CHAPTER 15

CAPITAL STRUCTURE
AND LEVERAGE
Aguado, Andraje, Ani, Asesor
Learning Objectives
01 Explain why there may be differences in a firm’s capital structure
whem measured on a stock value basis, a market-value basis, or a
target basis

02 Distinguish between business risk and financial risk, and explain the
effects that debt financing has on the firm’s expected return and risk

03 Discuss the analytical framework used when determining the optimal

structure

04 Discuss capital structure theory, and use it to explain why firm’s in

different industries tend to have different capital structure
 15-1 Book Market or Target Weights

Capital Optimal capital

Capital Structure structure
Investor- supplied fu the mix of debt pre the capital structure
nds such as long and ferred stock, comm that maximizes a sto
short term loans fro on equity that is us
m individuals and ins ck’s intrinsic value.
ed to finance the fi
titutions, preferred s rm’s assets.
tock, common stock a
nd retained earnings.
 15-1a Measuring Capital Structure
01 Deliberate Actions
If a firm is not currently at its target, it maye
deliberately raise new money in a manner that moves
the actual structure toward the target.

02 Market Actions
The firm could incur high profits or losses that lead t
o significant changes in book value equity as shown o
02 n its balance sheet and to a decline in its stock price.
Although the book value of its debt would probably n
ot change, interest rate changes or changes in firm’s
default risk could cause significant changes in its deb
t’s market value
Firms have specific target range in mind. If the actual debt ratio has surpassed the
target, a firm cans sell a large stock issue and use the proceeds to retire debt. If the
stock price has increased and pushed the debt ratio below the target, it can issue bonds
and use the proceeds to repurchase stock.
 15-2. Business and Financial Risk
Two new dimension of Risk:

Business Risk Financial Risk

which is the additional risk
which is the riskiness of th placed on the common stock
e firm’s asset if no debt is holders as a result of using
used debt
 Business Risk
 Riskiness inherent in the firm’s operation if it uses no debt

 The single most important determinant of capital structure, and it represents the amount of risk that is
inherent in the firm’s operation even if it uses no debt financing
 A commonly used measure of business risk is the standard deviation of the firm’s return on invested
capital, or ROIC ROIC= EBIT(1-T)/ Total invested capital
 ROIC (Return on Invested Capital)
 Measure the after tax return that the company provides for all of its investors.
 Does not vary with changes in capital structure, the standard deviation of it measures the
underlying risk of the firm before considering the effects of the debt financing, thereby
providing a good measure of business risk
Figure 15-1. Bigbee Electronics
 15-2b. Factors that Affect Business Risk
1. COMPETITION
If a firm has a monopoly on a necessary product, it will have little risk from competition and thus
have stable sales and sales prices. However, monopolistic firm’s prices are often regulated, and t
hey may not be able to raise prices enough to cover rising costs

Still, other things held constant, less competition lowers business risk

2. DEMAND VARIABILITY
The more stable the demand for a firm’s products, other things held constant, the lower its
business risk

3. SALES PRICE VARIABILITY

Firms whose products are sold in volatile markets are exposed to more business risk than firms w
hose output prices are stable, other things held constant
4. INPUT COST VARIABILITY
Firms whose input costs are uncertain have higher business risk

5. PRODUCT OBSOLESCENCE
Firms in high-tech industries like pharmaceuticals and computers depend on a constant
stream of new products. The faster its products become obsolete, the greater a firm’s business risk

6. FOREIGN RISK EXPOSURE

Firms that generate a high percentage of their earnings overseas are subject to earnings declines due
to exchange rate fluctuations
They are also exposed to political risk
7. REGULATORY RISK AND LEGAL EXPOSURE
Firms that operate in highly regulated industries such as financial services and utilities are subje
ct to changes in the regulatory environment that may have profound effect on company’s current
and future profitability. Other companies face significant legal exposure that could damage the c
ompany if they are forced to pay large settlements

8. THE EXTENT TO WHICH COSTS ARE FIXED : OPERATING LAVERAGE

If a high percentage of its costs are fixed and thus do not decline when demand falls, this increa
ses the firms business risk, called Operating Leverage.

Each of these factors is determined partly by industry characteristics and partly by managerial
decision.
 15-2c. Operating Leverage
Operating Leverage - the extent to which fixed costs are used in a firm’s operation.

