Capital Structure

Target Capital Structure

Optimal Capital Structure
Capital Structure Decisions
Desirable Norms for Capital
Structure
14-1
 The Target Capital
Structure
Capital Structure: The combination of debt and equity
used to finance a firm
Target Capital Structure: The ideal mix of debt,
preferred stock, and common equity with which the
firm plans to finance its investments and that would
maximize its stock price.
First determine optimal capital structure
Then set target capital structure
If actual debt ratio is less than target, management will
raise the capital by issuing debt
2
Determining the Optimal Capital
Structure

The capital structure or combination of debt and

equity that leads to the maximum value of the firm.
Capital Structure can affect the value of an company by
affecting either its expected earnings or the cost of capital but
in realty it affects the share of earnings available to the
ordinary shareholders which seek to maximize the price of
the firms stock.
It is concerned with the relationship between leverage and
cost of capital from the stand point of valuation.

3
 Debt Ratio of Industries in India
14-4

Debt Ratios of Industries in India

http://www.moneycontrol.com/stocks/mar
ketinfo/debt/bse/index.html
http://www.livemint.com/Money/dFgW11R2
lkxyfuK8jr0MhM/Debtequity-ratio-of-Ind
ian-corporate-sector-very-high.html
14-5
 Factors influencing Capital Structure
Decisions
6

Business Risk- riskiness of the firms

asset if no debt is used. Higher business
risk and low optimal debt ratio
Tax Position-tax deductible benefits
Financial Flexibility
Managerial attitude-conservative or
aggressiveness
 What is business risk?
14-7

Uncertainty about future operating income (EBIT), i.e.,

how well can we predict operating income?

Probability Low risk

High risk

Note that business risk does

0 not include financing
E(EBIT) EBIT
effects and it is the amount of risk that is inherent in
the firms operations even if its uses no debt.
 What determines business
14-8
risk?
Uncertainty about demand (sales)
Uncertainty about output prices
Uncertainty about costs
Product, other types of liability
Foreign Exchange risk
The extent to which cost are fixed:
Operating leverage
All are company specific risk and can be
diversified.
 What is operating leverage, and how does it
affect a firms business risk?
14-9

Operating leverage is the use of fixed

costs rather than variable cost and how
it leads to business risk.
If most costs are fixed, hence do not
decline when demand falls, then the firm
has high operating leverage.
Highly automotive , capital intensive firms
and industries
Highly skilled labors and high salary
High development cost
 Effect of Operating
14-10
Leverage
More operating leverage leads to more
business risk, for then a small sales
decline causes a big profit(EBIT)
decline.
$ Rev. $ Rev.
TC }Profit
TC
FC
FC
QBE Sales QBE Sales

What happens if variable costs change?

 Effect of Operating
14-11
Leverage
Breakeven quantity by recognizing that operating
breakeven occurs when EBIT=zero
The effect on the breakeven point is indeterminant.
An increase in fixed costs will increase the
breakeven point. However, a lowering of the
variable cost lowers the breakeven point. So its
unclear which effect will have the greater impact.
EBIT PQ - VQ - F 0

F
Q BE
P V
 Using Operating Leverage
14-12

Typical situation: Can use operating leverage to

get higher E(EBIT), but risk also increases.

Low operating leverage

Probability
High operating leverage

EBITL EBITH
 Degree of Operating
14-13
Leverage
Degree of Operating Leverage
Degree of operating leverage is the multiple by which operating
income of a business changes in response to a given percentage
change in sales.
Degree of operating leverage is a measure of the extent of operating
leverage i.e. the relationship between operating income and sales of
a business. If operating income is more sensitive to changes in sales,
the business is said to have high operating leverage and vice versa.
Similarly, if operating profit margin is higher, the business is said to
have high operating leverage and vice versa.
Formulas
Degree of operating leverage = change in operating income
changes in sales
= contribution margin percentage
operating margin
 Question
14-14

Calculate degree of operating leverage

in the following cases and predict the
increase in operating income subject to
15% increase in sales.
Company A: operating income increases by
15% if sales increase by 10%.
Company B: sales are $2,000,000,
contribution margin ratio is 40% and fixed
costs are $400,000
 What is Financial leverage?
Financial risk?
14-15

