1. Capital Structure (How Much Debt?)
MSBC 5060 Chapter 16
Capital Structure
(How Much Debt?)

2. Capital Structure Chapter Overview
We looked a the return required by a company’s investors
It is the same as the company’s cost
It is the required return on the company’s investments
WACC = WERE + WDRD(1 - T)
WE and WD are the Percentages of Equity and Debt
RE and RD are the Costs of Equity and Debt

3. βEquity = βAssets (1 + D/E)
Chapter Overview
We also looked (in the context of the CAPM) at the effects of debt on Equity Risk
βEquity = βAssets (1 + D/E)
For a given risk of the firms assets (βAssets)
A function of cyclicality and operating leverage
How does the choice of debt (D/E) change the risk of equity (βEquity)?
So the Question is:
How much Debt should a firm have?
What should be the firm’s Capital Structure?
Capital Structure is defined by WE and WD or D/E

4. Aside: Compare WD = D/V to D/E
If WD = D/V = 20% then calculate D/E:
E/V = 1 - D/V = 80%
D/E = (D/V)/(E/V) = 0.20/0.80 = 0.25
If WD = D/V = 50% then calculate D/E:
E/V = 1 - D/V = 50%
D/E = (D/V)/(E/V) = 0.50/0.50 = 1.00
If WD = D/V = 60% then calculate D/E:
E/V = 1 - D/V = 40%
D/E = (D/V)/(E/V) = 0.60/0.40 = 1.50

5. Chapter Overview WACC is the discount rate for all the firm’s projects
The lower the rate, the higher the value of the projects
A firm is the sum of its projects
So the higher the value of the firm
So how does WACC (and therefore firm value) change as WE and WD (or D/E) change?

6. Definition: Adding Financial Leverage
Issue bonds to finance an expansion
Issue bonds and use the proceeds to buy back stock
Examine what happens with additional leverage:
To the Value of the company
Value Unlevered (VU) versus the Value Levered (VL)
To the Required Return on the Assets (RA)
To the Required Return on the Equity (RE)
First assume no taxes
Second look at the effects of taxes

7. A = Assets or 0 = An All Stock firm
Notation:
In this chapter, the text book uses both:
D = Debt or B = Bond
and
E = Equity or S = Stock
A = Assets or 0 = An All Stock firm

8. We start with D/E and end with Firm Value
The Progression (Derivation):
Firm Value is the sum of the NPVs the projects or products:
Value = NPV1 + NPV2 + NPV3 + …
For each project or product, NPV is the PV of CFs less the Cost:
NPV = CF0 + CF1/(1+R) +…+ CFN/(1+R)N
WACC is the R for each of the company’s projects:
WACC = WE RE + WD RD(1 - T)
RD is the YTM on existing debt
RE is from the CAPM and is a function of βE
RE = Rf + βE[E(RM) – Rf]
βE is a function of three things:
The Cyclicality of the product (steel vs. soap)
The Degree of Operating Leverage (FC vs. VC)
Financial Leverage (the amount of debt or fixed vs. variable financing)
Cyclicality and DOL give the Asset Beta: (βA)
Debt/Equity (financial Leverage) gives the Equity Beta: βE
βE = βA(1 + D/E)
We start with D/E and end with Firm Value

9. So how does the Amount of Debt effect Value?
How Does Debt Change Company Value?
Cyclicality of the product and the method of production (DOL) gives Asset Beta (βA)
Given βA, the Amount of Debt gives the Equity Beta (βE)
βE = βA(1 + D/E)
Given the βE, the CAPM gives the cost of equity capital (RE)
RE = Rf + βE[E(RM) – Rf]
Given βA, Amount of Debt gives the cost of debt capital (RD)
The Amount of Debt, RE and RD give the WACC
WACC = E/V RE + D/V RD(1 - T)
The WACC (which is R) gives the NPV for each project or product
NPV = CF0 + CF1/(1+R) +…+ CFN/(1+R)N
The sum of the NPVs is the Value of the company.
So how does the Amount of Debt effect Value?

