1 / 19

Chapter 18 -- Capital Structure Decisions

Chapter 18 -- Capital Structure Decisions . Capital structure decisions when the participants are well informed: Managers can look to the market for clues to investor response Capital structure decisions when there is asymmetrical information:

haley
Download Presentation

Chapter 18 -- Capital Structure Decisions

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 18 -- Capital Structure Decisions • Capital structure decisions when the participants are well informed: • Managers can look to the market for clues to investor response • Capital structure decisions when there is asymmetrical information: • Managers typically use pro-forma analysis to project the firm’s ability to use debt and equity profitably

  2. Capital Structure Decisions – Four Sources of Information 1. Study the market’s response to similar offerings • Compare yourself to others to find a proxy company that has recently issued new debt or equity

  3. Capital Structure Decisions – Four Sources of Information 2. Study the market’s response to different capital structures • Look at industry ratios • Balance sheet (stock) ratios such as debt to total assets • Income statement (flow) ratios such as times interest earned

  4. Capital Structure Decisions – Four Sources of Information 2. Study the market’s response to different capital structures • From these ratios, judge the market response to a change in your firm’s capital structure • Must adjust for differing accounting interpretations

  5. Capital Structure Decisions – Four Sources of Information 3. Seek information from key market participants • Investment bankers • Rating agencies • Security analysts • Portfolio managers

  6. Capital Structure Decisions – Four Sources of Information 4. Attempt to judge market disequilibrium • There could be factors unique to the company, such as an unusual tax situation • Investment bankers may know what form of financing the market overall is favoring

  7. Capital Structure Decisions • Merits and demerits of generalizing from other offerings • Your situation may be unusual • You could get conflicting wealth and income ratio indications • Market may not be fully informed

  8. Capital Structure Decisions • Earnings volatility risk: • Indicator of ability to pay future obligations from future cash flows • Example measure is the times interest earned ratio

  9. Capital Structure Decisions • Liquidation or bankruptcy risk: • This is based on your ability to pay from collateral • Paying from collateral is usually inferior to paying from future cash flows • Example measure is the debt to total asset ratio

  10. Capital Structure Decisions • Income break-even point and the financing mix: • Step 1: Create a spreadsheet modeling the income statement and balance sheet • Step 2: Find break-even level of sales • Step 3: Vary the levels of debt and equity, then recalculate the break-even level of sales • Based on expected range of sales, choose the appropriate financing mix

  11. Capital Structure Decisions • Earnings per share crossover point: • Step 1: Create a spreadsheet modeling the income statement, balance sheet, and earnings per share • Step 2: Find the level of sales where the earnings per share are equal between two alternative debt-equity mixtures -- crossover point • Based on expected range of sales, choose the appropriate financing mix

  12. Capital Structure Decisions • Debt capacity analysis • Measures the firm’s ability to meet its cash flow obligations with various amounts of debt • Often run as a worst-case scenario analysis

  13. Capital Structure Decisions • Debt capacity analysis example • Model recession cash flow with differing financing • Develop back-up plans to cover periods of negative cash flows • Choose the maximum debt payment that can be met in a recession • Select debt (amount, maturity) within maximum debt payment

  14. Capital Structure Decisions • Tools used by managers to reduce the probability of default in times of negative cash flows. • Liquid reserves • costly in profitability • External backup credit lines • high out-of-pocket cost in fees

  15. Capital Structure Decisions • Tools used by managers to improve cash flows in times of duress. • Reduce the outflows in a particular period • Often means lost revenues • Reduction of a dividend, seen as negative signal • Sale of assets • Usually interpreted as a negative signal based on timing

  16. Capital Structure Decisions – Qualitative Factors • Future financing needs • Too much debt might close off future debt offerings • Nonpublic companies often overextend and risk either bankruptcy or a lesser bargaining position with a venture capitalist

  17. Capital Structure Decisions – Qualitative Factors • Flexibility • Watch your restrictive covenants -- debt issues • Typically debt is more restrictive than common stock

  18. Capital Structure Decisions – Qualitative Factors • Control • More shares could mean less control • More debt could mean less flexibility • Hedging • Important in • Maturity decisions • Source of funding for international subsidiaries

  19. Capital Structure – Qualitative Factors • Strategic issues • You may not want a weak financing position in an increasing competitive environment

More Related