Financial Policy - Writing Assignment

2018gCapitalStructurelecture.ppt

Capital Structure

Capital structure refers to the composition of a company’s financing: interest bearing long and short term debt and equity.
A company’s capital structure can impact its WACC, and therefore its value.
It also impacts a firm’s financial flexibility (its ability to source capital as needed).

Effects of Additional Debt on WACC

Debt holders have a prior claim on cash flows relative to stockholders.
As debt is increased, the debt holders’ increased claims for interest and principal payments creates increased risk for stockholders.
Therefore, the cost of stock (equity) goes up as the proportion of debt in the capital structure is increased.

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Effects of Additional Debt on WACC

Increased debt (increased leverage) also increases the risk of bankruptcy and the potential inability to make the increased debt service payments.
This causes both the cost of debt and the cost of equity to rise.

Additional debt affects debt ratings

Corporate bonds are rated by rating agencies based on the issuing firm’s ability to service the debt.
High ratings reflect low risks and result in reduced interest rates.
High ratings also make it easier for the firm to issue additional debt which increases financial flexibility.

Debt Ratings

Rating agencies consider many risk factors when rating a company’s bonds.
Primary factors include the firm’s ratio of total debt to capital and the extent to which EBIT covers interest expense (EBIT interest coverage ratio).

Key Ratios for Determining Debt Ratings

The ratio of total debt to capital equals total debt divided by total debt plus equity (expressed as a percentage).
In exhibit 6 of next week’s Deluxe case the above ratio is 5% for AAA rated firms and 47% for BBB rated firms.
The interest coverage ratio equals EBIT divided by the annual pre-tax interest expense.
In the Deluxe exhibit 6 the above ratio is 23.4 for AAA rated firms and 3.9 for BBB rated firms.

Effects of Additional Debt on WACC

Adding debt, which is both lower cost than equity and tax deductible can reduce the WACC.
However, adding debt also increases the cost of both debt and equity which can increase the WACC
The net effect on the WACC can be uncertain.

Capital Structure Theory

Debt-to-Value Ratio
[D / (E + D)] of U.S. Firms, 1975–2005

Historical pattern of capital structures

Debt ratios average about 40% of total capital.
The fact that debt ratios are not excessively high reflects the concerns over bankruptcy risks.
Even without experiencing bankruptcy, just the risk of not being able to pay bills and provide services can potentially disrupt a firm’s relationships with suppliers and customers.

Trade-off Theory

At low leverage levels (low debt levels), the tax benefits of debt outweigh the risk of bankruptcy, so you add on more lower cost debt.
At high levels of debt, the risk of bankruptcy outweighs tax benefits, so you try to avoid adding on more debt.
An optimal capital structure balances these risks and benefits.

Signaling Theory

Managers often have better information than investors. Thus, they would:
Sell stock if they feel the stock is overvalued.
Sell bonds if they feel stock is undervalued.
Investors understand this, so they tend to view new stock sales as a negative signal from management.

Pecking Order Theory

Firms use internally generated funds first, because there are no flotation (issuing) costs or negative signals.
If more funds are needed, firms then issue debt because it has lower flotation (issuing) costs than equity and does not send negative signals.
Finally, if still more funds are needed, and the firm is getting too much leverage, firms then issue equity.

Aggregate Sources of Funding
for Capital Expenditures, U.S. Corporations

Debt Financing and Agency Costs

One agency issue is that managers might use corporate funds for non-value maximizing purposes.
The use of financial leverage can reduce this risk:
Ties “free cash flow” to debt service requirements.
Forces discipline on managers to avoid perks, wasteful spending and non-value adding acquisitions.

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Debt Financing and Agency Costs

Another agency issue is the potential for “underinvestment”.
Debt increases risk of financial distress.
Therefore, when debt is high, managers might avoid risky projects even if the projects have positive NPVs.

Financial Flexibility and Reserve Borrowing Capacity

Financial flexibility reflects the extent of cash on hand, the amount of cash being generated by future free cash flows, the extent of future financial commitments (like debt service) and the company’s reserve borrowing capacity (ability to issue more debt on acceptable terms).
If a firm gets highly leveraged, it may not be able to raise added funds when needed to fund excellent investment opportunities. Thus it lacks flexibility.

Implications for Managers

Take advantage of tax benefits by issuing debt, but only up to a reasonable point where the WACC, if leveraged further, would increase due to accelerated increases in both the cost of equity and the cost of debt.

Implications for Managers (Continued)

Increase financial flexibility by avoiding excessive leverage and thereby maintaining excess borrowing capacity. This is especially important if the firm has:
Volatile sales or operating results
Many potential investment opportunities