A.5.5.2 What do CFOs say they consider when making a capital structure choice?

Appendix: Mathematics of the Mean–Variance Model

I. A.5.5.2 What do CFOs say they consider when making a capital structure choice?

A recent survey by Graham and Harvey (2001) asked US chief financial officers to describe the considerations that influenced the choice of capital structure. As can be seen from the extract from that survey (Figure I.A.5.4), the considerations are consistent with the discussion in the chapter.

Table I.A.5.4: Guidelines for selecting a capital structure

Consideration Guideline Reasoning

Tax Benefit x Firms with other tax x

shields will have less debt.

High depreciation, research and development and other tax deductions reduce the ‘room’ for interest to be incurring bankruptcy costs, therefore less debt capacity.

The bankruptcy and distress costs have a large fixed cost component. These become relatively less important the larger is the firm. collateral and it also generally means more opportunity to change risk and asset profile, thus greater agency costs of debt.

Flexibility x Firms with more growth x

opportunities will have more unused debt capacity.

Growth opportunities generally mean a need to act quickly and flexibly, thus a demand for standby-type facilities.

Figure I.A.5.4: Factors influencing debt–equity mix

Managing risk

Managing incentives

0% 10% 20% 30% 40% 50% 60% 70%

Bargain for Concessions from Employees Signalling to Competitors Personal Tax Rate of Investors Comparables Issue & Transaction Costs Tax Advantage of Interest

Financial Flexibility Ensure Management Focus

Avoid Takeover Threat Avoid Benefits Going to Debtholders Customer Concern about Distress Potential Distress Costs Volatility of Earnings of Cash Flow Credit Rating

Managing incentives

Source: J R Graham & C Harvey “The Theory and Practice of Corporate Finance" Working Paper

Interestingly, flexibility and credit ratings rate highly. Many CFOs will choose a desired credit rating then choose a capital structure that enables the firm to meet the criteria for that credit rating. While there are qualitative overlays that rating agencies apply to financial ratios, financial ratios can guide the likely rating of a credit organisation. Table I.A.5.5 indicates the median ratio for firms within Standard and Poor’s credit ratings. Thus, given forecast earnings before interest and taxes, a firm can try different capital structures and therefore different financial ratios to ‘fit’

within a desired credit rating and therefore interest cost.

For example, if the health insurance company considered in Section I.A.5.4.2 employs $500,000 in debt, its interest expense at 8% p.a. will be $40,000. With expected earnings of $150,000, interest cover is earnings/interest or 3.75. This places it in the BB to BBB range. To be rated AA on this measure the EBIT interest cover ratio would have to be 9.2⁶. This sets the interest expense at $16,300 ($150,000/9.2) which corresponds to debt of $293,750. Sensitivity analysis based on the volatility of earnings can further inform this choice.

Analysis of this type is consistent with the drivers of capital structure as discussed in this chapter.

Research has shown that there is a relationship between credit rating and probability of

6 EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortisation expenses i.e. a proxy for cash flow

bankruptcy. Thus high-rating firms will generally have lower proportions of debt and a lower probability of bankruptcy, as the discussion predicts.

Table I.A.5.5 Median ratio values for different credit ratings⁷ Industrial long-term debt

Three year medians (1996 to 1998)

EBIT interest cover EBITDA interest cover Funds Flo w/Total D ebt

Free operating cash flo w / total debt Return o n Capital

21.4 29.3 33.3 40.8 55.3 68.8 71.5

31.8 37.0 39.2 46.4 58.3 71.4 79.4

Industrial long-term debt

Three year medians (1996 to 1998)

EBIT interest cover EBITDA interest cover Funds Flo w/Total D ebt

Free operating cash flo w / total debt Return o n Capital

21.4 29.3 33.3 40.8 55.3 68.8 71.5

31.8 37.0 39.2 46.4 58.3 71.4 79.4

AAA AA A BBB BB B CC

21.4 29.3 33.3 40.8 55.3 68.8 71.5

31.8 37.0 39.2 46.4 58.3 71.4 79.4

Source: Standard and Poor’s Credit Week, 28 July 1999

I.A.5.6 Conclusion

How should a business be funded? How much debt? How much equity? Does it matter? Our discussion shows that the choice of capital structure does affect the value of the business and therefore it is an important decision area for managers and shareholders. The effect is both direct, for example though the taxes payments ‘saved’, and indirect, through the impact on managers’ motives and decision-making. Exactly what the best funding mix is for a particular business is a little imprecise, however there are a number of key guidelines that we can provide to help management make shareholder value-creating decisions in this area.

A key determinant of capital structure choice for a business is the risk or variability of the operating earnings stream. Generally, the higher this risk the less debt can be supported, essentially due to the exposure to distress and bankruptcy costs. Many firms will select a desired credit rating or probability of distress based on the volatility of the earnings stream and use this to establish the interest bill, or amount of debt that can be supported.

Financial institutions are a special class of company in the sense that there are high costs of distress associated with them. As a consequence, the choice of capital structure is generally directed at keeping the exposure to bankruptcy and distress costs at an ‘acceptable level’.

7 Source: Standard and Poor’s Credit Week, 28 July 1999

References

Barclay, M. and Smith, C W (1999) The capital structure puzzle: another look at the evidence.

Journal of Applied Corporate Finance, 12(1), pp. 8–20.

Barclay, M, Smith, C W and Watts, R L (1995) The determinants of corporate leverage and dividend policies. Journal of Applied Corporate Finance., 7(4), pp. 4–19.

Graham, J R and Harvey, C R (2001) Theory and practice of corporate finance – evidence from the field. Journal of Financial Economics, 60, pp. 87–243

Myers, S C (1977) Determinants of corporate borrowing. Journal of Financial Economics, 5(2), pp.

147–175.

Myers, S C and Majluf, N S (1984) Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 12, pp. 187–221.

Opler, T, Titman, S and Saron, M (1997) Corporate liability management: designing capital structure to create shareholder value. Journal of Applied Corporate Finance, 10(1).

Pham, T and Chow, D (1989) Some estimates of direct and indirect bankruptcy costs in Australia: September 1978 – May 1983. Australian Journal of Management, 14(1), pp. 75–96

Warner, J B (1977) Bankruptcy costs: some evidence. Journal of Finance, 32(2), pp. 337–348.

In document PRM_Handbook (Page 175-179)