Chapter 12 Determining the Financing Mix

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Chapter 12Determining the Financing Mix
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Capital Structure

• Capital structure is the mix of long-term sources
  of capital used by a firm.
• The mix that minimizes the firms weighted
  average cost of capital also maximizes the firms
  common stock price. This is called optimal
  capital structure.

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Capital Structure

• How does capital structure affects the risk a
  firms shareholders are subject to?
• From common stockholders point of view, risk is
  the variability of net income available to them.

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• SALES
• ? Cost of Goods Sold
• GROSS PROFIT
• ? Operating Expenses
  
• OPERATING INCOME (EBIT)
• ? Interest Expense
• EARNINGS BEFORE TAXES (EBT)
• ? Income Taxes
• NET INCOME
• ? Preferred Stock Dividends
• NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

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• SALES
• ? Cost of Goods Sold
• GROSS PROFIT
• ? Operating Expenses
  
• OPERATING INCOME (EBIT)
• ? Interest Expense
• EARNINGS BEFORE TAXES (EBT)
• ? Income Taxes
• NET INCOME
• ? Preferred Stock Dividends
• NET INCOME AVAILABLE TO COMMON STOCKHOLDERS

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Business Risk

• This refers to the variability in a firms
  expected earnings before interest and taxes
  (EBIT).
• Business risk is affected by the firms operating
  activities.

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Business Risk

• Demand variability
• Sales price variability
• Input cost variability
• Ability to adjust output prices for changes in
  input costs
• Ability to develop new products
• Operating leverage

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Financial Risk

• This is the additional variability of a firms
  earnings available to common shareholders that is
  caused by the firms financing decision.
• This additional risk arises when a firm uses
  financial leverage.

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Financial Leverage

• The use of fixed-cost sources of financing (debt,
  preferred stock) rather than variable-cost
  sources (common stock).
• The more debt and preferred stock a firm uses,
  the higher its financial leverage.

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An Example of Leverages

• Sales (100,000 units) 1,400,000
• Variable Costs 800,000
• Fixed Costs 250,000
• Interest Expenses 125,000
• Tax rate 34
• Preferred Stock 0

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Income Statement

• Sales 1,400,000
• Variable Costs (800,000)
• Fixed Costs (250,000)
• EBIT 350,000
• Interest (125,000)
• EBT 225,000
• Taxes (34) (76,500)
• Net Income 148,500

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An Example of Leverages

• If sales increase by 10, what would happen to
  operating income (EBIT)?
• Given the change in operating income, what would
  be the effect on net income available to common
  shareholders?

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The Results

• Sales 1,540,000 10
• Variable Costs (880,000)
• Fixed Costs (250,000)
• EBIT 410,000 17.14
• Interest (125,000)
• EBT 285,000
• Taxes (34) (96,900)
• Net Income 188,100 26.67

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The Results

• Sales 1,330,000 -5
• Variable Costs (760,000)
• Fixed Costs (250,000)
• EBIT 320,000 -8.57
• Interest (125,000)
• EBT 195,000
• Taxes (34) (66,300)
• Net Income 128,700 -13.33

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Financial Leverage

• The use of debt and preferred stock increases a
  firms financial leverage.
• Higher financial leverage results in higher
  expected returns to stockholders.
• On the other hand, higher financial leverage also
  causes higher risk due to interest and preferred
  dividend payments.

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Financial Structure vs. Capital Structure

• Financial Structure
• The mix of all items that appear on the
  right-hand side of the companys balance sheet.
• Capital Structure
• The mix of the long-term sources of funds
  used by the firm

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Capital Structure Theory

• Financial economists have developed numerous
  theories that attempt to explain how capital
  structure affects a firms value.
• The most important capital structure theory was
  developed by Modigliani and Miller (MM) in 1958.

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The Modigliani-Miller Model
Conclusion

• A firms value is unaffected by its capital
  structure.

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The Modigliani-Miller Model
Assumptions

• There are no transaction costs.
• There are no taxes.
• There are no bankruptcy costs.
• Individuals can borrow at the same rate as
  corporations.
• Investors have the same information as managers.
• EBIT is not affected by leverage.

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Modifications of MM Theory

• The effects of corporate taxes
• The effects of bankruptcy costs
• The effects of agency costs

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Moderate view, considering taxes and financial
distress saucer-shaped (or U-shaped) cost of
capital curve. (Kd after-tax cost of debt
Kc average cost of equity Ko average cost
of capital)
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Value of Firm
Financial Leverage
0
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Capital Structure Practices

• How are target debt ratios determined?
• Need to consider financing charges, bond
  rating, borrowing reserve, etc.
• Who Sets Target Debt Ratios?
• Table 12-13
• Different definitions of debt capacity
• Table 12-14
• High business risk low financial risk