Chapter 9

Capital Structure

© 2005 Thomson/South-Western

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The Target Capital Structure

Capital Structure: The combination of debt and equity used to finance a firm

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

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The Target Capital Structure

Four factors that influence capital structure decisions:

The firm’s business risk The firm’s tax position Financial flexibility Managerial attitude

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What is Business Risk?Uncertainty about future operating income

(EBIT).

How well can we predict operating income?

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Sales variability

Input price variability

Ability to adjust output prices for changes in input prices

The extent to which costs are fixed: operating leverage

Factors Affecting Business Risk

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What is Operating Leverage?

Operating Leverage: Use of fixed operating costs rather than variable costs

If most costs are fixed (i.e., they do not decline when demand falls) then the firm has high DOL (degree of operating leverage)

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What is Financial Risk?

Financial Leverage: The extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure

Financial Risk: Additional risk placed on stockholders as as result of financial leverage

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Business Risk vs. Financial Risk

Business risk depends on business factors such as competition, product liability, and operating leverage.

Financial risk depends only on type of securities issued: the more debt, the more financial risk.

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Determining the Optimal Capital Structure:

Seek to maximize the price of the firm’s stock.

Changes in use of debt will cause changes in earnings per share, and, thus, in the stock price.

Cost of debt varies with capital structure. Financial leverage increases risk.

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EPS Indifference Analysis

EPS Indifference Point:The level of sales at which EPS will be the same whether the firm uses debt or common stock (pure equity) financing.

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ProbabilityDensity

0 $2.40 $3.36

50% Debt Financing

Zero Debt Financing

EPS ($)

Probability Distribution of EPS with Different Amounts of Financial Leverage

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The Effect of Capital Structure on Stock Prices and the Cost of Capital

The optimal capital structure maximizes the price of a firm’s stock.

The optimal capital structure always calls for a debt/assets ratio that is lower than the one that maximizes expected EPS.

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Debt/ Assets

kd Expected EPS

Estimated Beta

ks = [kRF + (kM – kRF)s]

Estimated Price

Resulting P/E Ratio

WACC

0% - $2.40 1.50 12.0% $20.00 8.33 12.00% 10 8.0% 2.56 1.55 12.2 20.98 8.20 11.46 20 8.3 2.75 1.65 12.6 21.83 7.94 11.08 30 9.0 2.97 1.80 13.2 22.50 7.58 10.86 40 10.0 3.20 2.00 14.0 22.86 7.14 10.80 50 12.0 3.36 2.30 15.2 22.11 6.58 11.20 60 15.0 3.30 2.70 16.8 19.64 5.95 12.12

All earnings paid out as dividends, so EPS = DPS.Assume that kRF = 6% and kM = 10%. Tax rate = 40%.

WACC = wdkd(1 - T) + wsks

= (D/A) kd(1 - T) + (1 - D/A)ks

At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%

Stock Price and Cost of Capital Estimates with Different Debt/Assets Ratios

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Relationship Between Capital Structure and EPSEPS

0

0.5

1

1.5

2

2.5

3

3.5

0 10 20 30 40 50 60

Maximum EPS = $3.36Expected EPS ($)

Debt/Assets (%)

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0

5

10

15

20

0 10 20 30 40 50 60

Cost of Equity, ks

Cost of Capital (%)

Debt/Assets (%)

WACC

Minimum = 10.8%

Relationship Between Capital Structure and Cost of Cost of CapitalCapital

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22

23

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0 10 20 30 40 50 60

Maximum = $22.86

Stock Price ($)

Debt/Assets (%)

Relationship Between Capital Structure and Stock PriceStock Price

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Percentage change in NOIPercentage change in sales

EBITEBIT

SalesSales

EBITEBITQQ

DOL = = =

DOLQ = Q(P - V)

Q(P - V) - FC

DOLS = S - VCS - VC - F

Gross ProfitEBIT

=

Degree of Operating Leverage (DOL)

The percentage change in operating income (EBIT) associated with a given percentage change in sales.

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EPSEPS

EBITEBIT

Percentage change in EPSPercentage change in EBIT

EBITEBIT - Int

DFL = = =

Degree of Financial Leverage (DFL)

The percentage change in earnings available to common stockholders associated with a given percentage change in EBIT.

This equation assumes the firm has no preferred stock.

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S - VCS - VC - F - Int

Gross ProfitEBIT - Int

DTL = =

Q(P - V)Q(P - V) - F - Int

DTL =

DTL = DOL X DFL

Degree of Total Leverage (DTL)

The percentage change in EPS that results from a given percentage change in sales.

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Liquidity and Capital StructureDifficulties with Analysis

1. We cannot determine exactly how either P/E ratios or equity capitalization rates (ks values) are affected by different degrees of financial leverage.

2. Managers may be more or less conservative than the average stockholder, so management may set a different target capital structure than the one that would maximize the stock price.

3. Managers of large firms have a responsibility to provide continuous service and must refrain from using leverage to the point where the firm’s long-run viability is endangered.

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Liquidity and Capital Structure

Financial strength indicatorTimes-Interest-Earned (TIE) Ratio

Ratio that measures the firm’s ability to meet its annual interest obligations

Formula: divide EBIT (earnings before interest and taxes) by interest charges

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Capital Structure Theory

Trade-off Theory

Signaling Theory

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Trade-Off Theory (Modigliani and Miller)

1. Theory: 1. Interest is tax-deductible expense, therefore less

expensive than common or preferred stock.2. So, 100% debt is the preferred capital structure.

2. Theory: 1. Interest rates rise as debt/asset ratio increases2. Tax rates fall at high debt levels (lowers debt tax

shield)3. Probability of bankruptcy increases as debt/assets

ratio increases.

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Trade-Off Theory (continued)

3. Two levels of debt:

1. Threshold debt level (D/A1) = where bankruptcy costs become material

2. Optimal debt level (D/A2) = where marginal tax shelter benefits = marginal bankruptcy–related costs

3. Between these two debt levels, the firm’s stock price rises, but at a decreasing rate

4. So, the optimal debt level = optimal capital structure

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Trade-Off Theory (cont)

4. Theory and empirical evidence support these ideas, but the points cannot be identified precisely.

5. Many large, successful firms use much less debt than the theory suggests—leading to development of signaling theory.

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Signaling Theory

Symmetric Information Investors and managers have identical

information about the firm’s prospects.

Asymmetric Information Managers have better information about their

firm’s prospects than do outside investors.

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Signaling TheorySignal

An action taken by a firm’s management that provides clues to investors about how management views the firm’s prospects

Result: Reserve Borrowing CapacityAbility to borrow money at a reasonable cost

when good investment opportunities ariseFirms often use less debt than “optimal” to

ensure that they can obtain debt capital later if needed.

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Variations in Capital Structures among Firms

Wide variations in use of financial leverage among industries and firms within an industry TIE (times interest earned ratio) measures

how safe the debt is: percentage of debt interest rate on debt company’s profitability

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Country Equity Total Debt Long-Term Debt

Short-Term Debt

United Kingdom 68.3% 31.7% N/A N/A United States 48.4 51.6 26.8% 24.8% Canada 47.5 52.5 30.2 22.7 Germany 39.7 60.3 15.6 44.7 Spain 39.7 60.3 22.1 38.2 France 38.8 61.2 23.5 37.7 Japan 33.7 66.3 23.3 43.0 Italy 23.5 76.5 24.2 52.3

Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995

Capital Structures Around the World

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Before Next Class:

1.Review Chapter 9 material2.Do Chapter 9 homework3.Prepare for Chapter 9 quiz4.Read Chapter 10