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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
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1.5
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2.5
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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
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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