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Week 12 Risk Management

The document discusses capital structure and how effective capital structure decisions can lower a firm's cost of capital and increase project values and firm value. It defines key ratios like debt ratio, times interest earned ratio, and fixed charge coverage ratio that provide information on a firm's financial leverage and ability to meet debt payments. The optimal capital structure balances lower cost of capital from debt against higher risk from taking on more debt. Capital structure theory suggests firms' values are unaffected by capital structure in perfect markets but various real-world factors like taxes make some structures more optimal.

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Ray Mund
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87 views29 pages

Week 12 Risk Management

The document discusses capital structure and how effective capital structure decisions can lower a firm's cost of capital and increase project values and firm value. It defines key ratios like debt ratio, times interest earned ratio, and fixed charge coverage ratio that provide information on a firm's financial leverage and ability to meet debt payments. The optimal capital structure balances lower cost of capital from debt against higher risk from taking on more debt. Capital structure theory suggests firms' values are unaffected by capital structure in perfect markets but various real-world factors like taxes make some structures more optimal.

Uploaded by

Ray Mund
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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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Download as PDF, TXT or read online on Scribd
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THE CAPITAL STRUCTURE

The Firm’s
Capital Structure
PRESENTED BY: KIMBEARLY CHENG, MBA

Poor capital structure decisions Effective capital structure


can result in a high cost of decisions can lower the cost of
capital, thereby lowering the capital, resulting in higher NPVs
NPVs of projects and making and more acceptable projects—
more of them unacceptable. and thereby increasing the
value of the firm
External Assessment of
Capital Structure
Those outside the firm can make a rough
assessment of capital structure by using
measures found in the firm’s financial statements

Debt ratio show degree of indebtedness

Times interest earned ratio and the fixed-


payment coverage ratio measures ability to make
debt payments. These ratios provide indirect
information on financial leverage. Generally, the
smaller these ratios, the greater the firm’s
financial leverage and the less able it is to meet
payments as they come due.
Fixed Charge Coverage Ratio (FCCR)

A measure of a company’s ability to meet fixed-charge obligations


such as interest expenses and lease expenses.

A higher ratio value – preferably 2 or above – indicates a more


financially healthy, and less risky, company or situation.

A lower ratio value – less than 1 – indicates that the company is


struggling to meet its regularly scheduled payments.
EBITDA stands for earnings before interest,
taxes, depreciation, and amortization.

Fixed charges are regular, business expenses that


are paid regardless of business activity. Examples
of fixed charges include debt installment
payments and business equipment lease
payments.
EXAMPLE: Fixed Charge Coverage Ratio (FCCR)

The fixed-charge coverage ratio for Marites' salon would be calculated as follows:
EXAMPLE: Fixed Charge Coverage Ratio (FCCR)

Cont'd:
Times Interest Earned Ratio (TIE)

If it's high, it's good.


If it's low, it's bad.
If it's too high, it
may also be bad
because the firm
is using too much
earnings to pay
extra debt instead
of acquiring other
assets or projects.
Earnings Before Interest & Taxes (EBIT) –
represents profit that the business has realized,
without factoring in interest or tax payments

Interest Expense – represents the periodic debt


payments that a company is legally obligated to
make to its creditors
EXAMPLE: Times Interest Earned Ratio (TIE)

In the example, the TIE ratio increased five-fold from 2015 to 2018. This
shows that the firm is managing its creditworthiness well, since it is
continually able to increase its profitability without taking on additional
debt.

If it needs to fund a major project to expand its business, it can viably


consider financing it with debt rather than equity.
Every industry has its own Debt Ratio benchmark
and Times Interest Earned Ratio benhcmark.

If a firm in a specific industry deviates from this


negatively, there is a corresponding issue in the
capital structure and may be detrimental to the
company.
NON-US
Companies
Have higher level of indebtedness

This is because US Capital markets are more


developed
EU counterparts have more developed debt
markets (i.e. Germany)
Similarities with
US Companies
Similar industry patterns of capital structure

Capital structure of biggest multinational


company in the US is similar to other
multinational companies elsewhere; more than
they resemble smaller us multinational
companies

Worldwide trend is away from reliance on banks


and greater toward reliance on security issuance
There is an optimal capital structure range

It's impossible to provide managers the exact


methodology to achieve optimal capital structure

Financial understanding helps undertsnad how


the capital structure affects the value of the firm.
Capital
The idea of Modigliani and Miller (M&M) is that
assuming perfect markets, the capital structure a
Structure
Theory
firm chooses will not affect its value.

Perfect Markets - info flow is seamless and


symmetrical, no friction, no transaction cost, no
taxes, etc.
Capital
Structure
Theory
Capital
Structure
Theory
Capital
Structure
Theory
Capital
Structure
Theory
EXAMPLE:
Cooke Company, a soft drink manufacturer,
is preparing to make a capital structure
decision. It has obtained estimates of sales
and the associated levels of earnings before
interest and taxes (EBIT) from its forecasting
group: There is a 25% chance that sales will
total $400,000, a 50% chance that sales will
total $600,000, and a 25% chance that sales
will total $800,000. Fixed operating costs
total $200,000, and variable operating costs
equal 50% of sales
Cooke Company’s current capital
structure is as follows:
RETURN! RISK! RISK/
REWARD!
The cost of debt, ki , remains low because of the
tax shield, but it slowly increases as leverage
increases, to compensate lenders for increasing
risk.

The cost of equity, ks, is above the cost of debt. It


increases as financial leverage increases, but it
generally increases more rapidly than the cost of
debt since it has to cover higher return.

As debt is substituted for equity and as the debt


ratio increases, the WACC declines because the
debt cost is less than the equity cost (kiks). As

The Optimal
the debt ratio continues to increase, the
increased debt and equity costs eventually cause

Capital Structure
the WACC to rise.
VALUATION
ENDE

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