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What Is Capital Structure?

Dynamics of debt and equity, optimal capital structure.

• Capital Structure FAQs

The Bottom Line

• Corporate Finance
• Corporate Finance Basics

Capital Structure Definition, Types, Importance, and Examples

Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom.

Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock , or retained earnings. Short-term debt is also considered to be part of the capital structure.

Key Takeaways

• Capital structure is how a company funds its overall operations and growth.
• Debt consists of borrowed money that is due back to the lender, commonly with interest expense.
• Equity consists of ownership rights in the company, without the need to pay back any investment.
• The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company's borrowing practices.

Investopedia / Matthew Collins

Both debt and equity can be found on the balance sheet . Company assets , also listed on the balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and, therefore, poses a greater risk to investors. This risk, however, may be the primary source of the firm's growth.

Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.

Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a benefit to the company in the case of declining earnings . On the other hand, equity represents a claim by the owner on the future earnings of the company.

Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular. Investors can monitor a firm's capital structure by tracking the D/E ratio and comparing it against the company's industry peers.

It is the goal of company management to find the ideal mix of debt and equity, also referred to as the optimal capital structure , to finance operations.

Why Do Different Companies Have Different Capital Structure?

Firms in different industries will use capital structures better suited to their type of business. Capital-intensive industries like auto manufacturing may utilize more debt, while labor-intensive or service-oriented firms like software companies may prioritize equity.

How Do Managers Decide on Capital Structure?

Assuming that a company has access to capital (e.g. investors and lenders), they will want to minimize their cost of capital . This can be done using a weighted average cost of capital (WACC) calculation. To calculate WACC the manager or analyst will multiply the cost of each capital component by its proportional weight.

How Do Analysts and Investors Use Capital Structure?

A company with too much debt can be seen as a credit risk. Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital (as equity tends to be more costly than debt). Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. What defines a healthy blend of debt and equity varies depending on the industry the company operates in, its stage of development, and can vary over time due to external changes in interest rates and regulatory environment.

What Measures Do Analysts and Investors Use to Evaluate Capital Structure?

In addition to the weighted average cost of capital (WACC), several metrics can be used to estimate the suitability of a company's capital structure. Leverage ratios are one group of metrics that are used, such as the debt-to-equity (D/E) ratio or debt ratio.

Capital structure is the specific mix of debt and equity that a company uses to finance its operations and growth. Debt consists of borrowed money that must be repaid, often with interest, while equity represents ownership stakes in the company. The debt-to-equity (D/E) ratio is a commonly used measure of a company's capital structure and can provide insight into its level of risk. A company with a high proportion of debt in its capital structure may be considered riskier for investors, but may also have greater potential for growth.

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17.1 The Concept of Capital Structure

By the end of this section, you will be able to:

• Distinguish between the two major sources of capital appearing on a balance sheet.
• Explain why there is a cost of capital.
• Calculate the weights in a company’s capital structure.

The Basic Balance Sheet

In order to produce and sell its products or services, a company needs assets. If a firm will produce shirts, for example, it will need equipment such as sewing machines, cutting boards, irons, and a building in which to store its equipment. The company will also need some raw materials such as fabric, buttons, and thread. These items the company needs to conduct its operations are assets . They appear on the left-hand side of the balance sheet.

The company has to pay for these assets. The sources of the money the company uses to pay for these assets appear on the right-hand side of the balance sheet. The company’s sources of financing represent its capital . There are two broad types of capital: debt (or borrowing) and equity (or ownership).

Figure 17.2 is a representation of a basic balance sheet. Remember that the two sides of the balance sheet must be Assets = Liabilities  +   Equity Assets = Liabilities  +   Equity . Companies typically finance their assets through equity (selling ownership shares to stockholders) and debt (borrowing money from lenders). The debt that a firm uses is often referred to as financial leverage . The relative proportions of debt and equity that a firm uses in financing its assets is referred to as its capital structure .

Attracting Capital

When a company raises money from investors, those investors forgo the opportunity to invest that money elsewhere. In economics terms, there is an opportunity cost to those who buy a company’s bonds or stock.

Suppose, for example, that you have $5,000, and you purchase Tesla stock. You could have purchased Apple stock or Disney stock instead. There were many other options, but once you chose Tesla stock, you no longer had the money available for the other options. You would only purchase Tesla stock if you thought that you would receive a return as large as you would have for the same level of risk on the other investments.

