Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables. Poor capi- tal structure decisions can result in a high cost of capital, thereby lowering the NPVs of projects and making more of them unacceptable. Effective capital struc- ture decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects and thereby increasing the value of the firm.
TYPES OF CAPITAL
All the items on the right-hand side of the firm’s balance sheet, excluding current liabil- ities, are sources of capital. The following simplified balance sheet illustrates the basic breakdown of total capital into its two components, debt capital and equity capital:
Balance Sheet
Long-term debt
Assets Stockholders’ equity Preferred stock Common stock equity Common stock Retained earnings Current liabilities
Equity capital Debt capital
Total capital
The cost of debt is lower than the cost of other forms of financing. Lenders de- mand relatively lower returns because they take the least risk of any contributors of long-term capital. Lenders have a higher priority of claim against any earnings or assets available for payment, and they can exert far greater legal pressure against the company to make payment than can owners of preferred or common stock. The tax deductibility of interest payments also lowers the debt cost to the firm substantially.
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Unlike debt capital, which the firm must eventually repay, equity capital re- mains invested in the firm indefinitely; it has no maturity date. The two main sources of equity capital are (1) preferred stock and (2) common stock equity, which in- cludes common stock and retained earnings. Common stock is typically the most expensive form of equity, followed by retained earnings and then preferred stock.
Our concern here is the relationship between debt and equity capital. In general, the more debt a firm uses, the greater will be the firm’s financial leverage. That leverage makes the claims of common stockholders even more risky. In addition, a firm that increases its use of leverage significantly can see its cost of debt rise as lenders begin to worry about the firm’s ability to repay its debts. Whether the firm borrows very little or a great deal, it is always true that the claims of common stockholders are riskier than those of lenders, so the cost of equity always exceeds the cost of debt.
ExTERNAL ASSESSMENT OF CAPITAL STRuCTuRE
We saw earlier that financial leverage results from the use of fixed-cost financing, such as debt and preferred stock, to magnify return and risk. The amount of lever- age in the firm’s capital structure can affect its value by affecting return and risk.
Those outside the firm can make a rough assessment of capital structure by using measures found in the firm’s financial statements. Some of these important debt ratios were presented in Chapter 3. For example, a direct measure of the degree of indebtedness is the debt ratio (total liabilities 4 total assets). The higher this ratio is, the greater the relative amount of debt (or financial leverage) in the firm’s capital structure. Measures of the firm’s ability to meet contractual payments associated with debt include the times interest earned ratio (EBIT 4 interest) and the fixed- payment coverage ratio (see page 127). These ratios provide indirect information on financial leverage. Generally, the smaller these ratios, the greater the firm’s financial leverage and the less able it is to meet payments as they come due.
The level of debt (financial leverage) that is acceptable for one industry or line of business can be highly risky in another, because different industries and lines of business have different operating characteristics. Table 13.8 presents the debt and times interest earned ratios for selected industries and lines of business.
Significant industry differences can be seen in these data. Differences in debt posi- tions are also likely to exist within an industry or line of business.
Those who lend to individuals, like lenders to corporations, typically use ratios to assess the applicant’s ability to meet the contractual payments associated with the requested debt. The lender, after obtain- ing information from a loan application and other sources, calculates ratios and compares them to predetermined allowable values. Typically, if the applicant’s ra- tio values are within the acceptable range, the lender will make the requested loan.
The best example of this process is a real estate mortgage loan application.
The mortgage lender usually invokes the following two requirements:
1. Monthly mortgage payments , 25% to 30% of monthly gross (before-tax) income
2. Total monthly installment payments (including the mortgage payment) , 33% to 38% of monthly gross (before-tax) income
Assume that the Loo family is applying for a mortgage loan. The family’s monthly gross (before-tax) income is $5,380, and they currently have monthly Personal Finance Example 13.16 ▶
installment loan obligations that total $560. The $200,000 mortgage loan they are applying for will require monthly payments of $1,400. The lender requires (1) the monthly mortgage payment to be less than 28% of monthly gross income and (2) total monthly installment payments (including the mortgage payment) to be less than 37% of monthly gross income. The lender calculates and evaluates these ratios for the Loos, as shown below.
