CAPITAL STRUCTURE

Capital structure refers to the amount of debt and/or equity employed by a

firm to fund its operations and finance its assets. A firm’s capital structure is
typically expressed as a debt-to-equity or debt-to-capital ratio.
Debt and equity capital are used to fund a business’s operations, capital
expenditures, acquisitions, and other investments. There are tradeoffs firms
need to make when they decide whether to use debt or equity to finance
operations, and managers will balance the two to find the optimal capital
structure.
The optimal capital structure of a firm is often defined as the proportion
of debt and equity that results in the lowest weighted average cost of
capital (WACC) for the firm. It is a structure that would maximize its stock
price. This technical definition is not always used in practice, and firms
often have a strategic or philosophical view of what the ideal structure
should be.
The Central Issue
The study of capital structure revolves around a central question:  Can the
use of debt (leverage) increase the value of a firm’s equity? Stated slightly
differently: Can it increase stock price? We need to be sure we understand
exactly what this question means.
 To illustrate, think about a firm with $1 million in equity capital and no debt.
Then suppose it borrows $.25 million, buys up a quarter of its own stock,
and retires the shares. In effect, it has traded a quarter of its equity for debt.
The procedure is called a capital restructuring. Intuitively, the process
should not affect the price of the shares still outstanding.
Three-quarters of the original shares now represent three-quarters of the
former equity, so nothing should have changed on a per-share basis. But in
fact, adding financial leverage in the manner we have just described often
increases the price of the remaining shares and the value of the firm.
However, the effect is not consistent, and there are circumstances under
which adding leverage decreases stock price and a firm’s value.
In other words, there is a relationship between capital structure and stock
price, but it’s neither precise nor totally understood. A study in the field
attempts to explain the nature of the relationship and predict when
additional financial leverage will increase or decrease price and value. In
particular, we want to discover whether there’s an optimal capital structure
that maximizes stock price, all other things held constant.
There are four primary factors that influence capital structure decisions:

1. Business risk, or the riskiness inherent in the firm’s operations if it

used no debt. The greater the firm’s business risk, the lower its optimal
debt ratio.
2. The firm’s tax position. A major reason for using debt is that interest
is tax-deductible, which lowers the effective cost of debt. However, if
most of a firm’s income is already sheltered from taxes by depreciation
tax shields or interest on currently outstanding debt or tax loss
carryforwards, its tax rate will be low. In this case, additional debt would
not be as advantageous as it would be to a firm with a higher effective
tax rate.
3. Financial flexibility, or the ability to raise capital on reasonable
terms even under adverse market conditions. Corporate treasurers
know that a steady supply of capital is necessary for stable operations,
which is vital for long-run success. They also know that when money is
tight in the economy or when a firm is experiencing operating difficulties,
it is easier to raise debt than equity capital and lenders are more willing
to accommodate companies with strong balance sheets. Therefore, the
firm’s potential future need for funds and the consequences of a funds
shortage combine to influence its target capital structure—the greater
the probability that capital will be needed and the worse the
consequences of not being able to obtain it, the less debt the firm should
have on its balance sheet.
4. Managerial conservatism or aggressiveness. Some managers are
more aggressive than others; hence, they are more willing to use debt in
an effort to boost profits. This factor does not affect the true optimal, or
value-maximizing, capital structure; but it does influence the firm’s target
capital structure.

Synthesis: 
This topic discussed a firm's capital structure, which is typically expressed
as a debt-to-equity or debt-to-capital ratio. Debt and equity capital are used
to fund a business’s operations, capital expenditures, acquisitions, and
other investments. The optimal capital structure of a firm is often defined as
the proportion of debt and equity that results in the lowest weighted
average cost of capital (WACC) for the firm. There are four primary factors
that influence capital structure decisions, such as, business risk, firm's tax
position, financial flexibility, and managerial conservatism, or
aggressiveness.

BUSINESS AND FINANCIAL RISK

Before going on our discussion, let us review first the meaning of the
following terms: Measures of Performance

 EBIT - earnings before interest and taxes, is also called “operating

income.” It is the
 lowest line on the income statement that is independent of financing.
In other words, because EBIT is above interest expense, it is unaffected
by whether the firm is leveraged or not.
 ROE – Return on equity
 EPS - earnings per share
 EAT - earnings after-tax, the bottom line of the income statement
(also called “net income”).

