CAPITAL STRUCTURE

Capital Structure
Capital structurecombination of various types of
capital the firm uses to finance assets.
Does it matter in what proportion of each type of
capital the firm is financed?
WACC is affected the the weightsthat is, w
d
, w
ps
, and w
s
Perhaps the component coststhat is, r
dT
, r
ps
, and r
s
also
are affected by the weights


)
e
r or
s
(r
s
w
ps
r
ps
w
dT
r
d
w
stock
preferred %
debt
%
WACC
equity common
of Cost
equity
common %
stock preferred
of Cost
debt of cost
tax - After
+ + =
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+ +

Capital Structure
Objectivemaximize the firms value, which means
to minimize WACC = r.

=

Firms
Value

CF
1
(1 + r)
1
^

+

CF
2
(1 + r)
2
^

+ +

CF
4
(1 + r)
4
^



+
+ +
+
+
+
=
^ ^ ^
WACC) (1
CF

WACC) (1
CF

WACC) (1
CF

2
2
1
1
L
Target Capital Structure
Proportion of debt and equity a firm wants to use to finance
investmentsa benchmark when raising funds for investing in new
projects.
Debt
Using more debt generally increases the risk associated with future earnings
Debt has a fixed cost (that is, interest), so more debt allows the firm to earn a
higher expected rate of return.
Equity
Less risky to financial operations than debt, because there is no contractual
obligation to pay dividends
Higher cost, because stock is a riskier investment for investors
There is a risk/return tradeoff associated with increasing (decreasing)
debt relative to equity.
Best, or optimal, capital structure, is where the value of the firm is
maximized because the overall WACC, or r, is minimized.

Capital Structure
Riskgreater risk means greater costs to raise funds
Financial flexibilitya stronger financial positionthat is,
stronger balance sheetgenerally implies the firm is
better able to raise funds in the capital markets, especially
in slumping economies
Managerial attitude (conservatism or aggressiveness)
some financial managers are more conservative than
others when it comes to using debt, thus they are inclined
to use less debt, all else equal.

Factors that should be considered when making
decisions about the appropriate capital structure:
Capital StructureRisk
Business riskstability of a firms operations and its ability
to maintain operating income in the competitive arena in
which the firm operates.
Compared to firms with higher business risk, firms that have
lower business risk exhibit greater stability in sales,
operating expenses, and the like, greater flexibility in the
ability to change selling prices, and less relative fixed
operating costs.
Financial riskrisk associated with the ability of a firm to
meet its financial obligations
This form of risk arises when the firm uses sources of
financing that require fix payments or obligations, which we
term financial leverage.

Capital Structure
Introduction
EBIT/EPS Analysis
Stock Price & WACC
Leverage (risk measure)
Capital Structure Theory
Liquidity/Variations in Capital
Structures

Determining the Optimal Capital
Structure
The firm wants to choose a capital structure that
maximizes the price of the firms stockthat is, its
value.
EBIT/EPS analysis can be used to evaluate the
attractiveness of a particular capital structure by
examining how different proportions of debt affect a
firms EPS.
Although maximizing EPS does not maximize value
exactly, we should be able to approximate the
optimal capital structure using EBIT/EPS analysis.

Determining the Optimal Capital
StructureEBIT/EPS Analysis
Example: A firm that has no debt and assets equal to
$400,000 can issue debt and repurchase shares of stock at
$10 per share based on the following schedule:
Amount Debt/Asset Cost of Shares of Stock
Equity of Debt Ratio Debt, r
d
Outstanding
$400,000 $ 0 0.0% 0.0% 40,000
320,000 80,000 20.0 6.0 32,000
240,000 160,000 40.0 9.0 24,000
160,000 240,000 60.0 20.0 16,000

Determining the Optimal Capital
StructureEBIT/EPS Analysis
Assuming that operating expenses, such as cost of goods
sold, depreciation, and so forth, are not affected by capital
structure decisions, the firm is expected to generate the
operating income, EBIT, as follows:
Boom 0.1 $200,000
Normal 0.6 120,000
Recession 0.3 40,000

