Corporate Finance Course Basics of Corporate Capital Structure Zulfiqar Hasan BBA, MBA (Finance), London Associate Professor Zulfiqar Hasan

Contents Definition of Corporate capital Structure; Determinants of Corporate Capital Structure; The Capital-Structure Question and The Pie Theory, Maximizing Firm Value versus Maximizing Stockholder Interests, Financial Leverage and Firm Value: An Example, EPS, and ROE Capital Restructuring, Levered Firm, and un-levered or all-equity firm, Break Even EBIT Zulfiqar Hasan

What is Corporate Capital Structure? In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc. Zulfiqar Hasan

Factors That Influence a Company's Capital-Structure Decision  Business Risk: Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.  Company's Tax Exposure: Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.   Financial Flexibility : Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. The lower a company's debt level, the more financial flexibility a company has. Zulfiqar Hasan

Factors That Influence a Company's Capital-Structure Decision Management Style: Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS). Growth Rate: Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. Market Conditions: Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning that investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay.  Zulfiqar Hasan

The Capital-Structure Question and The Pie Theory The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity. V = B + S Here, B = Market value of the firm debt S = Market Value of the Equity V= Value of the Firm S B S S B B Value of the Firm If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible. Zulfiqar Hasan

The Capital-Structure Question There are really two important questions: Why should the stockholders care about maximizing firm value? Perhaps they should be interested in strategies that maximize shareholder value. What is the ratio of debt-to-equity that maximizes the shareholder’s value? As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases. Zulfiqar Hasan

Example 01: Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.) Current Assets $20,000 Debt $0 Equity $20,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $50 Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50 The firm borrows $8,000 and buys back 160 shares at $50 per share. Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Should the Firm change its current capital structure? Zulfiqar Hasan

Solution: EPS and ROE Under Both Capital Structures Current Capital Structure (All-Equity) Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 0 0 0 EBT $1,000 $2,000 $3,000 Tax@0% 0 0 0 Net income $1,000 $2,000 $3,000 EPS $2.50 $5.00 $7.50 ROA 5% 10% 15% ROE 5% 10% 15% Current Shares Outstanding = 400 shares Proposed Capital Structure (Leveraged) Recession Expected Expansion EBIT $1,000 $2,000 $3,000 Interest 640 640 640 Net income (if tax =0) $360 $1,360 $2,360 EPS $1.50 $5.67 $9.83 ROA 1.8% 6.8% 11.8% ROE 3% 11.33% 19.67% Proposed Shares Outstanding = 240 shares Zulfiqar Hasan

Practice 01: Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.). Compare the EPS, ROA and ROE in both capital structure. Proposed $40,000 $20,000 1 10% 200 $100 Current Assets $40,000 Debt $0 Equity $40,000 Debt/Equity ratio 0.00 Interest rate n/a Shares outstanding 400 Share price $100 Recession Expected Expansion EBIT $5,000 $6500 $8000 Zulfiqar Hasan

Practice 02: Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.). Compare the EPS, ROA and ROE in both capital structure. Proposed $40,000 $20,000 1 10% 40% 200 $100 Current Assets $40,000 Debt $0 Equity $40,000 Debt/Equity ratio 0.00 Interest rate n/a Tax@ 40% Shares outstanding 400 Share price $100 Recession Expected Expansion EBIT $5,000 $6500 $8000 Zulfiqar Hasan

Example 02: Break-Even EBIT Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan-I) and a levered plan (Plan-II). Under plan-I, Roslton would have 150000 shares of stock outstanding. Under Plan-II, there would be 60000 shares of stock outstanding and $1.5 million in debt outstanding. The interest rate on the debt is 10% and there are no taxes. If EBIT is $200000, which plan will result in the higher EPS? If EBIT is $700000, which plan will result in the higher EPS? What are the break-even EBIT? Use MM Proposition-I to find the price per share of equity under each of the two proposed plans. What is the value of the firm? Zulfiqar Hasan

EPS and ROE Under Both Capital Structures Requirement-a. Plan-I___ Plan-II EBIT $200000 $2,00000 Interest 0 (150000) EBT $200000 $50,000 Tax@0% 0 0 Net income $200000 $50,000 Number of Share 150000 60000 EPS ($200000/150000) ($50000/60000) $1.33 $0.83 Plan I has the higher EPS when EBIT is $200,000. Requirement-b. Plan-I Plan-II EBIT $700000 $7,00000 Interest 0 (150000) EBT $700000 $550,000 Tax@0% 0 0 Net income $700000 $550,000 Number of Share 150000 60000 EPS ($700000/150000) ($550000/60000) $4.67 $9.17 Plan II has the higher EPS when EBIT is $700,000. Zulfiqar Hasan

