Professional Documents
Culture Documents
Capital
Capital Structure
- The mix of debt, preferred stock, and common equity that is used to finance the firm’s assets
- The percentage of each investor-supplied capital, with the total being 100%
- Business Risk
o The riskiness inherent in the firm’s operations if it uses no debt
o Common measure of business risk: Standard deviation of firm’s Return on Invested Capital (ROIC)
Measures the underlying risk of the firm before considering the effect of debt financing
ROIC – measures the after-tax return that the company provides for all its investors
Does not vary with the changes in capital structure
𝐸𝐵𝐼𝑇 (1 − 𝑇)
𝑅𝑂𝐼𝐶 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑜𝑟 𝑠𝑢𝑝𝑝𝑖𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
o Factors Affecting Business Risk:
1. Competition 4. Input cost variability
2. Demand variability 5. Product obsolescence
3. Sales price variability
6. Foreign risk exposure – firms generating high percentage of earnings overseas are subject to exchange
rate fluctuations and political risks
7. Regulatory risk and legal exposure – firms operating under high regulation (e.g. financial services,
utilities) are subject to changes in regulatory environment which can affect current and future
profitability; companies that face significant legal exposure are damaged when forced to pay large
settlements (e.g. when being sued for damages caused by products)
8. Extent to which costs are fixed: operating leverage – when a high percentage of costs are fixed and
does not decline when demand falls, business risk increases
- Operating Leverage
o The extent to which fixed costs are used in a firm’s operations
Higher fixed costs higher business risk
Higher fixed costs are generally associated with highly automated, capital-intensive firms
and industries, businesses employing highly skilled workers that must be retained and
paid even during recessions, firms with high product development costs (because
amortization of development cost is a fixed cost)
o Higher percentage of total costs are fixed higher degree of operating leverage
A higher degree of operating leverage, other factors held constant, implies that a relatively small
change in sales results in a large change in ROIC
However a higher degree of operating leverage also entails a higher expected ROIC, but also
higher probability of losses
𝐶𝑀
𝐷𝑂𝐿 =
𝐸𝐵𝐼𝑇
Where DOL = degree of operating leverage CM = contribution margin EBIT = Earnings before interest and taxes
- Financial Risk
o An increase in stockholders’ risk, over and above the firm’s basic business risk, resulting from the use of
financial leverage
o Financial leverage – the extent to which fixed-income securities (debt and preferred stock) are used in a
firm’s capital structure
o Changes in debt would not affect ROIC, but affect the proportion of risk borne by the firm’s stockholders
Changes in use of debt changes in EPS changes in risk affect stock price
Typically, using debt increases the expected rate of return for an investment, but also increases
risk to the common stockholders (measured by coefficient of variation of ROE)
𝜎𝐸𝑃𝑆 𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇
𝐶𝑂𝑉 = 𝐷𝐹𝐿 = 𝑇𝐼𝐸 =
𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐸𝑃𝑆 𝐸𝐵𝑇 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
- “The optimal capital structure is the one that maximizes the price of the firm’s stock, and this generally calls for
a debt/capital ratio that is lower than the one that maximizes expected EPS”
- Stock prices are positively related to expected earnings but negatively related to higher risk
o To the extent that higher debt levels raise expected EPS, financial leverage increases stock price
o Higher debt levels also increase the firm’s risk, which increases cost of equity and reduces stock price
- Rule: Minimize WACC, maximize stock price
- Modern capital structure theory began in 1958 when Professors Franco Modigliani and Merton Miller published
the most influential finance article
o He proved that under a restrictive set of assumptions, that a firm’s value should be unaffected by its
capital structure
o Assumptions:
1. There are no brokerage costs
2. There are no taxes
3. There are no bankruptcy costs
4. Investors can borrow at the same rate as corporations
5. All investors have the same information as management about the firm’s future investment
opportunities
6. EBIT is not affected by the use of debt
o Some of these assumptions are unrealistic, but by indicating the conditions which capital structure is
irrelevant, MM provided clues about what is required to make capital structure relevant and, therefore,
to affect a firm’s value
- The Effect of Taxes
o Miller argued that investors are willing to accept relatively low before-tax returns on stocks than before-
tax returns on bonds
Why?
