CAPITAL STRUCTURE

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MAGARET AKINTUNDE

7/19/12

What is Capital Structure?

Definition

The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities
Bonds,

bank loans

Ordinary Hybrids,

shares (common stock), Preference shares (preferred stock) eg warrants, convertible bonds
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Sources of capital
Ordinary

shares (common stock) shares (preferred stock)

Preference Hybrid

securities
bonds

Warrants

Convertible

Loan

capital
loans bonds

Bank

Corporate

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Ordinary shares (common stock)

Risk

finance

Dividends

are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders high rate of return is required voting rights the power to hire and fire directors tax benefit, unlike borrowing
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Provide No

Preference shares (preferred stock)

Lower

risk than ordinary shares and a lower dividend Fixed dividend - payment before ordinary shareholders and in a liquidation situation No voting rights - unless dividend payments are in arrears Cumulative - dividends accrue in the event that the issuer does not make timely dividend payments Participating - an extra dividend is possible Redeemable - company may buy back at a fixed future date
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Loan capital
Financial

instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed) loans or corporate bonds on debt is allowed against tax

Bank

Interest

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Seniority of debt
Seniority Some In

indicates preference in position over other lenders. debt is subordinated. the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.

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Security
Security It

is a form of attachment to the borrowing firms assets. provides that the assets can be sold in event of default to satisfy the debt for which the security is given.

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Indenture
A

written agreement between the corporate debt issuer and the lender. forth the terms of the loan:
rate covenants
Maturity Interest

Sets

Protective

e.g. financial reports, restriction on further loan issues, restriction on disposal of assets and level of dividends

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Warrants
A

warrant is a certificate entitling the holder to buy a specific amount of shares at a specific price (the exercise price) for a given period. the price of the share rises above the warrant's exercise price, then the investor can buy the security at the warrant's exercise price and resell it for a profit. the warrant will simply expire or remain unused.
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If

Otherwise,

Convertible bonds
A

convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period. As bonds, they provide a coupon payment and are legally debt securities, which rank prior to equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer. Their conversion feature also gives them features of equity securities.
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Measuring capital structure

Debt/(Debt

+ Market Value of Equity) Book Value of Assets

Debt/Total

Interest

coverage: EBITDA/Interest

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Interpreting capital structures

Capital

structures can be changed is reduced by

costs, especially fixed costs

Leverage
Cutting Reducing

dividends or issuing stock

Leverage
Stock Using

increased by

repurchases, special dividends, generous wages debt rather than retained earnings
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Business risk and Financial risk

Firms But

have business risk generated by what they do firms adopt additional financial risk when they finance with debt

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Business Risk

The basic risk inherent in the operations of a firm is called business risk Business risk can be viewed as the variability of a firms Earnings Before Interest and Taxes (EBIT) measure is beta (controlling for financial risk)
Demand Sales Input

Standard Factors:

variability

price variability cost variability

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Financial Risk

Debt causes financial risk because it imposes a fixed cost in the form of interest payments. The use of debt financing is referred to as financial leverage. Financial leverage increases risk by increasing the variability of a firms return on equity or the variability of its earnings per share.

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Financial Risk vs. Business Risk

There is a trade-off between financial risk and business risk. A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even. A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).
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What is an optimal capital structure?

An

optimal capital structure is one that minimizes the firms cost of capital and thus maximizes firm value of Capital:
source of financing has a different cost
Each The

Cost

WACC is the Weighted Average Cost of Capital structure affects the WACC

Capital

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Capital Structure Theory

Major

theories
and Miller theory Theory Theory

Modigliani Trade-off Signaling

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Modigliani and Miller (MM)

Basic theory: Modigliani and Miller (MM) in 1958 and 1963 Old - so why do we still study them?
Before MM, no way to analyze debt financing First to study capital structure and WACC together Won the Nobel prize in 1990

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A Basic Capital Structure Theory

Debt versus Equity
A firms cost of debt is always less than its cost of equity
debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible.

It may appear a firm should use as much debt and as little equity as possible due to the cost difference, but this ignores the potential problems associated with debt.
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A Basic Capital Structure Theory

There is a trade-off between the benefits of using debt and the costs of using debt.
The use of debt creates a tax shield benefit from the interest on debt. The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.
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Summary
A firms capital structure is the proportion of a firms long-term funding provided by long-term debt and equity. Capital structure influences a firms cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk. Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.

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THANK YOU

7/19/12