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Capital Structure > Capital Structure Considerations
Capital Structure Considerations
• Optimal Capital Structure Considerations
• Tax Considerations
• Cost of Capital Considerations
• The Marginal Cost of Capital
• Trade-Off Consideration
• Signaling Consideration
• Constraint on Managers
• Pecking Order
• Window of Opportunity
• Bankruptcy Considerations
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Capital Structure > Capital Structure Considerations
Optimal Capital Structure Considerations
• Capital structure categorizes the way a company has its assets financed.
• Miller and Modigliani developed a theory which through its assumptions and
models, determined that in perfect markets a firm's capital structure should not
affect its value.
• In the real world, there are costs and variables that create different returns on
capital and, therefore, give rise to the possibility of an optimal capital structure for
a firm.
• The cost of capital is the rate of return that capital could be expected to earn in an
alternative investment of equivalent risk.
• For an investment to be worthwhile, the expected return on capital must be
Capital Structure
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greater than the cost of capital.
• The weighted average cost of capital multiplies the cost of each security (debt or
equity) by the percentage of total capital taken up by the particular security, and
then adds up the results from each security involved in the total capital of the
company.
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Capital Structure > Capital Structure Considerations
Tax Considerations
• Tax considerations have a major effect on the way a company determines its
capital structure and deals with its costs of capital.
• Under a classical tax system, the tax deductibility of interest makes debt financing
valuable; that is, the cost of capital decreases as the proportion of debt in the
capital structure increases. The optimal structure, then would be to have virtually
no equity at all.
• In general, since dividend payments are not tax deductible but interest payments
are, one would think that, theoretically, higher corporate tax rates would call for an
increase in usage of debt to finance capital, relative to usage of equity issuance.
• There are different kinds of debt that can be used, and they may have different
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deductibility and tax implications. This will affect the types of debt used in
financing, even if corporate taxes do not change the total amount of debt used.
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Capital Structure > Capital Structure Considerations
Cost of Capital Considerations
• For an investment to be worthwhile, the expected return on capital must be
greater than the cost of capital. The cost of capital is the rate of return that capital
could be expected to earn in an alternative investment of equivalent risk.
• Once cost of debt and cost of equity have been determined, their blend, the
weighted average cost of capital (WACC), can be calculated. This WACC can
then be used as a discount rate for a project's projected cash flows.
• The weighted average cost of capital multiplies the cost of each security (debt or
equity) by the percentage of total capital taken up by the particular security, and
then adds up the results from each security involved in the total capital of the
company.
The expected return on an asset is compared to
the cost of capital to invest in the asset.
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Capital Structure > Capital Structure Considerations
The Marginal Cost of Capital
• The marginal cost of capital is calculated as being the cost of the last dollar of
capital raised.
• When raising extra capital, firms will try to stick to desired capital structure, but
once sources are depleted they will have to issue more equity. Since this tends to
be higher than other sources of financing, we see an increase in marginal cost of
capital as capital levels increase.
• Since an investment in capital is logically only a good decision if the return on the
capital is greater than its cost, and a negative return is generally undesirable, the
marginal cost of capital often becomes a benchmark number in the decision
making process that goes into raising more capital.
Cost of Money
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Capital Structure > Capital Structure Considerations
Trade-Off Consideration
• An important purpose of the trade off theory is to explain the fact that corporations
are usually financed partly with debt and partly with equity. It states that there is
an advantage to financing with debt.
• The marginal benefit of further increases in debt declines as debt increases while
the marginal cost increases, so that a firm that is optimizing its overall value will
focus on this trade-off when choosing how much debt and equity to use for
financing.
• One would think that firms would use much more debt than they do in reality. The
reason they do not is because of the risk of bankruptcy and the volatility that can
be found in credit markets—especially when a firm tries to take on too much debt.
Structural Considerations
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Capital Structure > Capital Structure Considerations
Signaling Consideration
• Signaling becomes important in a state of asymmetric information.
• Signaling can affect the way investors view a firm, and corporate actions that are
made public can indirectly alter the value investors assign to a firm.
• In general, issuing new equity can be seen as a bad signal for the health of a firm
and can decrease current share value.
• While the issuance of equity does have benefits, in the sense that investors can
take part in potential earnings growth, a company will usually choose new debt
over new equity in order to avoid the possibility of sending a negative signal.
Signaling
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Capital Structure > Capital Structure Considerations
Constraint on Managers
• Debt-heavy capital structures put constraints on managers by limiting the amount
of free cash they have available to them.