Interest in bonds is taxed as personal income at rates going up to 35%
Income from stocks partly come from dividends and capital gains
o Most long-term capital gains are taxed at a maximum rate of 15% and this tax can
be deferred until the stock is sold and gain is realized
o Returns on common stock are taxed at lower effective rates than returns on debt
o Key concepts:
1. The deductibility of interest favors the use of debt in financing
2. The more favorable tax treatment of income from stocks lowers the required rates of return on stocks
and thus facors the use of equity
o Tax benefits associated with debt financing represent about 7% of the average firm’s value
If a leverage-free firm decided to use an average amount of debt, its value would rise by 7%
o Subsequent reductions in tax rates on both dividends and capital gains have continued the benefits of
equity over debt financing which has continued the trend toward a greater reliance on equity financing
1. Sales Stability
o A frim whose sales are relatively stable can safely take on more debt and incur higher fixed charges than
a company with unstable sales
o E.g. Utility companies (has more stable demand and was able to use more financial leverage than
industrial firm
2. Asset Structure
o Other factors constant, a company is able to take on more debt if it has more cash on the balance sheet
o Net debt – equal to the total debt less cash and equivalents
Companies often look at this measure when setting their target capital structure
𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 – 𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠
o General-purpose assets that can be used by many businesses make good collateral, while special-purpose
assets do not
Reason why real estate companies are usually high leveraged while companies involved in
technological research are not
3. Operating Leverage
o Other things constant, a firm with less operating leverage is better able to employ financial leverage
because it will have less business risk
4. Growth rate
o Other things the same, faster-growing firms must rely more heavily on external capital
Flotation costs > Costs in issuing debt these firms rely more heavily on debt
However these firms often face higher uncertainty which tends to reduce their willingness
to use debt
5. Profitability
o Firms with higher rates of return on investment use relatively little debt
Reason: Very profitable firms do not need to do much debt financing because high rates of return
enable them to do most of their financing with internally generated funds
6. Taxes
o Higher tax rate = Greater advantage of debt
Interest is a deductible expense and deductions are most valuable to firms with high rate taxes
7. Control
o Control considerations can lead to the use of debt or equity because the type of capital that best protects
management varies from situation to situation
If management currently has voting control but is not in a position to buy any more stock, it may
choose debt for new financings
Management may decide to use equity if the firm’s financial situation is so weak that the use of
debt might subject it to serious risk of default
If too little debt is used, management may run a risk of takeover
8. Management Attitudes
o Some managers tend to be relatively conservative and use less debt, whereas aggressive managers use a
relatively high percentage of debt to earn higher profits
9. Lender and Rating Agency Attitudes
o Corporations often discuss their capital structures with lenders and rating agencies and give much weight
to their advice
10. Market Conditions
o Conditions in the stock and bond markets undergo long- and short-run changes that can have an
important bearing on a firm’s optimal capital structure
11. The Firm’s Internal Condition
o When firm forecasts higher earnings, it would prefer to finance with debt until higher earnings materialize
and are reflected in the stock price
It could then sell an issue of common stock, use the proceeds to retire the debt, and return to its
target capital structure
12. Financial Flexibility
o A company should always be in a position to raise capital needed to support operations
Having to turn down promising ventures due to lack of funds reduces long-term profitability
When times are good, the firm can raise capital with either stocks or bonds
When times are bad, investors are more willing to give funds when given a stronger position which
is debt
When selling a new issue of stock, it sends out a negative “signal” to investors, so stock sales by a
mature company are not desirable
o Firms must maintain “adequate borrowing capacity”
Determining what is “adequate” reserve is judgmental
Depends on the firm’s forecasted need for funds, predicted capital market conditions,
management’s confidence in its forecasts, and consequences of capital shortage
- Some observations:
o Petroleum, aerospace, biotechnology, and steel companies use relatively little debt because their
industries tend to be cyclical, oriented toward research, or subject to high product liability suits
o Grocery stores, utility companies, and airline use debt relatively heavy because their fixed assets make
good security for mortgage bonds and their relatively stable sales make it safe to carry more than average
debt
- Times-interest-earned (TIE) ratio
o Gives an indication on how vulnerable the company is to financial distress
o Depends on 3 factors:
1. Percentage of debt
2. Interest rate on debt
3. Company’s profitability
o Low leveraged companies have high coverage ratios, while highly leveraged companies have lower
coverage ratios
𝐸𝐵𝐼𝑇
𝑇𝐼𝐸 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