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Chapter 16 - Planning the Firm’s
Financing Mix
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Financial
Structure
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Capital
Structure
Why is Capital Structure Important?
1) Leverage: Higher financial leverage
means higher returns to stockholders,
but higher risk due to fixed payments.
2) Cost of Capital: Each source of
financing has a different cost. Capital
structure affects the cost of capital.
The Optimal Capital Structure is the
one that minimizes the firm’s cost of
capital and maximizes firm value.
What is the Optimal Capital
Structure?
In a “perfect world” environment with
no taxes, no transaction costs and
perfectly efficient financial markets,
capital structure does not matter.
This is known as the Independence
hypothesis: firm value is independent of
capital structure.
Independence Hypothesis
Firm value does not depend on
capital structure.
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Capital Structure: 100% equity, no debt
Stock price: P 10.00 per share
Shares outstanding: 2 million
Operating income (EBIT): P 2,000,000.00
Calculate EPS:
With no interest payments and no taxes,
EBIT = net income.
P 2,000,000/2,000,000 shares = P 1.00
Independence Hypothesis:
Rix Camper Manufacturing Company
Capital Structure: 100% equity, no debt
Stock price: P 10.00 per share
Shares outstanding: 2 million
Operating income (EBIT): P 2,000,000.00
Calculate the Cost of Capital:
Independence Hypothesis:
Rix Camper Manufacturing Company
k = + g = + 0 = 10%
D1 1.00
P 10.00
P 20.0 million capitalization
P 8.0 million in debt issued to retire P 8.0
million in equity.
Equity = P 2.0m / P 20.0m = 60%
Debt = P 8.0m / P 20.0m = 40%
Capital Structure: 60% equity, 40% debt
Shares outstanding: P 12.0 million / P 10.00
= 1,200,000 shares.
Interest = P 8.0 m x .06 = P 480,000.00
Independence Hypothesis:
Rix Camper Manufacturing Company
Capital Structure: 60% equity, 40% debt
Stock price: P 10.00 per share
Shares outstanding: 1.2 million
Net income: P 2,000,000.00 – P 480,000.00 =
P 1,520,000.00
Calculate EPS:
P 1,520,000.00/1,200,000 shares = P 1.267
Independence Hypothesis:
Rix Camper Manufacturing Company
Capital Structure: 60% equity, 40% debt
Stock price: P 10.00 per share
Shares outstanding: 1.2 million
Net income: P 2,000,000.00 – P 480,000.00 =
P 1,520,000.00
Calculate the Cost of Equity:
Independence Hypothesis:
Rix Camper Manufacturing Company
k = + g = + 0 = 12.67%
D1 1.267
P 10.00
Capital Structure: 60% equity, 40% debt
Stock price: P 10.00 per share
Shares outstanding: 1.2 million
Net income: P 2,000,000.00 – P 480,000.00 =
P 1,520,000.00
Calculate the Cost of Capital:
.6 (12.67%) + .4 (6%) = 10%
Independence Hypothesis:
Rix Camper Manufacturing Company
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Cost of
Capital
kc
0% debt Financial Leverage 100% debt
.
kc = cost of equity
kd = cost of debt
ko = cost of capital
Independence Hypothesis
.
Independence Hypothesis
Cost of
Capital
kc
kd
kd
0% debt Financial Leverage 100% debt
.
Independence Hypothesis
Cost of
Capital
kc
kd
kd
0% debt Financial Leverage 100% debt
Increasing leverage causes
the cost of equity
to rise.
Independence Hypothesis
Cost of
Capital
kc
kd
kd
0% debt Financial Leverage 100% debt
Independence Hypothesis
Cost of
Capital
kc
kd
kc
kd
Increasing leverage causes
the cost of equity
to rise.
0% debt Financial Leverage 100% debt
Independence Hypothesis
Cost of
Capital
kc
kd
kc
kd
Increasing leverage causes
the cost of equity
to rise.
What will
be the net effect
on the overall cost
of capital?
0% debt Financial Leverage 100% debt
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Independence Hypothesis
Cost of
Capital
kc
kd
kc
kd
Increasing leverage causes
the cost of equity
to rise.
What will
be the net effect
on the overall cost
of capital?
0% debt Financial Leverage 100% debt
kc
kd
Independence Hypothesis
Cost of
Capital
kc
ko
kd
0% debt Financial Leverage 100% debt
If we have perfect capital markets,
capital structure is irrelevant.
In other words, changes in capital
structure do not affect firm value.
Independence Hypothesis
Dependence Hypothesis
Increasing leverage does not increase
the cost of equity.
Since debt is less expensive than equity,
more debt financing would provide a
lower cost of capital.
A lower cost of capital would increase
firm value.
Dependence Hypothesis
Cost of
Capital
kc
kd
Financial Leverage
kc
kd
Since the cost of debt is lower
than the cost of equity...
