CAPITAL CAPITAL STRUCTURE STRUCTURE ANALYSISANALYSIS

Chapter 14Chapter 14

CHAPTER 14 OBJECTIVESCHAPTER 14 OBJECTIVES

Describe the advantages and Describe the advantages and disadvantages of financial leverage.disadvantages of financial leverage.

Compute the financial leverage index, Compute the financial leverage index, debt to capital ratio, debt to equity debt to capital ratio, debt to equity ratio, and other techniques for ratio, and other techniques for analyzing capital structure.analyzing capital structure.

Relate capital structure composition to Relate capital structure composition to owner and creditor investment owner and creditor investment objectives. objectives.

CHAPTER 14 OBJECTIVES CHAPTER 14 OBJECTIVES (CONT.)(CONT.)

Discuss the various types of risks Discuss the various types of risks and their role in capital structure and their role in capital structure analysis. analysis.

Present a preliminary capital Present a preliminary capital structure analysis for a company structure analysis for a company or industry.or industry.

OBJECTIVE FOR ANALYZING CAPITAL OBJECTIVE FOR ANALYZING CAPITAL STRUCTURESTRUCTURE

To determine if the proportion of To determine if the proportion of debt to equity enables an entity to debt to equity enables an entity to create wealth without unduly create wealth without unduly jeopardizing the firmjeopardizing the firm

OBJECTIVE FOR ANALYZING CAPITAL OBJECTIVE FOR ANALYZING CAPITAL STRUCTURE (CONT.)STRUCTURE (CONT.)

Capital structure compositionCapital structure composition Consists of long-term liabilities, preferred Consists of long-term liabilities, preferred

stock, common stock, and retained stock, common stock, and retained earnings.earnings.

Sufficient equity must exist to provide Sufficient equity must exist to provide financial stabilityfinancial stability

Debt can be used as leverage to increase Debt can be used as leverage to increase returns to shareholders, but it can also returns to shareholders, but it can also reduce returns on shareholders’ reduce returns on shareholders’ investmentsinvestments

FINANCING ACTIVITIESFINANCING ACTIVITIES The balance sheet The balance sheet

Reports how funds are acquired and Reports how funds are acquired and allocatedallocated

Current assets are financed with current Current assets are financed with current obligations—not a factor in capital structure obligations—not a factor in capital structure analysisanalysis

Long-term debt and equity finance long-Long-term debt and equity finance long-term assets—assessing the pros and cons of term assets—assessing the pros and cons of these financing factors is the essence of these financing factors is the essence of capital structure analysiscapital structure analysis

FINANCING ACTIVITIES FINANCING ACTIVITIES (CONT.)(CONT.)

Capital structure valuationCapital structure valuation Long-term liabilities are reported at the Long-term liabilities are reported at the

present value of expected cash flowspresent value of expected cash flows Current liabilities are not adjusted for the time Current liabilities are not adjusted for the time

value of moneyvalue of money Contributed capital is reported at the Contributed capital is reported at the

historical proceeds received from selling stockhistorical proceeds received from selling stock Retained earnings are reported as a summary Retained earnings are reported as a summary

of all of the valuation methods used to of all of the valuation methods used to measure income measure income

FINANCING ACTIVITIES FINANCING ACTIVITIES (CONT.)(CONT.)

Equity investments are an entity’s Equity investments are an entity’s permanent financing, representing permanent financing, representing The ultimate risk capitalThe ultimate risk capital Insulation of the firm from random Insulation of the firm from random

business shocksbusiness shocks A margin of safety to debt investorsA margin of safety to debt investors The right to a return on investment The right to a return on investment

only after the other claimants have only after the other claimants have been satisfiedbeen satisfied

FINANCING ACTIVITIES FINANCING ACTIVITIES (CONT.)(CONT.)

