CAPITAL STRUCTURE ANALYSIS

1. CAPITAL STRUCTURE ANALYSIS Chapter 14

2. 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.

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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)

11. 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

12. 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)

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. eSTUFF’S CAPITAL STRUCTURE RATIOS

30. 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

31. 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

34. 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)