Capital structure

Issues:
      

What is capital structure? Why is it important? What are the sources of capital available to a company? What is business risk and financial risk? What are the relative costs of debt and equity? What are the main theories of capital structure? Is there an optimal capital structure?

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 shares (common stock), Preference shares (preferred stock) Hybrids, eg warrants, convertible bonds

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Preference shares Ordinary shares

Fixed Assets

Financial Structure

What is Capital Structure?

Balance Sheet
Current Assets Current Liabilities Debt Preference shares Ordinary shares

Fixed Assets

Capital Structure

Sources of capital
  

Ordinary shares (common stock) Preference shares (preferred stock) Hybrid securities
 

Warrants Convertible bonds Bank loans Corporate bonds

Loan capital
 

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 A high rate of return is required Provide voting rights the power to hire and fire directors No tax benefit, unlike borrowing

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

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) Bank loans or corporate bonds Interest on debt is allowed against tax

Seniority of debt


 

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

Security


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

Indenture


A written agreement between the corporate debt issuer and the lender. Sets forth the terms of the loan:
  

Maturity Interest rate Protective covenants



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

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. If 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. Otherwise, the warrant will simply expire or remain unused.

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.

The Cost of Capital

Expected Return

Risk premium Risk-free rate Time value of money _________________________________________________________ Risk _____ Treasury Corporate Preference Hybrid Ordinary Bonds Bonds Shares Shares Securities

Measuring capital structure



Debt/(Debt + Market Value of Equity) Debt/Total Book Value of Assets Interest coverage: EBITDA/Interest

Selected leverage data for US corporations

Company Debt/Debt +MVE Delta Air 53% Disney 9 GM 61 HP 13 McDon's 15 Safeway 55 Debt/Book Assets 32% 20 37 17 31 53 EBITDA / Interest 1.1 14.1 3.0 21.7 7.2 3.1

Interpreting capital structures



The capital structures we observe are determined both by deliberate choices and by chance events
  

Safeways high leverage came from an LBO HPs low leverage is the HP way Disneys low leverage reflects past good performance GMs high leverage reflects the opposite

Interpreting capital structures



Capital structures can be changed Leverage is reduced by

 

Cutting dividends or issuing stock Reducing costs, especially fixed costs

Leverage increased by
 

Stock repurchases, special dividends, generous wages Using debt rather than retained earnings

Business risk and Financial risk



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

Risk and the Income Statement

Operating Leverage Sales Variable costs Fixed costs EBIT Interest expense Earnings before taxes Taxes Net Income Net Income No. of Shares

Financial Leverage

EPS =

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)

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.

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).

Why should we care about capital structure?



By altering capital structure firms have the opportunity to change their cost of capital and therefore the market value of the firm

What is an optimal capital structure?



An optimal capital structure is one that minimizes the firms cost of capital and thus maximizes firm value Cost of Capital:
 

Each source of financing has a different cost The WACC is the Weighted Average Cost of Capital Capital structure affects the WACC

Features of an Optimal Capital Structure



An optimal capital structure should have the following features:

Profitability: The company should make maximum use of leverage at a minimum cost. Flexibility : The capital structure should be flexible to be able to meet the changing conditions. The company should be able to raise funds whenever the raises and also retire debts whenever it becomes too costly to continue with that particular source. Control: The capital structure should involve minimum dilution of control of the company. Solvency: The use of excessive debt threatens the solvency of the company.

Factors effecting the capital structure

     

Leverage Cost of capital Cash flows projections of the company Size of the company Dilution of control Floatation costs

Process of capital structure decisions

Capital budgeting decision Dynamism of Environment

Need for long term sources of finance Capital structure decision Existing capital structure Debt equity mix Dividend decision

Effect on earnings per share Effect on risks to be borne by investors Effect on cost of capital Optimal capital structure Value of the company

Essentials of a Sound or Optimal Capital Structure

        

Minimum Cost of Capital Minimum Risk Maximum Return Maximum Control Safety Simplicity Flexibility Attractive Rules Commensurate to Legal Requirements

Is there magic in financial leverage?



can a company increase its value simply by altering its capital structure?

yes and no

we will see.

Capital Structure Theory



Basic question


Is it possible for firms to create value by altering their capital structure?

Major theories
     

Modigliani and Miller (M-M) theory Trade-off Theory (Costs & Benefits of Leverage) Signaling Theory Net Income (NI) Theory Net Operating Income (NOI) Theory Traditional Theory

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.

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.

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.

