capital structure Essay

Submitted By faye0504
Words: 1283
Pages: 6
Open Document
Capital Structure
BUS ADM 775

Back to the concept…
The concept of a corporation
Investors

Corporation

Projects

A bit more realistic…
Shareholders
Corporation
Creditors

Capital structure
How should firms decide whether to issue debt the amount of debt to issue?
Does capital structure “matter”? for firm value?
Through CFs?
Through WACC?

Projects

The Balance Sheet
Balance sheet
Assets

Liabilities

Shareholders' equity

Recall…
Balance Sheet Identity

Assets = Liabilities + Stockholders’
Equity
Left-hand side reflects investment decisions
Right-hand side reflects financing decisions
Capital invested and retained by owners
(equity)
Additional capital raised from creditors
(debt)

Equity financing
Stockholders are owners of the company
Stockholders are residual claimants
Stockholders vote for the board of directors and other issues Periodic payments to stockholders (dividend payments) are not contractual not a liability of the firm not considered a cost of doing business not tax deductible

Debt financing
Creditors (or debtholders) are not owners of the company Creditors do not have voting rights
Payments to creditors (interest and principal payments) are contractually specified, and creditors have legal recourse if missed missed payments may lead to financial distress and bankruptcy interest is considered a cost of doing business and is tax deductible

Equity vs debt
Differ in
What happens if payments are missed
Debtholders can demand payment and seize assets Tax deductibility of periodic payments
Interest is tax deductible

Cost
Debt payments have priority
Debt is less risky, and thus costs less

Types of long-term debt
Bonds – public issue of long-term debt
Private issues
Bank credit
Private placements
Easier to renegotiate than public issues
Lower costs than public issues

The effect of debt on cash flows
How does leverage affect the EPS and ROE?
Cost of debt is lower than cost of equity
When we increase the amount of debt financing, we increase the fixed interest expense
In a good year, we pay our fixed cost and have more left over for our stockholders
In a bad year, we still have to pay our fixed costs and we have less left over for our stockholders
Debt increases the average level of both EPS and ROE
Debt amplifies the variation in both EPS and ROE
So, debt increases riskiness of equity

The effect of debt on cash flows
Current Capital Structure: No Debt, $8M
Recession Expected
$500,000 $1,000,000
0
0
$500,000 $1,000,000
6.25%
12.50%
$1.25
$2.50

EBIT
Interest
Net Income
ROE
EPS

equity
Expansion
$1,500,000
0
$1,500,000
18.75%
$3.75

Proposed Capital Structure: Debt = $4M , Equity = $4M
Recession
Expected
Expansion
$500,000
$1,000,000
$1,500,000
400,000
400,000
400,000
$100,000
$600,000
$1,100,000
2.50%
15.00%
27.50%
$0.50
$3.00
$5.50

EBIT
Interest
Net Income
ROE
EPS

Average

St dev

12.50%
$2.50

6.25%
$1.25

Average

St dev

15.00%
$3.00

12.50%
$2.50

Trade-off theory
Interest is tax deductible
When a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm
Consider bankruptcy costs
As the D/E ratio increases, the probability of bankruptcy increases
This increased probability will increase the expected bankruptcy costs
At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost

Example
Unlevered Firm
EBIT

Levered Firm

5000

Interest

5000

0

500

Taxable Income

5000

4500

Taxes (34%)

1700

1530

Net Income

3300

2970

CFFA

3300

3470

Interest tax shield
Annual interest tax shield
Tax rate times interest payment
6250 in 8% debt = 500 in interest expense
Annual tax shield = .34(500) = 170
Present value of annual interest tax shield
Assume perpetual debt for
Show More

Related Documents: capital structure Essay

Leverage And Capital Structure

Leverage and Capital Structure: Chapter 13 Key Concepts and Skills „ Understand the effect of financial leverage on cash flows and cost of equity „ Understand the impact of taxes and bankruptcy on capital structure choice „ Understand the basic components of bankruptcy FINS1613 Business Finance Week 10 Chapter 13 Capital Structure: Theory and Evidence 1 4 Revision Week 9 Chapter 13 Outline „ Chapter 12 ¾ We learnt how to determine RE, RD, RP using various methods „ The Capital Structure Question…

