CAPITAL STRUCTURE ANALYSIS
CHAPTER 14 OBJECTIVES
Describe the advantages and disadvantages of financial leverage. Compute the financial leverage index, debt to capital ratio, debt to equity ratio, and other techniques for analyzing capital structure. Relate capital structure composition to owner and creditor investment objectives.
CHAPTER 14 OBJECTIVES (CONT.)
Discuss the various types of risks and their role in capital structure analysis. Present a preliminary capital structure analysis for a company or industry.
OBJECTIVE FOR ANALYZING CAPITAL STRUCTURE
To determine if the proportion of debt to equity enables an entity to create wealth without unduly jeopardizing the firm
but it can also reduce returns on shareholders’ investments
. common stock. Sufficient equity must exist to provide financial stability Debt can be used as leverage to increase returns to shareholders. and retained earnings.)
Capital structure composition
Consists of long-term liabilities.OBJECTIVE FOR ANALYZING CAPITAL STRUCTURE (CONT. preferred stock.
The balance sheet
Reports how funds are acquired and allocated Current assets are financed with current obligations—not a factor in capital structure analysis Long-term debt and equity finance long-term assets—assessing the pros and cons of these financing factors is the essence of capital structure analysis
Capital structure valuation
Long-term liabilities are reported at the present value of expected cash flows Current liabilities are not adjusted for the time value of money Contributed capital is reported at the historical proceeds received from selling stock Retained earnings are reported as a summary of all of the valuation methods used to measure income
.FINANCING ACTIVITIES (CONT.
The ultimate risk capital Insulation of the firm from random business shocks A margin of safety to debt investors The right to a return on investment only after the other claimants have been satisfied
Equity investments are an entity’s permanent financing.FINANCING ACTIVITIES (CONT.
FINANCING ACTIVITIES (CONT.)
Long-term debt investments represent
Fixed contractual obligations Payable at specific times in specified amounts Returns on investment that are tax deductible Arise from the normal course of business operations Are liquidated with cash from current assets Excluded from capital structure analysis
Short-term debt obligations
The substitution of fixed-charge financing for variable-cost (dividend) equity financing Financial leverage concepts
The traditional view is that an optimal mix of debt and equity exists Research demonstrated that the mix of debt and equity is irrelevant. if taxes are ignored The tax deductibility of interest expense creates an advantage for incurring debt (Exhibit 14-1)
FINANCIAL LEVERAGE (CONT.)
The advantage of debt only exists up to a point (Exhibits 14-2A and 14-2B)
Low cost debt increases ROE relative to ROA Debt can become so costly that it reduces ROE below ROA
FINANCIAL LEVERAGE (CONT. which implies debt is always advantageous (so long as a positive profit margin exists)
The financial structure leverage ratio
Is computed as: average total assets / average common shareholders’ equity Produces a ratio of greater than one.
a favorable use of debt financing An index of less than one is bad.)
Financial leverage index
Is computed as adjusted return on equity / adjusted return on assets Superior to the financial structure leverage ratio because it factors in the adjusted rates of return in the computation An index in excess of one means ROE exceeds ROA. an unfavorable use of debt financing
. ROA exceeds ROE.FINANCIAL LEVERAGE (CONT.
Risk is the possibility of losing something of value Credit risk
The possibility that an entity will not be able to meet debt payment obligations on time
Capital structure influences credit risk A firm with a conservative capital structure is a low credit risk because it has
small amount of debt low fixed cost commitments a low default probability
.RISK ANALYSIS (CONT.
Business risk Fluctuations in earnings and cash flow.RISK ANALYSIS (CONT. due to
Changes in the economy Industry-specific conditions A high degree of leverage—leveraged firms have greater exposure to business risk than conservatively structured entities
whereby a firm may be unable to continue as a going concern Financial distress.)
Extreme case of credit risk. is the first sign of bankruptcy risk A company in financial distress might file for bankruptcy protection
. or the difficulty in meeting maturing obligations.RISK ANALYSIS (CONT.
RISK ANALYSIS (CONT. and court Will liquidate.)
A bankrupt firm
Losses autonomy in conducting its operations Has a court suspend its creditors’ claims Can have its debts rearranged. or go out of business. creditors. if continuing operations is not a viable option
. or eliminated with the mutual consent of the company. reduced.
Comprehensive risk The equity market’s determination of risk
Is a function of systematic risk Is inherent in investing Cannot be eliminated through investment diversity
.RISK ANALYSIS (CONT.
