Evaluating Capital Structure Policy
Analysts can compare a company’s capital structure to that of its primary competitors.
Analysts can also compare a company’s current capital structure to its historical capital structure. If a company is trending toward higher financial leverage, this may signal future bankruptcy.
Company management may never publicly state its target capital structure, but the analyst knows that the company’s primary capital structure goal should be to minimize its cost of capital. Armed with this understanding, analysts can model scenarios that calculate the impacts to debt and equity valuation, if the perceived ideal capital structure is realized.
Debt Ratings and Capital Structure Policy
Companies must pay debt rating agencies, such as Moody’s, to rate the investment quality of their bonds.
Debt rated at and above a certain mark is considered investment grade.
Debt rated below a certain mark is considered speculative (commonly called high yield or “junk”).
As a company’s financial leverage increases (i.e., its ratio of debt to equity rises), rating agencies tend to lower the grade/mark assigned to that company’s debt.
Lower debt ratings not only show increased risk to bondholders, but also to stockholders. Therefore, lower ratings increase the cost of both debt financing and equity financing.
Company management is very sensitive to the firm’s debt rating, as a lower rating leads to a higher cost of capital.
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- CFA Level 2: Corporate Finance Part 1 – Introduction
- Introduction to Capital Structure and Leverage
- Introductory Capital Budgeting Remarks
- Expansion Projects vs. Replacement Projects and Cash Flows
- Impacts of Depreciation Method Choice on Capital Budget Analysis
- Inflation and Capital Budgeting
- Mutually Exclusive Capital Projects with Unequal Lives
- Equivalent Annual Annuity (EAA) Approach
- Least Common Multiple of Lives Approach
- Stand Alone Risk and Capital Projects
- CAPM and a Capital Project’s Discount Rate
- Capital Projects and Real Options
- Common Pitfalls in Capital Budgeting
- Capital Budgeting Alternatives to NPV and IRR Analysis
- Modigliani-Miller and Capital Structure Theory
- Evaluating Capital Structure Policy
- International Differences in Financial Leverage
- Dividend and Share Repurchase Policies
- Factors Affecting Corporate Dividend Policy Decisions
- Signals from Dividend Policies