Tute 12: capital structure policy

  1. Optimal capital structure
    The capital structure that minimises the cost of financing a company's activities.
  2. M & M proposition 1
    • States that capital structure will have no effect on the value of the company if 
    • 1. there is no tax
    • 2. There is no information or transaction cost
    • 3. The real investment policy of the company is not affected by its capital structure decisions.
    • (if no one other than shareholders and debtholders are getting slice of pie)

    In perfect financial markets (markets in which th 3 conditions specified hold) investors can make changes in their own investment accounts that eill replicate the cash flows for any capital structure that the company's management might choose or desire.
  3. M & M proposition 2
    • The required rate of return on the company's equity (cost of equity) increases as the company's debt to equity ratio increases. 
    • Debt increases financial risk because debt holders get first claim. 
    • FInancial risk magnifies the effect of the operating leverage on profit.
  4. Benefits of tax
    • Tax shield
    • Less expensive to issue debt than shares. As shares require underwriting spreads and out of pocket costs. 
    • Debt provides managers incentives to maximise cash flow. BEcause interest must be paid when due whereas dividends are not.
  5. costs of debt (disadvantages)
    • Insolvency costs: costs associated with financial difficulties a company might experience because it uses debt financing. 
    • Direct insolvency costs: out of pocket costs that a company incurs when it gets into financial distress. 
    • eg. fees paid to lawyers, accountants, consultants. 
    • Lawyers used to negotiate deferring interest payments. 
    • Accounts used to satisfy extra info needs and figure out what went wrong. 
    • Consultants may be hired to implement changes in business. 
    • This is a form of transaction cost. 

    • Indirect insolvency costs: costs associated with changes in the behaviour of people who deal with a company when the company gets into financial distress. 
    • Eg. customers no longer buy product in fear of warranty not being fulfilled. Customers may demand lower prices. This will lower revenue below what it woud've been. 
    • Suppliers wanting cash on delivery. If no cash available, less stock available to customers and will deter customers. 
    • Employee productivity decreases and loss of skill.
    • Transaction costs that would not exist in MM

    • Agency costs:
    • Shareholder-manager: debt may cause them to make more conservative decisions. 
    • Has effect on real investment policy from MM
    • shareholder lender agency cost:
  6. Tho theories of capital structure
    • Trade off theory: the theory that managers trade off the benefits against the costs of using debt to identify the optimal capital structure for a company. 
    • Pecking order theory: the theory that in fianncing projects, managers first use retained earnings, which they view as the least expensive from of capital, then debt and finally externally raised equity, which they view as the most expensive.
  7. Practical considerations in choosing capital structure
    Financial flexibility: important consideration. Managers must ensure that they retain sufficient financial recources in the company to take advantage of unexpected opportunities and overcome unforeseeable problems. 

    • Managers also concerned with impact of financial leverage on the volatility of the company's earnings. Fluctuations in operating profits is magnified by higher fixed costs such as interest. 
    • MIght also affect how important they think accounting earnings are. 

    Control implications: founding family would prefer debt to avoid losing control however debt may lead to loss of control over business due to financial distress.
  8. Practical considerations in choosing capital structure
    • Financial flexibility: Managers must minimise the company’s cost of capital while also ensuring that the company has the flexibility to raise new capital quickly to deal with unexpected problems or to take advantage of unexpected opportunities.
    • 2. Profit Risk: Increasing the leverage of a company increases the risk associated with a company’s profit, and the risk of default.
    • 3. Earnings impact: When a project is financed with debt, the interest payments reduce the accounting dollar value of net income. However, when debt is used, no new shares of equity are issued, so the company’s earnings per share would be expected to increase (given a positive-PV project). Although financial theory suggests that neither of these effects should matter, managers often take them into account when making financing decisions.
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Tute 12: capital structure policy
Tute 12: capital structure policy