CAPITAL STRUCTURE AND LEVERAGE

• Optimal capital structure


  The structure that would maximize its stock price
• Target capital structure


  The mix of debt, preferred stock, and common equity the firm wants to have
• Adjusting capital structure


  1. If the actual debt ratio is significantly below the target level, management will raise capital by issuing debt

  2. If the debt ratio is above the target, equity will be used
• Trade-off between risk and return

  • Using more debt will raise the risk borne by stockholders
  • Using more debt generally increases the expected return on equity
• Firms should find the capital structure that strikes a balance between risk and return so as to maximize the stock price
• 4 primary factors that influence capital structure decisions

  • Business risk
  • The firm's tax position
  • Financial flexibility
  • Managerial conservatism or aggressiveness
• Business risk


  The riskiness inherent in the firm's operations if it used NO DEBT
• Factors that determine business risk

  • Competition
  • Demand variability
  • Sales price variability
  • Input cost variability
  • Ability to adjust output prices for changes in input costs
  • Ability to develop new products in a timely, cost-effective manner
  • Foreign risk exposure
  • Operating leverage
• Operating leverage


  The extent to which costs are FIXED
• High degree of operating leverage

  Relatively small change in sales results in a large change in profit and ROE
• Financial risk


  An increase in stockholder's risk, over and above the firm's basic business risk, resulting from the use of financial leverage
• Financial leverage


  The extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure
• Using leverage has both positive and negative effects: higher leverage increases expected EPS, but it also increases risk
• Optimal capital structure


  The one that maximizes the price of the firm's stock, and this generally calls for a debt ratio that is lower than the one that maximizes expected EPS
• Stock prices


  Positively related to expected earnings but negatively related to higher risk
• Target capital structure


  The debt-equity mix that maximizes the firm's stock price
• The capital structure that maximizes the stock price also minimizes the WACC
• It is easier to predict how a capital structure change will affect the WACC than the stock price
• Hamada equation


  Can help measure/quantify the effect of increasing debt ratio on the cost of equity
• BUSINESS RISK


  If the company has no debt, its ROE is equal to its ROA
• THE FIRM’S TAX POSITION

  A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt.
• FINANCIAL FLEXIBILITY

  The ability to raise capital on reasonable terms even under adverse market conditions. 
• MANAGERIAL CONSERVATISM or AGGRESSIVENESS

  Aggressive managers are more willing to use debt in an effort to boost profits.
• • DOL = Contribution margin / Net income
• Financial Risk The additional risk placed on common stockholders as a result of the decision to finance with debt
• Estimated relationship between capital structure and WACC : used as guide in capital structure decisions
• • It is harder to quantify leverage’s effects on the cost of equity
• A stock’s beta is the relevant measure of risk for a diversified investor; increases with financial leverage.