ROE and EPS are overall measures of business performance in that

they include both the results of operations and the effects of
financing. Both measures are important to investors when they consider
buying a company’s stock, but EPS is especially significant. It is usually
taken as an indication of the future earning power of the firm and is
therefore a major determinant of the stock’s market price.
We are used to thinking of risk in finance as a variation in the return on
investment. In this discussion, we will narrow our focus and think of risk as
variation in financial performance measured by the variation in ROE and
EPS. This notion is separable into two pieces, business risk, and financial
risk.
Business Risk
Business risk is variation in a firm’s operating performance as measured by
EBIT. It arises from variations in revenues, costs, and expenses. Hence,
business risk is defined as a variation in EBIT itself.
Financial Risk
In an unleveraged firm (one with no debt), the variation in ROE and EPS is
identical to the variation in EBIT. In a leveraged firm, the variation in ROE
and EPS is always greater than the variation in EBIT. Further, the more
leverage the firm uses, the larger is the incremental variation. This leads to
the definition of financial risk as an additional variation in ROE and EPS
that arises as a result of using financial leverage (debt).
The idea is illustrated in Figure 14.1. The left column shows that business
operations produce EBIT, to which we add financing to produce ROE and
EPS. In other words, EBIT measures operations, but ROE and EPS
measure overall performance, which is a combination of operations and
financing.
The second and third columns show the sources of variation in the
measures and how that variation is defined as risk. It is important to notice
that business risk flows down into ROE and EPS by itself. Financial risk is
added only if there is debt financing.

Lasher, W. (2014). Practical Financial Management. (7th edition). Singapore: Cengage

Learning. p. 552
Financial leverage is associated with and indeed causes financial risk. We
have also defined business risk as to the variation in EBIT. It turns out
there is another type of leverage, which has an influence on the business
risk that’s similar to the influence financial leverage has on financial risk.
This concept is called operating leverage.
Operating leverage is related to a company’s cost structure rather than to
its capital structure. Cost structure describes the relative amounts of fixed
and variable costs in productive and administrative processes. When the
term “leverage” is used by itself, it generally refers to financial leverage,
which is the more important concept.
Operating Leverage
The concept of operating leverage deals with costs rather than capital, but
the functions and effects that are similar to those of financial leverage. 
Operating leverage refers to the amount of fixed cost in the cost structure.
If a firm’s costs are largely fixed, it has a great deal of operating leverage.
 Breakeven Analysis
Breakeven analysis is widely used to determine the level of activity a firm
must achieve to stay in business in the long run. The technique explicitly
lays out the effect of sales volume on a firm’s use of fixed and variable
costs. In doing that it provides an excellent insight into the nature and effect
of operating leverage.
The term “breakeven” means zero profit or loss, generally measured at
EBIT (operating income). At breakeven, income (revenue) exactly equals
outgo (costs and expenses) and the firm just survives. Breakeven analysis
is a way of looking at operations to determine the volume, in either units or
dollars, a company must sell to achieve this zero-profit, zero-loss situation.
Break-even analysis gives us an excellent approach to understanding
exactly how operating leverage works.

T 2.1. Calculating Break Even

Sales Level
EBIT is revenue minus cost, which can be expressed in terms of price and
quantity as
(Equation 1)             EBIT = PQ - VQ - Fc
                                       where:
                                       P = price per unit,
                                      V = variable cost per unit,
                                     Q = quantity sold, and
                                     Fc = total fixed cost.
Notice in this equation that P and V are multiplied by Q to represent
revenue (PQ) and total variable cost (VQ), but the fixed cost is represented
by a single variable, Fc. EBIT is revenue minus both cost components,
variable, and fixed.
Breakeven occurs where revenue (PQ) equals total cost (VQ + Fc); hence,
EBIT = 0.
To find that point, rewrite the equation above with EBIT = 0.
                                    0 = PQ - VQ - Fc
Then factor out Q, rearrange terms, and solve for the breakeven value of
Q, which we have called QB/E
(Equation 2)             Q(P - V) - Fc = 0

                                         QB/E =  F c P − V
Notice that the breakeven volume is found by dividing fixed cost by (P - V),
which is the contribution per unit sold. In words, the breakeven
calculation tells how many units have to be sold to contribute enough
money to cover (pay for) fixed costs.
The breakeven point stated in terms of dollar sales rather than units is
equation 2 multiplied by price, P. If we call SB/E the breakeven dollar sales
level, we have

(Equation 3)                 SB/E =  P ( F c ) P − V

Dividing the numerator and denominator of equation 3 by P and
substituting from CM equation gives a useful expression.
Equation 4                SB/E =  =    F c ( P − V ) P = F c C m
Equation 4 says that the breakeven sales level is just fixed cost, Fc, divided
by the contribution margin, CM (stated in decimal form).
 