From Tesla’s perspective, this means that the company can only attract your capital if it offers an expected return high enough for you to choose it as the company that will use your money. Providing a return equal to what potential investors could expect to earn elsewhere for a similar risk is the cost a company bears in exchange for obtaining funds from investors. Just as a firm must consider the costs of electricity, raw materials, and wages when it calculates the costs of doing business, it must also consider the cost of attracting capital so that it can purchase its assets.

Weights in the Capital Structure

Most companies have multiple sources of capital. The firm’s overall cost of capital is a weighted average of its debt and equity costs of capital. The average of a firm’s debt and equity costs of capital, weighted by the fractions of the firm’s value that correspond to debt and equity, is known as the weighted average cost of capital (WACC) .

The weights in the WACC are the proportions of debt and equity used in the firm’s capital structure. If, for example, a company is financed 25% by debt and 75% by equity, the weights in the WACC would be 25% on the debt cost of capital and 75% on the equity cost of capital. The balance sheet of the company would look like Figure 17.3 .

These weights can be derived from the right-hand side of a market-value-based balance sheet. Recall that accounting-based book values listed on traditional financial statements reflect historical costs. The market-value balance sheet is similar to the accounting balance sheet, but all values are current market values.

Just as the accounting balance sheet must balance, the market-value balance sheet must balance:

This equation reminds us that the values of a company’s debt and equity flow from the market value of the company’s assets.

Let’s look at an example of how a company would calculate the weights in its capital structure. Bluebonnet Industries has debt with a book (face) value of $5 million and equity with a book value of $3 million. Bluebonnet’s debt is trading at 97% of its face value. It has one million shares of stock, which are trading for $15 per share.

First, the market values of the company’s debt and equity must be determined. Bluebonnet’s debt is trading at a discount; its market value is 0.97 × $ 5,000,000 = $ 4,850,000 0.97 × $ 5,000,000 = $ 4,850,000 . The market value of Bluebonnet’s equity equals Number of Shares   ×   Price per Share   =   1,000,000   ×   $ 15   =   $ 15,000,000 Number of Shares   ×   Price per Share   =   1,000,000   ×   $ 15   =   $ 15,000,000 . Thus, the total market value of the company’s capital is $ 4,850,000   +   $ 15,000,000   =   $ 19,850,000 $ 4,850,000   +   $ 15,000,000   =   $ 19,850,000 . The weight of debt in Bluebonnet’s capital structure is $ 4 , 850 , 000 $ 19 , 850 , 000 = 24.4% $ 4 , 850 , 000 $ 19 , 850 , 000 = 24.4% . The weight of equity in its capital structure is $ 15 , 000 , 000 $ 19 , 850 , 000 = 75.6% $ 15 , 000 , 000 $ 19 , 850 , 000 = 75.6% .

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Leverage and capital structure

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Presentation on theme: "Leverage and capital structure"— Presentation transcript:

Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved 1 Chapter 16 Assessing Long-Term Debt, Equity, and Capital Structure McGraw-Hill/Irwin.

© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Financial Leverage and Capital Structure Chapter Seventeen.

Chapter 16 Financial Leverage and Capital Structure Policy

Capital Structure Theory Under Three Special Cases

Capital Structure Policy Capital Structure Policy (Ch16)

Last Lecture.. Cost of Equity Cost of Preferred Stock Cost of Debt

McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Leverage and Capital Structure Chapter 13.

Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 17 Financial Leverage and Capital Structure Policy.

Key Concepts and Skills

Capital Structure, long term financing Policy, and dividend policy

Chapter Outline The Capital Structure Decision

Financial Leverage and Capital Structure Policy

Capital Structure Refers to the mix of debt and equity that a company uses to finance its business Capital Restructuring Capital restructuring involves.

12-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

Capital Structure: Basic Concepts

13.0 Chapter 13 Leverage and Capital Structure Key Concepts and Skills Understand the effect of financial leverage on cash flows and cost of equity.

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Best PowerPoint Templates to Optimize Your Company's Capital Structure and Maximize Its Profitability

Nidhi Malhotra

“It doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will.” - Michael Milken

A company’s capital structure — primarily, its mixture of equity and debt financing —is a substantial factor in valuing the business. The relative levels of equity and debt have effects on risk and cash flow. In turn, it affects the amount that an investor would be willing to pay for the company or an interest in it. Capital structure can have a severe impact on the return a company earns for its shareholders. It also determines if a firm can survive a recession or depression.

The financial manager should choose a capital structure for the firm that maximizes wealth for the company’s stakeholders as a whole. In order to do that, it is crucial to find the ideal mix of debt and equity. This takes us to another significant concept,  Optimal Capital Structure , which is the mix of debt and equity that maximizes a firm’s return on capital, thereby maximizing its value.

