CAPITAL STRUCTURE ANALYSIS Jihan Ahmad Kulliyyah of Muamalat Insaniah University College

Intended Learning Objective Describe the advantages and disadvantages of financial leverage. Compute the financial leverage index, debt to capital ratio, debt to equity ratio, and other techniques for analyzing capital structure. Relate capital structure composition to owner and creditor investment objectives.

Intended Learning Objective Discuss the various types of risks and their role in capital structure analysis. Present a preliminary capital structure analysis for a company or industry.

CAPITAL STRUCTURE ANALYSIS- OBJECTIVE To determine if the proportion of debt to equity enables an entity to create wealth without unduly jeopardizing the firm

CAPITAL STRUCTURE ANALYSIS- OBJECTIVE Capital structure composition Consists of long-term liabilities, preferred stock, common stock, and retained earnings. Sufficient equity must exist to provide financial stability Debt can be used as leverage to increase returns to shareholders, but it can also reduce returns on shareholders’ investments

FINANCING ACTIVITIES The Balance Sheet Capital Structure Valuation Equity investment Long-Term Debt investment

FINANCING ACTIVITIES The balance sheet Reports how funds are acquired and allocated Current assets are financed with current obligations—not a factor in capital structure analysis Long-term debt and equity finance long-term assets—assessing the pros and cons of these financing factors is the essence of capital structure analysis

FINANCING ACTIVITIES Capital structure valuation Long-term liabilities are reported at the present value of expected cash flows Current liabilities are not adjusted for the time value of money Contributed capital is reported at the historical proceeds received from selling stock Retained earnings are reported as a summary of all of the valuation methods used to measure income

FINANCING ACTIVITIES (CONT.) Equity investments are an entity’s permanent financing, representing The ultimate risk capital Insulation of the firm from random business shocks A margin of safety to debt investors The right to a return on investment only after the other claimants have been satisfied

FINANCING ACTIVITIES (CONT.) Long-term debt investments represent Fixed contractual obligations Payable at specific times in specified amounts Returns on investment that are tax deductible Short-term debt obligations Arise from the normal course of business operations Are liquidated with cash from current assets Excluded from capital structure analysis

FINANCIAL LEVERAGE The substitution of fixed-charge financing for variable-cost (dividend) equity financing Financial leverage concepts The traditional view is that an optimal mix of debt and equity exists Research demonstrated that the mix of debt and equity is irrelevant, if taxes are ignored The tax deductibility of interest expense creates an advantage for incurring debt (Exhibit 14-1)

FINANCIAL LEVERAGE (CONT.) Low cost debt increases ROE relative to ROA Debt can become so costly that it reduces ROE below ROA

FINANCIAL LEVERAGE (CONT.) The financial structure leverage ratio Is computed as: average total assets / average common shareholders’ equity Produces a ratio of greater than one, which implies debt is always advantageous (so long as a positive profit margin exists)

FINANCIAL LEVERAGE (CONT.) Financial leverage index Is computed as adjusted return on equity / adjusted return on assets Superior to the financial structure leverage ratio because it factors in the adjusted rates of return in the computation An index in excess of one means ROE exceeds ROA; a favorable use of debt financing An index of less than one is bad; ROA exceeds ROE; an unfavorable use of debt financing

RISK ANALYSIS Risk is the possibility of losing something of value Types of risk Business risk Financial risk Credit risk Bankruptcy risk

RISK ANALYSIS-Business Risk Standard measure is beta (controlling for financial risk) Factors: Demand variability Sales price variability Input cost variability Ability to develop new products Foreign exchange exposure Operating leverage (fixed vs variable costs)

RISK ANALYSIS-Business Risk Fluctuations in earnings and cash flow, due to Changes in the economy Industry-specific conditions A high degree of leverage—leveraged firms have greater exposure to business risk than conservatively structured entities

Example of Business Risk Suppose 10 people decide to form a corporation to manufacture disk drives. If the firm is capitalized only with common stock – and if each person buys 10% -- each investor shares equally in business risk

RISK ANALYSIS-Financial Risk The additional risk placed on the common stockholders as a result of the decision to finance with debt

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

Example of Relationship Between Financial and Business Risk If the same firm is now capitalized with 50% debt and 50% equity – with five people investing in debt and five investing in equity The 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered).

Business and Financial Risk Financial leverage concentrates the firm’s business risk on the shareholders because debt-holders, who receive fixed interest payments, bear none of the business risk.

