LG 4 13.2 The Firm’s Capital Structure

LG 3 LG 4 13.2 The Firm’s Capital Structure

Capital structure is one of the most complex areas of financial decision making because of its interrelationship with other financial decision variables. Poor cap- ital structure decisions can result in a high cost of capital, thereby lowering the NPVs of projects and making more of them unacceptable. Effective capital struc- ture decisions can lower the cost of capital, resulting in higher NPVs and more acceptable projects—and thereby increasing the value of the firm.

TYPES OF CAPITAL All of the items on the right-hand side of the firm’s balance sheet, excluding cur-

rent liabilities, are sources of capital. The following simplified balance sheet illus- trates the basic breakdown of total capital into its two components, debt capital and equity capital:

Balance Sheet

Current liabilities

Debt

Long-term debt

capital

Assets

Stockholders’ equity

Total

Preferred stock

Equity capital

Common stock equity

capital

Common stock Retained earnings

The cost of debt is lower than the cost of other forms of financing. Lenders demand relatively lower returns because they take the least risk of any contributors of long-term capital. Lenders have a higher priority of claim against any earnings or assets available for payment, and they can exert far greater legal pressure against

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Long-Term Financial Decisions

The tax deductibility of interest payments also lowers the debt cost to the firm substantially.

Unlike debt capital, which the firm must eventually repay, equity capital remains invested in the firm indefinitely—it has no maturity date. The two basic sources of equity capital are (1) preferred stock and (2) common stock equity, which includes common stock and retained earnings. Common stock is typically the most expensive form of equity, followed by retained earnings and then preferred stock. Our concern here is the relationship between debt and equity capital. In general, the more debt a firm uses, the greater will be the firm’s financial leverage. That leverage makes the claims of common stockholders even more risky. In addition, a firm that increases its use of leverage significantly can see its cost of debt rise as lenders begin to worry about the firm’s ability to repay its debts. Whether the firm borrows very little or a great deal, it is always true that the claims of common stockholders are riskier than those of lenders, so the cost of equity always exceeds the cost of debt.

EXTERNAL ASSESSMENT OF CAPITAL STRUCTURE We saw earlier that financial leverage results from the use of fixed-cost financing,

such as debt and preferred stock, to magnify return and risk. The amount of leverage in the firm’s capital structure can affect its value by affecting return and risk. Those outside the firm can make a rough assessment of capital structure by using measures found in the firm’s financial statements. Some of these important debt ratios were presented in Chapter 3. For example, a direct measure of the degree of indebtedness is the debt ratio (total liabilities , total assets) . The higher this ratio is, the greater the relative amount of debt (or financial leverage) in the firm’s capital structure. Measures of the firm’s ability to meet contractual payments associated with debt include the times interest earned ratio (EBIT , interest) and the fixed- payment coverage ratio (see page 78). These ratios provide indirect information on financial leverage. Generally, the smaller these ratios, the greater the firm’s financial leverage and the less able it is to meet payments as they come due.

The level of debt (financial leverage) that is acceptable for one industry or line of business can be highly risky in another, because different industries and lines of business have different operating characteristics. Table 13.8 presents the debt and times interest earned ratios for selected industries and lines of business. Significant industry differences can be seen in these data. Differences in debt posi- tions are also likely to exist within an industry or line of business.

Personal Finance Example 13.16 3 Those who lend to individuals, like lenders to corporations, typ- ically use ratios to assess the applicant’s ability to meet the con-

tractual payments associated with the requested debt. The lender, after obtaining information from a loan application and other sources, calculates ratios and com- pares them to predetermined allowable values. Typically, if the applicant’s ratio values are within the acceptable range, the lender will make the requested loan.

The best example of this process is a real estate mortgage loan application. The mortgage lender usually invokes the following two requirements:

1. Monthly mortgage payments 6 25% to 30% of monthly gross (before-tax)

income

2. Total monthly installment payments (including the mortgage payment) 6 33%

CHAPTER 13

Leverage and Capital Structure

Debt Ratios for Selected Industries and Lines of Business TA B L E 1 3 . 8 (Fiscal Year April 1, 2008 through March 31, 2009)

Times interest Industry or line of business

Times interest

Debt ratio earned ratio Manufacturing industries

Debt ratio

earned ratio

Industry or line of business

Retailing industries

61.7 1.9 Dairy products

Book printing

1.5 Department stores

82.0 1.2 Electronic computers

71.6 4.9 New car dealers

59.0 2.2 Supermarkets and

Iron and steel forgings

69.8 3.6 Machine tools,

58.6 5.5 grocery stores

Service industries

87.5 5.9 Women’s and girls’ dresses

metal cutting types

65.9 3.1 Advertising agencies

57.8 1.5 General automotive repair

Wholesaling industries

Insurance agencies and

Furniture

82.2 5.0 General groceries

65.5 3.9 brokerages

68.6 3.6 Offices of Certified Public

Men’s and boys’ clothing

69.7 8.5 Wines and distilled

57.6 4.0 Accountants

alcoholic beverages

Source: RMA Annual Statement Studies, 2009–2010 (Philadelphia: Risk Management Association, 2009). Copyright © 2009 by Risk Management Association.

Assume that the Loo family is applying for a mortgage loan. The family’s monthly gross (before-tax) income is $5,380, and they currently have monthly installment loan obligations that total $560. The $200,000 mortgage loan they are applying for will require monthly payments of $1,400. The lender requires (1) the monthly mortgage payment to be less than 28% of monthly gross income and (2) total monthly installment payments (including the mortgage payment) to

be less than 37% of monthly gross income. The lender calculates and evaluates these ratios for the Loos, as shown below.

1. Mort. pay. , Gross income = $1,400 , $5,380

= 26% 6 28% maximum, therefore OK

2. Tot. instal.pay. , Gross income = ($560 + $1,400) , $5,380

= 36.4% 6 37% maximum, therefore OK Because the Loos’ ratios meet the lender’s standards, assuming they have ade-

quate funds for the down payment and meet other lender requirements, the Loos will be granted the loan.

CAPITAL STRUCTURE OF NON–U.S. FIRMS In general, non–U.S. companies have much higher degrees of indebtedness than

their U.S. counterparts. Most of the reasons relate to the fact that U.S. capital mar- kets are more developed than those elsewhere and have played a greater role in corporate financing than has been the case in other countries. In most European countries and especially in Japan and other Pacific Rim nations, large commercial

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been true in the United States. Furthermore, in many of these countries, banks are allowed to make large equity investments in nonfinancial corporations—a practice prohibited for U.S. banks. Finally, share ownership tends to be more tightly con- trolled among founding-family, institutional, and even public investors in Europe and Asia than it is for most large U.S. corporations. Tight ownership enables owners to understand the firm’s financial condition better, resulting in their willingness to tolerate a higher degree of indebtedness.