The Firm’s Capital Structure
Chapter 12
Leverage • Capital structure is one of the most complex areas of
financial decision making due to its interrelationship
and Capital with other financial decision variables.
Structure • Poor capital structure decisions can result in a high cost
of capital, thereby lowering project NPVs and making
them more unacceptable.
• Effective decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable projects,
thereby increasing the value of the firm.
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Types of Capital Capital Structure Theory
• According to finance theory, firms possess a target
capital structure that will minimize its cost of capital.
• Unfortunately, theory can not yet provide financial
mangers with a specific methodology to help them
determine what their firm’s optimal capital structure
might be.
• Theoretically, however, a firm’s optimal capital
structure will just balance the benefits of debt financing
against its costs.
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Capital Structure Theory:
Capital Structure Theory (cont.)
Tax Benefits
• The major benefit of debt financing is the tax shield • Allowing companies to deduct interest payments when
provided by the federal government regarding interest computing taxable income lowers the amount of
payments. corporate taxes.
• The costs of debt financing result from: • This in turn increases firm cash flows and makes more
– the increased probability of bankruptcy caused by debt cash available to investors.
obligations,
– the agency costs resulting from lenders monitoring the firm’s
• In essence, the government is subsidizing the cost of
actions, and debt financing relative to equity financing.
– the costs associated with the firm’s managers having more
information about the firm’s prospects than do investors
(asymmetric information).
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Capital Structure Theory: Capital Structure Theory:
Probability of Bankruptcy Probability of Bankruptcy (cont.)
• The probability that debt obligations will lead to • The firm’s capital structure—the mix between debt
bankruptcy depends on the level of a company’s versus equity—directly impacts financial leverage.
business risk and financial risk.
• Financial leverage measures the extent to which a firm
• Business risk is the risk to the firm of being unable to employs fixed cost financing sources such as debt and
cover operating costs.
preferred stock.
• In general, the higher the firm’s fixed costs relative to
variable costs, the greater the firm’s operating leverage • The greater a firm’s financial leverage, the greater will
and business risk. be its financial risk—the risk of being unable to meet
• Business risk is also affected by revenue and cost its fixed interest and preferred stock dividends.
stability.
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Capital Structure Theory: Capital Structure Theory:
Probability of Bankruptcy (cont.) Probability of Bankruptcy (cont.)
• Business Risk
• Business Risk
Cooke Company, a soft drink manufacturer, is
preparing to make a capital structure decision. It When developing the firm’s capital structure, the
has obtained estimates of sales and EBIT from its financial manager must accept as given these levels
forecasting group as show in Table 12.9. of EBIT and their associated probabilities. These
Table 12.9 Sales and Associated EBIT Calculations for Cooke Company ($000) EBIT data effectively reflect a certain level of business
risk that captures the firm’s operating leverage, sales
revenue variability, and cost predictability.
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Capital Structure Theory: Capital Structure Theory:
Probability of Bankruptcy (cont.) Probability of Bankruptcy (cont.)
• Financial Risk • Financial Risk
Table 12.10
Capital Structures
Associated with
Alternative Debt
Ratios for Cooke
Let us assume that (1) the firm has no current liabilities, Company
(2) its capital structure currently contains all equity, and
(3) the total amount of capital remains constant at
$500,000, the mix of debt and equity associated with
various debt ratios would be as shown in Table 12.10.
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Capital Structure Theory: Capital Structure Theory:
Probability of Bankruptcy (cont.) Probability of Bankruptcy (cont.)
• Financial Risk • Financial Risk
Table 12.11 Table 12.12
Level of Debt, Calculation of
Interest Rate, and
Dollar Amount of
EPS for
Annual Interest Selected Debt
Associated with Ratios ($000)
Cooke for Cooke
Company’s Company (cont.)
Alternative
Capital Structures
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Capital Structure Theory: Capital Structure Theory:
Probability of Bankruptcy (cont.) Probability of Bankruptcy (cont.)
• Financial Risk • Financial Risk
Table 12.12 Table 12.12
Calculation of Calculation of
EPS for EPS for
Selected Debt Selected Debt
Ratios ($000) Ratios ($000)
for Cooke for Cooke
Company (cont.) Company
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Capital Structure Theory: Capital Structure Theory:
Probability of Bankruptcy (cont.) Probability of Bankruptcy (cont.)
