Chapter Capital Structure Decisions u Capital structure decisions when the participants are well informed: u Managers can look to the market for clues to investor response u Capital structure decisions when there is asymmetrical information: u Managers typically use pro-forma analysis to project the firm’s ability to use debt and equity profitably

Capital Structure Decisions – Four Sources of Information 1. Study the market’s response to similar offerings u Compare yourself to others to find a proxy company that has recently issued new debt or equity

Capital Structure Decisions – Four Sources of Information 2. Study the market’s response to different capital structures u Look at industry ratios u Balance sheet (stock) ratios such as debt to total assets u Income statement (flow) ratios such as times interest earned

Capital Structure Decisions – Four Sources of Information 2. Study the market’s response to different capital structures u From these ratios, judge the market response to a change in your firm’s capital structure u Must adjust for differing accounting interpretations

Capital Structure Decisions – Four Sources of Information 3. Seek information from key market participants u Investment bankers u Rating agencies u Security analysts u Portfolio managers

Capital Structure Decisions – Four Sources of Information 4. Attempt to judge market disequilibrium u There could be factors unique to the company, such as an unusual tax situation u Investment bankers may know what form of financing the market overall is favoring

Capital Structure Decisions u Merits and demerits of generalizing from other offerings u Your situation may be unusual u You could get conflicting wealth and income ratio indications u Market may not be fully informed

Capital Structure Decisions u Earnings volatility risk: u Indicator of ability to pay future obligations from future cash flows u Example measure is the times interest earned ratio

Capital Structure Decisions u Liquidation or bankruptcy risk: u This is based on your ability to pay from collateral u Paying from collateral is usually inferior to paying from future cash flows u Example measure is the debt to total asset ratio

Capital Structure Decisions u Income break-even point and the financing mix: u Step 1: Create a spreadsheet modeling the income statement and balance sheet u Step 2: Find break-even level of sales u Step 3: Vary the levels of debt and equity, then recalculate the break-even level of sales u Based on expected range of sales, choose the appropriate financing mix

Capital Structure Decisions u Earnings per share crossover point: u Step 1: Create a spreadsheet modeling the income statement, balance sheet, and earnings per share u Step 2: Find the level of sales where the earnings per share are equal between two alternative debt-equity mixtures -- crossover point u Based on expected range of sales, choose the appropriate financing mix

Capital Structure Decisions u Debt capacity analysis u Measures the firm’s ability to meet its cash flow obligations with various amounts of debt u Often run as a worst-case scenario analysis

Capital Structure Decisions u Debt capacity analysis example 1. Model recession cash flow with differing financing 2. Develop back-up plans to cover periods of negative cash flows 3. Choose the maximum debt payment that can be met in a recession 4. Select debt (amount, maturity) within maximum debt payment

Capital Structure Decisions u Tools used by managers to reduce the probability of default in times of negative cash flows. u Liquid reserves u costly in profitability u External backup credit lines u high out-of-pocket cost in fees

Capital Structure Decisions u Tools used by managers to improve cash flows in times of duress. u Reduce the outflows in a particular period u Often means lost revenues u Reduction of a dividend, seen as negative signal u Sale of assets u Usually interpreted as a negative signal based on timing

Capital Structure Decisions – Qualitative Factors u Future financing needs u Too much debt might close off future debt offerings u Nonpublic companies often o verextend and risk either bankruptcy or a lesser bargaining position with a venture capitalist

Capital Structure Decisions – Qualitative Factors u Flexibility u Watch your restrictive covenants -- debt issues u Typically debt is more restrictive than common stock

Capital Structure Decisions – Qualitative Factors u Control u More shares could mean less control u More debt could mean less flexibility u Hedging u Important in u Maturity decisions u Source of funding for international subsidiaries

Capital Structure – Qualitative Factors u Strategic issues u You may not want a weak financing position in an increasing competitive environment