• Managers may often act in their own best interests instead of those of the firm's
investors. This is known as an agency dilemma.
• We see that the firms that have debt-heavy capital structures limit free cash to
managers and, therefore, have managers with goals that tend to be more aligned
with those of the shareholder.
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Capital Structure > Capital Structure Considerations
Pecking Order
• When it comes to methods of raising capital, companies will prefer internal
financing, debt, and then issuing new equity, respectively.
• Outside investors tend to think managers issue new equity because they feel the
firm is overvalued and wish to take advantage, so equity is a less desired way of
raising new capital. This then gives the outside investors an incentive to lower the
value of the new equity.
• The form of debt a firm chooses can act as a signal of its need for external
finance. This sort of signalling can affect how outside investors view the firm as a
potential investment.
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Capital Structure > Capital Structure Considerations
Window of Opportunity
• Windows of opportunity must be taken into consideration by a corporation in order
to purchase capital to achieve maximum return.
• From the seller's perspective, the unique time a party will be able to sell a certain
product at its highest price point in order to get a maximum return on capital
purchased and used.
• The people in charge of a firm must take windows of opportunity into account in
order to keep costs low and returns high, in order to make the firm look like the
best investment possible for creditors of all types.
Capital Budeting
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Capital Structure > Capital Structure Considerations
Bankruptcy Considerations
• Generally, a debtor declares bankruptcy to obtain relief from debt. This is
accomplished either through a discharge of the debt or through a restructuring of
the debt.
• In the U.S. firms that go bankrupt generally file for Chapter 7 or 11. Chapter 7
involves basic liquidation for businesses. It is also known as straight bankruptcy.
Chapter 11 involves rehabilitation or reorganization while allowing the firm to
continue functioning.
• When liquidation occurs one must remember that bondholders and other lenders
are paid back first before equity holders. Usually, there is little to no capital left
over for common shareholders.
Chapter 9 Bankruptcy
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Appendix
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Capital Structure
Key terms
• Agency Dilemma Takes into account the difficulties in motivating one party (the "agent"), to act on behalf of another (the
"principal").
• asymmetric information State of being regarding decisions on transactions where one party has more or better information than
the other.
• bankruptcy Legal status of an insolvent person or an organisation, that is, one who cannot repay the debts they owe to
creditors.
• capital gains yield compound rate of return of increases in a stock's price
• capital rationing restrictions on how or how much a company can invest
• capital structure Capital structure is the way a corporation finances its assets, through a combination of debt, equity, and hybrid
securities.
• Chapter 11 In bankruptcy involves rehabilitation or reorganization and is known as corporate bankruptcy. It is a form of
corporate financial reorganization which typically allows companies to continue to function while they follow debt repayment
plans.
• Chapter 7 In bankruptcy involves basic liquidation for businesses. Also known as straight bankruptcy, it is the simplest and
quickest form of bankruptcy available.
• cost of capital the rate of return that capital could be expected to earn in an alternative investment of equivalent risk
• cost of capital The rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
• cost of preferred stock the additional premium paid to have an equity security with certain additional features not present in
common stock
• dividend A pro rata payment of money by a company to its shareholders, usually made periodically (e.g., quarterly or annually).
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Capital Structure
• Interest The price paid for obtaining, or price received for providing, money or goods in a credit transaction, calculated as a
fraction of the amount or value of what was borrowed.
• leverage Debt taken on by a firm in order to finance assets.
• Marginal Cost of Capital The cost of the last dollar of capital raised or the minimum acceptable rate of return or hurdle rate.
• marginal tax rate the percent paid out to the government of the last dollar (or applicable currency) earned
• optimal capital structure the amount of debt and equity that maximizes the value of the firm
• Pecking Order Theory that states that the cost of financing increases with asymmetric information. When it comes to methods
of raising capital, companies prefer financing that comes from internal funds, debt, and issuing new equity, respectively.
Raising equity can be considered a last resort.
• Signaling The idea that one party (termed the agent) credibly conveys some information about itself to another party (the
principal).
• trade credit a form of debt offered from one business to another with which it transacts
• trade-off Refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing
the costs and benefits.
• Window of opportunity The idea of a time when an asset or product. which is unattainable, will become available. It can be
extended to a time when a certain product will be attainable at a certain price, or from an opposite perspective, the unique time
a party will be able to sell a certain product at its highest price point in order to get a maximum return on investment.
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Capital Structure
Capital Structure
Captial structure is the assignment of the sources of company assets into equity or debt securities.
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Capital Structure
Capital Budeting
Windows of opportunity come into play when budgeting for capital because they can provide opportunities for firms to maximize returns on investment.
