Chapter 15

Capital Structure Decisions

1
Topics in Chapter
 Overview and preview of capital
structure effects
 Business versus financial risk
 The impact of debt on returns
 Capital structure theory.

2
Basic Symbols
 V = value of firm
 FCF = free cash flow
 WACC = weighted average cost of
capital
 rs and rd are costs of stock and debt
 ws and wd are percentages of the firm
that are financed with stock and debt.
3
Capital Structure
 Capital structure: firm’s mixture of debt and
equity.
 Firm’s capital structure decision includes it’s
choice of a target capital structure, the
average maturity of it’s debt, and the specific
types of financing it decides to use at any
particular time.
 Capital structure decisions should be
designed to maximize the firm’s intrinsic
value.
4
 Value of a firm’s operation is the PV of
its expected future free cash flows
(FCF).
 WACC depends on the percentages of
debt and common equity, cost of debt,
cost of stock and the corporate tax.
 A firm’s value can change by affecting
either FCF or the cost of capital.
5
A Preview of Capital Structure
Effects
 The only way any decision can change
a firm’s value is by affecting either free
cash flows or the cost of capital.
 A higher proportion of debt can affect
 WACC
 FCF
 Which in turn will affect firm’s value.

(Continued…)
6
The Effect of Additional
Debt on WACC
 Cost of common stock, rs goes up.
 Debt holders have a prior claim on cash flows relative to
stockholders.
 Debt holders’ “fixed” claim increases risk of stockholders’

“residual” claim.
 Debt reduces the tax a company pays. Higher the interest
expense, lower is the tax paid to the government. Companies
can deduct interest expense when calculating taxable income
which
 Reduces the taxes paid to the govt.

 Frees up more cash for payments to investors

(Continued…)
7
The Effect on WACC
(Continued)
 Debt increases risk of bankruptcy
As debt increases, probability of financial distress or
even bankruptcy goes up
 Net effect on WACC

Adding debt increases percent of firm financed with l

debt (wd) and decreases percent financed with equity
(ws). Changing capital structure affects all variables in
WACC equation, but it is not clear whether those
changes increase, decrease the WACC.

Net effect on WACC = uncertain.
(Continued…)
8
The Effect of Additional Debt
on Free cash flow, FCF
 Additional debt increases the probability of bankruptcy which
reduces FCF.
 Direct costs: This reduces NOPAT and FCF.

 Indirect costs: Lost customers, reduction in productivity of

managers and line workers. Hurts productivity, as workers

and managers spend more time worrying about their next
job than attending to current job. There is also reduction in
credit offered by suppliers as suppliers tighten their credit
terms, which reduces FCF.

(Continued…)
9
 Additional debt can affect the behavior of
managers.
 Reduction in agency costs: When times are good,
managers may waste cash flows on unnecessary
expenditures. But when there is lot of debt in
capital structure it “pre-commits,” or “bonds,” free
cash flow for use in making interest payments.
Thus, managers are less likely to waste FCF on
perquisites or non-value adding acquisitions.
 Increase in agency costs: debt can make
managers too risk-averse, causing them to reject
risky but positive NPV projects.
(Continued…)
10
Underinvestment problem
 It would be unfortunate for stockholder if the project causes the
company to go into bankruptcy. But at the same time most of
the stockholders have well diversified portfolios, which covers
for the risk.
 But managers reputation and wealth are generally tied to one
company, so they refuse to accept high risk projects. This can
cause managers to forgo positive NPV projects unless they are
extremely safe.
 This is called underinvestment problem and it is another type of
agency cost.
 Debt can reduce one aspect of agency costs (wasteful exp.) but
may increase another (underinvestment), so the net effect is
not clear.
11
Business Risk and Financial
risk
 Capital structure of a firm also affects
it’s risk.
 The two risks mentioned above
combine to determine the total risk of a
firm’s future return on equity.

