Capital Structure 050808 Ch 7 Capital Structure Balance

Capital Structure 05/08/08 Ch. 7

Capital Structure – Balance Sheet n Assets – Value of the Firm n n Listed by Closeness to Cash Current Assets Long-term Assets Physical and Intangible n Book Value or historical value of the assets adjusted for depreciation n Capital Structure n The “borrowed” money from the capital markets n Liabilities – Fixed claims against the assets n Owner’s Equity – Residual claim against assets n Book Values not Market Values 2

What is Debt? n Fixed claims against the company, the liabilities Current Liabilities, accounts payable… n Long-term Liabilities n n n Bank Loans Bonds n The “borrowed” money will be paid back usually in pre-specified amounts and at prespecified time…temporary funding 3

Examples of Debt n Loans – n Principal and interest due at maturity n Interest as you go, principal at maturity n Principal and interest as you go, usually equal payments at equal intervals, annuity n By Lender -n Banks n Bondholders n Interest portion is usually tax deductible 4

What is Equity? n Value of the company “claimed” by owners n What is left over after debt claims are satisfied n Permanent Capital n Repayment not required n Repayment via dividends n Dividends not tax deductible (not an expense of the company) n Outstanding Common Stock 5

Ways to Raise $$$$ n Borrow from suppliers – accounts payable n Borrow from bank – bank loan n Borrow from bondholders – issue bonds n Borrow from other companies – sign leases n Borrow from owners n Personal funds of founder/owner n Issue preferred stock n Issue common stock n Issue warrants 6

Some Hybrid Securities n Convertible Bonds n Initially issued as two assets, a straight bond an option to convert to stock n Set conversion ratio n Some protection on the down-side (bonds have fixed repayment) n Potential for up-side, convert to stock if company (stock prices rise) n Preferred Stock n Guaranteed dividends (consol or perpetuity) 7

Financing Options Tied to Life Cycle n Life Cycle of a firm… n Birth (Start-up) n Youth (Expansion) n Teen-age (Rapid or High Growth) n Adult (Mature) n Old Age (Decline) n Death (Bankruptcy) n Personal Funds, Angel Funds, Venture Capitalist, Loans, Public Equity, Bonds… 8

Raising Equity in Capital Markets n Usually in late teen – early adulthood n Have need for large $$$$ n Find Investment Banking Firm – Start IPO n File paperwork with SEC n Market Security n Conduct Auction n Distribute Stock and Collect $$$ n Subsequent issues are Seasoned Equity Offerings (SEO) 9

Cost of Going Public (IPO) n Legal Costs – Registration and Filing Fees n Payment to Investment Banker – Best efforts or Firm Commitment n Marketing Costs – Road Show n Underpricing Why on average are IPOs underpriced? n When do marginal clients get a call? n Marginal clients know they are marginal… n n After sale requirements and options 10

Cost of Debt n Legal Costs – Registration and Filing Fees n Payment to Investment Banker n Marketing Costs n Potential Default n If bondholders or bank not paid back on time the bondholders or bank can “claim” the firm n Direct bankruptcy costs n Indirect bankruptcy costs 11

Benefits of Debt n Discipline Managers – reduces free cash flow n Covenants in place to “restrict” certain types of behavior n Additional outside validation of management activities and choices Bond rating agencies n Bank loan officers n Subsequent borrowing n 12

Company Earnings Reinvested n Earnings of the company can be reinvested in the company n What is the cost of reinvesting? n What are the choices with company earnings? Pay it back to owners…let them invest it where they might n Cost should be the opportunity cost to the owners n Cost of equity w/o issuance costs n 13

Optimal Capital Structure n What combination of borrowing is best? n How do you choose which funds you should use for financing? n n Debt vs. Equity vs. Company Earnings How much of each? n Pecking Order Hypothesis n Static Theory – Separation of Investing and Financing Decisions n n Modigliani and Miller 1956 &1958 Marginal cost of bankruptcy vs. Marginal benefit of debt to find the lowest cost of capital 14

Homework n Problem #4 – Convertible Preferred Stock (me – I will do this one in class…) n Problem #5 – Debt-Equity Ratio n Missing data, bonds are ten year bonds n Problem #8 – Venture Financing n Problem #9 – Venture Financing n Problem #15 – Rights Offering n Problem #18 – Debt for Stock Swap n Problem #23 –Debt & Bankruptcy 15