RSM333H1 Chapter Notes - Chapter 21: Capital Structure, Sinking Fund, Financial Distress
CHAPTER – CAPITAL STRUCTURE
DECISIONS
FINANCIAL LEVERAGE
RISK AND LEVERAGE
• Invested capital (IC) – A firm’s capital structure, consisting of shareholders’ equity and
ST and LT debt
• ROE – the return earned by equity holders on their investment in the company
o NI/shareholders equity
o
• ROI – the return on all the capital provided by investors
o (EBIT – taxes)/IC
o
• Financial leverage – the effect of using debt as a source of capital
o
• ROI measures the return the firm earns from its operations and doesn’t consider how the
firm is financed
• ROI is a reflection of business risk
o Business risk – the variability of a firms operating income (EBIT) caused by its
operations
• ROE is a reflection of financial risk
o Financial risk – the variability of a firms NI caused by the use of financial
leverage
• Financial leverage equation shows how much of the risk is due to the firms operations
and how much is due to the way the firm is financed
o
o ROE that results from different levels of ROI for 2 financing strategies
▪ ROI: to simply finance using 100% equity and not use any debt →
ROE=ROI
▪ 70% strategy (debt to equity ratio is 70%)
THE RULES OF FINANCIAL LEVERAGE
• 2 breakeven points
o 1st: where each financial strategy cuts the horizontal axis
▪ Financial breakeven points – points at which a firm’s ROE = 0
o 2nd: indifference point – point at which 2 financing strategies produce the same
ROE
• Option pricing model tends to increase the ROE because the firm only has to earn more
than the after tax cost of debt
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• WACC is always higher than the after tax cost of debt
• Equity is always the most expensive form of capital
• For value maximizing firms, the use of debt increases the expected ROE so shareholders
expect to be better off by using debt financing, rather than equity financing
o The firm expects to be to the right of the indifference point
o The farther to the right the firm expects to be, the greater the value of using debt
financing
o Implies that the firm should always finance with debt, but this isn’t true
• Risk value of money – the principle that future cash flows (money) involving difference
amounts of risk have different PVs
• The range/variability of the ROE increases with debt financing
• The variability of the ROE increases as the firm finances with more debt
• There are fixed debt charges → fixed interest costs that a firm has to pay which are
independent of the firms ROI
• Financing with debt increases the variability of the firms ROE, which usually increases
the risk to the common shareholders
o The range of ROE values always increase with debt financing but doesn’t
necessarily mean that risk increases
o Variability doesn’t always mean risk
• Financing with debt increases the likelihood of the firm running into financial distress
and possibly even bankruptcy
• Effects of financial leverage are not confined to corporations
• Financial leverage tends to increase returns, but it also increases the risk of variability
and financial distress
• The amount of debt a firm can carry depends on the underlying business risk of the asset
being financed
INDIFFERENCE ANALYSIS
•
→ EPS in relation to the firms EBIT
• How EPS varies with EBIT:
o
▪ If the firm has no debt, the first term = 0
▪ If the firm finances with debt it incurs the after tax fixed interest expense
per share and then has fewer shares outstanding
▪ EPS-EBIT line pivots and gets steeper as more debt is used
• As the firm finances more debt, its EPS and ROE are more sensitive to its operating
results (EBIT and ROI)
• Profit planning charts – charts showing ROE-ROI and EPS-EBIT that allow firms to
analyze the impact of financing on their profits
• EPS indifference point – the EBIT level at which 2 financing alternatives generate the
same EPS
DETERMINING CAPITAL STRUCTURE
• Stock ratios measures the stock of outstanding debt relative to the total capital structure
of the firm or the amount of equity
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• Flow variables measure the flow of income over a period and the flow of payments the
firm is required to make
• Stock ratios are useful for bond rating agencies and others use them to do a quick check
on the firms financing and they also limit the amount of debt the firm can raise through
its trust indenture
• The maturity of the debt is what matters
• Stock ratios are not completely adequate since they ignore some of the cash flow
commitments attached to debt
• Often a clause in the trust indenture that states the firm cannot issue any more debt unless
it has an interest coverage ratio of 2.0 or more
o This doesn’t include all of the firms commitments
o Limitation: interest payments are made from cash and not from accounting
earnings
o The interest coverage ratio doesn’t show the impact of any sinking fund payments
or other commitments
• Fixed burden coverage ratio – an expanded interest coverage ratio that looks at a
broader measure of both income and the expenditures associated with debt
o
▪ SF = sinking fund payments
• Cash flow to debt (CFTD) ratio – a direct measure of the cash flow available over a
period to cover a firm’s stock of outstanding debt
o
FINANCIAL RATIOS AND CREDIT RATINGS
• Investment grade companies: firms with at least a BBB bond rating, higher coverage, less
debt (leverage), a larger cash flow to debt ratio, less liquidity, higher profit margins, and
a higher ROA than non investment grade bond ratings
• IG firms tend to have more stable sales and are growing faster than non IG firms with
greater capital expenditures to depreciation (asset growth)
• Firms with better credit ratings tend to be larger and more profitable, generate more cash,
and have more stable sales, meaning lower business risk
• Also tend to have better investment opportunities so are reinvesting at a higher rate than
firms with inferior credit ratings
• The final credit rating is based on both quantitative as well as qualitative assessments
• Prediction equation:
o
o Where:
▪ = Working capital dividend by total assets
▪ = Retained earnings divided by total assets
▪ = EBIT/total assets
▪ = Market value of total equity/non equity book liabilities
▪ = Sales/total assets
• High working capital means more receivables and inventory, which are more liquid than
fixed assets
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Document Summary
Risk and leverage: invested capital (ic) a firm"s capital structure, consisting of shareholders" equity and. Roe=roi: 70% strategy (debt to equity ratio is 70%) Indifference analysis: how eps varies with ebit, (cid:1831)(cid:1842)(cid:1845)= (cid:4666)(cid:3006)(cid:3003)(cid:3021) (cid:3019)(cid:3003)(cid:4667)(cid:4666)(cid:2869) (cid:3021)(cid:4667, (cid:1831)(cid:1842)(cid:1845)= (cid:3019)(cid:3003)(cid:4666)(cid:2869) (cid:3021)(cid:4667) Eps in relation to the firms ebit. If the firm has no debt, the first term = 0. Investment grade companies: firms with at least a bbb bond rating, higher coverage, less debt (leverage), a larger cash flow to debt ratio, less liquidity, higher profit margins, and a higher roa than non investment grade bond ratings. Ig firms have higher z scores than non ig firms. Buy (cid:2009) of levered firms debt: (cid:2009) = arbitrary percentage, u = unlevered firm, l = levered firm. If you don"t like the negative effects of financial leverage, you can remove them by unlevering the levered firms equity by buying some of the firms debt.
