1. Planning the Financing Mix
Capital Structure and Firm Value
Capital Structure Theories
Independence Hypothesis
Dependence Hypothesis
Moderate Position
EBIT-EPS Analysis

2. Financial Structure
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Financial
Structure

3. Capital Structure
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Capital
Structure

4. Why is Capital Structure Important?
Leverage: Higher financial leverage means higher returns to stockholders, but higher risk due to interest payments
Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital
The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value

5. Independence Hypothesis
In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter
This is known as the Independence hypothesis: firm value is independent of capital structure
Firm value does not depend on capital structure
This is also to say WACC or ko is constant

6. Independence Hypothesis (Continued)
Cost of
Capital
kcs kd
0% debt financial leverage % debt
kcs = cost of common stock
kd = cost of debt
ko = cost of capital 17

7. Independence Hypothesis
Cost of
Capital
kcs kd
Increasing leverage causes the
cost of equity to rise.
Equity becomes
riskier
What will
be the net effect
on the overall cost
of capital?
0% debt financial leverage % debt 18

8. Independence Hypothesis
Cost of
Capital
kcs ko kd
0% debt financial leverage %debt
Cost of capital stays constant.
Increase in cost of equity
is proportionate to
increase in debt
kcs kd 19

9. Independence Hypothesis
If we have perfect capital markets, capital structure is irrelevant
In other words, changes in capital structure do not affect firm value
Ignoring external equity cost:
No corporate taxes and cost of debt is constant and lower than cost of equity.
Any increase in proportion of debt in capital structure will cause a proportional increase in cost of equity leaving WACC constant. 21

10. Dependence Hypothesis
Increasing leverage does not increase the cost of equity
Since debt is less expensive than equity, more debt financing would provide a lower cost of capital
A lower cost of capital would increase firm value 21

11. Dependence Hypothesis
Cost of
Capital
kcs kd
financial leverage ko
Since the cost of debt is lower than the cost of equity…
Increasing leverage reduces the cost of capital.
Ignoring external equity cost:
No corporate taxes and cost of debt is constant and lower than cost of equity.
Also cost of equity is constant.
Any increase in proportion of debt in capital structure will not cause a proportional increase in cost of equity lowering WACC. 24

12. Moderate Position
The previous hypotheses examines capital structure in a “perfect market”
The moderate position examines capital structure under more realistic conditions
For example, what happens if we include corporate taxes?

13. Remember this example? Tax effects of financing with debt
with stock with debt
EBIT , ,000
- interest expense (50,000)
EBT , ,000
- taxes (34%) (136,000) (119,000)
EAT , ,000
- dividends (50,000)
Retained earnings , ,000 23

14. tax benefit associated with debt financing
Moderate Position
Cost of
Capital
kcs kd
financial leverage
Because of the
tax benefit associated
with debt financing
Even if the cost of equity rises as leverage
increases, the cost of debt is very low... 25

15. Moderate Position Cost of Capital kc ko kd financial leverage
The low cost of debt
reduces the cost of
capital. ko 27

16. Moderate Position
So, what does the tax benefit of debt financing mean for the value of the firm?
The more debt financing used, the greater the tax benefit, and the greater the value of the firm
So, this would mean that all firms should be financed with 100% debt, right?
Why are firms not financed with 100% debt?

17. Why is 100% Debt not Optimal?
Bankruptcy costs: costs of financial distress
Financing becomes difficult to get
Customers leave due to uncertainty
Possible restructuring or liquidation costs if bankruptcy occurs

18. Why is 100% Debt not Optimal?
Agency costs: costs associated with protecting bondholders
Bondholders (principals) lend money to the firm and expect it to be invested wisely
Stockholders own the firm and elect the board and hire managers (agents)
Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases

19. Moderate Position with Bankruptcy and Agency Costs
Cost of
Capital
financial leverage kc kd
If a firm borrows too much, the
costs of debt and equity will spike
upward, due to bankruptcy costs
and agency costs
More realistic: Corporate taxes, bankruptcy and agency costs are all considered. There two stages:
Stage 1: Benefits of lower leverage because tax deductibility of interest reduce cost of debt and WACC. However, as leverage increases cost of debt and equity also increase because of bankruptcy and agency costs increasing WACC. 34

20. Moderate Position with Bankruptcy and Agency Costs
Cost of
Capital
financial leverage kc kd ko 37

21. Moderate Position with Bankruptcy and Agency Costs
Cost of
Capital
financial leverage kc kd ko
Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital

22. Capital Structure Management
EBIT-EPS Analysis – used to help determine whether it would be better to finance a project with debt or equity
I = interest expense, t = corporate tax rate
P = preferred dividends,
S = number of shares of common stock outstanding 45

23. EBIT-EPS Example
Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options:
Sell 200,000 shares of common stock at $30 per share
Borrow $6,000,000 by issuing 10% bonds 47

24. If we expect EBIT to be $2,000,000:
Financing stock debt
EBIT 2,000, ,000,000
- interest (600,000)
EBT 2,000, ,400,000
- taxes (40%) (800,000) (560,000)
EAT 1,200, ,000
# shares outstanding 1,000, ,000
EPS $1.20 $1.05 48

25. If we expect EBIT to be $4,000,000:
Financing stock debt
EBIT 4,000, ,000,000
- interest (600,000)
EBT 4,000, ,400,000
- taxes (40%) (1,600,000) (1,360,000)
EAT ,400, ,040,000
# shares outstanding 1,000, ,000
EPS $ $2.55 49

26. If EBIT is $2,000,000, common stock financing is best
EBIT-EPS Example
If EBIT is $2,000,000, common stock financing is best
If EBIT is $4,000,000, debt financing is best
So, now we need to find a crossover EBIT where neither is better than the other 50

27. If we choose stock financing:51

28. If we choose bond financing:52

29. Crossover EBIT

30. Crossover EBIT (Continued)
Set 2 EPS calculations equal to each other and solve for EBIT:
Stock Financing Debt Financing
(EBIT – I)(1 – t) – P = (EBIT – I)(1 – t) – P
S S 54

31. Crossover EBIT (Continued)
Stock Financing Debt Financing
(EBIT – I)(1 – t ) – P = (EBIT – I )(1 – t ) – P
S S
(EBIT – 0) (1 – 0.40) = (EBIT – 600,000)(1 – 0.40)
800, , ,000
0.6 EBIT = 0.6 EBIT – 360,000
0.48 EBIT = 0.6 EBIT – 360,000
0.12 EBIT = 360,000
EBIT = $3,000,000 55