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Financial Management ­ MGT201
VU
Lesson 36
MANAGEMENT OF CAPITAL STRUCTURE
Learning objectives:
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
capital structure:
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
154
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Financial Management ­ MGT201
VU
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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
than Interest
·
Maintain Reserve Borrowing Capacity (recall Signaling Theory) in case attractive Positive NPV
projects are found & also to give the right Signal to Market
·
Management Control
­  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.
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Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios