# Capital Structure

```Capital Structure
Relative amount of debt and equity used to finance the
acquisition of assets.
Recall:
• Debt contractually obligates the firm to make fixed
payments.
o Lenders are only entitled to fixed payments they
do not share in the profit of the firm.
o If the firm is unable to make the payments it may
have to declare bankruptcy.
• The declaration of dividends to shareholders is at the
discretion of the board of directors. Dividends are a
distribution of earnings.
o The firm can avoid paying a dividend if it is short
of cash.
o Shareholders share in the profits of the firm.
• Owners are able to increase their return by investing
borrowed money.
o The extent by which the firm is able to increase
shareholder return by using borrowed money is
called “leverage”.
1
Investments
o Return is based on rates of return.
o There are two basic accounting measures of return.
o Return on Assets
Net income &divide; Total Assets
This is a measure of the return earned on all of
the assets of the firm. That is, the efficiency with
which the managers of the firm invested its
assets.
o Return on Equity
Net income &divide; Stockholders Equity
This is a measure of the return earned on the
assets provided by the shareholders (owners).
It is determined by the return earned by the assets
and the firm’s leverage.
There is a basic equation that relates the two:
Return on Assets x Leverage = Return on Equity
TotalAssets
NetIncome
NetIncome
x
=
TotalAssets StockholdersEquity StockholdersEquity
2
Examples:
Company
Apple
Microsoft
Nike
McDonalds
Walt Disney
Nordstrom
Intel
Company
Apple
Microsoft
Nike
McDonalds
Walt Disney
Nordstrom
Intel
Net
Income
786
9,421
579
1,948
920
203
7,314
Total
Assets
6,803
52,150
5,857
20,983
45,027
3,062
43,849
Return on
Assets Leverage
11.55%
1.6564
18.07%
1.2606
9.90%
1.8677
9.30%
2.1769
2.00%
1.8683
6.63%
2.5818
16.68%
1.3477
Stockholders
Equity
4,107
41,368
3,136
9,639
24,100
1,186
32,535
Return on
Equity
19.13%
22.78%
18.49%
20.25%
3.74%
17.12%
22.48%
3
To see how this works, I have graphed ROE as a function
of ROA, using the leverage measures of Microsoft (MSFT)
and Nordstrom (NORD).
40.00%
35.00%
30.00%
ROE
25.00%
MSFT
20.00%
NORD
15.00%
10.00%
5.00%
0.00%
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
ROA
Note that the higher leverage means that a given increase in
ROA translates into an even greater increase in ROE.
4
Other measures of capital structure
o Debt (long-term) to equity
o Debt (long-term) to total assets
Long-term Assets to
Company
Debt
Equity
Nordstrom
746
2.5817
McDonalds
5,632
2.1769
Walt Disney 6,959
1.8683
Nike
470
1.8677
Apple
300
1.6564
Intel
955
1.3477
Microsoft
0
1.2606
Debt to
Equity
0.629
0.584
0.289
0.150
0.073
0.029
0.000
Debt to
Assets
0.244
0.286
0.155
0.080
0.044
0.022
0.000
Note that although the interpretation of the individual
numbers varies, the rank ordering is the same across all of
the measures.
5
Dividend Payout
Dividend payout is the ratio of dividends per share to net
income. It tells the investor the proportion of income that
is distributed to investors as opposed to being reinvested in
Company
Apple
Microsoft
Nike
McDonalds
Walt Disney
Nordstrom
Intel
Dividend
Payout
0.00%
0.00%
21.92%
14.38%
35.00%
46.15%
4.6%
The central question is whether the shareholders or firm
managers are better able to invest the funds to increase
wealth.
6
Exercise 9-14
For each of the events or transactions below, indicate the
effect on each ratio listed. Use (I) to indicate Increase, (D)
to indicate Decrease, and (NE) to indicate No Effect.
Debt to
Equity
Debt to Financial Current
Assets Leverage Ratio
Sold common stock to
investors
Borrowed cash from a
bank on long-term note
Paid cash dividends on
stock
Sold inventory for cash
Paid off note from bank
Bought stock of another
company
Purchased treasury stock
7
Problem 9-2
2002
2001
Assets:
Cash
Accounts receivable
Inventory
Prepaid rent
Machinery, net
Land
Total assets
\$12,000
16,200
10,000
5,600
28,000
27,000
\$98,800
\$7,400
8,100
8,000
5,100
30,000
27,000
\$85,600
Liabilities and Equity:
Accounts payable
Wages payable
Bonds payable (long-term)
Common stock
Retained earnings
Treasury stock
Total liabilities &amp; equity
\$6,200
5,800
46,000
34,000
34,800
(28,000)
\$98,800
\$5,800
6,100
16,400
34,000
26,400
(3,100)
\$85,600
o Compute the long-term debt to equity ratio and the
long-term debt to assets ratio for 2001 and 2002.
o What was the return on assets and return on equity in
2001 and 2002?
o What role did the changes in capital structure have on
return on assets and return on equity in 2002?
8
Problem 9-9
2002
2001
2000
Giffen Company:
Total assets
Total liabilities
Net income
Dividends
\$6,000
3,273
300
75
\$5,500
4,014
200
80
\$5,000
3,750
100
25
Good Company:
Total assets
Total liabilities
Net income
Dividends
\$7,000
5,333
300
150
\$6,000
4,286
200
100
\$5,000
3,333
100
50
o Compute the debt to equity ratios for the two
companies.
o Compute the return on equity, return on assets and
financial leverage factors of the two companies.
o Compute and compare the dividend payout ratios of
the two companies.
9
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