Dependence Hypothesis
Since the cost of debt is lower
than the cost of equity…
increasing leverage reduces the
cost of capital.
Cost of
Capital
kc
kd
Financial Leverage
kc
kd
ko
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Moderate Position
The previous hypothesis examines
capital structure in a “perfect
market.”
The moderate position examines
capital structure under more
realistic conditions.
For example, what happens if we
include corporate taxes?
unlevered levered
EBIT 2,000,000 2,000,000
- interest expense 0 (480,000)
EBT 2,000,000 1,520,000
- taxes (50%) (1,000,000) (760,000)
Earnings available
to stockholders 1,000,000 760,000
Payments to all
securityholders 1,000,000 1,240,000
Rix Camper example:
Tax effects of financing with debt
Moderate Position
Cost of
Capital
kc
kd
Financial Leverage
kc
kd
Moderate Position
Cost of
Capital
kc
kd
Financial Leverage
kc
kd
Even if the cost of equity rises
as leverage increases, the
cost of debt is
very low...
Moderate Position
Cost of
Capital
kc
kd
Financial Leverage
kc
kd
because
of the tax benefit
associated with debt financing.
Even if the cost of equity rises
as leverage increases, the
cost of debt is
very low...
Moderate Position
Cost of
Capital
kc
kd
Financial Leverage
kc
kd
The low cost of debt
reduces the cost of
capital.
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Moderate Position
Cost of
Capital
kc
kd
Financial Leverage
kc
kd
The low cost of debt
reduces the cost of
capital.
ko
Moderate Position
So, what does the tax benefit of debt
financing mean for the value of the firm?
The more debt financing used, the greater
the tax benefit, and the greater the value
of the firm.
So, this would mean that all firms should
be financed with 100% debt, right?
Why are firms not financed with 100%
debt?
Why is 100% Debt Not Optimal?
Bankruptcy costs: costs of financial
distress.
Financing becomes difficult to get.
Customers leave due to uncertainty.
Possible restructuring or
liquidation costs if bankruptcy
occurs.
Agency costs: costs associated with
protecting bondholders.
Bondholders (principals) lend money to
the firm and expect it to be invested wisely.
Stockholders own the firm and elect the
board and hire managers (agents).
Bond covenants require managers to be
monitored. The monitoring expense is an
agency cost, which increases as debt
increases.
Why is 100% Debt Not Optimal?
Cost of
Capital
Financial Leverage
kc
kd
kd
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
Financial Leverage
kc
kd
kd
Moderate Position
with Bankruptcy and Agency Costs
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Cost of
Capital
Financial Leverage
kc
kd
kc
kd
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
Financial Leverage
kc
kd
kc
kd
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
Financial Leverage
kc
kd
kc
kd
If a firm borrows too much, the
costs of debt and equity will spike
upward, due to bankruptcy costs
and agency costs.
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
Financial Leverage
kc
kd
kc
kd
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
Financial Leverage
kc
kd
kc
kd
ko
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
Financial Leverage
kc
kd
kc
kd
ko
Moderate Position
with Bankruptcy and Agency Costs
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Cost of
Capital
Financial Leverage
kc
kd
kc
kd
ko
Ideally, a firm should use leverage
to obtain their optimum capital
structure, which will minimize the
firm’s cost of capital.
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
Financial Leverage
kc
kd
kc
kd
ko
Moderate Position
with Bankruptcy and Agency Costs
Capital Structure Management
EBIT-EPS Analysis - Used to help
determine whether it would be better
to finance a project with debt or
equity.
Capital Structure Management
EBIT-EPS Analysis - Used to help
determine whether it would be better
to finance a project with debt or
equity.
EPS = (EBIT - I)(1 - t) - P
S
Capital Structure Management
EBIT-EPS Analysis - Used to help determine
whether it would be better to finance a
project with debt or equity.
EPS = (EBIT - I)(1 - t) - P
S
I = interest expense, P = preferred dividends,
S = number of shares of common stock
outstanding.
EBIT-EPS Example
Our firm has 800,000 shares of common stock
outstanding, no debt, and a marginal tax rate
of 40%. We need P 6,000,000.00 to finance a
proposed project. We are considering two
options:
Sell 200,000 shares of common stock at
P 30.00 per share,
Borrow P 6,000,000.00 by issuing 10%bonds.
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If we expect EBIT to be P 2,000,000.00:
Financing stock debt
EBIT 2,000,000 2,000,000
- interest 0 (600,000)
EBT 2,000,000 1,400,000
- taxes (40%) (800,000) (560,000)
EAT 1,200,000 840,000
# shares outst. 1,000,000 800,000
EPS P 1.20 P 1.05
Financing stock debt
EBIT 4,000,000 4,000,000
- interest 0 (600,000)
EBT 4,000,000 3,400,000
- taxes (40%) (1,600,000) (1,360,000)
EAT 2,400,000 2,040,000
# shares outst. 1,000,000 800,000
EPS P 2.40 P 2.55
If we expect EBIT to be P 4,000,000.00:
If EBIT is P 2,000,000.00,
common stock financing is best.