Words 4579 - Pages 19

Capital Structure Analysis

Capital structure is one of the major financing decisions affecting the market value of the firm. Capital structure is the combination of the different sources of funds, debt and equity, a firm uses to finance its economic operations and growth. Capital structure decision is concerned with the issue of whether changes in financing arrangement will influence the value of the firm. In recent times, poor capital structure decision resulting to huge debt without commensurate investment in assets has…

Words 951 - Pages 4

Google Capital Structure

Valda Dedrick Unit 5: Cost of Capital, Capital Budgeting, and Cash Flow Evaluation Kaplan University Professor William Hudson July 22, 2014 Table of Contents Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 3 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 4 Capital Structure Issues . . . . . . . . . . .…

Words 2599 - Pages 11

Capital Structure Of A Company

All companies must have at least 1 director, all public companies must have a secretary (although proprietary companies tend to have 1). * Large companies tend to have officers that are involved in management Company Capital Structure 3 sources of funds: 1. Capital contributed by people who form the company or become members of the company 2. Creditors who lend money, 3. Profits not distributed to its members Shares Once a person has paid money, they are given a share, which…

Words 1179 - Pages 5

Capital Structure Case Essay

propose we split up this assignment. Each section should be about 150 - 200 words. 


Resource: Evaluating McGraw Industries’ Capital Structure Case in Ch. 11 of Principles of Managerial Finance Write a 350- to 700-word memo to the president of McGraw Industries that responds to questions in the case. Explain how the cost of debt, cost of equity, and weighted average cost of capital are determined. Cost of debt is simply the weighted rates of interest paid by the company on its debts. However, cost is…

Words 1145 - Pages 5

Intel Capital Structure Essay

Question 5: Evaluate the Put-Warrant/Convertible Bond proposal. Does it solve Intel’s capital structure dilemma? What arguments might be made in favor of it? Intel’s capital structure dilemma was that it was holding too much cash on hand. Eventually, there were three available strategies or alternatives that Intel could undertake in terms of cash disbursement policies. First, it could continue or expand its market-repurchase program. Secondly, Intel could declare dividends to its shareholders…

Words 885 - Pages 4

Capital Structure: Basic Concepts

Chapter 16: Capital Structure: Basic Concepts 16.1 a. A table outlining the income statement for the three possible states of the economy is shown below. The EPS is the net income divided by the 5,000 shares outstanding. The last row shows the percentage change in EPS the company will experience in a recession or an expansion economy. Recession Normal Expansion EBIT $7,600 $19,000 $24,700 Interest 0 0 0 NI $7,600 $19,000 $24,700 EPS $ 1.52 $ 3.80 $ 4.94…

Words 6700 - Pages 27

Capital Structure And Firm Performance

MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HOCHIMINH CITY --- oOo --- HUỲNH ANH KIỆT CAPITAL STRUCTURE AND FIRM PERFORMANCE: CASE STUDY: LISTED COMPANIES IN HOCHIMINH STOCK EXCHANGE MASTER THESIS Ho Chi Minh City – 2010 MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HOCHIMINH CITY --- oOo --- HUỲNH ANH KIỆT CAPITAL STRUCTURE AND FIRM PERFORMANCE: CASE STUDY: LISTED COMPANIES IN HOCHIMINH STOCK EXCHANGE MAJOR: BUSINESS ADMINISTRATION MAJOR CODE: 60…

Words 21138 - Pages 85

Essay on Decision Making and Capital Structure

decisions? Why are they important for business? 1. Capital budgeting: it is a kind of decisions that can help to analyze long-term investments or projects. It mainly considers the plans of capital expenditure and arranges the source of funds. Also, it is the important things that a company needs to have a consideration before making a decision. For example, when a company want to buy some new machines or set up new subsidiary, they need to do a capital budgeting analysis. “The process in which a business…

Words 765 - Pages 4

Essay about Diageo Capital Structure

1. What do you think about the capital structure policies Diageo has pursued in the past. Do they make sense? How does it compare to Diageo’s competitors’ policies? Which competitors would make for the best comparison? (40%) Diageo was formed from the merger of Grand Metropolitan plc and Guinness plc. Before the merge, both companies used little debt (based on the book D/E ratio and net debt to total capital in the table below) to finance themselves which helped them gain and maintain high credit…

Words 1114 - Pages 5