Kevin Campbell, University of Stirling, October 2006

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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?



Is there an optimal capital structure?

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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Financial
Structure

What is “Capital Structure”?

Balance Sheet

Current

Current

Assets

Liabilities

Debt

Fixed

Preference

Assets

shares

Ordinary

shares

Kevin Campbell, University of Stirling, October 2006

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Capital
Structure

What is “Capital Structure”?

Balance Sheet

Current Current

Assets

Liabilities

Debt

Fixed

Preference

Assets

shares

Ordinary

shares

Kevin Campbell, University of Stirling, October 2006

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Sources of capital



Ordinary shares (common stock)



Preference shares (preferred stock)



Hybrid securities



Warrants



Convertible bonds



Loan capital



Bank loans



Corporate bonds

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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.

Kevin Campbell, University of Stirling, October 2006

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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.

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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.

Kevin Campbell, University of Stirling, October 2006

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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.

Kevin Campbell, University of Stirling, October 2006

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The Cost of Capital

Expected Return

Risk premium

Risk-free rate

Time value of money

________________________________________________________
______

Risk

Treasury Corporate Preference

Hybrid

Bonds Bonds Shares

Securities

Ordinary

Shares

Kevin Campbell, University of Stirling, October 2006

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Measuring capital
structure



Debt/(Debt + Market Value of Equity)



Debt/Total Book Value of Assets



Interest coverage: EBITDA/Interest

Kevin Campbell, University of Stirling, October 2006

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Selected leverage data for
US corporations

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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

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 capital
structures

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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)

Kevin Campbell, University of Stirling, October 2006

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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.

Kevin Campbell, University of Stirling, October 2006

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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 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).

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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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

Kevin Campbell, University of Stirling, October 2006

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Modigliani and Miller
(MM)



Most influential papers ever
published in finance



Very restrictive assumptions



First “no arbitrage” proof in finance



Basis for other theories

Kevin Campbell, University of Stirling, October 2006

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

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

Kevin Campbell, University of Stirling, October 2006

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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.

Kevin Campbell, University of Stirling, October 2006

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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 tradeof between the tax

advantage to debt financing and risk, each firm

has an optimal capital structure that minimizes

the WACC and maximises firm value.

Kevin Campbell, University of Stirling, October 2006

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Is there magic in financial
leverage?



… can a company increase its value
simply by altering its capital structure?



…yes and no



…we will see….