CHAPTER SIXTEEN Capital Structure By J.D. Han

Evaluation of Capital Structures A capital structure that maximizes share prices generally will minimize the firm’s WACC A capital structure that maximizes share prices generally will minimize the firm’s WACC If a firm can lower its WACC, shareholders will receive greater returns reflected in increased share prices If a firm can lower its WACC, shareholders will receive greater returns reflected in increased share prices capital structure capital structure  market price per share,  WACC  market price per share,  WACC

Evaluation of Capital Structures Different capital structures results in different levels of financial risk created through leverage. Different capital structures results in different levels of financial risk created through leverage. Three trade-off possibilities include: Three trade-off possibilities include: 1. Cost equity increases with leverage at a moderate rate so that when combined with debt l WACC decreases with increased leverage 2. Cost of equity increases at a rate that offsets the benefits gained through cheaper financing l WACC remains constant 3. Cost of equity increases rapidly with leverage and increase more than offsets any gains from debt l WACC increases with leverage

Evaluation of Capital Structures Consequences of Different Shareholder Attitudes Toward Risk

Evaluation of Capital Structures Leverage is measured as the proportion of debt in relation to equity in the capital structure (B/E) Leverage is measured as the proportion of debt in relation to equity in the capital structure (B/E) With V = B + E WACC is: With V = B + E WACC is:

Theory of Capital Structure Case 1: Capital structure without taxes and bankruptcy costs Case 1: Capital structure without taxes and bankruptcy costs denoting k e u and k e L as the cost of equity for unlevered and levered firms we have: denoting k e u and k e L as the cost of equity for unlevered and levered firms we have: rearranged we get: rearranged we get:

Case 2: Capital Structure with Corporate taxes Case 2: Capital Structure with Corporate taxes exert an important influence on financing decisions because the amount of taxes depends on the capital structure exert an important influence on financing decisions because the amount of taxes depends on the capital structure levered firm’s taxes are reduced by the tax shield on interest (IT) levered firm’s taxes are reduced by the tax shield on interest (IT) V L > V u V L > V u Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity U Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity U

Assuming debt outstanding (B) is perpetual and the tax shield generated by interest payments becomes a perpetual annuity of IT then: Assuming debt outstanding (B) is perpetual and the tax shield generated by interest payments becomes a perpetual annuity of IT then: Present value of tax savings = then

l The cost of equity k e L increases at a slower rate, which can be seen through the formulas:

Theory of Capital Structure Relationship Between the WACC, Cost of Equity, and Leverage

Other 2 major Considerations Debt capacity and Bankruptcy Costs – the ability of an enterprise to tolerate higher leverage Debt capacity and Bankruptcy Costs – the ability of an enterprise to tolerate higher leverage Agency Problems Agency Problems when managers fail to act in the best interests of shareholders when managers fail to act in the best interests of shareholders

Market Imperfections and Practical Considerations l “Pecking order” of finance holds that 1. Retained earnings or depreciation should be used first 2. After internal resources are depleted, debt should be used 3. New common equity should be issued only when more debt is likely to increase the chance of bankruptcy