CAPITAL
STRUCTURE
ANALYSIS
Chapter 14
CHAPTER 14 OBJECTIVES
Describe the advantages and disadvantages
of financial leverage.
 Compute the financial leverage index, debt to
capital ratio, debt to equity ratio, and other
techniques for analyzing capital structure.
 Relate capital structure composition to owner
and creditor investment objectives.

CHAPTER 14 OBJECTIVES
(CONT.)
Discuss the various types of risks and
their role in capital structure analysis.
 Present a preliminary capital structure
analysis for a company or industry.

OBJECTIVE FOR ANALYZING CAPITAL
STRUCTURE

To determine if the proportion of debt
to equity enables an entity to create
wealth without unduly jeopardizing the
firm
OBJECTIVE FOR ANALYZING CAPITAL
STRUCTURE (CONT.)

Capital structure composition



Consists of long-term liabilities, preferred stock,
common stock, and retained earnings.
Sufficient equity must exist to provide financial
stability
Debt can be used as leverage to increase returns
to shareholders, but it can also reduce returns on
shareholders’ investments
FINANCING ACTIVITIES

The balance sheet



Reports how funds are acquired and allocated
Current assets are financed with current
obligations—not a factor in capital structure
analysis
Long-term debt and equity finance long-term
assets—assessing the pros and cons of these
financing factors is the essence of capital structure
analysis
FINANCING ACTIVITIES
(CONT.)

Capital structure valuation




Long-term liabilities are reported at the present
value of expected cash flows
Current liabilities are not adjusted for the time
value of money
Contributed capital is reported at the historical
proceeds received from selling stock
Retained earnings are reported as a summary of
all of the valuation methods used to measure
income
FINANCING ACTIVITIES
(CONT.)

Equity investments are an entity’s
permanent financing, representing
The ultimate risk capital
 Insulation of the firm from random
business shocks
 A margin of safety to debt investors
 The right to a return on investment only
after the other claimants have been
satisfied

FINANCING ACTIVITIES
(CONT.)

Long-term debt investments represent




Fixed contractual obligations
Payable at specific times in specified amounts
Returns on investment that are tax deductible
Short-term debt obligations



Arise from the normal course of business
operations
Are liquidated with cash from current assets
Excluded from capital structure analysis
FINANCIAL LEVERAGE
The substitution of fixed-charge financing for
variable-cost (dividend) equity financing
 Financial leverage concepts




The traditional view is that an optimal mix of debt
and equity exists
Research demonstrated that the mix of debt and
equity is irrelevant, if taxes are ignored
The tax deductibility of interest expense creates
an advantage for incurring debt (Exhibit 14-1)
FINANCIAL LEVERAGE
(CONT.)

The advantage of debt only exists up to
a point (Exhibits 14-2A and 14-2B)
Low cost debt increases ROE relative to
ROA
 Debt can become so costly that it reduces
ROE below ROA

FINANCIAL LEVERAGE
(CONT.)

The financial structure leverage ratio
Is computed as: average total assets /
average common shareholders’ equity
 Produces a ratio of greater than one, which
implies debt is always advantageous (so
long as a positive profit margin exists)

FINANCIAL LEVERAGE
(CONT.)

Financial leverage index




Is computed as adjusted return on equity /
adjusted return on assets
Superior to the financial structure leverage ratio
because it factors in the adjusted rates of return in
the computation
An index in excess of one means ROE exceeds
ROA; a favorable use of debt financing
An index of less than one is bad; ROA exceeds
ROE; an unfavorable use of debt financing
RISK ANALYSIS
Risk is the possibility of losing
something of value
 Credit risk


The possibility that an entity will not be
able to meet debt payment obligations on
time
RISK ANALYSIS (CONT.)
Capital structure influences credit risk
 A firm with a conservative capital
structure is a low credit risk because it
has

small amount of debt
 low fixed cost commitments
 a low default probability

RISK ANALYSIS (CONT.)
Business risk
 Fluctuations in earnings and cash flow,
due to

Changes in the economy
 Industry-specific conditions
 A high degree of leverage—leveraged firms
have greater exposure to business risk
than conservatively structured entities

RISK ANALYSIS (CONT.)

Bankruptcy risk
Extreme case of credit risk, whereby a firm
may be unable to continue as a going
concern
 Financial distress, or the difficulty in
meeting maturing obligations, is the first
sign of bankruptcy risk
 A company in financial distress might file
for bankruptcy protection

RISK ANALYSIS (CONT.)

A bankrupt firm




Losses autonomy in conducting its operations
Has a court suspend its creditors’ claims
Can have its debts rearranged, reduced, or
eliminated with the mutual consent of the
company, creditors, and court
Will liquidate, or go out of business, if continuing
operations is not a viable option
RISK ANALYSIS (CONT.)
Comprehensive risk
 The equity market’s determination of
risk

Is a function of systematic risk
 Is inherent in investing
 Cannot be eliminated through investment
diversity

RISK ANALYSIS (CONT.)