In this blog, we will provide you with our top picks of financial management templates that you can use to optimize your firm’s capital structure. These templates result from extensive research and aim to assist you in making financial strategies that can maximize your company’s profit and corporate value.

But before that, let us dive into the basics of capital structure.

An Introduction to Capital Structure

In simple words, the term capital structure refers to the money deployed by the company for its operations and financing its assets. Usually, it is in two forms, i.e., debt and equity capital. Equity capital is raised from ownership shares in a company and claims to its future cash flows and profits. Equity may also come in the form of common stock, preferred stock, or retained earnings. Debt capital in the company’s capital structure refers to the borrowed money that is at work in the business. It’s raised in the form of bond issues or loans. Additionally, short-term debt is also considered to be part of the capital structure. Capital structure is demonstrated as a debt-to-equity or debt-to-capital ratio. A ratio higher than 1.0 signifies that the company is financed more by debt than equity.

In a simple capital structure example, if a firm’s assets come from a $30 million equity issuance and lending that amounts to $70 million, the capital structure can be said to be 30% equity and 70% debt.

Optimal Capital Structure

The basic question is, what is the appropriate or optimum capital structure that a company should follow to achieve the highest profitability? The answer is the proportion of debt and equity that results in the lowest cost to obtain it. This ideal proportion of debt and equity refers to the optimal capital structure. It is the best combination of debt and equity that results in the firm's lowest weighted average cost of capital (WACC). The determination of the optimal capital structure aims to increase the shareholders’ wealth, by maximizing the profit and corporate value. For optimizing the structure, a firm can issue either more debt or equity. The firm may use this newly acquired capital to invest in new assets or to repurchase debt/equity that’s currently outstanding, as a form of recapitalization.

Ready to Use PowerPoint Templates to Download and Incorporate

Here are our hand-picked templates that will help optimize your company's capital structure. These PPT templates are ready-to-use, eliminating all the hassle of creating anything from scratch. Easily modify the slides with the required details, and you are good to go!

Taking advantage of this slide, you can showcase the sources of your company's capital structure funding. You can modify the provided table with details of sources of funding and amount. Additionally, you can highlight the share of funding sources in the pre-designed pie chart. Lastly, you can jot down the significant insights taken from the projected data.

Download Source of Capital Structure Funding Template

This PowerPoint template will aid you in capturing a financial analysis of your company's capital structure. It presents details of the company's capital structure showing the compositions of the company's financial performance. The financial performance is showcased in terms of levered beta, asset to equity ratio, asset to debt ratio, equity to debt ratio, WACC, percentage of the cost of ownership, and cost of debt.

Download Financial Analysis of the Company’s Capital Structure PPT

The below-displayed PowerPoint template is a helpful tool to analyze the debt-equity ratio. This slide highlights the relative proportion of shareholder's equity and debt used to finance a firm's assets. You can easily modify the provided table with your company's debt and equity capital details. Also, you can jot down the key points related to the slide in the note section for readers' further assistance.

Download Analyzing Debt Equity Ratio PPT Slide

This slide will assist you in capturing the present situation of your company's debt situation. You can provide the debt structure of your company by adding the various debts in the particulars section. Further, you can add the amount of debt for two consecutive years. This slide will also be helpful to compare the current debt situation of the company with the last year. Which, in turn, will be valuable to gather insights into your business performance .

Download Present Debt Situation of Company PowerPoint Template

Analyzing the current equity situation of your company will become easy with this PPT slide. Similar to the previous slide, you can highlight the equity structure of your company in this template for two consecutive years. By doing so, you can compare your company's previous year's equity structure to that of the current year.

Download Current Equity Situation of Firm Slide

Financial leverage denotes the reliability of a business on its debts to run its operations. Calculating the financial leverage is essential to determine a business's financial solvency and its dependency upon its borrowings. The below-showcased PPT slide will arm you in calculating the financial leverage of your company. You can mention the details for earnings before interest and tax, profit before tax for the period of five years. Further, you can jot down the ratio of the company's financial leverage. Additionally, use the finely-crafted graph to project the financial leverage of various years. Also, you can highlight keynotes of the projected data in the next section of this PPT slide.