12
Business Risk: Uncertainty in
EBIT, NOPAT, and ROIC
 Business risk is the risk inherent in the firm’s operations.
 In other words it arises from uncertainty about the future
operating profits and capital requirements.
 Uncertainty about demand (unit sales).
 Uncertainty about output prices.
 Uncertainty about input costs.
 Product and other types of liability.
 International operations add risk of currency fluctuations and
also political risk.
 Degree of operating leverage (DOL): greater percentage of
fixed costs which do not fall when demand falls, increases the
business risk.

13
What is operating leverage, and how
does it affect a firm’s business risk?
 Higher a firm’s fixed cost, greater is it’s
operating leverage.
 A higher degree of operating leverage
implies that a relatively small change in
sales results in relatively large change
in EBIT , NOPAT etc.
 The higher the proportion of fixed costs
relative to variable costs, the greater
(More...)
the operating leverage. 14
Higher fixed costs are generally
associated with
1) Capital intensive and highly automated
firms
2) Businesses that employ highly skilled

workers who must be retained and

paid even when sales are low
3) Firms with high product development

cost 15
 They have taken the case of a firm which has two
plans and each plan requires a capital invst. of $200
mn.
 Plan A has FC of 20 mn and plan U has FC of 60 mn.
 Each plan is expected to produce 100 mn. units per
year at sales price of $2 per unit.
 Which plan should be accepted by the
company?
 For this they should find out the operating breakeven
point.

16
Operating Breakeven

 How far sales can fall before operating

profits become negative.
 It occurs when EBIT equal zero.

 QBE = F / (P – V)

17
Continuation from the book
 Plan A: 20,000/2-1.5 =40,000 units
 Plan U: 60,000/2-1 = 60,000 units
 Plan A will be profitable if unit sales are
above 40,000.
 Plan U requires sales of 60,000 units
before it is profitable.
 Plan U has higher fixed costs, so more
units must be sold to cover the fixed
costs. 18
Operating Breakeven
 Q is quantity sold, F is fixed cost, V is variable
cost, TC is total cost, and P is price per unit.
 Operating breakeven = QBE
 QBE = F / (P – V)
 Example: F=$200, P=$15, and V=$10:
 QBE = $200 / ($15 – $10) = 40.
 If more than 40 units are sold, venture would
be profitable.
(More...)
19
DeLong Inc. has fixed operating costs of $470,000, variable costs of
$2.80 per unit produced, and its products sell for $4.00 per unit.
What is the company's breakeven point, i.e., at what unit sales
volume would income equal costs?
 
 

391,667  

411,250  

431,813  

453,403  

476,073  

20
Senbet Ventures is considering starting a new
company to produce stereos. The sales price
would be set at 1.5 times the variable cost per
unit; the VC/unit is estimated to be $2.50; and
fixed costs are estimated at $120,000. What
sales volume would be required in order to break
even, i.e., to have an EBIT of zero for the stereo
business?
   

86,640  

91,200  

96,000  

100,800   21
 Combination of higher fixed cost and lower variable
cost (higher operating leverage)magnifies it’s gains
or losses.

22
Business Risk versus Financial
Risk
 Business risk:
 Uncertainty in future EBIT, NOPAT, and ROIC.
 Depends on business factors such as competition,
operating leverage, etc.
 Financial risk:
 Additional business risk concentrated on common
stockholders when financial leverage (more use of
debt) is used.
 Depends on the amount of debt and preferred
stock financing.
23
 If a firm uses debt (financial leverage), then the
business risk is concentrated on the common
stockholders.
 Eg. Ten people come together and form a company.
If the firm is capitalized only with equity, all of them
bear the same business risk.
 But if the firm is capitalized with 50% debt and 50%
equity, with 5 investors putting their money in debt
and remaining five in equity. In this case 5 debt
holders are paid before the 5 equity holders, so
virtually all of the business risk is borne by the
remaining 5 stockholders. 24
Consider Two Hypothetical Firms
Identical Except for Debt
Firm U Firm L
Capital $20,000 $20,000
Debt $0 $10,000 (12% rate)
Equity $20,000 $10,000
Tax rate 40% 40%
EBIT $3,000 $3,000
NOPAT $1,800 $1,800
ROIC 9% 9%

25
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
ROIC 9.0% 9.0%
ROE (NI/Equity) 9.0% 10.8%

26
 FIRM L HAS LOWER NET INCOME
BECAUSE IT MUST PAY INETERST, BUT
IT HAS HIGHER ROE, BECAUSE THE
NET INCOME IS SPREAD OVER A
SMALL EQUITY BASE.
 Leverage magnifies risk and return!

