Chapter 9 Capital Structure © 2005 Thomson/South-Western

2 The Target Capital Structure  Capital Structure: The combination of debt and equity used to finance a firm  Target Capital Structure: The ideal mix of debt, preferred stock, and common equity with which the firm plans to finance its investments

3 The Target Capital Structure  Four factors that influence capital structure decisions:  The firm’s business risk  The firm’s tax position  Financial flexibility  Managerial attitude

4 What is Business Risk?  Uncertainty about future operating income (EBIT).  How well can we predict operating income?

5  Sales variability  Input price variability  Ability to adjust output prices for changes in input prices  The extent to which costs are fixed: operating leverage Factors Affecting Business Risk

6 What is Operating Leverage?  Operating Leverage: Use of fixed operating costs rather than variable costs  If most costs are fixed (i.e., they do not decline when demand falls) then the firm has high DOL (degree of operating leverage)

7 What is Financial Risk?  Financial Leverage: The extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure  Financial Risk: Additional risk placed on stockholders as as result of financial leverage

8 Business Risk vs. Financial Risk  Business risk depends on business factors such as competition, product liability, and operating leverage.  Financial risk depends only on type of securities issued: the more debt, the more financial risk.

9 Determining the Optimal Capital Structure:  Seek to maximize the price of the firm’s stock.  Changes in use of debt will cause changes in earnings per share, and, thus, in the stock price.  Cost of debt varies with capital structure.  Financial leverage increases risk.

10 EPS Indifference Analysis  EPS Indifference Point: The level of sales at which EPS will be the same whether the firm uses debt or common stock (pure equity) financing.

11 Probability Density 0 $2.40$ % Debt Financing Zero Debt Financing EPS ($) Probability Distribution of EPS with Different Amounts of Financial Leverage

12 The Effect of Capital Structure on Stock Prices and the Cost of Capital  The optimal capital structure maximizes the price of a firm’s stock.  The optimal capital structure always calls for a debt/assets ratio that is lower than the one that maximizes expected EPS.

13 All earnings paid out as dividends, so EPS = DPS. Assume that k RF = 6% and k M = 10%. Tax rate = 40%. WACC = w d k d (1 - T) + w s k s = (D/A) k d (1 - T) + (1 - D/A)k s At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80% Stock Price and Cost of Capital Estimates with Different Debt/Assets Ratios

14 EPS Relationship Between Capital Structure and EPS Maximum EPS = $3.36Expected EPS ($) Debt/Assets (%)

15 Cost of Equity, k s Cost of Capital (%) Debt/Assets (%) WACC Minimum = 10.8% Cost of Capital Relationship Between Capital Structure and Cost of Capital

16 Maximum = $22.86 Stock Price ($) Debt/Assets (%) Stock Price Relationship Between Capital Structure and Stock Price

17 Percentage change in NOI Percentage change in sales  EBIT EBIT  Sales Sales  EBIT EBIT  Q Q DOL = = = DOL Q = Q(P - V) Q(P - V) - FC DOL S = S - VC S - VC - F Gross Profit EBIT = Degree of Operating Leverage (DOL)  The percentage change in operating income (EBIT) associated with a given percentage change in sales.

18  EPS EPS  EBIT EBIT Percentage change in EPS Percentage change in EBIT EBIT EBIT - Int DFL = = = Degree of Financial Leverage (DFL)  The percentage change in earnings available to common stockholders associated with a given percentage change in EBIT. This equation assumes the firm has no preferred stock.

19 S - VC S - VC - F - Int Gross Profit EBIT - Int DTL = = Q(P - V) Q(P - V) - F - Int DTL = DTL = DOL X DFL Degree of Total Leverage (DTL)  The percentage change in EPS that results from a given percentage change in sales.

20 Liquidity and Capital Structure Difficulties with Analysis 1.We cannot determine exactly how either P/E ratios or equity capitalization rates (k s values) are affected by different degrees of financial leverage. 2.Managers may be more or less conservative than the average stockholder, so management may set a different target capital structure than the one that would maximize the stock price. 3.Managers of large firms have a responsibility to provide continuous service and must refrain from using leverage to the point where the firm’s long- run viability is endangered.

21 Liquidity and Capital Structure  Financial strength indicator  Times-Interest-Earned (TIE) Ratio  Ratio that measures the firm’s ability to meet its annual interest obligations  Formula: divide EBIT (earnings before interest and taxes) by interest charges

22 Capital Structure Theory  Trade-off Theory  Signaling Theory

23 Trade-Off Theory (Modigliani and Miller) 1.Theory: 1.Interest is tax-deductible expense, therefore less expensive than common or preferred stock. 2.So, 100% debt is the preferred capital structure. 2.Theory: 1.Interest rates rise as debt/asset ratio increases 2.Tax rates fall at high debt levels (lowers debt tax shield) 3.Probability of bankruptcy increases as debt/assets ratio increases.

24 Trade-Off Theory (continued) 3. Two levels of debt: 1.Threshold debt level (D/A 1 ) = where bankruptcy costs become material 2.Optimal debt level (D/A 2 ) = where marginal tax shelter benefits = marginal bankruptcy–related costs 3.Between these two debt levels, the firm’s stock price rises, but at a decreasing rate 4.So, the optimal debt level = optimal capital structure

25 Trade-Off Theory (cont) 4.Theory and empirical evidence support these ideas, but the points cannot be identified precisely. 5.Many large, successful firms use much less debt than the theory suggests—leading to development of signaling theory.

26 Signaling Theory  Symmetric Information  Investors and managers have identical information about the firm’s prospects.  Asymmetric Information  Managers have better information about their firm’s prospects than do outside investors.

27 Signaling Theory  Signal  An action taken by a firm’s management that provides clues to investors about how management views the firm’s prospects  Result: Reserve Borrowing Capacity  Ability to borrow money at a reasonable cost when good investment opportunities arise  Firms often use less debt than “optimal” to ensure that they can obtain debt capital later if needed.

28 Variations in Capital Structures among Firms  Wide variations in use of financial leverage among industries and firms within an industry  TIE (times interest earned ratio) measures how safe the debt is:  percentage of debt  interest rate on debt  company’s profitability

29 Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995 Capital Structures Around the World

30 Before Next Class: 1.Review Chapter 9 material 2.Do Chapter 9 homework 3.Prepare for Chapter 9 quiz 4.Read Chapter 10