copyright ©2003 south-western/thomson learning chapter 12 capital structure concepts

Copyright ©2003 South-Western/Thomson Learning

Chapter 12Capital Structure Concepts

Introduction

• This chapter examines some of the basic concepts used in determining a firm’s optimal capital structure. It deals only with the total permanent sources of a firm’s financing.

Capital Structure vs. Financial Structure

• Capital Structure

Permanent S-T

debt

– L-T debt

– P/S

– C/S

• Financial Structure

Total current

liabilities

– L-T debt

– P/S

– C/S


• Capital structure is defined as the amount of permanent short-term debt, long-term debt, preferred stock, and common equity used to finance a firm.

• Financial structure refers to the amount of total current liabilities, long-term debt, preferred stock, and common equity used to finance a firm.


• Capital structure is part of the financial structure, representing the permanent sources of the firm’s financing.

Capital Structure Terminology

• Optimal capital structure– Minimizes a firm’s weighted average

cost of capital– Maximizes the value of the firm

• Target capital structure– Capital structure at which the firm plans to

operate

• Debt capacity– Amount of debt contained in a firm’s optimal

capital structure

Capital Structure Terminology

• The optimal capital structure and, accordingly, the debt capacity of a firm are determined by the following factors:– Business risk of the firm– Tax structure– Extent of potential financial distress (e.g.,

bankruptcy)– Agency costs– Role played by capital structure policy in

providing signals to the capital markets regarding the firm’s performance

Capital Structure Assumptions

• It is assumed that a firm’s investment policy is held constant when we examine the effects of capital structure changes on firm value and particularly on the value of common stock, which means that the level and variability of EBIT is not expected to change as changes in capital structure are contemplated.

Capital Structure Assumptions

• Capital structure changes affect only distribution of the operating income between the claims of debt holders, preferred stockholders, and common stockholders.

• It is also assumed that the investments undertaken by the firm do not materially change the debt capacity of the firm.

Business Risk

• Business risk refers to the variability or uncertainty of a firm’s operating income (EBIT).

Factors Influencing a Firm’s Business Risk

• Variability of sales

volume

• Variability of selling

price

• Variability of cost

• Amount of market

power

• Extent of product

diversification

• Firm’s growth rate

• Degree of operating

leverage (DOL)

• Both systematic and

unsystematic risk

Web site for more info: http://finance.yahoo.com/

Business Risk: Systematic or Unsystematic Risk?

• Business risk possesses elements of both systematic risk and unsystematic risk. Some of the variability in operating income that results from business cannot be diversified away by investors who hold a broad-based portfolio of securities. – For example, variability attributable to

business cycle behavior is clearly systematic. In contrast, the variability attributable to specific managerial decisions, such as product line diversity, is primarily unsystematic.

Financial Risk

• Financial risk refers to the additional variability of earnings per share and the increased probability of insolvency that arises when a firm uses fixed-cost sources of funds, such as debt and preferred stock, in its capital structure.– Insolvency occurs when a firm is unable to

meet contractual financial obligations—such as interest and principal payments on debt, payments on accounts payable, and income taxes—as they come due.

Fixed Financial Costs

• Fixed financial costs represent contractual obligations a company must meet regardless of the EBIT.

• The use of increasing amounts of debt and preferred stock raises the firm’s fixed financial costs; this, in turn, increases the level of EBIT that the firm must earn in order to meet its financial obligations and remain in business.

Fixed Financial Costs

• The reason a firm accepts the risk of fixed-cost financing is to increase the possible returns to stockholders.

Financial Leverage

• The use of fixed-cost financing sources is referred to as the use of financial leverage.

• Financial leverage causes a firm’s earnings per share (EPS) to change at a rate greater than the change in operating income (EBIT).

Financial Leverage

• If a firm is 100 percent equity financed and EBIT increases (decreases) by 10 percent, EPS will also increase (decrease) by 10 percent. When financial leverage, such as long-term debt, is used, a 10 percent change in EBIT will result in a greater than 10 percent change in EPS.

