CAPITAL

STRUCTURE
ANALYSIS
Chapter 14
CHAPTER 14 OBJECTIVES
 Describe the advantages and disadvantages
of financial leverage.
 Compute the financial leverage index, debt to
capital ratio, debt to equity ratio, and other
techniques for analyzing capital structure.
 Relate capital structure composition to owner
and creditor investment objectives.
CHAPTER 14 OBJECTIVES
(CONT.)
 Discuss the various types of risks
and their role in capital structure
analysis.
 Present a preliminary capital
structure analysis for a company
or industry.
OBJECTIVE FOR ANALYZING CAPITAL
STRUCTURE

 To determine if the proportion of

debt to equity enables an entity to
create wealth without unduly
jeopardizing the firm
OBJECTIVE FOR ANALYZING CAPITAL
STRUCTURE (CONT.)

 Capital structure composition

 Consists of long-term liabilities, preferred stock,
common stock, and retained earnings.
 Sufficient equity must exist to provide financial
stability
 Debt can be used as leverage to increase returns
to shareholders, but it can also reduce returns on
shareholders’ investments
FINANCING ACTIVITIES
 The balance sheet
 Reports how funds are acquired and allocated
 Current assets are financed with current
obligations—not a factor in capital structure
analysis
 Long-term debt and equity finance long-term
assets—assessing the pros and cons of these
financing factors is the essence of capital
structure analysis
FINANCING ACTIVITIES
(CONT.)
 Capital structure valuation
 Long-term liabilities are reported at the present value
of expected cash flows
 Current liabilities are not adjusted for the time value
of money
 Contributed capital is reported at the historical
proceeds received from selling stock
 Retained earnings are reported as a summary of all of
the valuation methods used to measure income
FINANCING ACTIVITIES
(CONT.)
 Equity
investments are an entity’s
permanent financing, representing
 The ultimate risk capital
 Insulation of the firm from random
business shocks
 A margin of safety to debt investors
 The right to a return on investment only
after the other claimants have been
satisfied
FINANCING ACTIVITIES
(CONT.)
 Long-term debt investments represent
 Fixed contractual obligations
 Payable at specific times in specified amounts
 Returns on investment that are tax deductible
 Short-term debt obligations
 Arise from the normal course of business operations
 Are liquidated with cash from current assets
 Excluded from capital structure analysis
FINANCIAL LEVERAGE
 The substitution of fixed-charge financing for
variable-cost (dividend) equity financing
 Financial leverage concepts
 The traditional view is that an optimal mix of debt and
equity exists
 Research demonstrated that the mix of debt and equity
is irrelevant, if taxes are ignored
 The tax deductibility of interest expense creates an
advantage for incurring debt (Exhibit 14-1)
FINANCIAL LEVERAGE
(CONT.)
 Theadvantage of debt only exists
up to a point (Exhibits 14-2A and
14-2B)
 Low cost debt increases ROE relative
to ROA
 Debt can become so costly that it
reduces ROE below ROA
FINANCIAL LEVERAGE
(CONT.)
 The financial structure leverage ratio
 Is computed as: average total assets /
average common shareholders’ equity
 Produces a ratio of greater than one, which
implies debt is always advantageous (so long
as a positive profit margin exists)
FINANCIAL LEVERAGE
(CONT.)
 Financial leverage index
 Is computed as adjusted return on equity / adjusted return
on assets
 Superior to the financial structure leverage ratio because it
factors in the adjusted rates of return in the computation
 An index in excess of one means ROE exceeds ROA; a
favorable use of debt financing
 An index of less than one is bad; ROA exceeds ROE; an
unfavorable use of debt financing
RISK ANALYSIS
 Risk is the possibility of losing
something of value
 Credit risk
 The possibility that an entity will not be
able to meet debt payment obligations
on time
RISK ANALYSIS (CONT.)
 Capital structure influences credit
risk
 A firm with a conservative capital
structure is a low credit risk
because it has
 small amount of debt
 low fixed cost commitments

 a low default probability

RISK ANALYSIS (CONT.)
 Business risk
 Fluctuations in earnings and cash flow,
due to
 Changes in the economy
 Industry-specific conditions

 A high degree of leverage—leveraged firms

have greater exposure to business risk than
conservatively structured entities
RISK ANALYSIS (CONT.)
 Bankruptcy risk
 Extreme case of credit risk, whereby a
firm may be unable to continue as a
going concern
 Financial distress, or the difficulty in
meeting maturing obligations, is the first
sign of bankruptcy risk
 A company in financial distress might file
for bankruptcy protection
RISK ANALYSIS (CONT.)
 A bankrupt firm
 Losses autonomy in conducting its operations
 Has a court suspend its creditors’ claims
 Can have its debts rearranged, reduced, or
eliminated with the mutual consent of the
company, creditors, and court
 Will liquidate, or go out of business, if
continuing operations is not a viable option
 
RISK ANALYSIS (CONT.)
 Comprehensive risk
 The equity market’s determination
of risk
 Is a function of systematic risk
 Is inherent in investing

 Cannot be eliminated through

investment diversity
RISK ANALYSIS (CONT.)
 Beta measures of systematic risk
 Is the extent to which a stock moves
with the overall market
 In a range from –1.0 to +1.0

