The capital structure of a firm consists of long term
debt, preferred stock and equity. Capital structure is the financing mix of the
firm. In order to determine the proportion of debt and equity issued by the
firm, it is important to determine the debt to capitalization (D/E) ratio.
The firm must maintain a balance between debt and
equity. Too much debt can increase the risk of the firm, making investors
apprehensive about its ability to pay its creditors (issues with liquidity).
This may also increase the borrowing costs of the firm, cost of capital. Debt
financing is beneficial up to a certain point because it provides financial
leverage. The tax deductibility feature of interest payments paid to credit providers
enables the company to achieve higher earnings per share.
Financial leverage relates to issuing debt to finance
investments and consists of the relationship between earnings before interest
and taxes (EBIT) and earnings per share (EPS). The more debt the more fixed financial costs
incurred by the firm. Interest payments may become too large relative to EBIT,
hence the risk increases. An unlevered firm issues only equity. The higher debt
there is, the more the degree of financial leverage (DFL). The DFL is
determined by dividing EBIT by EBIT – Net Income. For example if a firm has a
DFL = 2.00, a 1% decrease in EBIT will produce a 2% decrease in EPS. So the
more financial leverage, the more volatile the EPS become, and the greater the
risk associated with the firm.
As the D/E ratio rises the possibility that the firm
will be unable to meet its interest payments to bondholders also rises. At this
point the firm’s assets are ultimately transferred from the stockholders to the
bondholders. When the value of the firm’s assets equals the value of its debt,
the firm is economically bankrupt in the sense that the equity has no value.
There are legal and administrative costs associated to bankruptcy. Due to this, bondholders will not get
all that they are owed. Some fraction of the firm’s assets will disappear in
the legal process of bankruptcy, known as direct bankruptcy costs. The firm is
experiencing financial distress. The costs of avoiding a bankruptcy filing are indirect
bankruptcy costs.
