1. Capital Structure Decisions: Part I
Chapter 15
Capital Structure Decisions:
Part I

2. Topics in Chapter Overview of capital structure effects
Business versus financial risk
The impact of debt on returns
Capital structure theory, evidence, and implications
Choosing the optimal capital structure: An example

3. Basic Definitions V = value of firm FCF = free cash flow
WACC = weighted average cost of capital
rs and rd = costs of stock and debt
wce and wd = percentages of the firm that are financed with stock and debt

4. Capital Structure and Firm Value= ∑ ∞
t=1
FCFt
(1 + WACC)t
(15-1)
WACC= wd (1-T) rd + wcers
(15-2)

5. Capital Structure Effects Preview
The impact of capital structure on value depends upon the effect of debt on:
WACC
FCF

6. The Effect of Debt on WACC
Debt increases the cost of equity, rs
Debt holders have a prior claim on cash flows relative to stockholders.
Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.
Debt reduces the firm’s taxes
Firm’s can deduct interest expenses.
Frees up more cash for payments to investors
Reduces after-tax cost of debt

7. The Effect of Debt on WACC
Debt increases risk of bankruptcy
Causes pre-tax cost of debt to increase
Adding debt:
Increases percent of firm financed with low-cost debt (wd)
Decreases percent financed with high-cost equity (wce)
Net effect on WACC = uncertain

8. The Effect of Debt on FCF
 debt   probability of bankruptcy
Direct costs:
Legal fees
“Fire” sales, etc.
Indirect costs:
Lost customers
Reduction in productivity of managers and line workers,
Reduction in credit (i.e., accounts payable) offered by suppliers

9. The Effect of Additional Debt
Impact of indirect costs
 Sales &  Productivity
Customers choose other sources
Workers worry about their jobs
NOWC 
Suppliers tighten credit
NOPAT 
FCF 

10. The Effect of Additional Debt on Managerial Behavior
Reduces agency costs:
Debt reduces free cash flow waste
Increases agency costs:
Underinvestment potential

11. Asymmetric Information and Signaling
“Asymmetric Information” = insiders know more than outsiders
Managers know the firm’s future prospects better than investors.
Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock
= Investors often perceive an additional issuance of stock as a negative signal
Stock price 

12. Business Risk vs. Financial Risk
Uncertainty about future EBIT
Depends on business factors such as competition, operating leverage, etc.
Financial risk:
Additional business risk concentrated on common stockholders when financial leverage is used

13. Business risk: Uncertainty about future pre-tax operating income (EBIT).
Probability
EBIT
E(EBIT)
Low risk
High risk
Note: Business risk focuses on operating income, ignoring financing effects.

14. Factors That Influence Business Risk
Demand variability (uncertainty unit sales)
Sales price variability
Input cost variability
Ability to adjust output prices for changes input costs
Ability to develop new products
Foreign risk exposure
Degree of operating leverage (DOL)

15. Operating Leverage
Operating leverage is the change in EBIT caused by a change in quantity sold.
> Fixed costs  > Operating leverage
The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.

16. Figure 15.1
Illustration of Operating Leverage

17. Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline.
Rev.
Rev. $ $ } TC
EBIT TC F F
QBE
Sales
Sales
QBE

18. Strasburg Electronics Company

19. Strasburg Expected Sales

20. Strasburg Plan A
Figure 15-1 Lower Panel

21. Strasburg Plan B
Figure 15-1 Lower Panel

22. Strasburg: Plans A & B
Figure 15-1 Upper Panel

23. Operating Breakeven: QBE
QBE = F / (P – V) (15-4)
QBE = Operating breakeven quantity
F = Fixed cost
V = Variable cost per unit
P = Price per unit

24. Strasburg Breakeven

25. Strasburg: Plans A & B

26. Higher operating leverage leads to higher expected EBIT and higher risk.
Low operating leverage
Probability
High operating leverage
EBITL
EBITH

