1. CHAPTER SIXTEEN Capital Structure By J.D. Han

2. Evaluation of Capital Structures 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 capital structure  market price per share,  WACC  market price per share,  WACC

3. Evaluation of Capital Structures Different capital structures results in different levels of financial risk created through leverage. 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

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

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

6. Case 1: Capital structure without taxes and bankruptcy costs - costs from equity financing and from bond financing should be the same with each other; capital structure does not matter. denoting k e u and k e L as the cost of equity for unlevered and levered firms we have: rearranged we get:

7. Case 2: Capital Structure with Corporate taxes –capital structure matters. levered firm’s taxes are reduced by the tax shield on interest (IT) V L > V u Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity U

8. 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 =

9. The total value of a levered firm is The residual value for the equity is

10. l The cost of equity k e L increases at a slower rate, which can be seen through the formulas: How? We will prove it in a separate page.We will prove it in a separate page. What is the required rate of return of equity for a levered firm?

11. Note that k b = (1-T) r b or the after-tax interest rate on bonds:

12. Thus, the Total Cost of Capital is

13. - Debt-Equity Ratio and Bankruptcy Costs: the ability of an enterprise to tolerate higher leverage : As debts rises, the Risk Premium rises. - Agency Problems: when managers fail to act in the best interests of shareholders in the equity financing: As debts rises, this Risk Premium falls. - Which one will be dominating the other? Two Competing Factors to be Considered

14. Evaluation of Capital Structures Consequences of Different Shareholder Attitudes Toward Risk