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 Katapatan Subd. Banaybanay, City of Cabuyao, Laguna

COURSE:FINANCIAL MANAGEMENT 2
Course Code: ACC 121A
Course Description: Conceptual Frameworks and Accounting Standards
Course: BS Accountancy

MODULE 4

ASSESING LONG TERM DEBT, EQUITY AND CAPITAL STRUCTURE

A firm mobilizes fund which, depending upon their maturity period can be classified as long
term and short term sources .

Long term sources consist of capital, reserves and financial institution while short term sources
made up of current liabilities and provisions.

Financing decision involve rising funds for the firms. It is concerned with formulation and
designing capital structure and leverage.

Investment decisions are related to the asset side of the balance sheet while financing
decisions are related to the liabilities and equity side.

Capital refered to investor-supplied funds, debt, preferred shares, ordinary shares and retained
earnings. Capital frequently defined to include only long term debt, that is, debt due in more
than year. However, many companies use short term loans from banks on a permanent and
regular basis, and for this reason the short term debt provided by investors is included in the
definition of capital.

Accounts payable and accruals are not included in the definition of capital because they are not
provided by investors.

Capital structure refers to the mix of debt, preferred stock and ordinary equity that the firm
uses to finance the firm's asset.
The financial manager's objective in making capital structure decisions is to find the financing
mix that maximizes the value of the firm. The structure is called the OPTIMAL CAPITAL
STRUCTURE.

A firm can choose any capital structure it wants ,if management so desired, a firm could
negotiate for a long term loan or issue some bonds and use the proceeds to buy back some
stocks, thereby increasing the debt-equity ratio .Alternatively, it could issue stock and use the
money to pay off some debt, thereby reducing the debt-equity ratio. Activities such as these,
which alter the firm's existing capital structure are called CAPITAL STRUCTURING. In capital
restructuring the firm’s asset unchanged. This means that firm can consider capital
restructuring decision independent of its investment decisions.

Reason why capital structure over time

1. Deliberate management actions

2. Market Actions...

CAPITAL STRUCRURE THEORY

1. Traditional approach.

2. The Franco Modigliani and Merton Miller approach

3. The Contemporary Approach

Traditional approach - capital structure suggest that a firm can lower it's weighted cost of
capital and increase its market value by the use of financial leverage. This theory suggest that
there is a trade off between cheaper debt and higher priced equity that leads to an optimal
capital structure. Thus, the cost of capital and the firms value are not independent of its capital
structure

Total market value of the firm can be determined ad follows:

1. Value of the firm = Market value of debt + Market Value of common shares outstanding or
Equity.

2. Value of the firm = Earnings before interest and tax (1-tax) / Weighted Average cost of
capital.

Illustration

PNC has no debt but is considering two plans to add leverage

Plan A = Issue ₱200,000 bonds

Plan B = Issue ₱ 300,000 bonds

The proceeds from both proposals shall be used to return the same amount of common stock.
Management wants to evaluate the impact of increasing PNC's financial leverage. Data about
the corporations current and proposed capital structure follow :

Current Plan A Plan B

Cost of debt 0 .070 .09

Cost of equity .100 .105 .12

Required:

Using the traditional approach. Determine the market value of the equity, Market value of the
firm, and the weighted average cost of capital.

Solution:

Market Value of Equity

Current S =[ ₱100,000 - ₱0 ] / .10 = ₱1,000,000

Plan A : S =[₱100,000- ₱14,000] /.105 = ₱819,048

Plan B: S =[₱100,00 - ₱27,000] /.12 = ₱608,333mo

Market Value of the firm

Current V = ₱0 + ₱1,000,000 = ₱1,000,000

Plan A : V = ₱200,000 + ₱819,048 =₱ 1,019,048

 Plan B : V = ₱300,000 + ₱608,333 = ₱908,333

Weighted Average Cost of Capital

Current A = ₱100,000 / ₱1,000,000 = 10%

Plan A : A = ₱100,000 / ₱ 1,019,048 = 9.8%

Plan B : A = ₱100,000 / ₱908,333 = 11%

The Modigliani and Miller (Perfect World) Approach

- this approach that the firm's value is determined by its real assets, not by the securities its
issue. Thus capital structure is irrelevant and all capital structured are equally desirable. This
theory assumes no taxes, no chance of bankruptcy, and no brokerage cost investors can borrow
at the same rate as corporations.

