CAPITAL STRUCTURE

AND DIVIDEND POLICY

o Capital Structure and leverage
1. The target capital structure
2. Business risk and financial risk
3. Determine the optimal capital structure
4. Capital structure theory
5. Checklists for capital structure decisions
6. Variations in capital structure
o Distributions to shareholders: dividends and share
repurchases
 CAPITAL STRUCTURE
AND LEVERAGE
Reporter:
Montaño, Queencyfaith C.
Avenido, Restituto E.
Tomampos, Ellah Jessah G.
CAPITAL STRUCTURE AND
LEVERAGE
– Identify the trade-offs that firms must consider when they
determine their target capital structure.
– Distinguish between business risk and financial risk and explain
the effects that debt financing has on the firms expected return
and risk.
– Discuss the analytical framework used when determining the
optimal capital structure.
– Discuss capital structure theory and use it to explain why firms in
different industries to have different capital structures.
oWhat is a capital ?
oWhat is a capital
structure?
Capital – defined as the
financial resources needed to
finance a company’s fixed and
operating assets and financial
instruments.
Capital structure- the
combination of the debt and
equity a company uses to
finance its long-term operations
and growth.
Primary form of capital:
1. Debt- comes in the form of bond issues or
long-term notes payable.
2. Equity- classified as common stock,
preferred stock, or retained earnings.
Debt financing:
 2 important advantage of debt financing:
1.The interest paid is tax deductible whereas dividends paid on
stock are not deductible, which lowers debt relative cost.
2.The return on debt is fixed, so stockholders do not have to
share the firm’s profits if the firm turns out to be extremely
successful.
 Disadvantage of debt financing
1.Increases the firm’s risk
2. Bankruptcy
 The Target Capital Structure
TARGET CAPITAL STRUCTURE- the mix of debt, preferred stock and common equity the
firm wants to have.
OPTIMAL CAPITAL STRUCTURE- the capital structure that maximize a firms stock price.

o Setting the capital structure involves a trade-off between risk and return:
1. Using more debt will raise the risk borne by stockholder.
2. However, using more debt generally increase the expected return on equity.

 The higher risk associated with using more debt tends to lower the stock price, but
the higher debt-induced expected rate of return raises it . Therefore, we seek to find
the capital structure that raises a balance risk and return so as to maximize the
stock price.
Four primary factors influence
capital structure:

1. Business risk. The riskiness inherent in the firm’s

operations if it used no debt.
2. The Firm’s tax position.
3. Financial flexibility. Ability to raise capital on
reasonable terms even under adverse market
conditions.
4. Managerial conservatism or aggressiveness.
2 New dimensions of risk:
1. BUSINESS RISK
2. FINANCIAL RISK

o Business risk- the riskiness inherent in the

firm’s operations if it used no debt.
Determinants of Business risk:
1. Demand variability. The more stable the demand for a firm’s products, other
things held constant, the lower its business risk.
2. Sales variability. Firms whose products are sold in highly volatile markets are
exposed to more business risk than similar firms whose output prices are more
stable.
3. Input cost variability. Firms whose input costs are highly uncertain are exposed
to a high degree of business risk.
4. Ability to adjust output prices for changes in input costs. Some firms are better
5. Ability to develop new products in a timely, costs-effective manner.
6. Foreign risk exposure.
7. The extent to which costs are fixed.
 Operating leverage
Operating leverage- the extent to which fixed costs are used in a firm’s operations. (figure 14-2)
Operating breakeven- can calculate when the EBIT is = to 0

Formula of BREAKEVEN QUANTITY:

WHEREAS;
P – average sales price per unit of output
Q- units of output
V- variable cost per unit
F- fixed operating costs
Calculating
breakeven
quantity:
Calculating breakeven quantity:
Financial risk
o Financial risk – an increase in stockholder’s risk,
over and above the firm’s basic business risk,
resulting from the use of financial leverage.
o Financial leverage- the extent to which fixed-
income securities (debt and preferred stock) are
used in a firm’s capital structure.
Thank you 