If EBIT is P 4,000,000.00, debt
financing is best.
So, now we need to find a
breakeven EBIT where neither is
better than the other.
If we choose stock financing:
EPS
EBIT
P 1m P 2m P 3m P 4m
stock
financing
0
3
2
1
If we choose
bond financing:
EPS
EBIT
P 1m P 2m P 3m P 4m
bond
financing
0
3
2
1
Breakeven EBIT
EPS
EBIT
P 1m P 2m P 3m P 4m
bond
financing
stock
financing
0
3
2
1
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Breakeven Point
Set two EPS calculations equal to each
other and solve for EBIT:
Stock Financing Debt Financing
(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P
S S
Breakeven Point
Stock Financing Debt Financing
(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P
S S
(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40)
800,000+200,000 800,000
Breakeven Point
Stock Financing Debt Financing
.6 EBIT = .6 EBIT - 360,000
1 .8
.48 EBIT = .6 EBIT - 360,000
.12 EBIT = 360,000
EBIT = P 3,000,000.00
Breakeven EBIT
EPS
EBIT
P 1m P 2m P 3m P 4m
bond
financing
stock
financing
0
3
2
1
For EBIT up to P 3.0 million,
stock financing is best.
Breakeven EBIT
EPS
EBIT
P 1m P 2m P 3m P 4m
bond
financing
stock
financing
0
3
2
1
For EBIT up to P 3.0 million,
stock financing is best.
For EBIT greater
than P 3.0 million,
debt financing
is best.
In-class Problem
Plan A: Sell 1,200,000 shares at
P 10.00 per share (P 12.0 million
total).
Plan B: Issue P 3.5 million in 9%
debt and sell 850,000 shares at
P 10.00 per share (P 12.0 million
total).
Assume a marginal tax rate of 50%.
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Breakeven EBIT
Stock Financing Levered Financing
(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
S S
EBIT-0 (1-.50) = (EBIT-315,000)(1-.50)
1,200,000 850,000
EBIT = P 1,080,000.00
Analytical Income Statement
Stock Levered
EBIT 1,080,000 1,080,000
I 0 (315,000)
EBT 1,080,000 765,000
Tax (540,000) (382,500)
NI 540,000 382,500
Shares 1,200,000 850,000
EPS P 0.45 P 0.45
levered
financing
stock
financing
EPS
EBIT
P .5m P 1m P 1.5m P 2m
0
.65
.45
.25
Breakeven EBIT
For EBIT up
to P 1.08 m,
stock
financing is
best.
levered
financing
stock
financing
EPS
EBIT
P .5m P 1m P 1.5m P 2m
0
.65
.45
.25
Breakeven EBIT
Breakeven EBIT
For EBIT up
to P 1.08 m,
stock
financing is
best.
For EBIT greater
than P 1.08 m,
the levered plan
is best.
levered
financing
stock
financing
EPS
EBIT
P .5m P 1m P 1.5m P 2m
0
.65
.45
.25
In-class Problem
Plan A: Sell 1,200,000 shares at
P 20.00 per share (P 24.0 million
total).
Plan B: Issue P 9.6 million in 9%
debt and sell shares at P 20.00 per
share (P 24.0 million total).
Assume a 35% marginal tax rate.
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Breakeven EBIT
Stock Financing Levered Financing
(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
S S
(EBIT-0) (1-.35) = (EBIT-864,000)(1-.35)
1,200,000 720,000
EBIT = P 2,160,000.00
Analytical Income Statement
Stock Levered
EBIT 2,160,000 2,160,000
I 0 (864,000)
EBT 2,160,000 1,296,000
Tax (756,000) (453,600)
NI 1,404,000 842,400
Shares 1,200,000 720,000
EPS P 1.17 P 1.17
Breakeven EBIT
levered
financing
stock
financing
EPS
EBIT
P 1m P 2m P 3m P 4m
0
1.5
1.17
.5
Breakeven EBIT
levered
financing
stock
financing
EPS
EBIT
P 1m P 2m P 3m P 4m
0
1.5
1.17
.5
For EBIT up
to P 2.16 m,
stock
financing is
best.
Breakeven EBIT
levered
financing
stock
financing
EPS
EBIT
P 1m P 2m P 3m P 4m
0
1.5
1.17
.5
For EBIT greater
than P 2.16 m,
the levered plan
is best.
For EBIT up
to P 2.16 m,
stock
financing
is best.