 As noted earlier, Business risk depends in part on the extent to which a firm builds fixed
costs into its operations
 If fixed costs are high, even a small decline in sales can lead to a large decline in ROIC
 So other things held constant, the higher a firm’s fixed costs, the greater its business ris
k
 Higher fixed cost are generally associated with more highly automated, capital-intensive
firms and industries.
When a high percentage of total costs are
fixed, the firm is said to have a high
degree of operating leverage.
a) In physics, leverage implies the use of a 80%
lever to raise a heavy object with a small
force. 50%
b) In politics, if people have leverage, their
smallest word or action can accomplish a
great deal. 40%
c) In business terminolgy, a high degree of
operating leverage, other factors held co 70%
nstant, implies that a relatively small ch
ange in sale results in a large change in
ROIC.
60%
 Operating Breakeven -The output quantity at which EBIT=0
EBIT = PQ-VQ-F=0
Here;
P- is average sales price per unit of output
Q-is units of output
V- is variable cost per unit
F- is fixed operating costs
If we solve for the break-even quanitity , 𝑄_𝐵𝐸 we get this exp
ression:
PLAN A PLAN B
𝐹 $25,000 $70,000
𝑄𝐵𝐸= 𝑄𝐵𝐸= = 𝑄𝐵𝐸= =
𝑃−𝑉 $2.00−&1.50 $2.00−$1.00
50,000 units 70,0000 units
How does operating leverage affect business risk? Figure 15-3. Analysis of Business Risk
Other things held constant the higher a firm’s operating
leverage, the higher its business risk.
TO WHAT EXTENT CAN FIRM’S CONTROL THEIR OPERATING
LEVERAGE?
To a large extent, operating leverage is determined by technology. Electric
utilities, telephone companies, airlines, steal mills, and chemical companie
s must have large investments in fixed assets, and this results in a high fix
ed costs and operating leverage.
Similarly, pharmaceutical, auto, computer, and other companies must spen
d heavily to develop new products, and product-development costs increase
operating leverage.
Grocery stores and service businesses such as accounting and consulting fir
ms, on the other hand, generally have significantly lower fixed costs and th
erefore lower operating leverage . Still, although industry factors do exert a
major influence, all firms Have some control over their operating leverage.
For Example:
An Electric utility can expand its generating capacity by building either gas-fired or nuclear plants.

 Nuclear plants world require larger investments and would

have higher fixed costs, but their variable operating costs
would be relatively low.

 Gas-fired plants, on the other hand would require small inv

estments and would have lower fixed costs, but the variabl
e costs (for gas) would be high. So, by its capital budgetin
g decisions, a utility (or any other company) can influence
its operating leverage and hence its business risk.

The concept of operating leverage was originally developed for use in capital budgeting. Mutually ex
clusive projects that involve alternative production methods for a given product often have different
of operating leverage and thus different degrees of risk
 15-2b. Factors that Affect Business Risk

Financial Risk Financial Leverage

the extent to which fixed income securitie
an increase in stockholder’s risk, over a
s (debt and preferred stock) are used in a
nd above the firm’s basic business risk,
firm’s capital structure
resulting from the use of financial levera
ge.
 Financial Risk is the additional risk placed on the common stock
holders as a result of the decision to finance with debt. Conceptu
ally, stockholders face a certain amount of risk that is inherent i
n the firm’s operation, this is its business risk defined as the un
certainty inherent in projections of future operating income. If a
firms uses debt (financial leverage), this concentrates the busine
ss risk on common stockholders.

Thus, the use of debt, or financial leverage, concentrates the firm’s business risk on the stockholders
Table 15.2 Interest Rates for Bigbee
with Different/ Capital Ratios
Table 15-3. Effect of Financial Leverage: Bigbee
Electronics Financed with Zero Debt or 50% Debt
The EPS figures can also be obtained using the ff. formula in which the numerator amounts to
an income statements at a given sales level displayed horizontally:
(𝑆𝑎𝑙𝑒𝑠−𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠−𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠−𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡)(1−𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)
EPS= =
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
(𝐸𝐵𝐼𝑇−1)(1−𝑇)
𝑆ℎ𝑎𝑟𝑒𝑠 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

For example, with zero debt and sales= $200,000, EPS is $1.80:
($200,000 − $70,000 − $100,000 − $0)(0.6)
𝐸𝑃𝑆 𝐷 = = $1.80
𝐷+𝐸
=0% 10,000

With 50% debt and sales=$200,000, EPS is $2.74:

