Capital structure

1

1996, Prentice Hall, Inc.

Determining the Financing MixDetermining the Financing Mix

Chapter 12 Part 2Chapter 12 Part 2

Lecture NotesLecture Notes

2

Learning ObjectivesLearning Objectives Understand the concept of an optimal capital structure. Explain the main underpinnings of capital structure theory. Distinguish between the independence hypothesis and

dependence hypothesis as these concepts relate to capital structure theory theory, and identify the Nobel prize winners in economics who are leading proponents of the independence hypothesis.

Understand and be able to graph the moderate position on capital structure importance.

Incorporate the concepts of agency costs and free cash flow into a discussion on capital structure management.

Use the basic tools of capital structure management. Familiarize others with corporate financing policies in practice.

3Planning the Firm’s Financial MixPlanning the Firm’s Financial MixFinancial Structure and Capital StructureFinancial Structure and Capital Structure

Financial structure is the mix of all sources of financing used by the firm

Balance Sheet

Assets Liabilities

Total Assets

Current LiabilitiesLong Term Liabilities

Equity

FinancialStructure



Capital structure is the mix of the long term sources of funds

Balance Sheet

Assets Liabilities

Total Assets


Equity

Capital Structure



Capital structure is the mix of the long term sources of funds

Capital structure is the focus of this chapter, so current liabilities will not be included.

Balance Sheet

Assets Liabilities

Total Assets


Equity

Capital Structure

6Capital Structure TheoriesCapital Structure Theories

Choose capital structure that minimizes cost of capital which in turn maximizes stock price



There are three theories on choosing the optimal capital structureIndependence TheoryDependence TheoryModerate Theory




For all theories, will use a simple valuation model:

P0 = D kc

where: P0 = price of stockD = constant dividendKc = cost of equity capital




For all theories, will use a simple valuation model:

If all earnings paid as dividends, so there is no growth:

P0 = D kc

where: P0 = price of stockD = constant dividendKc = cost of equity capital

P0 = D kc

EPS kc

=where: EPS = Earnings per share


Moderate PositionModerate PositionInterest is tax deductibleThe use of financial leverage increases the likelihood

of bankruptcy.The costs of equity and debt rise causing a “saucer-

shaped” cost of capital function.Firms should choose financial leverage with lowest

cost of capital

Financial Leverage

kO

kc

kd

CapitalCosts

11Agency Costs and Capital StructureAgency Costs and Capital Structure

Agency problems arise when management does not work in the best interests of the creditors.



Firms incur agency costs such as paying for outside monitors to reassure creditors.




The higher the leverage, the higher the agency costs.

Financial Leverage

FirmValue





Financial Leverage

FirmValue

Value of Unlevered Firm





Financial Leverage

FirmValue

Independence Theory

Value of Levered Firm





Financial Leverage

FirmValue

PV of Tax ShieldsIndependence Theory






Financial Leverage

FirmValue

Independence Theory


Actual Valueof the Firm





Financial Leverage

FirmValue

Independence Theory


Actual Valueof the Firm

PV of Agency and Bankruptcy Costs}

19Capital StructureCapital Structure

Basic Tools of Capital Structure ManagementBasic Tools of Capital Structure ManagementThe use of financial leverage increases variability of

EPS (as seen by DFL in Chapter 13)



EPS (as seen by DFL in Chapter 13)The use of financial leverage also changes EPS at any

given EBIT.




given EBIT.EBIT-EPS Analysis

Graphically demonstrates the impact of leverage on EPS at different levels of EBIT.

EBIT

EPS 50% Leverage

40% Leverage




given EBIT.EBIT-EPS Analysis

Graphically demonstrates the impact of leverage on EPS at different levels of EBIT.

EBIT

EPS 50% Leverage

40% Leverage

Indifference Point

23EBIT-EPS AnalysisEBIT-EPS Analysis

Compute EBIT at which EPS will be the same regardless of financing plan


Compute EBIT at which EPS will be the same regardless of financing plan

Set EPS for each plan equal to each other

EPS50% debt = EPS40% debt

At the EBIT indifference level:At the EBIT indifference level:

(EBIT - I50%)(1 - t)

S50%

(EBIT - I40%)(1 - t)

S40%

=

where: I = Interest cost of plan

S = # of shares of plan


Example:$1 million of financing are currently needed. Can raise the money with debt costing 8%, or stock at $10/share. Tax rate = 40%





(EBIT - I50%)(1 - t)

S50%

(EBIT - I40%)(1 - t)

S40%

=






(EBIT - I50%)(1 - t)

S50%

(EBIT - I40%)(1 - t)

S40%

=



I = $500,000 x 8% = $40,000

S = $500,000/$10 = 50,000




(EBIT - I50%)(1 - t)

S50%

(EBIT - I40%)(1 - t)

S40%

=



I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000

S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000




(EBIT - I50%)(1 - t)

S50%

(EBIT - I40%)(1 - t)

S40%

=

(EBIT - $40,000)(1 - .40)

50,000= (EBIT - $32,000)(1 - .40)

60,000



I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000

S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000




(EBIT - I50%)(1 - t)

S50%

(EBIT - I40%)(1 - t)

S40%

=

(EBIT - $40,000)(1 - .40)

50,000= (EBIT - $32,000)(1 - .40)

60,000



I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000

S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000

EBIT = $80,000Solve for EBIT:Solve for EBIT:

31Capital Structure in PracticeCapital Structure in Practice

The majority of financial officers believe there is an optimal capital structure for their company.

Managers adapt financial leverage to the business cycle, taking advantage of debt when it is less expensive.

The most important factor in determining leverage is a firm’s business risk.

Managers’ optimal choice to finance new projects is to use retained earnings.

Only after internal funds are exhausted, managers’ choice of leverage is consistent with the Moderate Theory of financial leverage.

Education

Capital structure