27. Strasburg & Financial Risk
Strasburg going with Plan B
Riskier
Higher expected EBIT and ROIC
Financial risk:
Additional business risk concentrated on common stockholders when financial leverage is used

28. Strasburg - Extended To date – no debt Two financing choices:
Remain at 0 debt
Move to $100,000 debt and $100,000 book equity

29. Table 15.1
Strasburg Electronics – Effects of Financial Leverage

30. Strasburg with No Debt Table 15-1 Section I
ROE = Net Income/Book Equity
Expected ROE = ROE under each demand X Probability

31. Strasburg with 50% Debt
Table 15-1 Section II

32. Strasburg w/ Zero Debt
Strasburg w/ 50% Debt
Higher ROE
Higher Risk

33. Leveraging Increases ROE
More EBIT goes to investors:
Total dollars paid to investors:
I: NI = $24,000
II: NI + Int = $18,000 + $10,000 = $28,000
Taxes paid:
I: $16,000; II: $12,000
Equity $ proportionally lower than NI

34. Strasburg’s Financial Risk
In a stand-alone sense, stockholders see much more risk with debt.
I: σROE = 14.8%
II: σROE = 29.6%
Strasburg’s financial risk = σROE - σROIC = 29.6% % = 14.8%

35. Capital Structure Theory
Modigliani & Miller theory
Zero taxes (MM 1958)
Corporate taxes (MM 1963)
Corporate and personal taxes (Miller 1977)
Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Windows of opportunity

36. MM Results: Zero Taxes
If two portfolios (firms) produce the same cash flows, then the two portfolios must have the same value.
A firm’s value is unaffected by its capital structure

37. MM (1958) Assumptions No brokerage costs No taxes No bankruptcy costs
Investors can borrow and lend at the same rate as corporations
All investors have the same information
EBIT is not affected by the use of debt

38. MM Theory: Zero Taxes Firm U Firm L EBIT $3,000 Interest 1,200 NI
1,200 NI
$1,800
CF to shareholder
CF to debt holder
$1,200
Total CF
Notice that the total CF are identical.

39. MM Results: Zero Taxes MM prove:
If total CF to investors of Firm U and Firm L are equal, then the total values of Firm U and Firm L must be equal:
VL = VU
Because FCF and values of firms L and U are equal, their WACCs are equal
Therefore, capital structure is irrelevant

40. MM (1963): Corporate Taxes Relaxed assumption of no corporate taxes
Interest may be deducted, reducing taxes paid by levered firms
More CF goes to investors, less to taxes when leverage is used
Debt “shields” some of the firm’s CF from taxes

41. MM Result: Corporate Taxes
MM show that the value of a levered firm = value of an identical unlevered form + any “side effects.”
VL = VU + TD (15-7)
If T=40%, then every dollar of debt adds 40 cents of extra value to firm

42. MM relationship between value and debt when corporate taxes are considered.
Value of Firm, V
Debt VL VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used. TD

43. MM relationship between capital costs and leverage when corporate taxes are considered
Cost of Capital (%) rs
WACC
rd(1 - T)
Debt/Value Ratio (%)

44. Miller (1977): Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing
Interest expenses deductible
Personal taxes favor equity financing
No gain is reported until stock is sold
Long-term gains taxed at a lower rate

45. Miller’s Model with Corporate and Personal Taxes
VL = VU + 1− D (15-8)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
(1 - Tc)(1 - Ts)
(1 - Td)

46. Tc = 40%, Td = 30%, and Ts = 12% VL = VU + 1− D (1 - 0.40)(1 - 0.12)
Value rises with debt; each $1 increase in debt raises Levered firm’s value by $0.25.
( )( )
( )

47. Trade-off Theory MM theory assume no cost to bankruptcy
The probability of bankruptcy increases as more leverage is used
At low leverage, tax benefits outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists (theoretically) that balances costs and benefits.

