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
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
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
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
Capital Structure Decisions –
Four Sources of Information
3. Seek information from key market
participants
Investment
bankers
Rating agencies
Security analysts
Portfolio managers
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
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
Capital Structure Decisions
Earnings
Indicator
volatility risk:
of ability to pay future
obligations from future cash
flows
Example measure is the times
interest earned ratio
Capital Structure Decisions
Liquidation
This
or bankruptcy risk:
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
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
Capital Structure Decisions
 Earnings
Step
per share crossover point:
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
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
Capital Structure Decisions

Debt capacity analysis example
1.
2.
3.
4.
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
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
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
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
Capital Structure Decisions –
Qualitative Factors
Flexibility
Watch
your restrictive covenants -debt issues
Typically debt is more restrictive than
common stock
Capital Structure Decisions –
Qualitative Factors
Control
More
shares could mean less control
More debt could mean less flexibility
Hedging
Important
Maturity
in
decisions
Source of funding for international
subsidiaries
Capital Structure –
Qualitative Factors
Strategic
You
issues
may not want a weak financing
position in an increasing competitive
environment