Capital Structure Decisions: The Basics

16 - 1
CHAPTER 16
Capital Structure Decisions:
The Basics
 Impact of leverage on returns
 Business versus financial risk
 Capital structure theory
 Perpetual cash flow example
 Setting the optimal capital
structure in practice
Copyright © 2002 by Harcourt, Inc. All rights reserved.
16 - 2
Consider Two Hypothetical Firms
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 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.
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Impact of Leverage on Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROE 9.0% 10.8%

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Why does leveraging increase return?
 Total dollar return to investors:

U: NI = $1,800.
L: NI + Int= $1,080 + $1,200 = $2,280.
Difference= $480.
 Taxes paid:
U: $1,200; L: $720.
Difference = $480.
 More EBIT goes to investors in Firm L.
 Equity $ proportionally lower than NI.
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What is business risk?
Uncertainty about future operating income

(EBIT). Probability
Low risk
High risk
0 E(EBIT) EBIT
Note that business risk focuses on operating
income, so it ignores financing effects.
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Factors That Influence Business Risk
 Uncertainty about demand (unit

sales).
 Uncertainty about output prices.
 Uncertainty about input costs.
 Product and other types of liability.
 Degree of operating leverage (DOL).
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What is operating leverage, and how

does it affect a firm’s business risk?
 Operating leverage is the use of fixed

costs rather than variable costs.
 The higher the proportion of fixed
costs within a firm’s overall cost
structure, the greater the operating
leverage.
(More...)

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 Higher operating leverage leads to
more business risk, because a small
sales decline causes a larger profit
decline.
$ Rev. $ Rev.
TC } Profit
TC
FC
FC
QBE Sales QBE Sales
(More...)
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Probability Low operating leverage
High operating leverage
EBITL EBITH
 In the typical situation, higher

operating leverage leads to higher
expected EBIT, but also increases risk.
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Business Risk versus Financial Risk
 Business risk:
Uncertainty in 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.
Depends on the amount of debt and
preferred stock financing.
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From a shareholder’s perspective, how

are financial and business risk
measured in the stand-alone sense?
Stand-alone Business Financial

risk = risk + risk .
Stand-alone risk = σ ROE.
Business risk = σ ROE(U).
Financial risk = σ ROE - σ ROE(U).

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Now consider the fact that EBIT is not

known with certainty. What is the
impact of uncertainty on stockholder
profitability and risk for Firm U and
Firm L?

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Firm U: Unleveraged
Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
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Firm L: Leveraged
Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
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Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
8
8
8
TIE
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 8.4% 11.4% 14.4%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
*ROI = (NI + Interest)/Total financing.
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Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROI) 9.0% 11.4%
E(ROE) 9.0% 10.8%
Risk Measures:
σROE 2.12% 4.24%
CVROE 0.24 0.39
E(TIE) 8 2.5x
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Conclusions
 Basic earning power = BEP =
EBIT/Total assets is unaffected by
financial leverage.
 L has higher expected ROI and ROE
because of tax savings.
 L has much wider ROE (and EPS)
swings because of fixed interest
charges. Its higher expected return
is accompanied by higher risk. (More...)
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 In a stand-alone risk sense, Firm L’s

stockholders see much more risk
than Firm U’s.
U and L: σ ROE(U) = 2.12%.
U: σ ROE = 2.12%.
L: σ ROE = 4.24%.
 L’s financial risk is σ ROE - σ ROE(U) =

4.24% - 2.12% = 2.12%. (U’s is zero.)
(More...)
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 For leverage to be positive (increase

expected ROE), BEP must be > kd.
 If kd > BEP, the cost of leveraging will
be higher than the inherent
profitability of the assets, so the use
of financial leverage will depress net
income and ROE.
 In the example, E(BEP) = 15% while
interest rate = 12%, so leveraging
“works.”
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Capital Structure Theory
 MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
 Trade-off theory
 Signaling theory
 Debt financing as a managerial
constraint
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MM Theory: Zero Taxes
 MM prove, under a very restrictive

set of assumptions, that a firm’s
value is unaffected by its financing
mix.
 Therefore, capital structure is
irrelevant.
 Any increase in ROE resulting from
financial leverage is exactly offset by
the increase in risk.
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MM Theory: Corporate Taxes
 Corporate tax laws favor debt

financing over equity financing.
 With corporate taxes, the benefits of
financial leverage exceed the risks:
More EBIT goes to investors and less
to taxes when leverage is used.
 Firms should use almost 100% debt
financing to maximize value.
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MM Theory: Corporate and

