Capital Structure Management

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1 MBA III Semester Capital Structure Management POST RAJ POKHAREL M.Phil. (TU) 01/2010) 1

3 What is Capital Structure? Definition The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Consists of long-term liabilities, preferred stock, common stock, and retained earnings. It usually refers to the specific proportions of debt, equity, preferred stock, etc. used to finance the firm.

4 What is Capital Structure? Securities Bonds, (bank loans in case of Nepal) Ordinary shares (common stock), Preference shares (preferred stock) Hybrids, eg warrants, convertible bonds (Absence of its Practice in Nepal) Capital structure composition Sufficient equity must exist to provide financial stability Debt can be used as leverage to increase returns to shareholders, but it can also reduce returns on shareholders investments

5 What is Capital Structure? Balance Sheet Current Assets Current Liabilities Fixed Assets Debt Preference shares Financial Structure Ordinary shares

6 What is Capital Structure? Balance Sheet Current Assets Current Liabilities Fixed Assets Debt Preference shares Ordinary shares Capital Structure

7 Optimal capital structure Significance: Significance in managerial decisions It influences the shareholders return and risk Market value of the firm may be affected by a capital structure decision If there is optimal capital structure for a company, it will minimize the opportunity cost of capital and maximize shareholders wealth. 7

8 Optimal capital structure Goals: To maximize wealth by increasing the stock price and to minimize the overall cost of capital or weighted average cost of capital Analysis of expected risk factors associated with the funds Target of specific capital structure or debt ratio should be kept in mind If actual debt ratio is below the target level, expansion of capital should be raised by debt Debt in capital structure is a two-edged sword: It increases shareholder s return when the firm has high operating income, but makes them worse than they otherwise would be when the firm has low operating income 8

9 Optimal capital structure Goals: A capital structure policy involves a trade off between risk and return: Using more debt raises the risk borne by stockholders However, using more debt generally leads to a higher expected rate of return on equity. 9

10 Features of Capital Structure Return: capital structure of a company should be the most advantageous. It should generate maximum return to the shareholders without adding additional cost to them. Risk: Use of excessive debt threatens the solvency of a company. To the point, debt does not add significant risk, it should be used. Otherwise, its use should be avoided. Flexibility: It should be possible for the company to provide funds whenever they are needed to finance its profitable activities Capacity: Capital structure should be determined within the debt capacity of the company. 10

11 Considerations in the capital structure decision Capital structure is not only concerned with the value, return and cost but also.. Attitudes of managers Operating flexibility Capacity of economies of scale. (if any) 11

12 1 st Assignment How do you differentiate capital structure with financial structure? What are the characteristics of optimal capital structure? 8m 12

13 Sources of capital Ordinary shares (common stock) Preference shares (preferred stock) Hybrid securities Warrants Convertible bonds Loan capital Bank loans Corporate bonds

14 Ordinary shares (common stock) Risk finance Dividends are only paid if profits are made and only after other claimants have been paid e.g. lenders and preference shareholders A high rate of return is required Provide voting rights the power to hire and fire directors No tax benefit, unlike borrowing

15 Preference shares (preferred stock) Lower risk than ordinary shares and a lower dividend Fixed dividend - payment before ordinary shareholders and in a liquidation situation No voting rights - unless dividend payments are in arrears Cumulative - dividends accrue in the event that the issuer does not make timely dividend payments Redeemable - company may buy back at a fixed future date

16 Loan capital Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed) Bank loans or corporate bonds Interest on debt is allowed against tax

17 Seniority of debt Seniority indicates preference in position over other lenders. Some debt is subordinated. In the event of default, holders of subordinated debt must give preference to other specified creditors who are paid first.

18 Security Security is a form of attachment to the borrowing firm s assets. It provides that the assets can be sold in event It provides that the assets can be sold in event of default to satisfy the debt for which the security is given.

19 Indenture A written agreement between the corporate debt issuer and the lender. Sets forth the terms of the loan: Maturity Interest rate Protective covenants e.g. financial reports, restriction on further loan issues, restriction on disposal of assets and level of dividends

20 Warrants A warrant is a certificate entitling the holder to buy a specific amount of shares at a specific price (the exercise price) for a given period. If the price of the share rises above the warrant's exercise price, then the investor can buy the security at the warrant's exercise price and resell it for a profit. Otherwise, the warrant will simply expire or remain unused.

21 Convertible bonds A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period. As bonds, they provide a coupon payment and are legally debt securities, which rank prior to equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer. Their conversion feature also gives them features of equity securities.

