Capital StructureCapital structure refers to the composition of a company’s financing: interest bearing long and short term debt and equity.A company’s capital structure can impact its WACC, and therefore its value.It also impacts a firm’s financial flexibility (its ability to source capital as needed). Effects of Additional Debt on WACCDebt holders have a prior claim on cash flows relative to stockholders. As debt is increased, the debt holders’ increased claims for interest and principal payments creates increased risk for stockholders.Therefore, the cost of stock (equity) goes up as the proportion of debt in the capital structure is increased. (Continued…) Effects of Additional Debt on WACCIncreased debt (increased leverage) also increases the risk of bankruptcy and the potential inability to make the increased debt service payments.This causes both the cost of debt and the cost of equity to rise. Additional debt affects debt ratingsCorporate bonds are rated by rating agencies based on the issuing firm’s ability to service the debt.High ratings reflect low risks and result in reduced interest rates.High ratings also make it easier for the firm to issue additional debt which increases financial flexibility. Debt RatingsRating agencies consider many risk factors when rating a company’s bonds.Primary factors include the firm’s ratio of total debt to capital and the extent to which EBIT covers interest expense (EBIT interest coverage ratio). Key Ratios for Determining Debt RatingsThe ratio of total debt to capital equals total debt divided by total debt plus equity (expressed as a percentage). In exhibit 6 of next week’s Deluxe case the above ratio is 5% for AAA rated firms and 47% for BBB rated firms.The interest coverage ratio equals EBIT divided by the annual pre-tax interest expense.In the Deluxe exhibit 6 the above ratio is 23.4 for AAA rated firms and 3.9 for BBB rated firms. Effects of Additional Debt on WACCAdding debt, which is both lower cost than equity and tax deductible can reduce the WACC.However, adding debt also increases the cost of both debt and equity which can increase the WACCThe net effect on the WACC can be uncertain. Capital Structure Theory Trade-off theorySignaling theoryPecking order Debt-to-Value Ratio [D / (E + D)] of U.S. Firms, 1975–2005 * Historical pattern of capital structuresDebt ratios average about 40% of total capital.The fact that debt ratios are not excessively high reflects the concerns over bankruptcy risks.Even without experiencing bankruptcy, just the risk of not being able to pay bills and provide services can potentially disrupt a firm’s relationships with suppliers and customers. Trade-off Theory At low leverage levels (low debt levels), the tax benefits of debt outweigh the risk of bankruptcy, so you add on more lower cost debt.At high levels of debt, the risk of bankruptcy outweighs tax benefits, so you try to avoid adding on more debt.An optimal capital s ...

1. Capital StructureCapital structure refers to the composition of a
company’s financing: interest bearing long and short term debt
and equity.A company’s capital structure can impact its WACC,
and therefore its value.It also impacts a firm’s financial
flexibility (its ability to source capital as needed).
Effects of Additional Debt on WACCDebt holders have a prior
claim on cash flows relative to stockholders. As debt is
increased, the debt holders’ increased claims for interest and
principal payments creates increased risk for
stockholders.Therefore, the cost of stock (equity) goes up as the
proportion of debt in the capital structure is increased.
(Continued…)
Effects of Additional Debt on WACCIncreased debt (increased
leverage) also increases the risk of bankruptcy and the potential
inability to make the increased debt service payments.This
causes both the cost of debt and the cost of equity to rise.
Additional debt affects debt ratingsCorporate bonds are rated by
rating agencies based on the issuing firm’s ability to service
the debt.High ratings reflect low risks and result in reduced
interest rates.High ratings also make it easier for the firm to
issue additional debt which increases financial flexibility.

2. Debt RatingsRating agencies consider many risk factors when
rating a company’s bonds.Primary factors include the firm’s
ratio of total debt to capital and the extent to which EBIT
covers interest expense (EBIT interest coverage ratio).
Key Ratios for Determining Debt RatingsThe ratio of total debt
to capital equals total debt divided by total debt plus equity
(expressed as a percentage). In exhibit 6 of next week’s Deluxe
case the above ratio is 5% for AAA rated firms and 47% for
BBB rated firms.The interest coverage ratio equals EBIT
divided by the annual pre-tax interest expense.In the Deluxe
exhibit 6 the above ratio is 23.4 for AAA rated firms and 3.9 for
BBB rated firms.
Effects of Additional Debt on WACCAdding debt, which is both
lower cost than equity and tax deductible can reduce the
WACC.However, adding debt also increases the cost of both
debt and equity which can increase the WACCThe net effect on
the WACC can be uncertain.
Capital Structure Theory
Trade-off theorySignaling theoryPecking order
Debt-to-Value Ratio

3. [D / (E + D)] of U.S. Firms, 1975–2005
*
Historical pattern of capital structuresDebt ratios average about
40% of total capital.The fact that debt ratios are not excessively
high reflects the concerns over bankruptcy risks.Even without
experiencing bankruptcy, just the risk of not being able to pay
bills and provide services can potentially disrupt a firm’s
relationships with suppliers and customers.
Trade-off Theory
At low leverage levels (low debt levels), the tax benefits of debt
outweigh the risk of bankruptcy, so you add on more lower cost
debt.At high levels of debt, the risk of bankruptcy outweighs
tax benefits, so you try to avoid adding on more debt.An
optimal capital structure balances these risks and benefits.
Signaling Theory
Managers often have better information than investors. Thus,
they would:Sell stock if they feel the stock is overvalued.Sell
bonds if they feel stock is undervalued.Investors understand
this, so they tend to view new stock sales as a negative signal
from management.

