Capital Structure

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Capital Structure

• FIL 341
• Prepared by Keldon Bauer

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Target Capital Structure

• Definition
• The mix of debt, preferred stock, and common
  stock the firm plans to use over the long-run to
  finance its operations.
• The proportions should be set in such a way as to
  balance risk/return and thereby maximize the
  price of the stock.
• This mix is called the Optimal Capital Structure
  (OCS).

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Finding Target Capital Structure

• Four Factors in Determining TCS
• Firms business risk
• As business risk increases level of debt
  decreases.
• Firms tax position
• As taxable income increases so does debt.
• Financial flexibility
• As access to markets increases, the firm can take
  advantage of current market conditions.

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Finding Target Capital Structure

• Managerial attitudes
• As managers are more conservative they will tend
  to use less debt.
• Note that this is the only factor that has
  nothing to do with optimal capital structure, and
  everything to do with target capital structure.

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Business and Financial Risk

• You know about market (beta) and firm-specific
  risk. Company risk is a composite of both of
  these risks, which itself has two components
• Business risk Uncertainty inherent in return
  projections in the absence of financial leverage.
• Financial risk Uncertainty in return resulting
  from financial leverage.

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Business Risk

• Biggest determinant of optimal capital structure.
• Best measured as high volatility (variance) in
  operational profit (EBIT).
• Most important factors
• Sales variability
• Input price variability
• Ability to adjust output prices
• Extent to which costs are fixed

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Financial Risk

• Financial leverage exists when a firm raises
  capital using debt (including leasing), or
  preferred stock.
• Degree of financial leverage measures the extent
  to which fixed income securities are used in a
  firms capital structure.
• Ideally, this should include all fixed financing
  costs like leasing!

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Financial Risk

• The use of debt intensifies the business risk
  borne by common shareholders.
• The appropriate level of financial leverage is
  what determining optimal capital structure is all
  about.

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Finding Optimal Capital Structure

• Definition
• Choosing the combination of debt and equity that
  will maximize the price of the stock.

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Effect of Leverage on EPS

• OptiCap example from the book

We will now examine the effect of adding leverage!
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Effect of Leverage on EPS
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Effect of Leverage on EPS

• One effect of increased leverage is increased
  interest rates (as risk increases).

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Effect of Leverage on EPS

• Next we perform a scenario analysis of sales next
  year. The top of the income statement is as
  follows

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Effect of Leverage on EPS

• If no leverage is taken on then

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Effect of Leverage on EPS

• If the firm is levered and equity purchased

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Effect of Leverage on EPS
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Effect of Leverage on EPS
Optimal Debt Level for EPS is 50
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Effect of Leverage on EPS
Note Optimal CV 0 Debt
Basic Business Risk
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EPS Indifference Analysis

• Finding the indifference point
• The level of sales at which EPS will be the same
  whether the firm uses debt or equity.
• Using the information from the scenario analysis
  and assuming that the relationship is linear
  beyond that (which in our model it was), we get
  the following

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EPS Indifference Analysis
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EPS Indifference Analysis

• At sales levels higher than the indifference
  point, leverage enhances EPS.
• At sales levels lower than the indifference
  point, leverage reduces EPS.

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Effect of Leverage on Firm Value

• Because financial leverage adds risk and expected
  return (to a point), the optimal capital
  structure is the one that maximizes the firms
  stock price, which is always lower than the point
  which maximizes EPS.

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Effect of Leverage on Firm Value

• Continuing with the OptiCap example

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Effect of Leverage on Firm Value

• Continuing with the OptiCap example

Maximum Price Minimum WACC at 40 Debt
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Effect of Leverage on Firm Value
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Degree of Leverage

• Leverage can be defined as the degree to which
  costs (operating or financial) are fixed.
• We can now explore how falling operating leverage
  affects the optimal capital structure.

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Degree of Leverage

• Using the scenario analysis we developed thus
  far, we will now calculate the degree of
  operating and financial leverage measures.

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Effect of Leverage on EPS

• We will use the levered example

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Effect of Leverage on EPS

• The two types of leverage magnify the others
  effect.
• DTL DOL DFL
• Degree of Total Leverage DTL
• Degree of Operating Leverage DOL
• Degree of financial Leverage DFL
• That means that if sales are going to be high,
  then the maximum point for leverage (both kinds)
  is also high because of what it does to EPS.

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Degree of Operating Leverage
Note As sales goes up, operating leverage goes
down!
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Degree of Financial Leverage
Note As sales goes up, financial leverage goes
down!
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Effect of Leverage on EPS
Going from 200 to 300 in the scenario analysis
represents a 50 increase in sales
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Effect of Leverage on EPS

• The reason that this analysis is interesting (for
  those of you trying to fall asleep), is that it
  tells us how much of the increase in EPS came
  from operating, and how much came from financial
  leverage.

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Liquidity and Capital Structure

• The theory is great, but there are still some
  problems that keep us from the optimal capital
  structure
• It is impossible to determine exactly how price
  and ks are affected by changes in DFL.
• Managers may be more or less conservative than
  the average shareholder, leading to a different
  optimum for them.

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Liquidity and Capital Structure

• Publicly necessary goods or services may not be
  allowed to hit the optimal for shareholders
  because of the risk implied to the public (e.g.
  utilities).
• Bankruptcy risk is a deterrent to optimal capital
  structure.
• Bankruptcy risk can be judged through use of the
  TIE ratio from chapter 3.

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Capital Structure Theory

• Trade-Off Theory
• A trade-off exists between tax benefits of debt
  and increasing bankruptcy costs.
• Miller Modigliani showed (with unrealistic
  assumptions) that shareholder value would be
  maximized with nearly 100 debt.
• Doesnt hold in the real world because interest
  rates rise as leverage rises, and because
  expected taxes go down as debt rises, and
  bankruptcy costs rise as leverage rises.

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Trade-Off Theory
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Signaling Theory

• And still some successful firms use less than
  optimal debt (even using trade-off theory).
• One possible reason for this discrepancy, is that
  MM assumed that investors had the same
  information as managers (Information Symmetry).

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Signaling Theory

• In reality, managers usually have better
  information than investors about corporate
  prospects (Information Asymmetry).
• If a companys prospects look good, managers
  wishing to maximize shareholder wealth will not
  issue stock to dilute their windfall.

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Signaling Theory

• Those companies with bad prospects will not want
  high leverage, because they may be forced into
  bankruptcy.
• These conclusions are consistent with what we
  found using EPS indifference and degrees of
  leverage analyses.

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Signaling Theory

• Therefore, when mature companies without clear
  profit potentials issue stock, this is seen as a
  bad signal that prospects look bad.
• On the other hand, if they issue debt, they are
  signaling that their prospects are good.
• As bad signals hit the market, price of the stock
  goes down, ks and WACC go up.

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Other Theories

• Normally, companies keep excess borrowing
  capacity (reserve borrowing capacity) for
  expansion, just in case the big one pops up.
• Even though it is sub-optimal.

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Capital Structure - Industries

• Capital structure varies by industry and firm.
• Much depends on operating leverage (business
  risk).
• RD, possible lawsuits, etc. contributed to
  expected operating leverage.
• Also depends on debt, market interest rates,
  taxes and expected profitability.

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Capital Structure - Industries
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Capital Structure - Internationally

• If tax codes, other costs, and investor
  preferences were the same around the world, we
  should see similar capital structures.
• Explanations for differences include
• Tax codes
• Accounting practices
• Monitoring costs

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Capital Structure - Internationally