($200,000−$70,000−$100,000−$7,200)(0.6)
𝐸𝑃𝑆 𝐷
=50%
= = $2.74
𝐷+𝐸
5,000
Figure 15-5. Relationships Among Expected EPS,
Risk, and Financial Leverage
 15-3:determining the optimal capital structure
 Optimal capital structure is a financial measurement that firms use to determine the best mix of debt
and equity financing to use for operations and expansions.
 This structure seeks to lower the cost of capital so that a firm is less dependent on creditors and more
able to finance its core operations through equity which maximizes the value of the firm.
 The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the
weighted average cost of capital (WACC) while maximizing its market value.
 The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted b
y the WACC.
 The chief goal of any corporate finance department should be to find the optimal capital structure that
will result in the lowest WACC and the maximum value of the company (shareholder wealth).
15-3a WACC AND CAPITAL STRUCTURE
The weighted average cost of capital (WACC) is the rate that a company is e
xpected to pay on average to all its security holders to finance its assets. Th
e WACC is commonly referred to as the firm's cost of capital. Importantly, it
is dictated by the external market and not by management. The WACC repre
sents the minimum return that a company must earn on an existing asset ba
se to satisfy its creditors, owners, and other providers of capital, or they will
invest elsewhere.
 Companies raise money from a number of sources: common stock, preferred stock, straight debt,
convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options
, governmental subsidies, and so on
 The WACC is calculated taking into account the relative weights of each component of the capital
structure. The more complex the company's capital structure, the more laborious it is to calculate
the WACC.
 Companies can use WACC to see if the investment projects available to them are worthwhile to un
dertake.
 A firm’s WACC increases as the beta and rate of return on equity increase because an increase in
WACC denotes a decrease in valuation and an increase in risk.
 WACC Formula and
Calculation
WACC= Wd(rd)(1-t)+ Wc(rs)

Wd and Wc represent the percentage of debt and equity in the firm's capi
tal structure and they must sum to 1.0.
Bondholders recognize that firm has a higher debt/capital ratio this incre
ases the risk of financial distress which leads to high interest rates.
Wd= Deb Debt/ Equ Rd(1-T) Expected Estimated Rs Estimated Resulting WACC
t/Capital ity EPS (and Beta Price P/E Ratio
DP(S)
(1) (2) (3) (4) (5) (6) (7) (8)
0% 0.00% 2.40% $1.80 1.00 9.00% $20.00 11.11 x 9.00%
10 11.11 2.40 1.95 1.071 9.40 20.71 10.64 8.70
20 25.00 2.58 2.12 1.51 9.90 21.42 10.10 8.44
30 42.86 3.00 2.31 1.26 10.54 21.95 9.49 8.28
40 66.67 3.48 2.54 1.40 11.40 22.25 8.77 8.23
50 100.00 4.32 2.74 1.60 12.60 21.71 7.94 8.46
60 150.00 6.00 2.70 1.90 14.40 18.75 6.94 9.36
 15-3B THE HAMADA EQUATION
Increasing the debt ratio increase the risk that bondholders face and thus
the cost the cost of debt.More debt also raises the risk borne by stockhold
ers, which raises the cost of equity,rs.
In corporate finance, Hamada’s equation, named after Robert Hamada, is
used to separate the financial risk of a levered firm from its business risk.
The equation combines the Modigliani-Miller theorem with the capital ass
et pricing model. It is used to help determine the levered beta and, throug
h this, the optimal capital structure of firms.
Hamada’s equation relates the beta of a levered firm (a firm financed by
both debt and equity) to that of its unlevered (i.e., a firm which has no de
bt) counterpart.
 Equation
bL= bU[ 1+(1-T)(D/E)

where
βL and βU are the levered and unlevered betas . If the firm was
debt free , its beta would depend entirely on its business risk an
dthuswould be a measure of the firm’s basic business risk
T the corporate tax rate
D/E as ratio of debt, D, to equity, E, of the firm.
The importance of Hamada's equation is that it separates the risk of the busine
ss, reflected here by the beta of an unlevered firm, βU, from that of its levered
counterpart, βL, which contains the financial risk of leverage. Apart from the e
ffect of the tax rate, which is generally taken as constant, the discrepancy betw
een the two betas can be attributed solely to how the business is financed.
 15-3B THE OPTIMAL STRUCTURE
Example: Barnes Co. currently has a capital structure that consists of40% debt and 60& common equty.
The company has a 40% tax rate. Currently, the levered beta(bL) on the companys stock’s is 1.4 .
a. What is the company’s unlevered beta (Bu)?

bL= bU[ 1+(1-T)(D/E)

bU= 1.4[ 1+(0.6)(0.4/0.6)
Bu= 1.0

Notice that Bu< Bl. Bu IS THE FIRMS BETA IFMIT HAD NO DEBT. Beta is measure of risk, so with no
debt one would anticipate bu<bl.
a. What would be the company’s levered beta (bL) if Branes changed its capital structure to 20%
debt and 80% common equity?