Practice Exercise:
#1 Suppose a company can make a unit of product for $7 in variable labor
and materials and sell it for $10. A. What are the contribution and
contribution margin?

1. What is the breakeven sales level in units and dollars for the
company if the firm has fixed costs of $1,800 per month?

#2 Suppose the low leverage firm in Figure 14.6a has fixed costs of $1,000
per period, sells its product for $10, and has variable costs of $8 per unit.
Further, suppose that the high leverage firm in Figure 14.6b has fixed costs
of $1,500 and also sells the product for $10 a unit.

Lasher, W. (2008). Practical Financial Management (11th Edition). Mason, OH:

Thompson South-Western. p. 572

The diagram shows the breakeven volumes for the two firms to be the
same. What variable cost per unit must the high leverage firm have if it is to
achieve the same breakeven point as the low leverage firm? State the
trade-off at the breakeven point. Which structure is preferred if there’s a
choice?

DETERMINING THE OPTIMAL CAPITAL

STRUCTURE
The optimal capital structure is the one that maximizes the price of the
firm’s stock, and this generally calls for a debt ratio that is lower than the
one that maximizes expected EPS (earnings per share).
We know that stock prices are positively related to expected earnings but
negatively related to higher risk. Therefore, to the extent that higher debt
levels raise expected EPS, leverage works to increase the stock price.
However, higher debt levels also increase the firm’s risk, which raises the
cost of equity and works to reduce the stock price. So even though
increasing the debt ratio from 40% to 50% raises EPS, in our example, the
higher EPS is more than offset by the corresponding increase in risk.
WACC and the Capital Structure Changes
Managers should set as the target capital structure the debt-equity mix that
maximizes the firm’s stock price. However, it is difficult to estimate how a
given change in the capital structure will affect the stock price. As it turns
out, the capital structure that maximizes the stock price also
minimizes the WACC, and at times, it is easier to predict how a capital
structure change will affect the WACC than the stock price. Therefore,
many managers use the estimated relationship between capital structure
and the WACC to guide their capital structure decisions. When a firm uses
no preferred stock, the WACC is found as follows:
With No Preferred Stock

In this expression, D/A and E/A represent the debt-to-assets and equity-to-
assets ratios, respectively, and they must sum to 1.0. An increase in the
debt ratio increases the costs of both debt and equity. Bondholders
recognize that if a firm has a higher debt ratio, this increases the risk of
financial distress, which leads to higher interest rates.
 With Preferred Stock

 
The Weighted Average Calculation – The WACC
A firm’s overall cost of capital is just the average of the costs of its separate
sources (debt or equity) weighted by the proportion of each source used.
The separate sources are the capital components we have been talking
about, and the proportions are the percentages of each component in the
firm’s capital structure.
The procedure has led to the term weighted average cost of capital,
abbreviated WACC. The expression has exactly the same meaning as the
simpler “cost of capital” we’ve been using until now. It’s customary to use
the expression WACC in discussions of the subject, because it avoids
confusion with the cost of capital for an individual component.
The Hamada Equation
Hamada’s Equation falls under the corporate finance umbrella. It is used to
differentiate a levered company’s financial risk from its business risk. It
combines two theorems: the Modigliani-Miller Theorem and the Capital
Asset Pricing Model (CAPM). Hamada’s equation is structured in a way
that helps determine, first, a company’s levered beta, and thus, how
best to structure its capital.
The equation gets its name from Robert Hamada, former dean of the
University of Chicago Booth School of Business. He received his B.A. in
Chemical Engineering from Yale University and his Ph.D. in Finance from
the MIT Sloan School of Management.
Hamada’s Equation is a hybrid of the Modigliani-Miller and Capital Asset
Pricing Model theorems. It is used to help understand how a company’s
cost of capital will be affected when leverage is applied. Higher beta
coefficients mean riskier companies.
Why Is Hamada’s Equation Useful?
Hamada’s equation is useful because it is an in-depth analysis of a
company’s cost of capital, showing how additional aspects of financial
leverage relate to the overall riskiness of the business.

Where:
                                BL = levered beta
                                BU = Unlevered beta
                                T    = Tax rate
                                D/E = Debt to equity ratio
 

Synthesis:
This topic discussed the optimal capital structure as the one that maximizes
the price of the firm’s stock, and this generally calls for a debt ratio that is
lower than the one that maximizes expected EPS. It also discussed that the
capital structure that maximizes the stock price also minimizes the WACC,
and at times, it is easier to predict how a capital structure change will affect
the WACC than the stock price. Many managers use the estimated
relationship between capital structure and the WACC to guide their capital
structure decisions.

