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
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
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 entity’s
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 leverage—leveraged 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 market’s 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 stock’s 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 long-term
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 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 indicate little probability of
bankruptcy
 Those below 1.81 indicate a high possibility of
bankruptcy
 Scores between 1.81 and 3.0 are inconclusive
eSTUFF’S CAPITAL
STRUCTURE RATIOS
Capital Structure Ratios 2003 2002 2001
Debt to capital 0.35 0.37 0.39
Debt to equity 0.53 0.58 0.63
Long-term debt to capital 0.19 0.25 0.21
Long-term debt to equity 0.29 0.40 0.34
Earnings coverage 0.25 2.95 2.75
Working capital/total assets-Z1 0.67 0.61 0.38
Retained earnings/total assets-Z2 0.10 0.09 0.06
EBIT/total assets-Z3 0.02 0.22 0.22
Revenues/total assets-Z4 1.52 1.42 1.49
Market equity/book liabilities-Z5 0.28 1.29 1.88
Total Z-score 2.59 3.63 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%

200%
Debt/Equity

150%

100%

50%

0%
1994 1995 1996 1997 1998

Apple Compaq Dell Gateway

 PC Industry
Financial Leverage Indexes
(cumulative 1994-1998)

2
Financial Leverage Index

0
Apple Compaq Dell Gateway
-1

-2

-3
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 Compaq
Long-
Long- Term
Term Debt
Debt 3%
12%

Current Current
Debt & Debt &
Equity Equity
88% 97%

Dell Gateway

Long- Long-
Term Term
Debt Debt
4% 8%

Current Current
Debt & Debt &
Equity Equity
96% 92%