Capital Structure English

8/6/2019 Capital Structure English

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Capital structureIssues:

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?


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What is Capital Structure?

Definition

Thecapital structureofa firm is themixof

differentsecurities issued by thefirm tofinanceits operations.

Securities

Bonds, bank loans

Ordinary shares (commonstock), Preferenceshares (preferred stock)

Hybrids, eg. convertiblebonds


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FinancialStructure


Balance Sheet

Current Current

Assets Liabilities

Debt

Fixed Preference

Assets shares

Ordinary

shares


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CapitalStructure


Balance Sheet

Current Current

Assets Liabilities

Debt

Fixed Preference

Assets shares

Ordinary

shares


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Sources of capital

Ordinary shares (common stock)

Preference shares (preferred stock) Loan capital

Bank loans

Corporate bonds Debentures


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Ordinary shares (common stock)

Risk finance Dividends are only paid if profits are

made and only after other claimants havebeen paid e.g. lenders and preferenceshareholders

A high rate of return is required

Provide voting rights the power to hireand fire directors No tax benefit, unlike borrowing


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Preference shares (preferred stock)

Lower risk than ordinary shares and a lowerdividend

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 Participating - an extra dividend is possible Redeemable - company may buy back at a fixed

future date


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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


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Seniority of debt

Seniority indicates preference in positionover other lenders.

Some debt is subordinated. In the event of default, holders of

subordinated debt must give preference

to other specified creditors who are paidfirst.


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Security

Security is a form of attachment to theborrowing firms assets.

It provides that the assets can be sold inevent of default to satisfy the debt forwhich the security is given.


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Debenture

A written agreement between thecorporate debt issuer and thelender.

Sets forth the terms of the loan: Maturity

Interest rate Protective covenants

e.g. financial reports, restriction onfurther loan issues, restriction on

disposal of assets and level of dividends


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Convertible bonds

A convertible bond is a bond that gives theholder the right to "convert" or exchange thepar amount of the bond for ordinary shares of

the issuer at some fixed ratio during aparticular period. As bonds, they provide a coupon payment and

are legally debt securities, which rank prior toequity securities in a default situation.

Their value, like all bonds, depends on the levelof prevailing interest rates and the creditquality of the issuer.

Their conversion feature also gives themfeatures of equity securities.


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The Cost of Capital

Expected Return

Risk premium

Risk-free rate

Time value of money_________________________________________________________

_____Risk

Treasury Corporate Preference

Bonds Bonds SharesOrdinary

Shares


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Measuring capital structure

Debt/(Debt + Market Value ofEquity)

Debt/Total Book Value of Assets

Interest coverage:EBITDA/Interest


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Interpreting capital structures

The capital structures we observe are determined bothby deliberate choices and by chance events

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


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Business risk and Financialrisk

Firms have business risk generated bywhat they do

But firms adopt additional financial riskwhen they finance with debt


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Risk and the IncomeStatement

Sales

Operating Variable costs

Leverage Fixed costs

EBIT Interest expense

Financial Earnings before taxes

Leverage TaxesNet Income

EPS = Net Income

No. of Shares


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Business Risk

The basic risk inherent in the operationsof a firm is called business risk

Business risk can be viewed as thevariability of a firms Earnings BeforeInterest and Taxes (EBIT)


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Financial Risk

Debt causes financial risk because itimposes a fixed cost in the form ofinterest payments.

The use of debt financing is referred toas financial leverage.

Financial leverage increases risk by

increasing the variability of a firmsreturn on equity or the variability of itsearnings per share.


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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 fixedcost source of financing. This increases thelevel of EBITa firm needs just to break even.

A firm will generally try to avoid financial risk

- a high level of EBITto break even - if itsEBITis very uncertain (due to high businessrisk).


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Why should we care aboutcapital structure?

By altering capital structure firms havethe opportunity to change their cost of

capital and therefore the market valueof the firm


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What is an optimal capital structure?

An optimal capital structure is one thatminimizes the firms 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 ofCapital

Capital structure affects the WACC


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Capital Structure Theory

Basic question Is it possible for firms to create value by

altering their capital structure? Major theories

Net Income Approach

Net Operating Income Approach

Traditional Approach

Modigliani and Miller theory


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Net Income Approach

( Capital structure is relevant) Given by Durand According to this approach, If we inc

Debt or leverage then cost of capital will

dec and value of firm will inc.Assumptions:-1) No Taxes2) Cost of Debt is less than equity or Kd

Capital Structure English

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