Download Analyzing Financial Leverage of Firm PPT Slide

This slide is a nifty tool to determine the pattern of the cost of equity vs. debt. Incorporating this template, on one side, you can highlight the cost of equity, and on another part, you can showcase details for the cost of debt. Lastly, you can mention the inferences about the patterns of the cost of equity vs. debt in the next section. For instance, the sample data provided in this slide represents that the firm is experiencing a decrease in the cost of equity as the firm's value is decreasing.

Download Cost of Equity vs Debt PPT Template

The template provides sample data for an over-leveraged firm looking to shift to an optimal debt ratio with a minimum cost of capital. This PPT slide summarizes the costs of debt, equity, projected firm value, stock prices, etc. values on different debt ratios. Taking the assistance of this template, you can modify the values with your company-specific statistics for estimating the optimal debt ratio.

Download Estimating Optimal Debt Ratio Template

This PPT slide is resourceful in providing readers with the various options through which a firm can achieve an optimal financial mix. The multiple options to alter the financial mix covered in this side are, Equity Recapitalization, Divestiture & use of Proceeds, and New Investment Financing. The stylish and modern layout of this slide makes it visually appealing.

Download Ways to Alter Financial Mix PowerPoint Template

Template 10

An initial public offering (IPO) represents the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance enables the company to acquire capital from public investors. This PPT template gives information about the IPO process that the company can use to raise funding through equity. Incorporating this slide, you can take reference and further modify the text values to set the IPO process for your company.

Download Initial Public Offering Process Template

Template 11

The following slide showcases details about the leveraged buyout process to raise equity funding. It is how a company can reduce its outstanding debt and significantly increase equity returns. This bar graph covered in this PPT template signifies the use of debt in a leveraged buyout transaction. In addition to that, it showcases how this process significantly increases the equity returns.

Download Leveraged Buyout Process to Raise Equity Funding PPT

Template 12

The slide is useful to determine the relation between net debt and asset trends. The data covered in this template showcases that the netblock is increasing whereas the debt is decreasing. Therefore, the new assets added to the system are being financed through equity and internal financing. Downloading upon this slide, you can easily modify the graph and key results section to cater to your requirements.

Download Impact on Debt PPT Template

Template 13

The below-displayed PPT template captures the equity distribution of a company and analyzes the value of equity issued to equity subscribed for a year. It determines the entire shares which are published and subscribed. Further, it covers the critical points taken that are deduced from the showcased data.

Download Impact on Firm Equity Pattern Template

Template 14

In the previous slides, we have explained how the company has taken initiatives to optimize its capital structure. This slide showcases the achievement of the optimal debt equity mix in the company. It covers a pre-developed table with five columns. It covers Debt-Equity Mix, Cost of Debt %, Cost of Debt %, and Composite cost of Capital % for four quarters. The sample data covered in this slide determines how the firm will gradually reach the optimal financial mix of debt and equity to incur a minimum cost of capital in the next year. The firm will have the lowest cost of capital with 19% debt and 81% equity.

Download Achieving Optimal Debt Equity Mix Slide

Template 15

This slide aims to analyze the firm's financial performance with the help of a balance sheet statement. This template provides a glimpse of the firm's balance sheet with information about assets, liabilities, and shareholder's equity for the current year. Companies can also make use of this pre-developed accounting tool to ease their work and, in turn, smoothen the work processes of their company.

Download Balance Sheet Statement PPT Template

In Conclusion

Needless to say, that the companies that have survived all times focus on the highest or maximum profits. Meanwhile, if the companies are not profit-oriented, they get crushed by the better efficient companies. Download this deck to help your organization optimize debt ratio to maximize firm value and reduce the cost of capital. These PPT templates will also be handy for the chief financial officer to analyze and present the company's financial performance to higher-level management.

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Capital Structure and Leverage

Jul 17, 2014

270 likes | 559 Views

Capital Structure and Leverage. Rest of Chapter 14. Capital Structure M&M (Modigliani and Miller). Background. skim. Capital structure refers to the mix of a firm’s debt and equity In this context Preferred S tock is assumed to be part of a firm’s debt

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Presentation Transcript

Capital Structure and Leverage Rest of Chapter 14

Capital Structure • M&M (Modigliani and Miller)

Background skim • Capital structure refers to the mix of a firm’s debt and equity • In this context Preferred Stock is assumed to be part of a firm’s debt • Financial leverage refers to using borrowed money to enhance the effectiveness of invested equity • Financial leverage of 40% means the firm’s capital structure contains 40% debt and 60% equity

