Financial Leverage And Capital Structure Policy - Introduction To Financial Leverage And Capital Structure Policy

Capital structure, the mixture of a firm's debt and equity, is important because it costs a company money to borrow. Capital structure also matters because of the different tax implications of debt vs. equity and the impact of corporate taxes on a firm's profitability. Firms must be prudent in their borrowing activities to avoid excessive risk and the possibility of financial distress or even bankruptcy. A firm's debt-to-equity ratio also impacts the firm's borrowing costs and its value to shareholders. The debtto-equity ratio is a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the

additional interest expense. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. Insufficient returns can lead to bankruptcy and leave shareholders with nothing. The debt/equity ratio also depends on the industry in which the company operates. For example, capitalintensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies tend to have a debt/equity ratio of under 0.5. (Read more in Spotting Companies In Financial Distress and Debt Ratios: Introduction.) A company can change its capital structure by issuing debt to buy back outstanding equities or by issuing new stock and using the proceeds to repay debt. Issuing new debt increases the debt-to-equity ratio; issuing new equity

lowers the debt-to-equity ratio. As you will recall from Section 13 of this walkthrough, minimizing the weighted average cost of capital (WACC) maximizes the firm's value. This means that the optimal capital structure for a firm is the one that minimizes WACC. In this section, we'll go into the details of a firm's capital structure, financial leverage, the optimal capital structure and real-world capital structures. We'll also talk about financial distress and bankruptcy, and Modigliani and Miller's ideas about capital structure and firm value when taking corporate taxes into account.

Capital Structure
For stock investors that favor companies with good fundamentals, a strongbalance sheet is an important consideration for investing in a company's stock. The strength of a company' balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure. In this section, we'll consider the importance of capital structure. A company's capitalization (not to be confused with market capitalization) describes its composition of

permanent or long-term capital, which consists of a combination of debt and equity. A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt and a corresponding high level of equity is a very positive sign of financial fitness. (Learn about market capitalization in Market Capitalization Defined.) Clarifying Capital Structure-Related Terminology The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's capitalization and acts as a permanent type of funding to support a company's growth and related assets. A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities. Investors should understand that there is a difference between operational and debt liabilities - it is the latter that forms the debt component of a company's capitalization. That's not the end of the debt story,

however. Among financial analysts and investment research services, there is no universal agreement as to what constitutes a debt liability. For many analysts, the debt component in a company's capitalization is simply a balance sheet's long-term debt. However, this definition is too simplistic. Investors should stick to a stricter interpretation of debt where the debt component of a company's capitalization should consist of the following: short-term borrowings (notes payable), the current portion of long-term debt, long-term debt, and two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock. Using a comprehensive total debt figure is a prudent analytical tool for stock investors. Capital Ratios and Indicators In general, analysts use three different ratios to assess the financial strength of a company's capitalization structure. The first two, the debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position. The debt ratio compares total liabilities to total assets.

Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and noncurrent operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities. The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt plus the total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt. (To continue reading about ratios, see Debt Reckoning.) Additional Evaluative Debt-Equity Considerations Funded debt is the technical term applied to the portion of a company's long-term debt that is made up of bonds and other similar long-term, fixed-maturity types of borrowings. No matter how problematic a company's

financial condition may be, the holders of these obligations cannot demand immediate and full repayment as long the company pays the interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses and/or covenants that allow the lender to call its loan. From the investor's perspective, the greater the percentage of funded debt to total debt, the better. Funded debt gives a company more wiggle room. Factors That Influence a Company's CapitalStructure Decision The primary factors that influence a company's capitalstructure decision are as follows: 1. Business Risk Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has less risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail

apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure [E1] in both good times and bad. 2. Company's Tax Exposure Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes. 3. Financial Flexibility Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times and avoid stretching their capabilities too far. The lower a company's debt level, the more financial flexibility a company has.

Let's take the airline industry as an example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top. (Learn more about this industry in Dead Airlines And What Killed Them and 4 Reasons Why Airlines Are Always Struggling.) 4. Management Style Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company'searnings per share (EPS). 5. Growth Rate Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable

and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as their revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise. 6. Market Conditions Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning that investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant. (Read more about market conditions in The Cost Of Unemployment To The Economy and Betting On The Economy: What Are The Odds?)

