Finance

💰Finance Unit 10 – Capital Structure and Leverage

Capital structure and leverage are crucial concepts in finance, shaping how companies fund operations and manage risk. This unit explores the mix of debt and equity financing, theories behind capital structure decisions, and the impact of leverage on firm value and performance. Students will learn about financial ratios, risk-return trade-offs, and optimal capital structure. The unit also covers real-world applications, helping students understand how these concepts influence corporate financial decisions and investor analysis in practice.

Key Concepts and Definitions

  • Capital structure refers to the mix of debt and equity financing a company uses to fund its operations and growth
  • Debt financing involves borrowing money from lenders (banks, bonds) that must be repaid with interest
  • Equity financing involves selling ownership stakes in the company to investors in exchange for capital
  • Leverage measures the degree to which a company uses debt financing relative to equity financing
    • Higher leverage means a greater proportion of debt financing
  • Financial leverage refers to the use of debt to increase the potential return on equity
  • Operating leverage refers to the proportion of fixed costs relative to variable costs in a company's cost structure
  • Weighted Average Cost of Capital (WACC) represents the average cost of all sources of capital (debt and equity) weighted by their respective proportions

Capital Structure Theories

  • Modigliani-Miller (MM) theorem proposes that in a perfect capital market, a firm's value is independent of its capital structure
    • Assumes no taxes, no transaction costs, no bankruptcy costs, and symmetric information
  • Trade-off theory suggests that firms balance the benefits of debt (tax shield) against the costs of debt (financial distress and bankruptcy costs) to determine an optimal capital structure
  • Pecking order theory argues that firms prefer internal financing (retained earnings) over external financing and debt over equity when external financing is necessary due to information asymmetry
  • Agency theory considers the conflicts of interest between shareholders and managers (agency costs) and how capital structure can be used to mitigate these conflicts
  • Market timing theory proposes that firms issue equity when market valuations are high and debt when market valuations are low to take advantage of temporary mispricing
  • Signaling theory suggests that capital structure decisions can convey information about a firm's future prospects to investors

Types of Leverage

  • Financial leverage refers to the use of debt financing to magnify returns to equity holders
    • Increases potential returns but also increases financial risk and the possibility of bankruptcy
  • Operating leverage refers to the proportion of fixed costs relative to variable costs in a company's cost structure
    • Higher operating leverage means greater sensitivity of operating income to changes in sales
  • Combined leverage is the product of financial leverage and operating leverage and measures the total impact of leverage on a firm's earnings per share (EPS)
  • Degree of Operating Leverage (DOL) measures the percentage change in operating income for a given percentage change in sales
  • Degree of Financial Leverage (DFL) measures the percentage change in EPS for a given percentage change in operating income
  • Degree of Combined Leverage (DCL) is the product of DOL and DFL and measures the percentage change in EPS for a given percentage change in sales

Calculating Financial Ratios

  • Debt-to-Equity Ratio = Total Debt / Total Equity
    • Measures the proportion of debt financing relative to equity financing
  • Debt-to-Assets Ratio = Total Debt / Total Assets
    • Measures the proportion of assets financed by debt
  • Interest Coverage Ratio = EBIT / Interest Expense
    • Measures a firm's ability to meet its interest obligations from operating income
  • Fixed Charge Coverage Ratio = (EBIT + Lease Payments) / (Interest Expense + Lease Payments)
    • Measures a firm's ability to meet all fixed financial obligations, including interest and lease payments
  • Return on Equity (ROE) = Net Income / Total Equity
    • Measures the return generated on equity capital
  • Return on Assets (ROA) = Net Income / Total Assets
    • Measures the return generated on all assets, regardless of financing source

Impact on Firm Value

  • Capital structure decisions can affect a firm's value by influencing its cost of capital (WACC)
    • Optimal capital structure minimizes WACC and maximizes firm value
  • Tax shield benefits of debt can increase firm value by reducing the effective cost of debt
  • Financial distress and bankruptcy costs associated with high leverage can decrease firm value
    • Direct costs include legal and administrative expenses
    • Indirect costs include lost sales, reduced credit terms, and employee turnover
  • Agency costs can impact firm value by creating conflicts of interest between shareholders and managers
    • Debt can mitigate agency costs by reducing free cash flow and increasing managerial discipline
  • Signaling effects of capital structure decisions can influence investor perceptions and firm value
    • Issuing debt may signal confidence in future cash flows, while issuing equity may signal overvaluation

Risk and Return Trade-offs

  • Higher leverage increases the potential return on equity but also increases financial risk and the probability of bankruptcy
  • Operating leverage magnifies the impact of changes in sales on operating income and increases business risk
  • Combined leverage amplifies the effect of changes in sales on EPS and increases overall risk
  • Firms must balance the potential benefits of leverage (higher returns) against the associated risks (financial distress, bankruptcy)
  • Cost of equity capital increases with leverage due to the higher risk borne by equity holders
  • Optimal capital structure balances the marginal benefits and costs of debt to minimize WACC and maximize firm value

Optimal Capital Structure

  • Optimal capital structure is the mix of debt and equity that minimizes a firm's WACC and maximizes its value
  • Trade-off theory suggests that the optimal capital structure balances the tax benefits of debt against the financial distress and bankruptcy costs
    • Marginal benefit of debt equals marginal cost at the optimum
  • Pecking order theory implies that firms have no specific target capital structure and instead follow a financing hierarchy
  • Industry factors can influence optimal capital structure
    • Capital-intensive industries (manufacturing) tend to have higher leverage than service-based industries
  • Firm-specific factors such as growth opportunities, profitability, and asset tangibility also affect optimal capital structure
  • Dynamic nature of optimal capital structure requires firms to periodically adjust their financing mix as conditions change

Real-world Applications

  • Firms use a variety of strategies to manage their capital structure, including debt issuance, equity issuance, and share repurchases
  • Capital structure decisions are influenced by macroeconomic conditions, such as interest rates and credit availability
  • Firms may deviate from their optimal capital structure for strategic reasons, such as funding an acquisition or investing in a new project
  • Financial managers use capital structure analysis to assess the impact of financing decisions on firm value and risk
  • Investors and analysts use financial ratios to evaluate a firm's leverage, risk, and financial health
  • Credit rating agencies consider a firm's capital structure when assigning credit ratings, which affect borrowing costs and access to capital markets
  • Bankruptcy and financial restructuring can result from excessive leverage and the inability to meet financial obligations


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© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.