CAPITAL

STRUCTURE
ANALYSIS
Chapter 14

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

OBJECTIVE FOR ANALYZING CAPITAL

STRUCTURE (CONT.)

Capital structure composition

Consists of long-term liabilities, preferred

stock, common stock, and retained
earnings.
Sufficient equity must exist to provide
financial stability
Debt can be used as leverage to increase
returns to shareholders, but it can also
reduce returns on shareholders
investments

FINANCING ACTIVITIES

The balance sheet

Reports how funds are acquired and

allocated
Current assets are financed with current
obligationsnot a factor in capital structure
analysis
Long-term debt and equity finance longterm assetsassessing the pros and cons of
these financing factors is the essence of
capital structure analysis

FINANCING ACTIVITIES
(CONT.)

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.)
Equity

investments are an entitys

permanent financing, representing
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

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

Short-term debt obligations

Arise from the normal course of business

operations
Are liquidated with cash from current assets
Excluded from capital structure analysis

FINANCIAL LEVERAGE

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.)
The

financial structure leverage

ratio
Is computed as: average total assets /
average common shareholders equity
Produces a ratio of greater than one,
which implies debt is always
advantageous (so long as a positive
profit margin exists)

FINANCIAL LEVERAGE
(CONT.)

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; a favorable use of debt financing
An index of less than one is bad; ROA exceeds
ROE; an unfavorable use of debt financing

RISK ANALYSIS
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

RISK ANALYSIS (CONT.)

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,
due to

Changes in the economy

Industry-specific conditions
A high degree of leverageleveraged
firms have greater exposure to business
risk than conservatively structured
entities

RISK ANALYSIS (CONT.)

Bankruptcy

risk

Extreme case of credit risk, whereby a

firm may be unable to continue as a
going concern
Financial distress, or the difficulty in
meeting maturing obligations, is the
first sign of bankruptcy risk
A company in financial distress might
file for bankruptcy protection

RISK ANALYSIS (CONT.)

A bankrupt firm

Losses autonomy in conducting its operations

Has a court suspend its creditors claims
Can have its debts rearranged, reduced, or
eliminated with the mutual consent of the
company, creditors, and court
Will liquidate, or go out of business, if
continuing operations is not a viable option

RISK ANALYSIS (CONT.)

Comprehensive

risk
The equity markets determination
of risk
Is a function of systematic risk
Is inherent in investing
Cannot be eliminated through
investment diversity

RISK ANALYSIS (CONT.)

Beta

measures of systematic risk

Is the extent to which a stock moves

with the overall market
In a range from 1.0 to +1.0
With an interpretation that he higher
the beta, the greater a stocks
variability

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

Common size statements

Provide insights between current and longterm financing sources and investments
Must be considered in conjunction with life
cycle stage

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

DEBT TO CAPITAL RATIOS

(CONT.)
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.)

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

DEBT TO CAPITAL RATIOS

(CONT.)

Earnings coverage ratio

Measures the extent to which an entity can

meet its fixed charges
Is known as the times interest earned ratio,
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

DEBT TO CAPITAL RATIOS

(CONT.)

Bankruptcy prediction

Mathematical models that provide information

about an entitys 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 indicate little probability of
bankruptcy
Those below 1.81 indicate a high possibility of
bankruptcy
Scores between 1.81 and 3.0 are inconclusive

eSTUFFS CAPITAL
STRUCTURE
RATIOS
Capital Structure Ratios
2003
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

0.35
0.53
0.19
0.29
0.25
0.67
0.10
0.02
1.52
0.28
2.59

2002
0.37
0.58
0.25
0.40
2.95
0.61
0.09
0.22
1.42
1.29
3.63

2001
0.39
0.63
0.21
0.34
2.75
0.38
0.06
0.22
1.49
1.88
4.03

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

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 14-7A)
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,
which was reduced by its net losses

PC Industry
Debt as a Percentage of Equity
250%

Debt/Equity

200%

150%

100%

50%

0%
1994

1995
Apple

1996
Compaq

1997
Dell

Gateway

1998

PC Industry
Financial Leverage Indexes
(cumulative 1994-1998)
3

Financial Leverage Index

2
1
0
Apple
-1
-2
-3

Compaq

Dell

Gateway

CAPITAL STRUCTURE ANALYSIS AND

THE PC INDUSTRY (CONT.)
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)

PC Industry
Long-Term Debt as a Percentage of Total Assets

Apple

LongTerm
Debt
3%

LongTerm
Debt
12%

Compaq

Current
Debt &
Equity
97%

Current
Debt &
Equity
88%
Dell

Gatew ay

LongTerm
Debt
4%

LongTerm
Debt
8%

Current
Debt &
Equity
96%

Current
Debt &
Equity
92%