Capital Structure by Rajat Jhingan

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Capital

Structure

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The Target Capital Structure

Capital Structure: The combination ofdebt and equity used to finance a firm

Target Capital Structure: The ideal mix

of debt, preferred stock, and commonequity with which the firm plans tofinance its investments

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The Target Capital Structure

Four factors that influence capital structuredecisions:

The firms business risk

The firms tax position Financial flexibility

Managerial attitude

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What is Business Risk?

Uncertainty about future operating income

(EBIT).

How well can we predict operating income?

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Sales variability

Input price variability

Ability to adjust output prices for changesin input prices

The extent to which costs are fixed:

operating leverage

Factors AffectingBusiness Risk

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What is Operating Leverage?

Operating Leverage: Use of fixed operatingcosts rather than variable costs

If most costs are fixed (i.e., they do not

decline when demand falls) then the firm hashigh DOL (degree of operating leverage)

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What is Financial Risk?

Financial Leverage: The extent to whichfixed-income securities (debt and preferredstock) are used in a firms capital structure

Financial Risk: Additional risk placed onstockholders as as result of financialleverage

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Business Risk vs. Financial Risk

Business risk depends on business factorssuch as competition, product liability, andoperating leverage.

Financial risk depends only on type ofsecurities issued: the more debt, the morefinancial risk.

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Determining theOptimal Capital Structure:

Seek to maximize the price of the firmsstock.

Changes in use of debt will cause changes inearnings per share, and, thus, in the stock

price. Cost of debt varies with capital structure.

Financial leverage increases risk.

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EPS Indifference Analysis

EPS Indifference Point:The level of sales at which EPS will bethe same whether the firm uses debt

or common stock (pure equity)financing.

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Probability

Density

0 $2.40 $3.36

50% Debt Financing

Zero Debt Financing

EPS ($)

Probability Distribution of

EPS with Different Amountsof Financial Leverage

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The Effect of Capital Structureon Stock Prices and the Cost

of CapitalThe optimal capital structure

maximizes the price of a firms stock.

The optimal capital structure alwayscalls for a debt/assets ratio that islower than the one that maximizesexpected EPS.

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Debt/Assets

kd ExpectedEPS

EstimatedBeta

ks = [kRF +

(kMkRF)s]

EstimatedPrice

ResultingP/E Ratio

WACC

0% - $2.40 1.50 12.0% $20.00 8.33 12.00%10 8.0% 2.56 1.55 12.2 20.98 8.20 11.4620 8.3 2.75 1.65 12.6 21.83 7.94 11.0830 9.0 2.97 1.80 13.2 22.50 7.58 10.86

40 10.0 3.20 2.00 14.0 22.86 7.14 10.80

50 12.0 3.36 2.30 15.2 22.11 6.58 11.2060 15.0 3.30 2.70 16.8 19.64 5.95 12.12

All earnings paid out as dividends, so EPS = DPS.Assume that kRF = 6% and kM = 10%. Tax rate = 40%.

WACC = wdkd(1 - T) + wsks

= (D/A) kd(1 - T)+ (1 - D/A)ks

At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80%

Stock Price and Cost of Capital Estimates

with Different Debt/Assets Ratios

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Relationship Between

Capital Structure and EPS

0

0.5

1

1.5

2

2.5

3

3.5

0 10 20 30 40 50 60

Maximum EPS = $3.36Expected EPS ($)

Debt/Assets (%)By: Rajat Jhingan


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0

5

10

15

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0 10 20 30 40 50 60

Cost of Equity, ks

Cost of Capital (%)

Debt/Assets (%)

WACC

Minimum = 10.8%

Relationship Between

Capital Structure and Cost of Capital

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0 10 20 30 40 50 60

Maximum = $22.86

Stock Price ($)

Debt/Assets (%)

Relationship BetweenCapital Structure and Stock Price

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Percentage change in NOIPercentage change in sales

DEBITEBITDSalesSales

DEBITEBITDQQ

DOL = = =

DOLQ = Q(P - V)Q(P - V) - FCDOLS = S - VCS - VC - F Gross ProfitEBIT=

Degree of Operating Leverage(DOL)

The percentage change in operating income (EBIT)associated with a given percentage change in sales.

