Week 9 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).
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.
Business Risk explained
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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.
Financial Risk explained
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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.
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
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Capital structure on the balance sheet
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Importance of capital structure
Cost of capital
Financial leverage
Target 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.
Financial Leverage importance
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
Target capital structure
Target capital structure
DEBT FINANCING
Debt financing involves the substitution of debt for equity in a company’s
capital structure which has two important and related effects:
(1) Debt financing increases the returns to (ordinary) shareholders
(2) However, debt financing also increases the financial risk borne by (ordinary) shareholders
(1) 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 due to:
(a) Lower interest rates
(debtholders typically require lower returns than ordinary shareholders); and
(b) Tax deductions for interest payments
(the interest payments associated with debt financing are tax deductible).
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.
The Effects Of DEBT FINANCING
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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.
COSTS OF DEBT FINANCING
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 nosuch 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
- Trade-off between the tax benefit versus the bankruptcy-related cost associated with debt financing.
Key points of the trade off theory
(i) 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.
(ii) 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.
(iii) 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 graphs
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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).
Key points of signalling theory
(i) 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.
(ii) 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.
Key points of signalling theory 2
(iii) 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.
(iv) This might account for the observation that a company’s share price tends to fall following company management’s decision to use equity financing to raise capital by issuing new equity.
Signalling theory reserve borrowing theory
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:
pecking order theory
(1st) : Use Retained Earnings;
(2nd) : Use Debt financing;
(3rd) : Use Equity financing.
