Capital Structure

By: Rajat Jhingan

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 firms business risk The firms 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?

By: Rajat Jhingan

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: By: operating leverageRajat Jhingan

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)

By: Rajat Jhingan

What is Financial Risk?

Financial Leverage: The extent to which fixed-income securities (debt and preferred stock) are used in a firms 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 firms 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 Density

Probability Distribution of EPS with Different Amounts of Financial Leverage

Zero Debt Financing

50% Debt Financing

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$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 firms 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 Assets EPS Beta Price P/E Ratio (kM kRF)s] 0% $2.40 1.50 12.0% $20.00 8.33 10 8.0% 2.56 1.55 12.2 20.98 8.20 20 8.3 2.75 1.65 12.6 21.83 7.94 30 9.0 2.97 1.80 13.2 22.50 7.58 40 10.0 3.20 2.00 14.0 22.86 7.14 50 12.0 3.36 2.30 15.2 22.11 6.58 60 15.0 3.30 2.70 16.8 19.64 5.95 WACC 12.00% 11.46 11.08 10.86 10.80 11.20 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 ($)
3.5 3 2.5 2 1.5 1 0.5 0 0 10 20 30 By: Rajat Jhingan 40 50 60

Maximum EPS = $3.36

Debt/Assets (%)

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Relationship Between Capital Structure and Cost of Capital

Cost of Capital (%)
20

Cost of Equity, ks
15

WACC
10

Minimum = 10.8%
5

0 0 10 20 30 By: Rajat Jhingan 40 50 60

Debt/Assets (%)

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Relationship Between Capital Structure and Stock Price

Stock Price ($)
24 23 22

Maximum = $22.86

21 20

19 18 0 10 20

By: Rajat Jhingan

30

40

50

60

Debt/Assets (%)

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Degree of Operating Leverage (DOL)

The percentage change in operating income (EBIT) associated with a given percentage change in sales.

DEBIT DEBIT DOL = Percentage change in NOI = EBIT = EBIT Percentage change in sales DSales DQ Sales Q Q(P - V) DOLQ = Q(P - V) - FC
DOLS = S - VC S - VC - F = Gross Profit 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.
DEPS Percentage change in EPS = EPS = EBIT DFL = Percentage change in EBIT DEBIT EBIT - Int EBIT

This equation assumesBy: Rajat firm has no preferred stock. the Jhingan 18

Degree of Total Leverage (DTL)

The percentage change in EPS that results from a given percentage change in sales.
DTL = DOL X DFL DTL = DTL = Q(P - V) Q(P - V) - F - Int S - VC S - VC - F - Int
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= Gross Profit 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 firms longrun viability is endangered.
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Liquidity and Capital Structure

Financial strength indicator
Times-Interest-Earned (TIE) Ratio
Ratio that measures the firms 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. 2. Threshold debt level (D/A1) = where bankruptcy costs become material Optimal debt level (D/A2) = where marginal tax shelter benefits = marginal bankruptcyrelated costs

3.
4.

Between these two debt levels, the firms stock price rises, but at a decreasing rate
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 suggestsleading to development of signaling theory.
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Signaling Theory
Symmetric Information
Investors and managers have identical information about the firms prospects.

Asymmetric Information
Managers have better information about their firms prospects than do outside investors.
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Signaling Theory
Signal
An action taken by a firms management that provides clues to investors about how management views the firms 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 companys 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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