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: 1 Firm’s business risk As business risk increases level of debt decreases. 2 Firm’s tax position As taxable income increases so does debt. 3 Financial flexibility As access to markets increases, the firm can take advantage of current market conditions. 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. Business and Financial Risk 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. Business Risk 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 all about. 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% Premium for Financial Risk 15% 10% ks Premium for Business Risk 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 Trade-Off 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. Trade-Off Theory 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 information than investors about corporate 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 a bad signal that prospects look bad. 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.