Using the unlevered beta calcuted in part a, the company’s new levered beta under the changed capi
tal structure of 20% debt and 80% equity is calculated as follows:

bL= bU[ 1+(1-T)(D/E)

bL= 1.0[ 1+(0.6)(0.2/0.8)
bL= 1.15
 15-4 CAPITAL STRUCTURE THEORY
 Business risk is an important determinant of  Capital Structures vary among firms within a given i
the optimal capital structure. Moreover, firm ndustry, which is harder to explain. Academics and
s in different industries have different busin practitioners have developed a number of theories to
ess risks. explain the factors.

 Capital structures vary considerably across i  Modern Structure theory began in 1958 when Profe
ndustries, and this is the case. ssor Franco Modigliani and Merton Miller (hereafter
, MM) published what has been called the most infl
For example: Biotechnology companies generally
uential finance article ever written. MM proved, un
have very different capital structures than food p
der a very restrictive set of assumptions, that a fir
rocessors.
m’s value is unaffected by its capital structure
 Put another way, MM’s results suggest that it does not matter how a firm finances its
operations, hence capital structure is irrelevant. However, MM’s study was based on some
unrealistic assumptions, including the following:

01 There are no brokerage costs 04 Investors can borrow at the

same rate as corporations.

All investors have the same

02 There are no taxes. 05 information as management about
the firm’s future investment
opportunities.
There are no bankruptcy
03 costs.
06 EBIT is not affected by the
use of debt.
 15-4a THE EFFECT OF TAXES
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 Because of the tax situation, Miller argued that investors are willing to accept relatively low
before-tax returns on stock relative to the before-tax returns on bonds.

 Thus, as Miller pointed out, (1) the deductibility of interest favors the use of debt financing, but (2)
the more favorable tax treatment of income from stocks lowers the required rate of return on stock
and thus favors the use of equity financing.
 Most observers believe that interest deductibility has the stronger effect, hence that our tax system
still favors the corporate use of debt. However, that effect is certainly reduced by the lower long-term
capital gains tax rate.
 15-4B THE EFFECT OF POTENTIAL BANKRUPTCY
 In practice, bankruptcy exists, and it can be quite costly.
 Bankruptcy often forces a firm to liquidate or sell assets for less th
an they would be worth if the firm were to continue operating. Ass
ets such as plant and equipment are often illiquid because they are
configured to a company’s individual needs and also because they ar
e difficult to disassemble and move.
 “threat of bankruptcy” not just bankruptcy per se, brings about th
ese problems. If they become concerned about the future, key emplo
yees start “jumping ship”, suppliers refuse to grant credit, customer
s seek more stable suppliers, and lenders demand higher interest ra
tes and impose more restrictive loan covenants if potential bankrup
tcy looms.
 Bankruptcy-related costs have two components: (1) the probability
of their occurrence and (2) the costs they would produce given tha
t financial distress has arisen
 15-4C TRADE- OFF THEORY
Figure 15.8 Effect of Financial
Leverage on the Value of Bigbee’s
Stock
The preceding arguments led to the
development of what is called “the
trade- off theory of leverage”.
A summary of the tradeoff theory”

Trade- off Theory

The capital structure that states
that firms trade off the tax benefits
of financing against problems
caused by potential bankruptcy.
 15-4d Signaling theory

