Finance Chapter 13 Capital structure & leverage

Financing assets  What is the best way for a firm to finance its asset?  What is the effect of financial leverage on stock prices, earnings per share, & the cost of capital  Leverage = the use of borrowed money to increase production volume, and thus sales and earnings. It is measured as the ratio of total debt to total assets; greater the amount of debt, greater the financial leverage.  BusinessDictionary.com

Target capital structure  Target capital structure = the mix of debt, preferred stock, and common equity the firm plans to use to raise capital  If debt level is below target, expansion capital should be raised using debt  If debt level is above target, expansion capital should be raised using equity

Capital structure Influences  Business risk  Tax position  Need for financial flexibility  Managerial conservatism or aggressiveness

Business risk  Business risk = the risk inherent in the firm’s operations if it uses no debt. The lower a firm’s business risk, the higher its optimal debt ratio. A firm has little risk if:  The demand for its products is stable (Demand variability)  Firms selling products in stable markets—no significant changes in prices (Sales price variability)  The prices for inputs and products remain relatively constant It can adjust its costs freely if costs increase  A high percentage of its costs are variable and will therefore decrease as sales decrease (operating leverage  A firm with high fixed costs is more exposed if sales decline

Business risk  In high tech industries (drugs, computers) if they are able to produce new products in a timely and cost-efficient manner  The firm’s dependence on foreign sales is minimized reducing exposure to currency rate fluctuations and political instability

Operating leverage  Operating leverage = the extent to which fixed costs are used in a form’s operations. A high degree of operating leverage, ceteris paribus, implies that a relatively small change in sales results in a large change in ROE. (pg. 483, figure 13.3)  Operating break even is the output quantity at which EBIT=0 (ROE = 0)

Financial risk  Financial risk is the additional risk placed on stockholders as a result of the decision to finance with debt  Financial risk = an increase in stockholders’ risk, above and beyond the firm’s basic business risk, resulting from the use of financial leverage  Financial leverage = the extent to which fixed income securities (debt & preferred stock) are used in a firm’s capital structure

Optimal capital structure  The optimal capital structure is one that maximizes the price of the firm’s stock  Recall that if the increase in debt raises the firm’s risk it may result in a higher cost of equity reducing the value of its stock  The (Robert) Hamada equation – shows the effect of financial leverage on beta (measure of risk for investors) (pg. 494) b = b u [1 + (1 – T)(D/E)] effect of financial leverage on beta b u = b/[1 + (1 – T)(D/E)] unlevered beta

Capital structure theory  Franco Modiglianni and Merton Miller (1958). Aka, MM, their theory posited that capital structure is irrelevant.  Unrealistic assumptions (e.g., taxes, bankruptcy)  Provided clues about what is required for a firm’s capital structure to be relevant and thus to effect a firm’s value  Impact of taxes  The deductibility of interest favors debt financing  The more favorable tax treatment from stock income lowers the RROR on stock and so favors equity financing

Capital structure theory  Potential bankruptcy  The probability of occurrence (e.g., higher interest rates; can assets be liquidated?)  Costs associated with financial stress (e.g., best employees leave the firm)  Trade-off theory of capital structure – debt is useful because interest is tax deductible but debt also brings costs associated with actual or potential bankruptcy. Therefore, optimal capital structure balances tax benefits of debt and the costs of bankruptcy

Signals  An alternative theory of capital structures relates to the signals given to investors by a firm’s decision to use debt vs. stock to raise new capital based on:  Symmetric information – managers and investors have similar access to information about the firm’s prospects  Asymmetric information – managers have better information about the firm’s prospects (pg. 506)  Stock = negative signal  Debt = neutral – positive signal  Reserve borrowing capacity – managers use less debt in normal times to avoid issuing stock in volatile times

Debt and management constraint  Owners may desire a high amount of debt to constrain managers since this raises the threat of bankruptcy. This results in managers being more careful with shareholders’ money.  Many corporate take-overs and LBO’s were aimed at improving efficiency by reducing the free cash flow available to managers

Capital structure practice  In practice, financial executives generally treat the optimal capital structure as a range (e.g., %) rather than a precise number

Capital structure checklist  Sales stability  Asset structure  Operating leverage  Growth rate  Profitability  Taxes  control  Management attitudes  Lender & rating agency attitudes  Market conditions  Firm’s internal conditions  Financial flexibility

Capital structure goal  Maintain financial flexibility  Maintain adequate reserve borrowing capacity