What is Capital Structure?

Capital Structure refers to the amount of debt financing as opposed to equity financing. Remember in Chapter Ten when we were estimating the OCC? One of the first steps was estimating the market value of our financing components. However, those weights are one of the decision variables that the firm can control. We can decide to sell bonds and/or buy back common stock to raise the weight of debt financing. Alternatively we can decide to sell shares of stock and/or buy back previously issued bonds to raise the weight of common stock financing.

We can see from the above discussion of capital structure that this decision is critical. Changing our financing weights can change the cost of capital. Since the cost of capital is the starting point in determining the required return for our capital budgeting projects, the capital structure decision will help determine how valuable our long-term investment projects will be.

Leverage

Leverage generally refers to the use of debt in the capital structure. The greater the use of debt the more leverage the firm is using. Also, a firm that has some degree of debt financing is sometimes called a levered firm. The leverage term is used because with large amounts of debt financing (our "lever") small changes in sales will lead to large changes in earnings per share. This arises because interest is a fixed cost item. If our firm does well, we don't pay any more in interest. However, if our firm does poorly we don't pay any less in interest. While this is what is generally meant by leverage, there are two other terms (which we will get to later) called the Degree of Operating Leverage (DOL) and Degree of Financial Leverage (DFL). It is easy to confuse these terms, so try to be careful not to.

Business Risk

Business Risk refers to the inherent risk in the firm BEFORE debt is introduced to the picture. Business risk is caused by such factors as:

• General Economic Factors
  • Inflation
  • Interest Rates
  • Recessionary or High Growth Economic periods
• Fixed vs Variable Costs
• Volatility of Input Costs
• Ability to Change Prices
• Sensitivity of Sales to Economic Factors

High levels of Business risk will mean one of two things (or sometimes both). First, sales will be volatile. Second, small changes in sales will result in large changes in Earnings Before Interest and Taxes (EBIT). Under either condition, the bottom line is that firms with high degrees of business risk will see high degrees of volatility in their EBIT.

Financial Risk

While business risk results from the firm's line of business and is (at least to a considerable degree) outside the firm's control, the Financial Risk is derived entirely from the firm's dec08/15/2007amount of debt that the firm uses, the higher the financial risk. Financial risk comes from one factor - debt.

Degree of Operating Leverage

The Degree of Operating Leverage (DOL) provides with a measure of business risk. Unfortunately it measures only one aspect of business risk - the level of fixed vs variable costs. It does not capture the sensitivity of sales to economic conditions, the firm's ability to control input prices or adjust output prices. Therefore, the firm must remember to consider these factors when attempting to estimate business risk with the DOL measure.

DOL = (S - VC)/(EBIT)

Here S refers to sales, VC refers to variable costs, and EBIT is earnings before interest and taxes. The DOL tells us how much a given % change in sales will cause EBIT to change. For example, if we estimate DOL to be 1.5, then a 10% increase in Sales will lead to a 15% increase in EBIT. Specifically,

% Change in EBIT = (% Change in Sales)*(DOL)

Degree of Financial Leverage

The Degree of Financial Leverage (DFL) provides us with a measure of financial risk. Since financial risk is determined solely by the firms level of debt, the DFL does an excellent job of measuring financial risk.

DFL = (EBIT)/(EBIT - INT)

INT refers to the interest expense for the firm. The DFL tells us how much a given % change in EBIT will cause Earnings After Taxes (EAT) or Earnings Per Share (EPS) to change. For example, if we estimate DFL to be 2.0, then a 10% decrease in EBIT will lead to a 20% decrease in EAT. Specifically,

% Change in EAT = (% Change in EBIT)*(DFL)

Degree of Combined Leverage

The Degree of Combined Leverage (DCL) takes both the DFL and DOL into account and, as the name implies, calculates the combined impact of both. Keep in mind that the DOL does not completely capture business risk, so the DCL does not capture the total risk of the firm. However, it still helps us determine how risky the firm in even though it is not a perfect measure.