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DEPSEPSDEBITEBIT

Percentage change in EPSPercentage change in EBIT EBITEBIT - IntDFL = = =

Degree of Financial Leverage(DFL)

The percentage change in earnings availableto common stockholders associated with agiven percentage change in EBIT.

This equation assumes the firm has no preferred stock.By: Rajat Jhingan


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S - VCS - VC - F - Int Gross ProfitEBIT - IntDTL = =

Q(P - V)Q(P - V) - F - IntDTL =DTL = DOL X DFL

Degree of Total Leverage(DTL)

The percentage change in EPS that results

from a given percentage change in sales.

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Liquidity and Capital StructureDifficulties with Analysis1. We cannot determine exactly how either P/E ratios

or equity capitalization rates (ks values) are affected

by different degrees of financial leverage.2. Managers may be more or less conservative than

the average stockholder, so management may set adifferent target capital structure than the one thatwould maximize the stock price.

3. Managers of large firms have a responsibility toprovide continuous service and must refrain fromusing leverage to the point where the firms long-run viability is endangered.

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Liquidity and Capital Structure

Financial strength indicatorTimes-Interest-Earned (TIE) Ratio

Ratio that measures the firms ability to meetits annual interest obligations

Formula: divide EBIT (earnings before interestand taxes) by interest charges

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Capital Structure Theory

Trade-off Theory

Signaling Theory

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Trade-Off Theory(Modigliani and Miller)

1. Theory:1. Interest is tax-deductible expense, therefore less expensive

than common or preferred stock.

2. So, 100% debt is the preferred capital structure.

2. Theory:

1. Interest rates rise as debt/asset ratio increases2. Tax rates fall at high debt levels (lowers debt tax shield)

3. Probability of bankruptcy increases as debt/assets ratioincreases.

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Trade-Off Theory (continued)

3. Two levels of debt:

1. Threshold debt level (D/A1) = where bankruptcy costsbecome material

2. Optimal debt level (D/A2) = where marginal tax shelterbenefits = marginal bankruptcyrelated costs

3. Between these two debt levels, the firms stock price rises,but at a decreasing rate

4. So, the optimal debt level = optimal capitalstructure

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Trade-Off Theory (cont)

4. Theory and empirical evidence supportthese ideas, but the points cannot beidentified precisely.

5. Many large, successful firms use much lessdebt than the theory suggestsleading todevelopment of signaling theory.

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Signaling Theory

Symmetric Information Investors and managers have identical

information about the firms prospects.

Asymmetric Information

Managers have better information about theirfirms prospects than do outside investors.

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Signaling Theory

SignalAn action taken by a firms management that

provides clues to investors about howmanagement views the firms prospects

Result: Reserve Borrowing CapacityAbility to borrow money at a reasonable cost when

good investment opportunities arise Firms often use less debt than optimal to ensure

that they can obtain debt capital later if needed.

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Variations in CapitalStructures among Firms

Wide variations in use of financial leverageamong industries and firms within anindustry TIE (times interest earned ratio) measures how

safe the debt is: percentage of debt interest rate on debt

companys profitability

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Country Equity Total Debt Long-Term

Debt

Short-Term

DebtUnited Kingdom 68.3% 31.7% N/A N/A

United States 48.4 51.6 26.8% 24.8%

Canada 47.5 52.5 30.2 22.7

Germany 39.7 60.3 15.6 44.7Spain 39.7 60.3 22.1 38.2

France 38.8 61.2 23.5 37.7

Japan 33.7 66.3 23.3 43.0

Italy 23.5 76.5 24.2 52.3

Capital Structure Percentages for Selected CountriesRanked by Common Equity Ratios, 1995

Capital Structures Around the World

By: Rajat Jhingan

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Capital Structure by Rajat Jhingan