Chapter 13

Capital Structure and Leverage

Learning Objectives
After reading this chapter, students should be able to:
Explain why capital structure policy involves a trade-of between risk and return, and list
the four primary factors that infuence capital structure decisions
!istinguish between a "rm#s business risk and its "nancial risk
Explain how operating leverage contributes to a "rm#s business risk and conduct a
breakeven analysis, complete with a breakeven chart
!e"ne "nancial leverage and explain its efect on expected $%E, expected E&', and the
risk borne by stockholders
(riefy explain what is meant by a "rm#s optimal capital structure
'pecify the efect of "nancial leverage on beta using the )amada e*uation, and transform
this e*uation to calculate a "rm#s unlevered beta, b+
,llustrate through a graph the premiums for "nancial risk and business risk at diferent
debt levels
-ist the assumptions under which .odigliani and .iller proved that a "rm#s value is
unafected by its capital structure, then explain trade-of theory, signaling theory, and the
efect of taxes and bankruptcy costs on capital structure
-ist a number of factors or practical considerations "rms generally consider when making
capital structure decisions
(riefy explain the extent that capital structure varies across industries, individual "rms in
each industry, and diferent countries
Chapter 13: Capital Structure and Leverage Learning Objectives 85
Lecture Suggestions
/his chapter is rather long, but it is also modular, hence sections can be omitted without loss
of continuity /herefore, if you are experiencing a time crunch, you could skip selected
sections
0hat we cover, and the way we cover it, can be seen by scanning the slides and
,ntegrated 1ase solution for 1hapter 23, which appears at the end of this chapter solution 4or
other suggestions about the lecture, please see the 5-ecture 'uggestions6 in 1hapter 7, where
we describe how we conduct our classes
DAYS O C!A"#$%: & O' 58 DAYS (5)*+inute periods,
8- Lecture Suggestions Chapter 13: Capital Structure and Leverage
Ans.ers to $nd*o/*Chapter 0uestions
13*1 %perating leverage is the extent to which "xed costs are used in a "rm#s operations ,f
operating leverage is increased 8"xed costs are high9, then even a small decline in
sales can lead to a large decline in pro"ts and in its $%E
13*1 a2 /he breakeven point will be lowered
b2 /he efect on the breakeven point is indeterminant An increase in "xed costs will
increase the breakeven point )owever, a lowering of the variable cost lowers the
breakeven point 'o it#s unclear which efect will have the greater impact
c2 /he breakeven point will be increased because "xed costs have increased
d2 /he breakeven point will be lowered
13*3 ,f sales tend to fuctuate widely, then cash fows and the ability to service "xed charges
will also vary 1onse*uently, there is a relatively large risk that the "rm will be unable
to meet its "xed charges As a result, "rms in unstable industries tend to use less debt
than those whose sales are sub:ect to only moderate fuctuations, or relatively stable
sales
13*& An increase in the personal tax rate makes both stocks and bonds less attractive to
investors because it raises the tax paid on dividend and interest income 1hanges in
personal tax rates will have difering efects, depending on what portion of an
investment#s total return is expected in the form of interest or dividends versus capital
gains 4or example, a high personal tax rate has a greater impact on bondholders
because more of their return will be taxed sooner at the new higher rate An increase
in the personal tax rate will cause some investors to shift from bonds to stocks because
of the attractiveness of capital gains tax deferrals /his raises the cost of debt relative
to e*uity ,n addition, a lower corporate tax rate reduces the advantage of debt by
reducing the bene"t of a corporation#s interest deduction that discourages the use of
debt 1onse*uently, the net result would be for "rms to use more e*uity and less debt
in their capital structures
13*5 a2 An increase in the corporate tax rate would encourage a "rm to increase the
amount of debt in its capital structure because a higher tax rate increases the
interest deductibility feature of debt
b2 An increase in the personal tax rate would cause investors to shift from bonds to
stocks due to the attractiveness of the deferral of capital gains taxes /his would
raise the cost of debt relative to e*uity; thus, "rms would be encouraged to use
less debt in their capital structures
c2 4irms whose assets are illi*uid and would have to be sold at 5"re sale6 prices
should limit their use of debt "nancing 1onse*uently, this would discourage the
"rm from increasing the amount of debt in its capital structure
d2 ,f changes to the bankruptcy code made bankruptcy less costly, then "rms would
tend to increase the amount of debt in their capital structures
Chapter 13: Capital Structure and Leverage Answers and Solutions 83
e2 4irms whose earnings are more volatile and thus have higher business risk, all else
e*ual, face a greater chance of bankruptcy and, therefore, should use less debt
than more stable "rms
13*- &harmaceutical companies use relatively little debt because their industries tend to be
cyclical, oriented toward research, or sub:ect to huge product liability suits +tility
companies, on the other hand, use debt relatively heavily because their "xed assets
make good security for mortgage bonds and also because their relatively stable sales
make it safe to carry more than average debt
13*3 E(,/ depends on sales and operating costs that generally are not afected by the "rm#s
use of "nancial leverage, because interest is deducted from E(,/ At high debt levels,
however, "rms lose business, employees worry, and operations are not continuous
because of "nancing di<culties /hus, "nancial leverage can infuence sales and cost,
hence E(,/, if excessive leverage causes investors, customers, and employees to be
concerned about the "rm#s future
13*8 Expected E&' is generally measured as E&' for the coming years, and we typically do
not refect in this calculation any bankruptcy-related costs Also, E&' does not refect
8in a ma:or way9 the increase in risk and rs that accompanies an increase in the debt
ratio, whereas &= does refect these factors /hus, the stock price will be maximi>ed at
a debt level that is lower than the E&'-maximi>ing debt level
13*4 /he tax bene"ts from debt increase linearly, which causes a continuous increase in the
"rm#s value and stock price )owever, bankruptcy-related costs begin to be felt after
some amount of debt has been employed, and these costs ofset the bene"ts of debt
'ee 4igure 23-? in the textbook
13*1) 0ith increased competition after the breakup of A/@/, the new A/@/ and the seven (ell
operating companies# business risk increased 0ith this component of total company
risk increasing, the new companies probably decided to reduce their "nancial risk, and
use less debt, to compensate 0ith increased competition the chance of bankruptcy
increases and lowering debt usage makes this less of a possibility ,f we consider the tax
issue alone, interest on debt is tax deductible; thus, the higher the "rm#s tax rate the
more bene"cial the deductibility of interest is )owever, competition and business risk
have tended to outweigh the tax aspect as we can see from the actual debt ratios of the
(ell companies
13*11 /he "rm may want to assess the asset investment and "nancing decisions :ointly 4or
instance, the highly automated process would re*uire fancy, new e*uipment 8capital
intensive9 so "xed costs would be high A less automated production process, on the
other hand, would be labor intensive, with high variable costs ,f sales fell, the process
that demands more "xed costs might be detrimental to the "rm if it has much debt
"nancing /he less automated process, however, would allow the "rm to lay of
workers and reduce variable costs if sales dropped; thus, debt "nancing would be more
attractive %perating leverage and "nancial leverage are interrelated /he highly
automated process would increase the "rm#s operating leverage; thus, its optimal
capital structure would call for less debt %n the other hand, the less automated
process would call for less operating leverage; thus, the "rm#s optimal capital structure
would call for more debt
88 Answers and Solutions Chapter 13: Capital Structure and Leverage
Solutions to $nd*o/*Chapter "roble+s
13*1 A(E B
C &
4

