CHAPTER 15 CAPITAL STRUCTURE AND LONG-TERM FINANCING DECISIONPART 3 — FINANCIAL MANAGEMENT. 826 CAPITAL STRUCTURE — the mix of the long-term sources of funds used by the firm. (This is different from FINANCIAL STRUCTURE which is the mix of all the firm’s assets.) to maximize the market value of the firm through an = OBJECTIVE: appropriate mix of long-term sources of funds. = Composition: Long-term debt, Preferred stock, Common stockholders’ equity Capital Structure = Financial Structure - Current Liabilities OPTIMAL CAPITAL STRUCTURE — mix of long-term sources of funds that will minimize the firm’s overall cost of capital COST OF CAPITAL the cost of using funds; it is also called hurdle rate, required rate of return, cut-off rate the weighted average rate of return the company must pay to its long-term creditors and shareholders for the use of their funds. COMPUTATION OF COST OF CAPITAL SOURCE I CAPITAL __COST OF CAPITAL Creditors | Long-term debt After-tax rate of interest i (1 —TxR) Stockholders: } : — ae oa Preference 7 Ereferred dividends per share | shares Current market price or Net : : _____issuance price Common | Ordinary shares CAPM or DGM J ior ees aura fea COMPUTATION OF COST OF ORDINARY SHARES: 1. Capital Asset Pricing Model (CAPM) R=Re+8(Ru—Rr) where: R = rate of return (or cost of capital)chapter 15 ~ Capital Structure and Long Term Financing Decision 827 Rr = risk-free rate determined by government securities | B = beta coefficient of an individual stock which ig the correlation between the volatility (price variation) of the stock market and the volatili f the pri the individual stock vote price of Example: If the price of an individual stock rises 10% and the stock market 15%, the beta is 1.5. Ru= market return (Ru— Re) = market risk premium or the amount above risk- free rate required to induce average investors to enter the market 8(Ru— Re) = risk premium Example: Assume a beta of 1.5, a market rate of return of approximately 16% and an expected risk-free rate of 12%, what is the R? Re + 6(Re— Re) = 12% + 1,5(16% - 12%) = 18% 2. The Dividend Growth Model a. Cost of Retained Earnings = where: Po = current price D; = next dividend G = growth rate in dividends per share (it is assumed that the dividend payout ratio, retention rate, and therefore the EI’S growth rate are constant) A company’s dividend is expected to be PS while the market price is P60 and the dividend is 9 | expected to grow ata constant rate of 10%, the { cost of retained earnings is: Example:PART 3 ~ FINANCIAL MANAGEMEN, 828 5 4 10% = 18.33 60 a Di b. Cost of New Ordinary Shares = Po (1 —Flotation Cost) *S Flotation Cost = the cost of issuing new securities FACTORS INFLUENCING CAPITAL STRUCTURE DECISIONS 4. BUSINESS Risk — uncertainty inherent in projections of future returns on assets. © The greater the business risk, the less debt should be included in the capital structure. 2. Tax Position — generally, the higher the firm’s tax rate, the more debt it should include in its capital structure. Reason: interest is tax deductible 3. - FINANCIAL FLexisiLity — refers to the firm’s ability to raise capital on reasonable terms even under adverse conditions. 4. MANAGERIAL AGGRESSIVENESS — refers to some financial managers’ inclination to use more debt to boost profit. LEVERAGE - refers to that portion of the fixed costs which represents a risk to the firm ‘A. OPERATING LEVERAGE — (a measure of operating risk) refers to the fixed operating costs found in the firm’s income statement The higher the firm's operating leverage, the higher its business risk, and the lower its optimal debt ratio CM EBIT Degree of Operating Leverage (DOL) = B. FINANCIAL LEVERAGE — (a measure of financial risk) refers to financing 5 Portion of the firm’s assets, bearing financing charges lopes of increasing the return to the common stockholders.chapter 15 ~ Capital Structure and Long Term Financing Deck ecision 829 «The higher the financial }, : leverage, i z and the higher the cost of capital ae Financial risk, Degree of Financial Leverage (DFL) = EBIT EBIT-1 c. TOTAL LEVERAGE ~ the measure of total tisk —_ e A decrease i erati recrease in operating leverage would cause an i i optimal amount of financial leverage 7 ¢ A decrease in operatin, / ; ig, leverage would i in the optimal amount of debt a —. | Degree of Total =DOL cM Leverage (DTL) ~ a EBIT-Interest SOURCES OF LONG-TERM FINANCING PRINCIPAL SOURCES OF FUNDS 1. External Sources: Debt, Equity, and Hybrid Financing 2. Internal Sources: Operations A. DEBT FINANCING ADVANTAGES: 1. Basic control of the firm is not shared with the creditor. 