Capital Structure. Relative amount of debt and equity used to finance the acquisition of assets.

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Barnard Joseph
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1 Capital Structure Relative amount of debt and equity used to finance the acquisition of assets. Recall: Debt contractually obligates the firm to make fixed payments. o Lenders are only entitled to fixed payments they do not share in the profit of the firm. o If the firm is unable to make the payments it may have to declare bankruptcy. The declaration of dividends to shareholders is at the discretion of the board of directors. Dividends are a distribution of earnings. o The firm can avoid paying a dividend if it is short of cash. o Shareholders share in the profits of the firm. Owners are able to increase their return by investing borrowed money. o The extent by which the firm is able to increase shareholder return by using borrowed money is called leverage. 1

2 Investors Use Risk and Return to Choose Investments o Return is based on rates of return. o There are two basic accounting measures of return. o Return on Assets Net income Total Assets This is a measure of the return earned on all of the assets of the firm. That is, the efficiency with which the managers of the firm invested its assets. o Return on Net income Stockholders This is a measure of the return earned on the assets provided by the shareholders (owners). It is determined by the return earned by the assets and the firm s leverage. There is a basic equation that relates the two: Return on Assets x Leverage = Return on NetIncome TotalAssets x TotalAssets Stockholders = NetIncome Stockholders 2

3 Examples: Company Net Income Total Assets Stockholders Apple 786 6,803 4,107 Microsoft 9,421 52,150 41,368 Nike 579 5,857 3,136 McDonalds 1,948 20,983 9,639 Walt Disney ,027 24,100 Nordstrom 203 3,062 1,186 Intel 7,314 43,849 32,535 Company Return on Assets Leverage Return on Apple 11.55% % Microsoft 18.07% % Nike 9.90% % McDonalds 9.30% % Walt Disney 2.00% % Nordstrom 6.63% % Intel 16.68% % 3

4 To see how this works, I have graphed ROE as a function of ROA, using the leverage measures of Microsoft (MSFT) and Nordstrom (NORD) % 35.00% 30.00% 25.00% ROE 20.00% 15.00% MSFT NORD 10.00% 5.00% 0.00% ROA Note that the higher leverage means that a given increase in ROA translates into an even greater increase in ROE. 4

5 Other measures of capital structure o Debt (long-term) to equity o Debt (long-term) to total assets Company Long-term Debt Assets to Debt to Debt to Assets Nordstrom McDonalds 5, Walt Disney 6, Nike Apple Intel Microsoft Note that although the interpretation of the individual numbers varies, the rank ordering is the same across all of the measures. 5

6 Dividend Payout Dividend payout is the ratio of dividends per share to net income. It tells the investor the proportion of income that is distributed to investors as opposed to being reinvested in the business. Dividend Company Payout Apple 0.00% Microsoft 0.00% Nike 21.92% McDonalds 14.38% Walt Disney 35.00% Nordstrom 46.15% Intel 4.6% The central question is whether the shareholders or firm managers are better able to invest the funds to increase wealth. 6

7 Exercise 9-14 For each of the events or transactions below, indicate the effect on each ratio listed. Use (I) to indicate Increase, (D) to indicate Decrease, and (NE) to indicate No Effect. Sold common stock to investors Borrowed cash from a bank on long-term note Paid cash dividends on stock Sold inventory for cash Paid off note from bank Bought stock of another company Purchased treasury stock Debt to Debt to Assets Financial Leverage Current Ratio 7

8 Problem Assets: Cash $12,000 $7,400 Accounts receivable 16,200 8,100 Inventory 10,000 8,000 Prepaid rent 5,600 5,100 Machinery, net 28,000 30,000 Land 27,000 27,000 Total assets $98,800 $85,600 Liabilities and : Accounts payable $6,200 $5,800 Wages payable 5,800 6,100 Bonds payable (long-term) 46,000 16,400 Common stock 34,000 34,000 Retained earnings 34,800 26,400 Treasury stock (28,000) (3,100) Total liabilities & equity $98,800 $85,600 o Compute the long-term debt to equity ratio and the long-term debt to assets ratio for 2001 and o What was the return on assets and return on equity in 2001 and 2002? o What role did the changes in capital structure have on return on assets and return on equity in 2002? 8

9 Problem Giffen Company: Total assets $6,000 $5,500 $5,000 Total liabilities 3,273 4,014 3,750 Net income Dividends Good Company: Total assets $7,000 $6,000 $5,000 Total liabilities 5,333 4,286 3,333 Net income Dividends o Compute the debt to equity ratios for the two companies. o Compute the return on equity, return on assets and financial leverage factors of the two companies. o Compute and compare the dividend payout ratios of the two companies. 9

Financial Statements, Forecasts, and Planning Chapter 6

C H A P T E R 6 Financial Statements, Forecasts, and Planning Chapter 6 Chapter Objectives Identify the elements of the balance sheet. Identify the elements of the income statement. Discuss the cash flow