Business Analysis

…is a process of evaluating a company’s economic prospects and risks for the purpose of making business decisions.

This includes analyzing a company’s business environment, its strategies, and its financial position and performance.

Financial Analysis

the use of financial statements to analyze a company’s financial position and performance, and to assess future financial performance.

It consists of three broad areas:

- profitability analysis

- risk analysis

- analysis of sources and uses of funds

Financial statement analysis

Is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis.

It decreases the uncertainty of business analysis, and provides a systematic and effective basis for it.

Comparability problems

1. Lack of uniformity in accounting leads to comparability problems.

2. Discretion and imprecision in accounting can distort financial statement information.

Comparability problems

- Arising when different companies adopt different accounting for similar transactions or events, leading to difficulties with interfirm comparability.

- Arising when a coy changes its accounting across time, leading to difficulties with temporal comparability.

What is Corporate Finance?

Corporate Finance addresses the following three questions:

1. What long-term investments should the firm choose?

2. How should the firm raise funds for the selected investments?

3. How should short-term assets be managed and financed?

The Financial Manager

The Financial Manager’s primary goal is to increase the value of the firm by:

1. Selecting value creating projects

2. Making smart financing decisions

The Corporate Firm

• The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.

• However, businesses can take other forms.

Forms of Business Organization

• The Sole Proprietorship

• The Partnership– General Partnership– Limited Partnership

• The Corporation

The Goal of Financial Management

• What is the correct goal?

– Maximize profit?

– Minimize costs?

– Maximize market share?

– Maximize shareholder wealth?

Financial Markets

• Primary Market– Issuance of a security for the first time

• Secondary Markets– Buying and selling of previously issued

securities– Securities may be traded in either a dealer or

auction market• NYSE• NASDAQ

The Balance Sheet

An accountant’s snapshot of the firm’s accounting value at a specific point in time

The Balance Sheet Identity is:

Assets ≡ Liabilities + Stockholder’s Equity

The Capital Budgeting Decision

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

What long-term investments should the firm choose?

Short-Term Asset Management

How should short-term assets be managed and financed?

Net Working Capital

Shareholders’ Equity

Current Liabilities

Long-Term Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible

The Capital Structure Decision

How should the firm raise funds for the selected investments?

Current Assets

Fixed Assets

1 Tangible

2 IntangibleShareholders’

Equity

Current Liabilities

Long-Term Debt

The Income Statement

• Measures financial performance over a specific period of time

• The accounting definition of income is:

Revenue – Expenses ≡ Income

Net Working Capital

Net Working Capital ≡

Current Assets – Current Liabilities

NWC usually grows with the firm

Net Working Capital

• A measure of both a company's efficiency and its short-term financial health.

• Positive working capital means that the company is able

to pay off its short-term liabilities.  

• Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

• A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis.

Financial Cash Flow

• In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.

• the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.

CF(A)≡ CF(B) + CF(S)

The Statement of Cash Flows

• is an official accounting statement

• helps explain the change in accounting cash.

• The three components of the statement of cash flows are:– Cash flow from operating activities– Cash flow from investing activities– Cash flow from financing activities

Financial Statements Analysis

• Common-Size Balance Sheets– Compute all accounts as a percent of total assets

• Common-Size Income Statements– Compute all line items as a percent of sales

• Standardized statements make it easier to compare financial information, particularly as the company grows.

• They are also useful for comparing companies of different sizes, particularly within the same industry.

Using Financial Statements

• Ratios are not very helpful by themselves: they need to be compared to something

• Time-Trend Analysis– Used to see how the firm’s performance is

changing through time

• Peer Group Analysis– Compare to similar companies or within

industries

Ratio Analysis

• Ratios also allow for better comparison through time or between companies.

• As we look at each ratio, ask yourself:– How is the ratio computed?– What is the ratio trying to measure and why?– What is the unit of measurement?– What does the value indicate?– How can we improve the company’s ratio?

Identification of the user of the analysis

• The IASB Framework states:The objective of financial statements is to provide information … that is useful to a wide range of users in making economic decisions.

Interpretation and analysis of the financial statements is the process of arranging, examining and comparing the results in order that users are equipped to make such economic decisions.

