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Capital Structure Decisions
Capital Structure Decisions
Capital Structure Decisions
Debt
$
4,000,000
450,000
---3,550,000
1,420,000
2,130,000
4,000,000
450,000
400,000
3,150,000
1,260,000
1,890,000
------------
-------------
2,130,000
1,890,000
500,000
$4.26
400,000
$4.73
Pref. Stock
$
4,000,000
450,000
.
3,550,000
1,420,000
2,130,000
380,000
-----------1,750,000
400,000
$4.38
Earnings available to common stockholder is higher under debt than preference shares
because of the debt tax shield, even though the cost of debt ( before tax ) is higher than
the cost of Pref. Shares. Also EPS is highest under debt.
2
However, what is the indifference point for financial leverage ? That is, the level of
EBIT below which financing with a common stock alternative will provide higher
earnings per share.
Mathematical solution :
EBIT* - C1
S1
Where EBIT*
C1 and C2
S1and S2
= EBIT* - C2
S2
EBIT* - 850,000
400,000
Graphical Presentation
3
3.Debt Service Coverage
This takes into account Principal repayments.
Debt service coverage =
EBIT
Interest + [ Principal/ (1- tax rate)]
e.g. if principal payment is $1 mill per annum :
Debt service coverage =
$6 mill
= 1.89 times.
$1.5 m + [ $1mill/ ( 1- .4)]
A coverage of 1.89 means that EBIT can fall by 47% before earnings coverage is
insufficient to service debt [ 1- ( 1/ 1.89) ] = .47 or 47%.
The financial risk associated with leverage should be analyzed on the basis of the firms
ability to service total fixed charges.
The Donaldson approach
Gordon Donaldson advocates examining the cash flows of the company under the most
adverse circumstances i.e. under recession conditions. The net cash balance in a recession
is :
CBr
Where
= CBo
NCFr
You should calculate a probability distribution of expected behaviour of a firm during a recession.
The beginning cash balance, CBo, should be combined with the probability distribution of recession cash
flows, NCFr, to give a probability distribution of cash balances in recession.
Debt capacity.
A company should know how much debt can be comfortably serviced.
First, calculate the fixed charges associated with each increment of debt.
For each addition, the firm would determine a probability of running out of cash.
By this method a probability distribution can be obtained.
Effect on debt ratio :
Debt ratios should be computed for various financing alternatives being considered. Also,
new debt ratios should be compared with other companies having similar business risk
e.g. those in the industry, Debt ratio can affect the ability of the company to raise debt
capital.
4
Effect on Security ratings :
Whenever a company sells a debt or preferred stock issue to the public ( as opposed to a
private placement) it must have the issue rated by a rating service. In the USA Moodys
Investors Service and Standard & Poor are well known. Security ratings indicate the
credit worthiness of the borrower.