Financial Leverage

• Figure 12.1 illustrates the concept of financial leverage. – Line A represents the financial leverage

used by a firm financed entirely with common stock. A given percentage change in EBIT results in the same percentage change in EPS.

– Line B represents a firm that use debt (or other sources of fixed-cost funds) in its capital structure. As a result, the slope of the EPS-EBIT line is increased, thus increasing the responsiveness of EPS to changes in EBIT.

Financial Leverage

• As can be seen in Figure 12.1, a given change in EBIT yields a larger change in EPS if the firm is using debt financing (ΔEPSB) than if the firm is financed entirely with common stock (ΔEPSA).

Financial Leverage

• It is also clear from Figure 12.1 that the use of financial leverage magnifies the returns—both positive and negative—to the shareholder. When EBIT is at a relatively high level, such as EBIT2, Firm B’s use of financial leverage increases EPS above the level attained by Firm A, which is not using financing leverage.

Financial Leverage

• On the other hand, when EBIT is relatively low—for example, at EBIT0—the use of financial leverage decreases EPS below the level that would be obtained otherwise; that is, EPS’0 < EPS0. At EBIT0, the use of financial leverage results in negative EPS for Firm B.

Financial Risk: Systematic or Unsystematic Risk?

• Financial risk, like business risk, contributes to both the systematic and unsystematic risk of a firm’s securities. To the extent that the use of financial leverage magnifies variations in operating income that come about because of unsystematic risk factors, financial leverage contributes to the unsystematic risk of a firm’s securities.

Financial Risk: Systematic or Unsystematic Risk?

• Financial researchers have also studied the contribution that financial leverage makes to the systematic risk of a firm’s securities. It is well established that systematic risk is a function both of financial risk and operating risk. Hence, security analysts and investors find the measurement of a company’s financial risk to be an important element of good financial analysis.

Factors Indicating a Firm’s Financial Risk

• Factors indicating financial risk– Debt-to-asset ratio – Debt-to-equity ratio– Fixed charge coverage ratio – DFL– Probability distribution of profits– Times interest earned ratio – EBIT-EPS analysis

Effect of Financial Leverage on Stockholder Returns and Risk

• Firms employ financial leverage to increase the returns to common stockholders at the expense of increased risk.

• The objective of capital structure management is to find the capital mix that leads to shareholder wealth maximization.


TABLE 12.1 Effect of Financial Leverage on Stockholder Returns and Risk at KMI Technology, Inc. Leverage Factor (Debt/Total Assets)

0% 40% 80%

Total Assets $1,000,000 $1,000,000 $1,000,000 Debt (at 10% interest) $0 $400,000 $800,000 Equity 1,000,000 600,000 200,000 Total liabilities and equity $1,000,000 $1,000,000 $1,000,000 Expected operating income (EBIT) $200,000 $200,000 $200,000 Interest (at 10%) 0 40,000 80,000 Earnings before tax $200,000 $160,000 $120,000 Income tax at 40% 80,000 64,000 48,000 Earnings after tax $120,000 $96,000 $72,000 Return on equity (= Earnings after tax/Equity)

12.0% 16.0% 36.0%


• To illustrate the effects of financial leverage on stockholder returns and risk, consider the following example of KMI Technology, Inc. As can be seen in Table 12.1, KMI has total assets of $1 million. Suppose KMI expects an operating income (EBIT) of $200,000. If KMI uses debt in its capital structure, the cost of this debt will be 10 percent per annum.


• Table 12.1 shows the effect of an increase in the debt to total assets ratio (debt ratio) from 0 percent to 40 percent and to 80 percent on the return stockholders’ equity.– With an all-equity capital structure, the

return on equity is 12 percent. – At a debt ratio of 40 percent, the return on

equity increases to 16 percent. – At a debt ratio of 80 percent, the return on

equity is 36 percent.


• KMI is earning 20 percent (pretax) on its assets. The cost of debt is 10 percent pretax. Thus, when KMI uses debt in its capital structure, the difference between the return on its assets and the cost of debt accrues to the benefit of equity holders.


TABLE 12.1 Effect of Financial Leverage on Stockholder Returns and Risk at KMI Technology, Inc.

