Capital Structure, Interest Rates and Credit Ratings

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Capital Structure

Capital Structure, Interest Rates and Credit Ratings
Prepared by Ece SARAÇOĞLU BILGI, MSc in International Finance INF 503 - Financial Economics and Interest Rates December 2012

TABLE OF CONTENTS I. II. III. a) b) c) d) e) f) g) h) i) j) k) l) m) n) o) p) q) IV. V. Why Capital Structure Matters To Investments How Debt and Equity Financing Differ Choosing Between Debt and Equity Financing Process Ownership rights Rights over profit Ease of doing business Repayment Cost to company Future funding Choice of capital Obtained from Debt-to-equity ratio Requirements Advantages Disadvantages Application process Credit check Term Options Other The Debt-to-Equity Ratio

The Optimal Capital Structure a) Firm Value and Stock Value b) Capital Structure and the Cost of Capital How Financial Leverage Affects the EPS and ROE of a Firm How Interest Rates Affect the Demand for Debt and Equity Capital

VI. VII. VIII.

The Significance of Credit Ratings for Capital Structure a) Regulations on Bond Investment b) Information Content of Ratings c) Costs Directly Imposed on the Firm

IX. Credit Ratings in the Context of Existing Capital Structure Theories a) Tradeoff Theory b) Pecking Order Theory X. REFERENCES

2

Why Capital Structure Matters To Investments A firm’s capital structure is the relative proportions of debt, equity, and other securities that it has outstanding or how a firm pays for its assets. The term capital structure refers to the percentage of capital (money) at work in a business by type. There are two forms of capital: equity capital and debt capital. Each has its own benefits and drawbacks and a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure in terms of risk / reward payoff for shareholders. How Debt and Equity Financing Differ In the academic world, it can be said that there is effectively no difference between debt and equity financing in valuing a company. However in debt financing, a company “borrows from a lender” in exchange for capital, while in equity financing, a company “offers stock” in exchange for capital. Despite the distinct difference, as a group of Nobel-winning economists have put out in their theory, “The market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. The basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.”(*) But in the real world, it would be difficult to agree with this theory. Given the fact that economic activity is cyclical and not linear, it will be an issue if a company has too much debt to handle the down phases of the business cycle. For example, the company would have to file for bankruptcy protection if it misses too much interest payments in its debt. Or if it skips dividends, its shareholders would be likely to react and the company stock would go down, however this would lead the company to have more money as to profit, which would allow it to pay dividends again. The distinction can be specified as follows:  Debt investors are concerned with the return “of” capital.  Equity investors are concerned with the return “on” capital. Debt financing means when a business owner, in order to raise finance, borrows money from some other source, such as a bank. The business owner has to pay back this loan or debt within a pre-determined time period along with the interest incurred on it. The lender has no ownership rights in the borrower's company. Debt financing can be both, short term as well as long term. Debt financing refers to any borrowed money which the entrepreneur must pay back to the lending institution. It can come in the form of a loan, line of credit, or a bond. An interest rate and other terms apply. Equity financing means when a business owner, in order to raise finance,...
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