Chapter 16

Capital Structure Decisions: The Basics

MINI CASE
Assume you have just een hire! as usiness mana"er o# $i%%a$alace& a pi%%a restaurant
locate! a!jacent to campus' The company(s EBIT )as *+,,&,,, last year& an! since the
university(s enrollment is cappe!& EBIT is e-pecte! to remain constant .in real terms/ over
time' Since no e-pansion capital )ill e re0uire!& $i%%a$alace plans to pay out all earnin"s
as !ivi!en!s' The mana"ement "roup o)ns aout +, percent o# the stoc1& an! the stoc1 is
tra!e! in the over2the2counter mar1et'
The #irm is currently #inance! )ith all e0uity3 it has 1,,&,,, shares outstan!in"3 an!
$
,
4 *5+ per share' 6hen you too1 your MBA Corporate 7inance course& your instructor
state! that most #irms( o)ners )oul! e #inancially etter o## i# the #irms use! some !et'
6hen you su""este! this to your ne) oss& he encoura"e! you to pursue the i!ea' As a #irst
step& assume that you otaine! #rom the #irm(s investment an1er the #ollo)in" estimate!
costs o# !et #or the #irm at !i##erent capital structures:
8 7inance! 6ith Det

9
!
,8 222
5, :',8
;, :'+
<, 1,',
+, 15',
I# the company )ere to recapitali%e& !et )oul! e issue!& an! the #un!s receive! )oul! e
use! to repurchase stoc1' $i%%a$alace is in the <, percent state2plus2#e!eral corporate ta-
rac1et& its eta is 1',& the ris12#ree rate is 6 percent& an! the mar1et ris1 premium is 6
percent'
a' $rovi!e a rie# overvie) o# capital structure e##ects' Be sure to i!enti#y the )ays
in )hich capital structure can a##ect the )ei"hte! avera"e cost o# capital an!
#ree cash #lo)s'
Ans)er: The basic definitions are:
(1) V = Value Of Firm
(2) FCF = Free Cash Flow
(3) WCC = Wei!hted "era!e Cost Of Ca#ital
($) %
s
nd %
d
are costs of stoc& and debt
(') W
e
nd W
d
are #ercenta!es of the firm that are financed with stoc& and debt(
Mini Case: 16 2 1
The im#act of ca#ital structure on "alue de#ends u#on the effect of debt on: WCC
and)or FCF(
*ebt holders ha"e a #rior claim on cash flows relati"e to stoc&holders( *ebt holders+
,fi-ed. claim increases ris& of stoc&holders+ ,residual. claim/ so the cost of stoc&/ r
s
/
!oes u#(
Firm+s can deduct interest e-#enses( This reduces the ta-es #aid/ frees u# more cash
for #a0ments to in"estors/ and reduces after1ta- cost of debt
*ebt increases the ris& of ban&ru#tc0/ causin! #re1ta- cost of debt/ r
d
/ to increase(
ddin! debt increase the #ercent of firm financed with low1cost debt (w
d
) and
decreases the #ercent financed with hi!h1cost e2uit0 (w
e
)(
The net effect on WCC is uncertain/ since some of these effects tend to increase
WCC and some tend to decrease WCC(
dditional debt can affect FCF( The additional debt increases the #robabilit0 of
ban&ru#tc0( The direct costs of financial distress are le!al fees/ ,fire. sales/ etc( The
indirect costs are lost customers/ reductions in #roducti"it0 of mana!ers and line
wor&ers/ reductions in credit (i(e(/ accounts #a0able) offered b0 su##liers( 3ndirect
costs cause 4O5T to !o down due to lost customers and dro# in #roducti"it0 and
causes the in"estment in ca#ital to !o u# due to increases in net o#eratin! wor&in!
ca#ital (accounts #a0able !oes u# as su##liers ti!hten credit)(
dditional debt can affect the beha"ior of mana!ers( 3t can cause reductions in
a!enc0 costs/ because debt ,#re1commits/. or ,bonds/. free cash flow for use in
ma&in! interest #a0ments( Thus/ mana!ers are less li&el0 to waste FCF on
#er2uisites or non1"alue addin! ac2uisitions(
6ut it can cause increases in other a!enc0 costs( *ebt can ma&e mana!ers too ris&1
a"erse/ causin! ,underin"estment. in ris&0 but #ositi"e 45V #ro7ects(
There are also effects due to as0mmetric information and si!nalin!( 8ana!ers &now
the firm+s future #ros#ects better than in"estors( Thus/ mana!ers would not issue
additional e2uit0 if the0 thou!ht the current stoc& #rice was less than the true "alue of
the stoc& (!i"en their inside information)( 9ence/ in"estors often #ercei"e an
additional issuance of stoc& as a ne!ati"e si!nal/ and the stoc& #rice falls(
' .1/ 6hat is usiness ris1= 6hat #actors in#luence a #irm(s usiness ris1=
Ans)er: 6usinsess ris& is uncertaint0 about :63T( Factors that influence business ris&
Mini Case: 16 2 5
include: uncertaint0 about demand (unit sales); uncertaint0 about out#ut #rices;
uncertaint0 about in#ut costs; #roduct and other t0#es of liabilit0; de!ree of o#eratin!
le"era!e (*O<)(
' .5/ )hat is operatin" levera"e& an! ho) !oes it a##ect a #irm(s usiness ris1= Sho)