Financial leverage is the use of debt and

preferred stock.
Financial risk is the additional risk
concentrated on common stockholders
as a result of financial leverage.
Small change in EBIT leads to greater
change in EPS
 Degree Of Financial Leverage - DFL
14-16

A ratio that measures the sensitivity of a

companysearnings per share (EPS)to
fluctuations in its operating income, as a result
of changes in itscapital structure. Degree of
Financial Leverage (DFL) measures the
percentage change in EPS for a unit change in
earnings before interest and taxes (EBIT)
DFL = % change in EPS
% change in EBIT
= EBIT
EBIT-Interest
 Business Risk vs. Financial
14-17
Risk
Business risk depends on business
factors such as competition, product
liability, and operating leverage.
Financial risk depends only on the types
of securities issued.
More debt, more financial risk.
Concentrates business risk on stockholders.
 An Example:
Illustrating Effects of Financial Leverage
14-18

Two firms with the same operating leverage,

business risk, and probability distribution of EBIT.
Only differ with respect to their use of debt
(capital structure).
 Firm U: Unleveraged
14-19

Economy
Bad Average Good
Probability 0.25 0.50 0.25

EBIT $2,000 $3,000 $4,000

Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
 Firm L: Leveraged
14-20
 Ratio Comparison Between Leveraged and
Unleveraged Firms
14-21

Firm U Bad Average Good

BEP 10.0% 15.0% 20.0%
ROE 6.0 9.0 12.0
TIE

Firm L Bad Average Good

BEP 10.0% 15.0% 20.0%
ROE 4.8 10.8 16.8
TIE 1.67 2.50x 3.30x
 Risk and Return for Leveraged and
Unleveraged Firms
14-22
 The Effect of Leverage on Profitability and
Debt Coverage
14-23

For leverage to raise expected ROE,

must have BEP > rd.
Why? If rd > BEP, then the interest
expense will be higher than the
operating income produced by debt-
financed assets, so leverage will depress
income.
As debt increases, TIE decreases
because EBIT is unaffected by debt, but
interest expense increases (Int Exp =
rdD).
 Conclusions
14-24

Basic earning power (BEP) is unaffected

by financial leverage.
L has higher expected ROE because BEP
> r d.
L has much wider ROE (and EPS) swings
because of fixed interest charges. Its
higher expected return is accompanied
by higher risk.
 Question
14-25

Calculate EPS, ROE and comment upon effects of Financial Leverage

 Optimal Capital Structure
14-26

The capital structure (mix of debt,

preferred, and common equity) at which P0
is maximized.
Trades off higher E(ROE) and EPS against
higher risk. The tax-related benefits of
leverage are exactly offset by the debts
risk-related costs.
The optimal capital structure is the mix
of debt, preferred stock, and common
equity which maximize the stock price
and also minimize the WACC.
 UNLEVERED AND LEVERED BETA

14-27

A type of metric that compares the risk of an

unlevered company to the risk of the market. The
unlevered beta is the beta of a company without
any debt. Unlevering a beta removes the financial
effects from leverage.

Cost of equity=Risk free+ business risk

premium + financial risk premium
 The Hamada Equation
14-28

If the level of debt increases, the firms risk

increases.
However, the risk of the firms equity also increases,
resulting in a higher rs. But it is harder to quantify the
leverage affects on the cost of equity.
Because the increased use of debt causes both the
costs of debt and equity to increase, we need to
estimate the new cost of equity.
Uses the firms unlevered beta, which represents the
firms business risk as if it had no debt.
 The Hamada Equation
14-29

bL = bU[1 + (1 T)(D/E)]

Suppose, the risk-free rate is 6%, as is

the market risk premium. The unlevered
beta of the firm is 1.0 and total assets
were $2,000,000.
 Cost of Debt at Different Debt
Ratios
14-30