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Capital Structure
Chapter 9 Bankruptcy
Jefferson County, Alabama underwent Chapter 9 bankruptcy in 2009.
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Capital Structure
The expected return on an asset is compared to the cost of capital to invest in the asset.
Cost of capital is an important way of determining whether or not a firm is a worthwhile investment.
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Boundless.com
Capital Structure
Signaling
Education credentials, such as diplomas, can send a positive signal to potential employers regarding a workers talents and motivation.
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Capital Structure
Cost of Money
The Marginal Cost of Capital is the cost of the last dollar of capital raised. It is an important consideration the firm must take into account when making
corporate decisions.
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Capital Structure
Structural Considerations
Trade-off considerations are important factors in deciding appropriate capital structure for a firm since they weigh the cost and benefits of extra capital
through debt vs. equity.
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Capital Structure
Taxes
A company's decision makers must take taxes into consideration when determining a firm's capital structure.
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Capital Structure
Which of the following factors explain why a company's capital
structure is relevant to its value?
A) All of these answers.
B) Bankruptcy costs.
C) Agency costs.
D) Information asymmetry between the company's management and its
investors.
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Capital Structure
Which of the following factors explain why a company's capital
structure is relevant to its value?
A) All of these answers.
B) Bankruptcy costs.
C) Agency costs.
D) Information asymmetry between the company's management and its
investors.
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Capital Structure
Under the best capital structure of a company, the goal of it is to
maximize:
A) profits
B) stock returns
C) the value of the company.
D) stock dividends
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Capital Structure
Under the best capital structure of a company, the goal of it is to
maximize:
A) profits
B) stock returns
C) the value of the company.
D) stock dividends
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Capital Structure
Which of the following statements regarding the cost of capital
and its effect on capital structure and investment choices is
correct?
A) Because of tax advantages, it is cheaper to issue new equity than
debt.
B) For an investment to be worthwhile, the expected return must be
greater than the cost of capital.
C) Adding debt does not increase a company's interest rate.
D) All of these answers.
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Capital Structure
Which of the following statements regarding the cost of capital
and its effect on capital structure and investment choices is
correct?
A) Because of tax advantages, it is cheaper to issue new equity than
debt.
B) For an investment to be worthwhile, the expected return must be
greater than the cost of capital.
C) Adding debt does not increase a company's interest rate.
D) All of these answers.
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Capital Structure
Under Miller and Modigliani's theory, business income taxes
encourage business's to take on debt instead of selling it equity.
Which of the following is a reason why that would be the case?
A) Interest payments on debt is tax deductible.
B) Dividends paid to shareholders are not tax deductible.
C) The cost of capital decreases as the proportion of debt in the capital
structure increases.
D) All of these answers.
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Capital Structure
Under Miller and Modigliani's theory, business income taxes
encourage business's to take on debt instead of selling it equity.
Which of the following is a reason why that would be the case?
A) Interest payments on debt is tax deductible.
B) Dividends paid to shareholders are not tax deductible.
C) The cost of capital decreases as the proportion of debt in the capital
structure increases.
D) All of these answers.
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Capital Structure
Which of the following statements regarding the cost of capital
and its effect on capital structure and investment choices is
correct?
A) Because of tax advantages, it is cheaper to issue new equity than
debt.
B) Adding debt does not increase a company's interest rate.
C) All of these answers.
D) For an investment to be worthwhile, the expected return must be
greater than the cost of capital.
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Capital Structure
Which of the following statements regarding the cost of capital
and its effect on capital structure and investment choices is
correct?
A) Because of tax advantages, it is cheaper to issue new equity than
debt.
B) Adding debt does not increase a company's interest rate.
C) All of these answers.
D) For an investment to be worthwhile, the expected return must be
greater than the cost of capital.
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Capital Structure
Which of the following statements about the marginal cost of
capital is NOT true?
A) The marginal cost of capital is the weighted average of a company's
cost of raising its capital.
B) The marginal cost of capital can be used to establish the minimum
acceptable rate of return.
C) As more capital is raised, the marginal cost of capital rises.
D) The marginal cost of capital can be used to help choose between
mutually exclusive projects.
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Capital Structure
Which of the following statements about the marginal cost of
capital is NOT true?
A) The marginal cost of capital is the weighted average of a company's
cost of raising its capital.
B) The marginal cost of capital can be used to establish the minimum
acceptable rate of return.
C) As more capital is raised, the marginal cost of capital rises.