A(E B
== 3 D == E D
=== , F== D

A(E B F==,=== units

13*1 /he optimal capital structure is that capital structure where 0A11 is minimi>ed and
stock price is maximi>ed (ecause Gackson#s stock price is maximi>ed at a 3=H debt
ratio, the "rm#s optimal capital structure is 3=H debt and I=H e*uity /his is also the
debt level where the "rm#s 0A11 is minimi>ed
13*3 a2 Expected E&' for 4irm 1:
E8E&'19 B =28-D7E=9 J =78D23F9 J =E8DF2=9 J =78D??F9 J
=28D27K=9
B -D=7E J D=7I J D7=E J D2II J D27K B DF2=
8Lote that the table values and probabilities are dispersed in a symmetric manner
such that the answer to this problem could have been obtained by simple
inspection9
b2 According to the standard deviations of E&', 4irm ( is the least risky, while 1 is the
riskiest )owever, this analysis does not consider portfolio efectsMif 1#s earnings
increase when most other companies# decline 8that is, its beta is low9, its apparent
riskiness would be reduced Also, standard deviation is related to si>e, or scale,
and to correct for scale we could calculate a coe<cient of variation 8Nmean9:
E8E&'9 1C B NE8E&'9
A DF2= D3K2 =I2
( E7= 7OK =I=
1 F2= E22 =?2
(y this criterion, 1 is still the most risky
13*& 4rom the )amada e*uation, b B b+P2 J 82 Q /98!NE9R, we can calculate b+ as b+ B bNP2 J 82
Q /98!NE9R
b+ B 27NP2 J 82 Q =E98D7,===,===ND?,===,===9R
b+ B 27NP2 J =2FR
b+ B 2=E3F
Chapter 13: Capital Structure and Leverage Answers and Solutions 84
13*5 a2 --: !N/A B 3=H
E(,/ DE,===,===
,nterest 8DK,===,=== =2=9 K==,===
E(/ D3,E==,===
/ax 8E=H9 2,3K=,===
Let income D7,=E=,===
$eturn on e*uity B D7,=E=,===ND2E,===,=== B 2EKH
)-: !N/A B F=H
E(,/ DE,===,===
,nterest 8D2=,===,=== =279 2,7==,===
E(/ D7,?==,===
/ax 8E=H9 2,27=,===
Let income D2,K?=,===
$eturn on e*uity B D2,K?=,===ND2=,===,=== B 2K?H
b2 --: !N/A B K=H
E(,/ DE,===,===
,nterest 8D27,===,=== =2F9 2,?==,===
E(/ D7,7==,===
/ax 8E=H9 ??=,===
Let income D2,37=,===
$eturn on e*uity B D2,37=,===ND?,===,=== B 2KFH
Although --#s return on e*uity is higher than it was at the 3=H leverage ratio, it is
lower than the 2K?H return of )-
,nitially, as leverage is increased, the return on e*uity also increases (ut, the
interest rate rises when leverage is increased /herefore, the return on e*uity will
reach a maximum and then decline
13*- a2 ?,=== units 2?,=== units
'ales D7==,=== DEF=,===
4ixed costs 2E=,=== 2E=,===
Cariable costs 27=,=== 7I=,===
/otal costs D7K=,=== DE2=,===
Sain 8loss9 8D K=,===9 D E=,===
b2 A(E B
C &
4

B
D2=
D2E=,===
B 2E,=== units
'(E B A(E8&9 B 82E,===98D7F9 B D3F=,===
4) Answers and Solutions Chapter 13: Capital Structure and Leverage
c2 ,f the selling price rises to D32, while the variable cost per unit remains "xed, & Q C
rises to D2K /he end result is that the breakeven point is lowered
A(E B
C &
4

B
D2K
D2E=,===
B ?,IF= units
'(E B A(E8&9 B 8?,IF=98D329 B D7I2,7F=
/he breakeven point drops to ?,IF= units /he contribution margin per each unit
sold has been increased; thus the variability in the "rm#s pro"t stream has been
increased, but the opportunity for magni"ed pro"ts has also been increased
d2 ,f the selling price rises to D32 and the variable cost per unit rises to D73, & Q C falls to D?
/he end result is that the breakeven point increases
A(E B
C - &
4
B
D?
D2E=,===
B 2I,F== units
'(E B A(E8&9 B 82I,F==98D329 B DFE7,F==
/he breakeven point increases to 2I,F== units because the contribution margin per
each unit sold has decreased
Chapter 13: Capital Structure and Leverage Answers and Solutions 41
Sales
Costs
Dollars
Units of Output
(Thousands)
800,000
600,000
400,000
200,000
0 5 10 15 20
i!ed Costs
Sales
Costs
Dollars
Units of Output
(Thousands)
800,000
600,000
400,000
200,000
0 5 10 15 20
i!ed Costs
13*3 Lo leverage: !ebt B =; E*uity B D2E,===,===
'tat
e
&s E(,/ 8E(,/ Q rd!982 Q /9 $%E' &'8$%E9 &'8$%E' Q
$TE9
7
2 =7
DE,7==,==
=
D7,F7=,=== =2? ==3K ===223
7 =F 7,?==,=== 2,K?=,=== =27 ==K= ====22
3 =3 I==,=== E7=,=== ==3 ===O = ==2KO
$TE B =2=F
Cariance B ===7O3
'tandard deviation B ==FE
$TE B 2=FH

7
B ===7O3
B FEH
1C B N$TE B FEHN2=FH B =F2E
-everage ratio B 2=H: !ebt B D2,E==,===; E*uity B D27,K==,===; rd B OH
'tat
e
&s E(,/ 8E(,/ Q rd!982 Q /9 $%E' &'8$%E9 &'8$%E' Q
$TE9
7
2 =7
DE,7==,==
=
D7,EEE,E== =2OE ==3O ===23?
7 =F 7,?==,=== 2,K=E,E== =27I ==KE ====23
3 =3 I==,=== 3EE,E== ==7I ===? = ==727
$TE B =222
Cariance B ===3K3
'tandard deviation B ==K=
$TE B 222H

7
B ===3K3
41 Answers and Solutions Chapter 13: Capital Structure and Leverage
Sales
Costs
Dollars
Units of Output
(Thousands)
800,000
600,000
400,000
200,000
0 5 10 15 20
i!ed Costs
B KH
1C B KHN222H B =FE2
-everage ratio B F=H: !ebt B DI,===,===; E*uity B DI,===,===; rd B 22H
'tat
e
&s E(,/ 8E(,/ Q rd!982 Q /9 $%E' &'8$%E9 &'8$%E' Q
$TE9
7
2 =7
DE,7==,==
=
D7,=F?,=== =7OE ==FO ===EF=
7 =F 7,?==,=== 2,72?,=== =2IE ==?I ====EF
3 =3 I==,=== 8E7,===9 8===K9 8===79 = ==KIF
$TE B =2EE
Cariance B ==22I=
'tandard deviation B =2=?
$TE B 2EEH

7
B ==22I=
B 2=?H
1C B 2=?HN2EEH B =IF=
-everage ratio B K=H: ! B D?,E==,===; E B DF,K==,===; rd B 2EH
'tat
e
&s E(,/ 8E(,/ Q rd!982 Q /9 $%E' &'8$%E9 &'8$%E' Q
$TE9
7
2 =7
DE,7==,==
=
D2,?2E,E== =37E ==KF ===KOO
7 =F 7,?==,=== OIE,E== =2IE ==?I ====K?
3 =3 I==,=== 87?F,K==9 8==F29 8==2F9 = =2=K=
$TE B =23I
Cariance B ==2?7I
'tandard deviation B =23F
$TE B 23IH

