1®2002 Prentice Hall Publishing

Chapter 10Making Capital Structure

Decisions

2®2002 Prentice Hall Publishing

EBIT-EPS Analysis

• Calculation of EPSCalculation of EPS

• Break-even, or indifference, analysisBreak-even, or indifference, analysis

• Use of EBIT-EPS informationUse of EBIT-EPS information

3®2002 Prentice Hall Publishing

Calculation of EPS

• EBIT indifference pointsEBIT indifference points

• EBIT-EPS analysisEBIT-EPS analysis

– Focuses on the EBIT indifference between Focuses on the EBIT indifference between financing methods with respect to EPSfinancing methods with respect to EPS

4®2002 Prentice Hall Publishing

Break-Even, or Indifference, Analysis

• Horizontal axis = EBITHorizontal axis = EBIT• Vertical axis = EPSVertical axis = EPS• Below Indifference point (IP)Below Indifference point (IP)

– Common stock alternative is bestCommon stock alternative is best• Above the IPAbove the IP

– Debt alternative is bestDebt alternative is best• Debt alternative always dominates preferred Debt alternative always dominates preferred

stockstock

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Use of EBIT-EPS Information

• Financing alternatives have different impacts on Financing alternatives have different impacts on EPS EPS

• Comparing with existing and expected EBITComparing with existing and expected EBIT– Higher EBIT Higher EBIT (stronger case for debt)(stronger case for debt)

– Lower EBIT Lower EBIT (stronger case for common stock)(stronger case for common stock)

• Assess likelihood of EBIT falling below IPAssess likelihood of EBIT falling below IP• Gives insight into risk-return trade-off that Gives insight into risk-return trade-off that

governs valuationgoverns valuation

6®2002 Prentice Hall Publishing

Cash-Flow Ability to Service Debt

• Fixed chargesFixed charges

• Times interest earnedTimes interest earned

• Debt-service coverageDebt-service coverage• EBIT, depreciation, and amortization EBIT, depreciation, and amortization (EBITDA)(EBITDA)

• Probability of cash insolvencyProbability of cash insolvency

• Donaldson approachDonaldson approach

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Fixed Charges

• IncludeInclude

– Principal and interest payments on debtPrincipal and interest payments on debt

– Lease paymentsLease payments

– Preferred stock dividendsPreferred stock dividends

• Inability to meet fixed charges may result in Inability to meet fixed charges may result in financial insolvencyfinancial insolvency

• Increased stability of expected future CFs Increased stability of expected future CFs results in increased debt capacityresults in increased debt capacity

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Times Interest Earned

• Important test of credit-worthinessImportant test of credit-worthiness

• Concern arises when ratio falls below 3 to 1Concern arises when ratio falls below 3 to 1

– Difficult to achieve an investment-grade Difficult to achieve an investment-grade credit ratingcredit rating

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Debt-Service Coverage

• Coverage ratioCoverage ratio

– Interest before taxInterest before tax

– Principal payment after taxPrincipal payment after tax

• Include lease paymentsInclude lease payments

• Debt service and business riskDebt service and business risk

– Electric utilities versus manufacturing Electric utilities versus manufacturing

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EBITDA

• EBITDA versus EBITEBITDA versus EBIT

• EBITDA may not be a good measure of the EBITDA may not be a good measure of the cash available for debt servicecash available for debt service

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Probability of Cash Insolvency• What are the chances of insolvency?What are the chances of insolvency?• AssessAssess

– The possible deviation of actual from expected The possible deviation of actual from expected CFsCFs

– Purchase or sale of assetsPurchase or sale of assets– Liquidity of the firmLiquidity of the firm– DividendsDividends– Seasonal patternsSeasonal patterns– Other factors impacting CFsOther factors impacting CFs

12®2002 Prentice Hall Publishing

Donaldson Approach

• Examine the CFs of the companyExamine the CFs of the company– Under the most adverse circumstances Under the most adverse circumstances

(i.e. recession)(i.e. recession)• Debt capacityDebt capacity

– Debt that can be comfortably servicedDebt that can be comfortably serviced• Calculate the probability of cash inadequacyCalculate the probability of cash inadequacy

– Cash insolvency versus cash inadequacyCash insolvency versus cash inadequacy

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Effect on Debt Ratios

• Pro forma debt ratiosPro forma debt ratios• Compare new debt ratiosCompare new debt ratios

– With past ratiosWith past ratios• Trend analysisTrend analysis

– Other companiesOther companies• Similar business riskSimilar business risk• In same industryIn same industry

• Justify position if capital structure is out of lineJustify position if capital structure is out of line

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Effect of Security Ratings

• Effect of financing alternativesEffect of financing alternatives

• Rating agenciesRating agencies

• Changes in Ratings of existing securitiesChanges in Ratings of existing securities

• RatingsRatings

– Indicate credit worthiness of a borrowerIndicate credit worthiness of a borrower

– First 4 are considered investment gradeFirst 4 are considered investment grade

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Analysis Before Assigning a Grade

• Trends in ratiosTrends in ratios

• Business riskBusiness risk

• Capital requirementsCapital requirements

• Specific security featuresSpecific security features

• Cash-flow abilityCash-flow ability

• Proportion of debtProportion of debt

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Timing and Flexibility

• Timing security issuesTiming security issues

– Debt or common stockDebt or common stock

– Financing is lumpyFinancing is lumpy

– General market conditionsGeneral market conditions

– Expectations for the companyExpectations for the company

• FlexibilityFlexibility

– Keeping open future financing optionsKeeping open future financing options

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A Pecking Order of Financing• Internal financingInternal financing• Straight debtStraight debt• Preferred stockPreferred stock• Hybrid securitiesHybrid securities

– Convertible bondsConvertible bonds• Straight equityStraight equity

– Least desirableLeast desirable• Financing decision should be based on a Financing decision should be based on a

rigorous analysis embracing valuationrigorous analysis embracing valuation

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Financing Checklist

• TaxesTaxes• Explicit costExplicit cost• Financial signalingFinancial signaling• EBIT-EPS analysisEBIT-EPS analysis• Agency costs and Agency costs and

incentive issuesincentive issues

• Debt ratioDebt ratio• Security ratingSecurity rating• TimingTiming• FlexibilityFlexibility• Cash flow ability to Cash flow ability to

service debtservice debt