10. So the lower the WACC… The greater the Value!
How Does Debt change Company Value?
WACC is the discount rate for the NPVs
Company Value is the sum of the NPVs
So the lower the WACC…
The greater the Value!

11. How Does Debt change WACC and Value?
WACC = WE RE + WD RD(1 - T)
In generally, RD < RE
Why?
And RD(1-T) < RE
So more Debt  Lower WACC  HIGHER VALUE
But adding Debt Increases βE
βE = βA(1 + D/E)
Increasing βE increases RE
RE = Rf + βE[E(RM) – Rf]
So more Debt  Higher WACC  LOWER VALUE
Which Dominates?

12. So How Much Debt? Here is the general idea: Start with no debt
Adding a little debt can Lower WACC and Increase Value
Lower RD and tax benefit offsets higher RE
As more debt is added
RD Increases
But still lower than RE
So WACC is still lower and value increases
As more and more debt is added
RD (and after tax RD) is greater that RE
As debt increases, cost of borrowing and default costs increase
WACC increases and value decrease

13. Determinants of the Amount of Debt
Volatility of EBIT
Cyclicality of the product
DOL (FC vs. VC - Method of Production)
Measured by βAssets
Assets Needed by the business
High vs. Low capital requirements
Airlines – high debt
Software – low debt
So low volatility, high capital industries tend to have more debt
Also the nature of the assets: Are the assets easily marketable?

14. Now to Capital Structure What does adding Leverage do to:
The Required Return on the Equity (RE)
The Required Return on the Assets (RA)
The Value of the Company
Value Unlevered (VU) versus the Value Levered (VL)

15. Modigliani & Miller
These theories, formulas and propositions were developed by Franco Modigliani and Merton Miller
MM I (without Taxes)
“Changing how the pie is sliced does not make it any bigger.”
A firm’s total value is not affected by its capital structure:
VL = VU
MM II (without Taxes)
Changing capital structure does increase equity risk and equity return but does not change the WACC since a Bigger RE is offset by smaller WE
RE = RA + (RA – RD)D/E
MM I (with Taxes):
With taxes, adding debt does increase firm value.
Firm value does depend on its capital structure:
VL = VU + TC x D
MM II (with Taxes):
With taxes Leverage increases equity risk and equity return and does decrease WACC.
RE = RA + (RA – RD)(1 – TC)D/E

16. ValueLevered = ValueUnlevered
First Results (no Taxes):
ValueLevered = ValueUnlevered
VL = VU
The value of the firm does not increase with the addition of leverage
Changing the way the pie is sliced does not increase the slice of the pie
People can borrow just as easily as the company
Result:
A company can’t create value just by replicating what people can do on their own
This result is know as MM I

17. MM I without Taxes: Levering Does Not Create Value
A company can’t create value just by replicating what people can do on their own
Show this by comparing a persons returns from
Owning a levered firm
Buying more shares of an Unlevered firm by using borrowed funds
Called “homemade leverage”
This is shown in Example 16.1, Page 491

18. Example: A company is valued at $8,000 1st Assume no debt:
If Earnings are $400 (all is paid to shareholders)
Return is $400/$8,000 = 5%
If Earnings are $1200
Return is $1,200/$8,000 = 15%
If Earnings are $2,000,
Return is $2,000/$8,000 = 25%
2nd Assume $4,000 of 10% debt  Int Exp = $400
If Earnings are $400, $400 in Int Exp, so to $0 to Equity
Return is $0/$4,000 = 0%
If Earnings are $1200, $400 in Int Exp, so to $800 to Equity
Return is $800/$4,000 = 20%
If Earnings are $2,000, $400 in Int Exp, so to $1,600 to Equity
Return is $1,600/$4,000 = 40%

