8.1 Capital Structure and Leverage

Capital structure and leverage are crucial concepts in corporate finance. They determine how companies finance their operations and assets using a mix of debt and equity. This balance impacts a firm's risk profile, cost of capital, and overall financial performance.

Understanding capital structure helps managers make informed decisions about financing. It involves weighing the benefits of debt, like tax advantages, against the risks of financial distress. The goal is to find an optimal mix that maximizes firm value and supports long-term growth.

Capital Structure Components

Debt and Equity Financing

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• Capital structure represents the mix of long-term funds used by a company to finance operations and assets
• Debt capital encompasses bonds, loans, and other borrowing requiring repayment with interest
• Equity capital includes common stock, preferred stock, and retained earnings representing ownership stakes
  • Common stock grants voting rights and potential dividends
  • Preferred stock typically offers fixed dividends without voting rights
  • Retained earnings are profits reinvested in the business
• Debt-to-equity ratio measures the proportion of debt to equity financing
  • Formula: $\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}}$
  • Example: A company with $1 million in debt and$2 million in equity has a debt-to-equity ratio of 0.5

Cost of Capital and Decision Making

• Capital structure decisions determine the optimal mix of debt and equity to maximize firm value
• Weighted average cost of capital (WACC) calculates the overall cost of a firm's capital structure
  • Formula: $\text{WACC} = (E/V \times R_e) + (D/V \times R_d \times (1-T_c))$
    • Where: E = market value of equity, D = market value of debt, V = total market value (E + D)
    • Re = cost of equity, Rd = cost of debt, Tc = corporate tax rate
• Example: A company with 60% equity at 10% cost and 40% debt at 6% cost (tax rate 30%) has a WACC of 7.68%
  • $\text{WACC} = (0.60 \times 10\%) + (0.40 \times 6\% \times (1-0.30)) = 7.68\%$

Leverage Impact on Performance

Financial Leverage and Risk

• Financial leverage uses debt to finance operations and assets, amplifying potential returns and risks
• Degree of financial leverage (DFL) measures sensitivity of earnings per share (EPS) to changes in operating income
  • Formula: $\text{DFL} = \frac{\text{Percentage Change in EPS}}{\text{Percentage Change in EBIT}}$
• Higher leverage can increase returns on equity (ROE) during strong performance (positive leverage effect)
  • Example: A company with 50% debt financing may see ROE increase from 10% to 15% when profits rise
• Leverage magnifies losses during downturns, potentially leading to financial distress or bankruptcy
  • Example: The same company might see ROE drop from 10% to 5% or lower during a recession

Financial Health Indicators

• Interest coverage ratio assesses a company's ability to meet debt obligations
  • Formula: $\text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}}$
  • Example: A ratio of 3 indicates earnings can cover interest payments 3 times over
• Leverage affects a company's credit rating, influencing borrowing costs and capital market access
  • Higher leverage typically leads to lower credit ratings and higher borrowing costs
  • Example: A company might see its credit rating drop from A to BBB due to increased leverage

Debt vs Equity Financing

Advantages and Disadvantages

• Debt financing offers tax advantages through interest payment tax deductibility (tax shield)
  • Tax shield formula: $\text{Tax Shield} = \text{Interest Expense} \times \text{Tax Rate}$
  • Example: $100,000 in interest expense with a 30$30,000 tax shield
• Equity financing requires no regular interest payments or principal repayment, reducing financial risk
  • Drawback includes potential dilution of ownership and control
  • Example: Issuing new shares might reduce an owner's stake from 51% to 45%
• Debt introduces financial risk, increasing earnings volatility and potential for financial distress
• Equity provides greater financial flexibility but may be more expensive due to higher required returns
  • Example: Equity investors might demand 12% returns compared to 6% for debt holders

Financing Theories

• Pecking order theory suggests companies prefer internal financing, then debt, and equity as a last resort
  • Order: Retained earnings, debt issuance, equity issuance
  • Example: A company might use $1 million in retained earnings before considering a bond issue
• Agency costs associated with debt and equity must be considered in financing decisions
  • Debt agency costs (restrictive covenants)
  • Equity agency costs (divergent interests between managers and shareholders)
  • Example: Debt covenants might restrict dividend payments or require maintaining certain financial ratios

Optimal Capital Structure

Theories and Models

• Optimal capital structure maximizes firm value by balancing benefits and costs of different financing sources
• Trade-off theory posits optimal structure is achieved when marginal benefits of debt equal marginal costs
  • Benefits (tax shields) vs. Costs (financial distress)
  • Example: A company might target a 40% debt ratio to balance tax benefits and bankruptcy risk
• Modigliani-Miller theorem suggests capital structure irrelevance to firm value under certain assumptions
  • Assumptions include perfect capital markets, no taxes, and no bankruptcy costs
  • Forms the basis for modern capital structure theory
• Market imperfections influence optimal capital structure determination in practice
  • Factors include taxes, bankruptcy costs, and information asymmetry
  • Example: High-tech firms often use less debt due to higher information asymmetry and growth uncertainty

Practical Considerations

• Industry characteristics, business risk, and growth opportunities affect optimal capital structure
  • Stable industries (utilities) often support higher debt levels
  • High-growth industries (technology) typically rely more on equity
• Dynamic capital structure theories recognize firms may deviate from target structure
  • Adjustment costs and market timing considerations influence decisions
  • Example: A company might delay issuing equity during a market downturn, temporarily increasing leverage
• Static trade-off model assumes firms constantly adjust toward optimal capital structure
• Dynamic trade-off model recognizes periodic adjustments due to transaction costs
  • Example: A firm might only adjust its capital structure every few years to minimize transaction costs