48. Figure 15.2
Effect of Leverage on Value

49. Signaling Theory
MM assumed that investors and managers have the same information.
Managers often have better information and would:
Sell stock if stock is overvalued
Sell bonds if stock is undervalued
Investors understand this, so view new stock sales as a negative signal.

50. Pecking Order Theory Firms use internally generated funds first (1):
No flotation costs
No negative signals
If more funds are needed, firms then issue debt (2)
Lower flotation costs than equity
If more funds are still needed, firms then issue equity (3)

51. Pecking Order Theory
INTERNAL
EXTERNAL
DEBT 2
EQUITY 1 3

52. Debt Financing & Agency Costs
Agency problem #1: Managers use corporate funds for non-value maximizing purposes
Financial leverage:
Bonds commit “free cash flow”
Forces discipline on managers to avoid perks and non-value adding acquisitions.
LBO = ultimate use of debt controlling management actions

53. Debt Financing & Agency Costs
Agency problem #2: “Underinvestment”
Debt increases risk of financial distress
Managers may avoid risky projects even if they have positive NPVs

54. Investment Opportunity Set and Reserve Borrowing Capacity
Firms should normally use more equity, less debt than optimal
“Reserve borrowing power”
Especially important if:
Many investment opportunities
Asymmetric information issues cause equity issues to be costly

55. Windows of Opportunity
Managers try to “time the market” when issuing securities.
Issue
When
And
Equity
Market is “high”
Stocks have “run up”
Debt
Market is “low”
Interest rates low
S/T Debt
Term structure is upward sloping
L/T Debt
Term structure is flat

56. Empirical Evidence Tax benefits are important Bankruptcies are costly
$1 debt adds  $0.10 to value
Supports Miller model with personal taxes
Bankruptcies are costly
Costs can =10% to 20% of firm value
Firms don’t make quick corrections when Δstock price  Δdebt ratios
Doesn’t support trade-off model

57. Empirical Evidence
After stock price , debt ratio , but firms tend to issue equity not debt
Inconsistent with trade-off model
Inconsistent with pecking order
Consistent with windows of opportunity
Firms tend to maintain excess borrowing capacity
Firms with growth options
Firms with asymmetric information problems

58. Implications for Managers
Take advantage of tax benefits by issuing debt, especially if the firm has:
High tax rate
Stable sales
Less operating leverage

59. Implications for Managers
Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has:
Volatile sales
High operating leverage
Many potential investment opportunities
Special purpose assets (instead of general purpose assets that make good collateral)

60. Implications for Managers
If manager has asymmetric information regarding firm’s future prospects, then:
Avoid issuing equity if actual prospects are better than the market perceives
Consider impact of capital structure choices on lenders’ and rating agencies’ attitudes

61. The Optimal Capital Structure
Maximizes shareholder wealth
Maximizes firm value
Maximizes stock price
Minimizes WACC
Does NOT maximize EPS

62. Estimating the Optimal Capital Structure: 5 Steps
Estimate the interest rate the firm will pay (cost of debt)
Estimate the cost of equity
Estimate the WACC
Estimate the free cash flows and their present value (value of the firm)
Deduct the value of debt to find Shareholder Wealth  Maximize

63. Choosing the Optimal Capital Structure: Strasburg Example
Currently all-equity financed
Expected EBIT = $40,000
10,000 shares outstanding
rs = 12% P0 = $25
T = 40% b = 1.0
rRF = 6% RPM = 6%

64. Step 1: Estimates of Cost of Debt
TABLE 15.2

65. The Cost of Equity at Different Levels of Debt: Hamada’s Equation
MM theory  beta changes with leverage
bU = the beta of a firm with NO debt
Unlevered beta
b = bU [1 + (1 - T)(D/S)]
D = Market value of firm’s debt
S = Market value of firm’s equity
T = Firm’s corporate tax rate

66. Step 2: The Cost of Equity for wd = 50%
Use Hamada’s equation to find beta:
b = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (50% / 50%) ]
= 1.60
Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% (6%) = 15.6%

