Agendapthistle.faculty.unlv.edu/FIN301-London/Chapter15.pdfthe optimal capital structure. Defining the Firm’s Capital Structure A firm’s capital structure consists of owner’s

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Capital Structure PolicyCapital Structure Policy

Chapter 15

Capital Structure PolicyCapital Structure Policy

AgendaAgenda

Learning Objectives Principles Used in This Chapter

1.A Glance at Capital Structure Choices in Practice2.Capital Structure Theory3.Why Do Capital Structures Differ Across Industries?3.Why Do Capital Structures Differ Across Industries?4.Making Financing Decisions

Learning ObjectivesLearning Objectives

1. Describe a firm’s capital structure.2. Explain why firms have different capital

structures and how capital structure influences a firm’s weighted average g gcost of capital.

3. Use the basic tools of financial analysis to analyze a firm’s financing decision.

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Principles Used in This ChapterPrinciples Used in This Chapter

Principle 2: There is a Risk-Return Tradeoff.◦ Managers are often tempted to take on more debt as it can increase the rate of return earned on the stockholders’ investment in the firm. Ho e e this highe et n comes ith a cost◦ However, this higher return comes with a cost. The higher use of debt financing makes the firm’s stock riskier, which increases the required rate of return on stock. In addition, it increases the default risk of the firm.

Principles Used in This ChapterPrinciples Used in This Chapter

Principle 3: Cash Flows Are the Source of Value.◦ Capital structure choice impacts the cash flows and thus affects the value of the firm.

15.1 A Glance at Capital 15.1 A Glance at Capital Structure Choices in PracticeStructure Choices in Practice

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A Glance at Capital Structure A Glance at Capital Structure Choices in PracticeChoices in Practice

The primary objective of capital structure management is to maximize the value of the shareholders’ equity.

The resulting financing mix that maximizes shareholder value is called the optimal capital structure.

Defining the Firm’s Capital StructureDefining the Firm’s Capital Structure

A firm’s capital structure consists of owner’s equity and its interest bearing debt, including short-term bank loans.

The combination of firm’s capital structure plus the firm’s non-interest bearing liabilities such as accounts payable is called the firm’s financial structure.

Defining the Firm’s Capital Structure Defining the Firm’s Capital Structure

A firm’s financial structure is often described by the debt ratio. ◦ a.k.a. debt/asset ratio

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The Debt to Value ratio is commonly used to describe a firm’s capital structure.

This ratio includes only interest bearing y gdebt and uses current market values rather than book values.


The total book value of interest bearing debt includes:◦ Short-term notes payable (e.g., bank loans),◦ Current portion of long-term debt, and◦ Long-term debt.


Table 15-1 shows that the book value based debt ratio is always higher than the market value based debt to value ratio because:◦ Debt ratio is based on book value and book value of equity is always lower than its market value.◦ Debt to value ratio excludes non-interest bearing debt in the numerator resulting in a lower value.

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Table 15-1 also reports the Times Interest Earned Ratio, which measures the firm’s ability to pay the interest on its debt out of operating earnings.

See Table 15-3 on the next slide


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Financial LeverageFinancial Leverage

The term financial leverage is often used to describe a firm’s capital structure. Leverage allows the firm to increase the potential return to its shareholders.

For example, if the firm is earning 17% on its investments and paying only 8% on borrowed money, the 9% differential goes to the firm’s owners.

This is known as favorable financial leverage.

Financial Leverage Financial Leverage

However, if the firm earns only 6% on its investments and must pay 8% then the 2% differential must come out of the owner’s share and they suffer unfavorable financial leverage.

So leverage is beneficial if the rate of return exceeds the borrowing cost.

How Do Firms in Different How Do Firms in Different Industries Finance Their Assets?Industries Finance Their Assets?

Figure 15-1 shows the variations in debt to value ratios across industries.

The average debt to value ratio is 42% gwith a wide variation across industries.