Capital Structure Theories



Major theories
     

Modigliani and Miller (M-M) theory Trade-off Theory (Costs & Benefits of Leverage) Signaling Theory Net Income (NI) Theory Net Operating Income (NOI) Theory Traditional Theory

Net Income (NI) Approach



According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100 per cent debt financing under NI approach.

Cost

ke, ko

ke

kd

ko kd

Debt

Net Operating Income (NOI) Approach



According to NOI approach the value of the firm and the weighted average cost of capital are independent of the firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive the same cash flows regardless of the capital structure and therefore, value of the company is the same.

Cost ke

ko kd

Debt

Traditional Approach


The traditional approach argues that moderate degree of debt can lower the firms overall cost of capital and thereby, increase the firm value. The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity.

Cost ke

ko

kd

Debt

Pecking Order Theory



The announcement of a share issue reduces the share price because investors believe managers are more likely to issue when shares are overpriced. Firms prefer internal finance since funds can be raised without sending adverse signals. If external finance is required, firms issue debt first and equity as a last resort. The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.

Pecking Order Theory

Implications:
  

Internal equity may be better than external equity. Financial slack is valuable. If external capital is required, debt is better.

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

Modigliani and Miller (MM)



  

Most influential papers ever published in finance Very restrictive assumptions First no arbitrage proof in finance Basis for other theories

MM Approach Without Tax: Proposition I



MMs Proposition I states that the firms value is independent of its capital structure. With personal leverage, shareholders can receive exactly the same return, with the same risk, from a levered firm and an unlevered firm. Thus, they will sell shares of the over-priced firm and buy shares of the under-priced firm until the two values equate. This is called arbitrage.

Cost

ko

Debt MM's Proposition I

Arbitrage
Levered Firm (L): Vl ! Sl  Dl ! 60,000  50,000 ! 110,000 kd ! interest rate ! 6%; NOI ! X ! 10,000 E l ! shares held by an investor in L ! 10% Unlevered Firm (U ): Vu ! Su ! 100,000 NOI ! X ! 10,000

Arbitrage
Return from Levered Firm: Investment ! 10% 110, 000  50 , 000 ! 10% 60, 000 ! 6 , 000 Return ! 10% 10, 000  6% v 50, 000 ! 1, 000  300 ! 700 Alternate Strategy: 1. Sell shares in L: 10% v 60,000 ! 6,000 2. Borrow (personal leverage): 10% v 50,000 ! 5,000 3. Buy shares in U : 10% v 100,000 ! 10,000 Return from Alternate Strategy: Investment ! 10,000 Return ! 10% v 10,000 ! 1,000 Less: Interest on personal borrowing ! 6% v 5,000 ! 300 Net return ! 1,000  300 ! 700 Cash available ! 11,000  10,000 ! 1,000

MMs Proposition II


The cost of equity for a levered firm equals the constant overall cost of capital plus a risk premium that equals the spread between the overall cost of capital and the cost of debt multiplied by the firms debt-equity ratio. For financial leverage to be irrelevant, the overall cost of capital must remain constant, regardless of the amount of debt employed. This implies that the cost of equity must rise as financial risk increases.

Cost ke

ko

kd

Debt MM's Proposition II

MM Hypothesis With Corporate Tax



Under current laws in most countries, debt has an important advantage over equity: interest payments on debt are tax deductible, whereas dividend payments and retained earnings are not. Investors in a levered firm receive in the aggregate the unlevered cash flow plus an amount equal to the tax deduction on interest. Capitalizing the first component of cash flow at the allequity rate and the second at the cost of debt shows that the value of the levered firm is equal to the value of the unlevered firm plus the interest tax shield which is tax rate times the debt (if the shield is fully usable). It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield. Also, it ignores bankruptcy and agency costs.

LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES Unlev 0% 0% 0% 0% 2500 0 2500 0 2500 2500 0 0 2500 0 2500 0 0 0 2500 Lev 0% 0% 0% 0% 2500 700 1800 0 1800 1800 0 0 1800 0 1800 700 0 700 2500 0 Unlev 35% 10% 0% 0% 2500 0 2500 875 1625 1477 148 1023 1477 0 1477 0 0 0 1477 Lev 35% 10% 0% 0% 2500 700 1800 630 1170 1064 106 736 1064 0 1064 700 0 700 1764 287

Corp tax Corp tax on div Pers tax on div Pers tax on int PBIT Int PBT Corp tax PAT Div Div tax Tol corp tax Div income Pers tax on div AT div income Int income Pers tax on int AT int income AT total income Net leverage benifit

Millers Approach WITH Corporate and Personal Taxes



To establish an optimum capital structure both corporate and personal taxes paid on operating income should be minimized. The personal tax rate is difficult to determine because of the differing tax status of investors, and that capital gains are only taxed when shares are sold. Merton miller proposed that the original MM proposition I holds in a world with both corporate and personal taxes because he assumes the personal tax rate on equity income is zero. Companies will issue debt up to a point at which the tax bracket of the marginal bondholder just equals the corporate tax rate. At this point, there will be no net tax advantage to companies from issuing additional debt. It is now widely accepted that the effect of personal taxes is to lower the estimate of the interest tax shield.

