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1)Youssef

What is Capital Structure?

Capital structure refers to the amount of debt and/or equity employed by a firm to
fund its operations and finance its assets. A firm’s capital structure is typically
expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’s operations, capital
expenditures, acquisitions, and other investments. There are tradeoffs firms have to
make when they decide whether to use debt or equity to finance operations, and
managers will balance the two to find the optimal capital structure.

Optimal capital structure

The optimal capital structure of a firm is often defined as the proportion of debt and
equity that results in the lowest weighted average cost of capital (WACC) for the firm.
This technical definition is not always used in practice, and firms often have a
strategic or philosophical view of what the ideal structure should be.

In order to optimize the structure, a firm can issue either more debt or equity. The
new capital that’s acquired may be used to invest in new assets or may be used to
repurchase debt/equity that’s currently outstanding, as a form of recapitalization.

Understanding Optimal Capital Structure

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes
the weighted average cost of capital (WACC) of a company while maximizing its market value. The
lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by
the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal
capital structure that will result in the lowest WACC and the maximum value of the company
(shareholder wealth)
Youstina Cost of capital

A firm’s total cost of capital is a weighted average of the cost of equity and the cost of
debt, known as the weighted average cost of capital (WACC).

Hint 3lshan nefham el WACC aktr:

(The weighted average cost of capital (WACC) represents a firm's average cost of capital from all sources,
including common stock, preferred stock, bonds, and other forms of debt)

The weighted average cost of capital is a common way to determine required rate of return because it
expresses, in a single number, the return that both bondholders and shareholders demand in order to provide
the company with capital. A firm’s WACC is likely to be higher if its stock is relatively volatile or if its debt is
seen as risky because investors will demand greater returns.

The formula is equal to:

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:

E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

Optimal Capital Structure and WACC

The cost of debt is less expensive than equity because it is less risky. The required return needed to
compensate debt investors is less than the required return needed to compensate equity investors,
because interest payments have priority over dividends, and debt holders receive priority in the
event of a liquidation. Debt is also cheaper than equity because companies get tax relief on interest,
while dividend payments are paid out of after-tax income.

However, there is a limit to the amount of debt a company should have because an excessive
amount of debt increases interest payments, the volatility of earnings, and the risk of bankruptcy.
This increase in the financial risk to shareholders means that they will require a greater return to
compensate them, which increases the WACC—and lowers the market value of a business. The
optimal structure involves using enough equity to mitigate the risk of being unable to pay back the
debt—taking into account the variability of the business’s cash flow.
Rolan Determining the Optimal Capital Structure
As it can be difficult to pinpoint the optimal capital structure, managers usually attempt to operate
within a range of values. They also have to take into account the signals their financing decisions
send to the market.

A company with good prospects will try to raise capital using debt rather than equity, to
avoid dilution and sending any negative signals to the market. Announcements made about a
company taking debt are typically seen as positive news, which is known as debt signaling. If a
company raises too much capital during a given time period, the costs of debt, preferred stock, and
common equity will begin to rise, and as this occurs, the marginal cost of capital will also rise.

To gauge how risky a company is, potential equity investors look at the debt/equity ratio. They also
compare the amount of leverage other businesses in the same industry are using—on the
assumption that these companies are operating with an optimal capital structure—to see if the
company is employing an unusual amount of debt within its capital structure.

Another way to determine optimal debt-to-equity levels is to think like a bank. What is the optimal
level of debt a bank is willing to lend? An analyst may also utilize other debt ratios to put the
company into a credit profile using a bond rating. The default spread attached to the bond rating can
then be used for the spread above the risk-free rate of a AAA-rated company.

Limitations of Optimal Capital Structure

Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world
optimal capital structure. What defines a healthy blend of debt and equity varies according to the
industries involved, line of business, and a firm's stage of development, and can also vary over time
due to external changes in interest rates and regulatory environment.

However, because investors are better off putting their money into companies with strong balance
sheets, it makes sense that the optimal balance generally should reflect lower levels of debt and
higher levels of equity.
 Reem
How to recapitalize a business

A firm that decides they should optimize their capital structure by changing the mix of
debt and equity has a few options to effect this change.

Methods of recapitalization include:

1. Issue debt and repurchase equity

2. Issue debt and pay a large dividend to equity investors
3. Issue equity and repay debt

Each of these three methods can be an effective way of recapitalizing the business.

In the first approach, the firm borrows money by issuing debt and then uses all of the
capital to repurchase shares from its equity investors. This has the effect of
increasing the amount of debt and decreasing the amount of equity on the balance
sheet.

In the second approach, the firm will borrow money (i.e., issue debt) and use that
money to pay a one-time special dividend, which has the effect of reducing the value
of equity by the value of the divided. This is another method of increasing debt and
reducing equity.

In the third approach, the firm moves in the opposite direction and issues equity by
selling new shares, then takes the money and uses it to repay debt. Since equity is
costlier than debt, this approach is not desirable and often only done when a firm is
overleveraged and desperately needs to reduce its debt.
feryal: (momkn te5tary 6 w 6 aw 5 w 5 mn el Pros and cons of equity/dept)

Tradeoffs between debt and equity

There are many tradeoffs that owners and managers of firms have to consider when
determining their capital structure. Below are some of the tradeoffs that should be
considered.

Pros and cons of equity:

 No interest payments
 No mandatory fixed payments (dividends are discretionary)
 No maturity dates (no capital repayment)
 Has ownership and control over the business
 Has voting rights (typically)
 Has a high implied cost of capital
 Expects a high rate of return (dividends and capital appreciation)
 Has last claim on the firm’s assets in the event of liquidation
 Provides maximum operational flexibility

Pros and cons of debt:

 Has interest payments (typically)

 Has a fixed repayment schedule
 Has first claim on the firm’s assets in the event of liquidation
 Requires covenants and financial performance metrics that must be met
 Contains restrictions on operational flexibility
 Has a lower cost than equity
 Expects a lower rate of return than equity

s
Hany

Theories on Capital Structure

Modigliani-Miller (M&M) Theory

This proposition states that in perfect markets the capital structure a

company uses doesn't matter because the market value of a firm is
determined by its earning power and the risk of its underlying assets.
According to Modigliani and Miller, value is independent of the method of
financing used and a company's investments. The M&M theorem made the
two following propositions: 1

Proposition I

This proposition says that the capital structure is irrelevant to the value of a
firm. The value of two identical firms would remain the same and value
would not be affected by the choice of financing adopted to finance the
assets. The value of a firm is dependent on the expected future earnings. It
is when there are no taxes. 2

Proposition II

This proposition says that the financial leverage boosts the value of a firm
and reduces WACC. It is when tax information is available. While the
Modigliani-Miller theorem is studied in finance, real firms do face taxes,
credit risk, transaction costs, and inefficient markets, which makes the mix
of debt and equity financing important.