7
B ==2?7I
B 23FH
1C B 23FHN23IH B =O?F =OO
As leverage increases, the expected return on e*uity rises up to a point (ut as the risk
increases with increased leverage, the cost of debt rises 'o after the return on e*uity
peaks, it then begins to fall As leverage increases, the measures of risk 8both the
standard deviation and the coe<cient of variation of the return on e*uity9 rise with
each increase in leverage
Chapter 13: Capital Structure and Leverage Answers and Solutions 43
13*8 4acts as given: 1urrent capital structure: 7FH debt, IFH e*uity; r$4 B FH; r. Q r$4 B KH; /
B E=H;
rs B 2EH
'tep 2:!etermine the "rm#s current beta
rs B r$4 J 8r. Q r$49b
2EHB FH J 8KH9b
OH B KHb
2F B b
'tep 7:!etermine the "rm#s unlevered beta, b+
b+ B b-NP2 J 82 Q /98!NE9R
B 2FNP2 J 82 Q =E98=7FN=IF9R
B 2FN27=
B 27F
'tep 3:!etermine the "rm#s beta under the new capital structure
b- B b+P2 J 82 Q /98!NE9R
B 27FP2 J 82 Q =E98=FN=F9R
B 27F82K9
B 7
'tep E:!etermine the "rm#s new cost of e*uity under the changed capital structure
rs B r$4 J 8r. Q r$49b
B FH J 8KH97
B 2IH
13*4 a2 /he current dividend per share, !=, B DE==,===N7==,=== B D7== !2 B D7==82=F9 B
D72= /herefore, &= B !2N8rs Q g9 B D72=N8=23E Q ==F9 B D7F==
b2 'tep 2:1alculate E(,/ before the recapitali>ation:
E(,/ B D2,===,===N82 Q /9 B D2,===,===N=K B D2,KKK,KKI
Lote: /he "rm is 2==H e*uity "nanced, so there is no interest expense
'tep 7:1alculate net income after the recapitali>ation:
PD2,KKK,KKI Q =228D2,===,===9R=K B DO3E,===
'tep 3:1alculate the number of shares outstanding after the recapitali>ation:
7==,=== Q 8D2,===,===ND7F9 B 2K=,=== shares
'tep E:1alculate !2 after the recapitali>ation:
!= B =E8DO3E,===N2K=,===9 B D733F
!2 B D733F82=F9 B D7EF2IF
'tep F:1alculate &= after the recapitali>ation:
4& Answers and Solutions Chapter 13: Capital Structure and Leverage
&= B !2N8rs Q g9 B D7EF2IFN8=2EF Q ==F9 B D7F?=IO D7F?2
13*1) a2 4irm A
2 4ixed costs B D?=,===
7 Cariable costNunit B
units (reakeven
costs 4ixed sales (reakeven
B
Nunit DE?= B
7F,===
D27=,===
B
7F,===
D?=,=== D7==,===
3 'elling priceNunit B
Nunit D?== B
7F,===
D7==,===
B
units (reakeven
sales (reakeven
4irm (
2 4ixed costs B D27=,===
7 Cariable costNunit B
units (reakeven
costs 4ixed sales (reakeven
B
,=== 3=
=,=== 27 D =,=== E D7
B DE==Nunit
3 'elling priceNunit B
units (reakeven
sales (reakeven
B
3=,===
D7E=,===
B D?==Nunit
b2 4irm ( has the higher operating leverage due to its larger amount of "xed costs
c2 %perating pro"t B 8'elling price98+nits sold9 Q 4ixed costs Q 8Cariable costsNunit9
8+nits sold9
4irm A#s operating pro"t B D?U Q D?=,=== Q DE?=U
4irm (#s operating pro"t B D?U Q D27=,=== Q DE==U
'et the two e*uations e*ual to each other:
D?U Q D?=,=== Q DE?=U B D?U Q D27=,=== Q DE==U
-D=?U B -DE=,===
U B DE=,===ND=?= B F=,=== units
'ales level B 8'elling price98+nits9 B D?8F=,===9 B DE==,===
At this sales level, both "rms earn D?=,===:
&ro"tA B D?8F=,===9 Q D?=,=== Q DE?=8F=,===9
Chapter 13: Capital Structure and Leverage Answers and Solutions 45
B DE==,=== Q D?=,=== Q D7E=,=== B D?=,===
&ro"t( B D?8F=,===9 Q D27=,=== Q DE==8F=,===9
B DE==,=== Q D27=,=== Q D7==,=== B D?=,===
13*11 a2 +sing the standard formula for the weighted average cost of capital, we "nd:
0A11B wdrd82 Q /9 J wcrs
B 8=798?H982 Q =E9 J 8=?9827FH9
B 2=OKH
b2 /he "rmVs current levered beta at 7=H debt can be found using the 1A&. formula
rs B r$4 J 8r. Q r$49b
27FHB FH J 8KH9b
b B 27F
c2 /o 5unlever6 the "rmVs beta, the )amada e*uation is used
b- B b+P2 J 82 Q /98!NE9R
27FB b+P2 J 82 Q =E98=7N=?9R
27FB b+822F9
b+ B 2=?KOFI
d2 /o determine the "rm#s new cost of common e*uity, one must "nd the "rm#s new
beta under its new capital structure 1onse*uently, you must 5relever6 the "rmVs
beta using the )amada e*uation:
b-,E=H B b+P2 J 82 Q /98!NE9R
b-,E=H B 2=?KOFI P2 J 82 Q =E98=EN=K9R
b-,E=H B 2=?KOFI82E9
b+ B 2F72I3O
/he "rmVs cost of e*uity, as stated in the problem, is derived using the 1A&.
e*uation
rs B r$4 J 8r. Q r$49b
rs B FH J 8KH92F72I3O
rs B 2E23H
e2 Again, the standard formula for the weighted average cost of capital is used
$emember, the 0A11 is a marginal, after-tax cost of capital and hence the relevant
before-tax cost of debt is now OFH and the cost of e*uity is 2E23H
0A11B wdrd82 Q /9 J wcrs
B 8=E98OFH982 Q =E9 J 8=K982E23H9
B 2=IKH
/2 /he "rm should be advised to proceed with the recapitali>ation as it causes the
0A11 to decrease from 2=OKH to 2=IKH As a result, the recapitali>ation would
lead to an increase in "rm value
13*11 a2 0ithout new investment:
'ales D27,OK=,===
4- Answers and Solutions Chapter 13: Capital Structure and Leverage
C1 2=,7==,===
41 2,FK=,===
E(,/ D 2,7==,===
,nterest 3?E,===W
E(/ D ?2K,===
/ax 8E=H9 37K,E==
Let income D E?O,K==
W,nterest B ==?8DE,?==,===9 B D3?E,===
2 E&'%ld B DE?O,K==N7E=,=== B D7=E
0ith new investment:
!ebt 'tock
'ales D27,OK=,=== D27,OK=,===
C1 8=?98D2=,7==,===9 ?,2K=,=== ?,2K=,===
41 2,?==,=== 2,?==,===
E(,/ D 3,===,=== D 3,===,===
,nterest 2,2=E,===WW 3?E,===
E(/ D 2,?OK,=== D 7,K2K,===
/ax 8E=H9 IF?,E== 2,=EK,E==
Let income D 2,23I,K== D 2,FKO,K==
WW,nterest B ==?8DE,?==,===9 J =2=8DI,7==,===9 B D2,2=E,===
7 E&'! B D2,23I,K==N7E=,=== B DEIE
3 E&'' B D2,FKO,K==NE?=,=== B D37I
E&' should improve, but expected E&' is signi"cantly higher if "nancial leverage is
used
b2 E&' B
L
/9 ,982 4 C1 8'ales
B
L
/9 ,982 4 CA 8&A

