CAPITAL STRUCTURE

The combination of debt and equity used to finance a firm s projects is referred to as its capital structure.

FINANCING THE FIRM

Proportions of Capital from Debt and Equity, 2001

ELECTRIC UTILITIES

Source: Financial Management Analysis; Pamela P. Peterson, Frank J. Fabozzi

Proportions of Capital from Debt and Equity, 2001

BEVERAGE INDUSTRY

Source: Financial Management Analysis; Pamela P. Peterson, Frank J. Fabozzi

Proportions of Capital from Debt and Equity, 2001

PHARMACEUTICAL COMPANIES

Source: Financial Management Analysis; Pamela P. Peterson, Frank J. Fabozzi

CAPITAL STRUCTURE AND FINANCIAL LEVERAGE

Consider Limited Corporation that has $40,000 of assets, all financed with equity. There are 1,000 shares of Limited Corporation stock outstanding, valued at $40 per share. Balance Sheet of Limited Corporation
Assets Assets Amount 40,000 Liabilities Liabilities Equity (1000 shares @ 40 each) 40,000 Amount 0 40,000

40,000

CAPITAL STRUCTURE AND FINANCIAL LEVERAGE

Suppose Limited Corporation has investment opportunities requiring $20,000 of new capital. Further suppose Limited Corporation can raise the new capital either of three ways: Option 1 : 100% thru Equity 0% debt Option 2 : 50% Equity , 50% Debt Option 3 : 0% Equity , 100% Debt

CAPITAL STRUCTURE AND FINANCIAL LEVERAGE

Option 1 : 100% thru Equity 0% debt That is Issue 500 shares @ $40 each Balance Sheet of Limited Corporation
Assets Assets Amount 60,000 Liabilities Liabilities Equity (1500 shares @ 40 each) 60,000 Amount 0 60,000

60,000

CAPITAL STRUCTURE AND FINANCIAL LEVERAGE

Option 2 : 50% Equity , 50% Debt That is Issue 250 shares @ $40 each and borrow $10,000 at the rate of 5% interest.
Assets Assets Amount 60,000 Liabilities Liabilities Amount 10,000

Balance Sheet of Limited Corporation Equity (1250 50,000

shares @ 40 each) 60,000 60,000

CAPITAL STRUCTURE AND FINANCIAL LEVERAGE

Option 3 : 0% Equity , 100% Debt Borrow $20,000 at the rate of 5% annual interest.
Assets Assets Amount 60,000 Liabilities Liabilities Amount 20,000

Balance Sheet of Limited Corporation Equity (1000 40,000

shares @ 40 each) 60,000 60,000

The only difference between the three alternative means of financing is with respect to how the assets are financed: Alternative 1: all equity Alternative 2: 1/6 debt, 5/6 equity Alternative 3: 1/3 debt, 2/3 equity

Financing Alternative 1 2 3

Debt-to-Equity Ratio 0/60000 = 0 or 0% 10,000/50,000 = 20% 20,000/40,000 = 50%

Debt-to-Assets Ratio 0/60000 = 0 or 0% 10,000/60,000 = 16.67% 20,000/60,000 = 33.3%

So, how do you interpret these ratios?

Suppose Limited Corporation has $9000 of operating earnings. Then what is Earning per share under the three scenarios?

Option 1 All Equity Operating Earnings Less Interest Expenses Net Income Number of Shares Earnings Per Share $9,000 0 9000 1500 6

Option 2 50% Equity, 50% Debt $9,000 500 8500 1250 6.8

Option 3 100% Debt $9,000 1000 8000 1000 8