Long-term debt investments representLong-term debt investments represent Fixed contractual obligationsFixed contractual obligations Payable at specific times in specified amountsPayable at specific times in specified amounts Returns on investment that are tax deductibleReturns on investment that are tax deductible

Short-term debt obligationsShort-term debt obligations Arise from the normal course of business Arise from the normal course of business

operationsoperations Are liquidated with cash from current assetsAre liquidated with cash from current assets Excluded from capital structure analysisExcluded from capital structure analysis

FINANCIAL LEVERAGEFINANCIAL LEVERAGE

The substitution of fixed-charge financing The substitution of fixed-charge financing for variable-cost (dividend) equity financingfor variable-cost (dividend) equity financing

Financial leverage conceptsFinancial leverage concepts The traditional view is that an optimal mix of The traditional view is that an optimal mix of

debt and equity exists debt and equity exists Research demonstrated that the mix of debt Research demonstrated that the mix of debt

and equity is irrelevant, if taxes are ignoredand equity is irrelevant, if taxes are ignored The tax deductibility of interest expense The tax deductibility of interest expense

creates an advantage for incurring debt (Exhibit creates an advantage for incurring debt (Exhibit 14-1)14-1)

FINANCIAL LEVERAGE FINANCIAL LEVERAGE (CONT.)(CONT.)

The advantage of debt only exists The advantage of debt only exists up to a point (Exhibits 14-2A and up to a point (Exhibits 14-2A and 14-2B)14-2B) Low cost debt increases ROE relative Low cost debt increases ROE relative

to ROAto ROA Debt can become so costly that it Debt can become so costly that it

reduces ROE below ROAreduces ROE below ROA

FINANCIAL LEVERAGE FINANCIAL LEVERAGE (CONT.)(CONT.)

The financial structure leverage The financial structure leverage ratio ratio Is computed as: average total assets / Is computed as: average total assets /

average common shareholders’ average common shareholders’ equityequity

Produces a ratio of greater than one, Produces a ratio of greater than one, which implies debt is always which implies debt is always advantageous (so long as a positive advantageous (so long as a positive profit margin exists)profit margin exists)

FINANCIAL LEVERAGE FINANCIAL LEVERAGE (CONT.)(CONT.)

Financial leverage indexFinancial leverage index Is computed as adjusted return on equity / Is computed as adjusted return on equity /

adjusted return on assetsadjusted return on assets Superior to the financial structure leverage Superior to the financial structure leverage

ratio because it factors in the adjusted rates ratio because it factors in the adjusted rates of return in the computationof return in the computation

An index in excess of one means ROE exceeds An index in excess of one means ROE exceeds ROA; a favorable use of debt financing ROA; a favorable use of debt financing

An index of less than one is bad; ROA exceeds An index of less than one is bad; ROA exceeds ROE; an unfavorable use of debt financingROE; an unfavorable use of debt financing

RISK ANALYSISRISK ANALYSIS

Risk is the possibility of losing Risk is the possibility of losing something of valuesomething of value

Credit riskCredit risk The possibility that an entity will not The possibility that an entity will not

be able to meet debt payment be able to meet debt payment obligations on timeobligations on time

RISK ANALYSIS (CONT.)RISK ANALYSIS (CONT.)

Capital structure influences credit Capital structure influences credit riskrisk

A firm with a conservative capital A firm with a conservative capital structure is a low credit risk structure is a low credit risk because it has because it has small amount of debt small amount of debt low fixed cost commitments low fixed cost commitments a low default probabilitya low default probability

RISK ANALYSIS (CONT.)RISK ANALYSIS (CONT.)

Business riskBusiness risk Fluctuations in earnings and cash Fluctuations in earnings and cash

flow, due toflow, due to Changes in the economyChanges in the economy Industry-specific conditionsIndustry-specific conditions A high degree of leverage—leveraged A high degree of leverage—leveraged

firms have greater exposure to business firms have greater exposure to business risk than conservatively structured risk than conservatively structured entities entities

RISK ANALYSIS (CONT.)RISK ANALYSIS (CONT.)

Bankruptcy riskBankruptcy risk Extreme case of credit risk, whereby Extreme case of credit risk, whereby

a firm may be unable to continue as a a firm may be unable to continue as a going concerngoing concern

Financial distress, or the difficulty in Financial distress, or the difficulty in meeting maturing obligations, is the meeting maturing obligations, is the first sign of bankruptcy riskfirst sign of bankruptcy risk

A company in financial distress might A company in financial distress might file for bankruptcy protectionfile for bankruptcy protection

RISK ANALYSIS (CONT.)RISK ANALYSIS (CONT.)

A bankrupt firmA bankrupt firm Losses autonomy in conducting its Losses autonomy in conducting its

operationsoperations Has a court suspend its creditors’ claimsHas a court suspend its creditors’ claims Can have its debts rearranged, reduced, or Can have its debts rearranged, reduced, or

eliminated with the mutual consent of the eliminated with the mutual consent of the company, creditors, and courtcompany, creditors, and court

Will liquidate, or go out of business, if Will liquidate, or go out of business, if continuing operations is not a viable optioncontinuing operations is not a viable option

  

RISK ANALYSIS (CONT.)RISK ANALYSIS (CONT.)

