Capital Structure Decisions

We have learnt so far that the value of the firm is the sum of the present value of
all the free cash flows it generate.
Free cash flows: Money left with the firm after paying everyone other than the
investors.
Ignore preferred stock for simplicity.

1 t
t
t
) WACC 1 (
FCF
V
WACC = w
d
(1-T) r
d
+ w
e
r
s
Recall how we find free cash flows:

Sales units sold x selling price per unit
- Variable Costs units sold x variable cost per unit
Gross Margin
- Fixed Operating Costs
EBIT
- Taxes
NOPAT
+Depreciation
Operating Cash Flows
- Change in Net Working Capital
- Change in Net Fixed Assets
Net Free Cash Flows available to all long term investors

If you want to find the total value of the firm, you would discount these free cash
flows by WACC and sum them up.

What can make these cash flows risky?

Capital Structure Decisions
Lets make our lives even simpler and assume that:
We either buy everything with cash or the accounts
payable do not change
We either sell everything on cash basis or accounts
receivables do not change.
Our inventory and cash reserves stay at the same level
too.
Result: we do not have to worry about change in net
working capital (because there is no change in NWC).
Also, we use only as much cash to buy new fixed assets
as the amount of depreciation we have to add back.
Result: the change in net fixed assets and add back
depreciation entries also disappear from our free cash
flow calculation.
Capital Structure Decisions
Here is our extremely simple world:
Sales
-variable costs
=Gross Margin
-Fixed Costs
=EBIT
-Taxes
=Free Cash flow available to all investors.

If you want to find the total value of the firm, you would discount these free
cash flows by WACC and sum them up.

How do you find the value of equity?
One method you have used over and over again: Take out debt from the
value of the firm and the remaining amount is value of equity.
There is another way: Just concentrate on cash flows to shareholders.
If you only want to know the value of equity, what are the free cash flows to
shareholders?
Capital Structure Decisions
If you only want to know the value of equity, how do you find the free
cash flows available to shareholders only?
Sales
- Variable Costs
= Gross Margin
- Fixed Costs
= EBIT
- Interest
Taxable Income
- Taxes
Net Income

Since we are only looking at cash flows to shareholders, what discount
rate will you use to find the total present value of all the cash flows?
Required rate of return on equity.

Why did we subtract interest here before finding taxes?
Why do we take account of tax deductibility (tax shield) here but not in
the cash flows to all investors.
Capital Structure Decisions
What can make these cash flows risky?
What makes the cash flows risky as seen by all
investors?
What makes the cash flows risky as seen by the
shareholders only?


Capital Structure Decisions
That was the top part of the story. Now lets look at
the denominator:

WACC = w
d
(1-T) r
d
+ w
e
r
s


What do we know about risk and return relationship?

Can we assume these required rates of returns to
stay constant no matter how we move along the risk
spectrum?
Capital Structure Decisions
So risk is the likelihood of getting a return different
from what you expected.
What brings about that chance?
Something unexpected. If you knew something will
change, you will adjust your expectations accordingly.
So the risk stems from a shock, the unexpected.
Our major concern is that we do not want to loose
money.
If something bad happens and we can deal with it so
that the impact is not negative, we are okay.
Capital Structure Decisions
Business risk: Uncertainty about future pre-tax operating income (EBIT).
Probability
EBIT E(EBIT) 0
? risk
? risk
Note that business risk focuses on operating
income, so it ignores financing effects.
Business risk: Uncertainty about future pre-tax operating income (EBIT).
Probability
EBIT E(EBIT) 0
Low risk
High risk
Note that business risk focuses on operating
income, so it ignores financing effects.
Just by looking at the cash flow calculations, we know that a lot of risk is
coming from the nature of the business. Things that determine that a
firm is safer or riskier include:

Demand Stability
Price Stability
Cost Stability
Pricing Flexibility
Uncertainty about new product development
Foreign risk
Operating Leverage
Capital Structure Decisions
Operating Leverage

So far, I hope, you are convinced that a big part of business risk stems
from costs side.

Which one of the cost component is the hardest to make changes to in
the short run (the least flexible)?

Of course, the fixed costs (just as the name says).

Do you ever want to have a business with negative gross margin?

Assume we are talking about a normal business where gross margin is
positive (otherwise they will shut that business down).

What can still get you into trouble?
Fixed costs
Capital Structure Decisions
What is the break-even quantity for each of these businesses?

Music:
Gross Margin = Sales Variable Cost = 20 2 = $ 18
Fixed Costs = $3,000,000
Q
BE
= 3,000,000/18 = 166,667 CDs

Gas Station:
Gross Margin = Sales Variable Cost = 2 1.50 = $ 0.50
Fixed Costs = $10,000
Q
BE
= 10,000/0.5 = 20,000 gallons

The question you would ask yourself is, how confident you are that you will be able to sell at
least 166,667 CDs or at least 20,000 gallons of gas. Would a small change in any factor put
you below the breakeven level?


