Corporate DR.

AMIRA TAREK

Finance LECTURE5
CAPITAL STRUCTURE
Chapter 12 Capital
structure

9-2
Topics to be Covered: Capital
structure
1. Describe the types of capital, external assessment of capital
structure, the capital structure of non-U.S. firms, and capital
structure theory.

2. Explain the optimal capital structure using a graphical view of

the firm’s cost of capital functions and a zero-growth valuation
model.

3. Discuss the EBIT-EPS approach to capital structure.

4. Review the return and risk of alternative capital structures,

their linkage to market value, and other important capital
structure considerations related to capital structure.

© 2012 Pearson Education 13-3

Capital structure
Capital structure is one of the most complex areas of financial decision
making because of its interrelationship with other financial decision
variables.
➢Poor capital structure decisions can result in a high cost of capital,
thereby lowering the NPVs of projects and making more of them
unacceptable.
➢Effective capital structure decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable projects—and thereby
increasing the value of the firm
The Firm’s Capital Structure:
Types of Capital
All of the items on the right-hand side of the firm’s balance sheet,
excluding current liabilities, are sources of capital. The following
simplified balance sheet illustrates the basic breakdown of total
capital into its two components, debt capital and equity capital.

© 2012 Pearson Education 13-5

The Firm’s Capital Structure:
Debt Capital
•The cost of debt is lower than the cost of other forms of
financing.
•Lenders demand relatively lower returns because they take
the least risk of any contributors of long-term capital.
•Lenders have a higher priority of claim against any earnings
or assets available for payment, and they can exert far
greater legal pressure against the company to make payment
than can owners of preferred or common stock.
•The tax deductibility of interest payments also lowers the
debt cost to the firm substantially.

© 2012 Pearson Education 13-6

The Firm’s Capital Structure:
Equity Capital (cont.)
•Unlike debt capital, which the firm must eventually repay, equity
capital remains invested in the firm indefinitely—it has no
maturity date.
•The two basic sources of equity capital are (1) preferred stock and
(2) common stock equity, which includes common stock and
retained earnings.
•Common stock is typically the most expensive form of equity,
followed by retained earnings and then preferred stock.
•Whether the firm borrows very little or a great deal, it is always
true that the claims of common stockholders are riskier than those
of lenders, so the cost of equity always exceeds the cost of debt.

© 2012 Pearson Education 13-7

The Firm’s Capital Structure:
External Assessment of Capital Structure

▪A direct measure of the degree of indebtedness is the debt

ratio (total liabilities ÷ total assets).
➢The higher this ratio is, the greater the relative amount of debt (or
financial leverage) in the firm’s capital structure.
▪Measures of the firm’s ability to meet contractual payments
associated with debt include the times interest earned ratio
(EBIT ÷ interest)
▪The level of debt (financial leverage) that is acceptable for one
industry or line of business can be highly risky in another,
because different industries and lines of business have
different operating characteristics.

© 2012 Pearson Education 13-8

Capital structure general
patterns
•First, in nearly all countries, pharmaceutical and other high-growth
industrial firms tend to have lower debt ratios than do steel companies,
airlines, and electric utility companies
•Second, in most countries there is a tendency for larger firms to borrow
more than smaller firms do.
•Third, companies that are riskier and have more volatile income streams
tend to borrow less, as do firms that are highly profitable
•Finally, the worldwide trend is away from reliance on banks for
financing and toward greater reliance on security issuance
The Firm’s Capital Structure:
Capital Structure Theories
•Research suggests that there is an optimal capital
structure range.
•It is not yet possible to provide financial managers
with a precise methodology for determining a firm’s
optimal capital structure.
•Nevertheless, financial theory does offer help in
understanding how a firm’s capital structure affects
the firm’s value.

© 2012 Pearson Education 13-10

The Firm’s Capital Structure:
Capital Structure Theories
Asymmetric Information
◦ Asymmetric information is the situation in which managers of a firm
have more information about operations and future prospects than do
investors.
◦ pecking order theory: is a hierarchy of financing that begins with
retained earnings, which is followed by debt financing and finally
external equity financing.
◦ Signaling theory: is a financing action by management that is
believed to reflect its view of the firm’s stock value; generally, debt
financing is viewed as a positive signal that management believes the
stock is “undervalued,” and a stock issue is viewed as a negative
signal that management believes the stock is “overvalued.”
The idea is that anyone can brag, but only those who are willing to
put real dollars at stake behind their claims ought to be believed

© 2012 Pearson Education 13-11

Benefits and costs of debt
financing
◦ A theoretical optimal capital structure based on balancing the
benefits and costs of debt financing.
◦ The major benefit of debt financing is the tax shield, which allows
interest payments to be deducted in calculating taxable income.

◦ The costs of debt financing result from:

➢the increased probability of bankruptcy caused by debt
obligations,
➢the agency costs resulting from lenders monitoring the firm’s
actions, and

© 2012 Pearson Education 13-12

Benefits and costs of debt
financing
Tax Benefits
◦ Allowing firms to deduct interest payments on debt when
calculating taxable income reduces the amount of the
firm’s earnings paid in taxes, thereby making more
earnings available for bondholders and stockholders.
◦ The deductibility of interest means the cost of debt, ri, to
the firm is subsidized by the government.
◦ Letting rd equal the before-tax cost of debt and letting T
equal the tax rate, we have ri = rd  (1 – T).

