Week 3 Everything Flashcards
Capital Structure
The combination of debt and equity used to finance a company’s assets.
Total Assets =
Total Liabilities (debt financing)
+
Total Equity (equity financing)
Target Capital Structure
The optimal mix of debt, preference shares and ordinary equity with which the company plans to use to finance its investments.
Business Risk
The risk associated with a company’s business operations, ignoring any fixed financing effects (i.e. the uncertainty inherent in a company’s earnings or operating income). Business Risk refers to the variability or uncertainty of a company’s operating income.
Financial Risk
The additional risk, over and above the basic business risk, that is borne by a company’s shareholders which arises from the manner in which the company’s assets are financed. Financial Risk refers to the variability or uncertainty of a company’s earnings per share (EPS) and the increased risk of bankruptcy when a company uses financial leverage.
Operating Income may be affected by:
Sales variability (e.g. changes in sales volume);
Cost variability (e.g. changes in input prices);
Competition from industry rivals
(may affect ability to adjust the selling price to reflect changes in input prices);
Product diversification;
Operating leverage (the extent to which the company’s costs are fixed).
Operating leverage
Operating Leverage refers to the presence of fixed operating costs (as opposed to variable operating costs) within a company’s cost structure. A company with relatively high fixed operating costs will experience greater variability in operating income if sales were to change.
Operating leverage
Basic profit equation:
Profit = Total revenue – Total costs
Profit = Total revenue – Total costs
This can be rewritten as
Profit = (Total revenue – Total VC) – Total FC
Contribution margin
Contribution margin is the total revenue minus total variable costs. CM per unit tells how much revenue from each unit can be applied toward FC
Degree of operating leverage
Is the ratio of a company’s fixed costs to its variable costs
Degree of operating leverage in terms of contribution margin
=
CM/PROFIT
=
(TR-TVC)/PROFIT
=
(P-V)*Q/PROFIT
Degree of operating leverage in terms of fixed costs
=
F/PROFIT + 1
Degree of operating leverage explained
Measures the extent to which the cost function is comprised of fixed costs. A high degree of operating leverage indicates a high proportion of fixed costs
Firms operating at a high degree of operating leverage
face higher risk of loss when sales decrease and enjoy profits that rise more quickly when sales increase
Operating leverage of 19.33 can be interpreted as:
The ratio of MM Bikes fixed costs to variable costs
A 10% increase in revenues should yield a 193.3% increase in operating income (10%*19.33)
Conversely, a 10% reduction in revenues will reduce operating income by 193.3%
The ratio of MM Bikes fixed costs to variable costs
A 10% increase in revenues should yield a 193.3% increase in operating income (10%*19.33)
Conversely, a 10% reduction in revenues will reduce operating income by 193.3%
IS THIS GOOD OR BAD
Need to compare with industry average and with past history. E.g. If industry average is 10, this means MM Bikes can make more money from incremental revenues than the industry average (i.e. 10% increase in revenues yields 100% increase in operating income for other competitors versus 193.3%). Important to understand cost structure, particularly in competitive markets and volatile markets where there is potential for downturns
Fiancial risk is affected by
Financial leverage;
Amount and type of debt obligations;
Changes in interest rates;
Economic cycle.
Financial leverage
Financial Leverage refers to the use of fixed-cost sources of finance (rather than variable-cost sources) to finance a portion of a company’s assets.
Fixed-cost sources of finance
Debt
Preference shares
Variable-cost sources of finance:
Ordinary shares
Business Risk versus Financial Risk
Business Risk refers to the relative variability of a company’s operating income or earnings (EBIT). Financial risk refers to the additional variability in earnings available to ordinary shareholders due to financing decisions. It includes the additional risk of bankruptcy that is borne by ordinary shareholders due to the use of financial leverage.
the link between business risk and financial risk
23/3/19
Capital structure on a balance sheet
23/3/19
Importance of capital structure
Cost of capital
Financial leverage
target or optimal capital structure
Importance of capital structure
Cost of capital
Since each source of financing has a different cost, the capital structure will affect the overall cost of capital for a company.
Importance of capital structure
Financial leverage
Higher financial leverage (in the form of greater debt financing) leads to potentially greater returns to shareholders, but also results in higher financial risks due to the need to make periodic fixed repayments on a regular basis.
Importance of capital structure
target or optimal capital structure
Therefore, the target (or optimal) capital structure for a company is the capital structure that minimizes the overall cost of capital for the company, thereby maximizing the market value of the company, which in turn maximizes the overall wealth of its (ordinary) shareholders.
DEBT FINANCING
Debt financing involves the substitution of debt for equity in a company’s capital structure which has two important and related effects:
Debt financing increases the returns to (ordinary) shareholders:
However, debt financing also increases the financial risk borne by (ordinary) shareholders:
Debt financing increases the returns to (ordinary) shareholders:
Debt financing is typically cheaper than equity financing, which results in relatively more earnings made available for distribution to ordinary shareholders as dividends.
