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
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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
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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)
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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
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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
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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
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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
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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
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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….