Small business (not the focus of this class) • Equity at a point in time is fixed • Add equity over time with retained earnings • Does not have easy access to equity capital market • Capital structure (amount of debt) a KEY business decision • Trade off of more risk as additional debt is taken off versus the additional return from adding the debt

skim The Central Issue for Corporations • Capital structure is independent (mostly) of the size of the company and its asset mix • The question is: can the use of debt increase the value of a firm’s equity? • Specifically, the firm’s stock price • Under certain conditions changing leverage increases stock price • An optimal capital structure maximizes stock price • The relationship between capital structure and stock price is not precise nor fully understood

skim Risk in the Context of Leverage • Leverage influences stock price • Alters the risk/return relationship in an equity investment • Measures of performance • Operating income (AKA: EBIT) • Unaffected by leverage because it is calculated prior to the deduction for interest • Leverage increases the EM and increases ROE if BEP>interest rate • Risk of ROE and EPS is very much effected by leverage

Financial Leverage • Borrowing money (leverage) is used because it is expected to increase average ROE and EPS • The use of borrowed money incurs interest, which is in essence a fixed cost, so risk is also increased • When returns are greater than the interest rate then financial leverage will improve a firm’s ROE and EPS • However, if returns are lower than the interest rate then borrowing money will worsen EPS and ROE

ROCE and BEP • Return on Capital Employed (ROCE) • Measures the profitability of operations before financing charges but after taxes on a basis comparable to ROE • When the ROCE exceeds the after-tax cost of debt, more leverage improves ROE and EPS • When ROCE is less than the after-tax cost of debt, more leverage makes ROE and EPS worse • BEP: Can compare to pre tax interest rate.

Table 13.1 As the firm’s debt ratio rises, both EPS and ROE rise dramatically. While EAT falls, the number of shares outstanding falls at a faster rate as debt replaces equity.

Table 13.2 ABC is now doing rather poorly—ROE and ROCE are quite low. As the firm adds leverage, EPS and ROE decrease.

Financial Leverage and Financial Risk skim • Financial leverage is a two-edged sword • Multiplies good results into great results • Multiples bad results into terrible results • ROE and EPS for leveraged firms experience more variation • Financial risk is the increased variability in financial results that comes from additional leverage

Putting the Ideas Together—The Effect on Stock Price skim • Leverage enhances returns while it adds risk, pushing stock prices in opposite directions • Enhanced performance increases dividends, which increases the PV of dividends per share (driving up the stock’s price) • The increased risk increases the stocks beta and this decreases the PV of dividends per share (drives down the stock’s price) • Which effect dominates, and when? • Principle of increasing. Risk increases at an increasing rate as leverage increases. • At low leverage an increase in debt increases risk a little • At high leverage an increase in debt increases risk a lot

Real Investor Behavior and the Optimal Capital Structure skim • When leverage is low an increase in debt has a positive effect on investors • At high debt levels concerns about risk dominate and adding more debt decreases the stock’s price • As leverage increase its effect goes from positive to negative, which results in an optimum capital structure

Figure 13.2: The Effect of Leverage on Stock Price

Finding the Optimum—A Practical Problem skim • There is no way to determine the exact optimum amount of leverage for a particular company at a particular time • Appropriate level tends to vary according to • Nature of a company’s business • If firm has high business risk it should use less leverage • Economic climate • If the outlook is poor investors are likely to be more sensitive to risk • As a practical matter the optimum capital structure cannot be precisely located • The best we can usually do is compare to the industry average

The Target Capital Structure • A firm’s target capital structure is management’s estimate of the optimal capital structure • An approximation or best guess as to the amount of debt that will maximize the firm’s stock price

Modigliani and Miller (MM) Capital Structure Theory • Restrictive Assumptions in the Original Model • In 1958 MM published their first paper on capital structure • Included numerous restrictions such as • No income taxes • Securities trade in perfectly efficient capital markets with no transaction costs • No costs to bankruptcy • Investors and companies can borrow as much as they want at the same rate

The Early Theory by Modigliani and Miller (MM) • The Result • Under MM’s initial set of restrictions, value is independent of capital structure • As cheaper debt is added the cost of equity increases because of increased risk • However the weight of the more expensive equity is decreasing while the weight of the cheaper debt is increasing, leading to a constant weighted average cost of capital • Thus the PV of the firm does not change

The Theory by Modigliani and Miller (MM) • The Assumptions and Reality • Realistically income taxes exist • Realistically the costs of bankruptcy are quite large • Realistically individuals cannot borrow at the same rate as companies and interest rates usually rise as more money is borrowed

