Basic Concepts

Chapter 6 - Capital Structure 1

1. The value of a firm is the sum of the value of the financial
claims of the firm i.e. firm’s debt and the firm’s equity.
V=B+S
If the goal of the management of
the firm is to make the firm as
valuable as possible, then the
S B
firm should choose the debt-
equity ratio that makes the value
as large as possible.

Value of the Firm

Chapter 6 - Capital Structure 2

There are 2 important questions:
1. Why should the stockholders care about maximizing
firm’s value? Perhaps they should be interested in strategies that
maximize shareholders’ value.
Answer: Shareholders will only benefit if the value of the firm
increases.
2. What is the ratio of debt-to-equity that maximizes the
shareholders’ value?

Answer: The “optimal” or “target” capital structure is the

debt/equity mix that simultaneously (a) maximizes the value of
the firm, (b) minimizes the WACC, and (c) maximizes the market
value of the common stock.
Chapter 6 - Capital Structure 3
CORPORATE STRUCTURE

Chapter 6 - Capital Structure 4

1. The value of the all equity firm is the same as the
value of the levered firm i.e. Vu=VL
2. Implication: Firms cannot change the total value of
its outstanding securities by changing proportions
of its capital structure.

Chapter 6 - Capital Structure 5

 The expected return rises with leverage.
 This leads to MM Proposition II, which says that:
◦ “the expected return on equity is positively related
to leverage because the risk of equity increases with
leverage.”

Chapter 6 - Capital Structure 6

EPS 6.00
Imply that higher
5.00 financial leverage Debt
increases the sensitivity
4.00 of EPS to EBIT No Debt

Advantage to
3.00 Break-even debt
point
2.00

1.00
800,000

0.00
Disadvantage to 1.2m
debt EBIT in RM, no taxes
(2.00)
Chapter 6 - Capital Structure 7
1. rWACC for a company is constant either with or without
leverage.
2. rWACC = B/B+S (rB) + S/B+S (rS)
3. rWACC = r in a world without corporate tax
O

4. rO = cost of capital for an all-equity firm

= Expected earnings to all equity firm
Unlevered equity

5. rWACC is unaffected by leverage

Chapter 6 - Capital Structure 8

 B
rS  r0   ( r0  rB )
SL

B S
r0 rW A C C   rB   rS
BS BS

rB rB

Debt-to-equity Ratio

Chapter 6 - Capital Structure 9