1

The Basics of Capital The Basics of Capital Structure DecisionsStructure Decisions

Corporate FinanceCorporate Finance

Dr. A. DeMaskey

2

Learning ObjectivesLearning Objectives

Questions to be answered:Questions to be answered: What factors affect the target capital structure?What factors affect the target capital structure? What is business risk? What is financial risk?What is business risk? What is financial risk? What is the optimal capital structure?What is the optimal capital structure? How do asymmetric information and signals affect How do asymmetric information and signals affect

capital structure decisions?capital structure decisions? Do international differences in financial leverage Do international differences in financial leverage

exist?exist?

3

Capital Structure PolicyCapital Structure Policy

Target capital structureTarget capital structure Mix of debt, preferred stock, and common Mix of debt, preferred stock, and common

stockstock Set equal to estimated optimal capital Set equal to estimated optimal capital

structurestructure Optimal capital structureOptimal capital structure

Balances risk and returnBalances risk and return Maximizes the firm’s stock priceMaximizes the firm’s stock price

4

Capital Structure DecisionsCapital Structure Decisions

Business riskBusiness risk TaxesTaxes Financial flexibilityFinancial flexibility Managerial conservatism or Managerial conservatism or

aggressivenessaggressiveness Growth opportunitiesGrowth opportunities

5

Uncertainty about future Uncertainty about future operating income operating income (EBIT).(EBIT).

Note that business risk focuses on operating Note that business risk focuses on operating income, so it ignores financing effects.income, so it ignores financing effects.

Business RiskBusiness Risk

Probability

EBITE(EBIT)0

Low risk

High risk

6

Factors That Influence Factors That Influence Business RiskBusiness Risk

Uncertainty about demand (unit sales).Uncertainty about demand (unit sales). Uncertainty about output prices.Uncertainty about output prices. Uncertainty about input costs.Uncertainty about input costs. Product and other types of liability.Product and other types of liability. Degree of operating leverage (DOL).Degree of operating leverage (DOL).

7

Operating Leverage and Operating Leverage and Business RiskBusiness Risk

Operating leverage Operating leverage is the use of fixed is the use of fixed costs rather than variable costs.costs rather than variable costs.

The higher the proportion of fixed costs The higher the proportion of fixed costs within a firm’s overall cost structure, the within a firm’s overall cost structure, the greater the greater the operating leverageoperating leverage..

(More...)

8

Higher operating leverage leads to more Higher operating leverage leads to more business risk, because a small sales business risk, because a small sales decline causes a larger profit decline.decline causes a larger profit decline.

(More...)

Sales

$ Rev.TC

FC

QBE Sales

$ Rev.

TC

FC

QBE

Profit}

9

Probability

EBITL

Low operating leverage

High operating leverage

EBITH

In the typical situation, higher operating In the typical situation, higher operating leverage leads to higher expected EBIT, leverage leads to higher expected EBIT, but also increases risk.but also increases risk.

10

Business Risk versus Business Risk versus Financial RiskFinancial Risk Business risk:Business risk:

Uncertainty in future EBIT.Uncertainty in future EBIT. Depends on business factors such as competition, Depends on business factors such as competition,

operating leverage, etc.operating leverage, etc. Financial risk:Financial risk:

Additional business risk concentrated on common Additional business risk concentrated on common stockholders when financial leverage is used.stockholders when financial leverage is used.

Depends on the amount of debt and preferred Depends on the amount of debt and preferred stock financing.stock financing.

11

Measure of Financial and Measure of Financial and Business Risk in a Stand-Alone Business Risk in a Stand-Alone SenseSense

Stand-alone Business Financialrisk risk risk= +

Stand-alone risk = ROE.

Business risk = ROE(U).

Financial risk = ROE - ROE(U).

12

EPS Indifference AnalysisEPS Indifference Analysis

Used to determine when debt financing Used to determine when debt financing is advantageous and when equity is advantageous and when equity financing is advantageous.financing is advantageous.

Can be illustrated graphically since the Can be illustrated graphically since the relationship between EBIT and EPS is relationship between EBIT and EPS is linear.linear.

EPS (debt financing) = EPS (equity EPS (debt financing) = EPS (equity financing)financing)

13

Capital Structure TheoryCapital Structure Theory

MM theoryMM theory Zero taxesZero taxes Corporate taxesCorporate taxes Corporate and personal taxesCorporate and personal taxes

Trade-off theoryTrade-off theory Signaling theorySignaling theory Debt financing as a managerial Debt financing as a managerial

constraintconstraint

14

MM Theory: Zero TaxesMM Theory: Zero Taxes

MM prove, under a very restrictive set MM prove, under a very restrictive set of assumptions, that a firm’s value is of assumptions, that a firm’s value is unaffected by its financing mix.unaffected by its financing mix.

Therefore, capital structure is irrelevant.Therefore, capital structure is irrelevant. Any increase in ROE resulting from Any increase in ROE resulting from

financial leverage is financial leverage is exactly offsetexactly offset by by the increase in risk.the increase in risk.

15

MM Theory: Corporate TaxesMM Theory: Corporate Taxes

Corporate tax laws favor debt financing Corporate tax laws favor debt financing over equity financing.over equity financing.