Type of Economy Probability EBIT = NOI
Determining the Optimal Capital
StructureEBIT/EPS Analysis
Debt/Assets = 0:
Debt = $0 Equity = $400,000
Interest = $0 Shares of stock = $400,000/$10 = 40,000
EBIT $200,000 $120,000 $40,000
Interest ( 0) ( 0) ( 0)
Taxable income, EBT 200,000 120,000 40,000
Taxes (40%) ( 80,000) ( 48,000) (16,000)
Net income $120,000 $72,000 $24,000
Type of Economy Boom Normal Recession
Probability 0.1 0.6 0.3
EPS = NI/(40,000 shrs) $3.00 $1.80 $0.60
Expected EPS $1.56
o
EPS
$0.72

EBIT $200,000 $120,000 $40,000
Interest ( 4,800) ( 4,800) ( 4,800)
Taxable income, EBT 195,200 115,200 35,200
Taxes (40%) ( 78,080) ( 46,080) (14,080)
Net income $117,120 $69,120 $21,120
Type of Economy Boom Normal Recession
Probability 0.1 0.6 0.3
EPS = NI/(32,000 shrs) $3.66 $2.16 $0.66
Expected EPS $1.86
o
EPS
$0.90

Determining the Optimal Capital
StructureEBIT/EPS Analysis
Debt/Assets = 20%:
Debt = 0.2($400,000) = $80,000 Equity = $400,000 - $80,000 = $320,000
Interest = 0.06($80,000) = $4,800 Shares of stock = $320,000/$10 = 32,000
EBIT $200,000 $120,000 $40,000
Interest ( 14,400) ( 14,400) ( 14,400)
Taxable income, EBT 185,600 105,600 25,600
Taxes (40%) ( 74,240) ( 42,240) (10,240)
Net income $111,360 $63,360 $15,360
Type of Economy Boom Normal Recession
Probability 0.1 0.6 0.3
EPS = NI/(24,000 shrs) $4.64 $2.64 $0.64
Expected EPS $2.24
o
EPS
$1.20

Determining the Optimal Capital
StructureEBIT/EPS Analysis
Debt/Assets = 40%:
Debt = 0.4($400,000) = $160,000 Equity = $400,000 - $160,000 = $240,000
Interest = 0.09($160,000) = $14,400 Shares of stock = $240,000/$10 = 24,000
EBIT $200,000 $120,000 $40,000
Interest ( 48,000) ( 48,000) ( 48,000)
Taxable income, EBT 152,000 72,000 ( 8,000)
Taxes (40%) ( 60,800) ( 28,800) 3,200
Net income $ 91,200 $43,200 ( $4,800)

Type of Economy Boom Normal Recession
Probability 0.1 0.6 0.3
EPS = NI/(16,000 shrs) $5.70 $2.70 $(0.30)
Expected EPS $2.10
o
EPS
$1.80

Determining the Optimal Capital
StructureEBIT/EPS Analysis
Debt/Assets = 60%:
Debt = 0.6($400,000) = $240,000 Equity = $400,000 - $240,000 = $160,000
Interest = 0.20($240,000) = $48,000 Shares of stock = $160,000/$10 = 16,000
Determining the Optimal Capital
StructureEBIT/EPS Analysis
Summarizing the results, we have:
0.0% $1.56 $0.72
20.0 1.86 0.90
40.0 2.24 1.20
60.0 2.10 1.80

Proportion Expected Standard
of Debt EPS Deviation
0.0% $1.56 $0.72
20.0 1.86 0.90
40.0 2.24 1.20
60.0 2.10 1.80
EPS Indifference Analysis
0.20
0.40
0.60
0.80
1.00
-0.20
-0.40
2 2.1 2.2
EPS($)
Sales
($ millions)
0
Fixed operating costs = $600,000
Variable cost ratio = 70%
100% Stock
Financing
40% Debt
Financing
EPS Indifference
$2.12 million
0.54
Capital StructureStock Price
The optimal capital structure is the mix of debt and
equity that maximizes the value of the firmthat is, its
stock pricenot the EPS.
The proportion of debt in the optimal capital structure
will be less than the proportion of debt needed to
maximize EPS because the market valuation of the
stock, P
0
, considers the risk associated with the firms
operations expected well into the future and EPS is
based only on the firms operations expected for the
next few years.