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15.2 Capital Structure Theory15.2 Capital Structure Theory

Capital Structure TheoryCapital Structure Theory

We begin with capital structure irrelevance theory that is based on unrealistic assumptions. ◦ We then relax these assumptions to examine how they influence a firm’s incentive to use debt and equity financing.

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A First Look at the Modigliani and A First Look at the Modigliani and Miller Capital Structure TheoremMiller Capital Structure Theorem

Modigliani and Miller showed that, under ideal conditions, it does not matter whether a firm uses no debt, a little debt or a lot of debt in its capital structure.

The theory relies on two basic assumptions:1. The cash flows that a firm generates are

not affected by how the firm is financed.2. Financial markets are perfect.

A First Look at the Modigliani and Miller A First Look at the Modigliani and Miller Capital Structure Theorem Capital Structure Theorem

Assumption 2 of perfect market implies that the packaging of cash flows, ◦ that is whether they are distributed to investors as dividends or interest payments,

is not important.

Yogi Berra and the M&M Capital Yogi Berra and the M&M Capital Structure TheoryStructure Theory

The number of pieces that a pizza is cut into doesn’t affect the total amount that is eaten.

The size of the pizza pie ◦ (the value of the firm, which is determined by the cash

flows to both creditors and owners)

does not depend on the size of the slices ◦ (the portions of firm’s cash flow that is distributed to

creditors or stockholders and consequently how much of the firm is financed with debt and equity).

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Capital Structure, the Cost of Equity, and the Capital Structure, the Cost of Equity, and the Weighted Average Cost of CapitalWeighted Average Cost of Capital

When there are no taxes, the firm’s weighted average cost of capital is also unaffected by its capital structure.

Capital Structure, the Cost of Equity, and the Capital Structure, the Cost of Equity, and the Weighted Average Cost of Capital Weighted Average Cost of Capital

Assume we are valuing a firm whose cash flows are a level perpetuity.

The value of the firms is then represented by the following equation.y g q


Since firm value and firm cash flows are unaffected by the capital structure, the firm’s weighted average cost of capital is also unaffected.

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The cost of equity will increase with the debt to equity ratio (D/E).

However, because there is less weight on , gthe more expensive equity, the firm’s WACC (equation 15-5) does not change and is always equal to the cost of capital of an unlevered firm.


Example 15.1

JNK can borrow money at 9% and its cost of capital if it uses no financial leverage is p g11%.

It has a debt-to-equity ratio of 1.0, the cost of debt is 8%, and weighted average cost of capital is 10%.

What is the cost of equity for JNK?


C t f it 11 ( 11 08) 1 0 Cost of equity = .11 + (.11-.08) × 1.0 = .14 or 14%

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Figure 15.3

Why Capital Structure Matters in Why Capital Structure Matters in RealityReality

In reality, financial managers care a great deal about how their firms are financed.

Indeed, there can be negative consequences for firms that select an qinappropriate capital structure

This means that, in reality, at least one of the two M&M assumptions is violated.

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Violation of Assumption 1Violation of Assumption 1

There are three reasons why capital structure affects the total cash flows available to its debt and equity holders:1. Interest is a tax-deductible expense, while

dividends are not. Thus, after taxes, firms have more money to

distribute to their debt and equity holders if they use more debt financing.


2. Debt financing creates a fixed legal obligation.

If the firm defaults on its payments, the creditors can force the firm into bankruptcy and the firm will incur the added cost that this process entails.

3. The threat of bankruptcy can influence the behavior of a firm’s executives as well as its employees and customers.


Transaction costs can be important◦ Because of these costs, the rate at which investors can borrow may differ from the rate at which firms can borrow.

When this is the case firm values may When this is the case, firm values may depend on how they are financed ◦ Individuals cannot substitute their individual borrowings for corporate borrowings to achieve a desired level of financial leverage.