With corporate taxes, the benefits of With corporate taxes, the benefits of financial leverage exceed the risks: financial leverage exceed the risks: More EBIT goes to investors and less to More EBIT goes to investors and less to taxes when leverage is used.taxes when leverage is used.

Firms should use almost 100% debt Firms should use almost 100% debt financing to maximize value.financing to maximize value.

16

MM Theory: Corporate and MM Theory: Corporate and Personal TaxesPersonal Taxes Personal taxes lessen the advantage of Personal taxes lessen the advantage of

corporate debt:corporate debt: Corporate taxes favor debt financing.Corporate taxes favor debt financing. Personal taxes favor equity financing.Personal taxes favor equity financing.

Use of debt financing remains Use of debt financing remains advantageous, but benefits are less advantageous, but benefits are less than under only corporate taxes.than under only corporate taxes.

Firms should still use 100% debt.Firms should still use 100% debt.

17

Hamada’s EquationHamada’s Equation

MM theory implies that beta changes MM theory implies that beta changes with leverage.with leverage.

bbUU is the beta of a firm when it has no is the beta of a firm when it has no

debt (the unlevered beta)debt (the unlevered beta) bbLL = b = bUU(1 + (1 - T)(D/E))(1 + (1 - T)(D/E)) In practice, D/E is measured in book In practice, D/E is measured in book

values when bvalues when bLL is calculated. is calculated.

18

Trade-off TheoryTrade-off Theory

MM theory ignores bankruptcy (financial MM theory ignores bankruptcy (financial distress) costs, which increase as more distress) costs, which increase as more leverage is used.leverage is used.

At low leverage levels, tax benefits outweigh At low leverage levels, tax benefits outweigh bankruptcy costs.bankruptcy costs.

At high levels, bankruptcy costs outweigh tax At high levels, bankruptcy costs outweigh tax benefits.benefits.

An optimal capital structure exists that balances An optimal capital structure exists that balances these costs and benefits.these costs and benefits.

19

Signaling TheorySignaling Theory

MM assumed that investors and managers MM assumed that investors and managers have the same information.have the same information.

But, managers often have better information. But, managers often have better information. Thus, they would:Thus, they would: Sell stock if stock is overvalued.Sell stock if stock is overvalued. Sell bonds if stock is undervalued.Sell bonds if stock is undervalued.

Investors understand this, so view new stock Investors understand this, so view new stock sales as a negative signal.sales as a negative signal.

Implications for managers?Implications for managers?

20

Debt Financing As Debt Financing As a Managerial Constrainta Managerial Constraint One agency problem is that managers One agency problem is that managers

can use corporate funds for non-value can use corporate funds for non-value maximizing purposes.maximizing purposes.

The use of financial leverage:The use of financial leverage: Bonds “free cash flow.”Bonds “free cash flow.” Forces discipline on managers.Forces discipline on managers.

However, it also increases risk of However, it also increases risk of financial distress. financial distress.

21

The MM and Miller models cannot The MM and Miller models cannot be applied directly because several be applied directly because several assumptions are violated.assumptions are violated.kkdd is not a constant. is not a constant.Bankruptcy and agency costs exist.Bankruptcy and agency costs exist.

In practice, Hamada’s equation is In practice, Hamada’s equation is used to find kused to find kSS for the firm with for the firm with different levels of debt.different levels of debt.

Capital Structure in PracticeCapital Structure in Practice

22

The Optimal Capital StructureThe Optimal Capital Structure

Calculate the cost of equity at each level of Calculate the cost of equity at each level of debt.debt.

Calculate the value of equity at each level of Calculate the value of equity at each level of debt.debt.

Calculate the total value of the firm (value of Calculate the total value of the firm (value of equity + value of debt) at each level of debt.equity + value of debt) at each level of debt.

The optimal capital structure maximizes the The optimal capital structure maximizes the total value of the firm.total value of the firm.

23

Capital Structure AnalysisCapital Structure Analysis

Financial forecasting models Financial forecasting models Can help show how capital structure changes are Can help show how capital structure changes are

likely to affect stock prices, coverage ratios, and so likely to affect stock prices, coverage ratios, and so on.on.

Can generate results under various scenarios, but Can generate results under various scenarios, but the financial manager must specify appropriate the financial manager must specify appropriate input values, interpret the output, and eventually input values, interpret the output, and eventually decide on a target capital structure.decide on a target capital structure.

In the end, capital structure decision will be In the end, capital structure decision will be based on a combination of analysis and based on a combination of analysis and judgment.judgment.

24

Checklist for Capital Structure Checklist for Capital Structure DecisionsDecisions Debt ratios of other firms in the industry.Debt ratios of other firms in the industry. Pro forma coverage ratios at different capital Pro forma coverage ratios at different capital

structures under different economic scenarios.structures under different economic scenarios. Lender and rating agency attitudesLender and rating agency attitudes

(impact on bond ratings).(impact on bond ratings). Reserve borrowing capacity.Reserve borrowing capacity. Effects on control.Effects on control. Type of assets: Are they tangible, and hence Type of assets: Are they tangible, and hence

suitable as collateral?suitable as collateral? Tax rates.Tax rates.