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Cap Structure: Theory, Principle, and Implications

April 6

2010

This research paper provides a broad analysis of capital structure theory and its implications while using Foot Locker as a mini case study.

By Try L. Muller GB550: Financial Management

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Table of Contents

Introduction to Capital Structure Issues ............................ 3

The Modigliani-Miller Approach (MM) ................................. 4

Mini Case Study – Foot Locker:

Business and Financial Risk ............................................... 6

Mini Case Study – Foot Locker:

Additional Observations ...................................................... 7

Foot Locker’s Proposed Optimal Capital Structure .......... 8

Conclusion ............................................................................ 9

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Introduction to Capital Structure Issues

The capital structure of any firm is heavily dependent on the industry it occupies. But the issues

surrounding capital structure are universal and have implications for all decisions made as to

how a firm chooses to combine debt and equity to finance business activity. There are numerous

factors that affect this decision process because there are varying dynamics exhibited by the

combination of debt and equity. It is hard for firms to adhere to a target optimal capital structure

because there are so many financial and economic components that play a vital role in how

management chooses to use debt and equity. Thus, understanding these dynamics directly

impacts the health of the firm.

There are various components to debt that raise certain issues when trying to find the

optimal cap structure. Financial leverage is the amount of debt a company takes on to finance

operations. Debt signifies an obligation to creditors and interest on these obligations must be

paid. A firm’s probability of bankruptcy increases as its financial leverage increases because it

becomes more difficult to make interest payments and there may be subsequent financial distress

costs due to this increased risk. Thus, debt holders will require a higher return on these

obligations which will increase the pre-tax cost of debt (Brigham and Ehrhardt, 2008).

Furthermore, since debt holders have the initial claim on a firm’s cash flows, this means that

there is an increase in the risk of free cash flows (FCF) not being sufficient enough to allocate to

stockholders (Brigham and Ehrhardt, 2008). This increases the cost of equity (stock).

A high level of financial leverage and the ensuing bankruptcy risk also have adverse

affects on employees and customers in the form of financial distress costs (Joyce, 2010).

Customers may not want long-term relationships with the firm and that will hurt profits and

FCF’s. Internally, employees could lose focus and become unproductive due to the poor health

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of the company and the implications for job loss (Brigham and Ehrhardt, 2008). While financial

leverage can bond cash flows and can curb potential agency costs (wasteful spending by

management), it can also incite ―gun shy‖ management. This means the firm would incur an

agency cost called underinvestment that takes place when management passes on value-adding

projects because of the current level of corporate debt (Brigham and Ehrhardt, 2008).

Many managers are reluctant to issue equity because of how it is perceived in the market. The

market perceives an issuance of equity as management communicating the idea that their stock is

overvalued. The market takes this as a negative signal and reacts by selling the share at a

discount and effectively lowering the stock value. This market reaction is often what CEO’s are

afraid when they speak about diluting the stock (Bielecki, and Rutokoski, 2000).

The Modigliani-Miller (MM) Approach

To further understand the dynamics of debt and equity as it pertains to financing we must take a

look at the Modigliani-Miller (MM) theoretical approach to capital structure decisions. The MM

approach says that a firm’s capital structure is irrelevant to its corporate valuation based on

certain assumptions. The most popular assumption is that there are no taxes, and where there are

taxes, a firm should be inclined to finance by high levels of debt even beyond the target capital

structure (Glen, 2010). The latter part of this assumption is the most interesting because it is

based on the idea that firms will want to finance with debt because of the tax shield on interests

payments— freeing up more FCF’s to distribute to investors (Hitt and Kochhar, 1998). This is

supplemented by the assumption that debt is riskless for both the firm and individual and there

are no bankruptcy costs for the firm (Glen, 2010). The rest of MM’s approach can be derived

from the assumption that securities are traded in perfect capital markets (Brigham and Ehrhardt,

2008). This assumption proposes the following situations: 1) assets are priced with total

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efficiency, 2) brokerage costs do not exist, 3) investors and firms borrow at the same rate, and 4)

there is no asymmetrical information (Brigham and Ehrhardt, 2008). Understanding the

assumptions and inconsistencies of MM’s theoretical approach is vital to understanding what

influences a firm’s optimal capital structure.

These assumptions eventually recognized the obvious cost issues that influence capital

structure. MM’s approach created a trade-off theory that took into consideration the

attractiveness of tax benefits with respect to bankruptcy costs and the financial distress costs that

might precede it. The risk of bankruptcy in highly leveraged firms can incur financial distress

costs in the form of lost employees, investors, underinvestment by managers, lost suppliers, etc

(Joyce, 2010). Bankruptcy risk increases the possibility that the firm may have to liquidate

assets at a distress price – a significantly undervalued price. Trade-off theory implies that the

optimal cap structure is one where financial leverage is at a point where the tax shield benefits

meet the marginal bankruptcy-related costs (Brigham and Ehrhardt, 2008). Below this point the

firm is undervalued and beyond this point the firm starts to lose value. However, the volatility of

markets and stock prices does not allow for companies to adhere to such an explicit optimal cap

structure.

Another important factor that questions MM’s trade-off theory is the idea of managers

trying to time the market. Trade-off theory suggests that management will always employ debt

and equity in a manner that will bring the firm back to its optimal cap structure. However,

evidence shows that firms issue stock when the price appreciate unexpectedly and tries to take

advantages of low interest rates by issuing debt (Brigham and Ehrhardt, 2008). This market-

timing concept makes more sense because it could explain the frequent fluctuation in capital

structures and why it is hard for firms to adhere to a static level of equity and debt financing.

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This goes to show that debt is not riskless for the firm or the individual. Firms with a lot

of financial leverage have an increased cost of equity and increased total return to each

additional debt holder. The risk of this debt will depend on the ability to make interest payments

and the quality of the credit markets. Likewise, the investor that creates homemade leverage—

uses debt financing— to buy stock of a financially leverage firm is doubling his risk because he

may lose equity in the risky company and not receive dividends to pay his own interest (Glen,

2010).

Lastly, assets are not priced with total efficiency because the market does not reflect all

relevant information and there is often no explicit asymmetrical information. Perfect capital

markets would imply that asset bubbles were not possible and that scandals would not happened

since all information is accurate, relevant, and equally available to firms and investors. Markets

are highly imperfect which often takes true asymmetric information out of the equation because

even managers try to time the market. This is not to imply that there is ever really symmetrical

information— investors will never have the same internal knowledge that managers of firms

have. However, if asymmetrical information played a significant role in capital structure

decisions then we would see more preemptive capital activity by managers; a debt offering

before a big stock increase and issuing equity before a decline in price. Even though the MM

approach is relatively outrageous, the underlying principles are vital to properly understanding

capital structure.

Mini Case Study – Foot Locker: Business and Financial Risk

We can now introduce a small case study of the capital structure exhibited by Foot Locker in

order to look at business risk, financial risk, and any other capital structure observations

(Reference Figure 1). The business risk is what common stockholders face if the firm forgoes

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the use of debt financing (Froot and Skin, 1998). A vital component of business risk is operation

leverage – the variability in earnings before interest and taxes (EBIT) as it pertains to sales.

EBIT relates directly to the cash available to stockholders after tax and debt claims. Figure 2

shows the potential relationship between EBIT and operating leverage. If operating leverage is

high then EBIT is more volatile and this increases business risk because stockholders will be

uncertain as to the level of future FCF’s. To further illustrate, Figure 3 shows Foot Locker’s

current degree of operating leverage (DOL) and how it pertains to a more volatile EBIT. The

calculation in Figure 3 means that a 1% increase or decrease in sales will have an 8% increase or

decrease in EBIT. Subsequently, the increased business risk due to a high operating leverage is

reflected in the volatility of earnings per share (EPS) — shown as a 25% difference over a one-

year period. This means that Foot Locker should limit its financial leverage since the high debt

levels concentrate the business risk on common stockholders and the high DOL is amplifying the

volatility in EPS (Brigham and Ehrhardt, 2008). Figure 1 shows the tendency of Foot Locker to

adhere to this principle as shown by the decreasing debt levels over the past few years.

We can find Foot Locker’s degree of financial leverage for debt and its affect on EPS to gather

insight on the additional risk that it puts on stockholders through the use of debt. Figure 4 shows

how a 1% change in sales will have a 3.6% change in earnings before taxes (EBT). This

constitutes a 32% change in EPS as opposed to 25%. Therefore, we can see how Foot Locker’s

financial leverage and subsequent financial risk adds to the risk of the common stockholders.

Mini Case Study – Foot Locker: Additional Observations

There are three more observations that should be addressed regarding Foot Locker’s capital

structure. The first is how capital structure affects return on equity (ROE). Figure 5 illustrates

this relationship and what we can derive from this is that financial leverage not only amplifies

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the variability in EPS – as shown previously – but it also does so for ROE (Minton and Schrand,

1999).

The second observation, shown by Figure 6, is that the weighted average cost of capital

(WACC) does not remain constant, but it actually falls initially when debt capital increases, and

then begins to increase with the increase in the cost of equity. The table also shows that the cost

of equity does increase with increased debt levels. The last observation is that 40% of Foot

Locker’s financing has come from retained earnings over the past four years. This may be

because management sees retained earnings as having no cost - that is the money can be used for

investment projects without involving stockholders or other outside sources (Hitt and Kochhar,

1998). Also, it avoids further diluting stock to raise capital. The stockholders may also rather

receive capital gains as opposed to dividends because of the favorable tax treatment on capital

gains (Brigham and Ehrhardt, 2008).

