Capital Structure.1

CAPITAL
STRUCTURE
Batangas State University
College of Accountancy, Business, Economics and International Hospitality Management
1
Topics in Chapter
Overview and preview of capital structure effects
Business versus financial risk
The impact of debt on returns
Capital structure theory, evidence, and implications for managers
Example: Choosing the optimal structure

2
CAPITAL
REFERS TO INVESTOR-PAID FUNDS, DEBT, PREFERED SHARES, ORDINARY
EQUITY AND RETAINED EARNINGS

3
CAPITAL STRUCTURE
REFERS TO THE MIX OF DEBT, PREFERED STOCK AND ORDINARY EQUITY
THATT THE FIRM USES TO FINANCE THE FIRM’S ASSETS.

4
INVESTMENT DECISIONS
ASSETS = LIABILITIES + EQUITY

- SHORT TERM DEBT = CAPITAL
FINANCING DECISIONS

5
CAPITAL STRUCTURE
THE OBJECTIVE IS TO FIND THE FINANCING MIX THAT MAXIMIZES THE
VALUE OF THE FIRM OR THE ‘OPTIMAL CAPITAL STRUCTURE’

6
CAPITAL
RESTRUCTURING
REFERS TO THE ALTERATION OF FIRM’S EXISTING CAPITAL STRUCTURE
NOTE THAT CAPITAL RESTRUCTURING IS A

FINANCING DECISION AND DOES NOT AFFECT THE
ASSETS OF THE FIRM; THEREFOR, IT IS
INDEPENDENT FROM INVESTMENT DECISIONS

7
WHY CAPITAL
STRUCTURE CHANGES?
DELIBERATE MANAGEMENT ACTIONS – TYPICALLY THE NEED TO RAISE
NEW MONEY
MARKET ACTIONS – CHANGES IN THE MARKET VALUE OF DEBT AND /
OR EQUITY

8
CAPITAL STRUCTURE
THEORY
TRADITIONAL APPROACH
FRANCO MODIGLIANI AND MERTON MILLER APPROACH
CONTEMPORARY APPROACH

9
TRADITIONAL APPROACH
VALUE OF FIRM = MARKET VALUE OF DEBT + MARKET VALUE OF
COMMON SHARES OUTSTANDING
VALUE OF FIRM = EBIT (1 – T)/ WACC

10
ALSO WHERE
MARKET VALUE OF
FIRM IS MAXIMIZED

11
Infinite Heart Center has no debt but is
considering two plans to add leverage.
Current Plan A Plan B
Cost of Debt 0 .07 .09
Cost of Equity .1 .105 .12
EBIT 100,000 100,000 100,000
DEBT 0 200,000 300,000
INTEREST 0 14,000 27,000
Required: Market Value of Equity, Market Value of Firm, and Weighted

Average Cost of Capital. Which plan will you choose? Why?
12
MARKET VALUE OF EQUITY = (EBIT – INTEREST) / COST OF EQUITY
MARKET VALUE OF FIRM = DEBT + MARKET VALUE OF EQUITY
WACC = EBIT / MARKET VALUE OF FIRM
YOU WANT A HIGH MARKET VALUE OF FIRM AND LOW WACC

13
MODIGLIANI AND
MILLER APPROACH I
ALSO KNOWN AS THE PERFECT WORLD APPROACH
ALL CAPITAL STRUCTURES ARE EQUALLY DESIRABLE
ASSUMPTIONS:
◦ NO TAXES, NO CHANCE OF BANKRUPTCY, AND NO
BROKERAGE COSTS AND THAT INVESTORS CAN BORROW
AT THE SAME RATE AS CORPORATIONS.
◦ THERE IS SYMMETRIC INFORMATION FOR ALL
PARTICIPANTS

14
SYMMETRIC
INFORMATION
WHERE INVESTORS AND MANAGERS HAVE IDENTICAL INFORMATION
ABOUT FIRM’S PROSPECTS

15
16
MM APPROACH II
CAPITAL STRUCTURE WITH CORPORATE TAXES
◦ IN A WORL OF INCOME TAXES, THERE IS A SUBSTANTIAL ADVANTAGE WHEN
DEBT IS USED

