Capital Structure, Dividends and Share Repurchases

There is usually more to lose than to gain when making a decision in this area.

Managers should manage capital structure with the goal of not destroying value as opposed to trying to create value.

There are three components of a company's financial decisions:

1. how much to invest,
2. how much debt to have, and 
3. how much cash to return to shareholders.

Choices concerning capital structure

Managers have many choices concerning capital structure, for example,

1. using equity,
2. straight debt,
3. convertibles and
4. off-balance-sheet financing.

Managers can create value from using tools other than equity and straight debt under only a few conditions.

Even when using more exotic forms of financing like convertibles and preferred stock, fundamentally it is a choice between debt and equity.




Debt and Equity Financial Choices trade-offs

Managers must recognise the many trade-offs to both the firm and investors when choosing between debt and equity financing.

The firm increases risk but saves on taxes by using debt; however, investing in debt rather than equity probably increases the tax liability to investors.

Debt has been shown to impose a discipline on managers and discourage over investment, but it can also lead to business erosion and bankruptcy.

Higher debt increases the conflicts among the stakeholders.




Credit rating is a useful indicator of capital structure health

Most companies choose a capital structure that gives them a credit rating between BBB- and A+, which indicates these are effective ratings and capital structure does not have a large effect on value in most cases.

The capital structure can make a difference for companies at the far end of the coverage spectrum.

Credit ratings

• are a useful summary indicator of capital structure health and 
• are a means of communicating information to shareholders.

The two main determinants of credit ratings are

• size and 
• interest coverage.

Two important coverage ratios are

• the EBITA to interest ratio and 
• the debt to EBITA ratio.

The former is a short-term measure, and the latter is more useful for long-term planning.




Methods to manage capital structure

Managers must weight the benefits of managing capital structure against

• the costs of the choices and 
• the possible signals the choices send to investors.

Methods to manage capital structure include

• changing the dividends, 
• issuing and buying back equity, and
• issuing and paying off debt

When designing a long-term capital structure, the firm should

• project surpluses and deficits, 
• develop a target capital structure, and 
• decide on tactical measures.  

The tactical, short-term tools include

• changing the dividend,
• repurchasing shares, and 
• paying an extraordinary dividend.

Cost of Equity and Investors' Required Rates of Return

You should think about the cost of equity as the minimum expected rate of return that a company must offer investors to purchase its shares in the primary market and to maintain its share price in the secondary market.

If the required rate of return is not maintained, the price of the security in the secondary market will adjust to reflect the minimum rate of return required by investors.

If investors require a higher return than the company's cost of equity, they will sell the company's shares and invest elsewhere, which would bring down the company's stock price.

This decline in the stock price will lead to an increase in the expected return on equity and bring it in line with the (higher) required rate of return.

Investors' Minimum Required Rates of Return, Cost of Debt and Cost of Equity

A company may raise capital by issuing

• debt or 
• equity, 

Both of which have associated costs.



Investors' Minimum Required Rates of Return

Investors' minimum required rates of return refer to the return they require for providing funds to the company.



Cost of Debts

A company's cost of debt is easy to estimate as it is reflected in the interest payments that the company is contractually obligated to make to debt holders.

For investors who provide debt capital to the company, their minimum required rate of return is the periodic interest rate they charge the company for using their funds.

All providers of debt capital receive the same interest rate.

Therefore, the company's cost of debt and investor's minimum required rate of return on debt are the same.



Cost of Equity

Estimating cost of equity is difficult because the company is not contractually obligated to make any payments to common shareholders.

For investors who provide equity capital tot he company, the future cash flows that they expect to receive are uncertain (in both timing and amount), so their minimum required rate of return must be estimated.

Further, each investor may have different expectations regarding future cash flows.

Therefore, the company's cost of equity may be different from investors' minimum required rate of return on equity.





Additional notes:

The company's cost of equity can be estimated using the dividend discount model (DDM) and capital asset pricing model (CAPM).

The costs of debt and equity are used to estimate a company's weighted average cost of capital (WACC), which represents the minimum required rate of return that the company must earn on its investments.

Financing a capital project with equity may be a signal to investors that a company's prospects are not good.

Corporate Finance - Signaling Prospects Through Financing Decisions

One of the key assumptions Modigliani and Miller make in their work is that market information is symmetric, meaning companies and investors have the same information with respect to the company's future projects/investments. This assumption, however, is not realistic. When making capital decisions, a company's management should have more information than an investor, which implies asymmetric information. 

A financing decision is a way in which a company can inadvertently signal its prospects to investors. For example, suppose Newco decides to finance a new project with equity. Newco's additional equity would in fact dilute stockholder value. Since companies typically try to maximize stockholder value, would an equity offering be a bad signal? The answer is yes.

There would be some benefit from the project to the stockholders; however, the dilution from the offering would offset some of that benefit. If a company's prospects are good, management will finance new projects with other means, such as debt, to avoid giving any negative signals to the market. 

Look Out!Financing a capital project with equity may be a signal to investors that a company's prospects are not good.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/signaling-prospects-financing-decisions.asp#ixzz1yhFwj3bz

Corporate Finance - Factors that Influence a Company's Capital-Structure Decision

The primary factors that influence a company's capital-structure decision are:

1.Business risk
2.Company's tax exposure
3.Financial flexibility
4. Management style
5.Growth rate
6.Market Conditions

1.Business RiskExcluding 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 in both good times and bad.