27
Why does leveraging increase
return to investors
 More cash goes to investors of Firm L.
 Total dollars paid to investors:
 U: NI = $1,800.
 L: NI + Int = $1,080 + $1,200 = $2,280.
 How is it that levered firm is able to pay more
to investors. This is also because of tax.
 Taxes paid:
 U: $1,200
 L: $720.

28
 What would happen if EBIT falls.
 ROIC would fall because of which ROE
will also fall.
 But now it would fall more for levered
firm, since financial leverage magnifies
returns for good or bad.

29
Impact of Leverage on
Returns if EBIT Falls
Firm U Firm L
EBIT $2,000 $2,000
Interest 0 1,200

EBT $2,000 $800

Taxes (40%) 800 320
NI $1,200 $480
ROIC 6.0% 6.0%
ROE 6.0% 4.8% 30
Capital Structure Theory
 Capital structure choices affects a firm’s
ROE and it’s risk.
 Capital structure varies across industries
and also within firms of the same
industry.
 What factors explain these differences?

31
Capital Structure Theories
 Modigliani and Miller theory
 Zero taxes
 Corporate taxes
 Corporate and personal taxes
 Trade-off theory
 Signaling theory
 Pecking order
 Debt financing as a managerial constraint
 Windows of opportunity

32
MM Theory: Zero Taxes
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
NI $3,000 $1,800

CF to shareholder $3,000 $1,800

CF to debtholder 0 $1,200
Total CF $3,000 $3,000
Notice that the total CF are identical for both firms.
33
MM Results: Zero Taxes
 MM assume: (1) no brokerage costs; (2) no taxes;
and (3) no bankruptcy cost, 4) individuals can
borrow at the same rate as corporations, 5) all
investors have the same information as management
about the firm, 6) EBIT is not affected by use of
debt.
 Because FCF and values of firms L and U are equal,
their WACCs are equal.
 Therefore, capital structure is irrelevant.

34
 He took two portfolios.
 First is of a firm which is unlevered, so portfolio’s value is Vu. Because firm has no growth
and no payment of taxes, firm can pay out all of it’s EBIT in the form of dividends
(stockholders). Thus cashflow from this first portfolio is equal to EBIT.
 Second portfolio is identical to unlevered firm except that it is partially financed with debt.
It contains all of the levered firm’s stock SL and debt D, so portfolios value is VL.
 If the interest rate is Rd, then the levered firm pays out interest of the amount RdD.
Because the firm is not growing and pays no taxes. It can pay out dividends of the amount
EBIT-RdD.
 If you owned all of the firm’s debt and equity, your cash flow would be equal to the sum of
the interest and dividends: RdD +(EBIT-RdD)= EBIT.
 Therefore the cash flow from owning this second portfolio is equal to EBIT.
 Notice that the cash flow of each portfolio is equal to EBIT.
 MM PROVED THAT A FIRM’S VALUE IS UNAFFECTED BY IT’S CAPITAL STRUCTURE.
 Therefore, capital structure is irrelevant

35
MM Theory: Corporate Taxes
 In 1963, MM published follow up paper in which they relaxed
the assumption of corporate taxes.
 Tax allows corporations to deduct in interest payment as an
expense, but dividend payments to stockholders are not tax
deductible.
 This encourages firms to use more debt in their capital
structure.
 Interest payment reduces tax payment by firms, means more
cashflow is available to investors.