Foot Locker’s Proposed Optimal Capital Structure

Foot Locker’s optimal capital structure is shown in Figure 6. The optimal capital

structure is said to be one that minimizes WACC. At a WACC of 10.66% the cap structure

adheres to this principle. At 50% debt the cost of debt remains relatively unchanged up to a

certain point at which it then begins to increase. Foot Locker’s proposed optimal capital

structure illustrates this threshold before the cost of debt increases. However, the target optimal

capital structure should probably be below a debt ratio of 50% and above a ratio of 45% if we

assume that firms try to maintain a reserve borrowing capacity.

Conclusion

We have found that a firm with less operating leverage can afford to have a greater level

of financial leverage. This is because they will have less business risk and less volatile earnings.

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Also, managers must seriously asses the firm’s tax position to find out where their tax shield

brings the most benefit. Subsequently, it is important to remember that financial leverage and

operating leverage increase the probability of bankruptcy and incite financial distress costs. This

makes it imperative for managers to pay attention to credit markets, lenders, and how credit

agencies are grading debt. The conclusion that can be drawn from this is that capital structure

decisions are highly complex because of the direct implications they have on the financial

functionality of the firm. While a single optimal capital structure may not exist, there is a target

optimal capital structure for each business situation that a firm encounters.

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Bielecki, T., and Rutokowski, M. (2000). “Valuing Corporate Securities”. Journal of Finance, 31 (2): 351-367 Froot, K.A., and Skin, J.C. (1999). “Risk Management, Capital Budgets, and Capital Structure Policy for Financial Institutions: An Integral Approach”. Journal of Financing Economics, 1 – 82. Glen, R. T. (2010). "Capital structure decisions: what have we learned?". Business

Horizons. FindArticles.com. 24 Mar, 2010. http://findarticles.com/p/articles/mi_m1038/is_n5_v40/ai_20135491/

Joyce, W.B. (2010). "Capital structure and financial stress". Credit & Financial Management Review. FindArticles.com. 24 Mar, 2010. http://findarticles.com/p/articles/mi_qa3857/is_200004/ai_n8899698/

Kochhar, R., Michael, H.A. (1998). "Linking Corporate Strategy to Capital Structure." Strategic Management Journal. June 1998.

Minton, B. and Schrand, C. (1999). “The Impact of Cash Flow Volatility on Discretionary Investment and the Costs of Debt and Equity Financing”. Journal of

Financing Economics, 430 – 460.

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FIGURE 1

Foot Locker’s Capital Structure

Debt Common Stock

Retained Earnings

2007 40% 24% 36%

2008 35% 35% 41%

2009 33% 22% 43%

2010 31% 29% 40%

FIGURE 2

Probability of

EBIT given

DOL

EBIT at a low DOL

EBIT at a high DOL

EBITL EBITH

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FIGURE 3

2008 2009

Sales Revenue $5.44M $5.24

EBIT $61 $49M

DOL = .24/.03 = 8

Change in EPS given a high DOL (8) that increases business risk (risk

of using no debt)

EBIT $61M $49M

Interest 0 0

EBT $61M $49M

Taxes (35%) -$21.2M -$17.2M

Earnings After Tax $39.8M $31.8M

Preferred Dividends 0 0

Operating Income $39.8M $31.8M

Divide by # of shares 156.9M 156.9M

EPS= $0.25 $0.20

3% change

24% change

25% Change (High DOL = High EPS

volatility)

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FIGURE 4

2008 2009

Sales Revenue $5.44M $5.24

EBT $45 $40M

DOL = .24/.03 = 3.6

Change in EPS given a high DOL (8) that increases business risk (risk

of using no debt)

EBIT $61M $49M

Interest -$16M -$9

EBT $45M $40M

Taxes (35%) -$15.8 -$14M

Earnings After Tax $39.7M $26M

Preferred Dividends 0 0

Operating Income $39.7M $26M

Divide by # of shares 156.9M 156.9M

EPS= $0.25 $0.17

11% change

32% Change (Foot Locker debt carries a

lot of additional risk)

3% change

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FIGURE 5

*Only debt levels are shown, reference FIGURE 1 for full cap structure

FIGURE 6 Foot Locker’s Optimal Capital Structure

% of Debt Market D/S

After tax cost of D

Estimated Beta

Cost of Equity

WACC Vale of ops

10%

11.11% 5.1% .88 12.9% 12.0%

20

25.02 5.25 .95 13.4 11.52

30

43.03 5.45 1.05 13.9 11.17

40

66.99 6.1 1.15 14.5 10.78

50

100.00 6.75 1.35 15.4 10.66 $38.6M

60

149.30 7.8 1.61 16.7 10.74

70

233.33 9.7 2.05 18.9 10.99

0

2

4

6

8

10

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2007 (40%) 2008 (35%) 2009 (33%) 2010 (31%)

ROE