DCL = (S - VC)/(EBIT - INT)

or DCL = (DOL)*(DFL)

The DCL tells us how much a given % change in sales will cause EAT to change. For example, if we estimate DCL to be 2.5 and Sales increase by 20%, then EAT will increase by 50%. Specifically,

% Change in EAT = (% Change in Sales)*(DCL)

Modigliani and Miller Capital Structure Theory

• There are only two types of securities -- long term debt and common stock
• No growth firm
• All earnings are paid out as dividends
• There are no costs or penalties to bankruptcy
• Debt is risk-free

Of these assumptions, the first three are not as critical. They make the mathematics of the theory a little cleaner, but do not drastically alter the model. However, as we will discuss later, the last two assumptions are critical. Relaxing them does drastically alter the conclusions of the model

M & M No Tax Case (1958)

In Modigliani and Miller's first analysis in 1958, they added one more assumption -- there are no corporate income taxes. In this analysis, they argued that while debt financing was indeed cheaper than common stock financing, there was no benefit gained by using more debt financing. The reason for this is that taking on more debt increases the risk to stockholders. To compensate them for this risk, they will demand higher rates of return. Therefore, as we increase our debt, we are reducing costs on one hand by using more of the cheaper financing source, but that advantage is EXACTLY offset by increasing our cost of equity financing. Thus, capital structure is irrelevant. The cost of capital (and in turn the value of the firm) will be unaffected by changes in the capital structure.

M & M Corporate Tax Case (1963)

In Modigliani and Miller's second analysis in 1963, the made the model more realistic by including corporate taxes. Remember from Chapter 8 that the cost of debt to the firm is lowered by the tax benefits. Since interest is paid before taxes, the firm pays lower taxes and thus offsets some of its interest expense with tax savings. If the benefits of using the cheaper debt financing were EXACTLY by the higher cost of equity financing in the previous (no tax) case, then by incorporating taxes (and lowering the effective cost of debt) the benefits of using the cheaper debt financing should now MORE than offset the higher cost of equity financing. Now, capital structure becomes critical. The higher our proportion of debt financing, the cheaper or cost of capital. Since the cost of capital is inversely related to the value of the firm, using more leverage (debt) in our capital structure will increase the value of the firm. Therefore the conclusion from M & M's corporate tax case is to use as much debt financing as possible.

Introduction of Financial Distress Costs (Post M & M)

Remember that two critical assumptions by M & M (risk-free debt and costless bankruptcy) are not realistic. When we relax those, we end up altering their conclusions. Increasing our capital structure increases the possibility of bankruptcy (slowly at first, but very rapidly at high proportions of debt financing). As the possibility of bankruptcy increases, the expected financial distress costs also increase. This leads to a situation where the cost of equity and cost of debt (since it is not risk-free) increases at an increasing rate as we increase our proportion of debt financing. Initially the increases in the cost of equity and debt are small and more than outweighed by the tax benefits previously discussed. However, after a certain point the financial distress costs start to outweigh the tax benefits. This leads to a situation where the cost of capital declines initially as we add debt to our capital structure, but then starts to increase after a certain point. Conversely, the value of the firm increases initially, but then starts to decline

Direct Financial Distress Costs include the lawyer fees and court costs associated with bankruptcy. Higher levels of debt make bankruptcy more possible and therefore creditors and stockholders will require a greater return to compensate them for this possibility.

Indirect Financial Distress Costs include all other costs associated with the perception that a firm may go bankrupt (whether or not it actually does). Indirect financial distress costs can affect each firm differently depending on the nature of that firm's activities. These costs include:

• Potential loss of sales
• Potential loss of key employees
• Potential problems with suppliers
• Potential problems raising necessary financing for future projects

Setting Capital Structure in Practice

Capital structure theory tells us a lot about potential advantages and disadvantages of debt financing. Unfortunately, it does not tell us what are debt/equity ratio should be for our firm. Instead, this is a decision made primarily by past experience and judgment. Key things that are considered in coming to this decision include:

• Risk
• Taxes
• Financial Slack
• Industry Norms
• Lender Standards

Risk is critical in that firms with high levels of business risk are going to feel the impact of financial distress costs at much lower debt levels than firms with low levels of business risk. Because of this, we tend to see firms with lower levels of business risk use more debt than firms with high levels of business risk.

Taxes are also an important consideration. One of the key advantages to debt is the tax benefits. If a firm has low (or negative earnings) or other tax shields (high levels of depreciation), it may not be able to take full advantage of the tax benefits of debt. Therefore, firms with high taxable earnings are more likely to use debt financing than firms with low levels of taxable earnings.

Financial Slack is also important. Firms that anticipate the need for high levels of borrowing in the near future will want to maintain lower levels of debt currently. This will allow them to tap their credit sources when necessary.

Firms also tend to follow Industry Norms when setting capital structures. Firms within the same industry tend to have similar capital structures. Part of this is related to business risk. However, firms have to be careful not to blindly "follow the leader" and to instead make sure there is a rational justification for their capital structure position beyond industry norms.

Finally, firms tend to observe Lender Standards. To the extent that they anticipate future borrowing needs, firms will want to make sure they are attractive in the eyes of potential lenders and not appear to risky. This will make it easier for them to obtain more debt later at reasonable interest rates.