CHECKLIST FOR CAPITAL STRUCTURE

In addition to the types of analysis discussed previously, firms generally
consider the following factors when making capital structure decisions:

1. Sales stability. A firm whose sales are relatively stable can safely
take on more debt and incur higher fixed charges than a company with
unstable sales. Utility companies, because of their stable demand, have
historically been able to use more financial leverage than industrial firms
can
2. Asset structure. Firms whose assets are suitable as security for
loans tend to use debt relatively heavily. General-purpose assets that
can be used by many businesses make good collateral, whereas
special-purpose assets do not. Thus, real estate companies are usually
 highly leveraged, whereas companies involved in technological research
are not.
3. Operating leverage. Other things the same, a firm with less
operating leverage is better able to employ financial leverage because it
will have less business risk.
4. Growth rate. Other things the same, faster-growing firms must rely
more heavily on external capital. Further, the flotation cost involved in
selling common stock exceeds that incurred when selling debt, which
encourages rapidly growing firms to rely more heavily on debt. At the
same time, however, those firms often face higher uncertainty, which
tends to reduce their willingness to use debt.
5. Profitability. It is often observed that firms with very high rates of
return on investment use relatively little debt. Although there is no
theoretical justification for this fact, one practical explanation is that very
profitable firms such as Intel, Microsoft, and Google do not need to do
much debt financing. Their high rates of return enable them to do most
of their financing with internally generated funds.
6. Interest is a deductible expense, and deductions are most valuable
to firms with high tax rates. Therefore, the higher a firm’s tax rate, the
greater the advantage of debt.
7. The effect of debt versus stock on a management’s control
position can influence capital structure. If management currently has
voting control (more than 50% of the stock) but is not in a position to buy
any more stock, it may choose debt for new financings. On the other
hand, management may decide to use equity if the firm’s financial
situation is so weak that the use of debt might subject it to serious risk of
default. The reason? If the firm goes into default, managers will probably
lose their jobs. However, if too little debt is used, management runs the
risk of a takeover. Thus, control considerations can lead to the use of
debt or equity because the type of capital that best protects
management varies from situation to situation. In any event, if
management is at all insecure, it will consider the control situation.
8. Management attitudes. No one can prove that one capital structure
will lead to higher stock prices than another. Management, then, can
exercise its own judgment about the proper capital structure. Some
managers tend to be relatively conservative and thus use less debt than
an average firm in the industry, whereas aggressive managers use a
relatively high percentage of debt in their quest for higher profits.
9. Lender and rating agency attitudes. Regardless of a manager’s
analysis of the proper leverage factors for his or her firm, the attitudes of
 lenders and rating agencies frequently influence financial structure
decisions. Corporations often discuss their capital structures with
lenders and rating agencies and give much weight to their advice. For
example, Moody’s and Standard & Poor’s recently told one large utility
that its bonds would be downgraded if it issued more bonds. This
influenced its decision, and its next financing was with common equity.
10. Market conditions. Conditions in the stock and bond markets
undergo long and short-run changes that can have an important bearing
on a firm’s optimal capital structure. For example, during a recent credit
crunch, the junk bond market dried up and there simply was no market
at a “reasonable” interest rate for any new long-term bonds rated below
BBB. Therefore, low-rated companies in need of capital were forced to
go to the stock market or to the short-term debt market, regardless of
their target capital structures. When conditions eased, however, these
companies sold long-term bonds to get their capital structures back on
target.
11. The firm’s internal condition. A firm’s own internal condition can
also have a bearing on its target capital structure. For example, suppose
a firm just successfully completed an R&D program, and it forecasts
higher earnings in the immediate future. However, the new earnings are
not yet anticipated by investors and hence are not reflected in the stock
price. This company would not want to issue stock—it would prefer to
finance with debt until the higher earnings materialize and are reflected
in the stock price. Then it could sell an issue of common stock, use the
proceeds to retire the debt, and return to its target capital structure. This
point was discussed earlier in connection with asymmetric information
and signaling.
12. Financial flexibility. From an operational viewpoint, means
maintaining adequate “reserve borrowing capacity.” Determining the
“adequate” reserve is judgmental, but it clearly depends on the firm’s
forecasted need for funds, predicted capital market conditions,
management’s confidence in its forecasts, and the consequences of a
capital shortage.