Page 20 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 21.c: Describe the role of debt ratings in capital READING 21: CAPITAL STRUCTURE
structure policy.

Debt ratings reflect the creditworthiness of a company’s debt.
MODULE 21.2: FACTORS AFFECTING CAPITAL STRUCTURE

LOS 21.d: Explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation.

• Capital structure changes over time, Assess how changes in debt ratio may reduce the WACC
• Capital structure of competitors with and impact of value as firm moves towards optimal capital
similar business risk. structure.
• Company-specific factors (e.g., quality of
corporate governance). Scenario analysis a useful tool for this purpose!

LOS 21.e: Describe international differences in the use of financial leverage, explaining factors, and implications for investment analysis.

• Total debt. Companies in Japan, Italy, and France tend to have more total debt in their capital structure than firms in the US and the U.K.
• Debt maturity. Companies in North America tend to use longer maturity debt than companies in Japan.
• Emerging market differences. Companies here tend to use more total debt and use longer maturity debt than firms in emerging markets.
But why? 3 broad categories…
Institutional and Legal Factors
• Strength of legal system: Weak legal systems = greater agency costs from lack of legal protection for investors (More leverage, specifically short-term debt).
• Information asymmetry: High levels = greater use of (short-term) debt, due to greater enforceability of rights. In countries where auditors and financial analysts
have a greater presence, information asymmetries are reduced, hence lower financial leverage.
• Taxes: The tax shield from debt = greater debt financing; as long as dividends is not taxed lower. Taxing dividends lower reduces the return that investors
require on equity capital, thus the lower cost of equity will cause firms in such countries to have less debt in their capital structure.
Financial Markets and Banking System Factors
• Liquidity of capital markets: Larger and more liquid capital markets tend to allow longer maturity debt;
• Reliance on banking system: More reliance means more leverage.
• Institutional investor presence: More active institutional investors issue relatively more long-term debt compared to short-term debt.

Macroeconomic Factors
• Inflation: Firms operating in countries with high inflation tend to use less debt financing, and the debt used has a shorter maturity.
• GDP growth: Firms operating in countries with higher GDP growth tend to use longer maturity debt.