• Financial Risk • Financial Risk
Table 12.13 Figure 12.3
Expected EPS, Probability
Standard Distributions
Deviation, and
Coefficient of
Variation for
Alternative Capital
Structures for
Cooke Company
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Capital Structure Theory: Capital Structure Theory: Agency Costs
Probability of Bankruptcy (cont.) Imposed by Lenders
• Financial Risk • When a firm borrows funds by issuing debt, the interest
Figure 12.4 Expected EPS and Coefficient of Variation rate charged by lenders is based on the lender’s
of EPS assessment of the risk of the firm’s investments.
• After obtaining the loan, the firm’s stockholders and/or
managers could use the funds to invest in riskier assets.
• If these high risk investments pay off, the stockholders
benefit but the firm’s bondholders are locked in and are
unable to share in this success.
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Capital Structure Theory: Agency Costs Capital Structure Theory:
Imposed by Lenders (cont.) Asymmetric Information
• To avoid this, lenders impose various • Asymmetric information results when managers of a
firm have more information about operations and future
monitoring costs on the firm. prospects than do investors.
• Examples would of these monitoring • Asymmetric information can impact the firm’s capital
costs would: structure as follows:
– include raising the rate on future debt issues,
Suppose management has identified an extremely lucrative
– denying future loan requests, investment opportunity and needs to raise capital. Based on
– imposing restrictive bond provisions. this opportunity, management believes its stock is
undervalued since the investors have no information about
the investment.
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Capital Structure Theory: Capital Structure Theory:
Asymmetric Information (cont.) Asymmetric Information (cont.)
• Asymmetric information results when managers of a • Asymmetric information results when managers of a
firm have more information about operations and future firm have more information about operations and future
prospects than do investors. prospects than do investors.
• Asymmetric information can impact the firm’s capital • Asymmetric information can impact the firm’s capital
structure as follows: structure as follows:
In this case, management will raise the funds using debt On the other hand, if the outlook for the firm is poor,
since they believe/know the stock is undervalued management will issue equity instead since they
(underpriced) given this information. In this case, the use of believe/know that the price of the firm’s stock is overvalued
debt is viewed as a positive signal to investors regarding the (overpriced). Issuing equity is therefore generally thought of
firm’s prospects. as a ―negative‖ signal.
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The Optimal Capital Structure The Optimal Capital Structure
• In general, it is believed that the market value of a company is Figure 12.5
maximized when the cost of capital (the firm’s discount rate) is Cost Functions
minimized.
and Value
• The value of the firm can be defined algebraically as follows:
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EPS-EBIT Approach EPS-EBIT Approach
to Capital Structure to Capital Structure (cont.)
• The EPS-EBIT approach to capital structure involves selecting
Example
the capital structure that maximizes EPS over the expected range
of EBIT. EBIT-EPS coordinates can be found by assuming specific
• Using this approach, the emphasis is on maximizing the owners EBIT values and calculating the EPS associated with them.
returns (EPS).
Such calculations for three capital structures—debt ratios of
• A major shortcoming of this approach is the fact that earnings
0%, 30%, and 60%—for Cooke Company were presented
are only one of the determinants of shareholder wealth
maximization. earlier in Table 12.2. For EBIT values of $100,000 and
• This method does not explicitly consider the impact of risk. $200,000, the associated EPS values calculated are
summarized in the table with Figure 12.6.
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EPS-EBIT Approach Basic Shortcoming
to Capital Structure (cont.) of EPS-EBIT Analysis
Figure 12.6 • Although EPS maximization is generally good for the
EBIT–EPS firm’s shareholders, the basic shortcoming of this
Approach method is that it does not necessary maximize
shareholder wealth because it fails to consider risk.
• If shareholders did not require risk premiums
(additional return) as the firm increased its use of debt,
a strategy focusing on EPS maximization would work.
• Unfortunately, this is not the case.
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Choosing the Optimal
Choosing the Optimal Capital Structure
Capital Structure (cont.)
• The following discussion will attempt to create a Table 12.14 Required Returns for Cooke Company’s
framework for making capital budgeting decisions that Alternative Capital Structures
maximizes shareholder wealth—i.e., considers both risk
and return.
• Perhaps the best way to demonstrate this is through the
following example:
Cooke Company, using as risk measures the
coefficients of variation of EPS associated with each
of seven alternative capital structures, estimated the
associated returns as shown in Table 12.14
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Choosing the Optimal Choosing the Optimal
Capital Structure (cont.) Capital Structure (cont.)
Table 12.15 Calculation of Share Value Estimates
By substituting the level of EPS and the associated Associated with Alternative Capital Structures for Cooke
Company
required return into Equation 12.12, we can
estimate the per share value of the firm, P 0.
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Choosing the Optimal Table 12.16 Important Factors to Consider
Capital Structure (cont.) in Making Capital Structure Decisions
Figure 12.7
Estimating Value
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