Amount D/A D/E Bond

Borrowed Ratio Ratio Rating rd
$ 0 0 0 -- --
250 AA
0.125 0.143 8.0%
500 A
0.250 0.333 9.0%
750 BBB
0.375 0.600 11.5%
1,000 BB
0.500 1.000 14.0%
 Table for Calculating Levered Betas and
Costs of Equity
14-31

Amount D/A D/E Levered

Borrowed Ratio Ratio Beta rs
$ 0 0% 0% 1.00
12.00%
250 12.50 14.29 1.09 12.51
500 25.00 33.33 1.20 13.20
750 37.50 60.00 1.36 14.16
1,000 50.00 100.00 1.60 15.60
 Finding Optimal Capital
14-32
Structure
The firms optimal capital structure can
be determined two ways:
Minimizes WACC.
Maximizes stock price.
Both methods yield the same results.
 Table for Calculating Levered Betas and
Costs of Equity
14-33

Amount D/A E/A

Borrowe Ratio Ratio rs rd(1 T) WACC
d
$ 0 0% 100% 12.00 -- 12.00%
%
250 12.50 87.50 12.51 4.80% 11.55
500 25.00 75.00 13.20 5.40% 11.25
750 37.50 62.50 14.16 6.90% 11.44
1,000 50.00 50.00 15.60 8.40% 12.00
 Determining the Stock Price Maximizing
Capital Structure
14-34

Amount
Borrowed DPS rs P0
$ 0 $3.00 12.00% $25.00

250 3.26 12.51 26.03

500 3.55 13.20 26.89

750 3.77 14.16 26.59

1,000 3.90 15.60 25.00

 What debt ratio maximizes
14-35
EPS?
Maximum EPS = $3.90 at D =
$1,000,000, and D/A = 50%.
(Remember DPS = EPS because payout
= 100%.)
Risk is too high at D/A = 50%.
 WACC and Capital Structure Changes
14-36
 Required Returns at Different Debt Levels
14-37
 Effects of Capital Structure on EPS, Cost of
capital and Stock Price
14-38
Capital Structure Theory

Net operating income (NOI) approach.

Traditional approach and Net income
(NI) approach.
Modigliani-Miller (MM) hypothesis.
Trade off- Signaling Theory

39
 Assumption of Capital Structure Theories
14-40

There are only two sources of funds i.e.: debt and equity.
The total assets of the company are given and do no change.
The total financing remains constant. The firm can change the
degree of leverage either by selling the shares and retiring
debt or by issuing debt and redeeming equity.
All the investors are assumed to have the same expectation
about the future profits.
Business risk is constant over time and assumed to be
independent of its capital structure and financial risk.
Corporate tax does not exit.
The company has infinite life and Dividend payout ratio =
100%.
Net Income (NI) Approach

The cost of debt and the cost of equity

are independent of the capital structure.
The financing risk perception of the
investor doesnt change with the change
in leverage. As a result, the overall cost
of capital declines and the firm value
increases with debt.

This approach has no basis in reality; the

optimum capital structure would be 100 41

per cent debt financing under NI

14-42
 Net Operating Income (NOI) Approach

According to NOI approach the value of

the firm and the weighted average cost
of capital are independent of the firms
capital structure.

The advantage associated with the use of

debt, supposed to be a cheaper source of
funds in term of the explicit cost is
exactly neutralized by the implicit
cost(financial risk) by the increase in cost 43
of equity.
Traditional Approach
At the optimum Capital Structure, the marginal real cost of
debt, defined to include both implicit and explicit cost will be
equal to real cost of equity.
For a debt equity-ratio before that level the marginal real cost
of debt would be less than that of equity capital while beyond
that level, the marginal real cost of debt would exceed that of
equity.
Increased Valuation and Decreased Cost of Capital
Constant Valuation and Constant Cost of Capital
Decreased Valuation and Increased Cost of Capital

44
Modigliani-Miller (MM)
hypothesis.
MMs Proposition I states that the firms
value is independent of its capital
structure.Similarly market price and COC
be same regardless of financing mix
MMs Proposition II states as a firm
increases its use of debt, its cost of equity
also increases; but its WACC remains
constant.

