Capital

Capital Structure
Structure

7-1
 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.

7-2
 The impact of capital structure on
value depends upon the effect of
debt on:
WACC
FCF

7-3
 The Effect of Additional Debt on
WACC
 Debt holders 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…)
7-4
 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…)
7-5
 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…)
7-6
 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.
7-7
 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).

7-8
 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...)

7-9
 Business Risk versus
Financial Risk
 Business risk:
 Uncertainty in 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.

7-10
 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.

7-11
 Methods

 Traditional
 Modigliani and Miller (MM) or Modern
Method

7-12
 Practice Qs
ABC Company is evaluation a number of possible capital
structure for their new project. Currently the company is
earning USD 300,000 per annum before paying interest and
Taxes. Their Finance Dept jot down following details:

Option Debt Cost of Debt Cost of Equity

$ ki ke
1 300,000 10% 12.00%
2 400,000 10% 12.50%
3 500,000 11% 13.50%
4 600,000 12% 15.00%
5 700,000 14% 18.00%

Required:
Determine the best capital structure from the above option
7-13
 Practice Qs
ABC Company currently earning USD 400,000 per annum
before paying interest and Taxes. Firm is currently indebted
and total outstanding is USD 1.5 million @ 10% per annum
while the cost of Equity is 16% per annum.
Required: a) Determine current value of firm and
capitalization rate.
b) Calculate leverage ratios.
c) The firm is considering to reduce its leverage by selling
share of $500,000 in order to redeem debt of 500,000. The Co
is anticipated that cost of debt will be unaffected while the
cost of capital will be reduced up to 14% per annum. Will you
recommend this proposal.

7-14
 Practice Qs
ABC is currently finance through Equity with current Market
value of Rs 1.6m with equity capitalization rate of 12.5%. The
company is planning for expansion which will require
investment of Rs 500,000. Their finance Dept is suggesting to
get the debt facility to finance their requirements. They have
prepared the following options. Tax rate is 50% per annum.
Option Debt Cost of Debt Cost of Equity
$ ki ke
1 100,000 10.00% 12.60%
2 200,000 10.40% 13.00%
3 300,000 11.00% 14.00%
4 400,000 12.00% 15.00%
5 500,000 13.00% 17.00%

Required:
Determine the best capital structure from the above option
via Traditional and modern method
7-15
 Equity vs Debt Financing (1)
 Since the WACC is the weighted average of
cost of equity + cost of debt, we can vary the
WACC by changing the mix of debt + equity
 If cost of debt < cost of equity, we can reduce
WACC by increasing the % of debt in the mix and
vice versa
 The value of the firm (its earning’s potential)
is maximized when its WACC is minimized.
 A firm with a lower cost of capital can more
easily return profits to its owners

7-16
 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

7-17
 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.

7-18
 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.

7-19
 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

7-20
 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 borrowing

7-21