Differences between users and their needs:

• Present and potential investors - are interested in information that is useful in making buy/sell/hold decisions. Return on capital employed (ROCE) and related performance and asset management ratios are likely to be of interest to this group of users.

• Lenders and potential lenders - are interested in assessing whether or not the loans that they have made are likely to be repaid, and whether or not the related interest charge will be paid in full and on time. They are particularly interested in ratios such as interest cover and gearing, and will be interested in the nature and longevity of other categories of loan to the entity.

Users of information:

Suppliers and other creditors - interested in information that helps them to decide whether or not to supply goods or services to an entity. Availability of cash will be of particular interest.

Working capital ratios, and the working capital cycle, may be appropriate calculations to undertake when analysing financial statements for the benefit of this class of user.

Users of information:

• Employees - they need to be able to assess the stability and performance of the entity in order to gauge how reliable it is likely to be as a source of employment in the longer term. Employees are likely to be interested in disclosures about retirement benefits and remuneration.

• Customers - interested in assessing the risks which threaten their supplier. Potentially they may be interested in takeover opportunities in order to ensure the continuing supply of a particular raw material.

Users of information:

• Governments and their agencies - require special-purpose reports, especially tax computations, general-purpose reports- statistics.

• Society

An annual report

• An annual report is a comprehensive report on a company's activities throughout the preceding year.

• Annual reports are intended to give shareholders and other interested people information about the company's activities and financial performance.

• Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry.

• Companies listed on a stock exchange are also required to report

at more frequent intervals (depending upon the rules of the stock exchange involved).

Typically annual reports includes: • Chairman's report • CEO's report • Auditor's report on corporate governance • Mission statement • Corporate governance statement of compliance • Statement of directors' responsibilities • Invitation to the company's AGM as well as financial statements including:• Auditor's report on the financial statements • Balance sheet • Statement of retained earnings • Income statement • Cash flow statement • Notes to the financial statements • Accounting policies

Ratio analysis

• Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities within a company.

The Analysis of Financial Statements

The Use Of Financial Ratios Analyzing Liquidity Analyzing Activity Analyzing Debt Analyzing Profitability A Complete Ratio Analysis

Analyzing Liquidity

Liquidity refers to the solvency of the firm;

"liquid firm" is one that can easily meet its short-term obligations as they come due.

A second meaning includes the concept of converting an asset into cash with little or no loss in value (cost, time).

1994, HarperCollins PublishersCopyright

Three Important Liquidity Measures

Net Working Capital (NWC)

NWC = Current Assets - Current Liabilities

Current Ratio (CR) Current Assets CR = Current Liabilities

Quick (Acid-Test) Ratio (QR) Current Assets - InventoryQR = Current Liabilities

1994, HarperCollins PublishersCopyright

Cash Conversion Cycle

• Expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable.

• The cash conversion cycle (CCC) measures the

number of days a company's cash is tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its creditors.

• The shorter this cycle, the more liquid the company's working capital position is.

• The CCC is also known as the "cash" or "operating" cycle.

Cash Conversion Cycle

Analyzing Activity

Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency

1994, HarperCollins PublishersCopyright

Inventory Turnover (IT)

Average Collection Period (ACP)

Average Payment Period (APP)

Fixed Asset Turnover (FAT)

Total Asset Turnover (TAT)

Cost of Goods SoldIT =

Inventory

Accounts ReceivableACP =

Annual Sales/360

Accounts PayableAPP=

Annual Purchases/360

Sales FAT =

Net Fixed Assets

SalesTAT =

Total Assets

Five Important Activity Measures

Operating Cycle

• Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash.

Analyzing Debt

Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners.

Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock.

Measures of Debt

There are Two General Types of Debt Measures:

Degree of Indebtedness Ability to Service Debts

13

Debt Ratio (DR)

Capital Structure Ratio(CSR)

Debt-Equity Ratio (DER)

Times Interest Earned TIE=

Ratio (TIE)

Total LiabilitiesDR= Total Assets

CSR = Long-Term Debt Stockholders’ Equity

DER = Total Debt Stockholders’ Equity

Earnings Before Interest & Taxes (EBIT) Interest

Four Important Debt Measures

Analyzing Profitability

– Profitability Measures assess the firm's ability to operate efficiently and are of concern to owners, creditors, and management

– A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm’s profitability relative to sales.

