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Capital Structure

Capital Structure. 05/08/08 Ch. 7. Assets – Value of the Firm Listed by Closeness to Cash Current Assets Long-term Assets Physical and Intangible Book Value or historical value of the assets adjusted for depreciation. Capital Structure The “borrowed” money from the capital markets

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Capital Structure

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  1. Capital Structure 05/08/08 Ch. 7

  2. Assets – Value of the Firm Listed by Closeness to Cash Current Assets Long-term Assets Physical and Intangible Book Value or historical value of the assets adjusted for depreciation Capital Structure The “borrowed” money from the capital markets Liabilities – Fixed claims against the assets Owner’s Equity – Residual claim against assets Book Values not Market Values Capital Structure – Balance Sheet

  3. What is Debt? • Fixed claims against the company, the liabilities • Current Liabilities, accounts payable… • Long-term Liabilities • Bank Loans • Bonds • The “borrowed” money will be paid back usually in pre-specified amounts and at pre-specified time…temporary funding

  4. Examples of Debt • Loans – • Principal and interest due at maturity • Interest as you go, principal at maturity • Principal and interest as you go, usually equal payments at equal intervals, annuity • By Lender -- • Banks • Bondholders • Interest portion is usually tax deductible

  5. What is Equity? • Value of the company “claimed” by owners • What is left over after debt claims are satisfied • Permanent Capital • Repayment not required • Repayment via dividends • Dividends not tax deductible (not an expense of the company) • Outstanding Common Stock

  6. Ways to Raise $$$$ • Borrow from suppliers – accounts payable • Borrow from bank – bank loan • Borrow from bondholders – issue bonds • Borrow from other companies – sign leases • Borrow from owners • Personal funds of founder/owner • Issue preferred stock • Issue common stock • Issue warrants

  7. Some Hybrid Securities • Convertible Bonds • Initially issued as two assets, a straight bond and an option to convert to stock • Set conversion ratio • Some protection on the down-side (bonds have fixed repayment) • Potential for up-side, convert to stock if company (stock prices rise) • Preferred Stock • Guaranteed dividends (consol or perpetuity)

  8. Financing Options Tied to Life Cycle • Life Cycle of a firm… • Birth (Start-up) • Youth (Expansion) • Teen-age (Rapid or High Growth) • Adult (Mature) • Old Age (Decline) • Death (Bankruptcy) • Personal Funds, Angel Funds, Venture Capitalist, Loans, Public Equity, Bonds…

  9. Raising Equity in Capital Markets • Usually in late teen – early adulthood • Have need for large $$$$ • Find Investment Banking Firm – Start IPO • File paperwork with SEC • Market Security • Conduct Auction • Distribute Stock and Collect $$$ • Subsequent issues are Seasoned Equity Offerings (SEO)

  10. Cost of Going Public (IPO) • Legal Costs – Registration and Filing Fees • Payment to Investment Banker – Best efforts or Firm Commitment • Marketing Costs – Road Show • Underpricing • Why on average are IPOs underpriced? • When do marginal clients get a call? • Marginal clients know they are marginal… • After sale requirements and options

  11. Cost of Debt • Legal Costs – Registration and Filing Fees • Payment to Investment Banker • Marketing Costs • Potential Default • If bondholders or bank not paid back on time the bondholders or bank can “claim” the firm • Direct bankruptcy costs • Indirect bankruptcy costs

  12. Benefits of Debt • Discipline Managers – reduces free cash flow • Covenants in place to “restrict” certain types of behavior • Additional outside validation of management activities and choices • Bond rating agencies • Bank loan officers • Subsequent borrowing

  13. Company Earnings Reinvested • Earnings of the company can be reinvested in the company • What is the cost of reinvesting? • What are the choices with company earnings? • Pay it back to owners…let them invest it where they might • Cost should be the opportunity cost to the owners • Cost of equity w/o issuance costs

  14. Optimal Capital Structure • What combination of borrowing is best? • How do you choose which funds you should use for financing? • Debt vs. Equity vs. Company Earnings • How much of each? • Pecking Order Hypothesis • Static Theory – Separation of Investing and Financing Decisions • Modigliani and Miller 1956 &1958 • Marginal cost of bankruptcy vs. Marginal benefit of debt to find the lowest cost of capital

  15. Homework • Problem #4 – Convertible Preferred Stock (me – I will do this one in class…) • Problem #5 – Debt-Equity Ratio • Missing data, bonds are ten year bonds • Problem #8 – Venture Financing • Problem #9 – Venture Financing • Problem #15 – Rights Offering • Problem #18 – Debt for Stock Swap • Problem #23 –Debt & Bankruptcy

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