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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?

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capital structure
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?
what is capital structure
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), Preferenceshares (preferred stock)
  • Hybrids, eg warrants, convertible bonds
what is capital structure3
What is “Capital Structure”?

Balance Sheet

Current Current

AssetsLiabilities

Debt

FixedPreference

Assets shares

Ordinary

shares

Financial

Structure

what is capital structure4
What is “Capital Structure”?

Balance Sheet

Current Current

AssetsLiabilities

Debt

FixedPreference

Assets shares

Ordinary

shares

Capital

Structure

sources of capital
Sources of capital
  • Ordinary shares (common stock)
  • Preference shares (preferred stock)
  • Hybrid securities
    • Warrants
    • Convertible bonds
  • Loan capital
    • Bank loans
    • Corporate bonds
ordinary shares common stock
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
preference shares preferred stock
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
  • Participating- an extra dividend is possible
  • Redeemable- company may buy back at a fixed future date
loan capital
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
seniority of debt
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.
security
Security
  • Security is a form of attachment to the borrowing firm’s assets.
  • It provides that the assets can be sold in event of default to satisfy the debt for which the security is given.
i ndenture
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
warrants
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.
convertible bonds
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.
the cost of capital
The Cost of Capital

Expected Return

Risk premium

Risk-free rate

Time value of money

______________________________________________________________

Risk

Treasury Corporate Preference

Hybrid

Ordinary

Bonds

Bonds Shares

Securities

Shares

measuring capital structure
Debt/(Debt+Market Value of Equity)

Debt/Total Book Value of Assets

Interest coverage: EBITDA/Interest

Measuring capital structure
interpreting capital structures
The capital structures we observe are determined both by deliberate choices and by chance events

Safeway’s high leverage came from an LBO

HP’s low leverage is the HP way

Disney’s low leverage reflects past good performance

GM’s high leverage reflects the opposite

Interpreting capitalstructures
interpreting capital structures18
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

Interpreting capitalstructures
business risk and financial risk
Business risk and Financial risk
  • Firms have business risk generated by what they do
  • But firms adopt additional financial risk when they finance with debt
risk and the income statement
Risk and the Income Statement

Sales

Operating –Variable costs

Leverage –Fixed costs

EBIT

–Interest expense

Financial Earnings before taxes

Leverage –Taxes

Net Income

EPS = Net Income

No. of Shares

business risk
Business Risk
  • The basic risk inherent in the operations of a firm is called business risk
  • Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT)
financial risk
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.
financial risk vs business risk
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 sourceof 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).
why should we care about capital structure
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
What is an optimal capital structure?
  • An optimalcapital 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
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
modigliani and miller mm
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
modigliani and miller mm28
Modigliani and Miller (MM)
  • Most influential papers ever published in finance
  • Very restrictive assumptions
  • First “no arbitrage” proof in finance
  • Basis for other theories
slide29

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.
a basic capital structure theory
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.
slide31

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