1. Kevin Campbell, University of Stirling, October 2006
Capital structure
Issues:
 What is capital structure?
 Why is it important?
 What are the sources of capital available to a company?
 What is business risk and financial risk?
 What are the relative costs of debt and equity?
 What are the main theories of capital structure?
 Is there an optimal capital structure?

2. Kevin Campbell, University of Stirling, October 2006
What is “Capital Structure”?
 Definition
The capital structure of a firm is the mix of
different securities issued by the firm to
finance its operations.
Securities
 Bonds, bank loans
 Ordinary shares (common stock), Preference
shares (preferred stock)
 Hybrids, eg warrants, convertible bonds

3. Kevin Campbell, University of Stirling, October 2006
Financial
Structure
What is “Capital Structure”?
Balance Sheet
Current Current
Assets Liabilities
Debt
Fixed Preference
Assets shares
Ordinary
shares

4. Kevin Campbell, University of Stirling, October 2006
Capital
Structure
What is “Capital Structure”?
Balance Sheet
Current Current
Assets Liabilities
Debt
Fixed Preference
Assets shares
Ordinary
shares

5. Kevin Campbell, University of Stirling, October 2006
Sources of capital
 Ordinary shares (common stock)
 Preference shares (preferred stock)
 Hybrid securities
 Warrants
 Convertible bonds
 Loan capital
 Bank loans
 Corporate bonds

6. Kevin Campbell, University of Stirling, October 2006
Ordinary shares (common stock)
 Risk finance
 Dividends are only paid if profits are made
and only after other claimants have been paid
e.g. lenders and preference shareholders
 A high rate of return is required
 Provide voting rights – the power to hire and
fire directors
 No tax benefit, unlike borrowing

7. Kevin Campbell, University of Stirling, October 2006
Preference shares (preferred stock)
 Lower risk than ordinary shares – and a lower
dividend
 Fixed dividend - payment before ordinary
shareholders and in a liquidation situation
 No voting rights - unless dividend payments are
in arrears
 Cumulative - dividends accrue in the event that
the issuer does not make timely dividend
payments
 Participating - an extra dividend is possible
 Redeemable - company may buy back at a fixed
future date

8. Kevin Campbell, University of Stirling, October 2006
Loan capital
 Financial instruments that pay a certain
rate of interest until the maturity date
of the loan and then return the principal
(capital sum borrowed)
 Bank loans or corporate bonds
 Interest on debt is allowed against tax

9. Kevin Campbell, University of Stirling, October 2006
Seniority of debt
 Seniority indicates preference in position
over other lenders.
 Some debt is subordinated.
 In the event of default, holders of
subordinated debt must give preference
to other specified creditors who are paid
first.

10. Kevin Campbell, University of Stirling, October 2006 11
Security
 Security is a form of attachment to the
borrowing firm’s assets.
 It provides that the assets can be sold in
event of default to satisfy the debt for
which the security is given.

11. Kevin Campbell, University of Stirling, October 2006 11
Indenture
 A written agreement between the
corporate debt issuer and the lender.
 Sets forth the terms of the loan:
 Maturity
 Interest rate
 Protective covenants

e.g. financial reports, restriction on further
loan issues, restriction on disposal of assets
and level of dividends

12. Kevin Campbell, University of Stirling, October 2006 11
Warrants
 A warrant is a certificate entitling the holder
to buy a specific amount of shares at a specific
price (the exercise price) for a given period.
 If the price of the share rises above the
warrant's exercise price, then the investor can
buy the security at the warrant's exercise
price and resell it for a profit.
 Otherwise, the warrant will simply expire or
remain unused.

13. Kevin Campbell, University of Stirling, October 2006 11
Convertible bonds
 A convertible bond is a bond that gives the
holder the right to "convert" or exchange the
par amount of the bond for ordinary shares of
the issuer at some fixed ratio during a
particular period.
 As bonds, they provide a coupon payment and
are legally debt securities, which rank prior to
equity securities in a default situation.
 Their value, like all bonds, depends on the level
of prevailing interest rates and the credit
quality of the issuer.
 Their conversion feature also gives them
features of equity securities.

14. Kevin Campbell, University of Stirling, October 2006 11
The Cost of Capital
Expected Return
Risk premium
Risk-free rate
Time value of money
________________________________________________________
______
Risk
Treasury Corporate Preference Hybrid
Bonds Bonds Shares Securities
Ordinary
Shares

15. Kevin Campbell, University of Stirling, October 2006 11
Measuring capital structure
 Debt/(Debt + Market Value of Equity)
 Debt/Total Book Value of Assets
 Interest coverage: EBITDA/Interest

16. Kevin Campbell, University of Stirling, October 2006 11
Selected leverage data for
US corporations
Company Debt/Debt
+MVE
Debt/Book
Assets
EBITDA /
Interest
Delta Air 53% 32% 1.1
Disney 9 20 14.1
GM 61 37 3.0
HP 13 17 21.7
McDon's 15 31 7.2
Safeway 55 53 3.1