Personal Taxes
 Personal taxes lessen the advantage

of corporate debt:
Corporate taxes favor debt financing.
Personal taxes favor equity financing.
 Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.
 Firms should still use 100% debt.
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Hamada’s Equation
 MM theory implies that beta changes

with leverage.
bU is the beta of a firm when it has no
debt (the unlevered beta)
bL = bU(1 + (1 - T)(D/E))
 In practice, D/E is measured in book
values when bL is calculated.
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Trade-off Theory
 MM theory ignores bankruptcy

(financial distress) costs, which
increase as more leverage is used.
 At low leverage levels, tax benefits
outweigh bankruptcy costs.
 At high levels, bankruptcy costs
outweigh tax benefits.
 An optimal capital structure exists that
balances these costs and benefits.
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Signaling Theory
 MM assumed that investors and
managers have the same information.
 But, managers often have better
information. Thus, they 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.
 Implications for managers?
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Debt Financing As
a Managerial Constraint
 One agency problem is that

managers can use corporate funds
for non-value maximizing purposes.
 The use of financial leverage:
Bonds “free cash flow.”
Forces discipline on managers.
 However, it also increases risk of
financial distress.
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Perpetual Cash Flow Example
Expected EBIT = $500,000; will remain

constant over time.
Firm pays out all earnings as
dividends (zero growth).
Currently is all-equity financed. BV of
equity = MV of equity
100,000 shares outstanding.
P0 = $20; T = 40%; kRF = 6%; RPM = 4%
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Component Cost Estimates
Amount
Borrowed (000) kd
$ 0 -
250 10.0%
500 11.0
750 13.0
1,000 16.0
If company recapitalizes, debt would be
issued to repurchase stock.
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 The MM and Miller models cannot

be applied directly because several
assumptions are violated.
kd is not a constant.
Bankruptcy and agency costs
exist.
 In practice, Hamada’s equation is
used to find kS for the firm with
different levels of debt.

16 - 31
The Optimal Capital Structure
 Calculate the cost of equity at each

level of debt.
 Calculate the value of equity at each
level of debt.
 Calculate the total value of the firm
(value of equity + value of debt) at each
level of debt.
 The optimal capital structure maximizes
the total value of the firm.
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Sequence of Events in a
Recapitalization
 Firm announces the recapitalization.

 Investors reassess their views and
estimate a new equity value.
 New debt is issued and proceeds are
used to repurchase stock at the new
equilibrium price.
(More...)
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 Shares Debt issued

= .
Bought New price/share
 After recapitalization firm would have
more debt but fewer common shares
outstanding.
 An analysis of several debt levels is
given next.

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Cost of Equity at Zero Debt
 Since the firm has 0 growth, its current

value, $2,000,000, is given by
Dividends/kS = (EBIT)(1-T)/kS
= 500,000 (1 - 0.40)/kS
 kS = 15.0% = unlevered cost of equity.
 bU = (kS - kRF)/RPM = (15 - 6)/4 = 2.25

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Cost of Equity at Each Debt Level

 Hamada’s equation says that
bL = bU (1 + (1-T)(D/E))
Debt(000s) D/E bL kS
0 0 2.25 15.00%
250 0.142 2.44 15.77
500 0.333 2.70 16.80
750 0.600 3.06 18.24
1,000 1.000 3.60 20.40
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D = $250, kd = 10%, ks = 15.77%.

(EBIT - kdD)(1 - T)
S1 = ks
[$500 - 0.1($250)](0.6)
= 0.1577 = $1,807.
V1 = S1 + D1 = $1,807 + $250 = $2,057.

$2,05
P1 = 7 = $20.57.
100
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Shares $250
= = 12.15.
repurchased $20.57
Shares
= n1 = 100 - 12.15 = 87.85.
remaining
Check on stock price:

S1 $1,807
P1 = = = $20.57.
n1 87.85
Other debt levels treated similarly.
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Value of Equity at Each Debt Level

 Equity Value = Dividends/kS
Debt(000s) kD Divs kS E
0 na 300 15.00% 2,000
250 10% 285 15.77 1,807
500 11% 267 16.80 1,589
750 13% 241.5 18.24 1,324
1,000 16% 204 20.40 1,000

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Total Value of Firm
Debt Total Price per

(000s) E Value Share
0 2,000 2,000 $20.00
250 1,807 2,057 20.57 Total Value
500 1,589 2,089 20.89 is Max-
750 1,324 2,074 20.74 imized with
1,000 1,000 2,000 20.00
500,000 in
debt.
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Calculate EPS at debt of $0, $250K,

$500K, and $750K, assuming that the
firm begins at zero debt and recap-
italizes to each level in a single step.
Net income = NI = [EBIT - kd D](1 - T).

