CAPITAL STRUCTURE AND LONG-TERM FINANCING

Capital Structure and Sources of Financing

- Capital Structure refers to the mix of debt, preferred stock and ordinary
(common) equity that the firm
uses to finance the firm’s assets. Assets = Liabilities + Owner’s Equity

CA + NCA = (CL + NCL) + (OS + PS +

Ending RE)

Beg. RE + Net Income/(Net Loss) = End.

RE
This means that the whole assets of the company
comes from the liability, or debt of the company,
and from the capital of the owner of the business,
and the net income it generated from the business
operations.

Capital Structure Theories

- Research suggests that there is an optimal capital structure range.
- It is not yet possible to provide financial managers with a precise methodology
for determining a firm’s optimal capital structure.
- Nevertheless, financial theory does offer help in understanding how a firm’s
capital structure affects the firm’s value.
MODIGLIANI AND MILLER THEOREM
- In 1958, Franco Modigliani and Merton H. Miller (commonly known as “M and M”)
demonstrated algebraically that, assuming perfect markets, the capital
structure that a firm chooses does not affect its value.
- Modigliani and Miller theorem or M&M Theorem suggested that the value of the
entity is calculated as present value of its future earnings and its underlying
assets and is not affected by the capital structure.
- Thus, the market value of the firm is measured by its revenue and risks on its
underlying assets.
The theorem holds true in case of perfectly efficient market.
Assumptions under Perfectly Efficient Market:
No taxes: In this Theory, you assume that the entity doesn’t pay any taxes, that is
why Interest expense will have no tax shield and will impact the net income at full
amount.
Tax Benefits
Allowing firms to deduct interest payments on debt when calculating taxable income
reduces the amount of the firm’s earnings paid in taxes, thereby making more
earnings available for bondholders and stockholders.
The deductibility of interest means that some cost of the debt (ri)to the firm is
subsidized by the government.
Letting rd equal the before-tax cost of debt and letting T equal the tax rate, we have ri
= rd × (1 – T).
We can say that the true impact of interest expense in the net income is computed as
follows:
Interest expense before tax – (1 less tax rate)
(Example on Separate Paper)
No bankruptcy costs: The chance that a firm will become bankrupt because of an
inability to meet its obligations as they come due depends largely on its level of both
business risk and financial risk. Under this theory, the entity is not immune to
bankruptcy, but there is no cost/expense in case that it will happen.
Business risk is the risk to the firm of being unable to cover its operating costs or
simply the risk of bankruptcy because of operation.
- In general, the greater the firm’s operating leverage—the use of fixed operating
costs—the higher its business risk.
- Although operating leverage is an important factor affecting business risk, two
other factors—revenue stability and cost stability—also affect it.
- Business risk has inverse relationship in the financial leverage of the entity.
Financial Leverage means the usage of liability.
- Firms with high business risk therefore tend toward less highly leveraged capital
structures, and vice versa
Financial risk is the risk of losing money on a failed investment or venture. There are
many forms of Financial risk, some are:
- Credit risk – also known as ‘Default risk”, the risk associated to borrowings. It is
the possibility that the debtor will not pay or will have a delay in paying its
obligation
- Liquidity risk – risk associated to the management of cash flow and current
assets. The management needs to ensure that the entity has enough liquid
assets to settle their currently maturing obligation
- Operational risk – the risk associated to the internal control. There are times
that bankruptcy starts from one internal failure such as accidents due to lack of
employee training, mismanagement, and human error.
- Market risk – risk associated to the economy in where the business operates. A
lot of times that a bankruptcy occur as a result of economy of the country where
the business operates.
No agency costs: It means that there is no cost associated in selling the bonds or
stocks of the corporation, thus there is no difference between the cost of issuing the
two.
Information is symmetric: A condition where all the information is known to all parties
involved. All the information has a full public disclosure, that is why investor has all
the possible information to be used in decision making.
Example:
Agency Costs Imposed by Lenders
- The managers of firms typically act as agents of the owners (stockholders).
- The owners give the managers the authority to manage the firm for the owners’
benefit.
 - The agency problem created by this relationship extends not only to the
relationship between owners and managers but also to the relationship between
owners and lenders.
- To avoid this situation, lenders impose certain monitoring techniques on
borrowers, who as a result incur agency costs.
Asymmetric Information: Situation in which managers of a firm have more
information about operations and prospects than the investors.
PECKING ORDER THEORY
- A pecking order is a hierarchy of financing that begins with retained earnings,
which is followed by debt financing and finally external equity financing.
- A theory that prioritizes the use of internal financing and consider the equity as
a last resort
- The following are the source of funding of the entity that applies the Pecking
order theory. (In order of priority)
1. Retained earnings
2. When RE is depleted, that is the time to issue bonds
3. When it is not good to issue more bonds, that is the time to issue shares
SIGNALING THEORY
- It is a theory that says “if managers have inside information, their choice of
capital structure will signal information to the market”
- A signal is a financing action by management that is believed to reflect its view
of the firm’s stock value; generally, debt financing is viewed as a positive signal
that management believes the stock is “undervalued,” and a stock issue is
viewed as a negative signal that management believes the stock is
“overvalued.”
Optimal Capital Structure
- The objectively best mix of debt, preferred stock, and common stock that
maximizes a firm’s value while minimizing the its cost of capital.
Value of the entity/Total Capital: Because the value of a firm equals the present value
of its future cash flows, it follows that the value of the firm is maximized when the
cost of capital is minimized.

Approaches in Optimal Capital Structure

- The goal of the financial manager is to maximize shareholder value.
OCP TECHNIQUES
EBIT-EPS Analysis
- An approach for selecting the capital structure that maximizes earnings per
share (EPS) over the expected range of earnings before interest and taxes
(EBIT).
- The mix with highest EPS is the optimal capital structure.
1. Common equity only
2. Common + Preferred equity
3. Common equity + long-term debt
4. Common + Preferred + Long-term Debt
Example: IT Really Hertz is contemplating on its capital structure. The finance
manager prepared the possible financing mix with expected return of 20% below for a
total funding of $ 1,000,000. Tax rate is at 35%.

Zero-Growth Valuation Model

- The value of the firm associated with alternative capital structures can be
estimated by using one of the standard valuation models, such as the zero-
growth model.
- Although some relationship exists between expected profit and value, there is
no reason to believe that profit-maximizing strategies necessarily result in
wealth maximization.
- It is therefore the wealth of the owners as reflected in the estimated share value
that should serve as the criterion for selecting the best capital structure.
Hamada Equation
- a fundamental analysis method of analyzing a firm's cost of capital as it uses
additional financial leverage, and how that relates to the overall riskiness of the
firm.
- The measure is used to summarize the effects this type of leverage has on a
firm's cost of capital—over and above the cost of capital as if the firm had no
Where:
debt. βL = Levered beta
βU = Unlevered beta
T = Tax rate
D/E = Debt to equity ratio*

Example: Samsan Tech has PHP 50,000,000 assets which has been purely financed
by equity. Its β is currently at 0.88. The company is planning to change its capital
structure with:
- PHP 10,000,000 debt; and
- PHP 40,000,000 equity.
Assuming the tax rate is 30%, calculate the new β.