0 With an interpretation that he higher the beta.RISK ANALYSIS (CONT.)
Beta measures of systematic risk
Is the extent to which a stock moves with the overall market In a range from –1. the greater a stock’s variability
.0 to +1.
CAPITAL STRUCTURE MEASURES
Capital structure composition Financing activities should correspond to investing activities
Short-term creditors finance current assets Long-term investors finance long-term assets
CAPITAL STRUCTURE MEASURES (CONT.)
Lack of correspondence signals financial distress
Long-term borrowing cannot be used to finance operations indefinitely Cash from operations should satisfy working capital operations Provide insights between current and long-term financing sources and investments Must be considered in conjunction with life cycle stage
Common size statements
DEBT TO CAPITAL RATIOS
Provide insight about the proportion of debt to equity financing Total debt to total capital
Measures the percentage of assets financed with debt Is computed as: average total debt / average total assets
Total debt to total equity
Measures debt financing as a percentage of total financing Is computed as: average total debt / average total shareholders’ equity
.DEBT TO CAPITAL RATIOS (CONT.
Long-term debt to total capital
Measures the percentage of assets financed with long-term debt Eliminates current obligations from the ratio because they are paid with maturing current assets Is computed as: average long-term debt / average total assets
.DEBT TO CAPITAL RATIOS (CONT.
DEBT TO CAPITAL RATIOS (CONT.)
Total long-term debt to total equity
Measures long-term debt financing as a percentage of total financing Eliminates current obligations from the ratio because they are paid with maturing current assets Is computed as: average long-term debt / average total shareholders’ equity
which is a simplified version of earnings coverage Times interest earned is computed as: operating income before interest and taxes / interest expense It is acceptable substitute for earnings coverage so long as accrual numbers approximate required cash payments for fixed changes
Earnings coverage ratio
Measures the extent to which an entity can meet its fixed charges Is known as the times interest earned ratio.DEBT TO CAPITAL RATIOS (CONT.
0 indicate little probability of bankruptcy Those below 1.DEBT TO CAPITAL RATIOS (CONT.)
Mathematical models that provide information about an entity’s bankruptcy probability The Z-score is an accepted measure of bankruptcy prediction Computed as a function of five weighted ratios Z-scores above 3.0 are inconclusive
.81 and 3.81 indicate a high possibility of bankruptcy Scores between 1.
22 1.38 0.53 0.25 0.52 0.10 0.29 3.61 0.29 0.02 1.39 0.34 2.42 1.28 2.63 0.67 0.49 1.40 2.58 0.37 0.59 2002 0.03
.09 0.63 2001 0.95 0.75 0.06 0.19 0.21 0.22 1.88 4.25 0.eSTUFF’S CAPITAL STRUCTURE RATIOS
Capital Structure Ratios Debt to capital Debt to equity Long-term debt to capital Long-term debt to equity Earnings coverage Working capital/total assets-Z1 Retained earnings/total assets-Z2 EBIT/total assets-Z3 Revenues/total assets-Z4 Market equity/book liabilities-Z5 Total Z-score 2003 0.35 0.
CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY
New economy capital structure Venture capital and retained earnings financed PC firms’ productive resources Little long-term debt
which was reduced by its net losses
.CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY (CONT.)
Capital structure measures
Apple and Dell carried more debt than Compaq or Gateway during the period analyzed (Exhibit 147A) Dell used debt to increase its returns on equity Apple acquired debt (and preferred stock) to bolster its insufficient cash from earnings and replenish its depleted equity base.
PC Industry Debt as a Percentage of Equity 250%
0% 1994 1995 Apple 1996 Compaq Dell 1997 Gateway 1998
PC Industry Financial Leverage Indexes (cumulative 1994-1998) 3 2
Financial Leverage Index
1 0 Apple -1 -2 -3 Compaq Dell Gateway
Long-term debt provided an relatively small amount of financing for all four firms (Exhibit 14-7B) Debt as a proportion of total assets and equity was relatively stable during the period examined (Exhibits 14-8A and 14-8B)
.CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY (CONT.
PC Industry Long-Term Debt as a Percentage of Total Assets
Apple LongTerm Debt 12%
LongTerm Debt 3%
Current Debt & Equity 88% Dell LongTerm Debt 4% LongTerm Debt 8% Gateway
Current Debt & Equity 97%
Current Debt & Equity 96%
Current Debt & Equity 92%