17
VALUE OF AN UNLEVERED FIRM WITH CORP TAXES = [EBIT(1-T)] / COST
OF EQUITY OF AN UNLEVERED FIRM
VALUE OF A LEVERED FIRM WITH CORP TAXES = VALUE OF THE
UNLEVERED FIRM + PRESENT VALUE OF THE INT TAX SHIELD

18
Cost of debt unaffected by
financial leverage
19
When value is macimized
with virtually 100% debt
financing
20
PROBLEM 1
VELVET CO. has EBIT of Php800,000 and interest cost of Php80,000. The
firm’s equity capitalization rates are 12% and 8%, respectively. Assume
no corporate taxes.
◦ What is the market value of the firm?
◦ What is the WACC?

21
PROBLEM 1 CONT…
Velvet Co. Sells additional debt and uses the proceeds to purchase its
common stock. The firm’s total interest costs increase to Php200,000
but its EBIT remains constant at Php800,000. The firm’s debt
capitalization rate remains at 8% but its equity capitalization rate
increases to 12.5%. Assume no corporate taxes.

22
Problem 1 Cont…
What is the total value of the firm?
What is the weighted cost of capital?
Is Velvet operating in a world hypothesized by the traditionalist or by
MM?

23
Exercise 1
Black Swan Co. is financd entirely with 400,000 shares of common stock
selling at Php25 per share. The firm pays 100% of its earnings as
dividends. EBIT is expected to remain constant at Php1,500,000 in the
future. Ignore taxes and assume no growth.

24
What is the total market value of the firm?
What is the cost of equity?

25
Fire
26
Mic Drop Corporation expects an EBIT of Php12,000 every year
forever. Mic Drop currently has no debt, and its cost of equity is 16%.
The firm can borrow at 9%.
If the corporate tax rate is 35%, what is the value of the firm?
What will the value be if Mic Drop converts to
◦ 50% debt
◦ 100% debt?

27
Contemporary Approach
also knows as the Trade-off Theory
Assets that there is an optimal capital structure or at least an optimal
range of structures
Factor that can lead to an OCS:
◦ Corporate income taxes
◦ Financial distress and related costs

28
29
Trade-off theory of Leverage
Firms trade off the tax benefits of debt financing against problem
caused by potential bankruptcy.
Optimal debt level is where Marginal Benefits = Marginal Costs
Value of the
Present Value
Levered Firm with Value of the Present
of Financial
Taxes, Financial levered Firm Value of Net
Distress and
Distress, and with taxes Tax Savings
related Costs
Related Costs
30
31
Common Assumptions
Traditional & MM Approach
Financing only occurs through long term debt and common stock
The firm’s investment decision is fixed, but its capital structure can be
changed by issuing bonds to repurchase stocks or issuing stocks to retire
debt
There is no tax or bankruptcy costs
32
Common Assumptions
Traditional & MM Approach
All earnings are paid out as dividends
Net operating income, or EBIT, is constant
Business risk is constant

33
Traditional VS Perfect World
Approach
MM I implies no transaction costs, symmetric information and rational
investor behavior

34
Factors influencing Optimal
Capital Structure
Control
If equity shareholders do not wish to dilute their control, the firm will rely
more on debt financing rather than issuing equity shares
Risk
◦ Business risk
Riskiness of the firm’s assets if no debt is used
◦ Financial risk
Additional risk place on Common Shareholders as a result of using debt

35
Capital Structure
Cost of Capital
A firm should possess easing power to generate income not only to meet its
costs but also to be able to finance its future growth
Firms that adjust their capital structure in order

to keep the riskiness of their debt and equity
reasonable should have lower COC
GENERALLY COE > COD (net of tax)

36
Capital Structure
Financial Leverage
Capital structure decision should always aim at having debt component, in
order to increase earnings for equity shareholders

37
Capital Structure
Flexibility
Debt capital is considered to have better flexibility than equity capital. Debt
may be raised and programmed for repayment after a fixed period, pre-
termination of debt is also possible. In case of equity capital, funds raised
through issue of stocks cannot ordinarily be reduced except with the court
and compliance with legal requirements

38
Capital Structure
Tax Consideration
Debt has tax advantage over equity because interest charges are deductible
from income and thereby could reduce a firm’s tax liabilities.
Timing
The time at which the capital structure decision is taken will be influenced by
the conditions of the economy.

