Please enable JavaScript.
Coggle requires JavaScript to display documents.
Capital Structure and Leverage - Coggle Diagram
Capital Structure and Leverage
Book, Market or Target Weights?
Capital = investor supplied funds (debt, preferred stock, common stock, and retained earnings)
Capital structure = percentage of each type of investor-supplied capital (total 100%)
optimal capital structure = mix of debt, preferred stock, common stock that maximize intrinsic value and minimize WACC
Measuring capital structure
WACC book = Wd book(rd)(1-T)+Wc book (rs)
WACC market = Wd market(rd)(1-T)+Wc market (rs)
WACC target = Wd target (rd)(1-T)+Wc target (rs)
capital structure changes over time
deliberate action
market action
Business and financial risk
business risk = riskiness of the firm's assets if no debt is used
ROIC = EBIT (1-T)/total invested capital
more uncertainty of this value --> the greater business risk
Factors that affect business risk
competition
demand variability
sales price variability
input cost variability
product obsolescence
foreign risk exposure
regulatory risk and legal exposure
operating leverage
= the extend to which fixed costs are used in a firm's operation
operating breakeven the output quantity at which EBIT = 0 EBIT = PQ-VQ-F = 0
the higher degree of operating leverage --> the greater business risk
financial risk
= additional risk placed on the common stockholders as a result of using debt
financial leverage = the extent to which fixed income securities (debt and preferred stock) are used in a capital structure
zero debt --> EPS = (sales fixed cost-variable cost-interest)(1-Tax rate)/ shares outstanding
Determining optimal capital structure = the one that maximizes the price of the firm's stock
WACC = wd (rd)(1-T)+wc (rs)
Wd = debt/ (debt+equity) = debt/capital
D/E = wd/(1-wd)
when EPS=DPS --> P0= DPS/rs
Hamada equation bL= bU [1+(1-T)(D/E)}
CAPM --> rs = rRF+(RPM)bi
unlevered beta (bu) bu = bL/[1+(1-T)(D/E)]
rs= rRF + premium for business risk + premium for financial risk
Capital structure theory
effect of taxes
deductibility of interest favors the use of debt financing
more favorable tax treatment of income from stock lowers the required rates of return on stock and thus favor the use of equity
effect of potential bankruptcy
the probability of their occurence
the cost that will be incurred if financial distress arises
trade off theory
= firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy
signaling theory
symmetric information = manager and investor have identical information about firms' prospect
asymmetric information = manager have better information than investor
signal = clues to investor about how management view the firms' prospect
reserve borrowing capacity = ability to borrow money at reasonable cost when good investment opportunities arise
using debt financing to constraint manager
to funnel through higher dividens or stock repurchases, 2. to tilt target capital structure toward more debt, 3. leveraged buyout (reduce excess flow)
packing order hypothesis = the sequence in which firm prefer to raise capital : spontaneous credit --> retained earning --> other debt --> common stock
windows opportunity
= occasion where a company's manager adjust its capital structure to take advantage of certain market situation
Checklist capital structure decisions
sales stability
asset structure
net debt = short term debt+ long term debt - cash and equivalent
operating leverage
growth rate
profitability
taxes
control
management attitude
lender and rating agency attitude
market condition
firm's internal condition
financial flexibility