19. The Unlevered Firm has $0 debt A share price of $20
Unlevered
Levered
Assets
$8,000
Debt $0
$4,000
Equity (Mkt and Book)
Interest Rate
10%
Market Value per Share
$20
Shares
400
200
Recession
Expected
Expansion
ROA (for Unlevered) 5%
15%
25%
Earnings Before Interest
$400
$1,200
$2,000
Interest
Earnings After Interest
ROE
Unlevered EPS (Earn/Shares)
$1.00
$3.00
$5.00
Unlevered Return (EPS/Price)
$800
$1,600 0%
20%
40%
Levered EPS
$0.00
$4.00
$8.00
Levered Return (EPS/Price)
Strategy A: Buy 100 Levered
Cost = 100 x $20
$2,000.00
EPS of 100 Levered Shares
EPS for 100 Shares
$400.00
$800.00
Return
Strategy B: Borrow 10%, Buy 200 Unlev $20
Cost = 200 x $20 - $2,000
EPS of 200 Unlevered Shares
$200.00
$600.00
$1,000.00
Interst Expense
Net EPS for 200 Shares - Int Exp
The Unlevered Firm has $0 debt
A share price of $20
And EPS of $1, $3 or $5

20. The Unlevered Firm has $0 debt A share price of $20
Unlevered
Levered
Assets
$8,000
Debt $0
$4,000
Equity (Mkt and Book)
Interest Rate
10%
Market Value per Share
$20
Shares
400
200
Recession
Expected
Expansion
ROA (for Unlevered) 5%
15%
25%
Earnings Before Interest
$400
$1,200
$2,000
Interest
Earnings After Interest
ROE
Unlevered EPS
$1.00
$3.00
$5.00
Unlevered Return (EPS/Price)
$800
$1,600 0%
20%
40%
Levered EPS
$0.00
$4.00
$8.00
Levered Return (EPS/Price)
Strategy A: Buy 100 Levered
Cost = 100 x $20
$2,000.00
EPS of 100 Levered Shares
EPS for 100 Shares
$400.00
$800.00
Return
Strategy B: Borrow 10%, Buy 200 Unlev $20
Cost = 200 x $20 - $2,000
EPS of 200 Unlevered Shares
$200.00
$600.00
$1,000.00
Interst Expense
Net EPS for 200 Shares - Int Exp
The Unlevered Firm has $0 debt
A share price of $20
And EPS of $1, $3 or $5
The Levered Firm has $4,000 debt
And EPS of $0, $4 or $8

21. The Unlevered Firm has $0 debt A share price of $20
Unlevered
Levered
Assets
$8,000
Debt $0
$4,000
Equity (Mkt and Book)
Interest Rate
10%
Market Value per Share
$20
Shares
400
200
Recession
Expected
Expansion
ROA (for Unlevered) 5%
15%
25%
Earnings Before Interest
$400
$1,200
$2,000
Interest
Earnings After Interest
ROE
Unlevered EPS
$1.00
$3.00
$5.00
Unlevered Return (EPS/Price)
$800
$1,600 0%
20%
40%
Levered EPS
$0.00
$4.00
$8.00
Levered Return (EPS/Price)
Strategy A: Buy 100 Levered
Cost = 100 x $20
$2,000.00
EPS of 100 Levered Shares
EPS for 100 Shares
$400.00
$800.00
Return
Strategy B: Borrow 10%, Buy 200 Unlev $20
Cost = 200 x $20 - $2,000
EPS of 200 Unlevered Shares
$200.00
$600.00
$1,000.00
Interst Expense
Net EPS for 200 Shares - Int Exp
The Unlevered Firm has $0 debt
A share price of $20
And EPS of $1, $3 or $5
The Levered Firm has $4,000 debt
And EPS of $0, $4 or $8
Put up $2,000, buy 100 shares of the Levered firm:
$0/$2,000 = 0%
$400/$2,000 = 20%
$800/$2,000 = 40%

