Chapter 10 Making Capital Structure Decisions

1. Chapter 10Making Capital Structure Decisions

2. EBIT-EPS Analysis • Calculation of EPS • Break-even, or indifference, analysis • Use of EBIT-EPS information

3. Calculation of EPS • EBIT indifference points • EBIT-EPS analysis • Focuses on the EBIT indifference between financing methods with respect to EPS

4. Break-Even, or Indifference, Analysis • Horizontal axis = EBIT • Vertical axis = EPS • Below Indifference point (IP) • Common stock alternative is best • Above the IP • Debt alternative is best • Debt alternative always dominates preferred stock

5. Use of EBIT-EPS Information • Financing alternatives have different impacts on EPS • Comparing with existing and expected EBIT • Higher EBIT (stronger case for debt) • Lower EBIT (stronger case for common stock) • Assess likelihood of EBIT falling below IP • Gives insight into risk-return trade-off that governs valuation

6. Cash-Flow Ability to Service Debt • Fixed charges • Times interest earned • Debt-service coverage • EBIT, depreciation, and amortization (EBITDA) • Probability of cash insolvency • Donaldson approach

7. Fixed Charges • Include • Principal and interest payments on debt • Lease payments • Preferred stock dividends • Inability to meet fixed charges may result in financial insolvency • Increased stability of expected future CFs results in increased debt capacity

8. Times Interest Earned • Important test of credit-worthiness • Concern arises when ratio falls below 3 to 1 • Difficult to achieve an investment-grade credit rating

9. Debt-Service Coverage • Coverage ratio • Interest before tax • Principal payment after tax • Include lease payments • Debt service and business risk • Electric utilities versus manufacturing

10. EBITDA • EBITDA versus EBIT • EBITDA may not be a good measure of the cash available for debt service

11. Probability of Cash Insolvency • What are the chances of insolvency? • Assess • The possible deviation of actual from expected CFs • Purchase or sale of assets • Liquidity of the firm • Dividends • Seasonal patterns • Other factors impacting CFs

12. Donaldson Approach • Examine the CFs of the company • Under the most adverse circumstances (i.e. recession) • Debt capacity • Debt that can be comfortably serviced • Calculate the probability of cash inadequacy • Cash insolvency versus cash inadequacy

13. Effect on Debt Ratios • Pro forma debt ratios • Compare new debt ratios • With past ratios • Trend analysis • Other companies • Similar business risk • In same industry • Justify position if capital structure is out of line

14. Effect of Security Ratings • Effect of financing alternatives • Rating agencies • Changes in Ratings of existing securities • Ratings • Indicate credit worthiness of a borrower • First 4 are considered investment grade

15. Trends in ratios Business risk Capital requirements Specific security features Cash-flow ability Proportion of debt Analysis Before Assigning a Grade

16. Timing and Flexibility • Timing security issues • Debt or common stock • Financing is lumpy • General market conditions • Expectations for the company • Flexibility • Keeping open future financing options

17. A Pecking Order of Financing • Internal financing • Straight debt • Preferred stock • Hybrid securities • Convertible bonds • Straight equity • Least desirable • Financing decision should be based on a rigorous analysis embracing valuation

18. Taxes Explicit cost Financial signaling EBIT-EPS analysis Agency costs and incentive issues Debt ratio Security rating Timing Flexibility Cash flow ability to service debt Financing Checklist