Effect of a 25 Percent Reduction in EBIT to $150,000 Leverage Factor (Debt/Total Assets)

0% 40% 80%

Expected operating income (EBIT) $150,000 $150,000 $150,000 Interest (at 10%) 0 40,000 80,000 Earnings before tax $150,000 $110,000 $70,000 Income tax at 40% 60,000 44,000 28,000 Earnings after tax $90,000 $66,000 $42,000 Return on equity (= Earnings after tax/Equity)

9.0% 11.0% 21.0%


TABLE 12.1 Effect of Financial Leverage on Stockholder Returns and Risk at KMI Technology, Inc.

Effect of a 60 Percent Reduction in EBIT to $80,000 Leverage Factor (Debt/Total Assets)

0% 40% 80%

Expected operating income (EBIT) $80,000 $80,000 $80,000 Interest (at 10%) 0 40,000 80,000 Earnings before tax $80,000 $40,000 $0 Income tax at 40% 32,000 16,000 0 Earnings after tax $48,000 $24,000 $0 Return on equity (= Earnings after tax/Equity)

4.8% 4.0% 0.0%


• However, this increased equity return is achieved only at the cost of higher risk. – For example, if EBIT declines by 25 percent

to $150,000, the return on equity for the all-equity capital structure also declines by 25 percent to 9.0 percent.

– In contrast, at a 40 percent debt ratio, the return on equity declines by 31.25 percent to 11 percent.

– At an 80 percent debt ratio, the return on equity declines by 41.67 percent to 21 percent.


• The effects of a 60 percent reduction in EBIT to $80,000 are even more dramatic. In this case, the pretax return on assets is less than the pretax cost of debt.

• To pay the prior claims of the debt holders, the equity returns are reduced to a level below those that prevail under the all-equity capital structure.


• In the case of a 40 percent debt ratio, the return on equity is only 4.0 percent, and in the case of an 80 percent debt ratio, the return on equity is 0 percent.


• Thus it can be seen that the use of financial leverage both increases the potential returns to common stockholders and the risk, or variability, of those returns.


• Generally, the greater a firm’s business risk, the less the amount of financial leverage that will be used in the optimal capital structure, holding constant all other relevant factors.

Capital Structure Theory

• Studies the relationship between

– Capital structure

• Debt/Total assets

– Cost of capital

• Value of the firm

Capital Structure without a Corporate Income Tax

• In 1958, two prominent financial researchers, Franco Modigliani and Merton Miller (MM), showed that, under certain assumptions, a firm’s overall cost of capital, and therefore its value, is independent of capital structure.


• In particular, assume that the following perfect capital market conditions exist:– There are no transaction costs for buying

and selling securities.– A sufficient number of buyers and sellers

exists in the market, so no single investor can have a significant influence on security prices.

– Relevant information is readily available to all investors and is costless to obtain.

– All investors can borrow or lend at the same rate.


– All investors are rational and have homogeneous expectations of a firm’s earnings.

– Firms operating under similar conditions are assumed to face the same degree of business risk. This assumption is called the homogeneous risk class assumption.

– There are no income tax.


• In the no-tax MM case, the cost of debt and the overall cost of capital are constant regardless of a firm’s financial leverage position, measured as the firm’s debt-to-equity ratio, B/E.


• As a firm increases its relative debt level, the cost of equity capital, ke, increases, reflecting the higher return requirement of stockholders due to the increased risk imposed by the additional debt.


• The increased cost of equity capital exactly offsets the benefit of the lower cost of debt, kd, so that the overall cost of capital does not change with changes in capital structure. This is illustrated in Figure 12.2.


• Because the firm’s market value is calculated by discounting its expected future operating income by the weighted (marginal) cost of capital, ka, the market value of the firm is independent of capital structure.


• MM support their theory by arguing that a process of arbitrage will prevent otherwise equivalent firms from having different market values simply because of capital structure differences.


• Arbitrage is the process of simultaneously buying and selling the same or equivalent securities in different markets to take advantage of price differences and make a profit.

• Arbitrage transactions are risk-free.