the operatin" rea1 even point i# a company has #i-e! costs o# *5,,& a sales price
o# *1+& an! variales costs o# *1,'
Ans)er: O#eratin! le"era!e is the chan!e in :63T caused b0 a chan!e in 2uantit0 sold( The
hi!her the #ro#ortion of fi-ed costs within a firm+s o"erall cost structure/ the !reater
the o#eratin! le"era!e( 9i!her o#eratin! le"era!e leads to more business ris&/
because a small sales decline causes a lar!er :63T decline(
= is 2uantit0 sold/ F is fi-ed cost/ V is "ariable cost/ TC is total cost/ and 5 is #rice
#er unit(
O#eratin! 6rea&e"en = =
6:
=
6:
= F ) (5 > V)
:-am#le: F=?2@@/ 5=?1'/ 4* V=?1@:
=
6:
= ?2@@ ) (?1' > ?1@) = $@(
c' No)& to !evelop an e-ample )hich can e presente! to $i%%a$alace>s
mana"ement to illustrate the e##ects o# #inancial levera"e& consi!er t)o
hypothetical #irms: #irm ?& )hich uses no !et #inancin"& an! #irm @& )hich
uses *1,&,,, o# 15 percent !et' Both #irms have *5,&,,, in assets& a <, percent
ta- rate& an! an e-pecte! EBIT o# *;&,,,'
1' Construct partial income statements& )hich start )ith EBIT& #or the t)o #irms'
Ans)er: 9ere are the full0 com#leted statements:
Firm A Firm <
ssets ?2@/@@@ ?2@/@@@
:2uit0 ?2@/@@@ ?1@/@@@
:63T ? 3/@@@ ? 3/@@@
34T (12B) @ 1/2@@
:6T ? 3/@@@ ? 1/C@@
Ta-es ($@B) 1/2@@ D2@
43 ? 1/C@@ ? 1/@C@
Mini Case: 16 2 ;
c' 5' No) calculate roe #or oth #irms'
Ans)er: Firm A Firm <
6:5 1'(@B 1'(@B
%O3 E(@B 11($B
%O: E(@B 1@(CB
T3: 2('
c' ;' 6hat !oes this e-ample illustrate aout the impact o# #inancial levera"e on
9AE=
Ans)er: Conclusions from the anal0sis:
The firm+s basic earnin! #ower/ 6:5 = :63T)total assets/ is unaffected b0 financial
le"era!e(
Firm < has the hi!her e-#ected %O3 because of the ta- sa"in!s effect:
o %O3
A
= E(@B(
o %O3
<
= 11($B(
Firm < has the hi!her e-#ected roe:
o %O:
A
= E(@B(
o %O:
<
= 1@(CB(
Therefore/ the use of financial le"era!e has increased the e-#ected #rofitabilit0 to
shareholders( The hi!her roe results in #art from the ta- sa"in!s and also because the
stoc& is ris&ier if the firm uses debt(
t the e-#ected le"el of :63T/ %O:
<
F %O:
A
(
The use of debt will increase roe onl0 if %O e-ceeds the after1ta- cost of debt( 9ere
%O = unle"era!ed roe = E(@B F r
d
(1 1 t) = 12B(@(G) = D(2B/ so the use of debt
raises roe(
Mini Case: 16 2 <
Finall0/ note that the T3: ratio is hu!e (undefined/ or infinitel0 lar!e) if no debt is
used/ but it is relati"el0 low if '@ #ercent debt is used( The e-#ected tie would be
lar!er than 2(' if less debt were used/ but smaller if le"era!e were increased(
!' E-plain the !i##erence et)een #inancial ris1 an! usiness ris1'
Ans)er: 6usiness ris& increases the uncertaint0 in future :63T( 3t de#ends on business factors
such as com#etition/ o#eratin! le"era!e/ etc( Financial ris& is the additional business
ris& concentrated on common stoc&holders when financial le"era!e is used( 3t
de#ends on the amount of debt and #referred stoc& financin!(
e( No) consi!er the #act that EBIT is not 1no)n )ith certainty& ut rather has the
#ollo)in" proaility !istriution:
Economic State $roaility EBIT
Ba! ,'5+ *5&,,,
Avera"e ,'+, ;&,,,
Boo! ,'5+ <&,,,
9e!o the part A analysis #or #irms ? an! @& ut a!! asic earnin" po)er
.BE$/& return on investment .9AI/& C!e#ine! as .net income D interest/E.!et
D e0uity/F& an! the times2interest2earne! .TIE/ ratio to the outcome
measures' 7in! the values #or each #irm in each state o# the economy& an!
then calculate the e-pecte! values' 7inally& calculate the stan!ar! !eviation
an! coe##icient o# variation o# 9AE' 6hat !oes this e-ample illustrate aout
the impact o# !et #inancin" on ris1 an! return=
Ans)er: 9ere are the #ro forma income statements:
Firm A Firm <
6ad "!( Hood 6ad "!( Hood
5rob( @(2' @('@ @(2' @(2' @('@ @(2'
:63T ?2/@@@ ?3/@@@ ?$/@@@ ?2/@@@ ?3/@@@ ?$/@@@
3nterest @ @ @ 1/2@@ 1/2@@ 1/2@@
:6T ?2/@@@ ?3/@@@ ?$/@@@ ? C@@ ?1/C@@ ?2/C@@
Ta-es ($@B) C@@ 1/2@@ 1/G@@ 32@ D2@ 1/12@
43 ?1/2@@ ?1/C@@ ?2/$@@ ? $C@ ?1/@C@ ?1/GC@
6:5 1@(@B 1'(@B 2@(@B 1@(@B 1'(@B 2@(@B
%O3C G(@B E(@B 12(@B G(@B E(@B 12(@B
Mini Case: 16 2 +
%O: G(@B E(@B 12(@B $(CB 1@(CB 1G(CB
T3: 1(D 2(' 3(3
:(6:5) 1'(@B 1'(@B
:(%O3C) E(@B E(@B
:(%O:) E(@B 1@(CB
I
%O3C
2(12B 2(12B
I
%O:
2(12B $(2$B
This e-am#le illustrates that financial le"era!e can increase the e-#ected return to
stoc&holders( 6ut/ at the same time/ it increases their ris&(
Firm < has a wider ran!e of %O:s and a hi!her standard de"iation of %O:/
indicatin! that its hi!her e-#ected return is accom#anied b0 hi!her ris&( To be
#recise:

%O: (Anle"era!ed)
= 2(12B/ and
%O: (<e"era!ed)
= $(2$B(
Thus/ in a stand1alone ris& sense/ firm < is twice as ris&0 as firm A11its business
ris& is 2(12 #ercent/ but its stand1alone ris& is $(2$ #ercent/ so its financial ris& is
$(2$B 1 2(12B = 2(12B(
#' 6hat !oes capital structure theory attempt to !o= 6hat lessons can e learne!
#rom capital structure theory= Be sure to a!!ress the MM mo!els'
Ans)er: 88 theor0 be!ins with the assum#tion of Jero ta-es( 88 #ro"e/ under a "er0
restricti"e set of assum#tions/ that a firm+s "alue is unaffected b0 its financin! mi-:
V
<
= V
A
(
Therefore/ ca#ital structure is irrele"ant( n0 increase in roe resultin! from financial
le"era!e is e-actl0 offset b0 the increase in ris& (i(e(/ r
s
)/ so WCC is constant(
88 theor0 later includes cor#orate ta-es( Cor#orate ta- laws fa"or debt financin!
o"er e2uit0 financin!( With cor#orate ta-es/ the benefits of financial le"era!e e-ceed
the ris&s because more :63T !oes to in"estors and less to ta-es when le"era!e is
used( 88 show that:
V
<
= V
A
K T*(
3f T=$@B/ then e"er0 dollar of debt adds $@ cents of e-tra "alue to firm(
8iller later included #ersonal ta-es( 5ersonal ta-es lessen the ad"anta!e of cor#orate
debt( Cor#orate ta-es fa"or debt financin! since cor#orations can deduct interest
e-#enses/ but #ersonal ta-es fa"or e2uit0 financin!/ since no !ain is re#orted until
stoc& is sold/ and lon!1term !ains are ta-ed at a lower rate( 8iller+s conclusions with
#ersonal ta-es are that the use of debt financin! remains ad"anta!eous/ but benefits
are less than under onl0 cor#orate ta-es( Firms should still use 1@@B debt( 4ote:
Mini Case: 16 2 6
howe"er/ miller ar!ued that in e2uilibrium/ the ta- rates of mar!inal in"estors would
ad7ust until there was no ad"anta!e to debt(
88 theor0 i!nores ban&ru#tc0 (financial distress) costs/ which increase as more
le"era!e is used( t low le"era!e le"els/ ta- benefits outwei!h ban&ru#tc0 costs( t
hi!h le"els/ ban&ru#tc0 costs outwei!h ta- benefits( n o#timal ca#ital structure
e-ists that balances these costs and benefits( This is the trade1off theor0(
88 assumed that in"estors and mana!ers ha"e the same information( 6ut mana!ers
often ha"e better information( Thus/ the0 would sell stoc& if stoc& is o"er"alued/ and
sell bonds if stoc& is under"alued( 3n"estors understand this/ so "iew new stoc& sales
as a ne!ati"e si!nal( This is si!nalin! theor0(
One a!enc0 #roblem is that mana!ers can use cor#orate funds for non1"alue
ma-imiJin! #ur#oses( The use of financial le"era!e bonds ,free cash flow/. and
forces disci#line on mana!ers to a"oid #er&s and non1"alue addin! ac2uisitions(
second a!enc0 #roblem is the #otential for ,underin"estment.( *ebt increases ris&
of financial distress( Therefore/ mana!ers ma0 a"oid ris&0 #ro7ects e"en if the0 ha"e
#ositi"e 45Vs(
"' 6ith the aove points in min!& no) consi!er the optimal capital structure #or
$i%%a$alace'
"' .1/ 7or each capital structure un!er consi!eration& calculate the levere! eta& the
cost o# e0uity& an! the 6ACC'
Ans)er: 88 theor0 im#lies that beta chan!es with le"era!e( 6
u
is the beta of a firm when it
has no debt (the unle"ered beta() 9amada+s e2uation #ro"ides the beta of a le"ered
firm: 6
<
= 6
A
L1 K (1 1 T)(*)M)N( For e-am#le/ to find the cost of e2uit0 for w
d
=
2@B/ we first use 9amada+s e2uation to find beta:
6
<
= 6
A
L1 K (1 1 T)(*)M)N
= 1(@ L1 K (11@($) (2@B ) C@B)N
= 1(1'
Then use C58 to find the cost of e2uit0:
%
M
= %
%F
K 6
<
(%5
8
)
= GB K 1(1' (GB) = 12(EB
We can re#eat this for the ca#ital structures under consideration(
Mini Case: 16 2 G
W
*
*)M 6
<
%
M