2.Company's Tax ExposureDebt 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 FlexibilityThis 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, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has.

The airline industry is a good 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.

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's earnings per share (EPS).

5.Growth RateFirms that are in the growth stage of their cycle typically finance that growth through debt, 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 its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.

6.Market ConditionsMarket 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 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: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/capital-structure-decision-factors.asp#ixzz1yevRPv00

Speculative-Growth Stocks - What Has Growth Done to the Balance Sheet?

Like most speculative-growth companies, Yahoo in 1999 doesn't generate enough cash internally to pay for an aggressive expansion.

It must look outside for capital - either by borrowing or by issuing stock in the equity markets.

Given the market's ravenous appetite for Internet stocks over the late 90s, Yahoo has understandably financed most of its expansion with equity.

It had its initial public offering in 1996, and since then it has issued stock to pay for its many acquisitions.

It has little long-term debt, which means it doesn't have to worry about interest payments.

Overall, its balance sheet looks very healthy.

In contrast, Amazon.com AMZN, another highly successful Internet company, has borrowed over $2 billion and is highly leveraged in 1999.

Sources of Finance for financing growth

WHAT CHOICES DO YOU HAVE TO RAISE FUNDS?

1.  DEBT FINANCING involves a loan that will accumulate future interest.
2.  EQUITY FINANCING involves accepting a lump sum in exchange for selling the future benefits and profits of your business to investors.

WHAT MIX OF DEBT/EQUITY IS USED IN A BUSINESS LIFE CYCLE?

1.  SEED STAGE
WHAT IS IT?  When your business is just a thought or an idea
FINANCIAL SOURCES:

• Family and friends
• Private savings
• Credit cards:  usually much quicker than waiting for a loan approval.

2.  START-UP STAGE
WHAT IS IT?  When the company has officially launched.
FINANCIAL SOURCES:

• Banking, typically the first option of small business owners.
• Small, community banks.
• Leasing:  paying a monthly payment for renting assets like equipment or office space.
• Factoring:  paying an advance rate to a third party (factor) in exchange for cash.
• Trade credit:  when a supplier allows the buyer to delay payment.

3.  GROWTH-STAGE
WHAT IS IT?  When a business has successfully traded for a period.
FINANCIAL SOURCES:

• Angel investor: a wealthy individual who hands over capital in return for ownership equity.
• Venture capital funds: large institutions seeking to invest considerable amounts of capital into growing businesses through a series of investment vehicles.
• Initial public offering (IPO):  the sale of equity in a company, generally in the form of shares of common stock, through an investment banking firm.

4.  MATURE STAGE
WHAT IS IT?  When its business has an established place in the market.
FINANCIAL SOURCES:

• Capital market securities such as common stock, dividends, voting rights.
• Bonds - loans that take the form of a debt security where the borrower (known as the issuer) owes the holder (the lender) a debt and is obliged to repay the principal and interest (the coupon).
• Commercial paper -  a money market security issued by large banks and corporations for short-term investments (maximum nine months) such as purchases of inventory

Key terms

Angel investor:  a wealthy individual, often a retired business owner or executive, who hands over capital to a new business in return for ownership equity.

Venture capitalists:  commonly large institutions seeking to invest considerable amounts of capital into growing businesses through a series of invesmtent vehicles that include state and private pension funds, university endowments, and insurance companies.

Commercial paper:  a money market secuirty issued by large banks and corporations for short term investments (maximum nine months) such as purchases of inventory.  These unsecured IOUs are consideed safe, but returns are small.

Factoring:  describes a loan by a third party (factor) given in the form of cash (often within 24 hours) for accounts receivable.  The borrower pays a percentage of the invoice.

What do people mean when they say debt is a relatively cheaper form of finance than equity?

What do people mean when they say debt is a relatively cheaper form of finance than equity?

 

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In this case, the "cost" being referred to is the measurable cost of obtaining capital.

• With debt, this is the interest expense a company pays on its debt.
• With equity, the cost of capital refers to the claim on earnings which must be afforded to shareholders for their ownership stake in the business.

 

For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbor for $40,000.

 

• Suppose your business earns $20,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.
• Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be $15,000 (75% x $20,000).
• From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity.
• Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).

 

Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage, as it presents a fixed expense, thus increasing a company's risk.

• Going back to our example, suppose your company only earned $5,000 during the next year.
• With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000).
• With equity, you again have no interest expense, but only keep 75% of your profits, thus leaving you with $3,750 of profits (75% x $5,000).
• So, as you can see, provided a company is expected to perform well, debt financing can usually be obtained at a lower effective cost.
• However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.

 

Companies are never 100% certain what their earnings will amount to in the future (although they can make reasonable estimates), and the more uncertain their future earnings, the more risk presented.

• Thus, companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries or companies who are very small and just beginning operations.
• New businesses with high uncertainty may have a difficult time obtaining debt financing, and thus finance their operations largely through equity.

 

(For more on the costs of capital, see Investors Need A Good WACC.)

 

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