Financial Management Chapter 14 1.
Business risk, which is the riskiness of the
CAPITAL STRUCTURE AND LEVERAGE firm’s assets if no debt is used.
2. Financial risk, which is the additional risk
optimal capital structure is defined as the placed on the common stockholders
structure that would maximize as a result of using debt.
its stock price.
Business risk is the single most important
Target Capital Structure determinant of capital structure, and it
The mix of debt, preferred represents the amount of risk that is inherent in
stock, and common equity the firm’s operations even if it uses
the firm wants to have. no debt financing.
--> If the actual debt ratio is
significantly below the target level, management - Higher fixed costs are generally
will raise capital by issuing debt, associated with more highly automated,
whereas if the debt ratio is above the target, capital-intensive firms and industries.
equity will be used. - When a high percentage of total costs
are fixed, the firm is said to have a high
Four primary factors influence capital degree of operating leverage.
structure decisions:
Operating Breakeven
1. Business risk, or the riskiness inherent The output quantity at
in the firm’s operations if it used no which EBIT ¼ 0.
debt.
2. The firm’s tax position. A major reason We can calculate the breakeven quantity by
for using debt is that interest is tax recognizing that operating
deductible, which lowers the effective breakeven occurs when earnings before interest
cost of debt. additional debt would not and taxes.
be as advantageous as it
would be to a firm with a higher Financial Risk
effective tax rate. An increase in stockholders’
3. Financial flexibility ability to raise risk, over and
capital on reasonable terms even above the firm’s basic
under adverse market conditions business risk, resulting
4. Managerial conservatism or from the use of financial
aggressiveness Some managers are leverage.
more aggressive
than others; hence, they are more Financial risk is the additional risk placed on the
willing to use debt in an effort to boost common stockholders as a result
profits. This factor does not affect the of the decision to finance with [Link], the use
true optimal, or value-maximizing, of debt, or financial leverage, concentrates the
capital structure; but it does influence firm’s business risk on the stockholders
the firm’s target capital structure.
The Hamada Equation
Now we introduce two new dimensions of Increasing the debt ratio increases the risks that
risk:
bondholders face and thus the cost
of debt. More debt also raises the risk borne by
stockholders, which raises the cost of equity, rs.
It is harder to quantify leverage’s effects on the
cost of equity, but a theoretical formula can help
measure the effect.
Trade-Off Theory
The capital structure
theory that states that
firms trade off the tax
benefits of debt financing
against problems caused
by potential bankruptcy.
Financial Management Chapter 15 Residual Dividend Model A model in which the
DISTRIBUTION TO SHAREHOLDERS: dividend paid is set equal to net income minus
DIVIDENDS AND SHARE REPURCHASE the amount of retained earnings necessary to
finance the firm’s optimal capital budget.
Target payout ratio—defined as the percentage Low-Regular-Dividend-Plus-Extras The policy
of net income to be paid out as cash dividends of announcing a low regular dividend that can be
maintained no matter what and then when times
Optimal Dividend Policy The dividend policy are good, paying a designated “extra” dividend.
that strikes a balance between current dividends
and future growth and Declaration Date The date on which a firm’s
maximizes the firm’s stock price. directors issue a statement declaring a dividend.
Dividend Irrelevance Theory The theory that a Holder-of-Record Date If the company lists the
firm’s dividend policy has no effect on either its stockholder as an owner on this date, then the
value or its cost of capital. stockholder receives the dividend.
Signal An action taken by man agement that Ex-Dividend Date The date on which the right to
provides clues to investors about how the current dividend no longer accompanies a
management views the firm’s prospects. stock; it is usually 2 business days prior to
the holder-of-record date.
Information Content (Signaling) The theory
that investors regard dividend changes as Payment Date The date on which a firm
signals of manage ment’s earnings forecasts. actually mails dividend checks.
Clienteles Different groups of stockholders that Dividend Reinvestment
prefer different dividend payout policies. Plan (DRIP) A plan that enables a stockholder to
automatically reinvest dividends received back
Clientele Effect The tendency of a firm to into the stock of the paying firm.
attract a set of investors that like its dividend
policy. Stock Split An action taken by a firm
to increase the number of shares outstanding,
such as doubling the number of shares
outstanding by giving each stockholder
two new shares for each one formerly held.
Stock Dividend A dividend paid in the
form of additional shares of stock rather than in
Cash.
There are three principal types of stock
repurchases:
(1) situations where the
firm has cash available for distribution to its
stockholders and it distributes this
cash by repurchasing shares rather than by
paying cash dividends,
(2) situations where the firm concludes that its
capital structure is too heavily weighted with
equity and it sells debt and uses the proceeds to
buy back its stock,
(3) situations where the firm has issued options
to employees and it uses open market
repurchases to obtain stock for use when the
options are exercised.