1. Mort. pay. 4 Gross income 5 $1,400 4 $5,380
5 26% , 28% maximum, therefore OK 2. Tot. instal. pay. 4 Gross income 5 ($560 1 $1,400) 4 $5,380
5 $1,960 4 $5,380
5 36.4% , 37% maximum, therefore OK The Loos’ ratios meet the lender’s standards. So, assuming that they have ade- quate funds for the down payment and meet other lender requirements, the Loos will be granted the loan.
CAPITAL STRuCTuRE OF NON–u.S. FIRMS
In general, non–U.S. companies have much higher degrees of indebtedness than their U.S. counterparts. Most of the reasons are because U.S. capital markets are more developed than those elsewhere and have played a greater role in corporate financing than has been the case in other countries. In most European countries,
Median Debt Ratios for Selected Industries (Fiscal Year 2011)
NAICS Industry Debt ratio
Times interest earned ratio
Agriculture, forestry, fishing, and hunting 41.0% 2.6
Mining, quarrying, and oil and gas extraction 44.8 1.8
Utilities 69.2 3.1
Construction 57.7 1.2
Manufacturing 47.8 3.8
Wholesale trade 58.7 5.5
Retail trade 56.4 5.2
Transportation and warehousing 61.2 2.8
Information 52.6 2.3
Finance and insurance 88.3 3.9
Real estate and rental and leasing 56.4 1.3
Professional, scientific, and technical services 46.9 3.9 Administrative and support and waste management
and remediation services 54.9 3.7
Educational services 38.8 21.5
Health care and social assistance 62.0 3.1
Arts, entertainment, and recreation 54.7 2.2
Accommodation and food services 59.3 2.8
Other services (except public administration) 76.2 3.0 Source: Author-generated values. Industries are 2012 NAICS industry sectors.
T A B L E 1 3 . 8
and especially in Japan and other Pacific Rim nations, large commercial banks are more actively involved in the financing of corporate activity than has been true in the United States. Furthermore, in many of these countries, banks are al- lowed to make large equity investments in nonfinancial corporations, a practice prohibited for U.S. banks. Finally, share ownership tends to be more tightly con- trolled among founding-family, institutional, and even public investors in Europe and Asia than it is for most large U.S. corporations. Tight ownership enables owners to understand the firm’s financial condition better, resulting in their will- ingness to tolerate a higher degree of indebtedness.
12.Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance, and the Theory of Invest- ment,” American Economic Review (June 1958), pp. 261–297.
13. Perfect-market assumptions include (1) no taxes, (2) no brokerage or flotation costs for securities, (3) symmetri- cal information (that is, investors and managers have the same information about the firm’s investment prospects), and (4) investor ability to borrow at the same rate as corporations.
Matter of fact
A study of the use of long-term debt in 42 countries found that firms in Argentina used more long-term debt than firms in any other country. Relative to their assets, firms in Argentina used almost 60 percent more long-term debt than did U.S. companies. Indian firms were heavy users of long-term debt as well. At the other end of the spectrum, companies from Italy, Greece, and Poland used very little long-term debt. In those countries, firms used only about 40 percent as much long-term debt as did their U.S. counterparts.
Leverage around the World
On the other hand, similarities do exist between U.S. corporations and corpora- tions in other countries. First, the same industry patterns of capital structure tend to be found all around the world. For example, in nearly all countries, pharmaceutical and other high-growth industrial firms tend to have lower debt ratios than do steel companies, airlines, and electric utility companies. In part, it has to do with the na- ture of assets held by these firms. High-growth firms whose main assets are intan- gibles (such as patents and rights to intellectual property) tend to borrow less than firms that have tangible assets that can be pledged as collateral for loans. Second, the capital structures of the largest U.S.–based multinational companies, which have access to capital markets around the world, typically resemble the capital structures of multinational companies from other countries more than they resemble those of smaller U.S. companies. In other words, in most countries there is a tendency for larger firms to borrow more than smaller firms do. Third, companies that are riskier and have more volatile income streams tend to borrow less, as do firms that are highly profitable. Finally, the worldwide trend is away from reliance on banks for financing and toward greater reliance on security issuance. Over time, the differ- ences in the capital structures of U.S. and non–U.S. firms will probably lessen.
