Capital Structure © 2005 Thomson/South-Western

Capital Structure Vs Financial Structure Total current liabilities L-T debt P/S C/S Right-Hand side of the balance sheet Capital Structure Permanent s-t debt L-T debt P/S C/S Finance 312

Capital Structure Terminology Optimal capital structure Minimizes a firm’s weighted cost of capital Maximizes the value of the firm Target capital structure Capital structure at which the firm plans to operate Debt capacity Amount of debt in the firm’s optimal capital structure Finance 312

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

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

What is Business Risk? Uncertainty about future operating income (EBIT). How well can we predict operating income? 2

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 3

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) 4

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 a result of financial leverage 7

Business Risk vs. Financial Risk Business risk depends on business factors such as competition, product , and operating leverage. Financial risk depends only on type of securities issued: the more debt, the more financial risk. 8

Business Risk Factors: Demand variability Sales price variability Input cost variability Ability to develop new products Foreign exchange exposure Operating leverage (fixed vs variable costs)

Financial Risk Leverage increases shareholder risk Leverage also increases the return on equity (to compensate for the higher risk)

Consider Two Hypothetical Firms Identical Except for Debt Firm U Firm L Capital $20,000 Debt $0 $10,000 (12% rate) Equity $10,000 Tax rate 40% EBIT $3,000 NOPAT $1,800 ROIC 9%

Impact of Leverage on Returns Firm U Firm L EBIT $3,000 Interest 1,200 EBT $1,800 Taxes (40%) 1 ,200 720 NI $1,080 ROIC (NI+Int)/TA] 9.0% 11.4% ROE (NI/Equity) 10.8%

Why does leveraging increase return? More cash goes to investors of Firm L. Total dollars paid to investors: U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280. Taxes paid: U: $1,200 L: $720. In Firm L, fewer dollars are tied up in equity.

Impact of Leverage on Returns if EBIT Falls Firm U Firm L EBIT $2,000 Interest 1,200 EBT $800 Taxes (40%) 800 320 NI $1,200 $480 ROIC 6.0% 8.4% ROE 4.8% Leverage magnifies risk and return!

Impact of Leverage on Returns if EBIT Rises Firm U Firm L EBIT $4,000 Interest 1,200 EBT $2,800 Taxes (40%) 1,600 1,120 NI $2,400 $1,680 ROIC 12.0% 14.0% ROE 16.8% Leverage magnifies risk and return!

Consider Two Hypothetical Firms Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

Impact of Leverage on Returns Firm U Firm L EBIT $3,000 $3,000 Interest 0 1,200 EBT $3,000 $1,800 Taxes (40%) 1 ,200 720 NI $1,800 $1,080 ROE 9.0% 10.8%

Why does leveraging increase return? More EBIT goes to investors in Firm L. Total dollars paid to investors: U: NI = $1,800. L: NI + Int = $1,080 + $1,200 = $2,280. Taxes paid: U: $1,200; L: $720. Equity $ proportionally lower than NI.

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. 17

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.

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.

Stock Price and Cost of Capital Estimates with Different Debt/Assets Ratios 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 At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%

Relationship Between Capital Structure and EPS Maximum EPS = $3.36 Expected EPS ($) Debt/Assets (%)

Relationship Between Capital Structure and Cost of Capital Cost of Equity, ks Cost of Capital (%) Debt/Assets (%) WACC Minimum = 10.8%

Relationship Between Capital Structure and Stock Price Maximum = $22.86 Stock Price ($) Debt/Assets (%)

Degree of Operating Leverage (DOL) The percentage change in operating income (EBIT) associated with a given percentage change in sales. Percentage change in NOI Percentage change in sales DEBIT EBIT DSales Sales DEBIT EBIT DQ Q DOL = =

Degree of Financial Leverage (DFL) The percentage change in earnings available to common stockholders associated with a given percentage change in EBIT. DEPS EPS DEBIT EBIT Percentage change in EPS Percentage change in EBIT DFL = = This equation assumes the firm has no preferred stock.

Degree of Total Leverage (DTL) The percentage change in EPS that results from a given percentage change in sales. DTL= DOL*DFL

Liquidity and Capital Structure Difficulties with Analysis We cannot determine exactly how either P/E ratios or equity capitalization rates (ks values) are affected by different degrees of financial leverage. 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. 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.

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

Assumptions of Modigliani and Miller (1958) No Taxes No Transactions Costs for buying and selling securities All investors can borrow or lend at the same rate Relevant information is costless and readily available to all investors Investors are rational and have homogeneous expectations of firm earnings. Finance 312

Modigliani-Miller (MM) Theory: Zero Taxes Firm U Firm L EBIT $3,000 Interest 1,200 NI $1,800 CF to shareholder CF to debtholder $1,200 Total CF Notice that the total CF are identical for both firms.

MM Results: Zero Taxes MM assume: (1) no transactions costs; (2) no restrictions or costs to short sales; and (3) individuals can borrow at the same rate as corporations. MM prove that if the total CF to investors of Firm U and Firm L are equal, then arbitrage is possible unless the total values of Firm U and Firm L are equal: VL = VU. Because FCF and values of firms L and U are equal, their WACCs are equal. Therefore, capital structure is irrelevant.

MM Theory: Corporate Taxes Corporate tax laws allow interest to be deducted, which reduces taxes paid by levered firms. Therefore, more CF goes to investors and less to taxes when leverage is used. In other words, the debt “shields” some of the firm’s CF from taxes.

Capital Structure Theory Trade-off Theory Signaling Theory

Trade-Off Theory (Modigliani and Miller) Interest is tax-deductible expense, therefore less expensive than common or preferred stock. So, 100% debt is the preferred capital structure. 2. Theory: Interest rates rise as debt/asset ratio increases Tax rates fall at high debt levels (lowers debt tax shield) Probability of bankruptcy increases as debt/assets ratio increases.

Trade-Off Theory (continued) 3. Two levels of debt: Threshold debt level (D/A1) = where bankruptcy costs become material 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

Trade-Off Theory (cont) 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.

Signaling Theory Symmetric Information Asymmetric 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.

Signaling Theory Signal Result: Reserve Borrowing Capacity 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.

Signaling Theory MM assumed that investors and managers have the same information. But, managers often have better information. Thus, they would: Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. Implications for managers?

Trade-off Theory MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh(more important) bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits.

Pecking Order Theory The pecking order of financing is internal financing first, and then if external financing is used, debt securities are issued before external equity. Alternative concept to Static Tradeoff Theory There may be no particular target or optimal capital structure for a firm. Profitable firms with limited needs for investment funds will tend to build up financial slack. Finance 312

Pecking Order Theory Firms use internally generated funds first, because there are no flotation costs or negative signals. If more funds are needed, firms then issue debt because it has lower flotation costs than equity and not negative signals. If more funds are needed, firms then issue equity.

Bankruptcy (Financial Distress) Costs Lenders may demand higher interest rates Lenders may decline to lend at all Customers may shift their business to other firms Distress incurs extra accounting & legal costs If forced to liquidate, assets may have to be sold for less than market value Finance 312

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

Capital Structures Around the World Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995