1. Topics in Chapter 15: Capital Structure
Business versus financial risk
Impact of financial leverage on returns
Analyzing alternative capital structures
Optimal capital structure

2. Business Risk
Business risk: the risk facing a firm’s shareholders if it has ______________.
Business risk is the risk associated with firm’s assets and the nature of the products it produces and sells.
One measure of business risk is the standard deviation of EBIT.

3. Factors Contributing to Business Risk
Uncertainty about _______________.
Uncertainty about sale _____________.
Uncertainty about input ____________.
Fixed operating costs.
Foreign risk exposure.

4. Capital Structure
To minimize the complexity of capital structure analysis, we simplify:
No preferred stock financing: the firm’s capital consists of common equity and debt
No __________________________ assets
100% dividend payout, so _____________

5. Capital Structure
We saw in Chapter 11 that the value of the firm is the PV of expected FCFs, discounted at the WACC (plus marketable securities, if any).
Now, we consider how changes in the firm’s capital structure affects FCF &/or WACC, and hence the firm value.

6. Capital Structure As a firm increases its use of debt:
rs and rd ____________________
WACC initially _____________________, then ______________________
Excessive use of debt might cause FCF to decrease, due to greater risk of financial distress & bankruptcy

7. Financial Distress
Financial distress resulting from debt financing includes:
Direct costs of _____________________
______________________ costs because bankruptcy is more likely (loss of customers, loss of key employees, etc.)

8. Financial Risk
Financial risk: the risk that results from ______________________ financing.
Measures of fin’l risk include debt ratio, debt/equity, times interest earned, etc.
If a firm relies heavily on debt financing, it has high financial leverage and high financial risk.
Why expose the firm to financial risk?

9. Consider Two Hypothetical Firms
Firm U
Firm L
No debt
$10,000 of 12% debt
$20,000 in assets
40% tax rate
Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt.

10. Impact of Leverage on Returns
Firm U
Firm L
EBIT
$3,000
Interest
1,200
EBT
$1,800
Taxes (40%)
1 ,200
720 NI
$1,080
ROE
9.0%
10.8%

11. Why does leveraging increase return?
More cash flow goes to investors and less is paid in taxes in Firm L.
Total dollars paid to investors:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200; L: $720.

12. Why Does Debt Financing Increase ROE?
Firm L’s ROE is higher because its basic earning power (BEP) > interest rate.
BEP = EBIT / (Total Assets)
= 3,000 / 20,000 = .15
Firm L is borrowing at 12% and investing in assets that earn 15%.

13. Conclusions
L has higher expected ROE due to tax savings and smaller equity base.
L has more volatile returns because of fixed interest charges.
Higher expected return is accompanied by higher risk.

14. Other issues in Capital Structure Theory
Trade-off theory
Signaling theory
Pecking order

15. Trade-off Theory of Capital Structure
At low leverage levels, __________ benefits outweigh bankruptcy ________
At high levels, bankruptcy ___________ outweigh _____________ benefits.
An optimal capital structure exists that balances these costs and benefits.

16. Signaling Theory
Managers have better information than investors. They will:
Sell stock if stock is __________________.
Sell bonds if stock is _________________.
Investors understand this, so view new stock sales as a __________________ ___________________.

17. Pecking Order Theory
Firms use retained earnings first, because there are no ______________ or negative __________________.
If more funds are needed, firms then issue debt because it has lower flotation costs than equity and no negative ___________________ to investors.
New equity is issued only as a last resort.

18. Empirical Evidence
Tax benefits are important– $1 debt adds about $0.10 to value.
Bankruptcies are costly– average costs are 10% to 20% of firm value.
Firms don’t make quick corrections when stock price changes cause their debt ratios to change.

19. Implications for Managers
Use _______ debt financing if firm has:
High business risk
Many potential investment opportunities
Special use assets
High tax rate
Low business risk

20. Choosing Capital Structure: Definitions
V = value of firm = D + S
D = market value of debt
S = market value of stock
rs & rd are costs of stock & equity
wce and wd are the percentage of financing from equity and debt
Varying wce and wd result in alternative capital structures

21. Choosing the Optimal Capital Structure: Example
Currently is all-equity financed.
Expected EBIT = $500,000.
Firm expects zero growth.
100,000 shares outstanding; P0 = $25; T = 40%; b = 1.0; rRF = 6%;
RPM = 6%.

