Chapter 12 Introduction

1. Chapter 12 Introduction • A firm’s capital structure is the proportion of a firm’s long-term funding provided by long-term debt, preferred stock, and common equity. • A firm’s target capital structure determines the proper weights to use in estimating the weighted average cost of capital (Chapter 8).

2. Organization of Chapter 12 • Definition of capital structure and optimal capital structure • Financial risk, business risk, and the tradeoff between them • The benefits versus the costs of debt financing

3. Organization of Chapter 12 • The various factors affecting a firm’s capital structure: • Taxes • Financial distress • Agency costs • Creditor requirements • Industry standards • Retention of firm control • Managerial risk aversion • Borrowing capacity • Profitability

4. Capital Structure • A firm’s capital structure is its proportion of long-term financing provided by debt, preferred stock, and common equity. • Recall from Chapter 8 the weighted average cost of capital equation: ka = wd x kd + wp x kp + we x ke The w’s represent the firm’s target capital structure and must add up to 100%.

5. Financial Risk • Debt and preferred stock financing cause financial risk because they have fixed financial costs in the form of interest expense and preferred dividend payments. • The use of debt or preferred stock financing is referred to as financial leverage. • Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.

6. Business Risk • The basic risk inherent in the operations of a firm is called business risk. • Business risk can be viewed as the variability of a firm’s earnings before interest and taxes (EBIT).

7. Business Risk • Since EBIT is sales revenue minus cost of goods sold minus operating expenses, business risk is determined by: • Variability of a firm’s sales • Variability of a firm’s cost of goods sold • Variability of a firm’s operating expenses

8. Financial Risk Versus Business Risk • There is a tradeoff between financial risk and business risk. Remember a firm with high financial risk is using fixed cost sources of financing. This increases the level of EBIT a firm needs just to break even. • A firm will generally try to avoid financial risk—a high level of EBIT to break even—if its EBIT is very uncertain (due to high business risk).

9. A Basic Capital Structure Theory • The tradeoff between the benefits of using debt and the costs of using debt leads to a basic capital structure theory. • The use of debt financing creates a tax shelter benefit from the resulting interest on debt. • The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.

10. A Basic Capital Structure Theory • Our basic capital structure theory is developed assuming a firm uses only long-term debt and common equity in its capital structure. • The elimination of preferred stock from consideration will make the development easier to understand, but not affect the relevance of the theory.

11. A Basic Capital Structure Theory • Debt Versus Equity • A firm’s cost of debt is always less than its cost of equity since debt has seniority over equity and, unlike equity, debt has a fixed return and its cost is tax-deductible. • It may appear a firm should use as much debt and as little equity as possible due to the cost difference, but this ignores the higher risk, greater financial distress, and agency problems associated with debt.

12. A Basic Capital Structure Theory • The costs of financial distress associated with debt • Bankruptcy costs including legal and accounting fees and a likely decline in the value of the firm’s assets • Financial distress may also cause customers, suppliers, and management to take actions harmful to firm value.

13. A Basic Capital Structure Theory • Agency costs associated with debt: • Restrictive covenants meant to protect creditors can reduce firm efficiency. • Monitoring costs may be expended to insure the firm abides by the restrictive covenants. • As the level of debt financing increases, the contractual and monitoring costs are expected to increase.

14. A Basic Capital Structure Theory • Financial leverage and the cost of capital • As a firm uses more debt financing in its capital structure: • Interest cost of debt will increase. • Financial distress costs of debt will increase. • Agency costs of debt will increase. • The higher costs from using debt financing will generally restrict a firm to using much less than 100% debt in its capital structure.

15. A Basic Capital Structure Theory • The weighted average cost of capital—WACC ka = wd x kd + we x ke • If a firm uses 100% equity, the WACC is equal to the cost of equity. • The use of some debt financing should initially cause the firm’s WACC to decline as relatively low cost debt is mingled with higher cost equity.

16. A Basic Capital Structure Theory • WACC • As the use of debt financing increases, the cost of debt and equity both increase at an increasing rate due to financial distress and agency costs. At some point, the use of more debt financing will cause the WACC to increase.

17. A Basic Capital Structure Theory • WACC • Therefore, the WACC is at a minimum when debt is used in the capital structure, but is less than 100% of total capital. • The proportion of debt and equity financing at the point where the WACC is minimized is called the optimal capital structure.

18. Practical Considerations in Capital Structure • There are many practical considerations regarding capital structure in addition to the impacts of financial risk, business risk, the tax-deductibility of interest, financial distress, and agency costs.

19. Practical Considerations in Capital Structure • Industry Standards • It is natural to compare a firm’s capital structure to other firms in the same industry. • Business risk is a significant factor impacting a firm’s capital structure and business risk is heavily influenced by industry. • Evidence indicate firms’ capital structures tend toward an industry average.

20. Practical Considerations in Capital Structure • Creditor and Rating Agency Requirements • Firms need to abide by restrictive covenants agreed upon. These may include restrictions on the amount of future debt. • Firms typically desire to appear financially strong to potential creditors in order to maintain borrowing capacity and low interest rates. Using less debt in capital structure helps to maintain this appearance.

21. Practical Considerations in Capital Structure • Maintaining Excess Borrowing Capacity • Successful firms typically maintain excess borrowing capacity. This provides financial flexibility to react to investment opportunities. • The maintenance of excess borrowing capacity causes firms to use less debt in their capital structure than otherwise.

22. Practical Considerations in Capital Structure • Profitability and the Need for Funds • Profits can be paid out as dividends to stockholders or reinvested in the firm. • If a firm generates high profits and reinvests a large proportion back into the firm, then it has a continuous source of internal funding. This will reduce the use of debt in the firm’s capital structure.

23. Practical Considerations in Capital Structure • Managerial Risk Aversion • Well-diversified stockholders are likely to welcome the use of financial leverage. Management wealth is typically much more dependent upon the success of the one company acting as employer. • To the extent management can act on their own desires, the firm is likely to have less debt in its capital structure than is desired by stockholders.

24. Practical Considerations in Capital Structure • Corporate Control • Controlling owners may desire to issue debt instead of common stock since debt does not grant ownership rights. • Firms with little financial leverage are often considered excellent takeover targets. Issuing more debt may help to avoid a corporate takeover.

25. Summary of Chapter 12 Topics • A firm’s capital structure is the proportion of a firm’s long-term funding provided by long-term debt, preferred stock, and common equity. • Capital structure influences a firm’s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk. • Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC.

26. Summary of Chapter 12 Topics • A variety of practical considerations impact a firm’s capital structure decisions: • Industry standards • Creditor and rating agency requirements • Maintaining excess borrowing capacity • Profitability and the need for funds • Managerial risk aversion • Corporate control