CAPITAL

STRUCTURE
ANALYSIS
Chapter 14
CHAPTER 14 OBJECTIVES
Describe the advantages and
disadvantages of financial leverage.
Compute the financial leverage index,
debt to capital ratio, debt to equity
ratio, and other techniques for analyzing
capital structure.
Relate capital structure composition to
owner and creditor investment
objectives.
CHAPTER 14 OBJECTIVES
(CONT.)
Discuss the various types of risks
and their role in capital structure
analysis.
Present a preliminary capital
structure analysis for a company or
industry.
OBJECTIVE FOR ANALYZING CAPITAL
STRUCTURE

To determine if the proportion of

debt to equity enables an entity to
create wealth without unduly
jeopardizing the firm
OBJECTIVE FOR ANALYZING CAPITAL
STRUCTURE (CONT.)

Capital structure composition

Consists of long-term liabilities, preferred
stock, common stock, and retained
earnings.
Sufficient equity must exist to provide
financial stability
Debt can be used as leverage to increase
returns to shareholders, but it can also
reduce returns on shareholders
investments
FINANCING ACTIVITIES
The balance sheet
Reports how funds are acquired and
allocated
Current assets are financed with current
obligationsnot a factor in capital structure
analysis
Long-term debt and equity finance long-
term assetsassessing the pros and cons of
these financing factors is the essence of
capital structure analysis
FINANCING ACTIVITIES
(CONT.)
Capital structure valuation
Long-term liabilities are reported at the
present value of expected cash flows
Current liabilities are not adjusted for the time
value of money
Contributed capital is reported at the
historical proceeds received from selling stock
Retained earnings are reported as a summary
of all of the valuation methods used to
measure income
FINANCING ACTIVITIES
(CONT.)
Equity
investments are an entitys
permanent financing, representing
The ultimate risk capital
Insulation of the firm from random
business shocks
A margin of safety to debt investors
The right to a return on investment
only after the other claimants have
been satisfied
FINANCING ACTIVITIES
(CONT.)
Long-term debt investments represent
Fixed contractual obligations
Payable at specific times in specified amounts
Returns on investment that are tax deductible
Short-term debt obligations
Arise from the normal course of business
operations
Are liquidated with cash from current assets
Excluded from capital structure analysis
FINANCIAL LEVERAGE
The substitution of fixed-charge financing
for variable-cost (dividend) equity financing
Financial leverage concepts
The traditional view is that an optimal mix of
debt and equity exists
Research demonstrated that the mix of debt and
equity is irrelevant, if taxes are ignored
The tax deductibility of interest expense creates
an advantage for incurring debt (Exhibit 14-1)
FINANCIAL LEVERAGE
(CONT.)
Theadvantage of debt only exists
up to a point (Exhibits 14-2A and
14-2B)
Low cost debt increases ROE relative
to ROA
Debt can become so costly that it
reduces ROE below ROA
FINANCIAL LEVERAGE
(CONT.)
The financial structure leverage
ratio
Is computed as: average total assets /
average common shareholders equity
Produces a ratio of greater than one,

which implies debt is always

advantageous (so long as a positive
profit margin exists)
FINANCIAL LEVERAGE
(CONT.)
Financial leverage index
Is computed as adjusted return on equity /
adjusted return on assets
Superior to the financial structure leverage
ratio because it factors in the adjusted rates
of return in the computation
An index in excess of one means ROE exceeds
ROA; a favorable use of debt financing
An index of less than one is bad; ROA exceeds
ROE; an unfavorable use of debt financing
RISK ANALYSIS
Riskis the possibility of losing
something of value
Credit risk
The possibility that an entity will not
be able to meet debt payment
obligations on time
RISK ANALYSIS (CONT.)
Capital structure influences credit
risk
A firm with a conservative capital
structure is a low credit risk
because it has
small amount of debt
low fixed cost commitments

a low default probability

RISK ANALYSIS (CONT.)
Business risk
Fluctuations in earnings and cash flow,
due to
Changes in the economy
Industry-specific conditions

A high degree of leverageleveraged

firms have greater exposure to business

risk than conservatively structured
entities
RISK ANALYSIS (CONT.)
Bankruptcy risk
Extreme case of credit risk, whereby a
firm may be unable to continue as a
going concern
Financial distress, or the difficulty in
meeting maturing obligations, is the
first sign of bankruptcy risk
A company in financial distress might
file for bankruptcy protection
RISK ANALYSIS (CONT.)
A bankrupt firm
Losses autonomy in conducting its operations
Has a court suspend its creditors claims
Can have its debts rearranged, reduced, or
eliminated with the mutual consent of the
company, creditors, and court
Will liquidate, or go out of business, if
continuing operations is not a viable option

RISK ANALYSIS (CONT.)
Comprehensive risk
The equity markets determination
of risk
Is a function of systematic risk
Is inherent in investing