17. Kevin Campbell, University of Stirling, October 2006 11
Interpreting capital structures
 The capital structures we observe are
determined both by deliberate choices and by
chance events
 Safeway’s high leverage came from an LBO
 HP’s low leverage is the HP way
 Disney’s low leverage reflects past good
performance
 GM’s high leverage reflects the opposite

18. Kevin Campbell, University of Stirling, October 2006 11
 Capital structures can be changed
 Leverage is reduced by
 Cutting dividends or issuing stock
 Reducing costs, especially fixed costs
 Leverage increased by
 Stock repurchases, special dividends, generous wages
 Using debt rather than retained earnings
Interpreting capital structures

19. Kevin Campbell, University of Stirling, October 2006 11
Business risk and Financial risk
 Firms have business risk generated by
what they do
 But firms adopt additional financial risk
when they finance with debt

20. Kevin Campbell, University of Stirling, October 2006 22
Risk and the Income Statement
Sales
Operating – Variable costs
Leverage – Fixed costs
EBIT
– Interest expense
Financial Earnings before taxes
Leverage – Taxes
Net Income
EPS = Net Income
No. of Shares

21. Kevin Campbell, University of Stirling, October 2006 22
Business Risk
 The basic risk inherent in the operations
of a firm is called business risk
 Business risk can be viewed as the
variability of a firm’s Earnings Before
Interest and Taxes (EBIT)

22. Kevin Campbell, University of Stirling, October 2006 22
Financial Risk
 Debt causes financial risk because it
imposes a fixed cost in the form of
interest payments.
 The use of debt financing is referred to
as financial leverage.
 Financial leverage increases risk by
increasing the variability of a firm’s
return on equity or the variability of its
earnings per share.

23. Kevin Campbell, University of Stirling, October 2006 22
Financial Risk vs. Business Risk
 There is a trade-off between financial risk and
business risk.
 A firm with high financial risk is using a fixed
cost source of financing. This increases the
level of EBIT a firm needs just to break even.
 A firm will generally try to avoid financial risk
- a high level of EBIT to break even - if its
EBIT is very uncertain (due to high business
risk).

24. Kevin Campbell, University of Stirling, October 2006 22
Why should we care about
capital structure?
 By altering capital structure firms have
the opportunity to change their cost of
capital and – therefore – the market value
of the firm

25. Kevin Campbell, University of Stirling, October 2006 22
What is an optimal capital structure?
 An optimal capital structure is one that
minimizes the firm’s cost of capital and
thus maximizes firm value
 Cost of Capital:
 Each source of financing has a different cost
 The WACC is the “Weighted Average Cost of
Capital”
 Capital structure affects the WACC

26. Kevin Campbell, University of Stirling, October 2006 22
Capital Structure Theory
 Basic question
 Is it possible for firms to create value by
altering their capital structure?
 Major theories
 Modigliani and Miller theory
 Trade-off Theory
 Signaling Theory

27. Kevin Campbell, University of Stirling, October 2006 22
Modigliani and Miller (MM)
 Basic theory: Modigliani and
Miller (MM) in 1958 and 1963
 Old - so why do we still study
them?
 Before MM, no way to analyze
debt financing
 First to study capital structure
and WACC together
 Won the Nobel prize in 1990

28. Kevin Campbell, University of Stirling, October 2006 22
Modigliani and Miller (MM)
 Most influential papers ever published
in finance
 Very restrictive assumptions
 First “no arbitrage” proof in finance
 Basis for other theories

29. Kevin Campbell, University of Stirling, October 2006 22
 Debt versus Equity
 A firm’s cost of debt is always less than its
cost of equity

debt has seniority over equity

debt has a fixed return

the interest paid on debt is tax-deductible.
 It may appear a firm should use as much debt
and as little equity as possible due to the
cost difference, but this ignores the
potential problems associated with debt.
A Basic Capital Structure Theory

30. Kevin Campbell, University of Stirling, October 2006 33
A Basic Capital Structure Theory
 There is a trade-off between the
benefits of using debt and the costs of
using debt.
 The use of debt creates a tax shield benefit
from the interest on debt.
 The costs of using debt, besides the obvious
interest cost, are the additional financial
distress costs and agency costs arising from
the use of debt financing.

31. Kevin Campbell, University of Stirling, October 2006 33
Summary
 A firm’s capital structure is the proportion of a
firm’s long-term funding provided by long-term debt
and equity.
 Capital structure influences a firm’s cost of capital
through the tax advantage to debt financing and the
effect of capital structure on firm risk.
 Because of the tradeoff between the tax advantage
to debt financing and risk, each firm has an optimal
capital structure that minimizes the WACC and
maximises firm value.

32. Kevin Campbell, University of Stirling, October 2006 33
Is there magic in financial leverage?
 … can a company increase its value
simply by altering its capital structure?
 …yes and no
 …we will see….