• For example, suppose two firms in the same industry differed only in that one was levered (that is, it had some debt in its capital structure) and the other was unlevered (that is, it had no debt in its capital structure). If the MM theory did not hold, the unlevered firm could increase its market value by simple adding debt to its capital structure.


• However, in a perfect capital market without transactions costs, MM argue that investors would not reward the firm for increasing its debt. Stockholders could change their own financial debt-equity structure without cost to receive an equal return.


• Therefore, stockholders would not increase their opinion of the market value of an unlevered firm just because it took on some debt.


• The MM argument is based on the arbitrage process. If one of two unlevered firms with identical business risk took on some debt and the MM theory did not hold, its value should increase and, therefore, so would the value of its stock. MM suggest that under these circumstances, investors will sell the overpriced stock of the levered firm.


• They can use an arbitrage process of borrowing, then buying the unlevered firm’s stock, and investing the excess funds elsewhere. Through these costless transactions, investors can increase their return without increasing their risk. Hence, they have substituted their own personal financial leverage for corporate leverage.


• MM argue that this arbitrage process will continue until the selling of the levered firm’s stock drives down its prices to the point where it is equal to the unlevered firm’s stock price, which has been driven up due to increased buying.


• The arbitrage process occurs so rapidly that the market values of the levered and unlevered firms are equal. Therefore, MM conclude that the market value of a firm is independent of its capital structure in perfect capital markets with no income taxes.


• The MM no-tax theory is illustrated in the example shown in Table 12.2. The table contains financial data on two firms, U and L, that have equal levels of net operating income (EBIT = $1,000) and operating risk and differ only in their capital structure. Firm U is unlevered, and firm L is levered, with a perpetual debt of $2,000 having a coupon rate (i) of 5 percent in its capital structure.


• For simplicity, we assume that the income of both firms available for stockholders is paid out as dividends. As a result, the expected growth rate of both firms is zero, because no income is available for the firms to reinvest.


• The present value of both firms is calculated using the following perpetuity valuation equation:Market value of firm = Market value of equity (E) + Market value of debt (B)

= (D ÷ ke) + (I ÷ Kd)where E and B are the respective market values of equity and debt in the firm’s capital structure; D is the annual of dividends paid to the firm’s stockholders; I is the interest paid on the firm’s debt; ke is the return required on common equity; and kd is the return on required on debt.


• The required rate of return on the common equity for the unlevered firm (U) is 10 percent. Because of the increased financial risk associated with the $2,000 in debt financing, the required rate of return on the common equity of the levered firm (L) is 11.25 percent. The required return on debt, kd, is assumed to equal the coupon rate on the debt, i.


• For firm U, the present value of the expected future cash flows is $10,000 calculated as follows:

Market value of firm U = $1,000/0.10 = $10,000

• For firm L, the present value is also $10,000, calculated as follows:

Market value of firm L= ($900/0.1125) + ($100/0.05) = $10,000


• Thus, the market value of firms U and L are equal. This example shows that the market value of the firm is independent of capital structure, assuming that the MM theory holds and no corporate income tax exists.

Capital Structure with a Corporate Income Tax

• Table 12.3 shows financial data for an unlevered firm, U, and a levered firm, L, assuming a corporate income tax rate, T, of 40 percent.


• The total income available to the security holders of firm U is $600, and assuming a cost of equity capital equal to 10 percent, the value of firm U is calculated as follows:

Market value of firm U

= $600/0.10 = $6,000


• Because interest paid to debt holders is a tax-deductible expense, the total income available to the debt and equity security holders of firm L, shown in Table 12.3, is $640. This amount is greater than the $600 available to the firm U equity security holders by $40. The $40 amount is the tax shield caused by the tax deductibility of the interest payments.


