CAPITAL STRUCTURE ANALYSIS Chapter 14

CHAPTER 14 OBJECTIVES Describe the advantages and disadvantages of financial leverage. 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. 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. Relate capital structure composition to owner and creditor investment objectives.

CHAPTER 14 OBJECTIVES (CONT.) Discuss the various types of risks and their role in capital structure analysis. Discuss the various types of risks and their role in capital structure analysis. Present a preliminary capital structure analysis for a company or industry. Present a preliminary capital structure analysis for a company or industry.

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

OBJECTIVE FOR ANALYZING CAPITAL STRUCTURE (CONT.) Capital structure composition Capital structure composition Consists of long-term liabilities, preferred stock, common stock, and retained earnings. Consists of long-term liabilities, preferred stock, common stock, and retained earnings. Sufficient equity must exist to provide financial stability 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 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 The balance sheet Reports how funds are acquired and allocated Reports how funds are acquired and allocated Current assets are financed with current obligations—not a factor in capital structure analysis 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 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 (CONT.) Capital structure valuation Capital structure valuation Long-term liabilities are reported at the present value of expected cash flows Long-term liabilities are reported at the present value of expected cash flows Current liabilities are not adjusted for the time value of money Current liabilities are not adjusted for the time value of money Contributed capital is reported at the historical proceeds received from selling stock 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 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 Equity investments are an entity’s permanent financing, representing The ultimate risk capital The ultimate risk capital Insulation of the firm from random business shocks Insulation of the firm from random business shocks A margin of safety to debt investors A margin of safety to debt investors The right to a return on investment only after the other claimants have been satisfied The right to a return on investment only after the other claimants have been satisfied

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

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

FINANCIAL LEVERAGE (CONT.) The advantage of debt only exists up to a point (Exhibits 14-2A and 14-2B) The advantage of debt only exists up to a point (Exhibits 14-2A and 14-2B) Low cost debt increases ROE relative to ROA Low cost debt increases ROE relative to ROA Debt can become so costly that it reduces ROE below ROA Debt can become so costly that it reduces ROE below ROA

FINANCIAL LEVERAGE (CONT.) The financial structure leverage ratio The financial structure leverage ratio Is computed as: average total assets / average common shareholders’ equity 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) 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 Financial leverage index Is computed as adjusted return on equity / adjusted return on assets 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 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 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 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 Risk is the possibility of losing something of value Credit risk Credit risk The possibility that an entity will not be able to meet debt payment obligations on time The possibility that an entity will not be able to meet debt payment obligations on time

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

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

RISK ANALYSIS (CONT.) Bankruptcy risk Bankruptcy risk Extreme case of credit risk, whereby a firm may be unable to continue as a going concern 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 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 A company in financial distress might file for bankruptcy protection

RISK ANALYSIS (CONT.) A bankrupt firm A bankrupt firm Losses autonomy in conducting its operations Losses autonomy in conducting its operations Has a court suspend its creditors’ claims 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 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 Will liquidate, or go out of business, if continuing operations is not a viable option

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

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

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

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

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

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

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

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

DEBT TO CAPITAL RATIOS (CONT.) Earnings coverage ratio Earnings coverage ratio Measures the extent to which an entity can meet its fixed charges 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 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 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 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 Bankruptcy prediction Mathematical models that provide information about an entity’s bankruptcy probability Mathematical models that provide information about an entity’s bankruptcy probability The Z-score is an accepted measure of bankruptcy prediction The Z-score is an accepted measure of bankruptcy prediction Computed as a function of five weighted ratios Computed as a function of five weighted ratios Z-scores above 3.0 indicate little probability of bankruptcy Z-scores above 3.0 indicate little probability of bankruptcy Those below 1.81 indicate a high possibility of bankruptcy Those below 1.81 indicate a high possibility of bankruptcy Scores between 1.81 and 3.0 are inconclusive 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 New economy capital structure Venture capital and retained earnings financed PC firms’ productive resources Venture capital and retained earnings financed PC firms’ productive resources Little long-term debt Little long-term debt

CAPITAL STRUCTURE ANALYSIS AND THE PC INDUSTRY (CONT.) Capital structure measures Capital structure measures Apple and Dell carried more debt than Compaq or Gateway during the period analyzed (Exhibit 14- 7A) 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 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 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) 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) Debt as a proportion of total assets and equity was relatively stable during the period examined (Exhibits 14-8A and 14-8B)