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					Capital Structure

05/08/08
Ch. 7

Capital Structure – Balance Sheet
 Assets – Value of the

Firm

  

Listed by Closeness to Cash Current Assets Long-term Assets Physical and Intangible

 Book Value or historical

value of the assets adjusted for depreciation

 Capital Structure  The “borrowed” money from the capital markets  Liabilities – Fixed claims against the assets  Owner’s Equity – Residual claim against assets  Book Values not Market

Values
2

What is Debt?
 Fixed claims against the company, the

liabilities
 

Current Liabilities, accounts payable… Long-term Liabilities
 

Bank Loans Bonds

 The “borrowed” money will be paid back

usually in pre-specified amounts and at prespecified time…temporary funding
3

Examples of Debt
 Loans –
  

Principal and interest due at maturity Interest as you go, principal at maturity Principal and interest as you go, usually equal payments at equal intervals, annuity

 By Lender - 

Banks Bondholders

 Interest portion is usually tax deductible
4

What is Equity?
 Value of the company “claimed” by owners  What is left over after debt claims are

satisfied  Permanent Capital


 

Repayment not required Repayment via dividends Dividends not tax deductible (not an expense of the company)

 Outstanding Common Stock
5

Ways to Raise $$$$
 Borrow from suppliers – accounts payable  Borrow from bank – bank loan

 Borrow from bondholders – issue bonds  Borrow from other companies – sign leases  Borrow from owners  Personal funds of founder/owner  Issue preferred stock  Issue common stock  Issue warrants
6

Some Hybrid Securities
 Convertible Bonds  Initially issued as two assets, a straight bond and an option to convert to stock  Set conversion ratio  Some protection on the down-side (bonds have fixed repayment)  Potential for up-side, convert to stock if company (stock prices rise)

 Preferred Stock  Guaranteed dividends (consol or perpetuity)

7

Financing Options Tied to Life Cycle
 Life Cycle of a firm…
    



Birth (Start-up) Youth (Expansion) Teen-age (Rapid or High Growth) Adult (Mature) Old Age (Decline) Death (Bankruptcy)

 Personal Funds, Angel Funds, Venture

Capitalist, Loans, Public Equity, Bonds…
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Raising Equity in Capital Markets
 Usually in late teen – early adulthood  Have need for large $$$$

 Find Investment Banking Firm – Start IPO  File paperwork with SEC  Market Security  Conduct Auction  Distribute Stock and Collect $$$
 Subsequent issues are Seasoned Equity

Offerings (SEO)
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Cost of Going Public (IPO)
 Legal Costs – Registration and Filing Fees  Payment to Investment Banker – Best efforts

or Firm Commitment  Marketing Costs – Road Show  Underpricing
  

Why on average are IPOs underpriced? When do marginal clients get a call? Marginal clients know they are marginal…

 After sale requirements and options
10

Cost of Debt
 Legal Costs – Registration and Filing Fees  Payment to Investment Banker

 Marketing Costs  Potential Default  If bondholders or bank not paid back on time the bondholders or bank can “claim” the firm  Direct bankruptcy costs  Indirect bankruptcy costs

11

Benefits of Debt
 Discipline Managers – reduces free cash flow  Covenants in place to “restrict” certain types

of behavior  Additional outside validation of management activities and choices
 



Bond rating agencies Bank loan officers Subsequent borrowing

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Company Earnings Reinvested
 Earnings of the company can be reinvested in

the company  What is the cost of reinvesting?  What are the choices with company earnings?
 


Pay it back to owners…let them invest it where they might Cost should be the opportunity cost to the owners Cost of equity w/o issuance costs
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Optimal Capital Structure
 What combination of borrowing is best?  How do you choose which funds you should use for

financing?
 

Debt vs. Equity vs. Company Earnings How much of each?

 Pecking Order Hypothesis  Static Theory – Separation of Investing and

Financing Decisions
 

Modigliani and Miller 1956 &1958 Marginal cost of bankruptcy vs. Marginal benefit of debt to find the lowest cost of capital
14

Homework
 Problem #4 – Convertible Preferred Stock

(me – I will do this one in class…)  Problem #5 – Debt-Equity Ratio


Missing data, bonds are ten year bonds

 Problem #8 – Venture Financing  Problem #9 – Venture Financing  Problem #15 – Rights Offering  Problem #18 – Debt for Stock Swap  Problem #23 –Debt & Bankruptcy
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