39
Capital Structure
Profitabilility
A company with higher profitability will have low reliance on outside debt
and can meet its additional requirements through internally generated funds
Marketability
Balancing of debt and equity is possible when company’s securities are
marketable. Marketability of securities will affect capital structure decisions

40
Capital Structure
Company size
Companies with small capital base rely more on owner’s funds and internal
earnings. But large companies have to depend on capital market and can top
finances by issue of different varieties of securities and instruments

41
Capital Structure
Sales Stability
A firm whose sales are relatively stable can safely take on more debt and
incur higher fixed charges than a company with unstable sales.
Example: Utilities companies, because of their stable demand have

historically been able to use more financial leverage than industrial firms

42
Capital Structure
Operating Leverage
Other things the same, firms with less operating leverage can employ
financial leverage better because it will have less business risk

43
Capital Structure
Growth Rate
Other things the same, fast-growing firms must rely more on external
capital. The flotation cost involve in selling common stocks exceeds that
incurred when selling debt, which encourages fast-growing firms to rely
more heavily on debt. However, these firm also face higher level of
uncertainty which tend to reduce their willing to use debt

Batangas
College State University
of Accountancy, Business, Economics and International Hospitality Management
44
Capital Structure
Management Attitudes
No one can prove with certainty that one capital structure will lead to higher
stock prices than another. Management can exercise its own judgement
about the capital structure. Some manager are conservative, opting for less
debt than average in the industry; while others are aggressive which uses
higher percentage of debt
45
Business Risk
the single most important determinant of capital structure ant it
represents the amount of risk that is inherent in the firm’s operations
even it uses no debt financing.
the equity risk that comes from the nature of the firm’s operating
activities

46
Business Risk
Return on Invested Capital
47
Return on Invested Capital
ROIC does not vary with changes in Capital Structure
the standard deviation of ROIC measures the underlying risk of the firm
considering the effect of debt financing

48
Factors that Affects Business
Risk
oVariability of Demand for Firm’s Products
Other things held constant, the more stable the
demand for firm’s product the lower its business
risk
oCompetition
In general, less competition lowers risk.
Monopolies have stable sales and prices. However,
monopolistic firm’s prices are often regulated

49
Risk
oVariability of Sale price
Other thing held constant, firms whose products are sold
in volatile markets are exposed to more business risk than
firms whose output prices are stable
oProduct Obsolescence
The faster a firm’s products become obsolete, the greater
a firm’s business risk

50
Risk
oVariability of Production Costs
Firms whose input (material labor) costs are uncertain
have higher business risk
oForeign Risk Exposure
Firms that generate high percentage of their earnings
overseas are subject to earnings decline due to exchange
rate fluctuations. They are also exposed to political risk.

51
Risk
o Legal exposure and Regulatory risk
Firms that operate in highly regulated industries are
subject to more business risk. Examples are financial
services, utilities, tabacco and pharma
o Degree of operating leverage
When high percentage of total costs are fixed, the firm is
said to have a high degree of operating leverage. All
things constant, high degree of operating leverage implies
relatively small change in sales result in a large change in
ROIC
52
Determinants of Intrinsic Value:
The Capital Structure Choice
Net operating Required investments

−
profit after taxes in operating capital
Free cash flow

=
(FCF)
FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
Weighted average Firm’s

cost of capital debt/equity
(WACC) mix
Market interest rates Cost of debt

Cost of equity
Market risk aversion Firm’s business risk
53
53
Goal of the Firm is
Maximize Firm Value
Minimize WACC
Thru:
◦ Lowering risk
◦ Increasing CFs
◦ Maximize Op. Profits
◦ Growth Business
◦ Reduce Taxes

