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```					Capital Structure
FIL 341
Prepared by Keldon Bauer
Target Capital Structure
   Definition:
   The mix of debt, preferred stock, and common
stock the firm plans to use over the long-run to
finance its operations.
   The proportions should be set in such a way
as to balance risk/return and thereby
maximize the price of the stock.
   This mix is called the Optimal Capital Structure
(OCS).
Finding Target Capital Structure
   Four Factors in Determining TCS:
   As business risk increases level of debt decreases.
2   Firm’s tax position
   As taxable income increases so does debt.
3   Financial flexibility
Finding Target Capital Structure
4   Managerial attitudes
   As managers are more conservative they will tend to
use less debt.
   Note that this is the only factor that has nothing to do with
optimal capital structure, and everything to do with target
capital structure.
Measuring Capital Structure
Rocky Shoe & Boot – Leverage Ratios

Leverage Ratios     2003   2002   2001   2000   1999
Debt Ratio1       23.58% 17.32% 25.47% 35.35% 40.21%
Debt Ratio2       23.58% 17.32% 25.47% 35.35% 40.21%
Debt/Equity Ratio 30.86% 20.95% 34.18% 54.68% 67.25%
Does Capital Structure Matter?
   Nobel Prize winning economists Merton
Miller and Franco Modigliani theoretically
investigated whether or not capital structure
of the firm mattered.
   They looked at whether it added value to the
firm.
   Their initial assumptions were that there was
no cash flow affects, and the cost of capital
should be the same.
Miller/Modigliani’s First Attempt
Does Capital Structure Matter?
   Given their initial assumptions, it appeared
that capital structure did not matter – value
was unaffected.
   But once they added tax to the equation, debt
acted as a tax shield, and therefore, the more
debt the company took on, the better.
Miller/Modigliani’s 2nd Attempt
Does Capital Structure Matter?
   But that is not what is observed in the world.
   Miller/Modigliani did not take into account
the expected cost of bankruptcy.
   As debt levels in the firm increase, the firm’s
fixed financing costs increase, as does their
probability of bankrutcy.
   You know about market (beta) and firm-
specific risk. Company risk is a composite of
both of these risks, which itself has two
components:
1   Business risk: Uncertainty inherent in return
projections in the absence of financial leverage.
2   Financial risk: Uncertainty in return resulting
from financial leverage.
   Biggest determinant of optimal capital
structure.
   Best measured as high volatility (variance) in
operational profit (EBIT).
   Most important factors:
1   Sales variability
2   Input price variability
3   Ability to adjust output prices
4   Extent to which costs are fixed
Financial Risk
   The use of debt intensifies the business risk
borne by common shareholders.
   The appropriate level of financial leverage is
what determining optimal capital structure is
Finding Optimal Capital Structure
   Definition:
   Choosing the combination of debt and equity that
will maximize the price of the stock.
Effect of Leverage on EPS

Zero Debt
50% Debt

-5   0    5    10   15      20
Effect of Leverage on Firm Value
20%
15%

10%
ks

5%
Pure Time Value of Money kRF
0%
0%   10%      20%      30%        40%   50%   60%
Debt/Assets
Liquidity and Capital Structure
   The theory is great, but there are still some
problems that keep us from the optimal capital
structure:
1   It is impossible to determine exactly how price
and ks are affected by changes in leverage.
2   Managers may be more or less conservative than
the average shareholder, leading to a different
optimum for them.
Liquidity and Capital Structure
3   Publicly necessary goods or services may not be
allowed to hit the optimal for shareholders
because of the risk implied to the public (e.g.
utilities).
   Bankruptcy risk is a deterrent to optimal
capital structure.
   Bankruptcy risk can be judged through use of the
TIE or EBITDA ratio from chapter 3.
Capital Structure Theory
   A trade-off exists between tax benefits of debt
and increasing bankruptcy costs.
   Miller & Modigliani showed (with unrealistic
assumptions) that shareholder value would be
maximized with nearly 100% debt.
   Doesn’t hold in the real world because interest rates
rise as leverage rises, and because expected taxes go
down as debt rises, and bankruptcy costs rise as
leverage rises.

M&M's original proposition
Firm Value

Value reduced by bankruptcy costs

Zero Leverage

Optimal Capital Structure

Leverage
Pecking Order Theory
   Managers are seen as preferring to finance the
company according to the availability of
funding in the following order:
   Retained earnings
   New debt issue
   New equity issue
   Seems to be supported by survey research.
Signaling Theory
   And still some successful firms use less than
optimal debt (even using trade-off theory).
   One possible reason for this discrepancy, is
that M&M assumed that investors had the
same information as managers (Information
Symmetry).
Signaling Theory
   In reality, managers usually have better
prospects (Information Asymmetry).
   If a company’s prospects look good,
managers wishing to maximize shareholder
wealth will not issue stock to dilute their
windfall.
Signaling Theory
   Those companies with bad prospects will not
want high leverage, because they may be
forced into bankruptcy.
   These conclusions are consistent with what we
found using EPS indifference and degrees of
leverage analyses.
Signaling Theory
   Therefore, when mature companies without
clear profit potentials issue stock, this is seen as
   On the other hand, if they issue debt, they are
signaling that their prospects are good.
   As bad signals hit the market, price of the stock
goes down, ks and WACC go up.
Other Theories
   Normally, companies keep excess borrowing
capacity (reserve borrowing capacity) for
expansion, just in case the big one pops up.
   Even though it is sub-optimal.

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