Capital Structure

The strength of a company' balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure.

 The Trade off theory recognizes that capital raised by firms is constituted by both debts and equity The theory states that there is an advantage of financing through debts due to tax benefit of the debts, however some costs arises as a result of debt costs and bankrupt costs and non bankrupt costs. The Pecking order theory was developed by Stewart Myers (1984) and it states that firms will adhere to the hierarchy of financing whereby the firm will prefer to finance itself internally and when all internal finances are depleted it will opt for equity, therefore this theory supports the fact that debts are preferred by firms than equity. Modgliani -Miller

 What is Capital Structure? K S is the mix of long term sources of funds used by a firm. What is Financial Structure?

Concept of Optimal K S Theories of K S Can the firm affect its overall cost of funds, either favorably or unfavorably by varying the mix of financing sources used?

 Assumptions 1. Firm employs only two types of Capital : debt and equity. 2. The firm has a policy of paying 100% of its earnings in dividends. 3. The operating earnings of the firm are not expected to grow. 4. Business risk is assumed to remain constant and independent of financial risk. 5. No Income Taxes. 6. A change in the K S is affected immediately i.e. no transaction costs.

Symbols Ki Ke Ko

Ko is defined as the overall capitalization rate of the firm. It is the firms WACC. Theories of K S 1. NI approach 2. NOI approach 3. Traditional approach 4. Modgliani Miller approach

 NI approach As capital structure consists of only debt and equity, earnings available to equity shareholders is synonymous with net income. It is net income that is actually capitalized to arrive at the market value Of equity. Because of this dependence, this approach is called Net Income approach to valuation.

 1000 in debt at 15% ROI, EBIT =1000, Ke=20% NO earnings 1000 Interest 150 EAC 850 Ke .20 Mkt value of stock 4250 Mkt value of debt 1000 Total Value of the 5250 firm Ko 1000/5250 19.05%

1000 450 550 .20 2750 3000 5750 1000/5750 17.39%

If the firm increases debt from 1000 to 3000 and uses the proceeds to repurchase stock.

 1000 in debt at 15% ROI, EBIT =1000, Ke=20% NOI 1000 1000 Ko .20 .20 Total value of the firm 5000 5000 Mkt value of debt 1000 Mkt value of Equity 4000 Ke 850/4000 21.25% 3000 2000 550/2000 27.50%

If the firm increases debt from 1000 to 3000 and uses the proceeds to repurchase stock.

 Other approaches to capital structure 1. Donaldson Approach CBr = CBo + NCFr Unused debt capacity, cash inadequacy, cash insolvency Determine cash flows under most adverse conditions 2. Childs approach Borrowing reserve, cost of capital, financial insurance, leverage, tax savings, Pools of capital. Favors a conservative debt policy AAA rating

Checklist for 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. 2. Asset structure: - Firms whose assets are suitable as security for loans tend to use debt rather heavily. Real estate companies are usually highly leveraged, whereas companies involved in technological research are not. 3. Operating Leverage:4. Growth rate: Other things the same, faster-growing firms must rely more heavily on external capital. 5. Profitability:One often observes 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 Coca-cola simply 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. Taxes:- Interest is a deductible expense, and deductions are most valuable to firms with high tax rates. Therefore, the higher a firms tax rate, the greater the advantage of debt. 7. Control: the effect of debt versus stock on a managements control position influence capital structure. 8. Management attitudes: - Because no one can prove that one capital structure will lead to higher stock prices than another, management can exercise its own judgment about the proper capital structure. Some management tends to be more conservative than others, and thus use less debt than the average firm in their industry, whereas aggressive managements use more debt in the quest for higher profits. 9. Lender and rating agency attitudes: - Regardless of managers own analyses of the proper leverage factors for their firms, lenders and rating agencies attitudes frequently influence financial structure decisions. 10. Market conditions: Conditions in the stock and bond markets undergo long and short run changes that can have an important bearing on a firms optimal capital structure.

 10. The firms internal condition: - firms own internal condition can also have a bearing on its target capital structure. For example, suppose a firm has just successfully completed an R & D program, and it forecast higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reflected in the stock price. The 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, retire the debt, and return to its target capital structure. 11. Financial flexibility: - Firms with profitable investment opportunities need to be able to fund them. An astute corporate treasurer made this statement to the authors: Our company can earn a lot more money from good capital budgeting and operating decisions than from good financing decisions.

 CAPITAL STRUCTURE THEORY: THE SIGNALING MODEL Some years ago, Professor Gordon Donaldson of Harvard conducted an extensive study of how corporations actually establish their capital structures. Here is a summary of his findings: 1. Firms prefer to finance with internally generated funds that is with retained earnings and depreciation cash flow. 2. Firms set target dividend payout ratios based on expected future investment opportunities and expected future cash flows. The target payout ratio is set at a level that causes retained earnings plus depreciation to cover capital expenditures under normal conditions. 3. Dividends are sticky in the short run-firms are reluctant to raise dividends unless they are confident that the higher dividend can be maintained and they are especially reluctant to cut the dividend Indeed they generally do not reduce the dividend unless things are so bad that they simply have to.