22. Firms create no value by levering!
Unlevered
Levered
Assets
$8,000
Debt $0
$4,000
Equity (Mkt and Book)
Interest Rate
10%
Market Value per Share
$20
Shares
400
200
Recession
Expected
Expansion
ROA (for Unlevered) 5%
15%
25%
Earnings Before Interest
$400
$1,200
$2,000
Interest
Earnings After Interest
ROE
Unlevered EPS
$1.00
$3.00
$5.00
Unlevered Return (EPS/Price)
$800
$1,600 0%
20%
40%
Levered EPS
$0.00
$4.00
$8.00
Levered Return (EPS/Price)
Strategy A: Buy 100 Levered
Cost = 100 x $20
$2,000.00
EPS of 100 Levered Shares
EPS for 100 Shares
$400.00
$800.00
Return
Strategy B: Borrow 10%, Buy 200 Unlev $20
Cost = 200 x $20 - $2,000
EPS of 200 Unlevered Shares
$200.00
$600.00
$1,000.00
Interst Expense
Net EPS for 200 Shares - Int Exp
The Unlevered Firm has $0 debt
A share price of $20
And EPS of $1, $3 or $5
The Levered Firm has $4,000 debt
And EPS of $0, $4 or $8
Put up $2,000, buy 100 shares of the Levered firm:
$0/$2,000 = 0%
$400/$2,000 = 20%
$800/$2,000 = 40%
Put up $2,000 and Borrow $2,000, buy 200 share of the Unlevered Firm
Returns of 0%, 20% or 40%
Since the returns available to an owner of the Levered Firm are easily replicated by an individual borrowing and buying shares of the Unlevered Firm
Firms create no value by levering!

23. ValueLevered = ValueUnlevered
This result is know as MM I
ValueLevered = ValueUnlevered
VL = VU
Without Taxes (or other frictions)
The value of the firm does not increase with the addition of debt (leverage)
Changing the way the pie is sliced does not increase the size of the pie
If people can borrow at the same cost as the company
Can they? Brokerage Margin Rates and Corporate Borrowing Rates
Result:
A company can’t create value just by replicating what people can do on their own

24. So how does RE change when D/E changes?
Second Result MM II (still no Taxes):
RE = RA + (RA – RD)D/E
RA is the required return on the firm’s assets
RA is function of cyclicality and operating leverage
RD is the required return on the firm’s debt
RD is a function of the risk of the assets and the amount of debt
D/E is the measure of leverage
RE is the required return on the firm’s equity
So how does RE change when D/E changes?
Result:
RE increases as leverage increases
This result is know as MM II

25. Check the Previous Example:
So Levered Firm has greater expected return
20% vs 15%
But also greater risk measured by stdev
16.33% vs 8.16%
Recession
Expected
Expansion
Probability
33%
Unlevered Return = EPS/Price 5%
15%
25%
Levered Return = EPS/Price 0%
20%
40%
E(R) σ
Unlevered
15.00%
8.16%
Levered
20.00%
16.33%

26. RA = E/(D + E)RE + D/(D + E) RD
Derivation:
WACC = WERE + WDRD
RA = WERE + WDRD
RA = (E/V) RE + (D/V) RD
RA = E/(D + E)RE + D/(D + E) RD
Do a bunch of Algebra:
See footnote 7, page 499
Note that I am using E, D and A, not S, B and 0
RE = RA + (RA – RD)D/E

27. New Example: An Unlevered Firm earns $100 per year forever
Unlevered means D/E = 0
No Interest Expense and No Taxes
 EBIT = EBT = NI = $100
The firm has 100 shares of stock
EPS = $100/100 = $1
Price per share = $10
RE = $1/$10 = 10%
RE = RA + (RA – RD)D/E
 10% = RA + 0  RA = 10%
Firm Value = 100 x $10 = $100/0.10 = $1,000
Assume the firm issues $200 of 5% debt
and Repurchases $200 of stock
Three Questions:
What does this do to the firm’s cost of equity (RE)?
What does this do the firm’s WACC?
What does this do to the firm’s value (VL versus VU)?