22 The Cost of Capital Expected Return Risk-free rate Risk premium Time value of money Treasury Corporate Preference Hybrid Ordinary Bonds Bonds Shares Securities Shares Risk

23 Measuring capital structure Debt/(Debt + Market Value of Equity) Debt/Total Book Value of Assets Interest coverage: EBIT/Interest

24 Interpreting capital structures Capital structures can be changed Leverage is reduced by Cutting dividends (???) or issuing stock Reducing costs, especially fixed costs Leverage increased by Stock repurchases, special dividends, generous wages Using debt rather than retained earnings

25 Capital Structure & Shareholder Wealth The goal of the financial manager is to maximize shareholder wealth: ( 1 T ) NOPAT EBIT V = = k a k a What level of debt will maximize the value of the firm to the shareholder?

26 Capital Structure & Shareholder Wealth Maximizing shareholder wealth = Maximizing firm value Minimizing WACC Objective: Choose the capital structure that Objective: Choose the capital structure that will minimize WACC and maximize stockholder wealth

27 Stock Price and Cost of Capital Estimates with Different Debt/Assets Ratios Debt/ k d Expected Estimated k s = [k RF + Estimated Resulting WACC Assets EPS Beta (k M k RF )β s ] Price P/E Ratio 0% - $ % $ % % All earnings paid out as dividends, so EPS = DPS. Assume that k RF = 6% and k M = 10%. Tax rate = 40%. WACC = w d k d (1 - T) + w s k s = (D/A) k d (1 - T) + (1 - D/A)k s At D/A = 40%, WACC = 0.4[(10%)(1-.4)] + 0.6(14%) = 10.80% 27

28 Business risk and Financial risk Firms have business risk generated by what they do But firms adopt additional financial risk when But firms adopt additional financial risk when they finance with debt

29 Risk and the Income Statement Operating Leverage Financial Leverage Sales Variable costs Fixed costs EBIT Interest expense Earnings before taxes Taxes Net Income EPS = Net Income No. of Shares

30 Business Risk The basic risk inherent in the operations of a firm is called business risk Business risk can be viewed as the variability Business risk can be viewed as the variability of a firm s Earnings Before Interest and Taxes (EBIT)

31 Financial Risk Debt causes financial risk because it imposes a fixed cost in the form of interest payments. The use of debt financing is referred to as financial leverage. Financial leverage increases risk by increasing the variability of a firm s return on equity or the variability of its earnings per share.

32 Financial Risk vs. Business Risk There is a trade-off between financial risk and business risk. A firm with high financial risk is using a fixed cost source of financing. This increases the level of EBIT a firm needs just to break even. A firm will generally try to avoid financial risk - a high level of EBIT to break even - if its EBIT is very uncertain (due to high business risk).

33 Why should we care about capital structure? By altering capital structure firms have the opportunity to change their cost of capital and therefore the market value of the firm

34 What is an optimal capital structure? An optimal capital structure is one that minimizes the firm s cost of capital and thus maximizes firm value Cost of Capital: Each source of financing has a different cost The WACC is the Weighted Average Cost of Capital Capital structure affects the WACC

35 Capital Structure Theory Basic question Is it possible for firms to create value by altering their capital structure? Major theories Modigliani and Miller theory Trade-off Theory Signaling Theory

them? Before MM, no way to analyze debt financing First to

36 Modigliani and Miller (MM) Basic theory: Modigliani and Miller (MM) in 1958 and 1963 Old - so why do we still study them? Before MM, no way to analyze debt financing First to study capital structure and WACC together Won the Nobel prize in 1990

37 Modigliani and Miller (MM) Most influential papers ever published in finance Very restrictive assumptions First no arbitrage proof in finance Basis for other theories

38 A Basic Capital Structure Theory Debt versus Equity A firm s cost of debt is always less than its cost of equity debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible. It may appear a firm should use as much debt and as little equity as possible due to the cost difference, but this ignores the potential problems associated with debt.

39 A Basic Capital Structure Theory There is a trade-off between the benefits of using debt and the costs of using debt. The use of debt creates a tax shield benefit from the interest on debt. The costs of using debt, besides the obvious interest cost, are the additional financial distress costs and agency costs arising from the use of debt financing.

40 Summary A firm s capital structure is the proportion of a firm s long-term funding provided by long-term debt and equity. Capital structure influences a firm s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk. Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.

41 Is there magic in financial leverage? can a company increase its value simply by altering its capital structure? yes and no we will see.

Chapter 15. Chapter 15 Overview

Chapter 15. Chapter 15 Overview Chapter 15 Debt Policy: The Capital Structure Decision Chapter 15 Overview Target and Optimal Capital Structure Risk and Different Types of Financing Business Risk Financial Risk Determining the Optimal