54
Basic Definitions
V = value of firm
FCF = free cash flow
WACC = weighted average cost of capital
rs and rd are costs of stock and debt
ws and wd are percentages of the firm that are
financed with stock and debt.
55
55
How can capital structure affect
value?
∞ FCFt
V = ∑
t=1 (1 + WACC)t
WACC= wd (1-T) rd + wsrs
56
The Effect of Additional
Debt on WACC
Debt holders have a prior claim on cash flows relative
to stockholders.
◦ Debt holders’ “fixed” claim increases risk of stockholders’
“residual” claim.
◦ Cost of stock, rs, goes up.
Firm’s can deduct interest expenses.

◦ Reduces the taxes paid
◦ Frees up more cash for payments to investors
◦ Reduces after-tax cost of debt
(Continued…)
57
The Effect on WACC
(Continued)
Debt increases risk of bankruptcy
◦ Causes pre-tax cost of debt, rd, to increase
Adding debt increase percent of firm financed with
low-cost debt (wd) and decreases percent financed
with high-cost equity (ws)
Net effect on WACC = uncertain.
58
The Effect of Additional Debt
on FCF
Additional debt increases the probability of
bankruptcy.
◦ Direct costs: Legal fees, “fire” sales, etc.
◦ Indirect costs: Lost customers, reduction in
productivity of managers and line workers, reduction
in credit (i.e., accounts payable) offered by suppliers
(Continued…)
59
Impact of indirect costs
◦ NOPAT goes down due to lost customers and
drop in productivity
◦ Investment in capital goes up due to increase
in net operating working capital (accounts
payable goes down as suppliers tighten
credit).
(Continued…)
60
Additional debt can affect the behavior of
managers.
◦ Reductions in agency costs: debt “pre-commits,” or
“bonds,” free cash flow for use in making interest
payments. Thus, managers are less likely to waste FCF on
perquisites or non-value adding acquisitions.
◦ Increases in agency costs: debt can make managers too
risk-averse, causing “underinvestment” in risky but
positive NPV projects.
(Continued…)
61
Business Risk: Uncertainty in
EBIT, NOPAT, and ROIC
Uncertainty about demand (unit sales).
Uncertainty about output prices.
Uncertainty about input costs.
Product and other types of liability.
Degree of operating leverage (DOL).
62
Operating Breakeven
Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P
is price per unit.
Operating breakeven = QBE
QBE = F / (P – V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
(More...)
63
Business Risk versus
Financial Risk
Business risk:
◦ Uncertainty in future EBIT, NOPAT, and ROIC.
◦ Depends on business factors such as competition,
operating leverage, etc.
Financial risk:
◦ Additional business risk concentrated on common
stockholders when financial leverage is used.
◦ Depends on the amount of debt and preferred stock
financing.
64
Consider Two Hypothetical Firms
Identical Except for Debt
Firm U Firm L
Capital $20,000 $20,000
Debt $0 $10,000 (12% rate)
Equity $20,000 $10,000
Tax rate 40% 40%
EBIT $3,000 $3,000
NOPAT $1,800 $1,800
ROIC 9% 9%
65
Impact of Leverage on Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROIC (NI+Int)/TA] 9.0% 11.0%

ROE (NI/Equity) 9.0% 10.8%
66
Why does leveraging increase
return?
More cash goes to investors of Firm L.
◦ Total dollars paid to investors:
◦ U: NI = $1,800.
◦ L: NI + Int = $1,080 + $1,200 = $2,280.
◦ Taxes paid:
◦ U: $1,200
◦ L: $720.
In Firm L, fewer dollars are tied up in equity.
67
if EBIT Falls
Firm U Firm L
EBIT $2,000 $2,000
Interest 0 1,200
EBT $2,000 $800

Taxes (40%) 800 320
NI $1,200 $480
ROIC 6.0% 6.0%
ROE 6.0% 4.8%
Leverage magnifies risk and return! 68
if EBIT Rises
Firm U Firm L
EBIT $4,000 $4,000
Interest 0 1,200
EBT $4,000 $2,800

