196.capital structure intro lecture 1

Kevin Campbell, University of Stirling, October 2006 11

Capital structure

Issues:

What is capital structure? Why is it important? What are the sources of capital available to a

company? What is business risk and financial risk? What are the relative costs of debt and equity? What are the main theories of capital structure? Is there an optimal capital structure?


What is “Capital Structure”?

DefinitionThe capital structure of a firm is the mix of different securities issued by the firm to finance its operations.Securities

Bonds, bank loans Ordinary shares (common stock), Preference

shares (preferred stock) Hybrids, eg warrants, convertible bonds


FinancialStructure


Balance Sheet

Current Current

Assets Liabilities

Debt Fixed Preference Assets shares

Ordinary

shares


CapitalStructure


Balance Sheet

Current Current

Assets Liabilities

Debt Fixed Preference Assets shares

Ordinary

shares


Sources of capital

Ordinary shares (common stock) Preference shares (preferred stock) Hybrid securities

Warrants Convertible bonds

Loan capital Bank loans Corporate bonds


Ordinary shares (common stock)

Risk finance Dividends are only paid if profits are made

and only after other claimants have been paid e.g. lenders and preference shareholders

A high rate of return is required Provide voting rights – the power to hire

and fire directors No tax benefit, unlike borrowing


Preference shares (preferred stock) Lower risk than ordinary shares – and a

lower dividend Fixed dividend - payment before ordinary

shareholders and in a liquidation situation No voting rights - unless dividend payments

are in arrears Cumulative - dividends accrue in the event

that the issuer does not make timely dividend payments

Participating - an extra dividend is possible Redeemable - company may buy back at a

fixed future date


Loan capital

Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed)

Bank loans or corporate bonds Interest on debt is allowed against tax


Seniority of debt

Seniority indicates preference in position over other lenders.

Some debt is subordinated. In the event of default, holders of

subordinated debt must give preference to other specified creditors who are paid first.


Security Security is a form of attachment to the

borrowing firm’s assets. It provides that the assets can be sold

in event of default to satisfy the debt for which the security is given.


Indenture

A written agreement between the corporate debt issuer and the lender.

Sets forth the terms of the loan: Maturity Interest rate Protective covenants

e.g. financial reports, restriction on further loan issues, restriction on disposal of assets and level of dividends


Warrants

A warrant is a certificate entitling the holder to buy a specific amount of shares at a specific price (the exercise price) for a given period.

If the price of the share rises above the warrant's exercise price, then the investor can buy the security at the warrant's exercise price and resell it for a profit.

Otherwise, the warrant will simply expire or remain unused.


Convertible bonds

A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period.

As bonds, they provide a coupon payment and are legally debt securities, which rank prior to equity securities in a default situation.

Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer.

Their conversion feature also gives them features of equity securities.


The Cost of Capital

Expected Return

Risk premium Risk-free rate Time value of money ________________________________________________________

______Risk

Treasury Corporate Preference Hybrid Bonds Bonds Shares

Securities

Ordinary Shares


Measuring capital structure

Debt/(Debt + Market Value of Equity)

Debt/Total Book Value of Assets

Interest coverage: EBITDA/Interest


Selected leverage data for US corporations

Company Debt/Debt+MVE

Debt/Book Assets

EBITDA / Interest

Delta Air 53% 32% 1.1 Disney 9 20 14.1 GM 61 37 3.0 HP 13 17 21.7 McDon's 15 31 7.2 Safeway 55 53 3.1


Interpreting capital structures

The capital structures we observe are determined both by deliberate choices and by chance events

Safeway’s high leverage came from an LBO HP’s low leverage is the HP way Disney’s low leverage reflects past good

performance GM’s high leverage reflects the opposite


Capital structures can be changed

Leverage is reduced by Cutting dividends or issuing stock Reducing costs, especially fixed costs

Leverage increased by Stock repurchases, special dividends, generous

wages Using debt rather than retained earnings

Interpreting capital structures


Business risk and Financial risk

Firms have business risk generated by what they do

But firms adopt additional financial risk when they finance with debt


Risk and the Income Statement

SalesOperating – Variable costsLeverage – Fixed costs

EBIT – Interest expense

Financial Earnings before taxesLeverage – Taxes

Net Income

EPS = Net Income No. of Shares


Business Risk

The basic risk inherent in the operations of a firm is called business risk

Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)


Financial Risk

Debt causes financial risk because it imposes a fixed cost in the form of interest payments.

The use of debt financing is referred to as financial leverage.

Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.


Financial Risk vs. Business Risk

There is a trade-off between financial risk and business risk.

A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even.

A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).


Why should we care about capital structure?

By altering capital structure firms have the opportunity to change their cost of capital and – therefore – the market value of the firm


What is an optimal capital structure?

An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value

Cost of Capital: Each source of financing has a different

cost The WACC is the “Weighted Average Cost

of Capital” Capital structure affects the WACC


Capital Structure Theory

Basic question Is it possible for firms to create value by

altering their capital structure? Major theories

Modigliani and Miller theory Trade-off Theory Signaling Theory


Modigliani and Miller (MM)

Basic theory: Modigliani and Miller (MM) in 1958 and 1963

Old - so why do we still study them? Before MM, no way to analyze

debt financing First to study capital structure

and WACC together Won the Nobel prize in 1990


Modigliani and Miller (MM)

Most influential papers ever published in finance

Very restrictive assumptions First “no arbitrage” proof in finance Basis for other theories


Debt versus Equity

A firm’s cost of debt is always less than its cost of equity debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible.

It may appear a firm should use as much debt and as little equity as possible due to the cost difference, but this ignores the potential problems associated with debt.

A Basic Capital Structure Theory


A Basic Capital Structure Theory

There is a trade-off between the benefits of using debt and the costs of using debt.

The use of debt creates a tax shield benefit from the interest on debt.

The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.


Summary

A firm’s capital structure is the proportion of a firm’s long-term funding provided by long-term debt and equity.

Capital structure influences a firm’s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk.

Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.


Is there magic in financial leverage?

… can a company increase its value simply by altering its capital structure?

…yes and no

…we will see….

Documents

196.capital structure intro lecture 1