• The annual tax shield amount is calculated using the following equation:

Tax shield amount

= i*B*T = (0.05)*($2,000)*(0.40) = $40


• The total market value of firm L is obtained as follows:

Market value of firm L

= (D ÷ ke) + (I ÷ Kd)

= ($540/0.1125) + ($100/0.05) = $6,800


• In this example, the value of firm L is greater than firm U’s value by an amount equal to $800. This difference in value is caused by the tax shield. In fact, the difference in value between the levered and unlevered firm is equal to the present value of the tax shield from the perpetual debt:

Present value of tax shield

= (i*B*T) ÷ i = B*T


• In this equation, the annual tax shield amount, i*B*T, is discounted at a rate, i(i = kd). In this case of firm L, the present value of the tax shield is $800, calculated as follows:


= B*T

= $2,000*0.40 = $800


• We can now state that the market value of the levered firm is equal to the market value of the unlevered firm plus the present value of the tax shield:

Market value of levered firm

= Market value of unlevered firm +



• From the equation in the previous slide, we can conclude that the value of the firm increases linearly as the amount of debt in the capital structure increases, as shown in Panel (a) of Figure 12.3. This result implies that a firm should increase its level of debt to the point at which the capital structure consists entirely of debt.


• In other words, the market value of the firm is maximized and its optimal capital structure is achieved when capital structure is all debt.


• As shown in Panel (b) of Figure 12.3, the weighted cost of capital ka declines with increases in financial leverage.

• In practice, we do not normally observe companies with extremely high levels of debt in their capital structures. Even in the face of leveraged buyouts, however, we still do not observe many companies that approach a 100 percent debt-financed capital structure.

VL = VU + Value of Tax Shield

MktValue

of Firm

Debt $

VU

VL

PV of

Tax Shield

Model 2

DebtTotal Assets

ki = kd (1 – T)

ka

ke

The cost of capital decreases with the amount of debt.The firm maximizes its value by choosing

a capital structure that is all debt.

Cost ofCapital


• Hence, other factors must be influencing the determination of an optimal capital structure. Two of the most important factors are financial distress costs and agency costs.

What Happens With Taxes, Bankruptcy, and Agency Costs?

• Bankruptcy and agency costs increase with the amount of leverage, eventually offsetting the marginal benefits from the value of the tax shield.

What Happens With Taxes, Bankruptcy, and Agency Costs?

• Market value of leveraged firm

= Market value of unleveraged firm

+ PV of tax shield

– PV of bankruptcy costs

– PV of agency costs

• See Figure 12.4.

Bankruptcy Costs

• Lenders may demand higher interest rates.

• Lenders may decline to lend at all.

• Customers may shift their business to other firms.

• Distress incurs extra accounting & legal costs.

• If forced to liquidate, assets may have to be sold for less than market value.

Agency CostsStockholder-Bondholder Relationship

• Investing in projects with high risk and high returns can shift wealth from bondholders to stockholders.

• Stockholders may forgo some profitable investments in the presence of debt.

Agency CostsStockholder-Bondholder Relationship

• Stockholders might issue high quantities of new debt and diminish the protection afforded to earlier bondholders.

• Bondholders will shift monitoring and bonding costs back to the stockholders by charging higher interest rates.

The Cost of Capital and the Optimal Capital Structure

• In this section, we examine the relationship between the cost of capital and the firm’s capital structure when corporate taxes, financial distress costs, and agency costs are considered.

• In the following analysis, we assume that capital structure contains only permanent debt and common equity; that is, we assume, for simplicity, that no preferred stock financing is used.


• The first step in the analysis considers the relationship between the cost of debt and capital structure.

• All other things being equal, investors in debt consider the debt less risky if the firm has a low, rather than high, proportion of debt in its capital structure.


• As the proportion of debt in the capital structure increases, investors require a higher return on the more risky debt. And because the firm’s cost of capital is the investor’s required return, the cost of debt increases as the proportion of debt increases.


• The precise relationship between the cost of debt and the debt ratio is difficult to determine, because it is impossible to observe the cost of debt at two different capital structures (at the same time) for a single firm. Nevertheless, evidence suggests that the cost of debt increases rather slowly for moderate amounts of debt.


• There is a point at which the capital markets begin to consider any new debt “excessive” and therefore much more risky. The cost of debt curve, ki, in Figure 12.5 illustrates such a relationship.

• The actual region where the cost of debt begins to increase more rapidly varies by firm and industry, depending on the firm’s level of business risk.


• The next step focuses on the relationship between the cost of equity capital and capital structure.