D) The marginal cost of capital can be used to help choose between
mutually exclusive projects.
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Capital Structure
Which of the following statements correctly describes the balance
between debt and equity as described in the trade-off theory?
A) A company should should use equity until its costs exceeds its
benefits; then use debt for the rest.
B) A company should finance itself using 50 percent debt, 50 percent
equity.
C) Debt shouldn't be used because the trade-off between the tax benefits
and risk is too volatile.
D) A company should should use debt until its costs exceeds its benefits;
then use equity for the rest.
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Capital Structure
Which of the following statements correctly describes the balance
between debt and equity as described in the trade-off theory?
A) A company should should use equity until its costs exceeds its
benefits; then use debt for the rest.
B) A company should finance itself using 50 percent debt, 50 percent
equity.
C) Debt shouldn't be used because the trade-off between the tax benefits
and risk is too volatile.
D) A company should should use debt until its costs exceeds its benefits;
then use equity for the rest.
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Capital Structure
Which of the following shows a capital structure shift and a way to
interpret that shift as a signal to investors?
A) When it issues new shares, a company signals that it has great
prospects and wants to capitalize.
B) When a company takes on debt, it signals that the company has
strong solvency and good prospects.
C) When a company takes on new debt, it signals that there are liquidity
issues.
D) All of these answers.
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Capital Structure
Which of the following shows a capital structure shift and a way to
interpret that shift as a signal to investors?
A) When it issues new shares, a company signals that it has great
prospects and wants to capitalize.
B) When a company takes on debt, it signals that the company has
strong solvency and good prospects.
C) When a company takes on new debt, it signals that there are liquidity
issues.
D) All of these answers.
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Capital Structure
If a company wanted to ensure that its managers' interests are
aligned with the company's shareholders, which of the following
capital structures should it use?
A) A debt-heavy capital structure.
B) An equity-heavy capital structure.
C) A balanced capital structure.
D) The company's capital structure has no effect on a manager's
interests.
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Capital Structure
If a company wanted to ensure that its managers' interests are
aligned with the company's shareholders, which of the following
capital structures should it use?
A) A debt-heavy capital structure.
B) An equity-heavy capital structure.
C) A balanced capital structure.
D) The company's capital structure has no effect on a manager's
interests.
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Capital Structure
Which of the following statements regarding the use of the
pecking order theory is true?
A) Some academics have demonstrated that pecking theory fails when
applied to small firms.
B) In pecking theory, internal financing is superior to debt which is
superior to selling more equity.
C) The pecking order theory argues that when a company sells its
shares, that is a negative signal.
D) All of these answers.
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Capital Structure
Which of the following statements regarding the use of the
pecking order theory is true?
A) Some academics have demonstrated that pecking theory fails when
applied to small firms.
B) In pecking theory, internal financing is superior to debt which is
superior to selling more equity.
C) The pecking order theory argues that when a company sells its
shares, that is a negative signal.
D) All of these answers.
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Capital Structure
Which of the following is NOT a window of opportunity?
A) You plan on spending the next month shopping for a car.
B) A company has 30 days to issue commercial paper before the Fed
raises interest rates.
C) A person has 24 hours to purchase a house before it goes back on the
market.
D) Soda is on sale for the next week.
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Capital Structure
Which of the following is NOT a window of opportunity?
A) You plan on spending the next month shopping for a car.
B) A company has 30 days to issue commercial paper before the Fed
raises interest rates.
C) A person has 24 hours to purchase a house before it goes back on the
market.
D) Soda is on sale for the next week.
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Capital Structure
If potential creditors and investors sense that a company has a
higher risk of going bankrupt, which of the following will occur?
A) Companies will have to sell more of their shares at a higher price.
B) More lenders will want to lend money to the company due to the
higher interest rate.
C) All of these answers.
D) The company will be charged a higher interest rate by potential
lenders.
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Capital Structure
If potential creditors and investors sense that a company has a
higher risk of going bankrupt, which of the following will occur?
A) Companies will have to sell more of their shares at a higher price.
B) More lenders will want to lend money to the company due to the
higher interest rate.
C) All of these answers.
D) The company will be charged a higher interest rate by potential
lenders.
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Capital Structure
Attribution
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• Wikipedia. "Optimal capital structure." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Optimal_capital_structure
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Capital Structure
• Wiktionary. "leverage." CC BY-SA 3.0 http://en.wiktionary.org/wiki/leverage
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Capital Structure
• Wikipedia. "Pecking Order Theory." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Pecking_Order_Theory
• Wikipedia. "Pecking Order." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Pecking%20Order
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