Capital Structure

FIL 341
Prepared by Keldon Bauer
Target Capital Structure
Definition:
The mix of debt, preferred stock, and common
stock the firm plans to use over the long-run to
finance its operations.
The proportions should be set in such a way
as to balance risk/return and thereby
maximize the price of the stock.
This mix is called the Optimal Capital Structure
(OCS).
Finding Target Capital Structure
Four Factors in Determining TCS:
1 Firms business risk
As business risk increases level of debt decreases.
2 Firms tax position
As taxable income increases so does debt.
3 Financial flexibility
As access to markets increases, the firm can take
advantage of current market conditions.
Finding Target Capital Structure
4 Managerial attitudes
As managers are more conservative they will tend to
use less debt.
Note that this is the only factor that has nothing to do with
optimal capital structure, and everything to do with target
capital structure.
Business and Financial Risk
You know about market (beta) and firm-
specific risk. Company risk is a composite of
both of these risks, which itself has two
components:
1 Business risk: Uncertainty inherent in return
projections in the absence of financial leverage.
2 Financial risk: Uncertainty in return resulting
from financial leverage.
Business Risk
Biggest determinant of optimal capital
structure.
Best measured as high volatility (variance) in
operational profit (EBIT).
Most important factors:
1 Sales variability
2 Input price variability
3 Ability to adjust output prices
4 Extent to which costs are fixed
Financial Risk
Financial leverage exists when a firm raises
capital using debt (including leasing), or
preferred stock.
Degree of financial leverage measures the
extent to which fixed income securities are
used in a firms capital structure.
Ideally, this should include all fixed financing
costs like leasing!
Financial Risk
The use of debt intensifies the business risk
borne by common shareholders.
The appropriate level of financial leverage is
what determining optimal capital structure is
all about.
Finding Optimal Capital Structure
Definition:
Choosing the combination of debt and equity that
will maximize the price of the stock.
Effect of Leverage on EPS
OptiCap example from the book:
Current assets 100,000 Debt 0
Net fixed assets 100,000 Common Equity (10,000 shares) 200,000
Total assets 200,000 Total Liabilities & Equity 200,000
OptiCap
Balance Sheet
We will now examine the effect of adding leverage!
Effect of Leverage on EPS
Sales 200,000
Fixed Operating Expenses -40,000
Variable operating Expenses -120,000 -160,000
EBIT 40,000
Interest 0
Taxable Income 40,000
Taxes (40%) -16,000
Net Income 24,000
EPS $2.40
Market Value per Share $20.00
PE Ratio $8.33
Opticap
Income Statement
Effect of Leverage on EPS
One effect of increased leverage is increased
interest rates (as risk increases).
Amount Debt/Asset Interest Rate
Borrowed Ratio on All Debt
$20,000 10% 8.0%
40,000 20% 8.3%
60,000 30% 9.0%
80,000 40% 10.0%
100,000 50% 12.0%
120,000 60% 15.0%
Effect of Leverage on EPS
Next we perform a scenario analysis of sales
next year. The top of the income statement is
as follows:
Probability of achieving sales: 0.2 0.6 0.2
Sales 100 200 300
Fixed costs -40 -40 -40
Variable costs (60% of sales) -60 -120 -180
EBIT 0 40 80
Scenario Analysis - Income Statement
OptiCap
Effect of Leverage on EPS
If no leverage is taken on then:
Probability of achieving sales: 0.2 0.6 0.2
EBIT 0 40 80
Less interest 0 0 0
Taxable Income 0 40 80
Taxes (40%) 0 -16 -32
Net income 0 24 48
EPS $0.00 $2.40 $4.80
Expected EPS $2.40
o of EPS $1.52
Coefficient of variation 0.63
OptiCap
Assuming Debt/Assets = 0%
Effect of Leverage on EPS
If the firm is levered and equity purchased:
Probability of achieving sales: 0.2 0.6 0.2
EBIT 0 40 80
Less interest -12 -12 -12
Taxable Income -12 28 68
Taxes (40%) 4.8 -11.2 -27.2
Net income -7.2 16.8 40.8
EPS -$1.44 $3.36 $8.16
Expected EPS $3.36
o of EPS $3.04
Coefficient of variation 0.90
OptiCap
Assuming Debt/Assets = 50%
Effect of Leverage on EPS
-5 0 5 10 15 20
Zero Debt
50% Debt
Effect of Leverage on EPS
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
0% 10% 20% 30% 40% 50% 60% 70%
Debt/Assets (%)
E
P
S