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Corporate Taxes and Capital Corporate Taxes and Capital StructureStructure

Since interest payments are tax deductible, the after-tax cash flows will be higher if the firm’s capital structure includes more debt.

Corporate Taxes and Capital Corporate Taxes and Capital Structure Structure

Consider two firms identical in every respect except for their capital structure. oEach firm has operating income of $200,000. oFirm A has no debt and has total equity f f $financing of $2,000.

oFirm B has borrowed $1,000 on which it pays 5% interest and raised the remaining $1,000 with equity.

oThe corporate tax rate is 25%.


Firm A Firm B

Operating Income $200 $200

Less: Interest Expense

- -$50

EBT $200 $150EBT $200 $150

Less : Taxes -$50 -37.50

Net Income $150 $112.50

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If we assume that both firms payout 100% of earnings in common stock dividends, we get the following:

Firm A Firm BEquity Dividends $150 $112.50Interest Payments - $50.00Total Distributions (to stockholders and bondholders)

$150.00 $162.50


The $12.50 additional distribution to Firm B can be traced to the tax benefits of interest payments, 0.25 ×$50 = $12.50. This is referred to as interest tax savings.

These tax savings add value to the firm and provide an incentive to the firm to include more debt in the capital structure.


If the firm saves $12.50 in taxes every year, then the present value of these tax savings is the extra value added by using debt financing.

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Bankruptcy and Bankruptcy and Financial Distress CostsFinancial Distress Costs

However, a firm cannot keep on increasing debt because if the firm’s debt obligations exceed it’s ability to generate cash, it will be forced into bankruptcy and incur financial distress costs.

Furthermore, debt financing also severely limits financial manager’s flexibility to raise additional funds.

The Tradeoff Theory and the The Tradeoff Theory and the Optimal Capital StructureOptimal Capital Structure

Thus two factors can have material impact on the role of capital structure in determining firm value and firms must tradeoff the pluses and minuses of both these factors:◦ Interest expense is tax deductible.◦ Debt makes it more likely that firms will experience financial distress costs.

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Capital Structure Decisions and Capital Structure Decisions and Agency CostsAgency Costs

It is argued that debt financing can help reduce agency costs.

For example, debt financing by creating p , g y gfixed dollar obligations will reduce the firm’s discretionary control over cash and thus reduce wasteful spending.

Making Financing Choices When Managers are Making Financing Choices When Managers are Better Informed than ShareholdersBetter Informed than Shareholders

When firms issue new shares, it is perceived that the firm’s stock is overpriced and accordingly share price generally falls.

This provides an added incentive for firms pto prefer debt.

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Making Financing Choices When Managers are Making Financing Choices When Managers are Better Informed than Shareholders Better Informed than Shareholders

Stewart Myers suggested that because of the information issues that arise when firms issue equity, firms tend to adhere to the following pecking order when they raise capital:

l f fi i◦ Internal sources of financing◦ Marketable securities◦ Debt ◦ Hybrid securities◦ Equity

Managerial ImplicationsManagerial Implications

1. Higher levels of debt can benefit the firm due to tax savings and potential to reduce agency costs.

2. Higher levels of debt increase the probability of financial distress costs and offset tax and agency cost benefits of debt.

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15 3 Why Do Capital Structures 15 3 Why Do Capital Structures 15.3 Why Do Capital Structures 15.3 Why Do Capital Structures Differ Across Industries?Differ Across Industries?

Why Do Capital Structures Differ Why Do Capital Structures Differ Across Industries?Across Industries?

Firms in some industries (such as utilities) tend to generate relatively more taxable income and can benefit more from tax savings on debt.

Financial distress can be fatal for some companies Financial distress can be fatal for some companies (like computer and software firms like Apple) as consumers will be very reluctant to buy the product if there is a possibility of bankruptcy. Thus such firms will tend to have lower levels of debt.