Beta measures of systematic risk
Is the extent to which a stock moves with
the overall market
 In a range from –1.0 to +1.0
 With an interpretation that he higher the
beta, the greater a stock’s variability

CAPITAL STRUCTURE
MEASURES
Capital structure composition
 Financing activities should correspond
to investing activities

Short-term creditors finance current assets
 Long-term investors finance long-term
assets

CAPITAL STRUCTURE
MEASURES (CONT.)

Lack of correspondence signals financial
distress



Long-term borrowing cannot be used to finance
operations indefinitely
Cash from operations should satisfy working
capital operations
Common size statements


Provide insights between current and long-term
financing sources and investments
Must be considered in conjunction with life cycle
stage
DEBT TO CAPITAL RATIOS
Provide insight about the proportion of
debt to equity financing
 Total debt to total capital

Measures the percentage of assets
financed with debt
 Is computed as: average total debt /
average total assets

DEBT TO CAPITAL RATIOS
(CONT.)

Total debt to total equity
Measures debt financing as a percentage
of total financing
 Is computed as: average total debt /
average total shareholders’ equity

DEBT TO CAPITAL RATIOS
(CONT.)

Long-term debt to total capital
Measures the percentage of assets
financed with long-term debt
 Eliminates current obligations from the
ratio because they are paid with maturing
current assets
 Is computed as: average long-term debt /
average total assets

DEBT TO CAPITAL RATIOS
(CONT.)

Total long-term debt to total equity
Measures long-term debt financing as a
percentage of total financing
 Eliminates current obligations from the
ratio because they are paid with maturing
current assets
 Is computed as: average long-term debt /
average total shareholders’ equity

DEBT TO CAPITAL RATIOS
(CONT.)

Earnings coverage ratio




Measures the extent to which an entity can meet
its fixed charges
Is known as the times interest earned ratio, which
is a simplified version of earnings coverage
Times interest earned is computed as: operating
income before interest and taxes / interest
expense
It is acceptable substitute for earnings coverage
so long as accrual numbers approximate required
cash payments for fixed changes
DEBT TO CAPITAL RATIOS
(CONT.)

Bankruptcy prediction






Mathematical models that provide information
about an entity’s bankruptcy probability
The Z-score is an accepted measure of bankruptcy
prediction
Computed as a function of five weighted ratios
Z-scores above 3.0 indicate little probability of
bankruptcy
Those below 1.81 indicate a high possibility of
bankruptcy
Scores between 1.81 and 3.0 are inconclusive
eSTUFF’S CAPITAL
STRUCTURE RATIOS
Capital Structure Ratios
Debt to capital
Debt to equity
Long-term debt to capital
Long-term debt to equity
Earnings coverage
Working capital/total assets-Z1
Retained earnings/total assets-Z2
EBIT/total assets-Z3
Revenues/total assets-Z4
Market equity/book liabilities-Z5
Total Z-score
2003
0.35
0.53
0.19
0.29
0.25
0.67
0.10
0.02
1.52
0.28
2.59
2002
0.37
0.58
0.25
0.40
2.95
0.61
0.09
0.22
1.42
1.29
3.63
2001
0.39
0.63
0.21
0.34
2.75
0.38
0.06
0.22
1.49
1.88
4.03
CAPITAL STRUCTURE ANALYSIS AND THE
PC INDUSTRY
New economy capital structure
 Venture capital and retained earnings
financed PC firms’ productive resources
 Little long-term debt

CAPITAL STRUCTURE ANALYSIS AND THE
PC INDUSTRY (CONT.)

Capital structure measures



Apple and Dell carried more debt than Compaq or
Gateway during the period analyzed (Exhibit 147A)
Dell used debt to increase its returns on equity
Apple acquired debt (and preferred stock) to
bolster its insufficient cash from earnings and
replenish its depleted equity base, which was
reduced by its net losses
PC Industry
Debt as a Percentage of Equity
250%
Debt/Equity
200%
150%
100%
50%
0%
1994
1995
Apple
1996
Compaq
1997
Dell
Gateway
1998
PC Industry
Financial Leverage Indexes
(cumulative 1994-1998)
3
Financial Leverage Index
2
1
0
Apple
-1
-2
-3
Compaq
Dell
Gateway
CAPITAL STRUCTURE ANALYSIS AND THE
PC INDUSTRY (CONT.)
Long-term debt provided an relatively
small amount of financing for all four
firms (Exhibit 14-7B)
 Debt as a proportion of total assets and
equity was relatively stable during the
period examined (Exhibits 14-8A and
14-8B)

PC Industry
Long-Term Debt as a Percentage of Total Assets
Apple
LongTerm
Debt
3%
LongTerm
Debt
12%
Compaq
Current
Debt &
Equity
97%
Current
Debt &
Equity
88%
Dell
Gateway
LongTerm
Debt
4%
LongTerm
Debt
8%
Current
Debt &
Equity
96%
Current
Debt &
Equity
92%