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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:
    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.

				
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