Debt financing is typically cheaper than equity financing
However, debt financing also increases the financial risk borne by (ordinary) shareholders:
Debt financing increases the variability of earnings made available for distribution to shareholders, thus resulting in a greater range of returns for ordinary shareholders; and at the same time, debt financing also increases the risk of bankruptcy for a company.
Debt financing is typically cheaper than equity financing due to:
Lower interest rates
(debtholders typically require lower returns than ordinary shareholders); and
Tax deductions for interest payments
(the interest payments associated with debt financing are tax deductible).
The Effects Of DEBT FINANCING
23/3/19
BENEFITS OF DEBT FINANCING
Maintaining ownership and control:
Tax deductions:
Lower interest rates:
Maintaining ownership and control:
Unlike equity financing, debt financing does not involve selling claims to ownership of the business to market investors. As such, the owner maintains ownership and control over the business.
Tax deductions:
Unlike the dividend payments associated with equity financing, the interest payments associated with debt financing are tax deductible.
Lower interest rates:
Since debtholders usually demand lower returns (in the form of lower interest rates) than ordinary shareholders, debt financing is typically cheaper than equity financing.
The costs of debt financing include:
Repayment obligations
Risk of bankruptcy
Need for collateral
Repayment obligations
With debt financing, need to make periodic fixed repayments to debtholder on a regular basis (c.f. there is no such obligation with equity financing). As such, the business must ensure that it can generate sufficient cash flows to meet the repayments when they fall due or face becoming bankrupt.
Risk of bankruptcy:
Debt financing increases the risk of bankruptcy for the business (c.f. there is no such risk of bankruptcy with equity financing). In the event the business becomes bankrupt, the debtholder has priority in claiming the assets of the business before ordinary shareholders.
Need for collateral
With debt financing, the business is usually required to pledge some of its assets as collateral in order to protect the debtholder against possible default (c.f. there is no such requirement for collateral with equity financing).
Relevance of CAPITAL STRUCTURE
Maximize market value by minimizing cost of capital:
Full utilisation of available funds:
Maximize returns to shareholders
Maximize market value by minimizing cost of capital:
A sound capital structure helps to maximize the market value of the company by minimizing the overall cost of capital for the company.
Full utilisation of available funds
A good capital structure enables the company to fully utilise its available funds to pursue profitable investment opportunities. In doing so, a good capital structure also protects the company from over-capitalisation and/or under-capitalisation.
Maximize returns to shareholders
A sound capital structure enables the company to increase profits, and thus maximize the returns to its shareholders.
THEORIES OF Capital Structure
Trade-off Theory
Signalling Theory
Pecking Order Theory
Trade-off Theory
Argues that there is a ‘trade-off’ between the tax benefit versus the bankruptcy-related cost associated with debt financing.
3 key points of the trade off theory
Since interest is a tax-deductible expense, the government effectively subsidizes part of the cost of debt capital, with more operating income or earnings flowing through to the company’s shareholders.
However, as the company uses greater amounts of debt, the risk of bankruptcy also increases, which results in the company having to pay higher interest rates.
Therefore, the optimal capital structure is the point at which the tax benefit from additional debt exactly offsets the increase in bankruptcy-related cost.
TRADE off theory in reality
In reality, however, large companies such as BHP use far less debt financing than Trade-off Theory suggests.
TRADE off theory diagram,
23/3/19
Signalling Theory
Argues that asymmetric information exists between company management and external investors (i.e. company managers have better information about the company’s future financial prospects than external investors).
First two key points of the signalling theory
Due to asymmetric information between company managers and external investors, company management’s choice between debt financing versus equity financing is viewed by market investors as a signal about company management’s perception of the future financial prospects for the company.
External investors expect that companies with bright financial prospects will prefer debt financing over equity financing. Therefore, the decision to use debt financing is viewed as a positive signal by market investors that company managers perceive the company’s future financial prospects to be bright.
Next two key points of the signalling theory
Conversely, since external investors expect that only companies with poor financial prospects will prefer equity financing, the decision to use equity financing is viewed as a negative signal by market investors that company managers perceive the company’s future financial prospects to be poor.
This might account for the observation that a company’s share price tends to fal following company management’s decision to use equity financing to raise capital by issuing new equity.
signalling theory reserve borrowing capacity
So companies should always maintain a reserve borrowing capacity. In other words, companies should generally use less debt than ‘the optimum debt level’ suggested by Trade-off Theory in order to ensure that further debt capital can be obtained later if required.
PECKING ORDER THEORY
Since external investors know that company managers will attempt to issue new equity when they perceive the company’s shares as overpriced, market investors will necessarily discount the price that they are willing to pay for the company’s shares by underpricing the company’s shares. Pecking Order Theory argues that, to avoid this underpricing, company managers prefer to finance investment opportunities using retained earnings, followed by debt financing, and will only choose equity financing as last resort.
Hierarchy or order of financing
Use Retained Earnings;
Use Debt financing;
Use Equity financing.