Comprehensive riskComprehensive risk The equity market’s determination The equity market’s determination

of riskof risk Is a function of systematic risk Is a function of systematic risk Is inherent in investing Is inherent in investing Cannot be eliminated through Cannot be eliminated through

investment diversityinvestment diversity

RISK ANALYSIS (CONT.)RISK ANALYSIS (CONT.)

Beta measures of systematic riskBeta measures of systematic risk Is the extent to which a stock moves Is the extent to which a stock moves

with the overall marketwith the overall market In a range from –1.0 to +1.0In a range from –1.0 to +1.0 With an interpretation that he higher With an interpretation that he higher

the beta, the greater a stock’s the beta, the greater a stock’s variabilityvariability

CAPITAL STRUCTURE CAPITAL STRUCTURE MEASURES MEASURES

Capital structure compositionCapital structure composition Financing activities should Financing activities should

correspond to investing activitiescorrespond to investing activities Short-term creditors finance current Short-term creditors finance current

assetsassets Long-term investors finance long-Long-term investors finance long-

term assetsterm assets

CAPITAL STRUCTURE CAPITAL STRUCTURE MEASURES (CONT.)MEASURES (CONT.)

Lack of correspondence signals financial Lack of correspondence signals financial distressdistress Long-term borrowing cannot be used to Long-term borrowing cannot be used to

finance operations indefinitelyfinance operations indefinitely Cash from operations should satisfy working Cash from operations should satisfy working

capital operationscapital operations Common size statementsCommon size statements

Provide insights between current and long-Provide insights between current and long-term financing sources and investmentsterm financing sources and investments

Must be considered in conjunction with life Must be considered in conjunction with life cycle stagecycle stage

DEBT TO CAPITAL RATIOSDEBT TO CAPITAL RATIOS

Provide insight about the Provide insight about the proportion of debt to equity proportion of debt to equity financingfinancing

Total debt to total capitalTotal debt to total capital Measures the percentage of assets Measures the percentage of assets

financed with debtfinanced with debt Is computed as: average total debt / Is computed as: average total debt /

average total assetsaverage total assets

DEBT TO CAPITAL RATIOS DEBT TO CAPITAL RATIOS (CONT.)(CONT.)

Total debt to total equityTotal debt to total equity Measures debt financing as a Measures debt financing as a

percentage of total financing percentage of total financing Is computed as: average total debt / Is computed as: average total debt /

average total shareholders’ equityaverage total shareholders’ equity

DEBT TO CAPITAL RATIOS DEBT TO CAPITAL RATIOS (CONT.)(CONT.)

Long-term debt to total capitalLong-term debt to total capital Measures the percentage of assets Measures the percentage of assets

financed with long-term debtfinanced with long-term debt Eliminates current obligations from Eliminates current obligations from

the ratio because they are paid with the ratio because they are paid with maturing current assetsmaturing current assets

Is computed as: average long-term Is computed as: average long-term debt / average total assetsdebt / average total assets

DEBT TO CAPITAL RATIOS DEBT TO CAPITAL RATIOS (CONT.)(CONT.)

Total long-term debt to total equityTotal long-term debt to total equity Measures long-term debt financing as Measures long-term debt financing as

a percentage of total financing a percentage of total financing Eliminates current obligations from Eliminates current obligations from

the ratio because they are paid with the ratio because they are paid with maturing current assetsmaturing current assets

Is computed as: average long-term Is computed as: average long-term debt / average total shareholders’ debt / average total shareholders’ equityequity

DEBT TO CAPITAL RATIOS DEBT TO CAPITAL RATIOS (CONT.)(CONT.)

Earnings coverage ratioEarnings coverage ratio Measures the extent to which an entity can Measures the extent to which an entity can

meet its fixed chargesmeet its fixed charges Is known as the times interest earned ratio, Is known as the times interest earned ratio,

which is a simplified version of earnings which is a simplified version of earnings coveragecoverage

Times interest earned is computed as: Times interest earned is computed as: operating income before interest and taxes / operating income before interest and taxes / interest expenseinterest expense

It is acceptable substitute for earnings coverage It is acceptable substitute for earnings coverage so long as accrual numbers approximate so long as accrual numbers approximate required cash payments for fixed changesrequired cash payments for fixed changes

DEBT TO CAPITAL RATIOS DEBT TO CAPITAL RATIOS (CONT.)(CONT.)

