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Financing assets
What is the best way for a firm to finance its asset?
What is the effect of financial leverage on stock prices, earnings per share, & the cost of capital
Leverage = the use of borrowed money to increase production volume, and thus sales and earnings. It is measured as the ratio of total debt to total assets; greater the amount of debt, greater the financial leverage. BusinessDictionary.com
Target capital structure
Target capital structure = the mix of debt, preferred stock, and common equity the firm plans to use to raise capital If debt level is below target, expansion capital
should be raised using debt If debt level is above target, expansion capital
should be raised using equity
Capital structure Influences
Business risk
Tax position
Need for financial flexibility
Managerial conservatism or aggressiveness
Business risk
Business risk = the risk inherent in the firm’s operations if it uses no debt. The lower a firm’s business risk, the higher its optimal debt ratio. A firm has little risk if:
The demand for its products is stable (Demand variability)
Firms selling products in stable markets—no significant changes in prices (Sales price variability)
The prices for inputs and products remain relatively constant It can adjust its costs freely if costs increase
A high percentage of its costs are variable and will therefore decrease as sales decrease (operating leverage A firm with high fixed costs is more exposed if sales decline
Business risk
In high tech industries (drugs, computers) if they are able to produce new products in a timely and cost-efficient manner
The firm’s dependence on foreign sales is minimized reducing exposure to currency rate fluctuations and political instability
Operating leverage
Operating leverage = the extent to which fixed costs are used in a form’s operations. A high degree of operating leverage, ceteris paribus, implies that a relatively small change in sales results in a large change in ROE. (pg. 483, figure 13.3)
Operating break even is the output quantity at which EBIT=0 (ROE = 0)
Financial risk
Financial risk is the additional risk placed on stockholders as a result of the decision to finance with debt
Financial risk = an increase in stockholders’ risk, above and beyond the firm’s basic business risk, resulting from the use of financial leverage
Financial leverage = the extent to which fixed income securities (debt & preferred stock) are used in a firm’s capital structure
Optimal capital structure
The optimal capital structure is one that maximizes the price of the firm’s stock Recall that if the increase in debt raises the
firm’s risk it may result in a higher cost of equity reducing the value of its stock
The (Robert) Hamada equation – shows the effect of financial leverage on beta (measure of risk for investors) (pg. 494)
b = bu [1 + (1 – T)(D/E)] effect of financial leverage on beta
bu = b/[1 + (1 – T)(D/E)] unlevered beta
Capital structure theory
Franco Modiglianni and Merton Miller (1958). Aka, MM, their theory posited that capital structure is irrelevant. Unrealistic assumptions (e.g., taxes, bankruptcy) Provided clues about what is required for a firm’s
capital structure to be relevant and thus to effect a firm’s value
Impact of taxes The deductibility of interest favors debt financing The more favorable tax treatment from stock
income lowers the RROR on stock and so favors equity financing
Capital structure theory
Potential bankruptcy The probability of occurrence (e.g., higher interest
rates; can assets be liquidated?) Costs associated with financial stress (e.g., best
employees leave the firm)
Trade-off theory of capital structure – debt is useful because interest is tax deductible but debt also brings costs associated with actual or potential bankruptcy. Therefore, optimal capital structure balances tax benefits of debt and the costs of bankruptcy
Signals
An alternative theory of capital structures relates to the signals given to investors by a firm’s decision to use debt vs. stock to raise new capital based on:
Symmetric information – managers and investors have similar access to information about the firm’s prospects
Asymmetric information – managers have better information about the firm’s prospects (pg. 506)
Stock = negative signal
Debt = neutral – positive signal
Reserve borrowing capacity – managers use less debt in normal times to avoid issuing stock in volatile times
Debt and management constraint
Owners may desire a high amount of debt to constrain managers since this raises the threat of bankruptcy. This results in managers being more careful with shareholders’ money. Many corporate take-overs and LBO’s were
aimed at improving efficiency by reducing the free cash flow available to managers
Capital structure practice
In practice, financial executives generally treat the optimal capital structure as a range (e.g., 40-50%) rather than a precise number
Capital structure checklist
Sales stability
Asset structure
Operating leverage
Growth rate
Profitability
Taxes
control
Management attitudes
Lender & rating agency attitudes
Market conditions
Firm’s internal conditions
Financial flexibility