22. Choosing the Optimal Capital Structure: Example
Initially:
rs = rRF + b (RPM)
= (6) = 12% = WACC
S0 = P0 x n0 = $25 x 100,000 = $2,500,000
V0 = S0 + D0 = $2,500,000

23. Estimates of Cost of Debt
% financed with debt, wd rd 0% -
20%
8.0%
30%
8.5%
40%
10.0%
50%
12.0%
If company recapitalizes, debt would be issued to repurchase stock.

24. The Cost of Equity at Different Levels of Debt: Hamada’s Equation
bU is the beta of a firm when it has no debt (the unlevered beta)
Hamada’s equation allows us to calculate beta at different levels of debt:
bL = bU [1 + (1 - T)(D/S)]

25. The Cost of Equity for wd = 20%
Use Hamada’s equation to find beta:
bL= bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% (6%) = 12.9%

26. Cost of Equity vs. Leveragewd
D/S bL rs 0%
0.00
1.000
12.00%
20%
0.25
1.150
12.90%
30%
0.43
1.257
13.54%
40%
0.67
1.400
14.40%
50%
1.00
1.600
15.60%

27. The WACC for wd = 20% WACC = wd (1-T) rd + wce rs
Repeat this for all capital structures under consideration.

28. WACC vs. Leverage wd rd rs WACC 0% 0.0% 12.00% 20% 8.0% 12.90% 11.28%
30%
8.5%
13.54%
11.01%
40%
10.0%
14.40%
11.04%
50%
12.0%
15.60%
11.40%

29. Corporate Value for wd = 20%
V = FCF(1+g) / (WACC-g)
g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T).
NOPAT = ($500,000)(1-0.40) = $300,000.
V = $300,000 / = $2,659,574.

30. Corporate Value vs. Leveragewd
WACC
Corp. Value 0%
12.00%
$2,500,000
20%
11.28%
$2,659,574
30%
11.01%
$2,724,796
40%
11.04%
$2,717,391
50%
11.40%
$2,631,579

31. Debt and Equity for wd = 20%
The dollar value of debt is:
D1 = wd x V1
= 0.2 ($2,659,574) = $531,915.
S1 = V1 – D1
S1 = $2,659,574 - $531,915
= $2,127,659.

32. Debt and Stock Value vs. Leveragewd
Debt, D
Stock Value, S 0% $0
$2,500,000
20%
$531,915
$2,127,660
30%
$817,439
$1,907,357
40%
$1,086,957
$1,630,435
50%
$1,315,789
Note: these are rounded; see Ch 15 Mini Case.xls for full calculations.

33. Wealth of Shareholders
Value of the equity declines as more debt is issued, because debt is used to repurchase stock.
But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).

34. Stock Price for wd = 20%
The firm issues debt, which changes its WACC, which changes value.
The firm then uses debt proceeds to repurchase stock.
Stock price changes when firm announces recapitalization.
(More…)

35. Stock Price for wd = 20% (Continued)
The stock price upon announcement reflects shareholder wealth:
S1, the new total value of stock
Cash paid in repurchase.
(More…)

36. Stock Price for wd = 20% (Continued)
D0 and n0 are debt and outstanding shares before recap.
D1 - D0 is equal to cash that will be used to repurchase stock.
S1 + (D1 - D0) = new wealth of shareholders.
(More…)

37. Stock Price for wd = 20% (Continued)
P1 = S1 + (D1 – D0) n0
P1 = $2,127,660 + ($531,915 – 0)
100,000
P1 = $ per share.

38. Number of Shares Repurchased
# Repurchased = (D1 - D0) / P1
# Rep. = ($531,915 – 0) / $26.596
= 20,000.
# Remaining = n1 = S1 / P1
n1 = $2,127,660 / $26.596
= 80,000.

39. Price per Share vs. Leverage
# shares wd P
Repurch.
Remaining 0%
$25.00
100,000
20%
$26.60
20,000
80,000
30%
$27.25
30,000
70,000
40%
$27.17
40,000
60,000
50%
$26.32
50,000

40. Optimal Capital Structure
wd = 30% is optimal:
Highest corporate value
Lowest WACC
Highest stock price per share
But wd = 40% is close. Optimal range is pretty flat.