1. Kevin Campbell, University of Stirling, October 2006 1 Capital structure Issues: What is capital structure? Why is it important? What are the sources of capital available to a company? What is business risk and financial risk? What are the relative costs of debt and equity? What are the main theories of capital structure? Is there an optimal capital structure?

2. Kevin Campbell, University of Stirling, October 2006 2 What is “Capital Structure”? Definition The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities Bonds, bank loans Ordinary shares (common stock), Preference shares (preferred stock) Hybrids, eg warrants, convertible bonds

3. Kevin Campbell, University of Stirling, October 2006 3 Financial Structure What is “Capital Structure”? Balance Sheet Current Current Assets Liabilities Debt Fixed Preference Assets shares Ordinary shares

4. Kevin Campbell, University of Stirling, October 2006 4 Capital Structure What is “Capital Structure”? Balance Sheet Current Current Assets Liabilities Debt Fixed Preference Assets shares Ordinary shares

5. Kevin Campbell, University of Stirling, October 2006 5 Sources of capital Ordinary shares (common stock) Preference shares (preferred stock) Hybrid securities Warrants Convertible bonds Loan capital Bank loans Corporate bonds

6. Kevin Campbell, University of Stirling, October 2006 6 Ordinary shares (common stock) Risk finance Dividends are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders A high rate of return is required Provide voting rights – the power to hire and fire directors No tax benefit, unlike borrowing

7. Kevin Campbell, University of Stirling, October 2006 7 Preference shares (preferred stock) Lower risk than ordinary shares – and a lower dividend Fixed dividend - payment before ordinary shareholders and in a liquidation situation No voting rights - unless dividend payments are in arrears Cumulative - dividends accrue in the event that the issuer does not make timely dividend payments Participating - an extra dividend is possible Redeemable - company may buy back at a fixed future date

8. Kevin Campbell, University of Stirling, October 2006 8 Loan capital Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed) Bank loans or corporate bonds Interest on debt is allowed against tax

9. Kevin Campbell, University of Stirling, October 2006 9 Seniority of debt Seniority indicates preference in position over other lenders. Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.

10. Kevin Campbell, University of Stirling, October 2006 10 Security Security is a form of attachment to the borrowing firm’s assets. It provides that the assets can be sold in event of default to satisfy the debt for which the security is given.

11. Kevin Campbell, University of Stirling, October 2006 11 Indenture A written agreement between the corporate debt issuer and the lender. Sets forth the terms of the loan: Maturity Interest rate Protective covenants e.g. financial reports, restriction on further loan issues, restriction on disposal of assets and level of dividends

12. Kevin Campbell, University of Stirling, October 2006 12 Warrants A warrant is a certificate entitling the holder to buy a specific amount of shares at a specific price (the exercise price) for a given period. If the price of the share rises above the warrant's exercise price, then the investor can buy the security at the warrant's exercise price and resell it for a profit. Otherwise, the warrant will simply expire or remain unused.

13. Kevin Campbell, University of Stirling, October 2006 13 Convertible bonds A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period. As bonds, they provide a coupon payment and are legally debt securities, which rank prior to equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer. Their conversion feature also gives them features of equity securities.

14. Kevin Campbell, University of Stirling, October 2006 14 The Cost of Capital Expected Return Risk premium Risk-free rate Time value of money _________________________________________________________ _____ Risk Treasury Corporate PreferenceHybrid Bonds Bonds Shares Securities Ordinary Shares

15. Kevin Campbell, University of Stirling, October 2006 15 Measuring capital structure Debt/(Debt + Market Value of Equity) Debt/Total Book Value of Assets Interest coverage: EBITDA/Interest

16. Kevin Campbell, University of Stirling, October 2006 16 Selected leverage data for US corporations

17. Kevin Campbell, University of Stirling, October 2006 17 Interpreting capital structures The capital structures we observe are determined both by deliberate choices and by chance events Safeway’s high leverage came from an LBO HP’s low leverage is the HP way Disney’s low leverage reflects past good performance GM’s high leverage reflects the opposite

18. Kevin Campbell, University of Stirling, October 2006 18 Capital structures can be changed Leverage is reduced by Cutting dividends or issuing stock Reducing costs, especially fixed costs Leverage increased by Stock repurchases, special dividends, generous wages Using debt rather than retained earnings Interpreting capital structures

19. Kevin Campbell, University of Stirling, October 2006 19 Business risk and Financial risk Firms have business risk generated by what they do But firms adopt additional financial risk when they finance with debt

20. Kevin Campbell, University of Stirling, October 2006 20 Risk and the Income Statement Sales Operating– Variable costs Leverage– Fixed costs EBIT – Interest expense Financial Earnings before taxes Leverage– Taxes Net Income EPS =Net Income No. of Shares

21. Kevin Campbell, University of Stirling, October 2006 21 Business Risk The basic risk inherent in the operations of a firm is called business risk Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)

22. Kevin Campbell, University of Stirling, October 2006 22 Financial Risk Debt causes financial risk because it imposes a fixed cost in the form of interest payments. The use of debt financing is referred to as financial leverage. Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.

23. Kevin Campbell, University of Stirling, October 2006 23 Financial Risk vs. Business Risk There is a trade-off between financial risk and business risk. A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even. A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).

24. Kevin Campbell, University of Stirling, October 2006 24 Why should we care about capital structure? By altering capital structure firms have the opportunity to change their cost of capital and – therefore – the market value of the firm

25. Kevin Campbell, University of Stirling, October 2006 25 What is an optimal capital structure? An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value Cost of Capital: Each source of financing has a different cost The WACC is the “Weighted Average Cost of Capital” Capital structure affects the WACC

26. Kevin Campbell, University of Stirling, October 2006 26 Capital Structure Theory Basic question Is it possible for firms to create value by altering their capital structure? Major theories Modigliani and Miller theory Trade-off Theory Signaling Theory

27. Kevin Campbell, University of Stirling, October 2006 27 Modigliani and Miller (MM) Basic theory: Modigliani and Miller (MM) in 1958 and 1963 Old - so why do we still study them? Before MM, no way to analyze debt financing First to study capital structure and WACC together Won the Nobel prize in 1990

28. Kevin Campbell, University of Stirling, October 2006 28 Modigliani and Miller (MM) Most influential papers ever published in finance Very restrictive assumptions First “no arbitrage” proof in finance Basis for other theories

29. Kevin Campbell, University of Stirling, October 2006 29 Debt versus Equity A firm’s cost of debt is always less than its cost of equity debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible. It may appear a firm should use as much debt and as little equity as possible due to the cost difference, but this ignores the potential problems associated with debt. A Basic Capital Structure Theory

30. Kevin Campbell, University of Stirling, October 2006 30 A Basic Capital Structure Theory There is a trade-off between the benefits of using debt and the costs of using debt. The use of debt creates a tax shield benefit from the interest on debt. The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.

31. Kevin Campbell, University of Stirling, October 2006 31 Summary A firm’s capital structure is the proportion of a firm’s long-term funding provided by long-term debt and equity. Capital structure influences a firm’s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk. Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.

32. Kevin Campbell, University of Stirling, October 2006 32 Is there magic in financial leverage? … can a company increase its value simply by altering its capital structure? …yes and no …we will see….