ANALYSIS RISK - Credit risk The possibility that an entity will not be able to meet debt payment obligations on time

ANALYSIS RISK - Credit risk Capital structure influences credit risk A firm with a conservative capital structure is a low credit risk because it has small amount of debt low fixed cost commitments a low default probability

RISK ANALYSIS - Bankruptcy risk Extreme case of credit risk, whereby a firm may be unable to continue as a going concern Financial distress, or the difficulty in meeting maturing obligations, is the first sign of bankruptcy risk A company in financial distress might file for bankruptcy protection

RISK ANALYSIS - Bankruptcy risk A bankrupt firm Losses autonomy in conducting its operations Has a court suspend its creditors’ claims Can have its debts rearranged, reduced, or eliminated with the mutual consent of the company, creditors, and court Will liquidate, or go out of business, if continuing operations is not a viable option  

RISK ANALYSIS – Comprehensive risk The equity market’s determination of risk Is a function of systematic risk Is inherent in investing Cannot be eliminated through investment diversity

RISK ANALYSIS (CONT.) Beta measures of systematic risk Is the extent to which a stock moves with the overall market In a range from –1.0 to +1.0 With an interpretation that he higher the beta, the greater a stock’s variability

CAPITAL STRUCTURE MEASURES Capital structure composition Financing activities should correspond to investing activities Short-term creditors finance current assets Long-term investors finance long-term assets

CAPITAL STRUCTURE MEASURES (CONT.) Lack of correspondence signals financial distress Long-term borrowing cannot be used to finance operations indefinitely Cash from operations should satisfy working capital operations Common size statements Provide insights between current and long-term financing sources and investments Must be considered in conjunction with life cycle stage

DEBT TO CAPITAL RATIOS Provide insight about the proportion of debt to equity financing Total debt to total capital Measures the percentage of assets financed with debt Is computed as: average total debt / average total assets

DEBT TO CAPITAL RATIOS (CONT.) Total debt to total equity Measures debt financing as a percentage of total financing Is computed as: average total debt / average total shareholders’ equity

DEBT TO CAPITAL RATIOS (CONT.) Long-term debt to total capital Measures the percentage of assets financed with long-term debt Eliminates current obligations from the ratio because they are paid with maturing current assets Is computed as: average long-term debt / average total assets

DEBT TO CAPITAL RATIOS (CONT.) Total long-term debt to total equity Measures long-term debt financing as a percentage of total financing Eliminates current obligations from the ratio because they are paid with maturing current assets Is computed as: average long-term debt / average total shareholders’ equity

DEBT TO CAPITAL RATIOS (CONT.) Earnings coverage ratio Measures the extent to which an entity can meet its fixed charges Is known as the times interest earned ratio, which is a simplified version of earnings coverage Times interest earned is computed as: operating income before interest and taxes / interest expense It is acceptable substitute for earnings coverage so long as accrual numbers approximate required cash payments for fixed changes

DEBT TO CAPITAL RATIOS (CONT.) Bankruptcy prediction Mathematical models that provide information about an entity’s bankruptcy probability The Z-score is an accepted measure of bankruptcy prediction Computed as a function of five weighted ratios Z-scores above 3.0 indicate little probability of bankruptcy Those below 1.81 indicate a high possibility of bankruptcy Scores between 1.81 and 3.0 are inconclusive

eSTUFF’S CAPITAL STRUCTURE RATIOS

CAPITAL STRUCTURE ANALYSIS AND THE PC INDUSTRY New economy capital structure Venture capital and retained earnings financed PC firms’ productive resources Little long-term debt

CAPITAL STRUCTURE ANALYSIS AND THE PC INDUSTRY (CONT.) Capital structure measures Apple and Dell carried more debt than Compaq or Gateway during the period analyzed (Exhibit 14-7A) Dell used debt to increase its returns on equity Apple acquired debt (and preferred stock) to bolster its insufficient cash from earnings and replenish its depleted equity base, which was reduced by its net losses

CAPITAL STRUCTURE ANALYSIS AND THE PC INDUSTRY (CONT.) Long-term debt provided an relatively small amount of financing for all four firms (Exhibit 14-7B) Debt as a proportion of total assets and equity was relatively stable during the period examined (Exhibits 14-8A and 14-8B)

CAPITAL STRUCTURE THEORY Modigliani and Miller Financial Choice Trade Off Theory Pecking Order Theory

Modigliani and Miller Assuming no taxes, the increase in return to shock-holders resulting from the use of leverage is exactly offset by the increase in risk – hence no benefit to using financial leverage (and no cost).

M&M (Debt Policy Doesn’t Matter) Modigliani & Miller When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure. 3

M&M (Debt Policy Doesn’t Matter) Assumptions By issuing 1 security rather than 2, company diminishes investor choice. This does not reduce value if: Investors do not need choice, OR There are sufficient alternative securities Capital structure does not affect cash flows e.g... No taxes No bankruptcy costs No effect on management incentives 4

Financial Choices Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt. Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.

Pecking Order Theory The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced. Therefore firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory Some Implications: Internal equity may be better than external equity. Financial slack is valuable. If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).