© 2012 Pearson Education 13-13

Benefits and costs of debt
financing
Probability of Bankruptcy
◦ The chance that a firm will become bankrupt because of an inability to
meet its obligations as they come due depends largely on its level of both
business risk and financial risk.
◦ Business risk is the risk to the firm of being unable to cover its operating
costs.
◦ In general, the greater the firm’s operating leverage—the use of fixed
operating costs—the higher its business risk.
◦ Although operating leverage is an important factor affecting business risk,
two other factors—revenue stability and cost stability—also affect it.
◦ Firms with high business risk therefore tend toward less highly leveraged
capital structures, and firms with low business risk tend toward more
highly leveraged capital structures.

© 2012 Pearson Education 13-14

Benefits and costs of debt
financing
Probability of Bankruptcy
◦ The firm’s capital structure directly affects its financial
risk, which is the risk to the firm of being unable to cover
required financial obligations.
◦ The penalty for not meeting financial obligations is
bankruptcy.
◦ The more fixed-cost financing—debt (including financial
leases) and preferred stock—a firm has in its capital
structure, the greater its financial leverage and risk.
◦ The total risk of a firm—business and financial risk
combined—determines its probability of bankruptcy.

© 2012 Pearson Education 13-15

EBIT-EPS approach
to capital structure

© 2012 Pearson Education 13-16

The Firm’s Capital Structure:
Sales and Associated EBIT Calculations
Ex: Cooke Company, a soft drink manufacturer, is preparing to make a capital
structure decision. It has obtained estimates of sales and the associated levels of
earnings before interest and taxes (EBIT) from its forecasting group: There is a 25%
chance that sales will total $400,000, a 50% chance that sales will total $600,000, and
a 25% chance that sales will total $800,000. Fixed operating costs total $200,000, and
variable operating costs equal 50% of sales.

© 2012 Pearson Education 13-17

Capital Structures Associated with Alternative Debt
Ratios

© 2012 Pearson Education 13-18

Level of Debt, Interest Rate, and Annual Interest payments
Associated with Alternative Capital Structures

© 2012 Pearson Education 13-19

Calculation of EPS for Selected
Debt Ratios

© 2012 Pearson Education 13-20

Calculation of EPS for Selected
Debt Ratios

© 2012 Pearson Education 13-21

Calculation of EPS for Selected
Debt Ratios

© 2012 Pearson Education 13-22

Expected EPS, Standard Deviation, and Coefficient of
Variation for Alternative Capital Structures for Cooke
Company

© 2012 Pearson Education 13-23

Capital Structure Theory:
Probability of Bankruptcy (cont.)
Financial Risk

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12-24
Wesley. All rights reserved.
EBIT-EPS Approach to Capital Structure: Basic
Shortcoming of EBIT-EPS Analysis

•The most important point to recognize when using EBIT–

EPS analysis is that this technique tends to concentrate on
maximizing earnings rather than maximizing owner wealth
as reflected in the firm’s stock price.
•The use of an EPS-maximizing approach generally ignores
risk.
•Because risk premiums increase with increases in financial
leverage, the maximization of EPS does not ensure owner
wealth maximization.

© 2012 Pearson Education 13-25

Optimal capital
structure using zero-
growth valuation
model
© 2012 Pearson Education 13-26
The Firm’s Capital Structure: Capital Structure Theory
Optimal capital structure
What, then, is the optimal capital structure, even if it exists (so far) only
in theory?
◦ Because the value of a firm equals the present value of its future cash flows, it
follows that the value of the firm is maximized when the cost of capital is
minimized.

where
EBIT = earnings before interest and taxes
T = tax rate
NOPAT = net operating profits after taxes, which is the after-tax operating
earnings available to the debt and equity holders, EBIT  (1 – T)
ra = weighted average cost of capital
© 2012 Pearson Education 13-27
Choosing the Optimal Capital
Structure: Linkage
To determine the firm’s value under alternative capital
structures, the firm must find the level of return that it must
earn to compensate owners for the risk being incurred.
The required return associated with a given level of
financial risk can be estimated in a number of ways.
◦ Theoretically, the preferred approach would be first to estimate the
beta associated with each alternative capital structure and then to use
the CAPM framework to calculate the required return, rs.
◦ A more operational approach involves linking the financial risk
associated with each capital structure alternative directly to the
required return.

© 2012 Pearson Education 13-28

Table 13.14 Required Returns for Cooke Company’s
Alternative Capital Structures

© 2012 Pearson Education 13-29

Choosing the Optimal Capital
Structure: Estimating Value
The value of the firm associated with alternative capital
structures can be estimated by using one of the standard
valuation models, such as the zero-growth model.

Although some relationship exists between expected profit

and value, there is no reason to believe that profit-
maximizing strategies necessarily result in wealth
maximization.
It is therefore the wealth of the owners as reflected in the
estimated share value that should serve as the criterion for
selecting the best capital structure.

© 2012 Pearson Education 13-30

Calculation of Share Value Estimates Associated
with Alternative Capital Structures

© 2012 Pearson Education 13-31

Thank you