Capital Structure

MM EM24a
A well design capital structure can create value (increase EPS or ROE)
provided that capital market are imperfect.

Corporate Finance 2
Indifferent Point
• EBIT level at which EPS are equivalent for the financing alternative
(debt or equity).
• The use of debt will increase value provided that Operating Rate of
Return (ROA) > Cost of Borrowing. It is called positive financial
leverage or gearing. Since, there is tax deductibility of interest
expenses.

Corporate Finance 3
 EPSA = EPSB

(EBIT − iA )(1 − tax ) − D preferred (EBIT − iB )(1 − tax )D preferred

=
CS A CS B

i = interest paid
CS = common stock shares
D = dividend

Corporate Finance 4
 debt

EPS
IP common stock
(equity)

EBIT

Once Indifferent point is reached, profits grow more quickly with

debt then equity (common stock).

Corporate Finance 5
 Example
Say, you need fund $400. If loan, interest is 10%. If equity you need to issue
40 shares (@ Rp10). Current share is 10, and tax is 40%.

Equity Debt Equity Debt

EBIT
Interest

Tax
Net Profit

Equity

EPS
• Weakness of IP:
• The use of EPS generally ignores risk.
• Owner should require risk premium, to maximize owner
wealth.
• To select the best capital structure, both return (EPS)
and risk must be integrated.
• Compute per share value of the firm 𝑃0 .

𝐸𝑃𝑆
𝑃0 =
𝑘𝑟

Corporate Finance 7
Firm Value and Cost of Capital
The value of the firm is maximized when the cost of capital is
minimized.
• Based on zero growth valuation model, the value of the firm is:
EBIT (1 − tax)
V=
kw
𝑘𝑤 = Weighted average cost of capital (WACC)

• As long as 𝑘𝑑 < 𝑘𝑒 , increase in debt to substitute equity (or increase in debt

ratio) WACC decline, and start to rise as 𝑘𝑑 > 𝑘𝑒 .

Corporate Finance 8
 Maximum share value
(Po max.)

Po ($)

EPS ($)

Max Po Debt Ratio (%)

Max EPS

• Based on zero growth model of valuation, as debt ratio increase, 𝑃0 increase, at certain point
decrease. Why? Increase in interest are not fully offset by the number of common stock
reduced.
• This is true in imperfect market where there is tax shield from debt financing (deductibility of
interest).

Corporate Finance 9
 EBIT (1 − tax )
V=
kw
Value

Annual Cost (%) 𝑘𝑤 = WACC

Debt Ratio (%)

M = optimal capital structure

• This M only exit in theory!

• Min 𝑘𝑤 is taken from trial and error (use table of V and 𝑘𝑤 ).

Corporate Finance 10
Thanks