Taxes (40%) 1,600 1,120
NI $2,400 $1,680
ROIC 12.0% 14.0%
ROE 12.0% 16.8%
Leverage magnifies risk and return! 69
Choosing the Optimal Capital
Structure: Example
b = 1.0; rRF = 6%; RPM = 6%.
Cost of equity using CAPM:
◦ rs = rRF +b (RPM)= 6% + 1(6%) = 12%
Currently has no debt: wd = 0%.
◦ WACC = rs = 12%.
Tax rate is T = 40%.
70
Current Value of Operations
Expected FCF = $30 million.
Firm expects zero growth: g = 0.
Vop = [FCF(1+g)]/(WACC − g)
op = [$30(1+0)]/(0.12 − 0)
Vop = $250 million.
71
Other Data for Valuation
Analysis
Company has no ST investments.
Company has no preferred stock.
100,000 shares outstanding
72
Current Valuation Analysis
Vop $250
+ ST Inv. 0
VTotal $250
− Debt 0
S $250
÷n 10
P $25.00
73
Investment bankers provided estimates of rd
for different capital structures.
wd 0% 20% 30% 40% 50%
rd 0.0% 8.0% 8.5% 10.0% 12.0%
If company recapitalizes, it will use proceeds from debt

issuance to repurchase stock.
74
The Cost of Equity at Different Levels of
Debt: Hamada’s Formula
MM theory implies that beta changes with leverage.
bU is the beta of a firm when it has no debt (the unlevered beta)
b = bU [1 + (1 - T)(wd/ws)]
75
The Cost of Equity for wd =
20%
Use Hamada’s equation to find beta:
b = bU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%
76
The WACC for wd = 20%
WACC = wd (1-T) rd + wce rs
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%
Repeat this for all capital structures under consideration.
77
Corporate Value for wd = 20%
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.1128 − 0)
Vop = $265.96 million.
Debt = DNew = wd Vop
Debt = 0.20(265.96) = $53.19 million.
Equity = S = ws Vop
Equity = 0.80(265.96) = $212.77 million.
78
Value of Operations, Debt, and
Equity
wd 0% 20% 30% 40% 50%
rd 0.0% 8.0% 8.5% 10.0% 12.0%
ws 100% 80% 70% 60% 50%
b 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
WACC 12.00% 11.28% 11.01% 11.04% 11.40%
Vop $250.00 $265.96 $272.48 $271.74 $263.16
D $0.00 $53.19 $81.74 $108.70 $131.58
S $250.00 $212.77 $190.74 $163.04 $131.58
Value of operations is maximized at wd = 30%.

79
Anatomy of a Recap: Before
Issuing Debt
Before Debt
Vop $250
+ ST Inv. 0
VTotal $250
− Debt 0
S $250
÷n 10
P $25.00
Total shareholder
wealth: S + Cash $250
80
Issue Debt (wd = 20%), But
Before Repurchase
WACC decreases to 11.28%.
Vop increases to $265.9574.
Firm temporarily has short-term investments of
$53.1915 (until it uses these funds to
repurchase stock).
Debt is now $53.1915.
81
Anatomy of a Recap: After
Debt, but Before Repurchase
After Debt,
Before Debt Before Rep.
Vop $250 $265.96
+ ST Inv. 0 53.19
VTotal $250 $319.15
− Debt 0 53.19
S $250 $265.96
÷n 10 10
P $25.00 $26.60
Total shareholder
wealth: S + Cash $250 $265.96
82
The Repurchase: No Effect on
Stock Price
The announcement of an intended repurchase might send a
signal that affects stock price, and the previous change in
capital structure affects stock price, but the repurchase
itself has no impact on stock price.
◦ If investors thought that the repurchase would increase the stock
price, they would all purchase stock the day before, which would
drive up its price.
◦ If investors thought that the repurchase would decrease the stock
price, they would all sell short the stock the day before, which would
drive down the stock price.
83
Remaining Number of Shares
After Repurchase
DOld is amount of debt the firm initially has, DNew is
amount after issuing new debt.
If all new debt is used to repurchase shares, then
total dollars used equals
◦ (DNew – DOld) = ($53.19 - $0) = $53.19.
nPrior is number of shares before repurchase, nPost is