Capital StructureStock Price, Cost of
Equity, r
s
, and WACC

Estimated WACC =
% Debt E(EPS) r
dT
=r
d
(1-0.4) Beta,
s
r
s
=4%+(5%)
s
%D(r
dT
)+%E(r
s
)
(1) (2) (3) (4) (5) (6) (7)
s
0
r
EPS
P =

0.0 $1.56 0.0%

10.0 1.70 3.3
20.0 1.86 3.6
30.0 2.05 4.2
40.0 2.24 5.4
50.0 2.22 9.0
60.0 2.10 12.0
1.1
1.2
1.3
1.4
1.7
1.9
2.2
0.0 $1.56 0.0%
10.0 1.70 3.3
20.0 1.86 3.6
30.0 2.05 4.2
40.0 2.24 5.4
50.0 2.22 9.0
60.0 2.10 12.0
9.5%
9.3
9.1
9.0
9.7
11.3
13.2
$16.42
16.97
17.71
18.62
17.92
16.44
14.00
$16.42
16.97
17.71
18.62
17.92
16.44
14.00
9.5%
9.3
9.1
9.0
9.7
11.3
13.2
9.5%
10.0
10.5
11.0
12.5
13.5
15.0
30.0 2.05 4.2 1.4 11.0 18.62 9.0

Capital StructureStock Price and the
Cost of Equity, r
s
The relationship of the cost of equity, r
s
, and the amount of
debt the firm uses to finance its assets can be illustrated as
follows:
r
RF
% Debt in
Capital Structure
Required Return on
Equity, r
s
(%)
Risk-free rate of return
r
s
= r
RF
+ Risk Premium
Total Risk
Premium
Premium for business risk at a
particular level of operations
Premium for
financial risk

0
Capital StructureStock Price and the
Cost of Equity, r
s
The relationship of the after-tax cost of debt, r
dT
, cost of
equity, r
s
, and WACC might be:
% Debt in
Capital Structure
Cost of
Capital, WACC (%)
Cost of
equity, r
s


After-tax
cost of debt,
r
dT

WACC
Minimum
WACC
Optimal Amount
of Debt (30%)
0
Capital StructureWACC
If the firm uses only equity to finance its assets (that is, zero
debt is used) then WACC = r
s
As the firm begins to use some debt for financing, WACC
declines, primarily because the tax benefit offered by the debt
more than offsets the increased cost of equity
At some point the tax benefit associated with debt is more than
offset by increases in the before-tax cost of debt and the cost of
equity that result from increases in the risk associated with the
additional debt and, at this point, WACC begins to increase
The point where WACC is the lowest is the optimal capital
structurethis is the point where the value of the firm is
maximized


Capital Structure and Leverage
Leveragefixed costs
Operating leveragefixed operating costs, such as depreciation
Financial leveragefixed financial costs, such as interest and
preferred dividends
Leverage, or fixed costs, result in a magnification effectthat
is a small change in sales will result in a larger change in
income (operating income, net income, or both)
The degree of leverage associated with a firm often is used to
indicate the degree of risk associated with the firm
Operating leverageoperating risk
Financial leveragefinancial risk
Operating Leverage
All else equal, if a firm can reduce its operating leverage, it can use
more debt (that is, increase its financial leverage), and vice versa, and
maintain the same degree of risk.
Degree of operating leverage (DOL) refers to the percentage change
in operating incomedesignated either NOI or EBITthat results from
a particular percentage change in sales.
DOL can be computed as follows:
EBIT
profit Gross
F VC S
VC S
F V) Q(P
V) Q(P
sales in change %
NOI in change %
DOL =


