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Financial Management MGT201

Lesson 36

MANAGEMENT OF CAPITAL STRUCTURE

Learning objectives:

After going through optimal capital structure theories, modifications made in them, applicability

of theses theories, impact of debt on value of firm and WACC, different principles to decide about

capital structure and different approaches to WACC calculation now we study the management of

capital structure:

Traditionalist Theory - Effect of Capital Structure on Firm Value & Share Price:

· As 100% Equity Firm Takes On More and More Debt (or Leverage):

Cost of Capital decreases (cost of debt is cheaper than equity), reaches a minimum

point, and then rises (excessive debt increases financial risk).

Total Market Value of Firm (V = D + E = Market Value of Debt + Market Value of

Equity) first rises (because of Interest Tax Shield savings), then reaches a maximum

point (optimal capital structure), and finally falls (because of excessive fall in Net

Income and Equity value because of interest payments).

Share Price (Po= Total Value / Original Number of Shares OR Equity value / Number

of Shares Outstanding) first rises, then reaches maximum (same point as maximum

Value), and finally falls. Follows same shape as Total Market Value of Firm. Share

Price is a measure of Firm Value.

Traditionalist Theory - Effect of Capital Structure on Earnings and Risk:

· As 100% Equity Firm Replaces More and More Equity with Debt (or Leverage):

Mean (or Expected) EBIT assumed to be unchanged although excessive debt can cause

it to rise because of higher operational costs because of financial distress

Mean EBT will fall because interest payments rise

Mean Net Income (or Earnings) generally falls continuously because interest payments

rise faster than any interest tax savings.

Mean Earnings Per Share (EPS = Net Income / Number of Shares outstanding)

generally first rises if number of shares falls if Equity is Replaced with Debt, then

reaches maximum (different capital structure mix from that which maximizes Value &

Share Price) , and finally falls (because interest payments grow faster). Similar shape to

Share Price Curve but reaches Maximum at a different Debt Ratio and Capital Structure.

For Optimizing Capital Structure, we should focus on Share Price and not EPS.

Earnings Risk (Variation or Standard Deviation) Increases because of Leveraging or

Magnifying effect of Debt. Debt increases Financial Distress and Risk of Bankruptcy.

And if Firm is financially unhealthy i.e. EBIT / Total Assets < Cost of Debt then small

fall in EBIT can lead to large fall in ROE.

Weaknesses of Capital Structure Mathematical Models:

Here are some of the rules of thumb or general principles financial managers keep in view while

deciding for capital structure of the company:

· Forecasting Errors

Changes in Cost of Debt and Equity (or Capitalization Rates) are unpredictable when

Debt Ratio is changing

Changes in EBIT are also difficult to correlate to changes in Debt or Capital Structure

· Share Price and EPS calculation is very sensitive to minor errors in the estimates.

· Focus on Corporate Finance is on Market Value (of Equity, Debt, and Stocks) BUT Market

Value may not be so important for Proprietorships and Private Ltd Companies where only a few

shareholders to whom the market value assessed by investors in the market is irrelevant.

· Fundamentally, Stock Prices should be fundamentally driven by Operating Decisions and Focus

on Improving Earnings and Cash Flows and NOT by manipulating Capital Structure. Capital

Structure and Corporate Financing can be used to fine tune the value.

Practical Capital Structure Management:

· Financial Stability and Conservatism vs. Real-time Capital Structure Optimization! Aim for

Target Capital Structure

· Long Run Viability vs. Short-term Stock Price Maximization

· Financial Ratio Targets

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Financial Management MGT201

Coverage Ratio i.e. TIE (Times Interest Earned)

= EBIT / Interest. Higher (over 2.0) is better.

Long Term Debt / Total Capitalization Ratio - about 30%

FCC (Fixed Charge Coverage) = (EBIT - Lease Rental) / (Interest + Lease Rental +

Adjusted Sinking Fund Payment). Takes into account Fixed Financial Charges other

than Interest

Maintain Reserve Borrowing Capacity (recall Signaling Theory) in case attractive Positive NPV

projects are found & also to give the right Signal to Market

Management Control

use Debt to avoid giving away voting rights and control BUT Creditors can take control

if firm becomes insolvent or defaults

Corporate Raiders can take over a firm with large assets if debt is too low - using LBO

(Leveraged Buy Out). They convince shareholders to give them control in exchange for

higher share prices and EPS as a result of future leveraging.

Firms with (1) solid assets that can be mortgaged as security against a loan and (2) stable sales

and Operating Leverage can generally use debt more safely.

Retained Earnings: profitable firms have sizeable Cash and Retained Earnings. These are ideal

sources of capital because No transaction costs.

High Tax Bracket Firms: such firms have greater advantage in using debt because of large

Interest Tax Shield Savings.

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