36
 MM Result: Corporate Taxes
 MM show that the total CF to Firm L’s investors is equal
to the total CF to Firm U’s investor plus an additional
amount due to interest deductibility:
 VL = Vu + PV OF TAX SHIELD
 Value of the tax shield is equal to corporate tax rate,

T, multiplied by the amount of debt, D (TD)


Therefore, VL = VU + TD.

37
 MM relationship between value and debt
when corporate taxes are considered.
Value of Firm, V

VL
TD
VU

Debt
0

38
Miller’s Theory: Corporate and
Personal Taxes
 Also incorporated effects of personal taxes.
 Income from bonds is generally interest which is taxed at
personal tax rate (Td) going upto 35%.
 Income from stocks generally comes from dividends and capital
gains. Long term capital gains are usually taxed at 15% and this
tax is deferred until the stock is sold and gains realized.
 So, On average, returns on stocks are taxed at lower effective
rates (Ts) than returns on debt.
 Because of personal taxes, investors are ready to accept
relatively low before tax returns on stock relative to the before
tax returns on bonds.

39
Miller’s Theory: Corporate and
Personal Taxes
 Miller pointed out that Personal taxes
lessen the advantage of corporate debt:
 More favorable tax treatment of income
from stocks lowers the required rate of
return on stock and thus favors the use of
equity financing.

40
Miller’s Model with Corporate
and Personal Taxes

(1 - Tc)(1 - Ts)
VL = VU + 1− D
(1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.

41
 Tc = 40%, Td = 30%,
and Ts = 12%.

(1 - 0.40)(1 - 0.12)
VL = VU + 1− D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in debt raises L’s
value by $0.25.
Presence of personal taxes reduces but doesnot completely
eliminate advantage of debt financing. 42
Conclusions with Personal
Taxes
 Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.

43
Trade-off Theory
 MM ignore bankruptcy costs.
 It has high costs, plus it forces firms to sell their assets for less than
what they are worth.
 Bankruptcy problems are most likely to arise when a firm includes a
great deal of debt in its capital structure.
 It has two components: 1) probability of financial distress and 2) costs
that would be incurred if financial distress does occur.
 Firms that would face high costs in the event of financial distress
should rely less heavily on debt.
 Tradeoff theory weighs the benefits of debt financing against higher
interest rates (less taxes) and bankruptcy costs.
 This theory says that the value of levered firm is equal to the value of
the unlevered firm plus the value of any side effects, which includes
tax shield and the expected costs due to financial distress.

44
Trade-off Theory
 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.

45
Signaling Theory
 MM assumed that investors and managers have the same information-
symmetric information
 But, managers often have better information- asymmetric information.
 Take two firms, firms with positive prospect, P and another with negative
prospect, N.
 Firm P, made a huge discovery and wants to capitalize on it and is making
higher profits. How will the firm’s management raise capital in this case. If they
sell stocks., since the company is making profits, so the price of the stock is
rising, many people would purchase it and reap benefits. Current stockholders
would also benefit, but not as much if they had not issued extra stock, Because
they now have to share the benefits with new stockholders as well.
Therefore firm with very positive prospects avoid selling stocks and instead raise
capital by issuing debt.
Consider firm N, which is losing in the market, because a new competitor has come.
It has to upgrade it’s own facilities to maintain current sales. ROI would fall. How
should the firm raise capital. It would issue stocks to bring in more investors to
share the losses.
To sum it all, firms with bright prospects do not like to finance with stocks, as
opposed to firms with no so bright prospects.
46
Signaling Theory
 Announcement of a stock offering is generally
taken as a signal that the firm’s prospects as
seen by it’s own management are not good,
conversely a debt offering is taken as positive
signal.
 Investors understand this, so view new stock
sales as a negative signal which may lower
the price.