(
$
)
Max = $3.36
Optimal Debt Level for
EPS is 50%
Effect of Leverage on EPS
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
0% 10% 20% 30% 40% 50% 60%
Debt/Assets (%)
R
i
s
k

(
C
V
)
Basic Business Risk
Added Risk Due to Leverage
Note Optimal CV = 0% Debt
EPS Indifference Analysis
Finding the indifference point:
The level of sales at which EPS will be the same
whether the firm uses debt or equity.
Using the information from the scenario
analysis and assuming that the relationship is
linear beyond that (which in our model it
was), we get the following:
EPS Indifference Analysis
($8.00)
($6.00)
($4.00)
($2.00)
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
0 50 100 150 200 250 300
Sales (Thousands of Dollars)
E
P
S

(
$
)
Unlevered
50% Debt
I ndifference Point
Sales =160
EPS =$1.44
EPS Indifference Analysis
At sales levels higher than the indifference
point, leverage enhances EPS.
At sales levels lower than the indifference
point, leverage reduces EPS.
Effect of Leverage on Firm Value
Because financial leverage adds risk and
expected return (to a point), the optimal
capital structure is the one that maximizes the
firms stock price, which is always lower than
the point which maximizes EPS.
Effect of Leverage on Firm Value
Continuing with the OptiCap example:
Debt/Asset Interest Rate Expected Expected Estimated
Ratio on All Debt EPS Beta k
s Price WACC
0% 0.0% 2.40 1.50 12.0% 20.00 12.00%
10% 8.0% 2.56 1.55 12.2% 20.98 11.46%
20% 8.3% 2.75 1.65 12.6% 21.83 11.08%
30% 9.0% 2.97 1.80 13.2% 22.50 10.86%
40% 10.0% 3.20 2.00 14.0% 22.86 10.80%
50% 12.0% 3.36 2.30 15.2% 22.11 11.20%
60% 15.0% 3.30 2.70 16.8% 19.64 12.12%
Effect of Leverage on Firm Value
Continuing with the OptiCap example:
Debt/Asset Interest Rate Expected Expected Estimated
Ratio on All Debt EPS Beta k
s Price WACC
0% 0.0% 2.40 1.50 12.0% 20.00 12.00%
10% 8.0% 2.56 1.55 12.2% 20.98 11.46%
20% 8.3% 2.75 1.65 12.6% 21.83 11.08%
30% 9.0% 2.97 1.80 13.2% 22.50 10.86%
40% 10.0% 3.20 2.00 14.0% 22.86 10.80%
50% 12.0% 3.36 2.30 15.2% 22.11 11.20%
60% 15.0% 3.30 2.70 16.8% 19.64 12.12%
Maximum Price & Minimum WACC at 40% Debt
Effect of Leverage on Firm Value
0%
5%
10%
15%
20%
0% 10% 20% 30% 40% 50% 60%
Debt/Assets
k
s
Pure Time Value of Money k
RF

Premium for Business Risk
Premium for Financial Risk
Degree of Leverage
Leverage can be defined as the degree to
which costs (operating or financial) are fixed.
We can now explore how falling operating
leverage affects the optimal capital structure.
Degree of Leverage
Using the scenario analysis we developed thus
far, we will now calculate the degree of
operating and financial leverage measures.
Probability of achieving sales: 0.2 0.6 0.2
Sales 100 200 300
Fixed costs -40 -40 -40
Variable costs (60% of sales) -60 -120 -180
EBIT 0 40 80
Scenario Analysis - Income Statement
OptiCap
Effect of Leverage on EPS
We will use the levered example:
Probability of achieving sales: 0.2 0.6 0.2
EBIT 0 40 80
Less interest -12 -12 -12
Taxable Income -12 28 68
Taxes (40%) 4.8 -11.2 -27.2
Net income -7.2 16.8 40.8
EPS -$1.44 $3.36 $8.16
Expected EPS $3.36
o of EPS $3.04
Coefficient of variation 0.90
OptiCap
Assuming Debt/Assets = 50%
Effect of Leverage on EPS
The two types of leverage magnify the others
effect.
DTL = DOL DFL
Degree of Total Leverage =DTL
Degree of Operating Leverage = DOL
Degree of financial Leverage = DFL
That means that if sales are going to be high,
then the maximum point for leverage (both
kinds) is also high because of what it does to
EPS.
Degree of Operating Leverage
DOL
DOL
DOL
Sales
=
=

=
=

=
Gross Profit
EBIT
200
300
200 120
40
2 00
300 180
80
150
.
.
Note: As sales goes up, operating leverage goes down!
Degree of Financial Leverage
DFL
DFL
DFL
Sales
=
=