Symmetric Information Asymmetric Information

The situation in which investors The situation in which managers
and managers have identical inf have different (better) informati
ormation about firms’ prospects on about firms’ prospects than d
205 2016 2017 o investors.
2018 2019
 MM assumed that investors have the same information about a firm’s prospects as its managers —
this is called symmetric information.
 However, in fact man- agers often have better information than outside investors. This is called
asymmetric information, and it has an important effect on the optimal capital structure.
Suppose, for example, that Firm F’s
R&D labs have just discovered a non-
patentable cure for the common cold.
They want to keep the new product a s
ecret as long as possible to delay comp
etitors’ entry into the market. New pla
nts must be built to make the new prod
uct, so capital must be raised. How sh
ould Firm F’s management raise the n
eeded capital? If the firm sells stock,
then, when profits from the new produc
t start flowing in, the price of the stock
would rise sharply, and the purchasers
of the new stock would make a bonanza
. ave information that new orders are off
The current stockholders (including th
e managers) would also do well, but n
ot as well as they would have done if th
e company had not sold stock before the
price increased, because then they wou
ld not have had to share the benefits o
f the new product with the new stockhol
ders. Therefore, one would expect a fir
m with very favorable prospects to try t
o avoid selling stock and, rather, to rais
e any required new capital by other mea
ns, including using debt beyond the nor
mal target capital structure. Now let’s c
onsider Firm U. Suppose its managers h
sharply because a competitor has install
ed new technology that has improved i
ts products’ quality.
Firm U must upgrade its own facilities, at high cost, just to maintain its current sales. As a
result, its return on investment will fall (but not by as much as if it took no action, which
would lead to a 100 percent loss through bankruptcy). How should Firm U raise the needed
capital? Here the situation is just the reverse of that the facing Firm F, which did not want
to sell stock so as to avoid having to share the benefits of future developments. A firm with
unfavorable prospects would want to sell stock, which would mean bringing in new investors.
Therefore, a firm with unfavorable prospects would want to sell stock,
which would mean bringing in new investors to share the losses!

The conclusion from all this is that firms with extremely bright prospect
s prefer not to finance through new stock offerings, whereas firms with
poor prospects do like to finance with outside equity. How should you, as
an investor, react to this conclusion? In a nutshell, the announcement of
a stock offering is generally taken as a signal that the firm’s prospects
as seen by its management are not bright. This, in turn, suggests that
when a firm announces a new stock offering, more often than not, the
price of its stock will decline. Empirical studies have shown that this
situation does indeed exist.
You ought to say, “If I see that a company plans to issue new stock, this should worry me
because I know that management would not want to issue stock if future prospects looked
good. However, management would want to issue stock if things looked bad. Therefore, I
should lower my estimate of the firm’s value, other things held constant, if it plans to issue
new stock. "If you gave the above answer, your views are consistent with those of
sophisticated portfolio managers of institutions such as Morgan Guaranty Trust, Prudential
Insurance, and so forth.
 Signal
An action taken by a firm’s manage
ment that provides clues to investors
about how management views the fir
m’s prospects.
Reserve Borrowing Capacity
The ability to borrow money at a reas
onable cost when good investment o
pportunities arise. Firms often use le
ss debt than specified by the MM opt
imal capital structure in “normal” ti
mes to ensure that they can obtain d
ebt capital later if they need to.

What are the implications of all this for capital structure decisions? Since is- suing stock emits
a negative signal and thus tends to depress the stock price, even if the company’s prospects
are bright, a firm should, in normal times, maintain a reserve borrowing capacity that can
be used in the event that some especially good investment opportunity comes along. This me
ans that firms should, in normal times, use more equity and less debt than is suggested by the
tax benefit/bankruptcy cost trade-off model expressed in Figure 5.8.
15-4e USING DeBT FINANCING
To CONSTRAIN MANAGERS
Firms can reduce excess cash flow in a variety of ways. One
way is to funnel some of it back to shareholders through hi
gher dividends or stock repurchases. Another alternative i
s to shift the capital structure toward more debt in th
e hope that higher debt service requirements will force
managers to become
A leveraged buyout (LBO) - is a good way to reduce excess
cash flow. In an LBO debt is used to finance the purchase o
f a high percentage of the company’s shares.. As noted, hig
h debt payments force managers to conserve cash by eli
minating unnecessary expenditures.
 15-4f Pecking order hypothesis

Firms finance in following order:

Another factor that influence capital struct

ures is the idea that managers have prefer
red, pecking order when it come to raising
capita and that pecking order affects capita
l structure decisions.
 15-4gWindows of opportunity
A Study of Malcolm Baker and Jeffrey Wurgler
documents that many companies take advantage of these windows opportunity, and they argue
that these attempts to time the market have had profound effect on these companies' capital
structures.

If a company’s stock selling for a price di

fferent than its intrinsic value, the comp When a company’s stock is overvalued, its
any’s managers can adjust the firm’s capi managers can take the opportunity to issue
tal structure to take advantage of the new equity at a time when its market value
mispricing. is relatively high.