15.4 Making Financing 15.4 Making Financing DecisionsDecisions

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Benchmarking the Firm’s Capital Benchmarking the Firm’s Capital StructureStructure

By benchmarking a firm’s capital structure, we compare the firm’s current and proposed capital structures to a set of firms that are considered to be in similar lines of business and consequently subject to the same types of risks.

Table 15-4 provides a simple template for benchmarking.

Checkpoint 15.1Checkpoint 15.1

Benchmarking a Financing DecisionSister Sarah’s Homemade Pies, Inc. is a rapidly growing manufacturer and distributor of frozen pastries and desserts. The company was founded in 1992 by Sarah Goodnight, who used old family recipes and southern home-style cooking to prepare a wide variety of desserts.

By 2010 the business had grown to the point that it was expected to By 2010 the business had grown to the point that it was expected to produce $50 million in revenues based on total assets of $29.8 million. The firm has outgrown its manufacturing facility and is planning to invest $10 million in a new, modern plant.

With the added capacity of the new plant, the firm expects to increase its revenues from $50 million to $60 million per year. In addition, the 20% increase in revenues will be accompanied by a 20% increase in cost of goods sold and operating expenses.

The new equipment will be depreciated over a 10-year life and result in $1 million in additional depreciation expense per year, assume a 30% tax rate.

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Checkpoint 15.1Checkpoint 15.1Two financing alternatives are being considered.

The first involves issuing 1.342 million shares of common stock, and the second involves borrowing the entire $10 million ($2 million in additional short-term debt and $8 million in long-term debt).

The firm currently owes $6 million in combined short- and long-y $ gterm debt on which it pays 8% interest and pays $1.2 million a year in principal payments.

If the debt option is selected then the firm will pay 8% interest on the added $10 million in shortplus long-term debt and in addition will pay $2 million per year in principal on the new debt until the note is repaid.

What will the effect be on Sister Sarah’s Homemade Pies, Inc.’s financial ratios if the firm uses the equity alternative? What about the debt alternative?



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Checkpoint 15.1:Checkpoint 15.1: Check YourselfCheck Yourself

Under the debt financing alternative, what will Sister Sarah’s financial ratios look like in just two years after the firm has repaid $4 million of the loan (assuming nothing else changes)?else changes)?

Step 1: Picture the ProblemStep 1: Picture the Problem

The pro-forma balance sheet after $4 million in long-term debt has been paid off will change and is given on the next slide.

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Balance Sheet Before After $4 million paid off

Accounts Payable $4,500,000 $4,500,000

Short-term Debt $3,200,000 $3,200,000

Total Current $7,700,000 $7,700,000Liabilities

$ , , $ , ,

Long-term Debt $12,800,000 $8,800,000

Total Liabilities $20,500,000 $16,500,000

Common Equity $19,300,000 $19,300,000

Total Liabilities and Equity

$39,800,000 $35,800,000

Step 1: Picture the Problem Step 1: Picture the Problem Income Statement Pro formas Adjusted for New Financing

2010 Equity Debt

Revenues $50,000,000 $60,000,000 $60,000,000

Cost of Goods Sold (25,000,000) (30,000,000) (30,000,000)

Gross Profit $25,000,000 $30,000,000 $30,000,000

Operating Expenses (10,000,000) (12,000,000) (12,000,000)

Depreciation Expenses (2,000,000) (3,000,000) (3,000,000)

EBIT $13,000,000 $15,000,000 $15,000,000

Interest Expense (480,000) (480,000) (960,000)

Earnings before Taxes $12,520,000 $14,520,000 $14,040,000

Taxes (3,756,000) (4,356,000) (4,212,000)

Net Income $8,764,000 $10,164,000 $9,828,000

Earnings per Share $1.461 $1.603 $1.638

Return on Equity 45.4% 34.7% 50.9%

Sinking Fund Payment 1,200,000 1,200,000 2,400,000


The total interest expense on the income statement will reduce as $4 million of debt has been paid off.

