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Management of Capital Structure

1) As a firm increases its use of debt, its cost of capital decreases at first but then increases once debt levels become excessive and increase financial risk. The firm's total market value and share price both initially rise due to interest tax shields but eventually fall with too much debt. 2) While earnings before interest and taxes remain unchanged as debt increases, earnings before taxes and net income decrease due to rising interest payments. Earnings per share initially increases but then falls once interest payments outpace tax savings from additional debt. 3) Managers consider financial stability, long-term viability, and maintaining reserve borrowing capacity rather than strictly optimizing capital structure in the short-term. They aim for target debt ratios and coverage ratios

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55 views3 pages

Management of Capital Structure

1) As a firm increases its use of debt, its cost of capital decreases at first but then increases once debt levels become excessive and increase financial risk. The firm's total market value and share price both initially rise due to interest tax shields but eventually fall with too much debt. 2) While earnings before interest and taxes remain unchanged as debt increases, earnings before taxes and net income decrease due to rising interest payments. Earnings per share initially increases but then falls once interest payments outpace tax savings from additional debt. 3) Managers consider financial stability, long-term viability, and maintaining reserve borrowing capacity rather than strictly optimizing capital structure in the short-term. They aim for target debt ratios and coverage ratios

Uploaded by

Kazi Hasan
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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MANAGEMENT OF CAPITAL STRUCTURE

Learning objectives:
After going through optimal capital structure theories, modifications
made in them, applicability of these theories, impact of debt on value of
firm and WACC, different principles to decide about capital structure
and different approaches to WACC calculation now we study the
management of capital structure:
Traditionalist Theory - Effect of Capital Structure on Firm Value &
Share Price:
As 100% Equity Firm Takes On More and More Debt (or Leverage):
Cost of Capital decreases (cost of debt is cheaper than equity), reaches a
minimum point, and then rises (excessive debt increases financial risk).
Total Market Value of Firm (V = D + E = Market Value of Debt +
Market Value of Equity) first rises (because of Interest Tax Shield
savings), then reaches a maximum point (optimal capital structure), and
finally falls (because of excessive fall in Net Income and Equity value
because of interest payments).
Share Price (Po= Total Value / Original Number of Shares OR Equity
value / Number of Shares Outstanding) first rises, then reaches
maximum (same point as maximum Value), and finally falls. Follows
same shape as Total Market Value of Firm. Share Price is a measure of
Firm Value.
Traditionalist Theory - Effect of Capital Structure on Earnings and
Risk:
As 100% Equity Firm Replaces More and More Equity with Debt (or
Leverage): Mean (or Expected) EBIT assumed to be unchanged
although excessive debt can cause it to rise because of higher operational
costs because of financial distress. Mean EBT will fall because interest
payments rise.
Mean Net Income (or Earnings) generally falls continuously because
interest payments rise faster than any interest tax savings.
Mean Earnings Per Share (EPS = Net Income / Number of Shares
outstanding) generally first rises if number of shares falls if Equity is

Replaced with Debt, then reaches maximum (different capital structure


mix from that which maximizes Value & Share Price) , and finally falls
(because interest payments grow faster). Similar shape to Share Price
Curve but reaches Maximum at a different Debt Ratio and Capital
Structure.
For Optimizing Capital Structure, we should focus on Share Price and
not EPS.
Earnings Risk (Variation or Standard Deviation) Increases because of
Leveraging or Magnifying effect of Debt. Debt increases Financial
Distress and Risk of Bankruptcy.
And if Firm is financially unhealthy i.e. EBIT / Total Assets < Cost of
Debt then small fall in EBIT can lead to large fall in ROE.
Weaknesses of Capital Structure Mathematical Models:
Here are some of the rules of thumb or general principles financial
managers keep in view while deciding for capital structure of the
company:
Forecasting Errors
Changes in Cost of Debt and Equity (or Capitalization Rates) are
unpredictable when Debt Ratio is changing
Changes in EBIT are also difficult to correlate to changes in Debt or
Capital Structure
Share Price and EPS calculation is very sensitive to minor errors in the
estimates.
Focus on Corporate Finance is on Market Value (of Equity, Debt, and
Stocks) BUT Market Value may not be so important for Proprietorships
and Private Ltd Companies where only a few shareholders to whom the
market value assessed by investors in the market is irrelevant.
Fundamentally, Stock Prices should be fundamentally driven by
Operating Decisions and Focus on Improving Earnings and Cash Flows
and NOT by manipulating Capital Structure. Capital
Structure and Corporate Financing can be used to fine tune the value.
Practical Capital Structure Management:
Financial Stability and Conservatism vs. Real-time Capital Structure
Optimization! Aim for Target Capital Structure

Long Run Viability vs. Short-term Stock Price Maximization


. financial ratio targets
Coverage Ratio i.e. TIE (Times Interest Earned)
= EBIT / Interest. Higher (over 2.0) is better.
Long Term Debt / Total Capitalization Ratio - about 30%
FCC (Fixed Charge Coverage) = (EBIT - Lease Rental) / (Interest +
Lease Rental + Adjusted Sinking Fund Payment). Takes into account
Fixed Financial Charges other than Interest

Maintain Reserve Borrowing Capacity (recall Signaling Theory) in case


attractive Positive NPV projects are found & also to give the right Signal
to Market
Management Control use Debt to avoid giving away voting rights and
control BUT Creditors can take control if firm becomes insolvent or
defaults Corporate Raiders can take over a firm with large assets if debt
is too low - using LBO (Leveraged Buy Out). They convince
shareholders to give them control in exchange for higher share prices
and EPS as a result of future leveraging.

Firms with (1) solid assets that can be mortgaged as security against a
loan and (2) stable sales and Operating Leverage can generally use debt
more safely.

Retained Earnings: profitable firms have sizeable Cash and Retained


Earnings. These are ideal sources of capital because No transaction
costs.

High Tax Bracket Firms: such firms have greater advantage in using
debt because of large Interest Tax Shield Savings.

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