The contemporary approach -Trade off theory

- asserts that there is an optimal capital structure or at least an optimal range of structures for
every firm. This approach identifies several factors that can lead to an optimal capital structure
for a given firm such as tax effects (corporate and personal) financial distress and related cost

FACTORS INFLUENCING OPTIMAL CAPITAL STRUCTURE

1. Control 8. Profitability

2. Risk 9. Marketability

3. Income 10. Company size

4. Cost of Capital 11. Sales stability

5. Financial leverage 12. Operating Leverage

6. Tax Consideration 13. Growth Rate

7. Timing 14. Management Attitudes

Business risk - which is the riskiness of the firm's assets if no debt is used. The most commonly
used measure of business risk is the standard deviation of the firm's return on invested capital
or ROIC

ROIC = [ EBIT (1-T) ] / Investor supplied capital

Factors that influence business risk

1. Variability of demand for the firm's 5. Variability of production cost

product
6. Foreign risk exposure
2. Competition
7. Legal exposure and Regulatory risk
3. Variability of sales price
8. Degree of operating leverage
4. Product obsolescence

EBIT - EPS analysis

One common used to analytical technique used to evaluate capital structure in order to select
the one that maximizes firm's earning per share( EPS).This approach measures impact of
financing alternatives on EPS at different level of EBIT

Another objective of EBIT -EPS analysis is to determine the EBIT-EPS indifference or breakdown
points between the various financing choices.

Indifference point id the level of EBIT where EPS of a firm is the same, regardless of which
alternative capital structures are employed.

EBIT levels above indifference point - firms with more financially levered capital structures will
produce higher levels of EPS

EBIT levels below the indifference point-firms with less financially levered capital structure will
produce higher levels of EPS.

Illustration

Lamina Equipment company’s current capital structure consist of 8% debt with s market value
and book value of 4,000,000 pesos and 200 000 shares of outstanding common stock with s
market value of 15,000,000 pesos. The firm is considering a 6,000,000 expansion program
using one of the ff. financing plans
Plan I : Sell additional debt at 10% interest

Plan II : Sell preferred shares worth a 10.5% dividend yield

Plan III : Sell new ordinary equity securities at P150 per share

The corporate tax rate is 34%. Ignore floatation cost.

(a) If the expected level of EBIT after tax expansion is P2,500,000, the EPS for each financing
plan is calculated as follows:

The financial break-even point is the level of EBIT at the firm's EPS equal zero.

Plan I = P920,000

Plan II = P320, 000 + [630,000 / 1-.34] = P 1,274,545

Plan III = P320, 000

In the graph the EBIT -EPS analysis chart for the three capital structure is presented as follows :
It shows that there is one indifference point between debt and ordinary equity share and another
between preferred share and ordinary equity share. There is no indifference point between debt and
preferred share because debt dominates preferred share by the same margin throughout the EBIT and
EPS

Mathematically, the indifference can be found by solving for EBIT.

(a) EPS (debt) = EPS ( ordinary share).

*( In thousands)

[(EBIT - P920)(1-.34)-P0 ] / 200 = [(EBIT-P320)(1.34)-P0 ] / 140

[( EBIT - P920)(.66)-P0 ] / 200 = [ (EBIT - P320)(.66)-P0] / 280

(280)(.66 EBIT-P607. 20)=(P200) (.66EBIT-P211. 20)

184.8 EBIT - P170, 016 = 132 EBIT -P42, 240

52.8 EBIT = P127, 776

EBIT = P2, 420,000 or P2, 420,000

(b) Preferred shared = EPS (Ordinary equity share)

[ (EBIT-P320) (1-.34) -P630 ] / 200 = [ (EBIT - P320)(1-.34)-P0] / 280

(280)(.66EBIT -P211. 20-P630) = (P200)(.66EBIT-P211.20)

184.8EBIT-P235, 536 = 132 EBIT - P42, 240

52.8 EBIT = P193, 296

EBIT = P 3,660,900

Plan I (debt) is favored over plan II (preferred share) at all level of EBIT. Plan I is favored over
Plan III (ordinary equity share) when EBIT is above the indifference point of P2, 420,000