1. Berat BAŞAT
Marmara University
Institute of Social Sciences
Department of Business Administration in English
Sub-Departent of Accounting and Finance
1
3. BALANCE SHEET
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
3
4. BALANCE SHEET
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
4
5. BALANCE SHEET
Current Current
Assets Liabilities
Debt and Financial
Fixed Preferred Structure
Assets
Shareholders’
Equity
5
6. BALANCE SHEET
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
6
7. BALANCE SHEET
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Capital
Assets
Structure
Shareholders’
Equity
7
8. Capital Structure is a mix of a company's long-
term debt, specific short-term debt, common
equity and preferred equity.
The capital structure is how a firm finances its
overall operations and growth by using different
sources of funds.
8
9. Optimal Capital Structure is the combination of
sources of capital that minimizes weighted
average cost of capital and maximizes the value
of firm.
9
10. Target Capital Structure is the mix of debt,
preferred stock, and common equity with which
the firm plans to finance its investments.
10
12. • Business Risk
• Tax Position
• Financial Flexibility
• Managerial Attitude
12
13. The risk that a company will not have adequate
cash flow to meet its operating expenses
Business risk is the uncertainty associated with
projections of a firm’s future returns on equity
There is also Financial Risk as well as Busines Risk;
Additional business risk concentrated on common
stockholders when financial leverage is used.
Depends on the amount of debt and preferred
stock financing. 13
14. Suppose 10 people decide to form a corporation
to manufacture disk drives.
If the firm is capitalized only with common stock
– and if each person buys 10% - each investor
shares equally in business risk
14
15. If the same firm is now capitalized with 50% debt
and 50% equity – with five people investing in
debt and five investing in equity
The 5 who put up the equity will have to bear all
the business risk, so the common stock will be
twice as risky as it would have been had the firm
been all-equity (unlevered).
15
16. Business risk:
Uncertainty in future EBIT.
Depends on business factors such as
competition, operating leverage, etc.
Financial risk:
Additional business risk concentrated on
common stockholders when financial
leverage is used.
Depends on the amount of debt and
preferred stock financing.
16
17. A major reason for using debt is that interest is tax
deductible, which lowers the effective cost of debt.
However, if much of a firm’s income is already
sheltered from taxes by accelerated depreciation or
tax loss carryovers, its tax rate will be low, and debt
will not be as advantageous as it would be to a firm
with a higher effective tax rate.
17
18. Financial flexibility is an ability to raise capital on
reasonable terms under adverse conditions.
Corporate treasures know that a steady supply of
capital is necessary for stable operations, which in
turn are vital for long-run success.
18
19. They also know that when money is tight in the
economy, or when a firm is experiencing operating
difficulties, a strong balance sheet is needed to
obtain funds from suppliers of capital.
Thus, it might be advantageous to issue equity to
strengthen the firm’s capital base and financial
stability.
19
20. Some managers are more aggressive than others;
hence, some firms are more inclined to use debt in
an effort to boost profits.
This factor does not affect the optimal, or value-
maximizing, capital structure, but it does influence
the target capital structure a firm actually
establishes.
20
21. 1. Flexibility:
The consideration of flexibility gives the financial
manager ability to alter the firm’s capital structure
with a minimum cost and delay warranted by a
changed situation.
It should also be possible for the company to
provide funds whenever needed to finance its
profitable activities.
21
22. 2. Profitability:
It should permit the maximum use of leverage
at a minimum cost with the constraints. Thus a
sound capital structure tends to minimize ‘cost’
of financing and maximize earnings per share
(EPS).
22
23. • Profits can be paid out as dividends to
shareholders or reinvested in the firm.
• If a firm generates high profits and reinvests a
large proportion back into the firm, then it has
a continuous source of internal funding.
• This will reduce the use of debt in the firm’s
capital structure.
23
24. 3. Solvency:
It should use the debt capital only up to the
point where significant risk it not added. As has
been already observed the use of excessive debt
threatens the solvency of the company.
24
25. 4. Conservation:
The capital structure should be conservative in the
sense that the debt capacity of the company should
not exceed. The debt capacity of a company
demands on its ability to generate future cash flows.
It should have enough cash to pay creditors fixed
charges and principal amount. It should be
remembered that cash insolvency might also lead to
legal insolvency.