47
Reserve borrowing capacity
 Because Investors so view new stock
sales as a negative signal which lowers
the price even if the company’s true
prospects are bright, the company
should try to maintain a reserve
borrowing capacity, so that debt can be
used if especially good opportunity
comes along.
48
Pecking Order Theory
 Firms use internally generated funds
first, because there are no flotation
costs or negative signals.
 If more funds are needed, firms then
issue debt because it has lower flotation
costs than equity and no negative
signals.
 If more funds are needed, firms then
issue equity. 49
Implications for Managers
 Take advantage of tax benefits by
issuing debt, especially if the firm has:
 High tax rate
 Stable sales
 Low operating leverage

50
Implications for Managers
(Continued)
 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)

51
Implications for Managers
(Continued)
 If manager has asymmetric information
regarding firm’s future prospects, then
avoid issuing equity if actual prospects
are better than the market perceives.
 Always consider the impact of capital
structure choices on lenders’ and rating
agencies’ attitudes

52
Choosing the Optimal Capital
Structure
 Managers should chose the capital structure that
maximizes the shareholder’s wealth.
 1) estimate the interest rate, Rd that the firms will
pay
 2) Estimate the cost of equity, Rs. Use Hamada
equation to find out beta of levered firm.
 3) Estimate the WACC
 4) Estimate the value of operations
 The objective is to find out the amount of debt
financing that maximizes the value of operations.

53
 Vop = [FCF(1+g)]/(WACC − g)
 HAMADA EQUATION:
 b = bU [1 + (1 - T)(wd/ws)]

54
Choosing the Optimal Capital
Structure: Example
 b = 1.0; rRF = 6%; RPM = 6%.
 Cost of equity using CAPM:
 rs = rRF +b (RPM)= 6% + 1(6%) = 12%

 Currently has no debt: wd = 0%.

 WACC = rs = 12%.
 Tax rate is T = 40%.
55
Current Value of Operations
 Expected FCF = $30 million.
 Firm expects zero growth: g = 0.
 Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.12 − 0)
Vop = $250 million.

56
Investment bankers provided estimates of
rd for different capital structures.
wd 0% 20% 30% 40% 50%
rd 0.0% 8.0% 8.5% 10.0% 12.0%

57
The Cost of Equity at Different Levels
of Debt: Hamada’s Formula
 An increase in debt also increases the risk faced by
shareholders and this has an effect on the Rs.
 Stock’s beta is the relevant measure of risk. MM theory implies
that beta increases with financial leverage.
 HAMADA EQUATION SPECIFIES THE EFFCT OF FINANCIAL
LEVERAGE ON BETA
 b = bU [1 + (1 - T)(wd/ws)]
 bU is the beta of a firm when it has no debt (the unlevered beta)

58
 The Cost of Equity for wd =
20%

 Use Hamada’s equation to find beta:

b = bU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
 Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%
59
The WACC for wd = 20%
 WACC = wd (1-T) rd + wce rs
 WACC = 0.2 (1 – 0.4) (8%) + 0.8
(12.9%)
 WACC = 11.28%

 Repeat this for all capital structures

under consideration.

60
 Beta, rs, and WACC
wd 0% 20% 30% 40% 50%
rd 0.0% 8.0% 8.5% 10.0% 12.0%
ws 100% 80% 70% 60% 50%
b 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
WACC 12.00% 11.28% 11.01% 11.04% 11.40%

The WACC is minimized for wd = 30%. This is the optimal

capital structure.

61
Corporate Value for wd = 20%
 Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.1128 − 0)
Vop = $265.96 million.
 Debt = DNew = wd Vop
Debt = 0.20(265.96) = $53.19 million.
 Equity = S = ws Vop
Equity = 0.80(265.96) = $212.77 million.
62
 Value of Operations, Debt,
and Equity
wd 0% 20% 30% 40% 50%
rd 0.0% 8.0% 8.5% 10.0% 12.0%
ws 100% 80% 70% 60% 50%
b 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
WACC 12.00% 11.28% 11.01% 11.04% 11.40%
Vop $250.00 $265.96 $272.48 $271.74 $263.16
D $0.00 $53.19 $81.74 $108.70 $131.58
S $250.00 $212.77 $190.74 $163.04 $131.58

Value of operations is maximized at wd = 30%.

63