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Capital Structure Management in Practice

©2006 Thomson/South-Western

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Introduction

This chapter focuses on tools of analysis that can assist managers in making capital structure decisions that will lead to a maximization of shareholder wealth.

It develops techniques, derived from accounting data, for measuring operating and financial leverage.

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Operating and Financial Leverage From fixed operating or fixed capital costs Operating costs

Costs of sales General & administrative costs

Capital costs Interest charges Preferred dividends Income taxes

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Operating and Financial Leverage Operating

Leverage Results from fixed

operating costs such that a change in sales revenue is magnified into a relatively large change in EBIT

Financial Leverage Results from fixed

capital costs such that a change in EBIT is magnified into a relatively large change in EPS

See leverage model

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Behavior of Variable Costs

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Behavior of Fixed Costs

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Behavior of Semivariable Costs

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Leverage Model

DOL

DFL

% Sales

% EBIT

% EPS

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DOL

Measured as a percent change in EBIT resulting from a given percent change in sales

Original values

Sales – VC – FC = EBIT

DOL at X = Sales – Variable CostsEBIT

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DFL Measured as the percent change in EPS

resulting from a given percent change in EBIT

P/S dividends before taxes

DFL at X =

How does a banker looks at financial leverage?

http://www.wisc.edu/uwcc/info/yic/22fin.html

EBIT EBIT – I – Dp/(1 – T)

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DCL

Measured as a percent change in EPS resulting from a given percent change in sales

See DCL model

DCL at X = DOL DFL

DCL at X = Sales – Variable Costs

EBIT – I – Dp/(1 – T)

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DCL Model

DOL

DFL

% Δ Sales

% Δ EBIT

% Δ EPS

DCL

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DOL & DFL Trade Off

A firm can trade off operating and financial leverage to control DCL.

A firm with a high DOL may choose a capital structure with a low DFL to avoid a high DCL.

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How Can You Find the Probability of EPS?

Loss level of EBIT is the amount of EBIT needed to cover interest charged and preferred dividends

The Z value can be looked up in Table V (Normal Distribution)

Probability of negative EPS

Loss level EBIT – Expected EBITStandard deviation of EBIT

Z =

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EBIT-EPS Analysis

Technique for comparing alternative capital structures

Determine the level of EBIT where EPS would be identical under either debt or equity financing:

Debt financing Equity financing

=Ne

(EBIT – Ie) (1 – T) – Dp

Nd

(EBIT – Id) (1 - T) – Dp

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Graphical Analysis of EBIT - EPS

EPS

EBIT

Debt Financing

Equity Financing

Indifference Point

Advantage to debt financing

Advantage to equity financing

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Analyze the Riskiness of the Capital Structure Compute the expected level of EBIT after

expansion. Estimate the variability of operating

income. Compute the indifference point between

two financing plans. Estimate the probability that EBIT will

exceed the indifference point.

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Analyze the Riskiness of the Capital Structure Examine the market evidence to see if

the capital structure is too risky in relation to the firm’s level of Business risk Industry norms for leverage and coverage

ratios Recommendation of the firm’s investment

bankers Check out the glossary of risk

management terms at this Web site: http://www.contingencyanalysis.com/

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Cash Insolvency Analysis

Helps managers choose their capital structure during a recession when liquidity is important

CBR = CB0 + FCFR

The firm needs cash (or access to cash) to survive a recession

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Factors Considered in Capital Structure Decisions Tendency to cluster around industry

average Need for funds Benchmark leverage ratios

By lenders and bond rating agencies Info on ratings

http://www.standardpoor.com/ratings Managerial risk aversion Retain control