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Unformatted text preview: Capital Structure Capital Structure
Capital Structure Capital structure : The combination of debt and equity used to finance a firm. Target capital structure : The mix of debt, preferred stock and common equity with which the firm plans to finance its investments. Optimal Capital Structure : Optimal capital structure is the one that strikes a balance between risk & return to achieve ultimate goal of maximizing the price of the stock. Factors influence the capital structure decisions
Factors influence the capital structure decisions Four primary factors influence the capital structure decisions :
• First is the firm’s Business Risk, or the riskiness that would be inherent in the firm’s operations if it is used no debt. The greater the firm’s business risk, the lower the amount of debt that that is optimal.
• The second key factor is the firm’s Tax position. A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. Factors influence the capital structure decisions
Factors influence the capital structure decisions The third important consideration is Financial Flexibility or the ability to raise capital on reasonable terms under adverse conditions. The forth debtdetermining factor has to do with managerial attitude (conservatism or aggressiveness) with regard to borrowing . Some managers are more aggressive than others; hence some firm’s are more inclined to use debt in an effort to boost profits. This factor affects the target capital structure. Business & Financial Risk
Business & Financial Risk Business risk B.R is defined as the uncertainty inherent in projections of future returns, either on assets (ROA) or on equity (ROE) , if the firm uses no debt or debtlike financing (i.e. preferred stock) – it is the risk associated with firm’s operations. Financial risk The portion of stockholders’ risk , over and above basic business risk, resulting from the manner in which the firm is financed is called Financial risk.
Financial risk results from using financial leverage, which exists when a firm uses fixed income securities, such as debt and preferred stock , to raise capital. Degree of Leverage
Degree of Leverage Degree of Operating Leverage (DOL) DOL is defined as the percentage change in operating income (EBIT) associated with a given percentage change in sales. DOL is concerned with the upper portion of the Income Statement. DOL for a particular level of production and sales, Q, can be computed using the following equation : DOL Q = Q ( P–V )____ Q ( P – V ) – F
DOL , based on dollar sales rather than units, can be computed using the following equation : DOL S = S – VC___ = Gross Profit S –VC –F EBIT Degree of Leverage
Degree of Leverage Degree of Financial Leverage (DFL) DFL is defined as the percentage change in earnings available to common stockholders associated with a given percentage in earnings before interest and taxes. DFL is concerned with the lower part of the Income Statement . DFL indicates about the proportion of fixed financial obligation exists in the firm’s operation. DFL is calculated as follows : DFL = Percentage change in EPS = EBIT___ Percentage change in EBIT EBIT – I Degree of Leverage
Degree of Leverage Degree of Total Leverage (DTL) DTL is defined as the percentage change in EPS that results from a given percentage change in sales. DTL shows the effects of both operating leverage and financial leverage. The three equivalent equations for DTL : 1. DTL = ( DOL) X ( DFL ) 2. DTL = Q (P –V )__ Q (PV) –F I
3. DTL = ___S –VC___ = Gross Profit S – VC – F I EBIT I Degree of Leverage
Degree of Leverage NOTE : I = Interest VC = Variable Cost F = Fixed Cost S = Sales MATH
MATH Capital Structure (Effect of debt on the EPS) Given the following information, calculate (i) Earnings Per Share (EPS) and (ii) Expected Earnings Per Share (iii) Degree of Operating Leverage (DOL) (iv) Degree of Financial Leverage (DFL) of ABC Company for 2002 if :
(i) Debt / Assets = 0%, (ii) Debt / Assets = 50% Probability of Indicated sales 0.2 0.6 0.2
Sales (thousand) $ 200 $ 400 $ 600
Fixed Cost (thousand) (80) (80) (80)
Variable Cost (thousand) (120) (240) (360)
Total Cost (Except Interest) (200) (320 ) (440)
EBIT 00 80 160 • Assume the following: (I) The firm is in the 40 percent tax bracket
(ii) Cost of debt is 12 percent
(iii) The value per share of ABC Company is $ 20
(iv) Total Capital of ABC Company is $ 200000 ...
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- Spring '09