E&'!ebtB
7E=,===
98=K9 D2,2=E,=== D2,?==,=== A D2?233 A 8D7??
B
7E=,===
98=K9 D7,O=E,=== A 8D2=KKI

E&''tock B
E?=,===
98=K9 D7,2?E,=== A 8D2=KKI

/herefore,
E?=,===
98=K9 D7,2?E,=== A 8D2=KKI
B
7E=,===
98=K9 D7,O=E,=== A 82=KKI
D2=KKIA B D3,K7E,===
Chapter 13: Capital Structure and Leverage Answers and Solutions 43
A B 33O,IF= units
/his is the 5indiference6 sales level, where E&'debt B E&'stock
c2 E&'%ld B
7E=,===
=K9 D3?E,===98 D2,FK=,=== A D77KKI A 8D7??
B =
DK233A B D2,OEE,===
A B 32K,OFI units
/his is the A(E considering interest charges
E&'Lew,!ebt B
7E=,===
,===98=K9 O=E , 7 D A 233 2? D A 8D7??
B =
D2=KKIA B D7,O=E,===
A B 7I7,7F= units
E&'Lew,'tock B
=,=== ? E
K9 ?E,===98= 2 D7, A KKI 2= 8D
B =
D2=KKIA B D7,2?E,===
A B 7=E,IF= units
d2 At the expected sales level, EF=,=== units, we have these E&' values:
E&'%ld 'etup B D7=E E&'Lew,!ebt B DEIE E&'Lew,'tock B D37I
0e are given that operating leverage is lower under the new setup Accordingly,
this suggests that the new production setup is less risky than the old oneMvariable
costs drop very sharply, while "xed costs rise less, so the "rm has lower costs at
5reasonable6 sales levels
,n view of both risk and pro"t considerations, the new production setup seems
better /herefore, the *uestion that remains is how to "nance the investment
/he indiference sales level, where E&'debt B E&'stock, is 33O,IF= units /his is well
below the EF=,=== expected sales level ,f sales fall as low as 7F=,=== units, these
E&' "gures would result:
E&'!ebt B
7E=,===
R8=K9 D7,O=E,=== ,===9 = D2?23387F ,===9 = PD7??87F
B -D=FO
E&''tock B
E?=,===
R8=K9 D7,2?E,=== ,===9 = D2?23387F ,===9 = PD7??87F
B D=K=
/hese calculations assume that & and C remain constant, and that the company
can obtain tax credits on losses %f course, if sales rose above the expected
EF=,=== level, E&' would soar if the "rm used debt "nancing
,n the 5real world6 we would have more information on which to base the decisionM
coverage ratios of other companies in the industry and better estimates of the
likely range of unit sales %n the basis of the information at hand, we would
probably use e*uity "nancing, but the decision is really not obvious
48 Answers and Solutions Chapter 13: Capital Structure and Leverage
Chapter 13: Capital Structure and Leverage Answers and Solutions 44
13*13 +se of debt 8millions of dollars9:
&robability =3 =E =3
'ales D7,7F== D7,I=== D3,2F==
E(,/ 82=H9 77F= 7I== 32F=
,nterestW II E II E II E
E(/ D 2EIK D 2O7K D 73IK
/axes 8E=H9 FO = II = OF =
Let income D ?? K D 22F K D 2E7 K
Earnings per share 87= million shares9 DE E3 DF I? DI 23
W,nterest on debt B 8D7I= =279 J 1urrent interest expense
B D37E J DEF B DIIE
Expected E&' B 8=3=98DEE39 J 8=E=98DFI?9 J 8=3=98DI239
B DFI? if debt is used

7
!ebt B 8=3=98DEE3 Q DFI?9
7
J 8=E=98DFI? Q DFI?9
7
J 8=3=98DI23 Q DFI?9
7
B
2=OE
'tandard deviation of E&' if debt "nancing is used:
!ebt B =OE 2 B D2=F
1C B
DFI?
D2=F
B =2?
E8/,E!ebt9 B
,
E8E(,/9
B
DIIE
D7I=
B 3EO
!ebtNAssets B 8DKF7F= J D3== J D7I=9N8D2,3F= J D7I=9 B IFFH
+se of stock 8millions of dollars9:
&robability =3 =E =3
'ales D7,7F== D7,I=== D3,2F==
E(,/ 77F= 7I== 32F=
,nterest EF = EF = EF =
E(/ D 2?== D 77F= D 7I==
/axes 8E=H9 I7 = O= = 2=? =
Let income D 2=? = D 23F = D 2K7 =
Earnings per share 87EF million shares9W DE E2 DF F2 DK K2
WLumber of shares B 8D7I= millionNDK=9 J 7= million
B EF million J 7= million B 7EF million
E&'E*uity B 8=3=98DEE29 J 8=E=98DFF29 J 8=3=98DKK29 B DFF2

