Lecture 6 Capital Structure 4

FNCE201 Corporate Finance

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Calculating Optimal Debt Ratios


D
Cost of Capital approach. The debt ratio that
D +E
minimizes the weighted average cost of capital (rwacc ).

Adjusted Present Value (APV) approach. The debt ratio

that maximizes VL in a simple trade-off model.

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 Part I

Cost of Capital Approach

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Cost of Capital Approach

The value of the firm based on DCF analysis:

FCFF1 FCFF2 FCFFn
V = + 2
+ ... (1)
(1 + rwacc ) (1 + rwacc ) (1 + rwacc )N

If cash flows are held constant, V is maximized when rwacc is

minimized.

Estimate rD and rE at different debt ratios to find the debt ratio

with the lowest rwacc .

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Cost of Equity
As leverage increases, the equity in the firm becomes riskier since
D
βE = βU + (βU − βD ). As βE ↑, the CAPM implies that rE ↑.
E

βE can be calculated for different debt ratios as follows:

➀ Unlever the current βE using:
βE
βU = (2)
D
1 + (1 − τc )
E
➁ Relever βU for the new debt ratio using:
 
D
βE = βU 1 + (1 − τc ) (3)
E

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Cost of Debt
As leverage increases, rD ↑ due to the increased risk of default.
This effect is typically captured by rating agencies that assess a
firm’s debt according to default risk, enabling bond ratings to
link leverage directly to rD :

Leverage ↑ =⇒ Default risk ↑ =⇒ Bond ratings ↓ =⇒ rD ↑

For unrated firms, a synthetic rating that relates default risk to

bond ratings can be obtained using the interest coverage ratio
(ICR), which is defined as:

EBIT
ICR = (4)
Interest Expenses

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ICRs, Ratings and Default Spreads
ICR (Large) ICR(Small) Rating Default Spread
(>$5 billion) (<$5 billion) over rF (%)
> 8.50 > 12.50 Aaa/AAA 0.54
6.50 − 8.50 9.50 − 12.50 Aa2/AA 0.72
5.50 − 6.50 7.50 − 9.50 A1/A+ 0.90
4.25 − 5.50 6.00 − 7.50 A2/A 0.99
3.00 − 4.25 4.50 − 6.00 A3/A− 1.13
2.50 − 3.00 4.00 − 4.50 Baa2/BBB 1.27
2.25 − 2.50 3.50 − 4.00 Ba1/BB+ 1.98
2.00 − 2.25 3.00 − 3.50 Ba2/BB 2.38
1.75 − 2.00 2.50 − 3.00 B1/B+ 2.98
1.50 − 1.75 2.00 − 2.50 B2/B 3.57
1.25 − 1.50 1.50 − 2.00 B3/B− 4.37
0.80 − 1.25 1.25 − 1.50 Caa/CCC 8.64
0.65 − 0.80 0.80 − 1.25 Ca2/CC 10.63
0.20 − 0.65 0.50 − 0.80 C2/C 13.95
< 0.20 < 0.5 D2/D 18.60

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Calculating the Optimal Debt Ratio
Question 1
Axel Traders currently has no debt and a beta of 1.5. The risk-free rate is 5%,
the market risk premium is 5.5%, the corporate tax rate is 40%, and Axel
currently has 500m shares outstanding at $20 per share. Compute Axel’s optimal
debt ratio using the Cost of Capital approach.

Debt Ratio ICR

0.0 9.0
0.1 7.5
0.2 5.0
0.3 2.75
0.4 2.15
0.5 1.65
0.6 1.05
0.7 0.75
0.8 0.45
0.9 0.15

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Workings

DR D/E βE rE ICR Rating Spr rD ATrD wD wE rwacc

0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9

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The U-shaped Cost of Capital

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Range Versus Point Estimates

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Calculating the Optimal Debt Ratio

Question 2
Magix Traders has the following balance sheet (in $m):

Assets Liabilities
Fixed Assets 4,000 Debt 2,500
Current Assets 1,000 Equity 2,500

Debt is in the form of long-term bonds currently rated AA and selling at a

yield of 12%, and the market value of its bonds is 80% of its face value.
The firm currently has 50m shares outstanding, a current market price of
$80 per share and a beta of 1.2. The risk-free rate is 8%, the tax rate is
40%, and the market risk premium is 5.5%.

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Calculating the Optimal Debt Ratio

Question 2 (Continued)
Option 1. Issue $1b in new stock and repurchase half of the
outstanding debt. Will be rated as AAA-rated firm as a result
(AAA-rated debt yields 11%).