Capital Structure Decisions
Capital Structure Decisions



Music Business
$-
$1,000,000
$2,000,000
$3,000,000
$4,000,000
$5,000,000
$6,000,000
$7,000,000
- 100,000 200,000 300,000 400,000
Units sold
R
e
v
e
n
u
e

a
n
d

c
o
s
t
s
Sales Total Costs Fixed Costs
Gas Station
$-
$100,000
$200,000
$300,000
$400,000
$500,000
$600,000
$700,000
- 100,000 200,000 300,000 400,000
Units Sold
R
e
v
e
n
u
e
s

a
n
d

c
o
s
t
s
Sales Total Costs Fixed Costs
15
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.
16
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 (Net Income) $1,800 $1,080
ROE
ROE = Return on Equity
= Net Income/ Total Equity
9.0% 10.8%
17
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 (Net Income) $1,800 $1,080
ROE
ROE = Return on Equity
= Net Income/ Total Equity
9.0% 10.8%
18
Why does leveraging increase
return?
More EBIT goes to investors in Firm L.
Total dollars paid to investors:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200; L: $720.
Equity $ proportionally lower than NI.
19
Continued
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?

20
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
21
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
22
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
23
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 $1,680
*same as for Firm U
24
Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0$
ROE 4.8% 10.8% 16.8%
TIE

BEP = Basic Earning
Power = EBIT/ Total
Assets
1.7x

ROIC = Return on
Invested Capital =
NOPAT/ Total Assets

2.5x

ROE = Net
Income/Total Equity
3.3x

TIE = Times Interest
Earned =
EBIT/Interest
25
Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0$
ROE 4.8% 10.8% 16.8%
TIE

BEP = Basic Earning
Power = EBIT/ Total
Assets
1.7x

ROIC = Return on
Invested Capital =
NOPAT/ Total Assets

2.5x

ROE = Net
Income/Total Equity
3.3x

TIE = Times Interest
Earned =
EBIT/Interest
26
Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROIC) 9.0% 9.0%
E(ROE) 9.0% 10.8%
Risk Measures:

ROIC
2.12% 2.12%

ROE

E() = Expected Value
2.12% 4.24%


27
Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROIC) 9.0% 9.0%
E(ROE) 9.0% 10.8%
Risk Measures:

ROIC
2.12% 2.12%

ROE

E() = Expected Value
2.12% 4.24%


28
Conclusions
Basic earning power (EBIT/TA) and ROIC
(NOPAT/Capital = EBIT(1-T)/TA) are unaffected
by financial leverage.
L has higher expected ROE: tax savings and
smaller equity base.
L has much wider ROE swings because of fixed
interest charges. Higher expected return is
accompanied by higher risk.
(More...)
29
In a stand-alone risk sense, Firm Ls
stockholders see much more risk than
Firm Us.
U and L:
ROIC
= 2.12%.
U:
ROE
= 2.12%.
L:
ROE
= 4.24%.
Ls financial risk is
ROE
-
ROIC
= 4.24% -
2.12% = 2.12%. (Us is zero.)
(More...)
30
For leverage to be positive (increase expected
ROE), BEP must be > r
d
.
If r
d
> 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.

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.


Business Risk versus Financial Risk

Effects of Additional Debt on WACC
+ From investors point of view, debt is less risk compared to equity. So the required rate
of return on debt is lower. Therefore, adding debt replaces an expensive source (equity) with
a cheaper source of capital.
+ Debt is tax deductible so after tax cost of debt is even lower. Therefore, adding debt
should lower WACC.

- Debt payments are fixed and legally binding. If the firm does not earn enough EBIT, the
shareholders have to foot the debt bill. So adding more debt makes the firm riskier (adds
financial risk). Therefore, the shareholders require a higher rate of return when the firm adds
more debt to its capital structure. WACC should go up.

- Failure to pay debt can result in bankruptcy. Bankruptcy involves loss of firms value to
non-stakeholders like lawyers and accountants. Both shareholders and debt-holders stand to
loose in this scenario. So additional debt makes the firm riskier for both bond and stock
holders, increasing their required rates of returns. WACC would go up.

What is the net effect of debt on the WACC?

Capital Structure Decisions
Indirect Effects of Additional Debt on WACC
+ Debt reduces agency costs.
High debt implies high fixed recurring payments that forces the
managers not to waste firms resources.
- For the same reason, additional debt might make the managers too
risk averse and they might loose profitable but risky projects.

- If people perceive the firm close to bankruptcy, they will stop buying
from the firm (fear of no customer service for the firms products in
future).

- With high level of outstanding debt, the suppliers might tighten their
credit terms. More money would get stuck in net working capital.