Bankruptcy predictionBankruptcy prediction Mathematical models that provide information Mathematical models that provide information

about an entity’s bankruptcy probabilityabout an entity’s bankruptcy probability The Z-score is an accepted measure of The Z-score is an accepted measure of

bankruptcy predictionbankruptcy prediction Computed as a function of five weighted ratiosComputed as a function of five weighted ratios Z-scores above 3.0 indicate little probability of Z-scores above 3.0 indicate little probability of

bankruptcybankruptcy Those below 1.81 indicate a high possibility of Those below 1.81 indicate a high possibility of

bankruptcybankruptcy Scores between 1.81 and 3.0 are inconclusive Scores between 1.81 and 3.0 are inconclusive

eSTUFF’S CAPITAL eSTUFF’S CAPITAL STRUCTURE RATIOSSTRUCTURE RATIOSCapital Structure Ratios 2003 2002 2001Debt to capital 0.35 0.37 0.39 Debt to equity 0.53 0.58 0.63 Long-term debt to capital 0.19 0.25 0.21 Long-term debt to equity 0.29 0.40 0.34 Earnings coverage 0.25 2.95 2.75 Working capital/total assets-Z1 0.67 0.61 0.38 Retained earnings/total assets-Z2 0.10 0.09 0.06 EBIT/total assets-Z3 0.02 0.22 0.22 Revenues/total assets-Z4 1.52 1.42 1.49 Market equity/book liabilities-Z5 0.28 1.29 1.88 Total Z-score 2.59 3.63 4.03

CAPITAL STRUCTURE ANALYSIS AND CAPITAL STRUCTURE ANALYSIS AND

THE PC INDUSTRYTHE PC INDUSTRY

New economy capital structureNew economy capital structure Venture capital and retained Venture capital and retained

earnings financed PC firms’ earnings financed PC firms’ productive resourcesproductive resources

Little long-term debtLittle long-term debt

CAPITAL STRUCTURE ANALYSIS AND CAPITAL STRUCTURE ANALYSIS AND

THE PC INDUSTRY (CONT.)THE PC INDUSTRY (CONT.)

Capital structure measuresCapital structure measures Apple and Dell carried more debt than Apple and Dell carried more debt than

Compaq or Gateway during the period Compaq or Gateway during the period analyzed (Exhibit 14-7A)analyzed (Exhibit 14-7A)

Dell used debt to increase its returns on Dell used debt to increase its returns on equityequity

Apple acquired debt (and preferred stock) to Apple acquired debt (and preferred stock) to bolster its insufficient cash from earnings bolster its insufficient cash from earnings and replenish its depleted equity base, and replenish its depleted equity base, which was reduced by its net losses which was reduced by its net losses

PC IndustryDebt as a Percentage of Equity

0%

50%

100%

150%

200%

250%

1994 1995 1996 1997 1998

Debt/

Equity

Apple Compaq Dell Gateway

PC IndustryFinancial Leverage Indexes

(cumulative 1994-1998)

-3

-2

-1

0

1

2

3

Apple Compaq Dell Gateway

Fin

anci

al L

ever

age

Inde

x

CAPITAL STRUCTURE ANALYSIS AND CAPITAL STRUCTURE ANALYSIS AND

THE PC INDUSTRY (CONT.)THE PC INDUSTRY (CONT.)

Long-term debt provided an Long-term debt provided an relatively small amount of relatively small amount of financing for all four firms (Exhibit financing for all four firms (Exhibit 14-7B)14-7B)

Debt as a proportion of total assets Debt as a proportion of total assets and equity was relatively stable and equity was relatively stable during the period examined during the period examined (Exhibits 14-8A and 14-8B)(Exhibits 14-8A and 14-8B)

Apple

Long-Term Debt12%

Current Debt & Equity88%

Compaq

Current Debt & Equity97%

Long-Term Debt3%

Dell

Current Debt & Equity96%

Long-Term Debt4%

Gateway

Current Debt & Equity92%

Long-Term Debt8%

PC IndustryLong-Term Debt as a Percentage of Total Assets