1 The Basics of Capital Structure Decisions Corporate Finance Dr. A. DeMaskey

2 Learning Objectives n Questions to be answered: n What factors affect the target capital structure? n What is business risk? What is financial risk? n What is the optimal capital structure? n How do asymmetric information and signals affect capital structure decisions? n Do international differences in financial leverage exist?

3 Capital Structure Policy n Target capital structure n Mix of debt, preferred stock, and common stock n Set equal to estimated optimal capital structure n Optimal capital structure n Balances risk and return n Maximizes the firm’s stock price

4 Capital Structure Decisions n Business risk n Taxes n Financial flexibility n Managerial conservatism or aggressiveness n Growth opportunities

5 Uncertainty about future operating income (EBIT). Uncertainty about future operating income (EBIT). Note that business risk focuses on operating income, so it ignores financing effects. Note that business risk focuses on operating income, so it ignores financing effects. Business Risk Probability EBITE(EBIT)0 Low risk High risk

6 Factors That Influence Business Risk n Uncertainty about demand (unit sales). n Uncertainty about output prices. n Uncertainty about input costs. n Product and other types of liability. n Degree of operating leverage (DOL).

7 Operating Leverage and Business Risk n Operating leverage is the use of fixed costs rather than variable costs. n The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage. (More...)

8 n Higher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline. (More...) Sales $ Rev. TC FC Q BE Sales $ Rev. TC FC Q BE Profit }

9 Probability EBIT L Low operating leverage High operating leverage EBIT H In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk. In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.

10 Business Risk versus Financial Risk n Business risk: n Uncertainty in future EBIT. n Depends on business factors such as competition, operating leverage, etc. n Financial risk: n Additional business risk concentrated on common stockholders when financial leverage is used. n Depends on the amount of debt and preferred stock financing.

11 Measure of Financial and Business Risk in a Stand-Alone Sense Stand-aloneBusinessFinancial riskriskrisk = + Stand-alone risk =  ROE. Business risk =  ROE(U). Financial risk =  ROE -  ROE(U).

12 EPS Indifference Analysis n Used to determine when debt financing is advantageous and when equity financing is advantageous. n Can be illustrated graphically since the relationship between EBIT and EPS is linear. n EPS (debt financing) = EPS (equity financing)

13 Capital Structure Theory n MM theory n Zero taxes n Corporate taxes n Corporate and personal taxes n Trade-off theory n Signaling theory n Debt financing as a managerial constraint

14 MM Theory: Zero Taxes n MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix. n Therefore, capital structure is irrelevant. n Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk.

15 MM Theory: Corporate Taxes n Corporate tax laws favor debt financing over equity financing. n With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used. n Firms should use almost 100% debt financing to maximize value.

16 MM Theory: Corporate and Personal Taxes n Personal taxes lessen the advantage of corporate debt: n Corporate taxes favor debt financing. n Personal taxes favor equity financing. n Use of debt financing remains advantageous, but benefits are less than under only corporate taxes. n Firms should still use 100% debt.

17 Hamada’s Equation n MM theory implies that beta changes with leverage. n b U is the beta of a firm when it has no debt (the unlevered beta) n b L = b U (1 + (1 - T)(D/E)) n In practice, D/E is measured in book values when b L is calculated.

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

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

20 Debt Financing As a Managerial Constraint n One agency problem is that managers can use corporate funds for non-value maximizing purposes. n The use of financial leverage: n Bonds “free cash flow.” n Forces discipline on managers. n However, it also increases risk of financial distress.

21 The MM and Miller models cannot be applied directly because several assumptions are violated. The MM and Miller models cannot be applied directly because several assumptions are violated. k d is not a constant. k d is not a constant. Bankruptcy and agency costs exist. Bankruptcy and agency costs exist. In practice, Hamada’s equation is used to find k S for the firm with different levels of debt. In practice, Hamada’s equation is used to find k S for the firm with different levels of debt. Capital Structure in Practice

22 The Optimal Capital Structure n Calculate the cost of equity at each level of debt. n Calculate the value of equity at each level of debt. n Calculate the total value of the firm (value of equity + value of debt) at each level of debt. n The optimal capital structure maximizes the total value of the firm.

23 Capital Structure Analysis n Financial forecasting models n Can help show how capital structure changes are likely to affect stock prices, coverage ratios, and so on. n Can generate results under various scenarios, but the financial manager must specify appropriate input values, interpret the output, and eventually decide on a target capital structure. n In the end, capital structure decision will be based on a combination of analysis and judgment.

24 Checklist for Capital Structure Decisions n Debt ratios of other firms in the industry. n Pro forma coverage ratios at different capital structures under different economic scenarios. n Lender and rating agency attitudes (impact on bond ratings). n Reserve borrowing capacity. n Effects on control. n Type of assets: Are they tangible, and hence suitable as collateral? n Tax rates.