Capital Structure

17-1
 Capital Structure
Capital Structure -- The mix (or proportion) of
a firm’s permanent long-term financing
represented by debt, preferred stock, and
common stock equity.

17-2
 The impact of capital structure on
value depends upon the effect of
debt on:
WACC
FCF

17-3
 The Effect of Additional Debt on
WACC
 Debtholders have a prior claim on cash
flows relative to stockholders.
 Firm’s can deduct interest expenses.
 Reduces the taxes paid
 Frees up more cash for payments to
investors
 Reduces after-tax cost of debt

(Continued…)
17-4
 The Effect on WACC (Continued)

 Debt increases risk of bankruptcy

 Adding debt increase percent of firm
financed with low-cost debt (wd) and
decreases percent financed with high-cost
equity (we)
 Net effect on WACC = uncertain.

(Continued…)
17-5
 The Effect of Additional Debt on FCF
 Additional
debt increases the probability
of bankruptcy.
 Direct costs: Legal fees, “fire” sales,
etc.
 Indirect costs: Lost customers,
reduction in productivity of managers
and line workers, reduction in credit
(i.e., accounts payable) offered by
suppliers

(Continued…)
17-6
 What is business risk?
Uncertainty about future pre-tax operating
income (EBIT).
Probability
Low risk

High risk

0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects.
17-7
 Factors That Influence
Business Risk

 Uncertainty about demand (unit sales).

 Uncertainty about output prices.

 Uncertainty about input costs.

 Product and other types of liability.

 Degree of operating leverage (DOL).

17-8
 What is operating leverage,
and how does it affect a firm’s
business risk?
Operating leverage is the change
in EBIT caused by a change in
quantity sold.
The higher the proportion of
fixed costs within a firm’s overall
cost structure, the greater the
operating leverage.
(More...)

17-9
 Business Risk versus
Financial Risk
 Business risk:
 Uncertaintyin future EBIT.
 Depends on business factors such as
competition, operating leverage, etc.
 Financial risk:
 Additional
business risk concentrated on
common stockholders when financial leverage
is used.
 Depends on the amount of debt and preferred
stock financing.

17-10
 How Firms Establish Capital
Structure?
 Most corporations have low debt-asset ratios
 Changes in Financial Leverage affect Firm Value
 There are differences in the Capital Structures of
Different Industries
 Most companies have a target debt ratio
 Target debt ratio is dependent on taxes, types of
assets, uncertainty of operating income, and
pecking order and financial slack.

17-11
 Practice Qs

17-12
 Equity vs Debt Financing (1)

 Sincethe WACC is the weighted average

of cost of equity + cost of debt, we can
vary the WACC by changing the mix of
debt + equity
 Ifcost of debt < cost of equity, we can reduce
WACC by increasing the % of debt in the mix
and vice versa
 Thevalue of the firm (its earning’s
potential) is maximized when its WACC is
minimized.
A firm with a lower cost of capital can more
17-13
easily return profits to its owners
 Debt vs Equity Financing (2):
 The optimal, or target capital structure is
the structure with the lowest possible
WACC
 The Interest Tax Shield (deductibility of
corp. interest) is critical here, because it
effectively lowers the cost of debt.
 Therefore for many firms, the use of
financial leverage (debt financing) can
lower WACC and increase profitability

17-14
 Debt vs. Equity Financing
(3):
 Warning: choice between debt & equity can not
be based on interest rates, etc. alone. Risk must
be considered as well
 Systematic risk consists of two factors which
must be considered
 Business risk—risk inherent in firm’s operations
 Financial risk—risk inherent in using debt financing
 Remember debt is a multiplier:
 it can multiply returns if returns > cost of debt; but
 it can also multiply losses, or returns < cost of debt.

17-15
 Financial Leverage
Considerations:
 If profits are down, dividends (the key cost of
equity financing) can often be deferred.
 Interest (cost of debt) must always be paid for a
firm to remain solvent
 Financial distress costs: costs incurred with
going bankrupt or costs that must be paid to
avoid bankruptcy
 According to the static theory of capital structure,
gains from the tax shield are offset by the greater
potential of financial distress costs.

17-16
 Optimal Capital Structure:
 Optimal capital structure is achieved by finding
the point at which the tax benefit of an extra
dollar of debt = potential cost of financial
distress. This is the point of:
 Optimal amount of debt
 Maximum value of the firm
 Optimal debt to equity ratio
 Minimal cost of WACC
 This will obviously vary from firm to firm and
takes some effort to evaluate. No single equation
can guarantee profitability or even survival

17-17
 Critical considerations:
 Firms with greater risk of financial distress must
borrow less
 The greater volatility in EBIT, the less a firm
should borrow (magnify risk of losses)
 Costs of financial distress can be minimized the
more easily firm assets can be liquidated to cover
obligations
 A firm with more liquid assets may therefore have
less financial risk in borrowing
 A firm with more proprietary assets (unique to the
firm, hard to liquidate) should minimize
17-18 borrowing