7
E*uity B 8=3=98DEE2 Q DFF29
7
J 8=E=98DFF2 Q DFF29
7
J 8=3=98DKK2 Q DFF29
7
B
=I7K=
E*uity B I7K= = B D=?F
1)) Answers and Solutions Chapter 13: Capital Structure and Leverage
1C B
DFF2
D=?F
B =2F
E8/,E'tock9 B
DEF
D7I=
B K==
Assets
!ebt
B
D7I= J D2,3F=
D3== J DKF7F=
B F??H
+nder debt "nancing the expected E&' is DFI?, the standard deviation is D2=F, the
1C is =2?, and the debt ratio increases to IFFH 8/he debt ratio had been I=KH9
+nder e*uity "nancing the expected E&' is DFF2, the standard deviation is D=?F, the
1C is =2F, and the debt ratio decreases to F??H At this interest rate, debt "nancing
provides a higher expected E&' than e*uity "nancing; however, the debt ratio is
signi"cantly higher under the debt "nancing situation as compared with the e*uity
"nancing situation (ecause E&' is not signi"cantly greater under debt "nancing
compared to e*uity "nancing, while the risk is noticeably greater, e*uity "nancing
should be recommended
Chapter 13: Capital Structure and Leverage Answers and Solutions 1)1
Co+prehensive5Spreadsheet "roble+
Note to Instructors:
#he solution to this proble+ is not provided to students at the bac6 o/ their te7t2
8nstructors can access the Excel 9le on the te7tboo6:s ;eb site or the 8nstructor:s
%esource CD2
13*1& /ax rate B E=H; r$4 B F=H; b+ B 27; r. Q r$4 B K=H
4rom data given in the problem and table we can develop the following table:
-everaged
!NA ENA !NE rd rd82 Q /9 beta
a
rs
b
0A11
c
=== 2== ===== I==H E7=H 27= 277=H 277=H
=7= =?= =7F== ?== E?= 23? 237? 22F?
=E= =K= =KKKI 2=== K== 2K? 2F=? 22EF
=K= =E= 2F=== 27== I7= 77? 2?K? 22IO
=?= =7= E==== 2F== O== E=? 7OE? 232=
Lotes:
a
/hese beta estimates were calculated using the )amada e*uation, b- B b+P2 J 82 Q /9
8!NE9R
b
/hese rs estimates were calculated using the 1A&., rs B r$4 J 8r. Q r$49b
c
/hese 0A11 estimates were calculated with the following e*uation: 0A11 B wd8rd982 Q
/9 J 8wc98rs9
a2 /he "rm#s optimal capital structure is that capital structure which minimi>es the
"rm#s 0A11 Elliott#s 0A11 is minimi>ed at a capital structure consisting of E=H
debt and K=H e*uity At that capital structure, the "rm#s 0A11 is 22EFH
b2 ,f the "rm#s business risk increased, the "rm#s target capital structure would consist
of less debt and more e*uity
c2 ,f 1ongress dramatically increases the corporate tax rate, then the tax deductibility
of interest would be greater /his should lead to an increase in the "rm#s use of
debt in its capital structure
d2
1)1 ComprehensiveSpreadsheet !roblem Chapter 13: Capital Structure and
Leverage
/he top graph is like the one in the textbook, because it uses the !NA ratio on the
hori>ontal axis /he bottom graph is a bit like .. showed in their original article in
that the cost of e*uity is linear and the 0A11 does not turn up sharply ,t is not
exactly like .. because it uses !NA rather than !NC, and also because ..
assumed that rd is constant whereas we assume the cost of debt rises with
leverage
Lote too that the minimum 0A11 is at the !NA and !NE levels indicated in the
table, and also that the 0A11 curve is very fat over a broad range of debt ratios,
indicating that 0A11 is not sensitive to debt over a broad range /his is important,
as it demonstrates that management can use a lot of discretion as to its capital
structure, and that it is %X to alter the debt ratio to take advantage of market
conditions in the debt and e*uity markets, and to increase the debt ratio if many
good investment opportunities are available
Chapter 13: Capital Structure and LeverageComprehensiveSpreadsheet !roblem
1)3
8ntegrated Case
13*15
Campus Deli Inc.
Optimal Capital Structure
Assu+e that <ou have just been hired as business +anager o/
Ca+pus Deli (CD,= .hich is located adjacent to the ca+pus2 Sales
.ere >1=1))=))) last <ear? variable costs .ere -)@ o/ sales? and
97ed costs .ere >&)=)))2 #here/ore= $A8# totaled >&))=)))2
Aecause the universit<:s enroll+ent is capped= $A8# is e7pected to be
constant over ti+e2 Aecause no e7pansion capital is reBuired= CD
pa<s out all earnings as dividends2 Assets are >1 +illion= and 8)=)))
shares are outstanding2 #he +anage+ent group o.ns about 5)@ o/
the stoc6= .hich is traded in the over*the*counter +ar6et2
CD currentl< has no debtCit is an all*eBuit< 9r+Cand its 8)=)))
shares outstanding sell at a price o/ >15 per share= .hich is also the
boo6 value2 #he 9r+:s /ederal*plus*state ta7 rate is &)@2 On the
basis o/ state+ents +ade in <our 9nance te7t= <ou believe that CD:s
shareholders .ould be better oD i/ so+e debt 9nancing .ere used2
;hen <ou suggested this to <our ne. boss= she encouraged <ou to
pursue the idea= but to provide support /or the suggestion2
8n toda<:s +ar6et= the ris6*/ree rate= r
%'
= is -@ and the +ar6et
ris6 pre+iu+= r
E
F r
%'
= is -@2 CD:s unlevered beta= b
G
= is 12)2 CD
currentl< has no debt= so its cost o/ eBuit< (and ;ACC, is 11@2
8/ the 9r+ .ere recapitaliHed= debt .ould be issued= and the
borro.ed /unds .ould be used to repurchase stoc62 Stoc6holders= in
turn= .ould use /unds provided b< the repurchase to bu< eBuities in
other /ast*/ood co+panies si+ilar to CD2 You plan to co+plete <our
report b< as6ing and then ans.ering the /ollo.ing Buestions2
1)& Integrated Case Chapter 13: Capital Structure and Leverage
A2 (1, ;hat is business ris6I ;hat /actors inJuence a 9r+:s
business ris6I
Ans.er: KSho. S13*1 through S13*3 here2L Ausiness ris6 is the
ris6iness inherent in the 9r+:s operations i/ it uses no debt2
A 9r+:s business ris6 is aDected b< +an< /actors= including
these: (1, variabilit< in the de+and /or its output= (1,
variabilit< in the price at .hich its output can be sold= (3,
variabilit< in the prices o/ its inputs= (&, the 9r+:s abilit< to
adjust output prices as input prices change= (5, the a+ount
o/ operating leverage used b< the 9r+= and (-, special ris6
/actors (such as potential product liabilit< /or a drug
co+pan< or the potential cost o/ a nuclear accident /or a
utilit< .ith nuclear plants,2
A2 (1, ;hat is operating leverage= and ho. does it aDect a 9r+:s
business ris6I
Ans.er: KSho. S13*& through S13*- here2L Operating leverage is
the e7tent to .hich 97ed costs are used in a 9r+:s
operations2 8/ a high percentage o/ the 9r+:s total costs are
97ed= and hence do not decline .hen de+and /alls= then
the 9r+ is said to have high operating leverage2 Other
things held constant= the greater a 9r+:s operating
leverage= the greater its business ris62
A2 (1, ;hat is +eant b< the ter+s M9nancial leverageN and
M9nancial ris6NI
Ans.er: KSho. S13*3 here2L 'inancial leverage re/ers to the 9r+:s
decision to 9nance .ith 97ed*inco+e securities= such as
Chapter 13: Capital Structure and Leverage Integrated Case 1)5
debt and pre/erred stoc62 'inancial ris6 is the additional
ris6= over and above the co+pan<:s inherent business ris6=
borne b< the stoc6holders as a result o/ the 9r+:s decision
to 9nance .ith debt2
A2 (1, !o. does 9nancial ris6 diDer /ro+ business ris6I
Ans.er: KSho. S13*8 here2L As .e discussed above= business ris6
depends on a nu+ber o/ /actors such as sales and cost
variabilit<= and operating leverage2 'inancial ris6= on the
other hand= depends on onl< one /actorCthe a+ount o/
97ed*inco+e capital the co+pan< uses2
C2 o.= to develop an e7a+ple that can be presented to CD:s
+anage+ent as an illustration= consider t.o h<pothetical
9r+s= 'ir+ G= .ith Hero debt 9nancing= and 'ir+ L= .ith
>1)=))) o/ 11@ debt2 Aoth 9r+s have >1)=))) in total
assets and a &)@ /ederal*plus*state ta7 rate= and the< have
the /ollo.ing $A8# probabilit< distribution /or ne7t <ear:
"robabilit< $A8#
)215 >1=)))
)25) 3=)))
)215 &=)))
(1, Co+plete the partial inco+e state+ents and the 9r+s:
ratios in #able 8C 13*12
1)- Integrated Case Chapter 13: Capital Structure and Leverage
#able 8C 13*12 8nco+e State+ents and %atios
'ir+ G 'ir+ L
Assets >1)=))) >1)=))) >1)=))) >1)=))) >1)=))) >1)=)))
$Buit< >1)=))) >1)=))) >1)=))) >1)=))) >1)=))) >1)=)))
"robabilit< )215 )25) )215 )215 )25) )215
Sales > -=))) > 4=))) >11=))) > -=))) > 4=))) >11=)))
Oper2 costs &=))) -=))) 8=))) &=))) -=))) 8=)))
$A8# > 1=))) > 3=))) > &=))) > 1=))) > 3=))) > &=)))
8nt2 (11@, ) ) ) 1=1))
1=1))
$A# > 1=))) > 3=))) > &=))) > 8)) > > 1=8))
#a7es (&)@, 8)) 1=1)) 1=-)) 31)
1=11)
et inco+e > 1=1)) > 1=8)) > 1=&)) > &8) >
> 1=-8)
A$" 1)2)@ 152)@ 1)2)@ 1)2)@ @ 1)2)@
%O$ -2)@ 42)@ 112)@ &28@ @ 1-28@
#8$ 123
323
$(A$", 152)@ @
$(%O$, 42)@ 1)28@
$(#8$, 125

