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

The lines in Figure 13.1 cross when EBIT equals $600,000. When EBIT exceeds $600,000,

HTMC’s shareholders earn more with the 50% debt/50% equity mix than with the current all-equity

structure. If EBIT is below $600,000, then the reverse is true: shareholders earn higher EPS with all-

equity financing than they would if HTMC were to borrow money.

For the proposed recapitalisation, the breakeven level of operating profits – the level of EBIT yielding

the same return on equity (ROE) for both capital structures – occurs when EBIT equals $600,000. It is

no accident that $600,000 defines the breakeven point here. Notice that if HTMC earns $600,000 on

assets of $10 million, then its return on assets equals 6%, the same rate that it pays on borrowed funds.

If the company can earn more on its assets than it pays on its debt, then EPS goes up relative to the

all-equity case. If EBIT falls short of $600,000, then the company earns less on its investments than

it pays in interest; hence EPS goes down relative to the all-equity case. The slopes of the lines in the

figure indicate that debt magnifies the effect on EPS of any change in EBIT. When EBIT changes, EPS

changes faster if the company is levered than if it is unlevered.

13 -1b THE FUNDAMENTAL PRINCIPLE OF FINANCIAL LEVERAGE

The simple example using High-Tech Manufacturing Company shows why employing long-term debt

financing is called applying financial leverage. Just as a lever magnifies the effect of a given force on an

FIGURE 13.1 THE EFFECT OF DEBT ON THE VOLATILITY OF EARNINGS

When the company uses debt, it magnifies both upside gains and downside losses, as shown by the steeper, ‘with debt’ line.

Earnings thus become riskier with leverage.

($500,000) $500,000 $1,000,000

With debt

With no debt

$1,500,000

–10

–5

5

10

15

Earnings before interest and taxes ($, no taxes)

Earnings per share ($)

0

0