2. Cost of debt is limited. Creditors usually do not participate in the superior earnings of the firm. i 3. Interest paid is tax deductible, thereby reducing cost of capital. 4. Substantial flexi by debt through the inclusi bility in the financial structure is enhanced ion of call provisions in the bond indenture. 5. The financial obligations are clearly specified and of a Hxe nee debt may be paid back with “cheaper 6. In time of inflation, pesos.”830 OD PART 3 — FINANCIAL MANAGEMENT ISADVANTAGES: 1. Since debt requires a fixed charge, there is a risk of not meeting this obligation if the earnings of the firm fluctuate. 2. Debt adds risk to a firm. Debt usually has a maturity date. Debt is a long-term commitment, a factor that can affect risk profiles. 5. Certain managerial prerogatives are usually given up in the contractual relationship outlined in the bond’s indenture contract. Example: specific ratios must be kept above a certain level during the term of the loan. 6. There are clear-cut limits to the amount of debt available to the individual firm. PS Basic TYPES OF BONDS OR LONG-TERM DEBT: 1. Debenture Bonds — unsecured loan; these can be issued only by companies with the best credit ratings 2. Mortgage Bonds — a pledge of certain assets, such as real property, for a loan. 3. Income Bonds - pay interest only if the issuing company has earnings; these bonds are riskier than other bonds. 4. Serial Bonds — bonds with staggered maturities. B. EQUITY FINANCING — major source is common stocks and retained earl nings ADVANTAGES OF COMMON STOCK AS SOURCE OF FUNDS: 1, 2. 3. Common stock does not require a fixed dividend -- dividends are paid from profits when available. There is no fixed maturity date for repayment of the capital. The sale of common stock is frequently more attractive to investors than debt, because it grows in value with the success of the firm. © The higher the common stock value, the more advantageous equity financing is over debt financing.amineimnntias chapter 15 ~ Capital Structure and Lon 18 Term Financiny 8 Decision 831 ANT) DISADVANTAGES OF COMMON STOCK AS SOURCE OF FUNDS: 1, As more shar . Shares are sold, th right: i , the stockholders’ area in earnings are usually fie - of common requii ; . costs. stocks requires higher underwriting 3. Common stock cash divid 5 . 4. The average ‘lends are not tax deductible cost of capital may inc ‘ : ay increase above t level when too much equity is issued neo RETAINED EARNINGS Eamings after deducting, interest, txes, and preferred dividends may be retained and used to pay coinmon cash dividends or be plowed back into the firm in the form of additional capital investment through stock dividends. ADVANTAGES: 1 Vv ‘The after-tax opportunity cost is lower than that for newly issued common stock. Financing with retained carnings leaves the present control structure intact. C. HYBRID FINANCING — sources of funds that possess a combination of features; these include preferred stock, leasing, and option securities such as warrants and convertibles. > a hybrid: security because some of its i © those of both common stocks common stock, it represents a ina firm, However, as in PREFERRED STOCK — characteristics are similar l and bonds. Legally, like part of ownership or equity bonds, it has only a limited claim ona firm's earnings and assets. Features of Preferred Stock Issues rnings ~ the satisfied bet ims of preterred a. Priority to assels and ea claim: 7 col , we the c stockholders: must first be jore the & stockholders receive anything,832 PART 3 - FINANCIAL MANAGEMENT b. Preferred stocks always have par value, which is important in determining the amount due to Preferred Stockholders in case of liquidation and in computing the preferred dividends. 