Chapter 9

Capital
Structure

© 2005 Thomson/South-Western
 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
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 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

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 What is Business Risk?
Uncertainty about future operating income
(EBIT).

How well can we predict operating income?

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 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 5
 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)

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 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

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 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.

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 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.
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 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.

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 Probability Distribution of
EPS with Different Amounts
of Financial Leverage
Probability
Density
Zero Debt Financing

50% Debt Financing

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0 $2.40 $3.36 EPS ($)
 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.
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 Stock Price and Cost of Capital Estimates
with Different Debt/Assets Ratios
Debt/ kd Expected Estimated ks = [kRF + Estimated Resulting WACC
Assets EPS Beta (kM – kRF)s] Price P/E Ratio
0% - $2.40 1.50 12.0% $20.00 8.33 12.00%
10 8.0% 2.56 1.55 12.2 20.98 8.20 11.46
20 8.3 2.75 1.65 12.6 21.83 7.94 11.08
30 9.0 2.97 1.80 13.2 22.50 7.58 10.86
40 10.0 3.20 2.00 14.0 22.86 7.14 10.80
50 12.0 3.36 2.30 15.2 22.11 6.58 11.20
60 15.0 3.30 2.70 16.8 19.64 5.95 12.12
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

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At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%
 Relationship Between
Capital Structure and EPS
Expected EPS ($) Maximum EPS = $3.36
3.5

2.5

1.5

0.5

0
0 10 20 30 40 50 60
Debt/Assets (%) 14
 Relationship Between
Capital Structure and Cost of Capital
Cost of Capital (%)
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Cost of Equity, ks

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WACC
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Minimum = 10.8%
5

0
0 10 20 30 40 50 60
Debt/Assets (%) 15
 Relationship Between
Capital Structure and Stock Price
Stock Price ($)
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Maximum = $22.86

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0 10 20 30 40 50 60
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Debt/Assets (%)
 Degree of Operating Leverage
(DOL)
 The percentage change in operating income (EBIT)
associated with a given percentage change in sales.
EBIT EBIT
DOL = Percentage change in NOI = EBIT = EBIT
Percentage change in sales Sales Q
Q(P - V) Sales Q
DOLQ =
Q(P - V) - FC

DOLS = S - VC = Gross Profit

S - VC - F EBIT
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 Degree of Financial Leverage
(DFL)
The percentage change in earnings available
to common stockholders associated with a
given percentage change in EBIT.
EPS
EBIT
DFL = Percentage change in EPS = EPS =
Percentage change in EBIT EBIT EBIT - Int
EBIT
This equation assumes the firm has no preferred stock.
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 Degree of Total Leverage
(DTL)
The percentage change in EPS that results
from a given percentage change in sales.

DTL = DOL X DFL

DTL = Q(P - V)
Q(P - V) - F - Int
S - VC
DTL = = Gross Profit
S - VC - F - Int EBIT - Int
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 Liquidity and Capital Structure
Difficulties with Analysis
1. We cannot determine exactly how either P/E ratios or
equity capitalization rates (ks 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.
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 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

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 Capital Structure Theory

Trade-off Theory

Signaling Theory

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 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.

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 Trade-Off Theory (continued)
3. Two levels of debt:

1. Threshold debt level (D/A1) = where bankruptcy costs

become material

2. 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
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 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.
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 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.
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 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.

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 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

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 Capital Structures Around the World
Capital Structure Percentages for Selected Countries
Ranked by Common Equity Ratios, 1995
Country Equity Total Debt Long-Term Short-Term
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 61.2 23.5 37.7
Japan 33.7 66.3 23.3 43.0
Italy 23.5 76.5 24.2 52.3
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 Before Next Class:
1.Review Chapter 9 material
2.Do Chapter 9 homework
3.Prepare for Chapter 9 quiz
4.Read Chapter 10

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