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CAPITAL STRUCTURE

CAPITAL STRUCTURE. Purpose to understand issues relating to capital structure or levels of debt and equity of firms Capital structure has a bearing on WACC via the weights …. WACC = WdRd (1 – Tc ) + WeRe Need to distinguish between business and financial risk. Capital structure.

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CAPITAL STRUCTURE

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  1. CAPITAL STRUCTURE • Purpose to understand issues relating to capital structure or levels of debt and equity of firms • Capital structure has a bearing on WACC via the weights …. WACC = WdRd(1 – Tc) + WeRe • Need to distinguish between business and financial risk

  2. Capital structure • Business risk and its relation with operating leverage • Operating leverage measures impact of changes in sales on operating profit (PBIT) • OL = Q(s – v)/Q(s – v) – FC where Q(s – v) – FC = PBIT • If %chgSales= X%, then %chg in PBIT = OL * X • Follow through example XYZ Bhd • Financial risk and its relation with financial leverage • Financial leverage measures the sensitivity of PAT (EPS) caused bt the use of fixed income securities such as debt capital and preference shares • FL = PBIT/PBIT – I where I is annual interest expense and/or preference dividend • If %chgPBIT = Y% then %chg in EPS = FL * Y • Follow through example XYZ Bhd

  3. Capital structure • Combined leverage: measures the combines effect of operating and financial leverages. If OL measures effect of chg in sales on PBIT and FL measures effect of chg in PBIT on EPS, then CL measures chg on sales on EPS. • CL = Q(s – v)/PBIT multiply by PBIT/PBIT – I • CL = Q(s – v)/PBIT – I • If %chg sales = Z%, then %chg in EPS = CL * Z% • Follow through with example XYZ Bhd

  4. Capital Structure Theory • MM Theory • Value of levered firms (VL)= Value of unlevered firms (Vu) + D (no tax) • VL = Vu + TcD (corporate tax) • Impact of both corporate and personal taxes • Extension of MM theory • Pecking Order theory • Ranking order from retained earnings to debt to new equity capital • Signaling theory • Firms with good prospects (many positive NPV projects) would avoid raising capital via shares but rather to raised any new capital via debt.

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