C- Break Even EBIT To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is: Zulfiqar Hasan

Practice 02: Break-Even EBIT Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan-I) and a levered plan (Plan-II). Under plan-I, Roslton would have 250000 shares of stock outstanding. Under Plan-II, there would be 160000 shares of stock outstanding and $1.95 million in debt outstanding. The interest rate on the debt is 12% and there are no taxes. If EBIT is $600000, which plan will result in the higher EPS? If EBIT is $1400000, which plan will result in the higher EPS? What are the break-even EBIT? Use MM Proposition-I to find the price per share of equity under each of the two proposed plans. What is the value of the firm? Zulfiqar Hasan

Example 02 (from text): EBIT and Leverage Control, Inc., has no debt outstanding and a total market value of $100,000. Earnings before interest and taxes, EBIT, are projected to be $6,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 60 percent lower. Control is considering a $40,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem. Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession. Repeat part (a) assuming that Control goes through with recapitalization (proposed capital structure). What do you observe? 2. EBIT, Taxes, and Leverage Repeat parts (a) and (b) in Problem 1 assuming Control has a tax rate of 35 percent. 3. ROE and Leverage Suppose the company in Problem 1 has a market-to-book ratio of 1.0. Calculate return on equity, ROE, under each of the three economic scenarios before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes. Repeat part (a) assuming the firm goes through with the proposed recapitalization. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent Zulfiqar Hasan

Solution: 1. a Current Position Assets $? Debt $0 Equity $100,000 Interest rate n/a Tax@ ? Shares outstanding 2500 Share price $40 Proposed $? $40,000 $60,000 5% ? 1500 $40 Data Analysis Recession Normal Expansion EBIT $2400 $6,000 $7800 Interest 0 0 0 Net Income $2400 $6000 $7800 EPS $ 0.96 $ 2.4 $ 3.12 %ΔEPS –60% –– +30% Currently 2,500 shares outstanding Zulfiqar Hasan

Solution: 1b Proposed Position b. Under the proposed recapitalization, Company will repurchase: Share price = Equity / Shares outstanding = $100,000/2500 = $40 Shares repurchased = Debt issued / Share price =$40,000/$40 = 1,000 The interest payment each year under all three scenarios will be: Interest payment = $40,000(.05) = $2000 Recession Normal Expansion EBIT $2400 $6,000 $7800 Interest $2000 $2000 $2000 Net Income $400 $4000 $5800 EPS $ 0.27 $ 2.67 $ 3.87 %ΔEPS –90% –– +45% Under the proposed recapitalization 1500 shares outstanding Zulfiqar Hasan

2. a. Current Position 2. b. Proposed Position Recession Normal Expansion EBIT $2400 $6,000 $7800 Interest 0 0 0 EBT $2400 $6,000 $7800 Tax@35% $ 840 $ 2100 $ 2730 Net Income ? ? ? EPS ? ? ? %ΔEPS ? ? ? 2. b. Proposed Position Recession Normal Expansion EBIT $2400 $6,000 $7800 Interest $2000 $2000 $2000 EBT $400 $4000 $5800 Tax@35% 140 1400 $2030 Net Income ? ? ? EPS ? ? ? %ΔEPS ? ? ? Zulfiqar Hasan

Calculating B/V and M/B Ratio: Example Zulfiqar Hasan

3. a. & 3. b 3. a. Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE: ROE = NI/$100,000 The ROE for each state of the economy under the current capital structure and no taxes is: Recession Normal Expansion ROE 0.024 0.060 0.078 %ΔROE –60 ––– +30 The second row shows the percentage change in ROE from the normal economy. b. If the company undertakes the proposed recapitalization, the new equity value will be: Equity = $100,000 – 40,000 Equity = $60,000 So, the ROE for each state of the economy is: ROE = NI/$60,000 Recession Normal Expansion ROE 0.0067 0.0667 0.0967 %ΔROE –60 ––– +30 Zulfiqar Hasan

3C c. If there are corporate taxes and the company maintains its current capital structure, the ROE is: Recession Normal Expansion ROE . 0.0156 0.039 0.0507 %ΔROE –60 ––– +30 If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each state of the economy is: Recession Normal Expansion ROE 0.0043 0.0433 0.0628 %ΔROE –90 ––– +45 Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage change in ROE is also the same with or without taxes. Zulfiqar Hasan