Capital Structure Impact on Return

Corporation, Mergers Acquisitions, and

Managing Subsidiaries
 Possible Capital Structure
• 1 2 3
• Equity 50,000 40,000 25,000
• Debt 0 10,000 25,000
• --------- --------- --------
• Total Capital 50,000 50,000 50,000

• Debt / Asset 0% 20% 50%

• # of Shares 50,000 40,000 25,000

 Capital Structure 1
• Scenario A B
• EBIT 1,000 10,000
• Interest Payment (10%) 0 ____0
• Earning Before Tax 1,000 10,000
• Tax @35% (350) (3,500)
• Net Profit After Tax 650 6,500

• Return On Equity 1.3% 13%

 Capital Structure 2
• Scenario A B
• EBIT 1,000 10,000
• Interest Payment (10%) (1,000) (1,000)
• Earnings Before Tax 0 9,000
• Tax @35% ____0 (3,150)
• Net Profit After Tax 0 5,850

• Return On Equity 0% 14.6%

 Capital Structure 3
• Scenario A B
• EBIT 1,000 10,000
• Interest Payment (10%) (2,500) (2,500)
• Earnings Before Tax (1,500) 7,500
• Tax @35% ____0 (2,625)
• Net Profit After Tax (1,500) 4,875

• Return On Equity (6%) 19.5%

 Tax Effect
Without The Expense With The Expense

• Revenue 100 • Revenue 100

• Expense _0 • Expense 20
• Net Profit 100 • Net Profit 80
• Tax@40% 40 • Tax@40% 32
• Profit After Tax 60 • Profit After Tax 48

• Difference: 60 - 48 = 12
• 12 = 20 x (1- 40%)
Borrowing save tax
 Tax Effect
Without Depreciation With Depreciation
• Revenue 100 • Revenue 100
• Depreciation _0 • Depreciation 20
• Net Profit 100 • Net Profit 80
• Tax@40% 40 • Tax@40% 32
• Profit After Tax 60 • Profit After Tax 48

• Cash flow = 60 + 0 = 60 • Cash flow = 48 + 20 = 68

• Difference is 8 = 20 x 40%
There is no cash outlay on depreciation
 Dividend – No Tax Effect
Without Dividend With Dividend
• Revenue 100 • Revenue 100
• Expense 20 • Expense 20
• Net Profit 80 • Net Profit 80
• Tax@40% 32 • Tax@40% 32
• Profit After Tax 48 • Profit After Tax 48
• Dividend 10
• Dividend 0
• Changes in RE 38
• Changes in RE 48
No tax saving on dividend
Cost Functions and Value
Economic Value Added
 EVA NI
Sales 1000 1000
Operating expenses 800 800
EBIT 200 200
Interest expense 100
Taxable income 200 100
Tax (40%) 80 40
NPAT 120 60
Performance Measurement:
Accounting Profit vs Economic Profit
Sales = $ 1000
Operating expenses = $ 800
Invested Capital = $ 2000 (50% Debt, 50% Equity)
Interest Expense = $ 100 (cost of debt 10%)
Tax rate = 40%
Cost of equity = 20%
Cost of capital (WACC) =
(50%)(20%) + (50%)(10%)(1-40%)= 13%
Capital Charges = 13% x 2000 = 260
 EVA NI
Sales 1000 1000
Operating expenses 800 800
Operating income 200 200
Interest expense 100
Taxable income 200 100
Tax (40%) 80 40
NOPAT 120 NPAT 60
Capital charges 260
-140
Cost of Debt (Kd) = Bondholders’ Required ROR
Effective cost of Debt is: After tax cost of debt = Kd (1-T)
Cost of Equity (Ke) = shareholders’ Required ROR
Alternative to calculate EVA:
EVA = (RONA – WACC) x Capital Invested
RONA = NOPAT/Capital Invested = 120/2000
EVA = (6% - 13%) x 2000 = - 140
Cost of Capital
Capital Suppliers’ required rate of return
Sources of Capital: Debt and Equity

Weighted Average Cost of Capital (WACC) is

Ws. Ks + Wd. Kd (1-T)
 Capital Structure and Value of the Firm

• The value of a firm is defined to be the sum of the

value of the firm’s debt and the firm’s equity.