Option 2. Issue $1b in new debt and buy back stock. Ratings will
drop to A− (A− rated debt yields 13%).

Option 3. Issue $3b in new debt and buy back stock. Ratings will
drop to CCC (CCC-rated debt yields 18%).

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Workings

Option D/E βE rE rD ATrD wD wE rwacc

1
2
3

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From Firm Value to Stock Price...

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Change in Firm Value
The change in firm value when there is a change in capital
structure may be estimated from the savings (or dissavings) to
the firm’s annual cost of financing its operating assets as
its rwacc changes.

The savings (or dissaving) over time may be valued as a

perpetuity with the new (optimal) rwacc as the appropriate
discount rate:
Annual Savings
PV (Savings) =
rwacc
(Current rwacc −New rwacc ) × Firm Value
=
New rwacc
(5)

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Change in Firm Value
Because shareholders receive the full benefits of the tax savings
(dissavings) upfront:

PV(Savings)
PV(Savings)/share =
Shares outstanding

The new stock price after the recapitalization is therefore equal

to:

Pnew = P0 + PV(Savings)/share (6)

This approach assumes that the increase in firm value is spread

evenly across shareholders who sell their stock back to the firm
and those who do not, leaving investors indifferent between
these two choices.
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Workings

Question 3
For each option, compute the firm’s stock price, assuming no growth
in perpetuity. Choose the option that maximizes firm value.

Option Current New PV PV(Savings) Pnew

rwacc rwacc (Savings) per share
1
2
3

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 Part II

APV Approach

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APV Approach

The APV approach is based on the simpler version of the

trade-off theory where:

VL = VU + PV (ITS) − ECFD (7)

where ECFD is the expected cost of financial distress.

VL is estimated at different levels of debt, with the optimal debt

ratio being the one with the highest VL .

The APV approach involves estimating VU , PV (ITS) and ECFD.

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Estimating VU and PV (ITS)
Find VU by valuing the firm as if it had no debt. This is done by
discounting the expected after-tax operating cash flows at rU . In
the special case where FCFF grows at a constant rate in
perpetuity, g :

FCFF1
VU = (8)
rU − g

In practice, VU is backed out from equation (8) by taking VL as

given, subtracting out PV(ITS), and adding back ECFD.

Assuming permanent debt, PV (ITS) is computed for different

levels of debt as follows:
PV (ITS) = τc D (9)
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Estimating ECFD

ECFD = Costs if in Distress × Probability of Distress

Costs if in Distress. Usually estimated from studies of actual

bankruptcies.

Probability of Distress (p). Empirically, the probability of

distress can be estimated by:
– Bond ratings. Based on default probabilities at each level
of debt from past history for a given rating.

– Probit Model. Computes the probability of default based

on a firm’s observable characteristics at each level of debt.

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Altman’s Default Ratings by Bond Rating Classes
Rating Likelihood of Default (%)
AAA 0.07
AA 0.51
A+ 0.60
A 0.66
A− 2.50
BBB 7.54
BB 16.63
B+ 25.00
B 36.80
B− 45.00
CCC 59.01
CC 70.00
C 85.00
D 100.00

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Implementing the APV Approach

Question 4
Bizlink Manufacturing has debt outstanding of $985 million and
40 million shares trading at $46.25 per share in January 2021.
The firm earned $203 million in earnings before interest and
taxes (EBIT) and has a marginal tax rate of 36.56%.
The probability of default for each debt level is given in the next
slide.
Direct and indirect bankruptcy costs are estimated to be 25% of
firm value.
The cost of debt can be computed from the synthetic ratings in
Slide 7 assuming a risk-free rate of 5 percent.
Find the optimal debt ratio for Bizlink using the APV approach.

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Implementing the APV approach

Question 3 (Continued)
Debt Ratio Bond Probability of
Rating default (%)
0.0 AAA 0.07
0.1 AAA 0.07
0.2 A− 2.50
0.3 BB 16.63
0.4 B− 45.00
0.5 CCC 59.01
0.6 CC 70.00
0.7 C 85.00
0.8 C 85.00
0.9 D 100.00

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Workings

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Workings
Debt Debt Rating Cost of Interest Tax PV(ITS)
Ratio Debt rate
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9

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Workings

Debt VU PV(ITS) Rating p Costs if ECFD VL

ratio in Distress
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9

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Workings

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Suggested Readings

FNCE201 Corporate Finance

Practice Questions 5 (Capital Structure 4)

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