Chapter 10 Making Capital Structure Decisions

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EBIT-EPS Analysis
Calculation of EPS
Break-even, or indifference, analysis Use of EBIT-EPS information

2002 Prentice Hall Publishing

Calculation of EPS
EBIT indifference points
EBIT-EPS analysis Focuses on the EBIT indifference between financing methods with respect to EPS

2002 Prentice Hall Publishing

Break-Even, or Indifference, Analysis

Horizontal axis = EBIT Vertical axis = EPS Below Indifference point (IP) Common stock alternative is best Above the IP Debt alternative is best Debt alternative always dominates preferred stock
2002 Prentice Hall Publishing

Use of EBIT-EPS Information

Financing alternatives have different impacts on EPS Comparing with existing and expected EBIT Higher EBIT (stronger case for debt) Lower EBIT (stronger case for common stock) Assess likelihood of EBIT falling below IP Gives insight into risk-return trade-off that governs valuation
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Cash-Flow Ability to Service Debt

Fixed charges Times interest earned Debt-service coverage EBIT, depreciation, and amortization (EBITDA) Probability of cash insolvency Donaldson approach
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Fixed Charges
Include Principal and interest payments on debt Lease payments Preferred stock dividends Inability to meet fixed charges may result in financial insolvency Increased stability of expected future CFs results in increased debt capacity
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Times Interest Earned

Important test of credit-worthiness
Concern arises when ratio falls below 3 to 1 Difficult to achieve an investment-grade credit rating

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Debt-Service Coverage
Coverage ratio Interest before tax Principal payment after tax Include lease payments Debt service and business risk Electric utilities versus manufacturing
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EBITDA
EBITDA versus EBIT

EBITDA may not be a good measure of the cash available for debt service

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Probability of Cash Insolvency

What are the chances of insolvency? Assess The possible deviation of actual from expected CFs Purchase or sale of assets Liquidity of the firm Dividends Seasonal patterns Other factors impacting CFs
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Donaldson Approach
Examine the CFs of the company Under the most adverse circumstances (i.e. recession) Debt capacity Debt that can be comfortably serviced Calculate the probability of cash inadequacy Cash insolvency versus cash inadequacy
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Effect on Debt Ratios

Pro forma debt ratios Compare new debt ratios With past ratios Trend analysis Other companies Similar business risk In same industry Justify position if capital structure is out of line
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Effect of Security Ratings

Effect of financing alternatives Rating agencies Changes in Ratings of existing securities Ratings Indicate credit worthiness of a borrower First 4 are considered investment grade
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Analysis Before Assigning a Grade

Trends in ratios
Business risk Capital requirements

Specific security features

Cash-flow ability Proportion of debt

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Timing and Flexibility

Timing security issues Debt or common stock Financing is lumpy General market conditions Expectations for the company Flexibility Keeping open future financing options
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A Pecking Order of Financing

Internal financing Straight debt Preferred stock Hybrid securities Convertible bonds Straight equity Least desirable Financing decision should be based on a rigorous analysis embracing valuation
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Financing Checklist
Taxes Explicit cost Financial signaling EBIT-EPS analysis Agency costs and incentive issues Debt ratio Security rating Timing Flexibility Cash flow ability to service debt

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