Question

Considerations of financial stress in capital structure decisions and how it can be modeled

Answer 1

Answer-

The capital structure of any company or firm in general consists of Equity and Debt.

The different sectors or industries have different capital structure and the weightage of debt and equity maintained by each sector varies.

For illustration the capital intensive sectors such as Steel, Telecom an Airlines have higher debt in their capital structure and have higher D/E ratio. With the increase in debt the leverage increases and the probability of default also increases.

The financial stress in Capital structure will help us analyze the company's debt and it's comparison with peer companies in the same sector and comparing the solvency ratios ( such as Debt / Equity ratio and Debt / Capital ratio ) of the peer companies. These ratios are compared by the industry average ratios which help in analysing the capital structure and arrive at Debt / Equity ratio that is required to be maintained by the company.

The company sometimes changes the capital structure by replacing debt with equity ie. raising equity to par debt or the other way round by raising debt to buy back shares which results in increasing debt of company.

The company can change the capital structue and moreover it has to maintain the Cost of capital or Weighted average cost of capital (WACC) which is the discount rate used to discount its cash flows.

WACC = Wt of equity x Cost of equity + Wt of debt x Cost of debt x ( 1 - tax rate)
Note - [ Wt in capital structure]

The cost of equity increases as the company raises debt as the increase in debt increases the leverage or debt and the equity holders require higher rate of return on equity to compensate the risk. The increase in debt will increase the probability of default for the company anfd hence the equity holders require higher premium to compensate the risk.

The company changes the capital structure to reduce debt and financial stress by repaying debt and decreasing the D/E ratio in line with peer companies and industry averages.