CAPITAL STRuCTuRE ThEORY
Research suggests that there is an optimal capital structure range. It is not yet possible to provide financial managers with a precise methodology for determin- ing a firm’s optimal capital structure. Nevertheless, financial theory does offer help in understanding how a firm’s capital structure affects the firm’s value.
In 1958, Franco Modigliani and Merton H. Miller12 (commonly known as
“M and M”) demonstrated mathematically that, assuming perfect markets,13 the
capital structure that a firm chooses does not affect its value. Many researchers, including M and M, have examined whether capital structure may in fact affect firm value in imperfect, real-world markets. The result is a theoretical optimal capital structure based on balancing the benefits and costs of debt financing. The major benefit of debt financing is the tax shield, which allows interest payments to be deducted in calculating taxable income. The cost of debt financing results from (1) the increased probability of bankruptcy caused by debt obligations, (2) the agency costs of the lender’s constraining the firm’s actions, and (3) the costs associated with managers having more information about the firm’s prospects than do investors.
Tax Benefits
Allowing firms to deduct interest payments on debt when calculating taxable in- come reduces the amount of the firm’s earnings paid in taxes, thereby making more earnings available for bondholders and stockholders. The deductibility of interest means the cost of debt, ri, to the firm is subsidized by the government.
Letting rd equal the before-tax cost of debt and letting T equal the tax rate, from Chapter 9 (Equation 9.2), we have ri = rd * (1 - T).
Probability of Bankruptcy
The chance that a firm will become bankrupt because of an inability to meet its obligations as they come due depends largely on its levels of both business risk and financial risk.
Business Risk We define business risk as the risk to the firm of being unable to cover its operating costs. In general, the greater the firm’s operating leverage—
the use of fixed operating costs—the higher its business risk. Although operating leverage is an important factor affecting business risk, two other factors—revenue stability and cost stability—also affect it. Revenue stability reflects the relative variability of the firm’s sales revenues. Firms with stable levels of demand and product prices tend to have stable revenues. The result is low levels of business risk. Firms with highly volatile product demand and prices have unstable revenues that result in high levels of business risk. Cost stability reflects the relative predict- ability of input prices such as those for labor and materials. The more predictable and stable these input prices are, the lower the business risk; the less predictable and stable they are, the higher the business risk.
Business risk varies among firms, regardless of their lines of business, and is not affected by capital structure decisions. The level of business risk must be taken as a “given.” The higher a firm’s business risk, the more cautious the firm must be in establishing its capital structure. Firms with high business risk therefore tend toward less highly leveraged capital structures, and firms with low business risk tend toward more highly leveraged capital structures. We will hold business risk constant throughout the discussions that follow.
Cooke Company, a soft drink manufacturer, is preparing to make a capital struc- ture decision. It has obtained estimates of sales and the associated levels of earn- ings before interest and taxes (EBIT) from its forecasting group: There is a 25%
chance that sales will total $400,000, a 50% chance that sales will total $600,000, and a 25% chance that sales will total $800,000. Fixed operating costs total Example 13.17 ▶
T A B L E 1 3 . 9 Sales and Associated EBIT Calculations for Cooke Company ($000)
Probability of sales 0.25 0.50 0.25
Sales revenue $400 $600 $800
Less: Fixed operating costs 200 200 200
Less: Variable operating costs (50% of sales) 200 300 400 Earnings before interest and taxes (EBIT) $ 0 $100 $200
Current capital structure
Long-term debt $ 0
Common stock equity (25,000 shares at $20) 500,000
Total capital (assets) $ 500,000
14. This assumption is needed so that we can assess alternative capital structures without having to consider the re- turns associated with the investment of additional funds raised. Attention here is given only to the mix of capital, not to its investment.