A$"
325@ @

%O$
121@ &21@

#8$
) )2-
Chapter 13: Capital Structure and Leverage Integrated Case 1)3
Ans.er: KSho. S13*4 through S13*11 here2L !ere are the /ull<
co+pleted state+ents:
'ir+ G 'ir+ L
Assets >1)=))) >1)=))) >1)=))) >1)=))) >1)=))) >1)=)))
$Buit< >1)=))) >1)=))) >1)=))) >1)=))) >1)=))) >1)=)))
"robabilit< )215 )25) )215 )215 )25) )215
$A8# > 1=))) > 3=))) > &=))) > 1=))) > 3=))) > &=)))
8nt2 (11@, ) ) ) 1=1)) 1=1))
1=1))
$A# > 1=))) > 3=))) > &=))) > 8)) > 1=8))
> 1=8))
#a7es (&)@, 8)) 1=1)) 1=-)) 31) 31) 1=11)
et inco+e > 1=1)) > 1=8)) > 1=&)) > &8) > 1=)8)
> 1=-8)
A$" 1)2)@ 152)@ 1)2)@ 1)2)@
1)2)@
%O$ -2)@ 42)@ 112)@ &28@
1-28@
#8$ 123
323
$(A$", 152)@ 152)@
$(%O$, 42)@ 1)28@
$(#8$, 125

A$"
325@ 325@

%O$
121@ &21@

#8$
) )2-
C2 (1, Ae prepared to discuss each entr< in the table and to
e7plain ho. this e7a+ple illustrates the eDect o/ 9nancial
leverage on e7pected rate o/ return and ris62
Ans.er: KSho. S13*13 through S13*15 here2L Conclusions /ro+ the
anal<sis:
12 #he 9r+:s basic earning po.er= A$" O $A8#5#otal assets=
is unaDected b< 9nancial leverage2
1)8 Integrated Case Chapter 13: Capital Structure and Leverage
12 'ir+ L has the higher e7pected %O$:
$(%O$
G
, O )215(-2)@, P )25)(42)@, P )215(112)@, O
42)@2
$(%O$
L
, O )215(&28@, P )25)(1)28@, P )215(1-28@, O
1)28@2
#here/ore= the use o/ 9nancial leverage has increased
the e7pected pro9tabilit< to shareholders2 #a7 savings
cause the higher e7pected %O$
L
2 (8/ the 9r+ uses debt=
the stoc6 is ris6ier= .hich then causes r
d
and r
s
to
increase2 ;ith a higher r
d
= interest increases= so the
interest ta7 savings increases2,
32 'ir+ L has a .ider range o/ %O$s= and a higher
standard deviation o/ %O$= indicating that its higher
e7pected return is acco+panied b< higher ris62 #o be
precise:

%O$ (Gnlevered,
O 1211@= and CQ O )21&2

%O$ (Levered,
O &21&@= and CQ O )2342
#hus= in a stand*alone ris6 sense= 'ir+ L is t.ice as
ris6< as 'ir+ GCits business ris6 is 1211@= but its
stand*alone ris6 is &21&@= so its 9nancial ris6 is &21&@ F
1211@ O 1211@2
&2 ;hen $A8# O >1=)))= %O$
G
R %O$
L
= and leverage has a
negative i+pact on pro9tabilit<2 !o.ever= at the
e7pected level o/ $A8#= %O$
L
R %O$
G
2
52 Leverage .ill al.a<s boost e7pected %O$ i/ the
e7pected unlevered %OA e7ceeds the a/ter*ta7 cost o/
Chapter 13: Capital Structure and Leverage Integrated Case 1)4
debt2 !ere $(%OA, O $(Gnlevered %O$, O 42)@ R r
d
(1 F
#, O 11@()2-, O 321@= so the use o/ debt raises
e7pected %O$2
-2 'inall<= note that the #8$ ratio is huge (unde9ned= or
in9nitel< large, i/ no debt is used= but it is relativel< lo.
i/ 5)@ debt is used2 #he e7pected #8$ .ould be larger
than 125 i/ less debt .ere used= but s+aller i/ leverage
.ere increased2
D2 A/ter spea6ing .ith a local invest+ent ban6er= <ou obtain
the /ollo.ing esti+ates o/ the cost o/ debt at diDerent debt
levels (in thousands o/ dollars,:
A+ount Debt5Assets Debt5$Buit< Aond
Aorro.ed %atio %atio %ating r
d

> ) )2))) )2)))) C C
15) )2115 )21&14 AA 82)@
5)) )215) )23333 A 42)
35) )2335 )2-))) AAA 1125
1=))) )25)) 12)))) AA 1&2)
o. consider the opti+al capital structure /or CD2
(1, #o begin= de9ne the ter+s Mopti+al capital structureN and
Mtarget capital structure2N
Ans.er: KSho. S13*1- here2L #he opti+al capital structure is the
capital structure at .hich the ta7*related bene9ts o/
leverage are e7actl< oDset b< debt:s ris6*related costs2 At
the opti+al capital structure= (1, the total value o/ the 9r+
is +a7i+iHed= (1, the ;ACC is +ini+iHed= and the price per
share is +a7i+iHed2 #he target capital structure is the +i7
o/ debt= pre/erred stoc6= and co++on eBuit< .ith .hich the
9r+ plans to raise capital2
11) Integrated Case Chapter 13: Capital Structure and Leverage
D2 (1, ;h< does CD:s bond rating and cost o/ debt depend on the
a+ount o/ +one< borro.edI
Ans.er: 'inancial ris6 is the additional ris6 placed on the co++on
stoc6holders as a result o/ the decision to 9nance .ith debt2
Conceptuall<= stoc6holders /ace a certain a+ount o/ ris6 that
is inherent in a 9r+:s operations2 8/ a 9r+ uses debt (9nancial
leverage,= this concentrates the business ris6 on co++on
stoc6holders2
'inancing .ith debt increases the e7pected rate o/
return /or an invest+ent= but leverage also increases the
probabilit< o/ a large loss= thus increasing the ris6 borne b<
stoc6holders2 As the a+ount o/ +one< borro.ed increases=
the 9r+ increases its ris6 so the 9r+:s bond rating
decreases and its cost o/ debt increases2
D2 (3, Assu+e that shares could be repurchased at the current
+ar6et price o/ >15 per share2 Calculate CD:s e7pected $"S
and #8$ at debt levels o/ >)= >15)=)))= >5))=)))= >35)=)))=
and >1=)))=)))2 !o. +an< shares .ould re+ain a/ter
recapitaliHation under each scenarioI
Ans.er: KSho. S13*13 through S13*15 here2L #he anal<sis /or the
debt levels being considered (in thousands o/ dollars and
shares, is sho.n belo.:
At D O >):
$"S O
g outstandin Shares
, # 1 ,L( D ( r $A8# K
d

