5. Chapter Capital Structure

• A firm’s optimal capital structure is defined as the structure that would maximize its stock price.

• In practice we tend to think of the optimal capital structure more as a range.

The expected optimal structure of equity and debt (risk and return)

• Using more debt will raise the risk borne by stockholders.

• However, using more debt generally increases the expected return on equity.

• The higher risk associated with more debt tends to lower the stock’s price

• the higher debt-induced expected rate of return raises it.

• Business risk

  • or the riskiness inherent in the firm’s operations if it used no debt. The greater the firm’s business risk, the lower its optimal debt ratio

• Tax position

  • A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt

• Financial flexibility

  • the ability to raise capital on reasonable terms under adverse conditions

• Conservatism or agressiveness

  • influence the firm’s target capital structure.

• If the company has no debt the ROA is the same as the ROE

• Business risk varies from industry to industry and also among firms in a given industry. Further, business risk can change over time. It depends on

  
  

  • Demand variability

  • Sales price variability

  • Input cost variability

  • Ability to adjust output prices for changes in input costs

  • Ability to develop new products in a timely, cost-effective manner

  • Foreign risk exposure

  • The extent to which costs are fixed: operating leverage

• if tax rate will be low, hence additional debt would not be as advantageous as it would be to a firm with a higher effective tax rate. Because it is not tax reductable.

• Financial risk is the additional risk placed on the common stockholders as a result of the decision to finance with debt (apply financial leverage).

• Conceptually, stockholders face a certain amount of risk that is inherent in the firm’s operations, its business risk.

• If a firm uses debt (financial leverage), this concentrates the business risk on common stockholders.

• The optimal capital structure is the one that maximizes the price of the firm’s stock

• and this generally calls for a debt ratio that is lower than the one that maximizes expected EPS.

• the capital structure that maximizes the stock prices also minimiies the WACC