28. Leverage increases the Equity’s risk so RE Increases!
What does this do to the firm’s cost of equity (RE)?
If the firm issues $200 of 5% debt and repurchases $200 of stock:
EBIT = $100
Assets, AT and PM did not change
Interest Expense = $200 x 5% = $10
EBT = NI = EBIT – Interest Expense = $100 - $10 = $90
$90 per year forever
New Number of Shares = $200/$10 = 100 – 20 = 80
New EPS = NI/Shares = $90/80 = $1.125
New RE = $1.125/$10 = 11.25% OR
RE = RA + (RA – RD)D/E
D/E = $200/$800 = 0.25
RA = 10%
The firm’s assets did not change
RE = 10% + (10% – 5%)0.25 = 11.25%
Leverage increases the Equity’s risk so RE Increases!

29. What does this do to the firm’s WACC?
Before the Leverage:
RE = 10.00%
WE = 1.00
No Taxes (yet)
WACC = WERE + WDRD(1 - T)
WACC = 1.00(10.00%) + 0 = 10.00%
If the firm issues $200 of 5% debt and repurchases $200 of stock:
RE = 11.25%
WE = $800/$1,000 = 0.80
RD = 5.00%
WD = $200/$1,000 = 0.20
Still No Taxes (yet)
WACC = 0.80(11.25%) (5.00%)(1 – 0) = 10.00%
WACC does not change!

30. Firm Value Does Not Change!
What does this do to the firm’s Value?
Firm Value is the Sum of the NPVs of all the firm’s projects
The WACC does not change so the discount rate does not change
If the discount rate does not change, then the NPVs do not change
Firm Value Does Not Change!
Recap:
MM I without Taxes: VL = VU
MM II without Taxes: RE = RA + (RA – RD)D/E
The Point:
Financing decisions do not create value
Operating decisions create value!
(Without Taxes)

31. Now Included Taxes Same Three Questions:
What does this do to the firm’s value (VL versus VU)?
What does this do to the firm’s cost of equity (RE)?
What does this do the firm’s WACC?
But answered in a slightly different order…

32. 1st look at Differences in Total CFs to Stakeholders
CFs to Stakeholders = CF to Stockholders + CF to Creditors
Example:
A firm’s EBIT = $100
Tax Rate = 35%
Unlevered: No Debt and therefore no Interest Expense:
EBIT = EBT = $100
Tax Expense = $100 x 0.35 = $35
NI = $100 - $35 =$65 OR
NI = EBIT(1 – T) = $100(1 – 0.35) = $65
So a total of $65 per year to investors
Just stockholders since nothing is given to bondholders (no debt)

33. With Taxes, Debt Increases Total Money Available to Stakeholders!
Now Assume $200 of 5% Debt:
RD = 5%
EBIT = $100
Interest Expense = 0.05 x $200 = $10
EBT = $100 - $10 = $90
Tax Expense = $90 x 0.35 = $31.50
NI = EBT – Tax Exp = $90 - $31.50 = $58.50 OR
NI = (EBIT – RDD) - (EBIT – RDD)T
NI = (EBIT – RDD)(1 –T)
NI = ($100 – 0.05 x $200)(1 – 0.35) = $58.50
NI = ($90)(0.65) = 58.50
$58.50 to Equity holders and $10 to Debt holders
CFs to Stakeholders = $ $10 = $68.50
Total CFs without Debt = NI = $65
Total CFs with Debt = NI + Int Exp = $ $10 = $68.50
With Taxes, Debt Increases Total Money Available to Stakeholders!