number after. Total shares remaining:
◦ nPost = nPrior – (DNew – DOld)/P
nPost = 10 – ($53.19/$26.60)
nPost = 8 million.
(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).
84
Anatomy of a Recap: After
Rupurchase
After Debt,
Before Debt Before Rep. After Rep.
Vop $250 $265.96 $265.96
+ ST Inv. 0 53.19 0
VTotal $250 $319.15 $265.96
− Debt 0 53.19 53.19
S $250 $265.96 $212.77
÷n 10 10 8
P $25.00 $26.60 $26.60
Total shareholder
wealth: S + Cash $250 $265.96 $265.96
85
Key Points
ST investments fall because they are used to
repurchase stock.
Stock price is unchanged.
Value of equity falls from $265.96 to $212.77
because firm no longer owns the ST investments.
Wealth of shareholders remains at $265.96
because shareholders now directly own the funds
that were held by firm in ST investments.
86
Intrinsic Stock Price
Maximized at Optimal Capital
Structure
wd 0% 20% 30% 40% 50%
rd 0.0% 8.0% 8.5% 10.0% 12.0%
ws 100% 80% 70% 60% 50%
b 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
WACC 12.00% 11.28% 11.01% 11.04% 11.40%
Vop $250.00 $265.96 $272.48 $271.74 $263.16
D $0.00 $53.19 $81.74 $108.70 $131.58
S $250.00 $212.77 $190.74 $163.04 $131.58
n 10 8 7 6 5
P $25.00 $26.60 $27.25 $27.17 $26.32
87
Shortcuts
The corporate valuation approach will always
give the correct answer, but there are some
shortcuts for finding S, P, and n.
Shortcuts on next slides.
88
Calculating S, the Value of
Equity after the Recap
S = (1 – wd) Vop
At wd = 20%:
S = (1 – 0.20) $265.96
S = $212.77.
(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).
89
Number of Shares after a
Repurchase, nPost
At wd = 20%:
nPost = nPrior(VopNew−DNew)/(VopNew−DOld)
nPost = 10($265.96 −$53.19)/($265.96 −$0)
nPost = 8
90
Calculating PPost, the Stock
Price after a Recap
At wd = 20%:
PPost = (VopNew−DOld)/nPrior
nPost = ($265.96 −$0)/10
nPost = $26.60
91
Optimal Capital Structure
wd = 30% gives:
◦ Highest corporate value
◦ Lowest WACC
◦ Highest stock price per share
But wd = 40% is close. Optimal range is pretty flat.
92
93
94
95

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CAPITAL

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ASSETS = LIABILITIES + EQUITY

Batangas State University

Batangas State University

NOTE THAT CAPITAL RESTRUCTURING IS A

Batangas State University

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Batangas State University

VALUE OF FIRM = EBIT (1 – T)/ WACC

Batangas State University

Batangas State University

Required: Market Value of Equity, Market Value of Firm, and Weighted

YOU WANT A HIGH MARKET VALUE OF FIRM AND LOW WACC

Batangas State University

Batangas State University

Batangas State University

Batangas State University

Batangas State University

Batangas State University

Batangas State University

Batangas State University

Batangas State University

Batangas State University

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Batangas State University

Batangas State University

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Firms that adjust their capital structure in order

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Batangas State University

Batangas State University

Example: Utilities companies, because of their stable demand have

Batangas State University

Batangas State University

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Batangas State University

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Net operating Required investments

Free cash flow

FCF1 FCF2 FCF∞

Weighted average Firm’s

Market interest rates Cost of debt

Batangas State University

WACC= wd (1-T) rd + wsrs

Firm’s can deduct interest expenses.

ROIC (NI+Int)/TA] 9.0% 11.0%

EBT $2,000 $800

EBT $4,000 $2,800

If company recapitalizes, it will use proceeds from debt

Repeat this for all capital structures under consideration.

Value of operations is maximized at wd = 30%.

nPrior is number of shares before repurchase, nPost is

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