=


= =

Q = number of products (units) the firm currently sells
P = sales price per unit
V = variable cost per unit
F = fixed operating costs
S = current sales stated in dollars such that S = Q P
VC = total variable costs of operations such that VC = Q V

Operating Leverage
Expected Sales = 5%
Outcome of Expectations %
Sales
Variable operating costs (60%)
Gross profit
Fixed operating costs
Net operating income = EBIT
$250,000
(150,000)
100,000



(75,000)
$237,500
4.0x
$25,000
$100,000
EBIT
profit Gross
DOL = = =

-5.0%
-5.0%
(142,500)
95,000


-5.0



(75,000)



0.0



20,000



-20.0



25,000

Risk = variability
Financial Leverage
Degree of financial leverage refers to the percentage
change in EPS that results from a particular percentage
change in earnings before interest and taxes, EBIT.
DFL is computed as follows:
I F VC S
F VC S
I EBIT
EBIT
EBIT in change %
EPS in change %
DFL


=

= =
I = dollar interest paid on debt
Financial Leverage
Expected Sales = 5%
Outcome of Expectations %
Sales $250,000 $237,500 -5.0%
Variable operating costs (60%) (150,000) (142,500) -5.0
Gross profit 100,000 95,000 -5.0
Fixed operating costs (75,000) (75,000) 0.0
Net operating income = EBIT 25,000 20,000 -20.0
Interest
Earnings Before Taxes
Taxes (40%)
Net Income
(12,500)
12,500

(5,000)



7,500
(12,500) 0.0
7,500


-40.0

(3,000)
-40.0
4,500 -40.0
2.0x
$12,500
$25,000
$12,500 - $25,000
$25,000
I - EBIT
EBIT
DFL = = = =
Risk = variability
Total Leverage
Degree of total leverage (DTL) refers to the
percentage change in EPS that results from a
particular percentage change in sales.
DTL combines DOL and DFL, and it is computed as
follows:
I EBIT
profit Gross
I F VC S
VC S
I F V) Q(P
V) Q(P
DFL DOL
sales in change %
EPS in change %
DTL

=


=


=
= =
Total Leverage
Expected Sales = 5%
Outcome of Expectations %
Sales $250,000 $237,500 -5.0%
Variable operating costs (60%) (150,000) (142,500) -5.0
Gross profit 100,000 95,000 -5.0
Fixed operating costs (75,000) (75,000) 0.0
Net operating income = EBIT 25,000 20,000 -20.0
Interest (12,500) (12,500) 0.0
Earnings Before Taxes 12,500 7,500 -40.0
Taxes (40%) (5,000) (3,000) -40.0
Net Income 7,500 4,500 -40.0
8.0x
$12,500
$100,000
$12,500 - $25,000
$100,000
I - EBIT
profit Gross
DTL = = = =
Risk = variability; thus the greater the degree of leverage (operating,
financial, or both), the greater the risk associated with the firm

Leverage
Expected Sales = +10%
Outcome of Expectations %
Sales $250,000 $275,000 +10.0%
Variable operating costs (60%) (150,000) (165,000) +10.0
Gross profit 100,000 110,000 +10.0
Fixed operating costs (75,000) (75,000) 0.0
Net operating income = EBIT 25,000 35,000 +40.0
Interest (12,500) (12,500) 0.0
Earnings Before Taxes 12,500 22,500 +80.0
Taxes (40%) (5,000) (9,000) +80.0
Net Income 7,500 13,500 +80.0
Risk = variability; thus the greater the degree of leverage (operating,
financial, or both), the greater the risk associated with the firm

DOL = 4.0x; DFL = 2.0x; DTL = 8.0x