capital structure berat başat

Berat BAŞAT

Marmara University

Institute of Social SciencesDepartment of Business Administration in English

Sub-Departent of Accounting and Finance

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DefinitionsFactorsFeaturesEBIT – EPS AnalysisCosts and Benefits of DebtTheoriesEmpirical Evidences

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BALANCE SHEET Current Current Assets Liabilities

Debt and Fixed Preferred Assets

Shareholders’ Equity

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BALANCE SHEET Current Current Assets Liabilities

Debt and Fixed Preferred Assets

Shareholders’ Equity

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BALANCE SHEET Current Current Assets Liabilities

Debt and Fixed Preferred Assets

Shareholders’ Equity

FinancialStructure

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BALANCE SHEET Current Current Assets Liabilities

Debt and Fixed Preferred Assets

Shareholders’ Equity

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BALANCE SHEET Current Current Assets Liabilities

Debt and Fixed Preferred Assets

Shareholders’ Equity

CapitalStructure

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Capital Structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity.

The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

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Optimal Capital Structure is the combination of sources of capital that minimizes weighted average cost of capital and maximizes the value of firm.

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Target Capital Structure is the mix of debt, preferred stock, and common equity with which the firm plans to finance its investments.

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• Business Risk• Tax Position• Financial Flexibility• Managerial Attitude

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The risk that a company will not have adequate cash flow to meet its operating expenses

Business risk is the uncertainty associated with projections of a firm’s future returns on equity

There is also Financial Risk as well as Busines Risk;

Additional business risk concentrated on common stockholders when financial leverage is used.

Depends on the amount of debt and preferred stock financing. 13

Suppose 10 people decide to form a corporation to manufacture disk drives.

If the firm is capitalized only with common stock – and if each person buys 10% - each investor shares equally in business risk

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If the same firm is now capitalized with 50% debt and 50% equity – with five people investing in debt and five investing in equity

The 5 who put up the equity will have to bear all the business risk, so the common stock will be twice as risky as it would have been had the firm been all-equity (unlevered).

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Business risk:Uncertainty in future EBIT.

Depends on business factors such as competition, operating leverage, etc.

Financial risk:Additional business risk concentrated on

common stockholders when financial leverage is used.

Depends on the amount of debt and preferred stock financing.

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A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt.

However, if much of a firm’s income is already sheltered from taxes by accelerated depreciation or tax loss carryovers, its tax rate will be low, and debt will not be as advantageous as it would be to a firm with a higher effective tax rate.

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Financial flexibility is an ability to raise capital on reasonable terms under adverse conditions.

Corporate treasures know that a steady supply of capital is necessary for stable operations, which in turn are vital for long-run success.

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They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, a strong balance sheet is needed to obtain funds from suppliers of capital.

Thus, it might be advantageous to issue equity to strengthen the firm’s capital base and financial stability.

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Some managers are more aggressive than others; hence, some firms are more inclined to use debt in an effort to boost profits.

This factor does not affect the optimal, or value-maximizing, capital structure, but it does influence the target capital structure a firm actually establishes.

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1. Flexibility:

The consideration of flexibility gives the financial manager ability to alter the firm’s capital structure with a minimum cost and delay warranted by a changed situation.

It should also be possible for the company to provide funds whenever needed to finance its profitable activities.

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2. Profitability:

It should permit the maximum use of leverage at a minimum cost with the constraints. Thus a sound capital structure tends to minimize ‘cost’ of financing and maximize earnings per share (EPS).

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• Profits can be paid out as dividends to shareholders or reinvested in the firm.

• If a firm generates high profits and reinvests a large proportion back into the firm, then it has a continuous source of internal funding.

• This will reduce the use of debt in the firm’s capital structure.

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3. Solvency:

It should use the debt capital only up to the point where significant risk it not added. As has been already observed the use of excessive debt threatens the solvency of the company.

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4. Conservation:

The capital structure should be conservative in the sense that the debt capacity of the company should not exceed. The debt capacity of a company demands on its ability to generate future cash flows.

It should have enough cash to pay creditors fixed charges and principal amount. It should be remembered that cash insolvency might also lead to legal insolvency.

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5. Control:

The capital structure should involve minimum risk of loss of control of the company. A careful consideration of these criteria points the conflicting nature.

For example the use of debt capital is more economical but the same capital adds to the financial risk of the company.

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• Controlling owners may desire to issue debt instead of ordinary shares since debt does not grant ownership rights.