$200,000, and variable operating costs equal 50% of sales. These data are sum- marized, and the resulting EBIT calculated, in Table 13.9.
Table 13.9 shows that there is a 25% chance that the EBIT will be $0, a 50%
chance that it will be $100,000, and a 25% chance that it will be $200,000.
When developing the firm’s capital structure, the financial manager must accept as given these levels of EBIT and their associated probabilities. These EBIT data effectively reflect a certain level of business risk that captures the firm’s operating leverage, sales revenue variability, and cost predictability.
The penalty for not meeting financial obligations is bankruptcy. The more fixed-cost financing—debt (including financial leases) and preferred stock—a firm has in its capital structure, the greater its financial leverage and risk. Finan- cial risk depends on the capital structure decision made by the management, and that decision is affected by the business risk the firm faces.
Total Risk The total risk of a firm—business and financial risk combined—
determines its probability of bankruptcy. Financial risk, its relationship to busi- ness risk, and their combined impact can be demonstrated by continuing the Cooke Company example.
Cooke Company’s current capital structure is as follows:
Example 13.18▶
Let us assume that the firm is considering seven alternative capital structures. If we measure these structures using the debt ratio, they are associated with ratios of 0%, 10%, 20%, 30%, 40%, 50%, and 60%. Assuming that (1) the firm has no current liabilities, (2) its capital structure currently contains all equity as shown, and (3) the total amount of capital remains constant14 at $500,000, the
mix of debt and equity associated with the seven debt ratios would be as shown in Table 13.10. Also shown in the table is the number of shares of common stock outstanding under each alternative.
Associated with each of the debt levels in column 3 of Table 13.10 would be an interest rate that would be expected to increase with increases in financial le- verage. The level of debt, the associated interest rate (assumed to apply to all debt), and the dollar amount of annual interest associated with each of the alter- native capital structures are summarized in Table 13.11. Because both the level of debt and the interest rate increase with increasing financial leverage (debt ratios), the annual interest increases as well.
Table 13.12 uses the levels of EBIT and associated probabilities developed in Table 13.9, the number of shares of common stock found in column 5 of Table 13.10, and the annual interest values calculated in column 3 of Table 13.11 to calculate the earnings per share (EPS) for debt ratios of 0%, 30%, and 60%.
T A B L E 1 3 . 1 1 Level of Debt, Interest Rate, and Dollar Amount of Annual Interest Associated with Cooke Company’s Alternative Capital Structures Capital structure
debt ratio
Debt ($000) (1)
Interest rate on all debt
(2)
Interest ($000) [(1) 3 (2)]
(3)
0% $ 0 0.0% $ 0.00
10 50 9.0 4.50
20 100 9.5 9.50
30 150 10.0 15.00
40 200 11.0 22.00
50 250 13.5 33.75
60 300 16.5 49.50
T A B L E 1 3 . 1 0 Capital Structures Associated with Alternative Debt Ratios for Cooke Company
Capital structure ($000)
Shares of common stock outstanding (000)
[(4) 4 $20]b (5) Debt ratio
(1)
Total assetsa (2)
Debt [(1) 3 (2)]
(3)
Equity [(2)2 (3)]
(4)
0% $500 $ 0 $500 25.00
10 500 50 450 22.50
20 500 100 400 20.00
30 500 150 350 17.50
40 500 200 300 15.00
50 500 250 250 12.50
60 500 300 200 10.00
aBecause the firm, for convenience, is assumed to have no current liabilities, its total assets equal its total capital of $500,000.
bThe $20 value represents the book value per share of common stock equity noted earlier.
A 40% tax rate is assumed. Also shown are the resulting expected EPS, the stan- dard deviation of EPS, and the coefficient of variation of EPS associated with each debt ratio.15
15. For explanatory convenience, the coefficient of variation of EPS, which measures total (nondiversifiable and diver- sifiable) risk, is used throughout this chapter as a proxy for beta, which measures the relevant nondiversifiable risk.