25
26. 5. Control:
The capital structure should involve minimum risk of
loss of control of the company. A careful
consideration of these criteria points the conflicting
nature.
For example the use of debt capital is more
economical but the same capital adds to the
financial risk of the company.
26
27. • Controlling owners may desire to issue debt
instead of ordinary shares since debt does not
grant ownership rights.
• Firms with little financial leverage are often
considered excellent takeover targets.
• Issuing more debt may help to avoid a
corporate takeover.
27
28. EBIT-EPS Analysis - used to help
determine whether it would be better to
finance a project with debt or equity.
EPS = (EBIT - I)(1 - t) - P
S
I = interest expense,
P = preferred dividends,
S = number of shares of common stock
outstanding.
28
30. Our firm has 800,000 shares of common stock
outstanding, no debt, and a marginal tax rate of
40%. We need $6,000,000 to finance a proposed
project.
We are considering two options:
1. Sell 200,000 shares of common stock at $30 per
share,
2. Borrow $6,000,000 by issuing 10% bonds.
30
35. If EBIT is $2,000,000, common stock financing
is best.
If EBIT is $4,000,000, debt financing is best.
So, now we need to find a breakeven EBIT
where neither is better than the other.
35
40. bond
financing
EPS
3
For EBIT up to $3 million, stock
stock financing is best. financing
2
1
0 EBIT
$1m $2m $3m $4m 40
41. bond
financing
EPS
3
For EBIT up to $3 million, stock
stock financing is best. financing
2
For EBIT greater
than $3 million,
1 debt financing is
best.
0 EBIT
$1m $2m $3m $4m 41
42. - Tax Benefits of Debt
- Debt-holders are limited to a fixed return
- Voting rights
- Discipline
42
43. Tax benefit of debt
Firm Unlevered Firm Levered
No debt $10,000 of 12% Debt
$20,000 Equity $10,000 in Equity
40% tax rate 40% tax rate
U has $20.000 in Equity L has $10.000 in Equity
Both firms have same business risk and EBIT of
$3,000.
They differ only with respect to use of debt.
43
47. Bankruptcy Costs or Costs of Financial Distress
Bankruptcy Costs are costs associated with financial
difficulties that a firm might get into because it uses
debt financing.
Financial distress occurs when a firm is not able to
make all of the interest and principal payments that
it owes its lender
As you borrow more, you increase the probability of
bankruptcy and hence the expected bankruptcy
cost.
47
48. Agency Costs
The managers and stockholders of a firm also often
behave in ways that reduce a firm's value when the
firm becomes financially distressed. The resulting
costs are a type of agency cost.
Agency costs result from conflicts of interest
between principals and agents. In agency
relationships, one party, known as the principal,
delegates decision-making authority to another
party, known as the agent.
48
49. To better understand agency costs, consider the
following example. Suppose that you have a
newspaper route and you want to go out of town
for a week. You offer a friend $100 to deliver your
papers while you are gone. If your friend agrees to
the arrangement, you will have entered into a
principal-agent relationship. Now assume that you
deliver the Wall Street Journal and that all papers
are supposed to be on your customers' doorsteps
by 6:00 A.M., before they leave home for work.
49
50. You tell this to your friend before you leave town,
but he likes to sleep late in the morning, so he
doesn't get all the papers delivered until 9:00 A.M.
Because the papers are late for five days in a row, a
few customers complain, and some don't give you
a tip at the end of the year as they have in the past.
Any problems that arise because of the complaints
and the lost tips are examples of agency costs.
These costs arose because you delegated decision-
making authority to your friend and he acted in his
best interest rather than yours.
50
52. M&M Proposition 1: ZERO TAXES
Modigliani and Miller (1958) show that financing
decisions don’t matter in perfect capital markets
-Firms can not change the total value of their
securities
-Firm value is determined by real assets
-Capital structure is irrelevant
52
53. When there are no taxes and capital markets
function well, it makes no difference whether the
firm borrows or individual shareholders borrow.
For example, it doesn't matter whether the debt is
short- or long-term, callable or call-protected,
straight or convertible, in dollars or euros, or some
mixture of all of these or other types.
Therefore, the market value of a company does not
depend on its capital structure.