@B @(@@ 1(@@@ 12(@@B
2@B @(2' 1(1'@ 12(E@B
3@B @($3 1(2'D 13('$B
$@B @(GD 1($@@ 1$($@B
'@B 1(@@ 1(G@@ 1'(G@B
4e-t/ find the WCC( For e-am#le/ the WCC for w
d
= 2@B is:
WCC = w
d
(11T) r
d
K w
e
r
s

WCC = @(2 (1 > @($) (CB) K @(C (12(EB)
WCC = 11(2CB

Then re#eat this for all ca#ital structures under consideration(

w
d
r
d


r
s
WCC

@B @(@B 12(@@B 12(@@B
2@B C(@B 12(E@B 11(2CB
3@B C('B 13('$B 11(@1B
$@B 1@(@B 1$($@B 11(@$B
'@B 12(@B 1'(G@B 11($@B
Mini Case: 16 2 :
"' .5/ No) calculate the corporate value& the value o# the !et that )ill e issue!& an!
the resultin" mar1et value o# e0uity'
Ans)er: For e-am#le the cor#orate "alue for w
d
= 2@B is:
V = FCF ) (WCC1H)
H=@/ so in"estment in ca#ital is Jero; so FCF = 4O5T = :63T (11T)( 3n this
e-am#le/ 4O5T = (?'@@/@@@)(11@($@) = ?3@@/@@@(

Asin! these "alues/ V = ?3@@/@@@ ) @(112C = ?2/G'E/'D$(
%e#eatin! this for all ca#ital structures !i"es the followin! table:
w
d
WCC Cor#( Value

