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What is “Capital Structure”?


The capital structure of a firm is the mix of different securities issued by the firm to finance its operations. Securities
 Bonds,

bank loans

 Ordinary  Hybrids,

shares (common stock), Preference shares (preferred stock) eg warrants, convertible bonds

Sources of capital  Ordinary shares (common stock) shares (preferred stock)  Preference  Hybrid  securities bonds Warrants Convertible  Loan capital loans bonds Bank Corporate 7/19/12 .

unlike borrowing 7/19/12 A  Provide  No . lenders and preference shareholders high rate of return is required voting rights – the power to hire and fire directors tax benefit.g.Ordinary shares (common stock)  Risk finance  Dividends are only paid if profits are made and only after other claimants have been paid e.

Preference shares (preferred stock)  Lower risk than ordinary shares – and a lower dividend  Fixed dividend .an extra dividend is possible  Redeemable .payment before ordinary shareholders and in a liquidation situation  No voting rights .unless dividend payments are in arrears  Cumulative .company may buy back at a fixed future date 7/19/12 .dividends accrue in the event that the issuer does not make timely dividend payments  Participating .

Loan capital  Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed) loans or corporate bonds on debt is allowed against tax  Bank  Interest 7/19/12 .

holders of subordinated debt must give preference to other specified creditors who are paid first. 7/19/12 . debt is subordinated.Seniority of debt  Seniority  Some  In indicates preference in position over other lenders. the event of default.

Security  Security  It is a form of attachment to the borrowing firm’s assets. 7/19/12 . provides that the assets can be sold in event of default to satisfy the debt for which the security is given.

g. forth the terms of the loan: rate covenants Maturity Interest  Sets Protective  e.Indenture A written agreement between the corporate debt issuer and the lender. financial reports. restriction on further loan issues. restriction on disposal of assets and level of dividends 7/19/12 .

the price of the share rises above the warrant's exercise price. the warrant will simply expire or remain unused. then the investor can buy the security at the warrant's exercise price and resell it for a profit.Warrants A warrant is a certificate entitling the holder to buy a specific amount of shares at a specific price (the exercise price) for a given period. 7/19/12  If  Otherwise. .

Convertible bonds A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for ordinary shares of the issuer at some fixed ratio during a particular period. depends on the level of prevailing interest rates and the credit quality of the issuer.  Their value.  Their conversion feature also gives them features of equity securities. they provide a coupon payment and are legally debt securities. 7/19/12 . like all bonds. which rank prior to equity securities in a default situation.  As bonds.

Measuring capital structure  Debt/(Debt + Market Value of Equity) Book Value of Assets  Debt/Total  Interest coverage: EBITDA/Interest 7/19/12 .

special dividends.Interpreting capital structures  Capital structures can be changed is reduced by costs. generous wages debt rather than retained earnings 7/19/12 . especially fixed costs  Leverage Cutting Reducing dividends or issuing stock  Leverage Stock Using increased by repurchases.

Business risk and Financial risk  Firms  But have business risk generated by what they do firms adopt additional financial risk when they finance with debt 7/19/12 .

Business Risk  The basic risk inherent in the operations of a firm is called business risk Business risk can be viewed as the variability of a firm’s Earnings Before Interest and Taxes (EBIT) measure is beta (controlling for financial risk) Demand Sales Input   Standard  Factors: variability price variability cost variability 7/19/12 .

The use of debt financing is referred to as financial leverage. Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.   7/19/12 .Financial Risk  Debt causes financial risk because it imposes a fixed cost in the form of interest payments.

A firm will generally try to avoid financial risk . This increases the level of EBIT a firm needs just to break even.Financial Risk vs.if its EBIT is very uncertain (due to high business risk). 7/19/12   . A firm with high financial risk is using a fixed cost source of financing. Business Risk  There is a trade-off between financial risk and business risk.a high level of EBIT to break even .

What is an optimal capital structure?  An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value of Capital: source of financing has a different cost Each The  Cost WACC is the “Weighted Average Cost of Capital” structure affects the WACC Capital 7/19/12 .

Capital Structure Theory  Major theories and Miller theory Theory Theory Modigliani Trade-off Signaling 7/19/12 .

so why do we still study them? – Before MM.Modigliani and Miller (MM) • Basic theory: Modigliani and Miller (MM) in 1958 and 1963 • Old . no way to analyze debt financing – First to study capital structure and WACC together – Won the Nobel prize in 1990 7/19/12 .

7/19/12 . but this ignores the potential problems associated with debt. – It may appear a firm should use as much debt and as little equity as possible due to the cost difference.A Basic Capital Structure Theory • Debt versus Equity – A firm’s cost of debt is always less than its cost of equity • • • debt has seniority over equity debt has a fixed return the interest paid on debt is tax-deductible.

– The costs of using debt. 7/19/12 .A Basic Capital Structure Theory • There is a trade-off between the benefits of using debt and the costs of using debt. besides the obvious interest cost. are the additional financial distress costs and agency costs arising from the use of debt financing. – The use of debt creates a tax shield benefit from the interest on debt.

Because of the tradeoff between the tax advantage to debt financing and risk. • • 7/19/12 .Summary • A firm’s capital structure is the proportion of a firm’s long-term funding provided by long-term debt and equity. Capital structure influences a firm’s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk. each firm has an optimal capital structure that minimizes the WACC and maximises firm value.

THANK YOU 7/19/12 .

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