Cannot be eliminated through

investment diversity
RISK ANALYSIS (CONT.)
Beta measures of systematic risk
Is the extent to which a stock moves
with the overall market
In a range from 1.0 to +1.0

With an interpretation that he higher

the beta, the greater a stocks
variability
CAPITAL STRUCTURE
MEASURES
Capital structure composition
Financing activities should
correspond to investing activities
Short-term creditors finance current
assets
Long-term investors finance long-term
assets
CAPITAL STRUCTURE
MEASURES (CONT.)
Lack of correspondence signals financial
distress
Long-term borrowing cannot be used to
finance operations indefinitely
Cash from operations should satisfy working
capital operations
Common size statements
Provide insights between current and long-
term financing sources and investments
Must be considered in conjunction with life
cycle stage
DEBT TO CAPITAL RATIOS
Provide insight about the
proportion of debt to equity
financing
Total debt to total capital
Measures the percentage of assets
financed with debt
Is computed as: average total debt /
average total assets
DEBT TO CAPITAL RATIOS
(CONT.)
Total debt to total equity
Measures debt financing as a
percentage of total financing
Is computed as: average total debt /
average total shareholders equity
DEBT TO CAPITAL RATIOS
(CONT.)
Long-term debt to total capital
Measures the percentage of assets
financed with long-term debt
Eliminates current obligations from
the ratio because they are paid with
maturing current assets
Is computed as: average long-term
debt / average total assets
DEBT TO CAPITAL RATIOS
(CONT.)
Total long-term debt to total equity
Measures long-term debt financing as a
percentage of total financing
Eliminates current obligations from the

ratio because they are paid with

maturing current assets
Is computed as: average long-term

debt / average total shareholders

equity
DEBT TO CAPITAL RATIOS
(CONT.)
Earnings coverage ratio
Measures the extent to which an entity can
meet its fixed charges
Is known as the times interest earned ratio,
which is a simplified version of earnings
coverage
Times interest earned is computed as: operating
income before interest and taxes / interest
expense
It is acceptable substitute for earnings coverage
so long as accrual numbers approximate
required cash payments for fixed changes
DEBT TO CAPITAL RATIOS
(CONT.)
Bankruptcy prediction
Mathematical models that provide information
about an entitys bankruptcy probability
The Z-score is an accepted measure of
bankruptcy prediction
Computed as a function of five weighted ratios
Z-scores above 3.0 indicate little probability of
bankruptcy
Those below 1.81 indicate a high possibility of
bankruptcy
Scores between 1.81 and 3.0 are inconclusive
eSTUFFS CAPITAL
STRUCTURE
Capital Structure Ratios
RATIOS2003 2002 2001
Debt to capital 0.35 0.37 0.39
Debt to equity 0.53 0.58 0.63
Long-term debt to capital 0.19 0.25 0.21
Long-term debt to equity 0.29 0.40 0.34
Earnings coverage 0.25 2.95 2.75
Working capital/total assets-Z1 0.67 0.61 0.38
Retained earnings/total assets-Z2 0.10 0.09 0.06
EBIT/total assets-Z3 0.02 0.22 0.22
Revenues/total assets-Z4 1.52 1.42 1.49
Market equity/book liabilities-Z5 0.28 1.29 1.88
Total Z-score 2.59 3.63 4.03
CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY

New economy capital structure

Venture capital and retained
earnings financed PC firms
productive resources
Little long-term debt
CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY (CONT.)
Capital structure measures
Apple and Dell carried more debt than
Compaq or Gateway during the period
analyzed (Exhibit 14-7A)
Dell used debt to increase its returns on
equity
Apple acquired debt (and preferred stock) to
bolster its insufficient cash from earnings
and replenish its depleted equity base,
which was reduced by its net losses
 PC Industry
Debt as a Percentage of Equity

250%

200%
Debt/Equity

150%

100%

50%

0%
1994 1995 1996 1997 1998

Apple Compaq Dell Gateway

 PC Industry
Financial Leverage Indexes
(cumulative 1994-1998)

2
Financial Leverage Index

0
Apple Compaq Dell Gateway
-1

-2

-3
CAPITAL STRUCTURE ANALYSIS AND
THE PC INDUSTRY (CONT.)

Long-term debt provided an

relatively small amount of
financing for all four firms (Exhibit
14-7B)
Debt as a proportion of total assets
and equity was relatively stable
during the period examined
(Exhibits 14-8A and 14-8B)
 PC Industry
Long-Term Debt as a Percentage of Total Assets

Apple Compaq
Long-
Long- Term
Term Debt
Debt 3%
12%

Current Current
Debt & Debt &
Equity Equity
88% 97%

Dell Gatew ay

Long- Long-
Term Term
Debt Debt
4% 8%

Current Current
Debt & Debt &
Equity Equity
96% 92%