Capital Structure 05/08/08 Ch. 7

2 Capital Structure – Balance Sheet Assets – Value of the Firm Listed by Closeness to Cash Current Assets Long-term Assets Physical and Intangible Book Value or historical value of the assets adjusted for depreciation Capital Structure The “borrowed” money from the capital markets Liabilities – Fixed claims against the assets Owner’s Equity – Residual claim against assets Book Values not Market Values

3 What is Debt? Fixed claims against the company, the liabilities Current Liabilities, accounts payable… Long-term Liabilities Bank Loans Bonds The “borrowed” money will be paid back usually in pre-specified amounts and at pre- specified time…temporary funding

4 Examples of Debt Loans – Principal and interest due at maturity Interest as you go, principal at maturity Principal and interest as you go, usually equal payments at equal intervals, annuity By Lender -- Banks Bondholders Interest portion is usually tax deductible

5 What is Equity? Value of the company “claimed” by owners What is left over after debt claims are satisfied Permanent Capital Repayment not required Repayment via dividends Dividends not tax deductible (not an expense of the company) Outstanding Common Stock

6 Ways to Raise $$$$ Borrow from suppliers – accounts payable Borrow from bank – bank loan Borrow from bondholders – issue bonds Borrow from other companies – sign leases Borrow from owners Personal funds of founder/owner Issue preferred stock Issue common stock Issue warrants

7 Some Hybrid Securities Convertible Bonds Initially issued as two assets, a straight bond and an option to convert to stock Set conversion ratio Some protection on the down-side (bonds have fixed repayment) Potential for up-side, convert to stock if company (stock prices rise) Preferred Stock Guaranteed dividends (consol or perpetuity)

8 Financing Options Tied to Life Cycle Life Cycle of a firm… Birth (Start-up) Youth (Expansion) Teen-age (Rapid or High Growth) Adult (Mature) Old Age (Decline) Death (Bankruptcy) Personal Funds, Angel Funds, Venture Capitalist, Loans, Public Equity, Bonds…

9 Raising Equity in Capital Markets Usually in late teen – early adulthood Have need for large $$$$ Find Investment Banking Firm – Start IPO File paperwork with SEC Market Security Conduct Auction Distribute Stock and Collect $$$ Subsequent issues are Seasoned Equity Offerings (SEO)

10 Cost of Going Public (IPO) Legal Costs – Registration and Filing Fees Payment to Investment Banker – Best efforts or Firm Commitment Marketing Costs – Road Show Underpricing Why on average are IPOs underpriced? When do marginal clients get a call? Marginal clients know they are marginal… After sale requirements and options

11 Cost of Debt Legal Costs – Registration and Filing Fees Payment to Investment Banker Marketing Costs Potential Default If bondholders or bank not paid back on time the bondholders or bank can “claim” the firm Direct bankruptcy costs Indirect bankruptcy costs

12 Benefits of Debt Discipline Managers – reduces free cash flow Covenants in place to “restrict” certain types of behavior Additional outside validation of management activities and choices Bond rating agencies Bank loan officers Subsequent borrowing

13 Company Earnings Reinvested Earnings of the company can be reinvested in the company What is the cost of reinvesting? What are the choices with company earnings? Pay it back to owners…let them invest it where they might Cost should be the opportunity cost to the owners Cost of equity w/o issuance costs

14 Optimal Capital Structure What combination of borrowing is best? How do you choose which funds you should use for financing? Debt vs. Equity vs. Company Earnings How much of each? Pecking Order Hypothesis Static Theory – Separation of Investing and Financing Decisions Modigliani and Miller 1956 &1958 Marginal cost of bankruptcy vs. Marginal benefit of debt to find the lowest cost of capital

15 Homework Problem #4 – Convertible Preferred Stock (me – I will do this one in class…) Problem #5 – Debt-Equity Ratio Missing data, bonds are ten year bonds Problem #8 – Venture Financing Problem #9 – Venture Financing Problem #15 – Rights Offering Problem #18 – Debt for Stock Swap Problem #23 –Debt & Bankruptcy