34. Because Debt Creates a Tax Shield
D = $ RD = 5% T = 35%
CF to Equity holders = NI
NI = (EBIT – RDD)(1 –T)
NI = EBIT(1 – T) – RDD(1 –T)
NI = EBIT(1 – T) – RDD + TRDD
CF to Debt holders = Interest Expense
Interest Expense = RDD
Total CFs to Equity and Debt holders
Total CFs = EBIT(1 – T) – RDD + TRDD + RDD
Total CFs = EBIT(1 – T) + TRDD
Unlevered: Total CFs = EBIT(1 – T)
Levered: Total CFs = EBIT(1 – T) + TRDD
TRDD is the increase in CFs from adding debt.
It is the annual tax savings or tax shield
So what is value of the TAX Shield?
TRDD = (0.35)(0.05)($200) = $3.50
Recall: $ $65 = $3.50

35. With Taxes, Adding Debt Increases Firm Value
Debt Creates a Tax Shield
Unlevered:
Total CFs = EBIT(1 – T) = $65
Levered:
Total CFs = EBIT(1 – T) + TRDD = $65 + $3.50 = $68.50
TRDD is the annual increase in Total CFs from adding debt
Assume T, Debt and RD are constant forever
Then the Tax Shield is a perpetuity
At what rate should we discount the perpetuity?
Assume the tax savings has the same risk as the debt
So discount the annual Tax Shield at RD
So if Tax Shield is a perpetuity discounted by RD,
Then the PV of the Tax Shield is:
PV of Tax Shield = TRDD/RD = TD
MM I with Taxes: VL = VU + TC x D
(Recall MM I without Taxes: VL = VU)
With Taxes, Adding Debt Increases Firm Value

36. What Happens to Equity Risk and Equity Return with Taxes?
Without Taxes: βEquity = βAssets (1 + D/E)
With Taxes: βEquity = βAssets [1 + (1 - T)D/E]
(See Chapter 13, footnote 7, page 409)
Equity Return:
Without Taxes: RE = RA + (RA – RD)D/E
With Taxes: RE = RA + (RA – RD)(1 – T)D/E

37. New Example: An Unlevered Firm earns $100 per year forever
Calculate the RE and WACC:
Unlevered means D/E = 0
No Interest Expense
So EBIT = EBT = $100
Taxes = 35%
NI = EBIT(1 – T) = $100(1 – 0.35) = $65
The firm has 100 shares of stock
EPS = $65/100 = $0.65
Price per share = $6.50
RE = $0.65/$6.50 = 10%
WACC = RA = WERE + WDRD(1 - T) = 1.00(10.00%) + 0 = 10.00%
Value = $6.50 x 100 = $650
The firm issues $200 of 5% debt and repurchases $200 of stock
What does this do to the firm’s value (VL versus VU)?
What does this do to the firm’s cost of equity (RE)?
What does this do the firm’s WACC?

38. With Taxes, Adding Debt Increases Firm Value
What does this do to the firm’s Value?
Unlevered Value (VU) is the PV of the after-tax EBIT
T = 35%
D = $200
RD = 5%
VU = EBIT(1 – T)/WACC = $100(1 – 0.35)/0.10 = $650
VL = VU + PV of Tax Shield
Recall:
Annual Tax Shield = Tax Rate x Interest Expense = RD x D x T
PV of Annual Tax Shield = (RD x D x T)/RD = TD
VL = VU + TD
VL = $650 + $200 x 0.35 = $650 + $70 = $720
With Taxes, Adding Debt Increases Firm Value

39. Leverage increases the Equity’s risk so RE Increases
What does this do to the firm’s cost of equity (RE)?
Calculate the New RE: for the Levered Firm:
RE = RA + (RA – RD)(1 – T)D/E
RA = 10.00%
RD = 5.00%
T = 35%
Value = $720
D = $200
E = $720 - $200 = $520
D/E = 200/520 =
= 10% + (10% - 5%)( ) = 11.25%
Unlevered RE = 10.00%
Levered RE = 11.25%
Leverage increases the Equity’s risk so RE Increases

40. Leverage Lowers the Cost of Capital!
What does this do to the firm’s WACC?
Before the Leverage:
RE = 10.00%
WE = 1.00
Taxes = 35%
WACC = WERE + WDRD(1 - T)
WACC = 1.00(10.00%) + 0 = 10.00%
If the firm issues $200 of 5% debt and repurchases $200 of stock:
RE = 11.25%
WE = $520/$720 =
RD = 5.00%
WD = $200/$720 =
T = 35%
WACC = (11.25%) (5.00%)(1 – 0.35) = 9.03%
Leverage Lowers the Cost of Capital!