=
=

=
EBIT
EBIT - I
200
300
40
40 12
143
80
80 12
117647
.
.
Note: As sales goes up, financial leverage goes down!
Effect of Leverage on EPS
DTL DOL DFL
DTL
Sales Sales Sales
= =
= =

=
Gross Profit
EBIT - I
200
2 00 143
200 120
40 12
286 . . .
( )
| |
EPS EPS DTL Sales
Sales Sales 2 1
1 = + %A
Going from 200 to 300 in the scenario analysis
represents a 50% increase in sales
( )
| |
| |
EPS EPS
300 200
1 286 50%
336 2 43 816
= +
= = =
.
. . . EPS for scenario 3
Effect of Leverage on EPS
The reason that this analysis is interesting (for
those of you trying to fall asleep), is that it
tells us how much of the increase in EPS
came from operating, and how much came
from financial leverage.
Liquidity and Capital Structure
The theory is great, but there are still some
problems that keep us from the optimal capital
structure:
1 It is impossible to determine exactly how price and
k
s
are affected by changes in DFL.
2 Managers may be more or less conservative than
the average shareholder, leading to a different
optimum for them.
Liquidity and Capital Structure
3 Publicly necessary goods or services may not be
allowed to hit the optimal for shareholders
because of the risk implied to the public (e.g.
utilities).
Bankruptcy risk is a deterrent to optimal
capital structure.
Bankruptcy risk can be judged through use of the
TIE ratio from chapter 3.
Capital Structure Theory
Trade-Off Theory
A trade-off exists between tax benefits of debt
and increasing bankruptcy costs.
Miller & Modigliani showed (with unrealistic
assumptions) that shareholder value would be
maximized with nearly 100% debt.
Doesnt hold in the real world because interest rates
rise as leverage rises, and because expected taxes go
down as debt rises, and bankruptcy costs rise as
leverage rises.
Trade-Off Theory
Leverage
F
i
r
m

V
a
l
u
e
M&M's original proposition
Zero Leverage
Value reduced by bankruptcy costs
Optimal Capital Structure
Signaling Theory
And still some successful firms use less than
optimal debt (even using trade-off theory).
One possible reason for this discrepancy, is
that M&M assumed that investors had the
same information as managers (Information
Symmetry).
Signaling Theory
In reality, managers usually have better
information than investors about corporate
prospects (Information Asymmetry).
If a companys prospects look good,
managers wishing to maximize shareholder
wealth will not issue stock to dilute their
windfall.
Signaling Theory
Those companies with bad prospects will not
want high leverage, because they may be
forced into bankruptcy.
These conclusions are consistent with what we
found using EPS indifference and degrees of
leverage analyses.
Signaling Theory
Therefore, when mature companies without
clear profit potentials issue stock, this is seen as
a bad signal that prospects look bad.
On the other hand, if they issue debt, they are
signaling that their prospects are good.
As bad signals hit the market, price of the stock
goes down, k
s
and WACC go up.
Other Theories
Normally, companies keep excess borrowing
capacity (reserve borrowing capacity) for
expansion, just in case the big one pops up.
Even though it is sub-optimal.
Capital Structure - Industries
Capital structure varies by industry and firm.
Much depends on operating leverage (business
risk).
R&D, possible lawsuits, etc. contributed to expected
operating leverage.
Also depends on debt, market interest rates, taxes
and expected profitability.
Capital Structure - Industries
Common Preferred Total TIE
Industry Equity Stock Debt Ratio
Drugs 70.1% 0.2% 29.7% 12.4%
Electronics 52.8% 0.3% 46.9% 16.3%
Industrial Machinery 51.8% 0.3% 47.9% 11.8%
Retailing 44.5% 0.5% 55.0% 4.9%
Utilities 35.6% 1.8% 62.6% 1.7%
Composite 51.3% 0.8% 47.9% 4.3%
Capital Structure - Internationally
If tax codes, other costs, and investor
preferences were the same around the world,
we should see similar capital structures.
Explanations for differences include:
Tax codes
Accounting practices
Monitoring costs
Capital Structure - Internationally
Total Long-Term Short-Term
Country Equity Debt Debt Debt
United Kingdom 68.3% 31.7% N/A N/A
United States 48.4% 51.6% 26.8% 24.8%
Canada 47.5% 52.5% 30.2% 22.7%
Germany 39.7% 60.3% 15.6% 44.7%
Spain 39.7% 60.3% 22.1% 38.2%
France 38.8% 31.2% 23.5% 37.7%
Japan 33.7% 66.3% 23.3% 43.0%
Italy 23.5% 76.5% 24.2% 52.3%