CAPITAL STRUCTURE AND FINANCIAL LEVERAGE Debt and equity financing create different types of obligations for the

CAPITAL STRUCTURE AND FINANCIAL LEVERAGE Debt and equity financing create different types of obligations for the

firm. Debt financing obligates the firm to pay creditors interest and prin- cipal—usually a fixed amount—when promised. If the firm earns more than necessary to meet its debt payments, it can either distribute the sur- plus to the owners or reinvest.

Equity financing does not obligate the firm to distribute earnings. The firm may pay dividends or repurchase stock from the owners, but there is no obligation to do so.

The fixed and limited nature of the debt obligation affects the risk of the earnings to the owners. Consider Capital Corporation that has $20,000 of assets, all financed with equity. There are 1,000 shares of Capital Corporation stock outstanding, valued at $20 per share. The firm’s current balance sheet is simple:

Capital Corporation Balance Sheet

Assets $20,000 Liabilities

Equity (1,000 shares)

Suppose Capital Corporation has investment opportunities requir- ing $10,000 of new capital. Further suppose Capital Corporation can raise the new capital either of three ways:

FINANCING DECISIONS

EXHIBIT 18.3 Capital Corporation’s Projected Balance Sheet for Alternative

Financing ALTERNATIVE 1: $10,000 EQUITY, $0 DEBT

Assets $30,000 Liabilities $0 Equity (1,500 shares) $30,000

ALTERNATIVE 2: $5,000 EQUITY, $5,000 DEBT

Assets $30,000 Liabilities $5,000 Equity (1,250 shares) $25,000

ALTERNATIVE 3: $0 EQUITY, $10,000 DEBT

Assets $30,000 Liabilities $10,000 Equity (1,000 shares) $20,000

Alternative 1: Issue $10,000 equity (500 shares of stock at $20 per share) Alternative 2: Issue $5,000 of equity (250 shares of stock at $20 per share) and borrow $5,000 with an annual interest of 5% and

Alternative 3: Borrow $10,000 with an annual interest of 5% It may be unrealistic to assume that the interest rate on the debt in

Alternative 3 will be the same as the interest rate for Alternative 2 since in Alternative 3 there is more credit risk. For purposes of illustrating the point of leverage, however, let’s keep the interest rate the same.

The balance sheet representing each financing method is shown in Exhibit 18.3. The only difference between the three alternative means of financing is with respect to how the assets are financed:

Alternative 1: all equity Alternative 2: Alternative 3:

Stated differently, the debt ratio and the debt-to-asset ratio of Capital Corporation under each alternative is:

Capital Structure

Financing Debt Ratio or Alternative

Debt-to-Equity Ratio Debt-to-Assets Ratio

1 --------------------- $0 = 0.000 or 0% --------------------- $0 = 0.000 or 0% $30,000

2 --------------------- $5,000 = 0.200 or 20% --------------------- $5,000 = 0.167 or 16.7% $25,000

3 --------------------- $10,000 = 0.500 or 50% --------------------- $10,000 = 0.333 or 33.3% $20,000

How can managers interpret these ratios? Let’s look at Alternative

2. The debt ratio of 20% tells us that the firm finances its assets using $1 of debt for every $5 of equity. The debt-to-assets ratio means that 16.7% of the assets are financed using debt or, in other words, almost

17 cents of every $1 of assets is financed with debt. Suppose Capital Corporation has $4,500 of operating earnings. This means it has a $4,500/$30,000 = 15% return on assets (ROA = 15%). And suppose there are no taxes. What are the earnings per share (EPS) under the different alternatives?

Alternative 2: Alternative 1:

$5,000 Equity Alternative 3: $10,000 Equity and $5,000 Debt $10,000 Debt

Operating earnings

$4,500 Less interest expense

1,000 Net income

$3,500 Number of shares

÷ 1,000 Earnings per share

Suppose that the return on assets is 10% instead of 15%. Then,

Alternative 2: Alternative 1:

$5,000 Equity Alternative 3: $10,000 Equity and $5,000 Debt $10,000 Debt

$3,000 Less interest expense

Operating earnings

1,000 Net income

$2,000 Number of shares

÷ 1,000 Earnings per share

$2.00 $2.00 If you are earning a return that is the same as the cost of debt, 10%, the

earnings per share are not affected by the choice of financing.

FINANCING DECISIONS

Now suppose that the return on assets is 5%. The net income under each alternative is:

Alternative 2: Alternative 1:

$5,000 Equity Alternative 3: $10,000 Equity and $5,000 Debt $10,000 Debt

Operating earnings

$1,500 Less interest expense

1,000 Net income

$500 Number of shares

÷ 1,000 Earnings per share

$0.80 $0.50 If the return on assets is 15%, Alternative 3 has the highest earnings

per share, but if the return on assets is 5%, Alternative 3 has the lowest earnings per share.

You cannot say ahead of time what next period’s earnings will be. So what can you do? Well, you can make projections of earnings under different economic climates, and make judgments regarding the likeli- hood that these economic climates will occur.

Comparing the results of each of the alternative financing methods provides information on the effects of using debt financing. As more debt is used in the capital structure, the greater the “swing” in EPS.

Summarizing the EPS under each financing alternative and each eco- nomic climate:

Earnings per Share under Different Economic Conditions

Normal Boom Financing Alternative

Slow

(ROA = 5%) (ROA = 10%) (ROA = 15%)

1. $10,000 equity

$2.00 $3.00 2. $5,000 equity, $5,000 debt

$2.00 $3.50 When debt financing is used instead of equity (Alternative 3), the

owners don’t share the earnings—all they must do is pay their creditors the interest on debt. But when equity financing is used instead of debt (Alternative 1), the owners must share the increased earnings with the additional owners, diluting their return on equity and earnings per share.

Capital Structure

EXHIBIT 18.4 Capital Corporation’s Earnings per Share for Different Operating

Earnings for Each of the Three Financing Alternatives