Financial Management MGT201
MANAGEMENT OF CAPITAL STRUCTURE
After going through optimal capital structure theories, modifications made in them, applicability
of theses theories, impact of debt on value of firm and WACC, different principles to decide about
capital structure and different approaches to WACC calculation now we study the management of
Traditionalist Theory - Effect of Capital Structure on Firm Value & Share Price:
· As 100% Equity Firm Takes On More and More Debt (or Leverage):
Cost of Capital decreases (cost of debt is cheaper than equity), reaches a minimum
point, and then rises (excessive debt increases financial risk).
Total Market Value of Firm (V = D + E = Market Value of Debt + Market Value of
Equity) first rises (because of Interest Tax Shield savings), then reaches a maximum
point (optimal capital structure), and finally falls (because of excessive fall in Net
Income and Equity value because of interest payments).
Share Price (Po= Total Value / Original Number of Shares OR Equity value / Number
of Shares Outstanding) first rises, then reaches maximum (same point as maximum
Value), and finally falls. Follows same shape as Total Market Value of Firm. Share
Price is a measure of Firm Value.
Traditionalist Theory - Effect of Capital Structure on Earnings and Risk:
· As 100% Equity Firm Replaces More and More Equity with Debt (or Leverage):
Mean (or Expected) EBIT assumed to be unchanged although excessive debt can cause
it to rise because of higher operational costs because of financial distress
Mean EBT will fall because interest payments rise
Mean Net Income (or Earnings) generally falls continuously because interest payments
rise faster than any interest tax savings.
Mean Earnings Per Share (EPS = Net Income / Number of Shares outstanding)
generally first rises if number of shares falls if Equity is Replaced with Debt, then
reaches maximum (different capital structure mix from that which maximizes Value &
Share Price) , and finally falls (because interest payments grow faster). Similar shape to
Share Price Curve but reaches Maximum at a different Debt Ratio and Capital Structure.
For Optimizing Capital Structure, we should focus on Share Price and not EPS.
Earnings Risk (Variation or Standard Deviation) Increases because of Leveraging or
Magnifying effect of Debt. Debt increases Financial Distress and Risk of Bankruptcy.
And if Firm is financially unhealthy i.e. EBIT / Total Assets < Cost of Debt then small
fall in EBIT can lead to large fall in ROE.
Weaknesses of Capital Structure Mathematical Models:
Here are some of the rules of thumb or general principles financial managers keep in view while
deciding for capital structure of the company:
· Forecasting Errors
Changes in Cost of Debt and Equity (or Capitalization Rates) are unpredictable when
Debt Ratio is changing
Changes in EBIT are also difficult to correlate to changes in Debt or Capital Structure
· Share Price and EPS calculation is very sensitive to minor errors in the estimates.
· Focus on Corporate Finance is on Market Value (of Equity, Debt, and Stocks) BUT Market
Value may not be so important for Proprietorships and Private Ltd Companies where only a few
shareholders to whom the market value assessed by investors in the market is irrelevant.
· Fundamentally, Stock Prices should be fundamentally driven by Operating Decisions and Focus
on Improving Earnings and Cash Flows and NOT by manipulating Capital Structure. Capital
Structure and Corporate Financing can be used to fine tune the value.
Practical Capital Structure Management:
· Financial Stability and Conservatism vs. Real-time Capital Structure Optimization! Aim for
Target Capital Structure
· Long Run Viability vs. Short-term Stock Price Maximization
· Financial Ratio Targets
Financial Management MGT201
Coverage Ratio i.e. TIE (Times Interest Earned)
= EBIT / Interest. Higher (over 2.0) is better.
Long Term Debt / Total Capitalization Ratio - about 30%
FCC (Fixed Charge Coverage) = (EBIT - Lease Rental) / (Interest + Lease Rental +
Adjusted Sinking Fund Payment). Takes into account Fixed Financial Charges other
Maintain Reserve Borrowing Capacity (recall Signaling Theory) in case attractive Positive NPV
projects are found & also to give the right Signal to Market
use Debt to avoid giving away voting rights and control BUT Creditors can take control
if firm becomes insolvent or defaults
Corporate Raiders can take over a firm with large assets if debt is too low - using LBO
(Leveraged Buy Out). They convince shareholders to give them control in exchange for
higher share prices and EPS as a result of future leveraging.
Firms with (1) solid assets that can be mortgaged as security against a loan and (2) stable sales
and Operating Leverage can generally use debt more safely.
Retained Earnings: profitable firms have sizeable Cash and Retained Earnings. These are ideal
sources of capital because No transaction costs.
High Tax Bracket Firms: such firms have greater advantage in using debt because of large
Interest Tax Shield Savings.
Table of Contents: