Capital Structure Analysis
We have arrived at one of the most important topics of the course--analyzing how a firm
goes about determining its capital structure, i.e. the mix of debt, preferred stock and
The analysis examines the choice of the capital structure in terms of return and
risk, and the associated tradeoffs faced by a risk-averse firm.
In this case, "return" refers to
maximizing firm value and minimizing WACC, and risk refers to the financial risk
(financial leverage) associated with debt.
That is, for the corporation, debt has a greater
financial risk but a lower (after-tax) cost of capital, while equity has a smaller risk but a
greater cost of capital.
The starting point of the discussion is to view the total risk of the firm as consisting of two
distinct parts, business risk and financial risk. The interaction (in a non-mathematical
manner, the "sum of") the business leverage and the financial leverage determine the total
leverage of the firm.
The business leverage comes solely from operations, and therefore the
key variable is EBIT.
On the finance side, we take the business leverage as given, and focus on the financial
which increases as the firm takes on more debt. Of course the absolute level of
debt is not the key factor, but rather the relative importance of debt in the capital structure.
Therefore, the focus will be on the debt/asset ratio (D/A) or the debt/equity ratio (D/E or
However, even though we take the business risk as given we recognize that the firm focuses
on total risk, and financial risk will build on the business risk to increase the total risk of the
Intuitively (and supported by the empirical evidence), a firm with smaller business
risk is more likely to choose greater financial risk (more debt), and a firm with greater
business risk is more likely to take on less financial risk (less debt).
In analyzing the capital structure,
we make two simplifying assumptions. First, we assume
the firm does not raise capital with preferred stock.
This assumption is used as in the U.S.
we observe that preferred stock is a relatively unimportant source of capital.
assumption indicates that the capital structure decision of the firm comes down to a choice
between debt (lower cost but riskier) and common equity ("equity), which is less risky but
Second, we assume that the firm does not have enough retained earnings to fund the entire
Therefore, the marginal equity financing is coming from issuing new
This leads to the key issue that will be analyzed--should the firm raise
capital by issuing new debt or using new common equity (retained earnings or new