Chapter 18 -- Capital

Structure Decisions

Capital structure decisions when the

participants are well informed:
Managers

can look to the market for clues to

investor response

Capital

structure decisions when there is

asymmetrical information:
Managers

typically use pro-forma analysis to

project the firms ability to use debt and equity
profitably

Capital Structure Decisions

Four Sources of Information
1. Study the markets response to
similar offerings

Compare yourself to others to

find a proxy company that has
recently issued new debt or equity

Capital Structure Decisions

Four Sources of Information
2. Study the markets response to
different capital structures

Look at industry ratios

Balance sheet (stock) ratios such as debt to

total assets
Income statement (flow) ratios such as
times interest earned

Capital Structure Decisions

Four Sources of Information
2. Study the markets response to
different capital structures
From

these ratios, judge the market

response to a change in your firms
capital structure
Must adjust for differing accounting
interpretations

Capital Structure Decisions

Four Sources of Information
3. Seek information from key market
participants
Investment

bankers
Rating agencies
Security analysts
Portfolio managers

Capital Structure Decisions

Four Sources of Information
4. Attempt to judge market disequilibrium
There could be factors unique to the
company, such as an unusual tax
situation
Investment bankers may know what
form of financing the market overall
is favoring

Capital Structure Decisions

Merits

and demerits of
generalizing from other offerings
Your

situation may be unusual

You could get conflicting wealth
and income ratio indications
Market may not be fully informed

Capital Structure Decisions

Earnings
Indicator

volatility risk:

of ability to pay future

obligations from future cash
flows
Example measure is the times
interest earned ratio

Capital Structure Decisions

Liquidation
This

or bankruptcy risk:

is based on your ability to pay

from collateral
Paying from collateral is usually
inferior to paying from future cash
flows
Example measure is the debt to total
asset ratio

Capital Structure Decisions

Income

break-even point and the

financing mix:
Step

1: Create a spreadsheet modeling the

income statement and balance sheet
Step 2: Find break-even level of sales
Step 3: Vary the levels of debt and equity,
then recalculate the break-even level of sales
Based on expected range of sales, choose the
appropriate financing mix

Capital Structure Decisions

Earnings
Step

per share crossover point:

1: Create a spreadsheet modeling the

income statement, balance sheet, and earnings
per share
Step 2: Find the level of sales where the
earnings per share are equal between two
alternative debt-equity mixtures -- crossover
point
Based on expected range of sales, choose the
appropriate financing mix

Capital Structure Decisions

Debt

capacity analysis

Measures

the firms ability to meet its

cash flow obligations with various
amounts of debt
Often run as a worst-case scenario
analysis

Capital Structure Decisions

Debt capacity analysis example

1.
2.
3.
4.

Model recession cash flow with differing

financing
Develop back-up plans to cover periods of
negative cash flows
Choose the maximum debt payment that
can be met in a recession
Select debt (amount, maturity) within
maximum debt payment

Capital Structure Decisions

Tools

used by managers to reduce the

probability of default in times of
negative cash flows.
Liquid

reserves
costly in profitability
External backup credit lines
high out-of-pocket cost in fees

Capital Structure Decisions

Tools

used by managers to improve

cash flows in times of duress.
Reduce

the outflows in a particular period

Often

means lost revenues

Reduction of a dividend, seen as negative
signal
Sale

of assets

Usually

interpreted as a negative signal

based on timing

Capital Structure Decisions

Qualitative Factors
Future

financing needs

Too

much debt might close off future

debt offerings
Nonpublic companies often
overextend and risk either

bankruptcy or a lesser bargaining

position with a venture capitalist

Capital Structure Decisions

Qualitative Factors
Flexibility
Watch

your restrictive covenants -debt issues

Typically debt is more restrictive than
common stock

Capital Structure Decisions

Qualitative Factors
Control
More

shares could mean less control

More debt could mean less flexibility
Hedging
Important
Maturity

in

decisions
Source of funding for international
subsidiaries

Capital Structure
Qualitative Factors
Strategic
You

issues

may not want a weak financing

position in an increasing competitive
environment