Capital Structure Decisions
Indirect Effects of Additional Debt on
WACC
+ Issuing debt can be perceived to be a positive signal for the
shareholders.
Asymmetric Information:
One party knows more about the trade (dealing) than the
counterparty.
Who knows more about the prospects of the firm, the
management or the investors?
When would managers like to issue new shares? When the
stock is over-valued or undervalued?
For this reason, the issue of new stock is taken to be a negative
signal.
What is the net effect of issuing new debt on the WACC?

Capital Structure Decisions
Capital Structure Theory
Miller Modigliani (MM) theories
MM1: Zero taxes
MM2: Corporate taxes
Miller: Corporate and personal taxes
Trade-off theory
Signaling theory
Debt financing as a managerial
constraint
MM 1958
Assumptions:
No transactions (brokerage) costs
No taxes
Same borrowing and lending rate for all.
Same level of information with all participants.
Debt does not affect EBIT.
Then
V
L
= V
U
.
Capital structure is irrelevant.
What about the point that required rate of return on equity increases with
increased leveraged?
Does it not apply here?
The increase in WACC due to increase in R
E
is exactly offset by the
decrease produced by shifting to the cheaper source (debt).
MM 1963
Assumptions:
Same as before except this time there are taxes.
Last time, the increase in WACC due to increase in R
E
was offset by the
decrease coming from higher weight on cheaper R
D
.
If the same story holds and on top of that you add a tax benefit, what
would happen to WACC with increased leverage?
WACC should get smaller with increased leverage.
How much extra advantage is the leveraged firm getting?
Equal to the tax benefit over the life of the debt, or
Tax Rate * Debt.
Then
V
L
= V
U
+ Tax Rate*Debt
Capital structure is not irrelevant.
There is an optimal capital structure and that is ?
100% Debt
Value of Firm, V
0
Debt
V
L
V
U
MM relationship between value and debt
when corporate taxes are considered.
Under MM with corporate taxes, the firms value
increases continuously as more and more debt is used.
TD
Cost of
Capital (%)
0 20 40 60 80 100
Debt/Value
Ratio (%)
MM relationship between capital costs
and leverage when corporate taxes are
considered.
r
s
WACC
r
d
(1 - T)
Miller 1977
Debt gives the firm a tax benefit but equity also gives a tax benefit. To whom?
To the investors!
Interest payments are not taxed at corporate level but are taxed fully (say, at
about 35%) when the lender receives interest income.
Equity income is taxed at corporate rate. It goes to the shareholders in two
forms: Dividend Income and, Capital Gains
Capital Gains tax has historically been very low.
Even Dividend income is now taxed at a much lower rate (about 15%).
Due to this, an equity investor is willing to accept a rate or return lower than
what is dictated by risk alone.
So, the firm that has high equity versus debt also has some advantage (it can
get away with paying something less to its investors than the what the risk
level requires).
The net advantage for the leveraged firm is then:
Then
V
L
= V
U
+ [1 - ]D
Will the leveraged firm always have higher value than the unlevered one?
What is the optimal capital structure?
(1 - T
c
)(1 - T
s
)
(1 - T
d
)
T
c
= 40%, T
d
= 30%, and T
s
= 12%.
V
L
= V
U
+ [1 - ]D
= V
U
+ (1 - 0.75)D
= V
U
+ 0.25D.
Value rises with debt; each $1 increase in
debt raises Ls value by $0.25.
(1 - 0.40)(1 - 0.12)
(1 - 0.30)
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.
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?
Reserve Borrowing Capacity
Pecking order
Choosing the Optimal Capital Structure:
Example
Currently is all-equity financed.
Expected EBIT = $500,000.
Firm expects zero growth.
100,000 shares outstanding; r
s
= 12%;
P
0
= $25; T = 40%; b = 1.0; r
RF
= 6%;
RP
M
= 6%.
Estimates of Cost of Debt
Percent financed
with debt, w
d
r
d


0% N/A
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%
If company recapitalizes, debt would be issued to repurchase
stock.
How about Cost of Equity? How will it change with a change in
leverage?
Hamadas Equation
We know so far that:
When leverage increases, equitys cash flow become
riskier.
As a result, the cost of equity goes up.
But by how much?
Hamadas equation tries to answer this question.
To use this, you have to be a believer in CAPM.
b
U
is the beta of a firm when it has no debt (the
unlevered beta)
b
L
= b
U
[1 + (1 - T)(D/S)]
Hamadas Equation
What if you do not know the unlevered beta?
That is your firm is moving from one level of debt to another, not from
being totally unlevered to levered.
So your previous beta was for the previous level of debt and you want
to find a new one for the new capital structure. How would you do that?
Use the same Hamada equation to first unlever your beta. If,
b
L
= b
U
[1 + (1 - T)(D/S)]
Then, using old D/S
b
U
= b
L
/[1 + (1 - T)(D
old
/S
old
)]
Once you have the unlevered beta, you can use new D/S to find the
new beta.
b
L
= b
U
[1 + (1 - T)(D
new
/S
new
)]
Use your levered beta in CAPM equation to find the cost of equity.
Use that cost of equity in CAPM to find the WACC.

