💰Corporate Finance Analysis Unit 11 – Capital Structure and Leverage Optimization

Key Concepts and Definitions

• Capital structure refers to the mix of debt and equity a company uses to finance its operations and growth
• Debt financing involves borrowing money that must be repaid with interest (bonds, loans)
• Equity financing involves selling ownership stakes in the company (common stock, preferred stock)
• Leverage measures the degree to which a company uses debt in its capital structure
  • Financial leverage is calculated as total debt divided by total assets
• Cost of capital represents the minimum return a company must earn on its investments to satisfy its debt and equity holders
  • Weighted average cost of capital (WACC) is the average cost of all sources of capital weighted by their proportions in the capital structure
• Capital structure optimization aims to find the mix of debt and equity that minimizes the cost of capital and maximizes firm value

Capital Structure Basics

• A company's capital structure is a strategic decision that impacts its financial risk, cost of capital, and overall value
• Debt and equity have different characteristics, benefits, and costs
  • Debt is cheaper than equity due to tax deductibility of interest and lower required returns, but it increases financial risk
  • Equity provides a permanent source of capital without fixed obligations, but it dilutes ownership and is more expensive
• The optimal capital structure balances the trade-offs between debt and equity to minimize the cost of capital and maximize firm value
• Changes in capital structure can be achieved through issuing new debt or equity, repurchasing shares, or retiring debt
• A company's industry, growth stage, and financial stability influence its capital structure choices

Types of Financing

• Debt financing includes various types of borrowing instruments
  • Bonds are fixed-income securities that obligate the issuer to make periodic interest payments and repay the principal at maturity (corporate bonds, government bonds)
  • Loans are direct borrowings from banks or other financial institutions (term loans, revolving credit facilities)
  • Leases are contracts that allow the use of an asset in exchange for periodic payments (operating leases, capital leases)
• Equity financing involves selling ownership stakes in the company
  • Common stock represents the residual ownership in the company and entitles holders to voting rights and dividends
  • Preferred stock provides a higher claim on assets and earnings than common stock, but typically lacks voting rights
  • Retained earnings are profits reinvested in the company rather than distributed to shareholders
• Hybrid securities combine features of debt and equity (convertible bonds, warrants)
• The choice between debt and equity depends on factors such as cost, flexibility, risk, and control considerations

Leverage and Its Impact

• Leverage amplifies the potential returns and risks of a company's operations
• Operating leverage arises from the presence of fixed costs in a company's cost structure
  • Degree of operating leverage (DOL) measures the sensitivity of operating income to changes in sales
• Financial leverage results from the use of debt in a company's capital structure
  • Degree of financial leverage (DFL) measures the sensitivity of earnings per share (EPS) to changes in operating income
• Combined leverage captures the total impact of operating and financial leverage on a company's risk and return
  • Degree of combined leverage (DCL) is calculated as DOL multiplied by DFL
• Higher leverage increases the potential returns to equity holders, but also magnifies the potential losses and financial risk
• Excessive leverage can lead to financial distress, default, and bankruptcy

Capital Structure Theories

• The Modigliani-Miller (MM) theorem states that in a perfect capital market, a company's value is independent of its capital structure
  • MM Proposition I: The value of a levered firm equals the value of an unlevered firm plus the present value of the tax shield
  • MM Proposition II: The cost of equity increases linearly with the debt-to-equity ratio due to the higher financial risk
• The trade-off theory suggests that companies balance the benefits and costs of debt to reach an optimal capital structure
  • Benefits of debt include tax deductibility of interest and reduced agency costs of free cash flow
  • Costs of debt include financial distress costs and agency costs of debt
• The pecking order theory proposes that companies prefer internal financing and issue debt before equity due to information asymmetry and signaling considerations
• The market timing theory argues that companies issue securities when market conditions are favorable and their securities are overvalued

Optimal Capital Structure

• The optimal capital structure minimizes the weighted average cost of capital (WACC) and maximizes firm value
• WACC is calculated as: $WACC = (E/V) * R_e + (D/V) * R_d * (1-T_c)$
  • $E$ is the market value of equity, $D$ is the market value of debt, $V$ is the total market value of the firm ($E+D$)
  • $R_e$ is the cost of equity, $R_d$ is the cost of debt, and $T_c$ is the corporate tax rate
• The cost of equity can be estimated using the capital asset pricing model (CAPM): $R_e = R_f + \beta_e * (R_m - R_f)$
  • $R_f$ is the risk-free rate, $\beta_e$ is the equity beta, and $R_m$ is the expected market return
• The cost of debt is the yield to maturity on the company's outstanding debt, adjusted for the tax deductibility of interest
• The optimal capital structure occurs at the point where the marginal benefits of debt equal the marginal costs
  • Marginal benefits include the tax shield and reduced agency costs of free cash flow
  • Marginal costs include increased financial distress costs and agency costs of debt
• Companies should periodically review and adjust their capital structure to maintain optimality as market conditions and firm characteristics change

Risk and Return Trade-offs

• Higher leverage increases the potential returns to equity holders, but also amplifies the financial risk and potential losses
• The risk-return trade-off is a fundamental principle in finance that states that higher expected returns are associated with higher risk
• Equity holders demand higher returns than debt holders due to their residual claim on the company's assets and earnings
• The capital asset pricing model (CAPM) quantifies the relationship between systematic risk (beta) and expected return for securities
• The cost of equity increases with the level of financial leverage due to the higher financial risk borne by equity holders
• Companies must balance the potential benefits of higher returns with the increased risk of financial distress and default when making capital structure decisions
• Diversification can help mitigate the impact of company-specific risks on an investor's portfolio, but systematic risk cannot be diversified away

Practical Applications and Case Studies

• Capital structure analysis is crucial for corporate financial decision-making, such as mergers and acquisitions, capital budgeting, and dividend policy
• Companies often use a combination of debt and equity financing to fund large investments or acquisitions (leveraged buyouts, project finance)
• Start-up companies typically rely on equity financing from venture capitalists and angel investors due to their high risk and lack of collateral
• Mature, stable companies with predictable cash flows can support higher levels of debt in their capital structure (utilities, real estate investment trusts)
• High-growth companies often prioritize equity financing to maintain financial flexibility and avoid the constraints of debt covenants (technology, biotech)
• During economic downturns or financial crises, companies may need to deleverage and reduce their reliance on debt financing (2008 global financial crisis)
• Case studies of notable capital structure decisions:
  • Apple's $17 billion bond issue in 2013 to fund share repurchases and dividends while keeping foreign cash reserves offshore
  • Tesla's mix of debt, convertible notes, and equity financing to fund its growth and expansion plans in the electric vehicle market
  • Berkshire Hathaway's conservative approach to leverage and preference for using retained earnings and insurance float to finance investments