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05 Ch15 Capital Structure & Leverage

The document discusses capital structure and leverage, including the target capital structure, business and financial risk, and optimal capital structure. It examines factors that influence capital structure decisions and how operating leverage, financial risk, and taxes impact the optimal debt-to-equity ratio.

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voves44055
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29 views14 pages

05 Ch15 Capital Structure & Leverage

The document discusses capital structure and leverage, including the target capital structure, business and financial risk, and optimal capital structure. It examines factors that influence capital structure decisions and how operating leverage, financial risk, and taxes impact the optimal debt-to-equity ratio.

Uploaded by

voves44055
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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CAPITAL STRUCTURE & LEVERAGE

MODULE 5 CHAPTER 15
Capital Structure & Leverage

I. The Target Capital Structure


II. Business & Financial Risk
III. Optimal Capital Structure

2
The Target Capital Structure

Optimal Capital Structure


- Maximizes a firm’s stock price
- Many managers think of it as a range rather than a precise number

4 Primary Factors Influence Capital Structure Decisions

Business Risk Tax Position

Financial Flexibility Managerial Conservatism / Aggressiveness

3
Business & Financial Risk

Business Risk
- inherent in the firm’s operations if it uses no debt
- Can be estimated using ROE = ROA
Some of Business Risk Factors

Demand Variability Sales Price Variability Input Cost Variability


Ability to Adjust Output Ability to Develop New
Prices for Input Costs Products

Foreign Risk Exposure Operating Leverage

4
Business & Financial Risk

Operating Leverage
- The extent to which fixed costs are used in a firm’s operations

Where P = avg sales price per unit of output


Q = units of output
V = variable cost per unit
F = fixed operating cost

Where Qbe = Break-even Quantity

5
Business & Financial Risk

6
Business & Financial Risk

Plan A

Plan B

Other things held constant, the higher a firm’s operating leverage, the higher its business risk.

7
Business & Financial Risk

Financial Risk
- additional risk placed on the common stockholders as a result of the
decision to finance with debt

8
Optimal Capital Structure

Optimal Capital Structure


- maximizes the price of the firm’s stock

Where D/A = Debt-to-Assets


E/A = Equity-to-Assets
D/A + E/A = 1
rd = cost of debt
T = tax rate
rs = cost of equity (CAPM) = rrf + RPM x b
wd, wc = weights of debt and equity, respectively

9
Optimal Capital Structure

The Hamada Equation

where bL = firm’s current beta


bU = firm’s beta if it was debt-free (unlevered)
T = corporate tax rate
D/E = Debt-Equity

10
Optimal Capital Structure

CAPM

11
Optimal Capital Structure

Effects of Capital Structure on EPS, Cost of


Capital, and Stock Price

From the given example

● 50% Debt Ratio maximizes expected EPS


● But, expected stock price is maximized & WACC is
minimized at 40% Debt Ratio

Capital Structure that minimizes WACC is also the capital structure


that maximizes the firm’s stock price.

Hence, Optimal Capital Structure:

40% Debt and 60% Equity

12
Optimal Capital Structure

Factors for Capital Structure Decisions


1. Sales Stability
2. Asset Structure
3. Operating Leverage
4. Growth Rate
5. Profitability
6. Taxes
7. Control
8. Management Attitudes
9. Lender & Rating Agency Attitudes
10. Market Conditions
11. Firm’s Internal Condition
12. Financial Flexibility

13
CAPITAL STRUCTURE & LEVERAGE
MODULE 5 CHAPTER 15

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