Thi ill d th i t t b This will reduce the interest expense by $4,000,000 × .08 = $320,000

New interest expense = $1,280,000 – $320,000= $960,000

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Step 2: Decide on a Solution StrategyStep 2: Decide on a Solution Strategy

Table 15-4 can be used to solve the four key financial leverage ratios.


Step 3: SolveStep 3: Solve Given:

2010 Equity Financing Debt Financing

Borrowing Rate 8.0% 8.0% 8.0%

Shares of Common Stock 6,000,000 6,342,309 6,000,000

Tax Rate 30.0% 30.0% 30.0%

Revenues $50,000,000 $60,000,000 $60,000,000

Cost of Goods Sold/Sales 50.0% 50.0% 50.0%/

Operating Expenses/Sales 20.0% 20.0% 20.0%

Depreciation Expense $2,000,000 $3,000,000 $3,000,000

New Borrowing — $10,000,000

New Equity $10,000,000 —

Price Earnings Ratio 20 20 20

Sinking Fund as % of Debt 20% 20% 20%

Cost of Capital Equipment 10,000,000.00 10,000,000.00

Depreciable Life 10 10

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Step 3: SolveStep 3: Solve

($7.7m + $8.8m)/$35.8m

($3.2m+$8.8m)/$35.8mRatio

Ratio with Current

Debt Financing

Ratios after 2-years with $4 million debt

paid off

Debt Ratio 51 5% 46 09%

$15m/$0.96m

$15m+$.96m$.96m+$2.4m/.7

Debt Ratio 51.5% 46.09%

Interest Bearing Debt Ratio

40.020% 33.52%

Times Interest Earned Ratio

11.72 15.625

EBITDA Coverage Ratio

3.08 4.10

Step 4: AnalyzeStep 4: Analyze

We observe in step 3 that all ratios drop and become stronger, after $4 million debt is paid off.

Comparing it to the benchmark ratios given, we can conclude that the debt alternative is still more aggressive compared to industry norms.

Step 4: Analyze Step 4: Analyze

The firm’s management will have to analyze and determine whether the firm can support a higher than average leverage in the capital structure.

If the firm’s future earnings prospects are favorable, a higher leverage may be justified.

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Evaluating the Effect of Financial Evaluating the Effect of Financial Leverage on Firm’s Earnings per ShareLeverage on Firm’s Earnings per Share

Firms that use more debt financing will experience greater swings in their earnings per share in response to changes in firm revenues and operating earnings.

This is referred to as the financial leverage effect.

Financial Leverage and the Volatility Financial Leverage and the Volatility of EPSof EPS

The table below also illustrates the impact of financial leverage on the volatility of earnings per share.

Capital Structure

Worst caseEBIT =$10,000

Best CaseEBIT = $40,000

$ Change in EPS

% Change in EPS

Plan A 2.50 10.00 7.50 300%Plan B 2.00 12.00 10.00 500%Plan C 1.50 14.00 12.50 833%

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Financial Leverage and the Volatility Financial Leverage and the Volatility of EPSof EPS

We observe that when EBIT is high, a more levered firm will realize higher EPS.

However, if EBIT falls, a firm that uses more financial leverage will suffer a large g gdrop in earnings per share (EPS) than a firm that relies less on financial leverage.

Using the EBITUsing the EBIT--EPS Chart to Analyze the EPS Chart to Analyze the Effect of Capital Structure on EPSEffect of Capital Structure on EPS

Checkpoint 15.2 illustrates the EBIT-EPS chart that evaluates the effect of capital structure choices on earnings per share.

The EBIT-EPS chart analyzes:y◦ Whether the debt plan produces a higher level of EPS for the most likely range of EBIT values.◦ Possible swings in EPS that might occur under the capital structure alternatives.


Evaluating the Effect of Financing Decisions on EPS

The House of Toast, Inc. is considering a new investment that will cost $50,000 and that will increase the firm’s annual operating earnings (EBIT) by $10,000 per year from the current level of $20,000 to $30,000.