The Early Theory by Modigliani and Miller (MM) • The Arbitrage Concept • Arbitrage means making a profit by buying and selling the same thing at the same time in two different markets • MM proposed that arbitrage by equity investors would hold the value of the firm constant as debt levels changed • Equity investors could sell shares in a leveraged firm and buy shares in an unleveraged firm by borrowing money on their own • Interpreting the Result • The MM result implies that leverage affects value because of market imperfections • Such as taxes and transaction costs (including bankruptcy)

Relaxing the Assumptions—More Insights • Financing and the U.S. Tax System • Tax system favors debt financing over equity financing • Interest expense on debt is tax deductible while dividends on stock are not • Bankruptcy costs • Greater chance of incurring cost as more debt is used, thus causes value of stock to decline at some point as risk gets too high • Interest rate on debt rises as debt increases – causing stock price to decline at some point

Relaxing the Assumptions—More Insights • Corporate taxes and bankruptcy costs discussed in the text. • Relaxing MM assumptions suggests that an optimal amount of debt exists for a corporation, but doesn’t really help us find it.

Capital Structures Around the World $424$ Capital Structure Percentages for Selected Countries Ranked by Common Equity Ratios, 1995 Source: Essentials of Managerial Finance by Besley and Brigham

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Leverage and Optimal Capital Structure

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Capital Structure and Leverage. Business vs. financial risk Optimal capital structure Operating leverage Capital structure theory. What is business risk?. Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?

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Financial Leverage and Capital Structure

Lecture 13. Financial Leverage and Capital Structure. Key Concepts and Skills. Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process.

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Financial Leverage and Capital Structure. Chapter Seventeen. Key Concepts and Skills. Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice

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Capital Restructuring. We are going to look at how changes in capital structure affect the value of the firm, all else equalCapital restructuring involves changing the amount of leverage a firm has without changing the firm's assetsIncrease leverage by issuing debt and repurchasing outstanding sha

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Capital Structure and Leverage Chapter 13

Capital Structure and Leverage Chapter 13. Sources of Risk Business, Financial, & Operating. Capital Structure. RHS is called the financial structure of the firm The Firm’s Financial Structure includes; funds obtained in the money markets (short term)

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Financial Leverage and Capital Structure Policy

Chapter Seventeen. Financial Leverage and Capital Structure Policy. FIGURE 17.1. FIGURE 17.2. FIGURE 17.3. FIGURE 17.4. FIGURE 17.5. FIGURE 17.6. FIGURE 17.7. FIGURE 17.8. FIGURE 17.9.

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Capital Structure and Leverage. Business vs. financial risk Operating leverage Financial leverage Optimal capital structure Capital structure theory. What is business risk?. Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?

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Leverage and Capital Structure

Leverage and Capital Structure. Prof. W. J. Hunter Lesson 13. Capital Restructuring. We are going to look at how changes in capital structure affect the value of the firm, all else equal

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Chapter Seventeen. Financial Leverage and Capital Structure. Key Concepts and Skills. Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice

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LEVERAGE AND CAPITAL STRUCTURE

LEVERAGE AND CAPITAL STRUCTURE. Business Risk and Financial Risk. Risk – the likely variability associated with expected revenue streams. The variations in the income stream can be attributed to: The firm’s exposure to business risk The firm’s decision to incur financial risk

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KHALID AZIZ 0322-3385752. Capital Structure and Leverage. JOIN KHALID AZIZ. ACCOUNTING, ECONOMICS,COST ACCOUNTING & STATISTICS OF: ICMAP STAGE 1,2,3,4 ICAP MODULE A,B,C,D PIPFA.COMPLETE BBA & MBA B.COM O/A LEVELS (ACCOUNTING) MA-ECONOMICS INTERMEDIATE COMMERCE

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Chapter 14. Business vs. Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory. Capital Structure and Leverage. What is business risk?. Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?

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Chapter 14. Capital Structure and Leverage. Business vs. Financial Risk Optimal Capital Structure Operating Leverage Capital Structure Theory. What is business risk?. The riskiness inherent in the firm’s operations if it uses no debt. A commonly used measure of business risk is  ROIC.

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CAPITAL STRUCTURE & LEVERAGE

CAPITAL STRUCTURE & LEVERAGE. Capital Structure: The combination of debt and equity used to finance a firm. Target Capital Structure: The mix of debt, preferred stock, and common equity with which the firm plans to finance its investments. Optimal Capital Structure:

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Leverage and Capital Structure. Chapter 13. Key Concepts and Skills. Understand the effect of financial leverage on cash flows and cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components of the bankruptcy process.

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