Gross Profit Margin (GPM)

Operating Profit Margin (OPM)

Net Profit Margin (NPM)

Return on Total Assets (ROA)

Return On Equity (ROE)

Earnings Per Share (EPS)

Price/Earnings (P/E) Ratio

Gross ProfitsGPM=

Sales

Operating Profits (EBIT)OPM =

Sales

Net Profit After TaxesNPM=

Sales

Net Profit After TaxesROA=

Total AssetsNet Profit After Taxes

ROE= Stockholders’ Equity

Earnings Available for Common Stockholder’sEPS = Number of Shares of Common Stock Outstanding

Market Price Per Share of Common StockP/E =

Earnings Per Share

Seven Basic Profitability Measures

A Complete Ratio Analysis

DuPont System of Analysis

– DuPont System of Analysis is an integrative approach used to dissect a firm's financial statements and assess its financial condition

– It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE

17

3.3 The Du Pont Identity

• ROE = NI / TE

• Multiply by 1 and then rearrange:– ROE = (NI / TE) (TA / TA)– ROE = (NI / TA) (TA / TE) = ROA * EM

• Multiply by 1 again and then rearrange:– ROE = (NI / TA) (TA / TE) (Sales / Sales)– ROE = (NI / Sales) (Sales / TA) (TA / TE)– ROE = PM * TAT * EM

DuPont System of Analysis

The firm's return is broken into three components:

– A profitability measure (net profit margin)

– An efficiency measure (total asset turnover)

– A leverage measure (financial leverage multiplier)

18

An approach that views all aspects of the firm's activities to isolate key areas of concern

Comparisons are made to industry standards (cross-sectional analysis)

Comparisons to the firm itself over time are also made (time-series analysis)

Summarizing All Ratios19

ALTMAN MODEL (U.S. - 1968)

He was the first person to successfully use step-wise multiple discriminate analysis to develop a prediction model with a high degree of accuracy. Using the sample of 66 companies, 33 failed and 33 successful, Altman's model achieved an accuracy rate of 95.0%.

ALTMAN MODEL (U.S. - 1968)

• Altman's model takes the following form :           Z = 1.2A + 1.4B + 3.3C + 0.6D + .999E

          Z < 2.675; then the firm is classified as "failed"

WHERE:     A = Working Capital / Total Assets

          B = Retained Earnings / Total Assets

          C = Earnings before Interest and Taxes / Total Assets

          D = Market Value of Equity / Book Value of Total Debt

          E = Sales / Total Assets

Capital structure

Issues:

• What is capital structure?

• Why is it important?

• What are the sources of capital available to a company?

• What is business risk and financial risk?

• What are the relative costs of debt and equity?

• What are the main theories of capital structure?

• Is there an optimal capital structure?

Capital Structure and the Pie

• The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.

V = B + S

• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.

Value of the Firm

S BS BS BS B

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.

Securities• Bonds, bank loans• Ordinary shares (common stock), Preference

shares (preferred stock)• Hybrids, eg warrants, convertible bonds

Sources of capital

• Ordinary shares (common stock)• Preference shares (preferred stock)• Hybrid securities

– Warrants– Convertible bonds

• Loan capital– Bank loans– Corporate bonds

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

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.

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

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

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

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.

BUSINESS RISK vs FINANCIAL RISKBUSINESS RISK vs FINANCIAL RISK

• Business RiskBusiness Risk::

““the equity risk that arises from the nature of the the equity risk that arises from the nature of the firm’s operations”firm’s operations”

• Financial RiskFinancial Risk: :

““the equity risk that arises from the financial the equity risk that arises from the financial policy of the firm”policy of the firm”