 With an interpretation that he higher

the beta, the greater a stock’s
variability
CAPITAL STRUCTURE
MEASURES
 Capitalstructure composition
 Financing activities should
correspond to investing activities
 Short-term creditors finance current
assets
 Long-term investors finance long-term
assets
CAPITAL STRUCTURE
MEASURES (CONT.)
 Lack of correspondence signals financial
distress
 Long-term borrowing cannot be used to finance
operations indefinitely
 Cash from operations should satisfy working capital
operations
 Common size statements
 Provide insights between current and long-term
financing sources and investments
 Must be considered in conjunction with life cycle
stage
DEBT TO CAPITAL RATIOS
 Provide insight about the proportion of
debt to equity financing
 Total debt to total capital
 Measures the percentage of assets financed
with debt
 Is computed as: average total debt /
average total assets
DEBT TO CAPITAL RATIOS
(CONT.)
 Total debt to total equity
 Measures debt financing as a
percentage of total financing
 Is computed as: average total debt /
average total shareholders’ equity
DEBT TO CAPITAL RATIOS
(CONT.)
 Long-term debt to total capital
 Measures the percentage of assets
financed with long-term debt
 Eliminates current obligations from
the ratio because they are paid with
maturing current assets
 Is computed as: average long-term
debt / average total assets
DEBT TO CAPITAL RATIOS
(CONT.)
 Total long-term debt to total equity
 Measures long-term debt financing as a
percentage of total financing
 Eliminates current obligations from the
ratio because they are paid with
maturing current assets
 Is computed as: average long-term
debt / average total shareholders’ equity
DEBT TO CAPITAL RATIOS
(CONT.)
 Earnings coverage ratio
 Measures the extent to which an entity can meet its fixed
charges
 Is known as the times interest earned ratio, which is a
simplified version of earnings coverage
 Times interest earned is computed as: operating income
before interest and taxes / interest expense
 It is acceptable substitute for earnings coverage so long
as accrual numbers approximate required cash payments
for fixed changes
DEBT TO CAPITAL RATIOS
(CONT.)
 Bankruptcy prediction
 Mathematical models that provide information about an entity’s
bankruptcy probability
 The Z-score is an accepted measure of bankruptcy prediction
 Computed as a function of five weighted ratios
 Z-scores above 3.0 indicate little probability of bankruptcy
 Those below 1.81 indicate a high possibility of bankruptcy
 Scores between 1.81 and 3.0 are inconclusive
eSTUFF’S CAPITAL
STRUCTURE RATIOS
C a p i t a l S tr u c t u r e R a t i o s 2003 2002 2001
D e b t t o c a p it a l 0 .3 5 0 .3 7 0 .3 9
D e b t t o e q u it y 0 .5 3 0 .5 8 0 .6 3
L o n g -t e r m d e b t t o c a p it a l 0 .1 9 0 .2 5 0 .2 1
L o n g -t e r m d e b t t o e q u it y 0 .2 9 0 .4 0 0 .3 4
E a rn in g s c o ve ra g e 0 .2 5 2 .9 5 2 .7 5
W o rk in g c a p it a l/ t o t a l a s s e t s - Z 1 0 .6 7 0 .6 1 0 .3 8
R e t a in e d e a r n in g s / t o t a l a s s e t s -Z 2 0 .1 0 0 .0 9 0 .0 6
E B IT / t o t a l a s s e t s -Z 3 0 .0 2 0 .2 2 0 .2 2
R e ve n u e s / t o t a l a s s e t s - Z 4 1 .5 2 1 .4 2 1 .4 9
M a r k e t e q u it y / b o o k lia b ilit ie s - Z 5 0 .2 8 1 .2 9 1 .8 8
T o t a l Z -s c o re 2 .5 9 3 .6 3 4 .0 3
CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY

 New economy capital structure

 Venture capital and retained
earnings financed PC firms’
productive resources
 Little long-term debt
CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY (CONT.)

 Capital structure measures

 Apple and Dell carried more debt than Compaq
or Gateway during the period analyzed (Exhibit
14-7A)
 Dell used debt to increase its returns on equity
 Apple acquired debt (and preferred stock) to
bolster its insufficient cash from earnings and
replenish its depleted equity base, which was
reduced by its net losses
 PC Industry
Debt as a Percentage of Equity

250%

200%
Debt/Equity

150%

100%

50%

0%
1994 1995 1996 1997 1998

Apple Compaq Dell Gateway

 PC Industry
Financial Leverage Indexes
(cumulative 1994-1998)

2
Financial Leverage Index

0
Apple Compaq Dell Gateway
-1

-2

-3
CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY (CONT.)

 Long-term debt provided an

relatively small amount of financing
for all four firms (Exhibit 14-7B)
 Debt as a proportion of total assets
and equity was relatively stable
during the period examined
(Exhibits 14-8A and 14-8B)
 PCIndustry
Long-TermDebt asa Percentage of Total Assets

Apple Compaq
Long-
Long- Term
Term Debt
Debt 3%
12%

Current Current
Debt & Debt &
Equity Equity
88% 97%

Dell Gateway

Long- Long-
Term Term
Debt Debt
4% 8%

Current Current
Debt & Debt &
Equity Equity
96% 92%