• When a firm has low financial leverage, that is, a low debt-to-equity ratio, any equity employed is less risky than equity used when the firm is financed with a relatively high proportion of debt.


• Earlier in this chapter was shown that the greater the fraction of debt used, the greater is the variability in earnings per common share.

• In addition, the greater the fraction of debt used, the greater is the risk of financial distress.


• Because the returns expected by stockholders in the form of present and future dividends depend partly on current earnings, it can be concluded that variability in earnings per common share can result in variability of the returns to investors, that is, greater risk.


• Therefore, it can be stated that investors’ required returns and the cost of equity capital increase as the relative amount of debt used to finance the firm increases.


• Once again, the exact nature of the relationship between the cost of equity and financial leverage is difficult to determine in practice.

• However, there is agreement that the cost of equity capital increases at a relatively slow rate as the debt proportion increases up to moderate amounts.


• Then, in the range where additional debt begins to be viewed as excessive and more risky, the cost of equity increases more rapidly. This is shown in Figure 12.5.

• As is true in the debt illustration, the region where the cost of equity capital, ke, begins to increase more rapidly varies by firm and industry.


• The relationship between the weighted cost of capital, ka, and financial leverage can now be considered.

• Because the relationships between financial leverage and ke and ki have been developed, the relationship between ka and financial leverage follows accordingly.


• The following equation can be used to calculated ka for any level of financial leverage, provided that the values of ke and ki at the level of financial leverage are known (B is the market value of debt, and E is the market value of equity in the firm’s capital structure.):

a e i( ) ( )E B

k k kB E B E


• The ka curve, shown in Figure 12.5, begins at ka = ke because, by definition, the weighted cost of capital for an all-equity firm equals the cost of equity.

• As even small increments of debt are used, ka “bottoms out” and then begins to increase.


• The resulting saucer-shaped curve contains a point at which the firm’s overall cost of capital is minimized and its value maximized. This point is the firm’s optimal capital structure.

• If the firm is thought of as a cash-flow generator, then the lower the discount rate (the weighted cost of capital), the higher the firm’s value.


• Figure 12.6 ties together the relationship between the optimal capital structure (with taxes, financial distress costs, and agency costs) and the market value of a firm and its weighted cost of capital.

• Note that at the optimal capital structure, B*/E*, the market value of the firm is maximized and its weighted cost of capital is minimized.

Optimal Debt Ratio

DebtRatio

VU

PVof Tax

Shield

M

kt value of leveraged firm

PVB&A

Costs

VL

Optimal Debt Ratio

Market Value of the Firm

Model 3Least Cost Capital Structure is Optimal

Cost of Capital

BB + E

ki

ke

ka

Optimal CapitalStructure

0

Other Impacts on the Optimal Capital Structure

• Personal tax effects– Could reverse some tax benefits

• Industry effects– Profitability and bankruptcy patterns

• Signaling effects– Asymmetric information

• Managerial preferences– Pecking order theory

Personal Tax Effects

• The MM tax case led to the conclusion that, in the absence of financial distress costs and agency costs, the firm should attempt to minimize its taxes by employing the maximum amount of debt. The MM tax case did not consider the effect of personal income taxes, however.


• Miller has extended the tax case analysis to include both corporate and personal income taxes.

• Miller argued that although a firm can save taxes by increasing its debt ratio, individual investors would pay greater taxes on their returns from the firm if these returns were predominantly interest, rather than dividends and capital appreciation on common stock.


• Historically, the tax code has favored capital gains income from stock over interest income because capital gains generally have been taxed at a lower rate than ordinary income (including interest income) and because taxes on capital gains are deferred until the capital gain is realized.


• Miller concluded that when both personal and corporate income taxes are considered, there is no optimal debt ratio for an individual firm, although there is an optimal amount of total debt in the marketplace, reflecting the difference in corporate and personal tax rates.

Industry Effects

• A number of studies have found significant capital structure difference among industries. The more profitable firms are, the less debt they tend to use.

• Other studies have found that leverage ratios are negatively related to the frequency of bankruptcy in the industry.