O
)=))) 8
, ))=)))()2- & >
O >32))2
#8$ O
8nterest
$A8#
O 2
Chapter 13: Capital Structure and Leverage Integrated Case 111
At D O >15)=))):
Shares repurchased O >15)=)))5>15 O 1)=)))2
%e+aining shares outstanding O 8)=))) F 1)=))) O 3)=)))2
(ote: $"S and #8$ calculations are in thousands o/
dollars2,
$"S O
) 3
-, (>15),L()2 )8 )2 )) & K>
O >321-2
#8$ O
) >1
)) & >
O 1)2
At D O >5))=))):
Shares repurchased O >5))=)))5>15 O 1)=)))2
%e+aining shares outstanding O 8)=))) F 1)=))) O -)=)))2
(ote: $"S and #8$ calculations are in thousands o/
dollars2,
$"S O
-)
-, (>5)),L()2 )4 )2 )) & K>
O >32552
#8$ O
5 & >
)) & >
O 8242
At D O >35)=))):
Shares repurchased O >35)=)))5>15 O 3)=)))2
%e+aining shares outstanding O 8)=))) F 3)=))) O 5)=)))2
(ote: $"S and #8$ calculations are in thousands o/
dollars2,
$"S O
) 5
-), (>35),L()2 15 )21 )) & K>
O >32332
111 Integrated Case Chapter 13: Capital Structure and Leverage
#ie O
5 1 2 8- >
)) & >
O &2-2
At D O >1=)))=))):
Shares repurchased O >1=)))=)))5>15 O &)=)))2
%e+aining shares outstanding O 8)=))) F &)=))) O &)=)))2
(ote: $"S and #8$ calculations are in thousands o/
dollars2,
$"S O
) &
)2-), (>1=))),L( & )21 )) & K>
O >324)2
#8$ O
) & >1
)) & >
O 1242
D2 (&, Gsing the !a+ada eBuation= .hat is the cost o/ eBuit< i/ CD
recapitaliHes .ith >15)=))) o/ debtI >5))=)))I >35)=)))I
>1=)))=)))I
Ans.er: KSho. S13*1- through S13*3) here2L
r
%'
O -2)@ r
E
F r
%'
O -2)@
b
G
O 12) #otal assets O >1=)))
#a7 rate O &)2)@
A+ount Debt5Assets Debt5$Buit< Levered
Aorro.ed
a
%atio
b
%atio
c
Aeta
d
r
s
e

> ) )2))@ )2))@ 12)) 112))@
15) 1125) 1&214 12)4 11251
5)) 152)) 33233 121) 1321)
35) 3325) -)2)) 123- 1&21-
1=))) 5)2)) 1))2)) 12-) 152-)
otes:
a
Data given in proble+2
b
Calculated as a+ount borro.ed divided b< total assets2
Chapter 13: Capital Structure and Leverage Integrated Case 113
c
Calculated as a+ount borro.ed divided b< eBuit< (total
assets less a+ount borro.ed,2
d
Calculated using the !a+ada eBuation= b
L
O b
G
K1 P (1 F #,
(D5$,L2
e
Calculated using the CA"E= r
s
O r
%'
P (r
E
F r
%'
,b= given the
ris6*/ree rate= the +ar6et ris6 pre+iu+= and using the
levered beta as calculated .ith the !a+ada eBuation2
D2 (5, Considering onl< the levels o/ debt discussed= .hat is the
capital structure that +ini+iHes CD:s ;ACCI
Ans.er: KSho. S13*31 and S13*31 here2L
r
%'
O -2)@ r
E
F r
%'
O -2)@
b
G
O 12) #otal assets O >1=)))
#a7 rate O &)2)@
A+ount
Aorro.e
d
a
Debt5Asse
ts
%atio
b
$Buit<5Asse
ts
%atio
c
Debt5$Buit
<
%atio
d
Levered
Aeta
e
rs
/
rd
a
rd(1 F
#,
;ACC
g
>
)
)2))@ 1))2))@ )2))@ 12)) 112))@ )2)@ )2)@ 112))@
15) 1125) 8325) 1&214 12)4 11251 82) &28 11255
5)) 152)) 352)) 33233 121) 1321) 42) 52& 11215
35) 3325) -125) -)2)) 123- 1&21- 1125 -24 112&&
1=))) 5)2)) 5)2)) 1))2)) 12-) 152-) 1&2) 82& 112))
otes:
a
Data given in proble+2
b
Calculated as a+ount borro.ed divided b< total assets2
c
Calculated as 1 F D5A2
d
Calculated as a+ount borro.ed divided b< eBuit< (total
assets less a+ount borro.ed,2
e
Calculated using the !a+ada eBuation= b
L
O b
G
K1 P (1 F #,
(D5$,L2
11& Integrated Case Chapter 13: Capital Structure and Leverage
/
Calculated using the CA"E= r
s
O r
%'
P (r
E
F r
%'
,b= given the
ris6*/ree rate= the +ar6et ris6 pre+iu+= and using the
levered beta as calculated .ith the !a+ada eBuation2
g
Calculated using the ;ACC eBuation= ;ACC O .
d
r
d
(1 F #, P
.
c
r
s
2
CD:s ;ACC is +ini+iHed at a capital structure that consists o/
15@ debt and 35@ eBuit<= or a ;ACC o/ 11215@2
D2 (-, ;hat .ould be the ne. stoc6 price i/ CD recapitaliHes .ith
>15)=))) o/ debtI >5))=)))I >35)=)))I >1=)))=)))I
%ecall that the pa<out ratio is 1))@= so g O )2
Ans.er: KSho. S13*33 here2L ;e can calculate the price o/ a
constant gro.th stoc6 as D"S divided b< r
s
+inus g= .here
g is the e7pected gro.th rate in dividends: "
)
O D
1
5(r
s
F g,2
Since in this case all earnings are paid out to the
stoc6holders= D"S O $"S2 'urther= because no earnings are
plo.ed bac6= the 9r+:s $A8# is not e7pected to gro.= so g O
)2
!ere are the results:
Debt Level D"S r
s
Stoc6 "rice
> ) >32)) 112))@ >152))
15)=))) 321- 11251 1-2)3
5))=))) 3255 1321) 1-284S
35)=))) 3233 1&21- 1-254
1=)))=))) 324) 152-) 152))
SEa7i+u+
D2 (3, 8s $"S +a7i+iHed at the debt level that +a7i+iHes share
priceI ;h< or .h< notI
Chapter 13: Capital Structure and Leverage Integrated Case 115
Ans.er: KSho. S13*3& here2L ;e have seen that $"S continues to
increase be<ond the >5))=))) opti+al level o/ debt2
#here/ore= /ocusing on $"S .hen +a6ing capital structure
decisions is not correctC.hile the $"S does ta6e account o/
the diDerential cost o/ debt= it does not account /or the
increasing ris6 that +ust be borne b< the eBuit< holders2
D2 (8, Considering onl< the levels o/ debt discussed= .hat is CD:s
opti+al capital structureI
Ans.er: KSho. S13*35 here2L A capital structure .ith >5))=))) o/
debt produces the highest stoc6 price= >1-284? hence= it is
the best o/ those considered2
D2 (4, ;hat is the ;ACC at the opti+al capital structureI
Ans.er: 8nitial debt level:
Debt5#otal assets O )@= so #otal assets O 8nitial eBuit< O
>15 8)=))) shares O >1=)))=)))2
;ACCO