• If the goal of the firm’s management is to make the

firm as valuable as possible, then the firm should
pick the debt-equity ratio that makes the pie as big
as possible.
 Terminal Value Calculation

• Corporate potentially has an infinite life. The

value is therefore the present value of cash flow
forever :

∞
Value = ∑
CFt
t =1 (1 + r ) t
 The Capital Structure Theory
1) Capital Structure Irrelevance or MM Theory
[Modigliani-Miller, 1958]
2 ) Trade - Off Model
[Kraus – Litzenberger, 1973]
3) Pecking Order Hypothesis [Myers, 1984]
4) Market Timing [Malcolm Baker, 2004]
 The Firm’s Capital Structure:
1. MM-II [Modigliani-Miller, 1963]

– Letting rd (kd) equal the before-tax cost of debt and letting T equal
the tax rate, we have ri = rd × (1 – T).

– The result is a theoretical optimal capital structure based on

balancing the benefits and costs of debt financing.
– The cost of debt financing results from:
– the increased probability of bankruptcy caused by debt
obligations,
– the agency costs of the lender’s constraining the firm’s actions,
and
– the costs associated with managers having more information
about the firm’s prospects than do investors.
 2. Trade-Off Model
[Kraus – Litzenberger, 1973]

• Use of debt allows tax saving, but at the expense of increasing

probability of financial distress.

• Corporate value will be maximized when the marginal benefit of

debt (tax benefit) equals the marginal cost of debt (financial
distress and bankruptcy costs).

<<Optimal Capital Structure >>

Marginal benefit of Debt (Tax benefit) =
Marginal cost of debt (financial distress + bankruptcy costs )
 The Firm’s Capital Structure:
Capital Structure Theory - Trade-Off Model

Probability of Bankruptcy
– The chance that a firm will become bankrupt because of an
inability to meet its obligations as they come due depends largely
on its level of both business risk and financial risk.

– Business risk is the risk to the firm of being unable to cover its
operating costs.

– In general, the greater the firm’s operating leverage—the use of

fixed operating costs—the higher its business risk.

– Although operating leverage is an important factor affecting

business risk, two other factors—revenue stability and cost
stability—also affect it.
© 2012 Pearson Education
 3. Pecking Order Hypothesis
[Myers, 1984]

1. Firms prefer internal financing (from retained earnings).

2. If firms must seek external financing, they will start from the
safest security first, lower cost of capital and then
progressing down:
1. Debt
2. Convertible debt
3. Preferred stock
4. Common stock (last resort)
 4. Market Timing [Malcolm Baker, 2004]

• Firms just choose the form of financing which, at that

point in time, seems to be more valued by financial
market.

• Use more equity when market is bullish

• Use more debt when market is bearish

 The Firm’s Capital Structure:
Optimal Capital Structure

What, then, is the optimal capital structure, even if it exists (so far)
only in theory?
– Because the value of a firm equals the present value of its future cash flows,
it follows that the value of the firm is maximized when the cost of capital is
minimized.

where
EBIT = earnings before interest and taxes
T = tax rate
NOPAT = net operating profits after taxes, which is the after-tax operating
earnings available to the debt and equity holders, EBIT × (1 – T)
ra = Weighted Average Cost of Capital (WACC)
Cost Functions and Value
 EBIT-EPS Approach to Capital Structure

The EBIT–EPS approach is an approach for selecting the

capital structure that
maximizes earnings per share (EPS)
over the expected range of
earnings before interest and taxes (EBIT).
 Financial Leverage, EPS, and ROE
Without DEBT
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000 Note 1- Without Debt:
Interest 0 0 0 Asset = $20.000
Net income $1,000 $2,000 $3,000 Equity = $20.000
EPS $2.50 $5.00 $7.50
ROA 5% 10% 15%
ROE 5% 10% 15%
Current Shares Outstanding = 400 shares
With DEBT
Recession Expected Expansion
EBIT $1,000 $2,000 $3,000
Interest 640 640 640 Note 2 - WithDebt:
Net income $360 $1,360 $2,360 Asset = $20.000
EPS $1.50 $5.67 $9.83 Equity = $12.000
ROA 2% 7% 12%
ROE 3% 11% 20%
Proposed Shares Outstanding = 240 shares
 Financial Leverage and EPS
12.00
Debt
10.00

8.00 No Debt

6.00 Advantage
Break-even
EPS

point to debt
4.00

2.00

0.00
1,000 2,000 3,000
(2.00) Disadvantage to debt EBIT in dollars, no taxes
 Conclusion
• Debt increases ROE

• But debt also increases volatility of ROE

[additional risk, namely financial risk]