Capital Structure :12/1/2008 Richard MacMinn 1 Capital Structure Theories of optimal capital structure Significance of capital structure decisions Tools of capital structure management


Financial Structure versus Capital Structure :12/1/2008 Richard MacMinn 2 Financial Structure versus Capital Structure Financial structure is the mix of all items that appear on the right-hand side of the firm’s balance sheet. Capital structure refers to the long-term sources of funds used by the firm. One objective of corporate management is to determine an optimal set of financial contracts. A set of contracts is optimal if it maximizes current shareholder value.


Capital Structure: Independence Theory :12/1/2008 Richard MacMinn 3  Capital Structure: Independence Theory According to this theory the firm’s market value is unaffected by the firm’s capital structure, i.e., VL = VU. No arbitrage yields rd = rs and so value is independent of the capital structure.


Capital Structure: Dependence Theory :12/1/2008 Richard MacMinn 4 Capital Structure: Dependence Theory According to this theory the firm’s market value is affected by the firm’s use of leverage, i.e., VL > VU. According to this theory, rd < rs and the rates do not depend on the firm’s leverage. Increased leverage reduces the weighted cost of capital and so increases the firm’s value


Capital Structure: Agency Theory :12/1/2008 Richard MacMinn 5 Capital Structure: Agency Theory Firms face agency problems due to conflict of interest between stockholders and bondholders. The agency problems gives rise to agency costs of debt borne by the owners of the firm. The market value of a levered firm can be stated as follows: VL = VU + T - Awhere T is the value of the tax shields, and A is the value of the agency costs.


Slide 6:12/1/2008 6 Optimal Capital Structure


Tools of Capital Structure Management :12/1/2008 Richard MacMinn 7 Tools of Capital Structure Management Comparative Leverage Ratios Industry Norms Cash Flow Analysis Target Debt Ratio Debt Capacity EBIT-EPS Analysis


Comparative Leverage :12/1/2008 Richard MacMinn 8 Comparative Leverage This involves the computation of various balance sheet leverage ratios and coverage ratios for alternative financing plans.


Industry Norms :12/1/2008 Richard MacMinn 9 Industry Norms The use of industry norms in conjunction with comparative leverage ratios can aid the financial manager in arriving at an appropriate financial mix. Industry groupings may contain firms whose basic business risk may differ widely. Corporate financial analysts, investment bankers, commercial loan officers, and bond rating agencies, nevertheless, rely on industry classes in order to compute such “normal” ratios.


Cash Flow Analysis :12/1/2008 Richard MacMinn 10 Cash Flow Analysis This involves the preparation of a series of cash budgets under (i) different economic conditions and (ii) different capital structures. The net cash flow under these situations can be examined to determine if the financing requirements expose the firm to a high degree of default risk that is unbearable.


Target Debt Ratio :12/1/2008 Richard MacMinn 11 Target Debt Ratio This method is widely used by financial officers. Survey indicates that the firm’s actual target debt ratio is affected by several factors including (i) the firm’s ability to adequately meet it’s financing charges (ii) maintaining a desired bond rating (iii) providing an adequate borrowing reserve and (iv) exploiting the perceived advantage of financial leverage.


Debt Capacity :12/1/2008 Richard MacMinn 12 Debt Capacity This is defined as the maximum proportion of debt that a firm can include in it’s capital structure and still maintain it’s lowest composite cost of capital. The most popular approach is to define the firm’s debt capacity as a target percentage of total capitalization.


EBIT-EPS Analysis :12/1/2008 Richard MacMinn 13 EBIT-EPS Analysis The objective of EBIT-EPS analysis is to find the EBIT level that will equate EPS regardless of the financing plan chosen. The limitation of EBIT-EPS analysis is that it considers only the level of the earnings stream and ignores risk. EBIT-EPS Analysis