• Firms with little financial leverage are often considered excellent takeover targets.

• Issuing more debt may help to avoid a corporate takeover.

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EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity.

EPS = (EBIT - I)(1 - t) - P S

I = interest expense, P = preferred dividends,S = number of shares of common stock outstanding.

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Question: for different levels of EBIT, how does financial leverage affect EPS?

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Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project.

We are considering two options:

1. Sell 200,000 shares of common stock at $30 per share,

2. Borrow $6,000,000 by issuing 10% bonds.

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Financing stock debt EBIT 2,000,000 2,000,000- interest 0 (600,000)EBT 2,000,000 1,400,000- taxes (40%) (800,000) (560,000)Net Income 1,200,000 840,000# shares outst. 1,000,000 800,000EPS $1.20 $1.05

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Financing stock debt EBIT 4,000,000 4,000,000- interest 0 (600,000)EBT 4,000,000 3,400,000- taxes (40%) (1,600,000) (1,360,000)Net Income 2,400,000 2,040,000# shares outst. 1,000,000 800,000EPS $2.40 $2.55

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EPS

EBIT$1m $2m $3m $4m

stock financing

0

3

2

1

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EPS

EBIT$1m $2m $3m $4m

bond financing

0

3

2

1

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If EBIT is $2,000,000, common stock financing is best.

If EBIT is $4,000,000, debt financing is best.

So, now we need to find a breakeven EBIT where neither is better than the other.

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Formula:

Stock Financing Debt Financing(EBIT-I) (1-t) = (EBIT-I) (1-t) S S

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Stock Financing Debt Financing(EBIT-I) (1-t) = (EBIT-I) (1-t) S S

(EBIT-0) (1-.40) = (EBIT-600,000) (1-.40) 800,000+200,000 800,000

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Stock Financing Debt Financing (EBIT-0) x 0.6 = (EBIT - 600,000) x 0.6 1 0.8

.48 EBIT = .6 EBIT - 360,000

.12 EBIT = 360,000

EBIT = $3,000,000 38

EPS

EBIT$1m $2m $3m $4m

bond financing

stock financing

0

3

2

1

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EPS

EBIT$1m $2m $3m $4m

bond financing

stock financing

0

3

2

1

For EBIT up to $3 million,stock financing is best.

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EPS

EBIT$1m $2m $3m $4m

bond financing

stock financing

0

3

2

1

For EBIT up to $3 million,stock financing is best.

For EBIT greaterthan $3 million, debt financing is

best.

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- Tax Benefits of Debt

- Debt-holders are limited to a fixed return

- Voting rights

- Discipline

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Firm Unlevered Firm Levered

No debt $10,000 of 12% Debt$20,000 Equity $10,000 in Equity40% tax rate 40% tax rate

Tax benefit of debt

Both firms have same business risk and EBIT of $3,000.

They differ only with respect to use of debt.

U has $20.000 in Equity L has $10.000 in Equity

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EBIT $3,000 $3,000Interest 0 1,200EBT $3,000 $1,800Taxes (40%) 1 ,200 720NI $1,800 $1,080ROE 9.0% 10.8%

Firm U Firm L

U; 1.8 / 20 = 9% L; 1.08 / 10K = 10.8%

Tax benefit of debt

The relation between amounts of debt and equity

- Bankruptcy Costs

- Agency Costs

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Bankruptcy Costs or Costs of Financial Distress

Bankruptcy Costs are costs associated with financial difficulties that a firm might get into because it uses debt financing.

Financial distress occurs when a firm is not able to make all of the interest and principal payments that it owes its lender

As you borrow more, you increase the probability of bankruptcy and hence the expected bankruptcy cost.

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Agency Costs

Agency costs result from conflicts of interest between principals and agents. In agency relationships, one party, known as the principal, delegates decision-making authority to another party, known as the agent.

The managers and stockholders of a firm also often behave in ways that reduce a firm's value when the firm becomes financially distressed. The resulting costs are a type of agency cost.

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To better understand agency costs, consider the following example. Suppose that you have a newspaper route and you want to go out of town for a week. You offer a friend $100 to deliver your papers while you are gone. If your friend agrees to the arrangement, you will have entered into a principal-agent relationship. Now assume that you deliver the Wall Street Journal and that all papers are supposed to be on your customers' doorsteps by 6:00 A.M., before they leave home for work.