EBIT-EPS ANALYSISEBIT-EPS ANALYSISEBIT-EPS ANALYSISEBIT-EPS ANALYSIS

• A technique that illustrates the impact of leverage on EPS at different levels of EBITA technique that illustrates the impact of leverage on EPS at different levels of EBIT• The objective is to find the EBIT level that will equate EPS regardless of the financing plan The objective is to find the EBIT level that will equate EPS regardless of the financing plan

chosenchosen• The limitation of EBIT-EPS analysis is that it considers only the level of the earnings stream The limitation of EBIT-EPS analysis is that it considers only the level of the earnings stream

and ignores and ignores riskrisk

Calculation of Break-Even EBITCalculation of Break-Even EBIT

EPS = (EBIT-I)(1-EPS = (EBIT-I)(1-tctc)/No. of shares)/No. of shares

Company ACompany A (no debt) (no debt)

(EBIT-0)(1-0.4)/4 million(EBIT-0)(1-0.4)/4 million

Company BCompany B (with debt) (with debt)

(EBIT-£200,000)(1-0.4)/2 million(EBIT-£200,000)(1-0.4)/2 million

These are equal when:These are equal when:

(EBIT-0)(1-0.4)/4 m = (EBIT-£200,000)(1-0.4)/2 m(EBIT-0)(1-0.4)/4 m = (EBIT-£200,000)(1-0.4)/2 m

With a little algebra, EBIT = £400,000With a little algebra, EBIT = £400,000

EBIT-EPS ANALYSISEBIT-EPS ANALYSISSUMMARYSUMMARY

• The effect of financial leverage depends upon EBITThe effect of financial leverage depends upon EBIT

• When EBIT is high, financial leverage raises EPS and When EBIT is high, financial leverage raises EPS and ROEROE

• The variability of EPS and ROE is increased with The variability of EPS and ROE is increased with financial leveragefinancial leverage

Cost of Capital

• The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk.

• the expected return on capital must be greater than the cost of capital.

Cost of Capital

• The cost of capital represents the overall cost of financing to the firm

• The cost of capital is normally the relevant discount rate to use in analyzing an investment

• The overall cost of capital is a weighted average of the various sources:– WACC = Weighted Average Cost of Capital– WACC = After-tax cost x weights

Cost of Debt

• The cost of debt to the firm is the effective yield to maturity (or interest rate) paid to its bondholders

• Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity:– After-tax cost of debt = yield x (1 - tax rate)

• The cost of debt should also be adjusted for flotation costs (associated with issuing new bonds)

Cost of New Preferred Stock

• Preferred stock:

– has a fixed dividend (similar to debt)

– has no maturity date

– dividends are not tax deductible and are expected to be perpetual or infinite

• Cost of preferred stock = dividend price - flotation cost

Cost of Equity

• There are a number of methods used to determine the cost of equity

• We will focus on two

• Dividend growth Model

• CAPM

The Dividend Growth Model Approach

Estimating the cost of equity: the dividend growth model approach

According to the constant growth (Gordon) model, D1

P0 = RE - g

Rearranging D1

RE = + g P0

Capital Asset Pricing Model (CAPM)

)( fmf RRβRkj

Cost ofcapital Risk-free

return

Average rate of returnon common stocks

(WIG)

Co-varianceof returns against

the portfolio(departure from the average)

B < 1, security is safer than WIG averageB > 1, security is riskier than WIG average

Weighted Average Cost of Capital (WACC)

• WACC weights the cost of equity and the cost of debt by the percentage of each used in a firm’s capital structure

• WACC=(E/ V) x RE + (D/ V) x RD x (1-tC)– (E/V)= Equity % of total value– (D/V)=Debt % of total value– (1-tc)=After-tax % or reciprocal of corp tax rate tc.