@B 12(@@B ?2/'@@/@@@
2@B 11(2CB ?2/G'E/'D$
3@B 11(@1B ?2/D2$/DEG
$@B 11(@$B ?2/D1D/3E1
'@B 11($@B ?2/G31/'DE
s this shows/ "alue is ma-imiJed at a ca#ital structure with 3@B debt(
"' .;/ Calculate the resultin" price per share& the numer o# shares repurchase!& an!
the remainin" shares'
Ans)er: First/ find the dollar "alue of debt and e2uit0( For e-am#le/ for w
d
= 2@B/ the dollar
"alue of debt is:
d = w
d
V = @(2 (?2/G'E/'D$) = ?'31/E1'(
We can then find the dollar "alue of e2uit0:
M = V > *
M = ?2/G'E/'D$ 1 ?'31/E1' = ?2/12D/G'E(
We re#eat this #rocess for all the ca#ital structures(
w
d
*ebt/ * Mtoc& Value/ M
Mini Case: 16 2 H

@B ?@ ?2/'@@/@@@
2@B ?'31/E1' ?2/12D/GG@
3@B ?C1D/$3E ?1/E@D/3'D
$@B ?1/@CG/E'D ?1/G3@/$3'
'@B ?1/31'/DCE ?1/31'/DCE
4ote: these are rounded; see F811 Ch 1G mini case(-ls for full calculations(
4otice that the "alue of the e2uit0 declines as more debt is issued/ because debt is
used to re#urchase stoc&( 6ut the total wealth of shareholders is the "alue of stoc&
after the reca# #lus the cash recei"ed in re#urchase/ and this total !oes u# (it is e2ual
to cor#orate "alue on earlier slide)(
The firm issues debt/ which chan!es its WCC/ which chan!es "alue( The firm then
uses debt #roceeds to re#urchase stoc&( The stoc& #rice chan!es after debt is issued/
but does not chan!e durin! actual re#urchase (or arbitra!e is #ossible)( The stoc&
#rice after debt is issued but before stoc& is re#urchased reflects shareholder wealth/
which is the sum of the stoc& and the cash #aid in re#urchase(
For e-am#le/ to find the stoc& #rice for w
d
= 2@B/ let *
@
and 4
@
denote debt and
outstandin! shares before the reca#( * 1 *
@
is e2ual to cash that will be used to
re#urchase stoc&( M K (* 1 *
@
) is the wealth of shareholders+ after the debt is issued
but immediatel0 before the re#urchase( We can e-#ress the stoc& #rice #er share
#rior to the re#urchase/ 5/ for w
d
= 2@B/ as:
5 = LM K (* > *
@
)N)4
@
(
5 = L?2/12D/GG@ K (?'31/E1' > @)N ) 1@@/@@@
5 = ?2G('EG #er share(
The number of shares re#urchased is:
O re#urchased = (* 1 *
@
) ) 5
O re#( = (?'31/E1' > @) ) ?2G('EG
= 2@/@@@(
The number of remainin! shares after the re#urchase is:
O remainin! = 4 = M ) 5
4 = ?2/12D/GG@ ) ?2G('EG
= C@/@@@(
We can a##l0 this same #rocedure to all the ca#ital structures under consideration(
Mini Case: 16 2 1,
O Mhares O Mhares
W
d
5 %e#urch( %emainin!
@B ?2'(@@ @ 1@@/@@@
2@B ?2G(G@ 2@/@@@ C@/@@@
3@B ?2D(2' 3@/@@@ D@/@@@
$@B ?2D(1D $@/@@@ G@/@@@
'@B ?2G(32 '@/@@@ '@/@@@
h' Consi!erin" only the capital structures un!er analysis& )hat is $i%%a$alace(s
optimal capital structure=
Ans)er: The o#timal ca#ital structure is for w
d
= 3@B( This !i"es the hi!hest cor#orate "alue/
the lowest WCC/ and the hi!hest stoc& #rice #er share( 6ut notice that w
d
= $@B is
"er0 similar to the o#timal solution; in other words/ the o#timal ran!e is #rett0 flat(
i' 6hat other #actors shoul! mana"ers consi!er )hen settin" the tar"et capital
structure=
Ans)er: 8ana!ers should also consider the debt ratios of other firms in the industr0/ #ro
forma co"era!e ratios at different ca#ital structures under different economic
scenarios/ lender and ratin! a!enc0 attitudes (i(e(/ the im#act on bond ratin!s)/ reser"e
borrowin! ca#acit0/ the effects on control (i(e(/ does the ca#ital structure ma&e it
easier of harder for an outsider to ta&e o"er the firm)/ the firm+s t0#es of assets (i(e(/
are the0 tan!ible/ and hence suitable as collateralP/ and the firm+s #ro7ected ta- rates(
Mini Case: 16 2 11