41. With Taxes, Adding Debt Lowers WACC And this Increases Firm Value
One More Look at Value – Lowering the WACC
Unlevered WACC was 10%
VU = EBIT(1 – T)/WACC
VU = $100(1 – 0.35)/0.10 = 65/0.10 = $650
Levered WACC is 9.03%
VL = EBIT(1 – T)/WACC
VL = $100(1 – 0.35)/ = 65/ = $720
With Taxes, Adding Debt Lowers WACC
And this Increases Firm Value

42. One More Look at the Firm’s Cost of Equity (RE)
Consider the CAPM:
RE = Rf + βEquity[E(RM) – Rf]
For the Market:
E(RM) – Rf = 8.33%
Rf = 5.00%
RE for the Unlevered Firm:
βEquity = 0.60
RE = Rf + βEquity[E(RM) – Rf] = 5.00% [8.33%] = 10.00%
Also:
βEquity = βAssets [1 + (1 - T)D/E]
0.60 = βAssets [1 + (1 - T)0/E]
βAssets = 0.60

43. One More Look at the Firm’s Cost of Equity (RE) For the Levered Firm
D/E = 200/520 =
βAssets = 0.60
βEquity = βAssets [1 + (1 - T)D/E] = 0.60[1 + (0.65)(0.3846)]
βEquity = 0.60[ ] = 0.60(1.25) = 0.75
RE = Rf + βEquity[E(RM) – Rf] = 5.00% [8.33%] = 11.25%
This is the same RE as we got from MM II:
RE = RA + (RA – RD)(1 – T)D/E
= 10% + (10% - 5%)( ) = 11.25%

44. Recap: With Taxes: Leverage Increases Equity Risk (βEquity)
βEquity = βAssets [1 + (1 - T)D/E]
βEquity from 0.60 to 0.75
Leverage Increases Equity Return (RE)
RE = RA + (RA – RD)(1 – T)D/E
RE from 10.00% to 11.25%
Leverage Decreases WACC
WACC from 10.00% to 9.03%
Leverage Increases Value
VL = VU + TD
Value from $650 to $720

45. So if Increasing Leverage Increases Value
Why not 100% Debt?
Let’s try 90% debt instead:
Same Company with NI = $65 and VU = $650
Now issue $854 of 5% Debt (instead of $200)
VL = VU + TD = $650 + (.35)$854 = $650 + $299 = $949
E = $949 – $854 = $95
WE = $95/$949 = and WD = 854/949 = 0.90
D/E = $854/$95 = 9.00
Calculate New RE:
RE = RA + (RA – RD)(1 – T)D/E = 10% + (10% - 5%)(.65)9 = 39.22%
Calculate New WACC:
WACC = 0.10(39.22%) (5%)(1 – 0.35) = 6.85%
WACC from 10.00% to 6.85%
Old Value: $65/0.10 = $650
New Value: $65/ = $948
Why does this not work?

46. How Firms Establish Capital Structure
Most corporations have low Debt-Asset ratios.
Changes in financial leverage affect firm value.
Firm value increases with leverage
This is consistent with M&M with taxes.
Another interpretation is that firms signal good news when they lever up
Differences in capital structure across industries.
Evidence that firms behave as if they had a target Debt-Equity ratio

47. Factors in Target D/E Ratio
Taxes
Since interest is tax deductible, highly profitable firms should use more debt (i.e., greater tax benefit).
Types of Assets
The costs of financial distress depend on the types of assets the firm has.
Airplanes vs. Fixed Assets
Uncertainty of Operating Income
Cyclicality and Operating Leverage
Even without debt, firms with uncertain operating income have a high probability of experiencing financial distress

48. Some Debt to Value Ratios
Table 17.3 Page 546

49. Other Industries Goto Spreadsheet
“Damodaran Corporate Financial Leverage.xlsx” 