The after-tax rate must be considered because interest on corporate debt is deductible

Final notes on WACC

• The WACC is not constant

• It changes in accordance with the risk of the company and with the floatation costs of new capital

IMPLICATIONS OF PRE-MM THEORIESIMPLICATIONS OF PRE-MM THEORIES

SUMMARYSUMMARY

• Net Income (NI) TheoryNet Income (NI) Theory

Financial leverage is beneficialFinancial leverage is beneficial• Net Operating Income (NOI) TheoryNet Operating Income (NOI) Theory

Financial leverage is irrelevantFinancial leverage is irrelevant• Traditional TheoryTraditional Theory

There exists an optimal capital structureThere exists an optimal capital structure

Summary of the Arbitrage TransactionSummary of the Arbitrage Transaction

– The share price of firm A The share price of firm A risesrises based on increased based on increased demanddemand

– The share price in firm B The share price in firm B falls falls based on selling based on selling pressurespressures

• Arbitrage continues until total firm values are identical Arbitrage continues until total firm values are identical • Conclusion: Firm value is independent of capital Conclusion: Firm value is independent of capital

structurestructure

Investors use “homemade” rather than corporate Investors use “homemade” rather than corporate financial leveragefinancial leverage

MM IRRELEVANCEMM IRRELEVANCESUMMARYSUMMARY

• Investors can Investors can lever up lever up an investment in an an investment in an unlevered firm by unlevered firm by borrowing moneyborrowing money and and buying buying stockstock

• Investors can Investors can unleverunlever an investment in a levered an investment in a levered firm by firm by selling stock selling stock and and lending moneylending money

• ConclusionConclusion:: investors can create their own payoff investors can create their own payoff patterns, irrespective of the capital structurepatterns, irrespective of the capital structure

Importance of MMImportance of MM • How can MM seriously argue that financing policy doesn't How can MM seriously argue that financing policy doesn't

matter?matter?

• PointPoint: all of their assumptions are unrealistic - if MM were : all of their assumptions are unrealistic - if MM were true we would see random D/E ratios across firmstrue we would see random D/E ratios across firms

• Their important contribution is to have identified the factors Their important contribution is to have identified the factors that will make financing policy matter to the firmthat will make financing policy matter to the firm

• If financing policy If financing policy doesdoes affect the value of the firm it will do affect the value of the firm it will do so through at least one violation of the underlying so through at least one violation of the underlying assumptionsassumptions

MM’s PROPOSITIONSMM’s PROPOSITIONS

• PROPOSITION IPROPOSITION I

The value of the firm is independent of its capital The value of the firm is independent of its capital structurestructure

• PROPOSITION IIPROPOSITION II

A firm’s cost of equity capital is a positive linear A firm’s cost of equity capital is a positive linear function of its capital structurefunction of its capital structure

MM’s PROPOSITIONSMM’s PROPOSITIONS

• PROPOSITION IPROPOSITION I

The WACC is constant, regardless of the capital The WACC is constant, regardless of the capital structurestructure

• PROPOSITION IIPROPOSITION II

The cost of equity must increase, as leverage is The cost of equity must increase, as leverage is increased,in order for the WACC to remain constantincreased,in order for the WACC to remain constant

CAPITAL STRUCTURE IICAPITAL STRUCTURE II WHAT MM (1958) LEFT OUTWHAT MM (1958) LEFT OUT

• Corporate taxesCorporate taxes

• Costs of financial distressCosts of financial distress

• Agency costs of debtAgency costs of debt• Debt capacityDebt capacity• Pecking order of financingPecking order of financing• Personal TaxesPersonal Taxes

MM PROPOSITION II MM PROPOSITION II WITH TAXESWITH TAXES

• With corporate taxes, the firm’s Weighted Average Cost of With corporate taxes, the firm’s Weighted Average Cost of Capital is calculated as follows:Capital is calculated as follows:

WACC = WACC = rr00 = (S /V = (S /VLL) . r) . rss + (B /V + (B /VLL) . r) . rB B . (1 – . (1 – TTC C ) )

• With a little algebra: With a little algebra:

rrss = = rr00 + ( + (rr00 – – rrB B ) . () . (B/S B/S ) . (1 – ) . (1 – TTC C ))

MM WITH TAXESMM WITH TAXES

• Implication is that firms will maximise their Implication is that firms will maximise their value by taking on value by taking on maximum maximum debtdebt

• However, empirical evidence suggests that However, empirical evidence suggests that firms take on only firms take on only modestmodest amounts of debt amounts of debt

• So, what other factors influence the choice of So, what other factors influence the choice of capital structure?capital structure?