The firm can raise the $50 000 by (1) selling 500 shares of The firm can raise the $50,000 by (1) selling 500 shares of common stock at $100 each, or (2) selling bonds that will net the firm $50,000 and carry an interest rate of 8.5 percent.

What is the EPS for the expected level of EBIT equal to $30,000?

What is the effect of the financing alternatives on the level and volatility of the firm’s EPS if the firm anticipates that its EBIT will fall within the range of $20,000 to $40,000 per year?

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Checkpoint 15.2:Checkpoint 15.2: Check YourselfCheck Yourself

House of Toast likes the new investment very much.

However, in the weeks since the project was first analyzed, the firm has learned that credit tightening in the financial markets has credit tightening in the financial markets has caused the cost of debt financing for the debt financing plan to increase to 10%.

What level of EBIT produces zero EPS for the new borrowing rate?


The current and prospective capital structure alternatives can be described using pro forma balance sheets as given in the next slide.

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Step 1: Picture the Problem Step 1: Picture the Problem Current Capital

StructureWith New Debt

Financing

Long-term debt at 8% $50,000 $50,000

Long-term debt at 10% $50,000

Common Stock $150,000 $150,000

Total Liabilities and Equity

$200,000 $250,000

Common Shares Outstanding

1,500 1,500


A firm’s capital structure will affect both the EPS for a given level of operating earnings (EBIT) and the volatility of changes in EPS corresponding to changes in EBIT.

We can use pro forma income statements for a range of levels of EBIT that the firm believes is relevant to its future performance.

Step 3: SolveStep 3: Solve

We calculate the EPS over a range of EBITs. 50,000*.08+50,000*.10

EBIT/EPS AnalysisEBIT $5,000 $9,000 $20,000 $25,000 $30,000 $35,000

EPS =Net income/1500

Less: Interest Expense $9,000 $9,000 $9,000 $9,000 $9,000 $9,000

EBT $(4,000) $ — $11,000 $16,000 $21,000 $26,000

Less: Taxes $(2,000) $ — $5,500 $8,000 $10,500 $13,000

Net Income $(2,000) $ — $5,500 $8,000 $10,500 $13,000

EPS $(1.33) $ — $3.67 $5.33 $7.00 $8.67Tax rate=50%

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Step 3: Solve Step 3: Solve

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EBIT-EPS Chart for House of Toasts, Inc

-2

0

2

4

6

0 5 10 15 20 25 30 35 40

EPS

($)

EBIT($, thousands)

$9,000

Step 4: AnalyzeStep 4: Analyze

We examine the EPS within the EBIT range of $5,000 to $35,000.

The EPS ranges from a low of -$1.33 to a high of $8.67. g

At EBIT of $9,000, the EPS is equal to zero.

Computing EPS Indifference Points Computing EPS Indifference Points for Capital Structure Alternativesfor Capital Structure Alternatives

The point of intersection of the two capital structure lines found in Figure 15-7 is called the EBIT-EPS indifference point.

The point identifies the level at which EPS pwill be the same regardless of the financing plan chosen by the firm.

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Computing EPS Indifference Points for Computing EPS Indifference Points for Capital Structure Alternatives Capital Structure Alternatives

At EBIT amounts in excess of the EBIT indifference level, the financing plan with more leverage will generate a higher EPS.

At EBIT amounts below the EBIT indifference level, the financing plan involving less leverage will generate a higher EPS.

Survey Evidence: Factors that Survey Evidence: Factors that Influence CFO Debt PolicyInfluence CFO Debt Policy

Figure 15-8 captures the survey of 392 CFOs who were asked about the potential determinants of capital structure choices on a scale of 0 to 4, with a 0 indicating not important and 4 representing very important.

Documents

Agendapthistle.faculty.unlv.edu/FIN301-London/Chapter15.pdfthe optimal capital structure. Defining the Firm’s Capital Structure A firm’s capital structure consists of owner’s