EPS = NI/n.
D NI n EPS
$ 0 $300 100.00 $3.00
250 285 87.85 3.24
500 267 76.07 3.51
750 242 63.84 3.78
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 EPS continues to increase beyond

the $500,000 optimal debt level.
 Does this mean that the optimal
debt level is $750,000, or even
higher?

16 - 42
Find the WACC at each debt level.

D S V kd Ks WACC
$ 0 $2,000 $2,000 -- 15.00% 15.0%
250 1,807 2,057 10% 15.77 14.6
500 1,589 2,089 11.0 16.80 14.4
750 1,324 2,074 13.0 18.24 14.5
1,000 1,000 2,000 13.0 20.40 15.0
e.g. D = $250:
WACC = ($250/$2,057)(10%)(0.6)
+ ($1,807/$2,057)(15.77%)
= 14.6%.
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 The WACC is minimized at D =

$500,000, the same debt level that
maximizes stock price.
 Since the value of a firm is the
present value of future operating
income, the lowest discount rate
(WACC) leads to the highest value.

16 - 44
How would higher or lower

business risk affect
the optimal capital structure?
 At any debt level, the firm’s probability

of financial distress would be higher.
Both kd and ks would rise faster than
before. The end result would be an
optimal capital structure with less debt.
 Lower business risk would have the
opposite effect.
16 - 45
Is it possible to do an analysis exactly

like the one above for most firms?
 No. The analysis above was based

on the assumption of zero growth,
and most firms do not fit this
category.
 Further, it would be very difficult, if
not impossible, to estimate ks with
any confidence.
16 - 46
What type of analysis should firms

conduct to help find their optimal, or
target, capital structure?
 Financial forecasting models can

help show how capital structure
changes are likely to affect stock
prices, coverage ratios, and so on.
(More...)
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 Forecasting models can generate

results under various scenarios, but
the financial manager must specify
appropriate input values, interpret
the output, and eventually decide on
a target capital structure.
 In the end, capital structure decision
will be based on a combination of
analysis and judgment.

16 - 48
What other factors would managers

consider when setting the target
capital structure?
 Debt ratios of other firms in the

industry.
 Pro forma coverage ratios at
different capital structures under
different economic scenarios.
 Lender and rating agency attitudes
(impact on bond ratings).
16 - 49
 Reserve borrowing capacity.

 Effects on control.
 Type of assets: Are they tangible,
and hence suitable as collateral?
 Tax rates.

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16 - 1

Consider Two Hypothetical Firms

Both firms have same operating

Impact of Leverage on Returns

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Why does leveraging increase return?

 Total dollar return to investors:

What is business risk?

Uncertainty about future operating income

Factors That Influence Business Risk

 Uncertainty about demand (unit

What is operating leverage, and how

 Operating leverage is the use of fixed

Copyright © 2002 by Harcourt, Inc. All rights reserved.

QBE Sales QBE Sales

Probability Low operating leverage

High operating leverage

 In the typical situation, higher

Business Risk versus Financial Risk

From a shareholder’s perspective, how

Stand-alone Business Financial

Stand-alone risk = σ ROE.

Business risk = σ ROE(U).

Financial risk = σ ROE - σ ROE(U).

Now consider the fact that EBIT is not

Copyright © 2002 by Harcourt, Inc. All rights reserved.

 In a stand-alone risk sense, Firm L’s

 L’s financial risk is σ ROE - σ ROE(U) =

 For leverage to be positive (increase

Capital Structure Theory

MM Theory: Zero Taxes

 MM prove, under a very restrictive

MM Theory: Corporate Taxes

 Corporate tax laws favor debt

MM Theory: Corporate and

 Personal taxes lessen the advantage

 MM theory implies that beta changes

 MM theory ignores bankruptcy

 One agency problem is that

Perpetual Cash Flow Example

Expected EBIT = $500,000; will remain

Component Cost Estimates

 The MM and Miller models cannot

Copyright © 2002 by Harcourt, Inc. All rights reserved.

The Optimal Capital Structure

 Calculate the cost of equity at each

 Firm announces the recapitalization.

 Shares Debt issued

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Cost of Equity at Zero Debt

 Since the firm has 0 growth, its current

 kS = 15.0% = unlevered cost of equity.

 bU = (kS - kRF)/RPM = (15 - 6)/4 = 2.25

Cost of Equity at Each Debt Level

D = $250, kd = 10%, ks = 15.77%.

V1 = S1 + D1 = $1,807 + $250 = $2,057.

Check on stock price:

Value of Equity at Each Debt Level

Copyright © 2002 by Harcourt, Inc. All rights reserved.

Total Value of Firm

Debt Total Price per

Calculate EPS at debt of $0, $250K,