Capital Structure: Debt vs. Equity

Capital Structure

• Capital structure refers to the mix of long-term funds, including debt and equity, used to finance a company's assets.
• Two primary types of capital are debt capital (interest-bearing liabilities) and equity capital.

Debt Capital

• Debt capital represents funds obtained through long-term borrowings like mortgages and bonds.
• This capital must be repaid with interest plus the principal amount.
• Interest rates on debt can be fixed, determined at a set increment above the prime rate, which remains constant until maturity.
• Floating (variable) interest rates fluctuate with the prime rate until maturity.
• Prime rate is the lowest interest rate banks charge their most reliable business borrowers.

Equity Capital

• Equity capital is long-term funding provided by shareholders.
• It comes from two main sources: preference share equity (preferred stocks) and ordinary share equity (ordinary shares + retained earnings).
• Equity capital remains invested in the firm indefinitely.
• Equity possesses a residual nature where shareholders receive what is left after settling obligations from debt capital.
• Suppliers of equity take on greater risk compared to debt suppliers and should receive higher returns.
• Ordinary shares are typically the most expensive long-term funds, followed by retained earnings, preference shares, and then debt.
• Tax-deductibility of interest payments lowers the cost of debt.
• Debt increases both firm value and the probability of bankruptcy.

Financial Leverage & Risk

• Greater debt usage leads to higher financial leverage.
• Increased leverage makes common stockholder claims riskier, raising the cost of equity as debt increases.
• Probability of bankruptcy (insolvency risk) increases with the inability to meet obligations, which depends on business and financial risk.
• Business risk reflects the variation in expected EBIT.
• It indicates how the firm may be unable to cover operating costs and increases with higher operating leverage.
• Financial risk is caused by the level of debt capital relative to equity capital.
• The firm's capital structure directly affects financial risk through its impact on financial leverage on earnings available to ordinary shareholders.

Capital Structure Decisions

• Effective capital structure decisions can lower the cost of capital, resulting in higher NPV and more acceptable products, and increasing firm value
• A sound capital structure helps maximizes the market value of the company by minimizing overall cost of capital
• A good capital structure enables a company to fully utilise its available funds to pursue profitable investment opportunities
• A sound capital structure enables a company to increase profits, and maximize the returns to its shareholders

Assessing Capital Structure

• External assessment of capital structure can be done using firms financial statements
• The acceptable level of debt can be highly risky depending on industry lines and operating characteristics

Capital Structure Theory

• Capital structure theory has been researched extensively, including by Modigliani and Miller.
• The general consensus that there is an optimal capital structure to balance the benefits and cost of debt financing.

Debt Financing Benefits

• Tax shield: Interest payments associated with debt financing are tax-deductible.
• Lower interest rates: Debtholders typically demand lower returns than shareholders.
• Debt financing does not involve selling claims to ownership.

Debt Financing Costs

• Major costs of debt financing include the increased probability of bankruptcy caused by debt obligations.
• Business is usually required to pledge collateral to protect the debtholder

Three Theories of Capital Structure

• Trade-off theory: Proposed by Franco Modigliani and Merton Miller.
• In trade-off theory there is a trade-off because interest is a tax-deductible expense that subsidizes debt cost. Also companies use more debt, the risk of bankruptcy increases leading to have paying higher interest rates. The benefit from additional debt offsets the increase in bankruptcy related to cost.
• Signaling theory: Owing to asymmetric information between company managers and external investors, the company managements choice between debt/equity is viewed as a signal about the future financial prospects from management for the company.
• Since external investors expect that companies with brighter prospects will prefer debt, the decision to use debt is viewed in a positive light because it also means managers see the company future to be bright. The implication of signaling theory is that companies should always maintain a reserve borrowing capacity by using less debt in order to ensure that further debt can be obtained if required.
• Pecking order theory: external investors know company managers will attempt to issue shares when stocks are overpriced. This means the market investors will discount prices they are willing to pay if manager is underpricing the company shares. This means companies prefer to find investment opportunities in retained earnings.

Capital Structure Financing Orders

• First is Retained Earnings
• Second is Debt Capital
• Lastly Equity Capital

Conclusion on Capital Structure

• There is an optimal capital structure, the theories above do not provide financial managers with a specific methodology to determine
• The theories do give help on how a firms chosen financing affects its value

Optimal Capital Structure

• Value of the firm is maximized when the cost of capital is minimized
• The value of the firm can be defined as CF/Ra or the EBIT*(1-T)/Ra
• CF is the After tax cash flow to debt and equity holders
• The equation EBIT(1-T) is the net operating profit after taxes (NOPAT)
• As the after tax earnings from operations available to debt and equity holders
• Ra is the WACC or Weighted average cost of capital what estimates the cost of capital

Optimal Capital Structure Graph Values

• Value V is maximized when capital is at it's minimum
• the WACC or Ra, results from weighted debt costs and costs of equities
• The after tax cost of debt is low due to the tax shield, and rises with risk
• Rs is higher than the cost of debut and increases faster than the cost of debt
• Ra declines as the debt ratio rises, but will rise once the debt continues to increase and the ri and rs rise

Operating in Capital

• It is impossible to remain at the precise capital structure
• Firms must operate near what they believe is their optimal capital structure

Goal for Maximizing Wealth

• The goal for maximizing wealth is considering return and risk when making capital
• Can be achieved through analysis of debt ratios and EBIT-EPS analysis

Debt Ratio

• Measures the proportion of assets financed by creditors
• A debt ratio of 45% indicates the company is financing 45% of its assets through it's debt.

Times Interest Earned Ratio

• Higher the ratio means the greater the financial leverage
• Measures the ability to make contractual interest payments

Value for Rate of Interest

• The average value is 3.0, but preferably closer to 5.0

Fixed Payments Coverage Ratio

• The assessment of the ability for the firm to make fixed obligations such as: loans, interests, lease payments and preference dividends
• The term 1/(1-T) is to adjust the tax rate to the after-tax principal and dividend from payments

Determining if Fixed-Payment Obligations Have Been Fulfilled

• A ratio of 1.9 indicates that a firms appears able to meet it's fixed payments safely because available earnings are nearly twice it's fixed-payment obligations
• This includes inter-company ratio comparison and analyzing trends
• Industry Averages comparison

EBIT-SPS

• EBIT-SPS Analysis (EBIT-EPS) Approach has you selecting the capital structure that will maximize earnings/share (EPS) over expected earnings before interest/taxes (EBIT)

Assessment of EPS

• EBIT-SPS helps firms determine the effects on its capital structure and can establish the per share value/stock price

Considerations When Making Capital Structure Decisions

• Revenue Firms that have stable predictable revenue can make highly leveraged structures than firms with patterns of sales revenues
• Cash Flow the firm must use it's assets to generate the cash flows necessary to meet obligations
• Contractual obligations A firm may be constricted with respect to funds depending on sales and dividends to stakeholders
• Management A firm can impose internal constraints to use to limit risk exposure that accepted to management

Factors for Making Capital Structure Decisions

• Control A management group can decide between to issue debt as opposed to common to maintain control.
• External Risk Assessment The firms ability to raise funds depends on assessment of the lenders and bond raisers
• Timing Depends whether the firms are experiencing low interest rates of when debt financing maybe more attractive or the sale of stock market depending.