The Cost of Equity for w
d
= 20%
Use Hamadas equation to find beta:
b
L
= b
U
[1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
r
s
= r
RF
+ b
L
(RP
M
)
= 6% + 1.15 (6%) = 12.9%
You can find the cost of equity for a whole
host of different capital structures.
Cost of Equity vs. Leverage
w
d
D/S b
L
r
s
0% 0.00 1.000 12.00%
20% 0.25 1.150 12.90%
30% 0.43 1.257 13.54%
40% 0.67 1.400 14.40%
50% 1.00 1.600 15.60%
WACC vs. Leverage
w
d
r
d


r
s
WACC

0% 0.0% 12.00% 12.00%
20% 8.0% 12.90% 11.28%
30% 8.5% 13.54% 11.01%
40% 10.0% 14.40% 11.04%
50% 12.0% 15.60% 11.40%
The WACC for w
d
= 20%
WACC = w
d
(1-T) r
d
+ w
e
r
s
WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%

Repeat this for all capital structures under
consideration and find the optimal capital
structure.
WACC vs. Leverage
w
d
r
d


r
s
WACC

0% 0.0% 12.00% 12.00%
20% 8.0% 12.90% 11.28%
30% 8.5% 13.54% 11.01%
40% 10.0% 14.40% 11.04%
50% 12.0% 15.60% 11.40%
Corporate Value for w
d
= 20%
V = FCF / (WACC-g)
g=0, so investment in capital is zero; so FCF = NOPAT
= EBIT (1-T).
NOPAT = ($500,000)(1-0.40) = $300,000.

V = $300,000 / 0.1128 = $2,659,574.
Find the value of the firm for all the capital structures in
the previous slide.
Corporate Value vs. Leverage
w
d
WACC Corp. Value

0% 12.00% $2,500,000
20% 11.28% $2,659,574
30% 11.01% $2,724,796
40% 11.04% $2,717,391
50% 11.40% $2,631,579
Debt and Equity for w
d
= 20%
The dollar value of debt is:
D = w
d
V = 0.2 ($2,659,574) = $531,915.
S = V D
S = $2,659,574 - $531,915 = $2,127,659.
Debt and Stock Value vs.
Leverage
w
d
Debt, D Stock Value, S

0% $0 $2,500,000
20% $531,915 $2,127,660
30% $817,439 $1,907,357
40% $1,086,957 $1,630,435
50% $1,315,789 $1,315,789
Wealth of Shareholders
Value of the equity declines as more debt
is issued, because debt is used to
repurchase stock.
But total wealth of shareholders is value of
stock after the recap plus the cash
received in repurchase, and this total goes
up (It is equal to Corporate Value on
earlier slide).
Stock Price for w
d
= 20%
The firm issues debt, which changes its
WACC, which changes value.
The firm then uses debt proceeds to
repurchase stock.
Stock price changes after debt is issued, but
does not change during actual repurchase
(or arbitrage is possible).
(More)
Stock Price for w
d
= 20%
(Continued)
The stock price after debt is issued
but before stock is repurchased
reflects shareholder wealth:
S, value of stock
Cash paid in repurchase.
(More)
Stock Price for w
d
= 20%
D
0
and n
0
are debt and outstanding
shares before recap.
D - D
0
is equal to cash that will be used to
repurchase stock.
S + (D - D
0
) is wealth of shareholders
after the debt is issued but immediately
before the repurchase.
Stock Price for w
d
= 20%
(Continued)
P = S + (D D
0
)
n
0
P = $2,127,660 + ($531,915 0)
100,000
P = $26.596 per share.

Number of Shares Repurchased
# Repurchased = (D - D
0
) / P
# Rep. = ($531,915 0) / $26.596
= 20,000.
# Remaining = n = S / P
n = $2,127,660 / $26.596
= 80,000.
Price per Share vs. Leverage
# shares # shares
w
d
P Repurch. Remaining

0% $25.00 0 100,000
20% $26.60 20,000 80,000
30% $27.25 30,000 70,000
40% $27.17 40,000 60,000
50% $26.32 50,000 50,000
Optimal Capital Structure
w
d
= 30% gives:
Highest corporate value
Lowest WACC
Highest stock price per share
But w
d
= 40% is close. Optimal range
is pretty flat.
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).
What other factors would managers
consider when setting the target
capital structure?
Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible, and
hence suitable as collateral?
Tax rates.