Financial Leverage
Financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the

higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share. Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company. (Learn more about leverage in ETFs: Losing At Leverage and 5 Ways Debt Can Make You Money.) Degree of Financial Leverage The formula for calculating a company's degree of financial leverage (DFL) measures the percentage change in earnings per share over the percentage change in EBIT. DFL is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt. Formula: DFL = percentage change in EPS or EBIT

percentage change in EBIT EBIT-interest

A shortcut to keep in mind with DFL is that if interest is 0, then the DLF will be equal to 1. Example: Degree of Financial Leverage With Newco's current production, its sales are $7 million annually. The company's variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annual interest expense is $100,000. If we increase Newco's EBIT by 20%, how much will the company's EPS increase? Calculation and Answer: The company's DFL is calculated as follows: DFL = ($7,000,000-$2,800,000$2,400,000)/($7,000,000-$2,800,000-$2,400,000$100,000) DFL = $1,800,000/$1,700,000 = 1.058

Modigliani And Miller's Capital Structure Theories

Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect

markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends. The basic M&M proposition is based on the following key assumptions:

No taxes No transaction costs No bankruptcy costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same information No effect of debt on a company's earnings before interest and taxes

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries and effects of debt on earnings. To understand how the M&M proposition works after factoring in corporate taxes, however, we must first understand the basics of M&M propositions I and II without taxes.

Modigliani and Miller's Capital-Structure Irrelevance Proposition The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this simplified view, the weighted average cost of capital (WACC) should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC. Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price. However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs. Modigliani and Miller's Tradeoff Theory of Leverage The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments - that is, because interest paid on debt is tax deductible, issuing bonds

effectively reduces a company's tax liability. Paying dividends on equity, however, does not. Thought of another way, the actual rate of interest companies pay on the bonds they issue is less than the nominal rate of interest because of the tax savings. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal. (Learn more about corporate tax liability in How Big Corporations Avoid Big Tax Bills and Highest Corporate Tax Bills By Sector.) In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure, which comes from the tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes, and thus the tax benefit of interest payments, are recognized. In summary, the MM I theory without corporate taxes says that a firm's relative proportions of debt and equity don't matter; MM I with corporate taxes says that the firm with the greater proportion of debt is more valuable because of the interest tax shield. MM II deals with the WACC. It says that as the proportion

of debt in the company's capital structure increases, its return on equity to shareholders increases in a linear fashion. The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company's stock. However, because the company's capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction and thus concludes that changes in the debt-equity ratio do affect WACC. Therefore, a greater proportion of debt lowers the company's WACC.

Bankruptcy Costs And Optimal Capital Structure

Bankruptcy Costs M&M II might make it sound as if it is always a good thing when a company increases its proportion of debt relative to equity, but that's not the case. Additional debt is good only up to a certain point because of bankruptcy costs.

Bankruptcy costs can significantly affect a company's cost of capital. When a company invests in debt, the company

is required to service that debt by making required interest payments. Interest payments alter a company's earnings as well as cash flow.

For each company there is an optimal capital structure, including a percentage of debt and equity, and a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender.

The risk of bankruptcy increases with the increased debt load. Since the cost of debt becomes higher, the WACC is thus affected. With the addition of debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increased debt load will then cause the WACC to increase significantly. (Read more about bankruptcy in Not Too Big To Fail: Corporate Financial Struggles and An Overview Of Corporate Bankruptcy.)

Optimal Capital Structure Is there an optimal debt-equity relationship? In financial terms, debt is a good example of the proverbial twoedged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expenses and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments. (For more stories on company debt loads, see Will Corporate Debt Drag Your Stock Down? and Burn Rate Key Factor In Company's Sustainability.) A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.

Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels. (Read about personal debt in What's Your Debt Really Costing You? and Debt Settlement Arrangements And Your Credit Score.)

What Is the Optimal Capital Structure? As we have seen, some debt is often better than no debt, but too much debt increases bankruptcy risk. In technical terms, additional debt lowers theweighted average cost of capital. Of course, at some point, additional debt becomes too risky. The optimal capital structure, the ideal ratio of long-term debt to total capital, is hard to estimate. It depends on at least two factors, but keep in mind that the following are general principles:

First, optimal capital structure varies by industry, mainly because some industries are more asset-intensive than others. In very general terms, the greater the investment in fixed assets (plant, property and equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Industries that require a great deal of plant investment, such as telecommunications, generally use more long-term debt.

Second, capital structure tends to track with the company's growth cycle. Rapidly growing startups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments in favor of future price returns. These companies are considered growth stocks. High-growth companies do not need to give these shareholders cash today; however lenders would expect semi-annual or quarterly interest payments.

In summary, the optimal capital structure is the mix of debt, preferred stock and common equity that will

optimize the company's stock price. As a company raises new capital it will focus on maintaining this optimal capital structure.