T A B L E 1 3 . 1 2 Calculation of EPS for Selected Debt Ratios ($000) for Cooke Company
Probability of EBIT 0.25 0.50 0.25
Debt ratio 5 0%
EBIT (Table 13.9) $ 0.00 $100.00 $200.00
Less: Interest (Table 13.11) 0.00 0.00 0.00
Net profits before taxes $ 0.00 $100.00 $200.00
Less: Taxes (T 5 0.40) 0.00 40.00 80.00
Net profits after taxes $0.00 $ 60.00 $120.00
EPS (25.0 shares, Table 13.10) $ 0.00 $ 2.40 $ 4.80
Expected EPSa $2.40
Standard deviation of EPSa $1.70
Coefficient of variation of EPSa 0.71
Debt ratio 5 30%
EBIT (Table 13.9) $ 0.00 $100.00 $200.00
Less: Interest (Table 13.11) 15.00 15.00 15.00
Net profits before taxes ($15.00) $ 85.00 $185.00
Less: Taxes (T5 0.40) ( 6.00)b 34.00 74.00
Net profits after taxes ($ 9.00) $ 51.00 $111.00
EPS (17.50 shares, Table 13.10) ( 0.51) $ 2.91 $ 6.34
Expected EPSa $2.91
Standard deviation of EPSa $2.42
Coefficient of variation of EPSa 0.83
Debt ratio 5 60%
EBIT (Table 13.9) $ 0.00 $100.00 $200.00
Less: Interest (Table 13.11) 49.50 49.50 49.50
Net profits before taxes ($49.50) $ 50.50 $150.50
Less: Taxes (T 5 0.40) ( 19.80)b 20.20 60.20
Net profits after taxes ($29.70) $ 30.30 $ 90.30
EPS (10.00 shares, Table 13.10) ($ 2.97) $ 3.03 $ 9.03
Expected EPSa $3.03
Standard deviation of EPSa $4.24
Coefficient of variation of EPSa 1.40
aThe procedures used to calculate the expected value, standard deviation, and coefficient of variation were presented in Chapter 8.
bIt is assumed that the firm receives the tax benefit from its loss in the current period as a result of applying the tax loss carryback procedures specified in the tax law but not discussed in this text.
Table 13.13 summarizes the pertinent data for the seven alternative capital structures. The values shown for 0%, 30%, and 60% debt ratios were developed in Table 13.12; calculations of similar values for the other debt ratios (10%, 20%, 40%, and 50%) are not shown. Because the coefficient of variation mea- sures the risk relative to the expected EPS, it is the preferred risk measure for use in comparing capital structures. As the firm’s financial leverage increases, so does its coefficient of variation of EPS. As expected, an increasing level of risk is asso- ciated with increased levels of financial leverage.
The relative risks of the two extremes of the capital structures evaluated in Table 13.12 (debt ratios 5 0% and 60%) can be illustrated by showing the prob- ability distribution of EPS associated with each of them. Figure 13.3 shows these T A B L E 1 3 . 1 3 Expected EPS, Standard Deviation, and Coefficient of Variation
for Alternative Capital Structures for Cooke Company
Capital structure debt ratio
Expected EPS (1)
Standard deviation of EPS
(2)
Coefficient of variation of EPS
[(2) 4 (1)]
(3)
0% $2.40 $1.70 0.71
10 2.55 1.88 0.74
20 2.72 2.13 0.78
30 2.91 2.42 0.83
40 3.12 2.83 0.91
50 3.18 3.39 1.07
60 3.03 4.24 1.40
F I G u R E 1 3 . 3 Probability Distributions Probability distributions of EPS for debt ratios of 0 percent and 60 percent for Cooke Company
0 –1 –2 –3
–4 1 2 3
3.03 2.40
4 5 6 7 8 9
EPS ($)
Debt Ratio = 0%
Debt Ratio = 60%
Probability Density