4. Pecking Order TheoryFirms use internally generated funds first,
because there are no flotation (issuing) costs or negative
signals.If more funds are needed, firms then issue debt because
it has lower flotation (issuing) costs than equity and does not
send negative signals.Finally, if still more funds are needed,
and the firm is getting too much leverage, firms then issue
equity.
Aggregate Sources of Funding
for Capital Expenditures, U.S. Corporations
*
Debt Financing and Agency CostsOne agency issue is that
managers might use corporate funds for non-value maximizing
purposes.The use of financial leverage can reduce this risk:Ties
“free cash flow” to debt service requirements.Forces discipline
on managers to avoid perks, wasteful spending and non-value
adding acquisitions.
(More...)
Debt Financing and Agency CostsAnother agency issue is the
potential for “underinvestment”.Debt increases risk of financial
distress.Therefore, when debt is high, managers might avoid
risky projects even if the projects have positive NPVs.

5. Financial Flexibility and Reserve Borrowing CapacityFinancial
flexibility reflects the extent of cash on hand, the amount of
cash being generated by future free cash flows, the extent of
future financial commitments (like debt service) and the
company’s reserve borrowing capacity (ability to issue more
debt on acceptable terms).If a firm gets highly leveraged, it may
not be able to raise added funds when needed to fund excellent
investment opportunities. Thus it lacks flexibility.
Implications for ManagersTake advantage of tax benefits by
issuing debt, but only up to a reasonable point where the
WACC, if leveraged further, would increase due to accelerated
increases in both the cost of equity and the cost of debt.
Implications for Managers (Continued)Increase financial
flexibility by avoiding excessive leverage and thereby
maintaining excess borrowing capacity. This is especially
important if the firm has:Volatile sales or operating
resultsMany potential investment opportunities
Keys to good writingWrite in a clear and well organized
manner. Recommendations should be supported by reasons that
make it clear why you are making the recommendation. Each
paragraph should have a topic sentence that clearly introduces
the subject matter of the paragraph. The other sentences in the

6. paragraph can support, clarify or expand on the topic sentence.
Avoid run-on sentences. These are sentences that are too long
and may express multiple thoughts. They should be broken up
into smaller sentences for clarity.Be concise. Don’t add words
and sentences that are not needed. Allow the reader to
understand your recommendation and reasons quickly, without
any excess discussion.
Example of a good paragraph with a topic sentenceThe
paragraph below is responding to the question of how TRX (a
future case study firm) can increase its future free cash
flows.For TRX, the best way to increase its future free cash
flows would be to increase its gross margins. TRX’s customer
care business segment has lower gross margins than its other
business segments. By growing its other higher margin
business segments, while allowing the lower margin customer-
care business segment to decline, overall corporate gross
margins can be increased.
Paragraph responding to the same question that is not clearly
written
TRX is growing fast. Customer care has been a big business
segment of TRX. Customer care call centers respond to
customer inquiries. There are also other business segments.
TRX wants to increase its free cash flows. TRX should
decrease the customer care segment.The above paragraph did
not use a topic sentence to clearly introduce the subject
matter.The above recommendation was not well explained and
supported by reasons.It was not clear, concise or well
organized.

7. Bad paragraph that is adversely affected by run-on
sentences.TRX is a data processing company with three
business segments, each with different gross margins, that
wants to increase its free cash flows by increasing the average
gross margin for the company as a whole. The customer care
segment is the TRX business segment with the lowest gross
margin and by growing the company’s other business segments
which have the higher gross margins while allowing the
customer care segment sales to decrease then TRX will have an
increased average gross margin and that increased average gross
margin will then have the desired effect of increasing TRX’s
free cash flows.Run-on sentences are too long. Break run-on
sentences into shorter sentences. Let each sentence express one
thought.
Financial Policy Writing Assignment
For the writing assignment you should review the two April 3
class lectures, as posted on Blackboard Learn. These lectures
are: (1) Capital Structure and (2) Good Writing.
Your assignment:
Assume that you report to Elizabeth Jenkins at Clark
Corporation. She has asked you to recommend a debt and
equity percentage mix for the Clark Corporation capital
structure. You need to write her a memo recommending a well
balanced capital structure of 40% debt and 60% equity. Your
memo will consist of three paragraphs. The first paragraph is
already provided for you below. You only need to write by
yourself the second and third paragraph.
The first paragraph, which is provided below, includes your
recommendation. Your recommendation reflects a reasonable
balance between debt and equity.

8. The second paragraph, which you will write, should present
your reasons for not having too much debt in the capital
structure. The third paragraph, which you will also write,
should present your reasons for not having too much equity in
the capital structure.
Your reasons for not having too much debt or too much equity
must all be taken from theclass Capital Structure lecture posted
on Blackboard Learn. Your written comments are not to make
use of online material or other outside reference material. You
must write the writing assignment on your own.
Your grade will be based on (1) how well your two paragraphs
are written; (2) how well you have presented arguments from
the class lecture against having too much debt or too much
equity in the capital structure and (3) how well you have
followed the assignment instructions. You should raise all the
key points to support your recommendation, yet also be concise.
Provided below is the start of your memo including the first
paragraph. Copy this first paragraph and then add on the two
additional required paragraphs.
To: Elizabeth Jenkins
From: (your name)
Subject: Recommended Capital Structure
In response to your request, I am recommending that Clark
Corporation pursue a reasonably balanced capital structure of
approximately 40% debt and 60% equity. A well balanced
capital structure will favorably affect our weighted average cost
of capital and our financial flexibility.