VL = V U 53
54. Capital Markets are perfect.
Individuals can borrow and lend at the risk-free
rate
There are no bankruptcy costs
All firms are assumed to be in the same risk class
(operating risk)
54
55. •Corporate insiders and outsiders have the same
information. (Symmetric Information)
•Managers always maximize shareholders’ wealth
(No agency costs)
•Operating cash flows are completely unaffected
by changes in capital structure
55
56. M&M Proposition 2: WITH CORPORATE TAX
Corporate tax laws favor debt financing over
equity financing.
With corporate taxes, the benefits of financial
leverage exceed the risks: More EBIT goes to
investors and less to taxes when leverage is
used.
MM show that: VL = VU + TD.
If T=40%, then every dollar of debt adds 40
cents of extra value to firm.
56
57. The tradeoff theory justifies moderate debt ratios.
Profitable firms will borrow up to the point where
the marginal value of tax shields on additional
debt is just offset by the increase in the present
value of possible costs of financial distress.
Financial distress refers to the costs of bankruptcy
or reorganization, and also to the agency costs
that arise when the firm's creditworthiness is in
doubt.
57
59. Kraus and Litzenberg
Theory states that why firms prefer to issue debt
rather than equity. The reason of this is not
requiring the external funds.
Companies finance investments by raising funds in
this order:
(1)internal funds (retained earnings),
(2) debt,
(3) sale of new common stock (the most expensive
form of financing). 59
60. The pecking-order theory is at odds with the
trade-off theory:
1. There is no target D/E ratio.
2. Profitable firms use less debt.
3. Companies like financial slack
60
61. - MM assumes symmetric information.
- However, the existence of asymmetric information
has important effect on decisions to use either
debt or equity.
- A firm with very favorable prospects tries to avoid
selling stock and raises new capital by other
means including using debt beyond normal target
capital structure.
. 61
62. - A firm with unfavorable prospects would want
to sell stock, which would mean bringing in
new investors to share losses.
- Announcement of a stock offering by a
mature firm signals that future prospects are
not bright. So, investors often perceive an
additional issuance of stock as a negative
signal, and the stock price falls.
- Therefore, firms should maintain a reserve
borrowing capacity and use less debt than
would be suggested by the trade-off theory
62
64. Frank and Goyal (2003)
Assume that company operations and the associated accounting
structures are more complex than the standard pecking order
representation
Data related to publicly traded American firms over the years 1971-
1998
They find leverage to increase with
Median industry leverage
Firm size
Intangibles
Corporate income tax rate
They find leverage to decrease with
Bankruptcy risk
Market-to-book ratio
Dividends
Profitability
64
Small firms do not follow the Pecking Order
65. Debt ratios of publicly traded firms in the US and economies undergoing
rapid economic development (China, and India) are modeled using traditional
capital structure specifications
This study seeks to test whether the determinants of debt ratios identified by
leading researchers in this area also apply to both Chinese and Indian firms.
Dependent Variables:
Liabilities to total assets
Long-term debt issuance to total assets
Control Variables:
Market-to-book ratio
Asset tangibility:
Profitability
Firm size
Product uniqueness
65
66. Sample
4905 firms
Years 2000-2006
Results
Indian firms tend to have higher debt ratios than US
Firms
Chinese firms are less levered than US counterparts
Chinese firms have issued more long-term debt relative to
assets
Negative & significant sign of market to book ratio
supports financial signaling hypothesis
Positive & significant on asset tangibility & firm size
supports trade-off theory
Product uniqueness and profitability are negatively
associated with the debt ratio 66
67. Firms that are acquired in hostile takeovers are generally
characterized by poor performance in both accounting
profitability and stock returns.
There is evidence that increases in leverage are followed
by improvements in operating efficiency, as measured by
operating margins and returns on capital.
Palepu (1990) presents evidence of modest improvements in
operating efficiency at firms involved in leveraged buyouts.
Kaplan(1989) and Smith (1990) also find that firms earn higher
returns on capital following leveraged buyouts.
Denis and Denis (1993) study leveraged recapitalizations and
report a median increase in the return on assets of 21.5%.
67
Investment Decisions: Invest in assets that earn a return greater than the minimum acceptable hurdle rate. Financing Decisions: Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations. Dividend Decisions: If you cannot find investments that make your minimum acceptable rate, return the cash to owners of your business