Windows of Opportunity
The occasion where a company’s managers adjust it’s firm capital structure to take advantage
a certain market situations
Malcolm Baker
Prior to graduate study he was a senior associate at Charles River A
ssociates, and during graduate study he served as a teaching fellow
at Harvard University. He has been on the faculty at the Harvard B
usiness School since earning his PhD in 2000. He was an assistant
professor from 2001 to 2004, associate professor from 2004 to 2
007 and has been a full professor since
As a professor he has written numerous case studies and has been
widely published. He has served as associate editor for the Journal
of Finance and the Review of Financial Studies.[4] During his career
he has been a three-time Brattle Prize nominee and a two-time Smi
th Breeden Prize nominee. In 2002, "Market Timing and Capital St
ructure" (co-authored with Jeffrey Wurgler) was recognized with th
e Brattle Prize by the American Finance Association as the best cor
porate finance research paper published in the Journal of Finance t
hat year.
Jeffrey Wurgler
Jeffrey Wurgler is the Nomura Professor of Finance at New York U
niversity Stern School of Business. His research and teaching inter
ests include corporate finance and behavioral finance.
Before joining Stern in 2001, Professor Wurgler was the Robert B.
and Candice J. Haas Assistant Professor of Corporate Finance at Y
ale School of Management. He has also been a Visiting Fellow at th
e University of Oxford Said Business School.
Professor Wurgler received a Bachelor of Arts and Sciences degree
from Stanford University and a PhD in Business Economics from H
arvard University.
Research Interests: Corporate finance, Capital markets, Asset prici
ng & Behavioral finance
 15-5 checklist for capita structure decision
1. Sales stability
A firm whose sales are relatively stable can safetly take on more debt and incur higher fixed char
ges than a company with a unstable sales.

2. Asset structure
Many companies also take their desired cash holdings into account when their target capital stru
cture.Holding other factors constant, a company is able to take on more debt if it has more cash
on the balance sheet.For this reason, some analayst also evaluate an alternative measure, net deb
t, which subtracts cash and equivalent sequrities from the company’s total debt:

Net debt= short-term debt+Long-term debt – Cash equvalents

3. Operating Leverage
Other things the same, a firm with less operating leverage is better able to employ financial lever
age because it will have less business risk.

4. Growth rate
Other things the same, faster growing firms must rely more heavily on external capital

5. profitability
It is often observed that firms with very high rates of return on investment use relatively little
debt.

6. Taxes
Interest is a deductible expense, and deductions are most valuable to firms with high tax rates.
Therefore, the higher s firm’s tax rate, the greater the advantage of debt.
7. control
The effect od debt versus stock on a management’s control position can influence capital struct
ure.If management currently has voting control (more than 50% of the stock) but is not in a p
osition to buy any more stock, if may choose debt for new financing.

8.Management attitudes
No one can prove that one capital structure will lead to higher stock prices than other.Manage
ment, then, can exercise its own judgement about the proper capital structure.

9. Lender and rating agency attitudes

Regardless of a manager’s analysis of the proper leverage factors for his or her firm, the attitu
des of lenders and rating agencies frequently influence financial structure decision.

10. Market condition

Conditions in the stock and bond markets undergo long-and short-run changes that can have an
important bearing on a firm’s optimal capital structure.
11. The firm’s internal condition
A firm’s own internal condition can also have a bearing on its target capital structure.
 Financial flexibility
An astute corporate treasurer made this statement to the authors:
Our company can earn a lot of money from good capital budgeting and operating decisions that
from good financing decisions. Indeed, we are not sure exactly how financing decision affect our

“
stock price, but we know for sure that having to turn down promising venture because fund are
not available will reduce our long-run profitability.For this reason, my primary goal as treasurer
is to always be in a position to raise the capital needed to support operation:
“
We alsonknoe that when times are good, we can raise capital with either stocks or bonds, but
when time are bad, suppliers of capital are much more willing to make funds availabale if we
give them a stringer position, and this means debt.Further, when we sell a new issue of stock,
this ends a negative “signal” to investors, so stock sales by a mature company such as ours are
not desirable

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Contents
 15-6 variations in capital structure
The times-interested-earned (TIE) ratio gives an indication of how vulnerable the company is to financ
ial distress.T his ratio depends on ‘three factors:
 The percentage of debt
 The interest rate on the debt
 The company’s profitability.
 Thank you
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