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You tell this to your friend before you leave town, but he likes to sleep late in the morning, so he doesn't get all the papers delivered until 9:00 A.M. Because the papers are late for five days in a row, a few customers complain, and some don't give you a tip at the end of the year as they have in the past. Any problems that arise because of the complaints and the lost tips are examples of agency costs. These costs arose because you delegated decision-making authority to your friend and he acted in his best interest rather than yours.

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Modigliani and Miller (1958) show that financing decisions don’t matter in perfect capital markets

-Firms can not change the total value of their securities

-Firm value is determined by real assets

-Capital structure is irrelevant

M&M Proposition 1: ZERO TAXES

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When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow.

For example, it doesn't matter whether the debt is short- or long-term, callable or call-protected, straight or convertible, in dollars or euros, or some mixture of all of these or other types.

Therefore, the market value of a company does not depend on its capital structure. VL = VU 53

Capital Markets are perfect.

Individuals can borrow and lend at the risk-free rate

There are no bankruptcy costs

All firms are assumed to be in the same risk class (operating risk)

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•Corporate insiders and outsiders have the same information. (Symmetric Information)

•Managers always maximize shareholders’ wealth (No agency costs)

•Operating cash flows are completely unaffected by changes in capital structure

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Corporate tax laws favor debt financing over equity financing.

With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.

MM show that: VL = VU + TD.

If T=40%, then every dollar of debt adds 40 cents of extra value to firm.

M&M Proposition 2: WITH CORPORATE TAXES

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The tradeoff theory justifies moderate debt ratios.

Profitable firms will borrow up to the point where the marginal value of tax shields on additional debt is just offset by the increase in the present value of possible costs of financial distress.

Financial distress refers to the costs of bankruptcy or reorganization, and also to the agency costs that arise when the firm's creditworthiness is in doubt.

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Theory states that why firms prefer to issue debt rather than equity. The reason of this is not requiring the external funds.

Companies finance investments by raising funds in this order: 

(1)internal funds (retained earnings),

(2) debt,

(3) sale of new common stock (the most expensive form of financing).

Kraus and Litzenberg

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The pecking-order theory is at odds with the trade-off theory:

1. There is no target D/E ratio.

2. Profitable firms use less debt.

3. Companies like financial slack

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- MM assumes symmetric information.

- However, the existence of asymmetric information has important effect on decisions to use either debt or equity.

- A firm with very favorable prospects tries to avoid selling stock and raises new capital by other means including using debt beyond normal target capital structure.

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- A firm with unfavorable prospects would want to sell stock, which would mean bringing in new investors to share losses.

- Announcement of a stock offering by a mature firm signals that future prospects are not bright. So, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.

- Therefore, firms should maintain a reserve borrowing capacity and use less debt than would be suggested by the trade-off theory

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Frank and Goyal (2003) Assume that company operations and the associated accounting

structures are more complex than the standard pecking order representation

Data related to publicly traded American firms over the years 1971-1998

They find leverage to increase with Median industry leverage Firm size Intangibles Corporate income tax rate

They find leverage to decrease with Bankruptcy risk Market-to-book ratio Dividends Profitability

Small firms do not follow the Pecking Order64

Debt ratios of publicly traded firms in the US and economies undergoing rapid economic development (China, and India) are modeled using traditional capital structure specifications

This study seeks to test whether the determinants of debt ratios identified by leading researchers in this area also apply to both Chinese and Indian firms.

Dependent Variables: Liabilities to total assets Long-term debt issuance to total assets

Control Variables: Market-to-book ratio Asset tangibility: Profitability Firm size Product uniqueness

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Sample4905 firmsYears 2000-2006

ResultsIndian firms tend to have higher debt ratios than US

FirmsChinese firms are less levered than US counterpartsChinese firms have issued more long-term debt relative to

assets Negative & significant sign of market to book ratio

supports financial signaling hypothesisPositive & significant on asset tangibility & firm size

supports trade-off theoryProduct uniqueness and profitability are negatively

associated with the debt ratio 66

Firms that are acquired in hostile takeovers are generally characterized by poor performance in both accounting profitability and stock returns.

There is evidence that increases in leverage are followed by improvements in operating efficiency, as measured by operating margins and returns on capital.

Palepu (1990) presents evidence of modest improvements in operating efficiency at firms involved in leveraged buyouts.

Kaplan(1989) and Smith (1990) also find that firms earn higher returns on capital following leveraged buyouts.

Denis and Denis (1993) study leveraged recapitalizations and report a median increase in the return on assets of 21.5%.

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