The Basics of Capital Structure Decisions

1. The Basics of Capital Structure Decisions Corporate Finance Dr. A. DeMaskey

2. Learning Objectives • Questions to be answered: • What factors affect the target capital structure? • What is business risk? What is financial risk? • What is the optimal capital structure? • How do asymmetric information and signals affect capital structure decisions? • Do international differences in financial leverage exist?

3. Capital Structure Policy • Target capital structure • Mix of debt, preferred stock, and common stock • Set equal to estimated optimal capital structure • Optimal capital structure • Balances risk and return • Maximizes the firm’s stock price

4. Capital Structure Decisions • Business risk • Taxes • Financial flexibility • Managerial conservatism or aggressiveness • Growth opportunities

5. Business Risk • Uncertainty about future operating income (EBIT). • Note that business risk focuses on operating income, so it ignores financing effects. Probability Low risk High risk 0 E(EBIT) EBIT

6. Factors That Influence Business Risk • Uncertainty about demand (unit sales). • Uncertainty about output prices. • Uncertainty about input costs. • Product and other types of liability. • Degree of operating leverage (DOL).

7. Operating Leverage and Business Risk • Operating leverage is the use of fixed costs rather than variable costs. • The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage. (More...)

8. Rev. Rev. $ $ } TC Profit TC FC FC QBE QBE Sales Sales • Higher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline. (More...)

9. Probability Low operating leverage High operating leverage EBITL EBITH • In the typical situation, higher operating leverage leads to higher expected EBIT, but also increases risk.

10. Business Risk versus Financial Risk • 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.

11. Measure of Financial and Business Risk in a Stand-Alone Sense Stand-alone Business Financial risk risk risk = + Stand-alone risk = ROE. Business risk = ROE(U). Financial risk = ROE - ROE(U).

12. EPS Indifference Analysis • Used to determine when debt financing is advantageous and when equity financing is advantageous. • Can be illustrated graphically since the relationship between EBIT and EPS is linear. • EPS (debt financing) = EPS (equity financing)

13. Capital Structure Theory • MM theory • Zero taxes • Corporate taxes • Corporate and personal taxes • Trade-off theory • Signaling theory • Debt financing as a managerial constraint

14. MM Theory: Zero Taxes • MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix. • Therefore, capital structure is irrelevant. • Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk.

15. MM Theory: Corporate Taxes • 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. • Firms should use almost 100% debt financing to maximize value.

16. MM Theory: Corporate and Personal Taxes • Personal taxes lessen the advantage of corporate debt: • Corporate taxes favor debt financing. • Personal taxes favor equity financing. • Use of debt financing remains advantageous, but benefits are less than under only corporate taxes. • Firms should still use 100% debt.

17. Hamada’s Equation • MM theory implies that beta changes with leverage. • bU is the beta of a firm when it has no debt (the unlevered beta) • bL = bU(1 + (1 - T)(D/E)) • In practice, D/E is measured in book values when bL is calculated.

18. Trade-off Theory • MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. • At low leverage levels, tax benefits outweigh bankruptcy costs. • At high levels, bankruptcy costs outweigh tax benefits. • An optimal capital structure exists that balances these costs and benefits.

19. Signaling Theory • MM assumed that investors and managers have the same information. • But, managers often have better information. Thus, they would: • Sell stock if stock is overvalued. • Sell bonds if stock is undervalued. • Investors understand this, so view new stock sales as a negative signal. • Implications for managers?

20. Debt Financing As a Managerial Constraint • One agency problem is that managers can use corporate funds for non-value maximizing purposes. • The use of financial leverage: • Bonds “free cash flow.” • Forces discipline on managers. • However, it also increases risk of financial distress.

21. Capital Structure in Practice • The MM and Miller models cannot be applied directly because several assumptions are violated. • kd is not a constant. • Bankruptcy and agency costs exist. • In practice, Hamada’s equation is used to find kS for the firm with different levels of debt.

22. The Optimal Capital Structure • Calculate the cost of equity at each level of debt. • Calculate the value of equity at each level of debt. • Calculate the total value of the firm (value of equity + value of debt) at each level of debt. • The optimal capital structure maximizes the total value of the firm.

23. Capital Structure Analysis • Financial forecasting models • Can help show how capital structure changes are likely to affect stock prices, coverage ratios, and so on. • Can generate results under various scenarios, but the financial manager must specify appropriate input values, interpret the output, and eventually decide on a target capital structure. • In the end, capital structure decision will be based on a combination of analysis and judgment.

24. Checklist for Capital Structure Decisions • Debt ratios of other firms in the industry. • Pro forma coverage ratios at different capital structures under different economic scenarios. • Lender and rating agency attitudes(impact on bond ratings). • Reserve borrowing capacity. • Effects on control. • Type of assets: Are they tangible, and hence suitable as collateral? • Tax rates.