LEVERAGE BENEFIT UNDER CORPOATE AND PERSONAL TAXES Unlev 0% 0% 0% 0% 2500 0 2500 0 2500 2500 0 0 Lev 0% 0% 0% 0% 2500 700 1800 0 1800 1800 0 0 1800 0 1800 700 0 700 2500 0 Unlev 35% 10% 0% 0% 2500 0 2500 875 1625 1477 148 1023 1477 0 1477 0 0 0 1477 Lev 35% 10% 0% 0% 2500 700 1800 630 1170 1064 106 736 1064 0 1064 700 0 700 1764 287 Unlev 35% 10% 20% 0% 2500 0 2500 875 1625 1477 148 1023 1477 295 1182 0 0 0 1182 Lev 35% 10% 20% 0% 2500 700 1800 630 1170 1064 106 736 1064 213 851.2 700 0 700 1551 370 Unlev 35% 10% 20% 20% 2500 0 2500 875 1625 1477 148 1023 1477 295 1182 0 0 0 1182 Lev Unlev 35% 35% 10% 10% 20% 20% 20% 30% 2500 700 1800 630 1170 1064 106 736 1064 213 851.2 700 140 560 1411 230 2500 0 2500 875 1625 1407 148 1023 1407 281 1126 0 0 0 1126 Lev 35% 10% 20% 30% 2500 700 1800 630 1170 1064 106 736 1064 213 851.2 700 210 490 1341 216

Corp tax Corp tax on div Pers tax on div Pers tax on int PBIT Int PBT Corp tax PAT Div Div tax Tol corp tax

Div income 2500 Pers tax on div 0 AT div income 2500 Int income 0 Pers tax on int 0 AT int income 0 AT total income 2500 Net leverage benifit

Is there magic in financial leverage?



can a company increase its value simply by altering its capital structure?

yes and no

I guess we have already seen it.

Factors Influencing Capital Structure

 

Internal Factors External Factors

Internal Factors
         

Size of Business Nature of Business Regularity and Certainty of Income Assets Structure Age of the Firm Desire to Retain Control Future Plans Operating Ratio Trading on Equity Period and Purpose of Financing

External Factors
        

Capital Market Conditions Nature of Investors Statutory Requirements Taxation Policy Policies of Financial Institutions Cost of Financing Seasonal Variations Economic Fluctuations Nature of Competition

MM Propositions I and II
MM Proposition I : X V ! ko X ko ! V MM Proposition II : X  kd D S ke ! ko  (ko  kd )D/S ke !

MM Hypothesis with Corporate Tax

After-tax earnings of Unlevered Firm: X ! X (1  T ) Value of Unlevered Firm: X (1  T ) ku After-tax earnings of Levered Firm: Vu !
T T

X ! ( X  kd D)(1  T )  kd D ! X (1  T )  Tkd D Value of Levered Firm: Vl ! X (1  T ) T kd D  ku kd

! Vu  TD

Millers Approach with Corporate and Personal Taxes

After-tax earnings of Unlevered Firm: X ! X (1  T )(1  Te ) Value of Unlevered Firm: Vu ! X (1  T )(1  Te ) ku
T

After-tax earnings of Levered Firm: X ! ( X  kd D)(1  T )(1  Te )  kd D(1  Td ) ! X (1  T )(1  Te )  kd D (1  Td )  kd D(1  Td )(1  Te ) Value of Levered Firm: X (1  T )(1  Te ) kd D ?(1  Td )  (1  T )(1  Te )A Vl !  ku (1  Te ) kd (1  Tb ) (1  T )(1  Te ) ! Vu  D 1  (1  Tb )
T

Practical Considerations in Determining Capital Structure

           

Control Widely-held Companies Closely-held Companies Flexibility Loan Covenants Early Repay ability Reserve Capacity Marketability Market Conditions Flotation Costs Capacity of Raising Funds Agency Costs