67. TABLE 15.3
Strasburg’s optimal Capital Structure

68. Step 3: Strasburg’s WACC & Optimal Capital Structure
Note: The Capital Structure that MAXIMIZES firm value is the one that MINIMIZES WACC

69. Notes to Table 15-3

70. Figure 15.3
Strasburg’s Required Rate of Return on Equity

71. Figure 15-4: Effects of Capital Structure on Cost of Capital

72. Step 4: Corporate Value for wd = 0%
Vop = FCF(1+g) / (WACC-g)
g=0, so investment in capital is zero
FCF = NOPAT = EBIT (1-T)
NOPAT = ($40,000)(1-0.40) = $24,000
Vop = $24,000 / 0.12 = $200,000

73. Step 4: Strasburg’s Firm Value
Note: The Capital Structure that MAXIMIZES firm value is the one that MINIMIZES WACC

74. Implications for Strasburg
Firm should recapitalize (“recap”)
Issue debt
Use funds to repurchase equity
Optimal debt = 40%
WACC = 10.80%
Maximizes Firm Value

75. Anatomy of Strasburg’s Recap: Before Issuing Debt

76. Issue Debt (wd = 40%), But Before Repurchase
WACC decreases to 10.80%
Vop increases to $222,222
Short-term funds = $88,889
Temporary until it uses these funds to repurchase stock
Debt is now $88,889

77. Anatomy of a Recap: After Debt, but Before Repurchase
Vop  $222,222
Debt = $88,889
S/T funds = $88,889
Stock Price  $22.22
Shareholder wealth  $

78. The Repurchase: No Effect on Stock Price
Announcement of intended repurchase might send a signal that affects stock price
The repurchase itself has no impact on stock price.
If investors think the repurchase would:
 stock price, they would purchase stock the day before, which would drive up its price.
 stock price, they would all sell short the stock the day before, which would drive down the stock price.

79. Remaining Number of Shares After Repurchase
D0 = original amount of debt
D = amount after issuing new debt
If all new debt is used to repurchase shares, then total dollars used equals:
(D – D0) = ($88,889 - $0) = $88,889
n0 = number of shares before repurchase,
n = number after repurchase.
n = n0 – (D – D0)/P = 10,000 - $88,889/$22.22
n = 10,000 – 4,000 = 6,000

80. Anatomy of Strasburg’s Recap: After Repurchase

81. Strasburg after Recapitalization Key Points
Short Term investments used to repurchase stock
Stock price is unchanged
Value of stock falls to $133,333
Firm no longer owns the short-term investments
Wealth of shareholders remains at $222,222

82. Shortcuts
The corporate valuation approach will always give the correct answer
There are some shortcuts for finding S, P, and n
Shortcuts on next slides

83. Calculating S, the Value of Equity after the Recap
S = (1 – wd) Vop (15-13)
At wd = 40%:
SPrior = S + (D – D0) (15-14)
S = (1 – 0.40) $222,222
S = $133,333
SPrior = $133,333 + (88,889 – 0)
SPrior = $222,222

84. Calculating P, the Stock Price after the Recap
P = [S + (D – D0)]/n0 (15-15)
P = $133,333 + ($88,889 – 0)
10,000
P = $22.22 per share

85. Number of Shares after a Repurchase, n
# Repurchased = (D - D0) / P
n = n0 - (D - D0) / P
# Rep. = ($88,889 – 0) / $22.22
# Rep. = 4,000
n = 10,000 – 4,000
n = 6,000

86. TABLE 15.5
Strasburg’s Stock Price & EPS

87. Analyzing the Recap
Table 15-5

88. FIGURE 15.5 Effects of Capital Structure on Firm Value, Price and EPS

89. Effects of Capital Structure on Price and EPS

90. Optimal Capital Structure
wd = 40% gives:
Highest corporate value
Lowest WACC
Highest stock price per share
Does NOT maximize EPS