))) = ))) = 1 >

))) = 5)) >
(4@,()2-), P

))) = ))) = 1 >

))) = 5)) = 1 >
(1321@,
O 1235@ P 424)@ O 11215@2
ote: 8/ .e had (1, used the eBuilibriu+ price /or
repurchasing shares and (1, used +ar6et value .eights to
calculate ;ACC= then .e could be sure that the ;ACC at
the price*+a7i+iHing capital structure .ould be the
+ini+u+2 Gsing a constant >15 purchase price= and boo6
value .eights= inconsistencies +a< creep in2
11- Integrated Case Chapter 13: Capital Structure and Leverage
$2 Suppose <ou discovered that CD had +ore business ris6
than <ou originall< esti+ated2 Describe ho. this .ould
aDect the anal<sis2 ;hat i/ the 9r+ had less business ris6
than originall< esti+atedI
Ans.er: KSho. S13*3- here2L 8/ the 9r+ had higher business ris6= then=
at an< debt level= its probabilit< o/ 9nancial distress .ould be
higher2 8nvestors .ould recogniHe this= and both r
d
and r
s
.ould
be higher than originall< esti+ated2 8t is not sho.n in this
anal<sis= but the end result .ould be an opti+al capital
structure .ith less debt2 Conversel<= lo.er business ris6 .ould
lead to an opti+al capital structure that included +ore debt2
'2 ;hat are so+e /actors a +anager should consider .hen
establishing his or her 9r+:s target capital structureI
Ans.er: KSho. S13*33 and S13*38 here2L Since it is diTcult to
Buanti/< the capital structure decision= +anagers consider
the /ollo.ing judg+ental /actors .hen +a6ing capital
structure decisions:
12 #he average debt ratio /or 9r+s in their industr<2
12 "ro /or+a #8$ ratios at diDerent capital structures
under diDerent scenarios2
32 Lender5rating agenc< attitudes2
&2 %eserve borro.ing capacit<2
52 $Dects o/ 9nancing on control2
-2 Asset structure2
32 $7pected ta7 rate2
Chapter 13: Capital Structure and Leverage Integrated Case 113
82 Eanage+ent attitudes2
42 Ear6et conditions2
1)2 'ir+:s internal conditions2
112 'ir+:s operating leverage2
112 'ir+:s gro.th rate2
132 'ir+:s pro9tabilit<2
Optional 0uestion
Eodigliani and Eiller proved= under a ver< restrictive set o/
assu+ptions= that the value o/ a 9r+ .ill be +a7i+iHed b< 9nancing
al+ost entirel< .ith debt2 ;h<= according to EE= is debt bene9cialI
Ans.er: EE argued that using debt increases the value o/ the 9r+
because interest is ta7 deductible2 #he govern+ent= in
eDect= pa<s part o/ the interest= and this lo.ers the cost o/
debt relative to the cost o/ eBuit<= +a6ing debt 9nancing
+ore attractive than eBuit< 9nancing2 "ut another .a<=
since interest is deductible= the +ore debt a co+pan< uses=
the lo.er its ta7 bill= and the +ore o/ its operating inco+e
Jo.s through to investors= so the greater its value2
Optional 0uestion
;hat assu+ptions underlie the EE theor<I Are these assu+ptions
realisticI
Ans.er: EE:s 6e< assu+ptions are as /ollo.s:
12 #here are no bro6erage costs2
12 #here are no ta7es2
118 Integrated Case Chapter 13: Capital Structure and Leverage
32 8nvestors can borro. at the sa+e rate as corporations2
&2 8nvestors have the sa+e in/or+ation as +anagers
about the 9r+:s /uture invest+ent opportunities2
52 All o/ the 9r+:s debt is ris6less= regardless o/ ho. +uch
it uses2 (#here are no ban6ruptc< costs2,
-2 $A8# is not aDected b< the use o/ debt2
#hese assu+ptions are obviousl< unrealisticCinvestors do
incur bro6erage /ees and personal inco+e ta7es? the<
cannot borro. at the sa+e rate as corporations? and the<
do not have the sa+e in/or+ation as the 9r+:s +anagers
regarding /uture invest+ent opportunities2 Also= corporate
debt is ris6<= especiall< i/ a 9r+ uses lots o/ debt= and the
interest rate .ill rise as the debt level increases2
Chapter 13: Capital Structure and Leverage Integrated Case 114
'igure 8C 13*12 %elationship bet.een Capital Structure and Stoc6
"rice
U2 "ut labels on 'igure 8C 13*1= and then discuss the graph as
<ou +ight use it to e7plain to <our boss .h< CD +ight .ant
to use so+e debt2
Ans.er: KSho. S13*34 and S13*&) here2L #he use o/ debt per+its a
9r+ to obtain ta7 savings /ro+ the deductibilit< o/ interest2
So the use o/ so+e debt is good? ho.ever= the possibilit< o/
ban6ruptc< increases the cost o/ using debt2 At higher and
higher levels o/ debt= the ris6 o/ ban6ruptc< increases=
bringing .ith it costs associated .ith potential 9nancial
distress2 Custo+ers reduce purchases= 6e< e+plo<ees
leave= and so on2 #here is so+e point= generall< .ell belo.
a debt ratio o/ 1))@= at .hich proble+s associated .ith
potential ban6ruptc< +ore than oDset the ta7 savings /ro+
debt2
#heoreticall<= the opti+al capital structure is /ound at
the point .here the +arginal ta7 savings just eBual the
11) Integrated Case Chapter 13: Capital Structure and Leverage
Value of Firms
Stock
0 D1 Leverage, D/
D!
+arginal ban6ruptc<*related costs2 !o.ever= anal<sts
cannot identi/< this point .ith precision /or an< given 9r+=
or /or 9r+s in general2 Anal<sts can help +anagers
deter+ine an opti+al range /or their 9r+:s debt ratios= but
the capital structure decision is still +ore judg+ental than
based on precise calculations2
!2 !o. does the e7istence o/ as<++etric in/or+ation and
signaling aDect capital structureI
Ans.er: KSho. S13*&1 through S13*&& here2L #he as<++etric
in/or+ation concept is based on the pre+ise that
+anage+ent:s choice o/ 9nancing gives signals to
investors2 'ir+s .ith good invest+ent opportunities .ill
not .ant to share the bene9ts .ith ne. stoc6holders= so
the< .ill tend to 9nance .ith debt2 'ir+s .ith poor
prospects= on the other hand= .ill .ant to 9nance .ith
stoc62 8nvestors 6no. this= so .hen a large= +ature 9r+
announces a stoc6 oDering= investors ta6e this as a signal
o/ bad ne.s= and the stoc6 price declines2 'ir+s 6no. this=
so the< tr< to avoid having to sell ne. co++on stoc62 #his
+eans +aintaining a reserve o/ borro.ing capacit< so that
.hen good invest+ents co+e along= the< can be 9nanced
.ith debt2
Chapter 13: Capital Structure and Leverage Integrated Case 111
Optional 0uestion
You +ight e7pect the price o/ a +ature 9r+:s stoc6 to decline i/ it
announces a stoc6 oDering2 ;ould <ou e7pect the sa+e reaction i/
the issuing 9r+ .ere a <oung= rapidl< gro.ing co+pan<I
Ans.er: 8/ a +ature 9r+ sells stoc6= the price o/ its stoc6 .ould
probabl< decline2 A +ature 9r+ should have other
9nancing alternatives= so a stoc6 issue .ould signal that its
earnings potential is not good2 A <oung= rapidl< gro.ing
9r+= ho.ever= +a< have so +an< good invest+ent
opportunities that it si+pl< cannot raise all the eBuit< it
needs as retained earnings= and investors 6no. this2
#here/ore= the stoc6 price o/ a <oung= rapidl< gro.ing 9r+
.ould probabl< not /all because o/ a ne. stoc6 issue=
especiall< i/ the 9r+:s +anagers announce that the< are
not selling an< o/ their o.n shares in the oDering2
111 Integrated Case Chapter 13: Capital Structure and Leverage