1. Capital Structure
© 2005 Thomson/South-Western

2. Capital Structure Vs Financial Structure
Total current liabilities
L-T debt
P/S
C/S
Right-Hand side of the balance sheet
Capital Structure
Permanent s-t debt
L-T debt
P/S
C/S
Finance 312

3. Capital Structure Terminology
Optimal capital structure
Minimizes a firm’s weighted cost of capital
Maximizes the value of the firm
Target capital structure
Capital structure at which the firm plans to operate
Debt capacity
Amount of debt in the firm’s optimal capital structure
Finance 312

4. 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

5. 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

6. What is Business Risk?
Uncertainty about future operating income (EBIT).
How well can we predict operating income? 2

7. Factors Affecting Business Risk
Sales variability
Input price variability
Ability to adjust output prices for changes in input prices
The extent to which costs are fixed: operating leverage 3

8. 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) 4

9. 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 a result of financial leverage 7

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

11. Business Risk Factors: Demand variability Sales price variability
Input cost variability
Ability to develop new products
Foreign exchange exposure
Operating leverage (fixed vs variable costs)

12. Financial Risk Leverage increases shareholder risk
Leverage also increases the return on equity (to compensate for the higher risk)

13. Consider Two Hypothetical Firms Identical Except for Debt
Firm U
Firm L
Capital
$20,000
Debt $0
$10,000 (12% rate)
Equity
$10,000
Tax rate
40%
EBIT
$3,000
NOPAT
$1,800
ROIC 9%

14. Impact of Leverage on Returns
Firm U
Firm L
EBIT
$3,000
Interest
1,200
EBT
$1,800
Taxes (40%)
1 ,200
720 NI
$1,080
ROIC (NI+Int)/TA]
9.0%
11.4%
ROE (NI/Equity)
10.8%

15. Why does leveraging increase return?
More cash goes to investors of Firm L.
Total dollars paid to investors:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200
L: $720.
In Firm L, fewer dollars are tied up in equity.

16. Impact of Leverage on Returns if EBIT Falls
Firm U
Firm L
EBIT
$2,000
Interest
1,200
EBT
$800
Taxes (40%)
800
320 NI
$1,200
$480
ROIC
6.0%
8.4%
ROE
4.8%
Leverage magnifies risk and return!

17. Impact of Leverage on Returns if EBIT Rises
Firm U
Firm L
EBIT
$4,000
Interest
1,200
EBT
$2,800
Taxes (40%)
1,600
1,120 NI
$2,400
$1,680
ROIC
12.0%
14.0%
ROE
16.8%
Leverage magnifies risk and return!

18. Consider Two Hypothetical Firms
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

19. Impact of Leverage on Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest ,200
EBT $3,000 $1,800
Taxes (40%) ,
NI $1,800 $1,080
ROE % %

20. Why does leveraging increase return?
More EBIT goes to investors in Firm L.
Total dollars paid to investors:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200; L: $720.
Equity $ proportionally lower than NI.

21. 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. 17

22. 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.

23. 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.

24. Stock Price and Cost of Capital Estimates with Different Debt/Assets Ratios
All earnings paid out as dividends, so EPS = DPS. Assume that kRF = 6% and kM = 10%. Tax rate = 40%.
WACC = wdkd(1 - T) + wsks
= (D/A) kd(1 - T) + (1 - D/A)ks
At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%

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

26. Relationship Between Capital Structure and Cost of Capital
Cost of Equity, ks
Cost of Capital (%)
Debt/Assets (%)
WACC
Minimum = 10.8%

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

28. Degree of Operating Leverage (DOL)
The percentage change in operating income (EBIT) associated with a given percentage change in sales.
Percentage change in NOI Percentage change in sales
DEBIT EBIT DSales Sales
DEBIT EBIT DQ Q
DOL = =

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

30. Degree of Total Leverage (DTL)
The percentage change in EPS that results from a given percentage change in sales.
DTL= DOL*DFL

31. Liquidity and Capital Structure Difficulties with Analysis
We cannot determine exactly how either P/E ratios or equity capitalization rates (ks values) are affected by different degrees of financial leverage.
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.
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.

32. 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

33. Assumptions of Modigliani and Miller (1958)
No Taxes
No Transactions Costs for buying and selling securities
All investors can borrow or lend at the same rate
Relevant information is costless and readily available to all investors
Investors are rational and have homogeneous expectations of firm earnings.
Finance 312

34. Modigliani-Miller (MM) Theory: Zero Taxes
Firm U
Firm L
EBIT
$3,000
Interest
1,200 NI
$1,800
CF to shareholder
CF to debtholder
$1,200
Total CF
Notice that the total CF are identical for both firms.

35. MM Results: Zero Taxes
MM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations.
MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal:
VL = VU.
Because FCF and values of firms L and U are equal, their WACCs are equal.
Therefore, capital structure is irrelevant.

36. MM Theory: Corporate Taxes
Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms.
Therefore, more CF goes to investors and less to taxes when leverage is used.
In other words, the debt “shields” some of the firm’s CF from taxes.

37. Capital Structure Theory
Trade-off Theory
Signaling Theory

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

39. Trade-Off Theory (continued)
3. Two levels of debt:
Threshold debt level (D/A1) = where bankruptcy costs become material
Optimal debt level (D/A2) = 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

40. Trade-Off Theory (cont)
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.

41. Signaling Theory Symmetric Information Asymmetric 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.

42. Signaling Theory Signal Result: Reserve Borrowing Capacity
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.

43. Signaling Theory
MM assumed that investors and managers have the same information.
But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as a negative signal.
Implications for managers?

44. Trade-off Theory
MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used.
At low leverage levels, tax benefits outweigh(more important) bankruptcy costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists that balances these costs and benefits.

45. Pecking Order Theory
The pecking order of financing is internal financing first, and then if external financing is used, debt securities are issued before external equity.
Alternative concept to Static Tradeoff Theory
There may be no particular target or optimal capital structure for a firm.
Profitable firms with limited needs for investment funds will tend to build up financial slack.
Finance 312

46. Pecking Order Theory
Firms use internally generated funds first, because there are no flotation costs or negative signals.
If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals.
If more funds are needed, firms then issue equity.

47. Bankruptcy (Financial Distress) Costs
Lenders may demand higher interest rates
Lenders may decline to lend at all
Customers may shift their business to other firms
Distress incurs extra accounting & legal costs
If forced to liquidate, assets may have to be sold for less than market value
Finance 312

48. 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

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