The cut-off rate for investment purpose is 45

completely independent of the way in
 Proposition I:

levered firm value = unlevered firm

value.
VL = VU

= (EBIT/WACC)
= EBIT/keU

where: keU = cost of equity for an

unlevered firm.
Firm value is independent of
46 leverage.
 Proof with capital structure arbitrage

Arbitrageis the practice of taking advantage of a price

difference between two or moremarkets: striking a
combination of matching deals that capitalize upon the
imbalance, the profit being the difference between
themarket prices. For instance, an arbitrage is present when
there is the opportunity to instantaneously buy low and sell
high.
For two firms with exactly the same business characteristics
and different financial leverage levels, if they are differently
valued, investors can do capital structure arbitrage by short-
selling the stocks of the high-value firm, and using the
proceeds to buy the stocks of the low-value firm, which
creates profits. This will continue till the market price of the
two identical firms become identical. 47
 MM Version Two: with
Corporate Taxes

Becauseinterestisataxdeductibleexpenseforcorporations,a
leveredfirmshouldbemorevaluablethananunleveredfirm
(assumingthatthisdifferenceincapitalstructureistheonly
difference)

VL=VU+TD

where: T = firms tax rate, D = value of debt.

 Trade-off theory
14-49

Corporations usually are financed partly withdebt and

partly withequity. It states that there is an advantage
to financing with debt, thetax benefits of debtand
there is a cost of financing with debt, the costs of
financial distress includingbankruptcy costs of
debtand non-bankruptcy costs (e.g. staff leaving,
suppliers demanding disadvantageous payment terms,
bondholder/stockholder infighting, etc.)

Themarginal benefitof further increases in debt

declines as debt increases, while themarginal
costincreases, so that a firm that isoptimizingits
overall value will focus on this trade-off when
 Trade-off theory
14-50

Financial Distress
Liquidation of assets
Less market value
Cost of bankruptcy
Myopic atttitude
Dilution of commitment from stakeholders

Agency cost
Shareholder v/s Creditor
Creditor bear downside risk and shareholder enjoy
upside potential
 Trade-off theory
14-51

Effect of Financial Distress and Agency Cost

Stable earning-more debt

Assets are risky-less debt

Why some profitable companies go for less

debt?
14-52
 Pecking order theory
14-53

The pecking order theory was popularized by Stewart

C. Myers when he argues that equity is a less preferred
means to raise capital.
Investors believe that managers overvalue the firms
and are taking advantage of this over-valuation. As a
result, investors will place a lower value to the new
equity issuance.
This theory maintains that businesses adhere to
ahierarchyof financing sources and prefer internal
financing when available, and debt is preferred over
equity if external financing is required. Thus, the form
of debt a firm chooses can act as a signal of its need
for external finance. This sort of signaling can
affect how outside investors view the firm as a
potential investment, and once again must be
considered by the people in charge of the firm
 Pecking order theory
14-54

Prefer internal accruals, retained earning

Target dividend payout ratio(cash flows and investment
opportunity)
Dividends tend to be sticky in short run
If internal accrual exceed capital expenditure or less

Profitable companies use less debt because

they dont need much external finance and not
because they have a low target debt-equity
ratio.
 Signaling Theory
14-55

Tradeoff theory fails on the assumption that all parties

have same information and equal expectations
But in general, we can say that the management is
more information about the prospects of the business
compared to shareholders, debt-holders and other
parties. This is called information asymmetry.
The information asymmetry directly affects the
agency costs: the higher the information
asymmetry, the greater will be the agency costs.
 What are signaling effects in capital
structure?
14-56

Assumptions:
Managers have better information about a firms
long-run value than outside investors.
Managers act in the best interests of current
stockholders.
What can managers be expected to do?
Issue stock if they think stock is overvalued.
Issue debt if they think stock is undervalued.
As a result, investors view a stock offering
negativelymanagers think stock is overvalued.
 Signaling Theory
14-57

Asymmetric information is resolved before

the equity issue
Asymmetric information is resolved
immediately after the equity issue
Asymmetric information is resolved
immediately after the equity issue but
NPV is higher
Project is financed with debt
Firm has bleak prospects
 Signaling Theory
14-58