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Chapter 18 -- Capital Structure Decisions

Chapter 18 -- Capital Structure Decisions . Capital structure decisions when the participants are well informed: Managers can look to the market for clues to investor response Capital structure decisions when there is asymmetrical information:

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Chapter 18 -- Capital Structure Decisions

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  1. Chapter 18 -- Capital Structure Decisions • Capital structure decisions when the participants are well informed: • Managers can look to the market for clues to investor response • Capital structure decisions when there is asymmetrical information: • Managers typically use pro-forma analysis to project the firm’s ability to use debt and equity profitably

  2. Capital Structure Decisions – Four Sources of Information 1. Study the market’s response to similar offerings • Compare yourself to others to find a proxy company that has recently issued new debt or equity

  3. Capital Structure Decisions – Four Sources of Information 2. Study the market’s response to different capital structures • Look at industry ratios • Balance sheet (stock) ratios such as debt to total assets • Income statement (flow) ratios such as times interest earned

  4. Capital Structure Decisions – Four Sources of Information 2. Study the market’s response to different capital structures • From these ratios, judge the market response to a change in your firm’s capital structure • Must adjust for differing accounting interpretations

  5. Capital Structure Decisions – Four Sources of Information 3. Seek information from key market participants • Investment bankers • Rating agencies • Security analysts • Portfolio managers

  6. Capital Structure Decisions – Four Sources of Information 4. Attempt to judge market disequilibrium • There could be factors unique to the company, such as an unusual tax situation • Investment bankers may know what form of financing the market overall is favoring

  7. Capital Structure Decisions • Merits and demerits of generalizing from other offerings • Your situation may be unusual • You could get conflicting wealth and income ratio indications • Market may not be fully informed

  8. Capital Structure Decisions • Earnings volatility risk: • Indicator of ability to pay future obligations from future cash flows • Example measure is the times interest earned ratio

  9. Capital Structure Decisions • Liquidation or bankruptcy risk: • This is based on your ability to pay from collateral • Paying from collateral is usually inferior to paying from future cash flows • Example measure is the debt to total asset ratio

  10. Capital Structure Decisions • Income break-even point and the financing mix: • Step 1: Create a spreadsheet modeling the income statement and balance sheet • Step 2: Find break-even level of sales • Step 3: Vary the levels of debt and equity, then recalculate the break-even level of sales • Based on expected range of sales, choose the appropriate financing mix

  11. Capital Structure Decisions • Earnings per share crossover point: • Step 1: Create a spreadsheet modeling the income statement, balance sheet, and earnings per share • Step 2: Find the level of sales where the earnings per share are equal between two alternative debt-equity mixtures -- crossover point • Based on expected range of sales, choose the appropriate financing mix

  12. Capital Structure Decisions • Debt capacity analysis • Measures the firm’s ability to meet its cash flow obligations with various amounts of debt • Often run as a worst-case scenario analysis

  13. Capital Structure Decisions • Debt capacity analysis example • Model recession cash flow with differing financing • Develop back-up plans to cover periods of negative cash flows • Choose the maximum debt payment that can be met in a recession • Select debt (amount, maturity) within maximum debt payment

  14. Capital Structure Decisions • Tools used by managers to reduce the probability of default in times of negative cash flows. • Liquid reserves • costly in profitability • External backup credit lines • high out-of-pocket cost in fees

  15. Capital Structure Decisions • Tools used by managers to improve cash flows in times of duress. • Reduce the outflows in a particular period • Often means lost revenues • Reduction of a dividend, seen as negative signal • Sale of assets • Usually interpreted as a negative signal based on timing

  16. Capital Structure Decisions – Qualitative Factors • Future financing needs • Too much debt might close off future debt offerings • Nonpublic companies often overextend and risk either bankruptcy or a lesser bargaining position with a venture capitalist

  17. Capital Structure Decisions – Qualitative Factors • Flexibility • Watch your restrictive covenants -- debt issues • Typically debt is more restrictive than common stock

  18. Capital Structure Decisions – Qualitative Factors • Control • More shares could mean less control • More debt could mean less flexibility • Hedging • Important in • Maturity decisions • Source of funding for international subsidiaries

  19. Capital Structure – Qualitative Factors • Strategic issues • You may not want a weak financing position in an increasing competitive environment

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