1 ¢. Most preferred stocks provide for cumulative dividends. d. Some preferred stock issues are convertible to common stocks. Advantages and Disadvantages of Issuing Preferred Stocks: Advantages Disadvantages 1. No default risk because non- 1. Preferred dividends are payment of dividends does not tax deductible, not necessarily mean hence, cost for the bankruptcy. company is higher than 2. Dividend payment is limited that of bonds. to stated amount 2. The cumulative feature 3. No voting rights like common of preferred stock makes stocks, except in the case of payment of preferred financial distress. dividends almost mandatory 4. Call features and provision of sinking fund may be included, so the firm may replace the issue if interest rates decline. 7 LEASE FINANCING Lease — a rental agreement that typically requires a series of fixed payments that extend over several periods. LEASING VS. BorROWING — leasing represents an alternative to borrowing. The lease payments are very similar to loan amortization, with part of payment applied to principal, and part to interest. Like loan agreements, lease contracts usually contain restrictive covenants like the requirementchai pter 15 ~Capital Structure and Long Term Financing Decision 833 to maintain minimum debt-equity ratios © OT minimu m Jovel of liquid assets. © Basic difference of leasing from lebt: asset Ownership of the Leasing Benefits 1. Ww Increased Flexibility - in some cases, lease can be . Be Ca c or replaced with a new one, dep firm. = ancelled ending on the need of the Certain maintenance at a known cost Lower administrative costs - a company may just Iet some other party to take care of its assets instead of creating a new department to take care of the acquisition, maintenance. and eventual sale of the asset. The tax shield generated by lease payments usually exceeds that from depreciation if the asset were purchased. Types of Leases 1. Operating Lease ~ usually short-term and often cancelable; obligation is not shown on the balance sheet; maintenance and upkeep of asset is provided by the lessor; lease payment is treated as rent expense. Financial or Capital Lease — non-cancelable, longer-term lease that fully amortizes the lessor’s cost of the asset; service and maintenance are usually provided by the lessee. Sale-Leaseback Arrangement — assets that are ae owned by a firm are purchased by a lessor and leased back to the firm. arrangement, Di A i .-leaseback rect Leases ~ iclentical to the sale-lease! the leased except that the lessee does not necessarily own a rent ee834 Option ~ created by outsiders rather than the WARRANT ~ an option granted by the PART 3 ~ FINANCIAL MANAGEMENT asset; the lessor already owns or acquires the asset, which is then provided to the lessee. Leveraged Leases - a special lease arrangement ne which the lessor borrows a substantial portion of the acquisition cost of the leased asset from a third party. ConverTiBLe SecuriTiEs - preferred stock or debt issue that can be exchanged for a specified number of shares of common stock at the will of the owner. These are considered hybrid securities because they provide the stable income associated with preferred stock and bonds in addition to the possibility of capital gains associated with common stocks. Advantages/Disadvantages of Issuing Convertible Securities: Advantages Disadvantages By giving investors an 1. Sale of convertibles may be opportunity to realize thought of as selling capital gains, a firm can common stock at higher than sell debt with a lower market price at the time the interest rate convertible is issued. 2. If the firm’s stock price rises Convertibles provide a sharply, it would have been way of selling common better off if it waited and stock at prices higher sold the common shares at a than those currently higher price. prevailing firm itself, it is a | right to buy (or sell) mined price within a specitied contract that gives its holders the stocks at some predete period of time, corporation to purchase a specified number of shares of common stock at a statedChapter 15 — Capital Structure and Long Term Financing Decision 835 price exercisable until sometime in the future called the expiration date. Itis a company-issued call option. Often, it is attached to debt instruments as an incentive for investors to buy the combined issue at a lower interest rate.