Industry Effects

• Some evidence indicates that firms generating stable cash flows over the business cycle tend to have higher debt ratios.

• In general, the studies of industry effects in capital structure tend to conclude that there is an optimal capital structure for individual firms. The market rewards firms that achieve this capital structure.

Signal Effects

• The officers and managers of a company, as insiders, have access to information about the expected future earnings and cash flows of the firm that is not available to outside investors. This situation is referred to as asymmetric information.

Signal Effects

• Given that managers know more about the firm than do outside investors, changes in a company’s investment, financing, or dividend decisions can represent a signal to investor concerning management’s assessment of the expected future returns, and hence market value, of the company.

Signal Effects

• Thus, when a firm issues new securities, this event can be viewed as providing a signal to the financial marketplace regarding the future prospects of the firm or the future actions planned by the firm’s managers.

Signal Effects

• Ross argues that signals provided by capital structure changes are credible because of the potential bankruptcy cost penalty incurred if the implied future cash flows do not occur.

Signal Effects

• In general, studies of capital structure changes have found that new common equity offerings tend to yield negative stock price responses and new debt offering tend to yield no significant stock price responses.

Signal Effects

• Repurchases of common stock have led to large positive announcement returns on the company’s common stock.

Signal Effects

• Actions that increase leverage have generally been associated with positive stock returns, and actions that decrease leverage are associated with negative stock returns.

Signal Effects

• The results of many studies of capital structure changes are consistent both with direct effects of the change, such as the benefits of greater tax shields, and with indirect information effects.

Signal Effects

• Therefore, when a firm makes capital structure changes it must be mindful of the potential signal that the proposed transaction will transmit to the marketplace regarding the firm’s current and future earnings prospects and the intentions of its managers.

Managerial Preference Effects: The Pecking Order Theory

• According to the pecking order theory, as developed by Myers, a firm may not have a particular target or optimal capital structure. Instead, a company’s capital structure changes when an imbalance between internal cash flows, net of cash dividend payments, and acceptable (i.e., NPV > 0) investment opportunities occurs.


• Firms whose investment opportunities exceed internally generated funds tend to issue more debt securities and hence have higher debt ratios.


• Conversely, highly profitable firms with limited needs for investment funds will tend to have lower debt ratios. In this situation, the firm builds up financial slack in the form of highly liquid assets (i.e., cash and marketable securities) and unused debt capacity. Financial slack allows a firm to take advantage of any attractive investment opportunities that may occur in the future.


• The pecking order theory indicates that firms prefer internal financing (retained earnings) to external financing (new security issues).


• This preference for internal financing is based on two considerations. – First, because of flotation costs of new

security issues, internal financing is less costly than external financing.

– Second, internal financing avoids the discipline and monitoring that occurs when new securities are sold publicly.


• Also, according to the pecking order theory, dividends are “sticky,” that is, many firms are reluctant to make major changes in dividend payments and only gradually adjust dividend payout ratios to reflect their investment opportunities and thereby avoid the issuance of new securities.


• If external financing is required, the “safest” securities, namely debt, are issued first. As discussed in Chapter 7, the flotation costs of debt securities are generally lower than the costs of equity securities.


• Also, as noted in the discussion of asymmetric information above, the stock market tends to react negatively to announcements of new common stock offerings, whereas debt security announcements tend to have little impact on stock prices.


• As additional external financing is needed, the firm will work down the pecking order—from safe to more risky debt, then possibly to convertible debt, and finally to common equity as a last resort.

Managerial Implications of Capital Structure Theory

• First, it is clear that the capital structure decision is one of the centrally important decisions facing financial managers. There is little doubt that changes in capital structure result in changes in the market value of the firm.


• Second, the benefits of the tax shield from debt lead to increased firm value, at least up to the point that increased financial distress and agency costs begin to offset the debt advantage.

• Third, the optimal capital structure is heavily influenced by the business risk facing the firm.


• Fourth, when managers make explicit changes in a firm’s capital structure, these actions transmit important information to investors about expected future returns and the market value of a company.

copyright ©2003 south-western/thomson learning chapter 12 capital structure concepts

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