Capital Structure

Financial Analysis revised

Page 22 of 54 pages. Chapter: 13: Module 2.4: Capital Structure and Value...

Session 1: Introduction to Capital Structure

A telecommunication regulator needs to know about capital structure and the value of the firm in order to assess if the firm is adequately financed. Capital structure gives the early warning indications on the firm’s financial distress. With a number of firms to be regulated the firm’s capital structure becomes important for continued client service.

Important Learning Terms

Capital structure

Break even analysis

Leverage/Gearing

MM model

Degree of Financial Leverage

Degree of Operation Leverage

Degree of Combined Leverage

Introduction

The firm's session structure, the proportions of debt and equity used to finance the firm's assets, has implications for stockholder value. Additionally, capital structure affects leverage, which, in turn, affects the expected return and risk facing owners and creditors of the firm. This session analyzes the co-dependent leverage/capital structure phenomenon when the corporation has both fixed operating and fixed financial expenses in its cost structure.

Capital Structure, Leverage, Leverage Effects, and the Return/Risk Relationship

Definitions: Capital structure is the mixture of sources of funds a firm uses (debt, preferred stock, common stock). The amount of debt that a firm uses to finance its assets is called leverage. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt is said to be unlevered.

Capital structure can be viewed as the permanent financing the firm represented primarily by long-term debt, preferred stock, and common equity but excluding all short term credit.

Debt Vs Equity Financing

Financing a business through borrowing is cheaper than using equity. This is because:

Lenders require a lower rate of return than ordinary shareholders. Debt financial securities present a lower risk than shares for the finance providers because they have prior claims on annual income and liquidation. In addition security is often provided and covenants imposed.

A profitable business effectively pays less for debt capital than equity for another reason: the debt interest can be offset against pre-tax profits before the calculation of the corporation tax bill, thus reducing the tax paid.

Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares.

There are some valuable benefits from financing a firm with debt.

So why do firms tend to avoid very high gearing levels?

One reason is financial distress risk. This could be induced by the requirement to pay interest regardless of the cash flow of the business. If the firm hits a rough patch in its business activities it may have trouble paying its bondholders, bankers and other creditors their entitlement.

Relationship between Expected return (Earnings per share) and the level of gearing can be represented below.

Leverage can occur in either the operating or financing portions of the income statement

The effect of leverage is to magnify the effects of changes in sales volume on earnings

Leverage serves to increase both expected return and risk to the firm's stockholders

Types of Leverage

Operating leverage occurs when the firm has fixed operating expenses in its cost structure.

Operating