COSTS OF FINANCIAL DISTRESSCOSTS OF FINANCIAL DISTRESS

• DIRECT COSTSDIRECT COSTS

““The legal and administrative expenses associated The legal and administrative expenses associated

with bankruptcy or reorganizationwith bankruptcy or reorganization””

• INDIRECT COSTSINDIRECT COSTS

““Costs arising from impaired ability to conduct Costs arising from impaired ability to conduct

business and agency costs”business and agency costs”

AGENCY COSTSAGENCY COSTS

• Agency costs arise from potential Agency costs arise from potential conflicts of conflicts of interest interest between a firm’s security holdersbetween a firm’s security holders

• The interests of The interests of creditorscreditors and and shareholdersshareholders may be in conflict when the firm is in financial may be in conflict when the firm is in financial distressdistress

• This ‘agency problem’ gives rise to agency This ‘agency problem’ gives rise to agency costs of debtcosts of debt

• Shareholders may engage in Shareholders may engage in ‘selfish ‘selfish strategies’strategies’ at the expense of creditors at the expense of creditors

SELFISH STRATEGIES: SUMMARYSELFISH STRATEGIES: SUMMARY

• Lenders will anticipate the costs Lenders will anticipate the costs associated with the selfish strategiesassociated with the selfish strategies

• A higher rate of interest will be demanded A higher rate of interest will be demanded in compensationin compensation

• Agency costs ultimately come out of Agency costs ultimately come out of shareholders’ pocketsshareholders’ pockets

THE EXTENDED PIE MODELTHE EXTENDED PIE MODEL

• Marketed claimsMarketed claims can be bought & sold in financial markets can be bought & sold in financial markets

ieie shareholder & bondholder claims shareholder & bondholder claims• Nonmarketed claimsNonmarketed claims cannot be bought & sold in financial cannot be bought & sold in financial

markets, markets, ieie tax claims & bankruptcy claims tax claims & bankruptcy claims• The total value of all claims is unaltered by capital structureThe total value of all claims is unaltered by capital structure• The value of The value of marketedmarketed claims may be affected by capital claims may be affected by capital

structure changesstructure changes• Any increaseAny increase in marketed claims must imply an identical in marketed claims must imply an identical

decrease in decrease in nonmarketednonmarketed claims claims

TRADE-OFF THEORY OF CAPITAL STRUCTURETRADE-OFF THEORY OF CAPITAL STRUCTURE

• Target debt ratios will vary across firmsTarget debt ratios will vary across firms• Firms with safe tangible assets and plenty of taxable Firms with safe tangible assets and plenty of taxable

income should have high target ratiosincome should have high target ratios• Marginally profitable companies with risky, intangible Marginally profitable companies with risky, intangible

assets should rely primarily on equity financingassets should rely primarily on equity financing

PECKING ORDER THEORYPECKING ORDER THEORY

• This implies a “pecking order” of financing:This implies a “pecking order” of financing:

Retained earningsRetained earnings

Debt financeDebt finance

External equity finance External equity finance

The pecking order model can explain:The pecking order model can explain: Why debt ratios & profitability are Why debt ratios & profitability are inversely relatedinversely related Why stock markets reactWhy stock markets react negatively negatively to new equity issues to new equity issues Why managers of successful firms hold on to more cash than Why managers of successful firms hold on to more cash than common sense suggests they shouldcommon sense suggests they should

SUMMARYSUMMARYWhat affects Capital Structure?What affects Capital Structure?

• TaxesTaxes - firms with high taxable income will have more debt - firms with high taxable income will have more debt

However, if dividends are taxed at a lower personal tax However, if dividends are taxed at a lower personal tax rate than interest payments, the tax advantage to debt is rate than interest payments, the tax advantage to debt is partially offset partially offset

• Costs of financial distressCosts of financial distress• Type of assetsType of assets -firms that have good collateral (tangible -firms that have good collateral (tangible

assets) tend to have more debtassets) tend to have more debt• Uncertainty of incomeUncertainty of income - firms with safer (ie less variable) - firms with safer (ie less variable)

income streams will have more debtincome streams will have more debt

• Pecking OrderPecking Order - issue the safest security - issue the safest security first because first because less is given up to outside investorsless is given up to outside investors