Capital Structure and Leverage

Part II

Lecture # 8
Optimal Capital Structure
The capital structure (mix of debt, preferred,
and common equity) at which P0 is
maximized.
Trades off higher E(ROE) and EPS against
higher risk. The tax-related benefits of
leverage are exactly offset by the debt’s risk-
related costs.
The target capital structure is the mix of
debt, preferred stock, and common equity
with which the firm intends to raise capital.

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Finding Optimal Capital Structure
The firm’s optimal capital structure can be
determined two ways:
Minimizes WACC.
Maximizes stock price.
Both methods yield the same results.

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WACC and Capital Structure Changes
WACC = Cost of equity + Cost of debt
The capital structure that maximizes the stock price is
also the one that minimizes the WACC.
Since it is easy to predict how a capital structure
change will affect the WACC than the stock price,
many managers use the predicted changes in the
WACC to guide their capital structure decision.

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 What effect does more debt have
on a firm’s cost of equity?
If the level of debt increases, the riskiness of the firm
increases.
We have already observed the increase in the cost of
debt.
However, the riskiness of the firm’s equity also
increases, resulting in a higher rs.

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Sequence of events in a recapitalization.
Firm announces the
recapitalization.
New debt is issued.
Proceeds are used to repurchase
stock.
The number of shares repurchased is
equal to the amount of debt issued
divided by price per share.
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 Analyze the recapitalization at various debt
levels and determine the EPS and TIE at each
level.

D  $0
( EBIT - rdD )( 1 - T )
EPS 
Shares outstandin g
($400,000)(0.6)

80,000
 $3.00

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Determining EPS and TIE at different levels of debt.
(D = $250,000 and rd = 8%)

$250,000
Shares repurchase d   10,000
$25
( EBIT - rdD )( 1 - T )
EPS 
Shares outstandin g
($400,000 - 0.08($250,000))(0.6)

80,000 - 10,000
 $3.26

EBIT $400,000
TIE    20x
Int Exp $20,000

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Determining EPS and TIE at different levels of debt
(D = $500,000 and rd = 9%)

$500,000
Shares repurchase d   20,000
$25
( EBIT - rdD )( 1 - T )
EPS 
Shares outstandin g
($400,000 - 0.09($500,000))(0.6)

80,000 - 20,000
 $3.55

EBIT $400,000
TIE    8.9x
Int Exp $45,000

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Determining EPS and TIE at different levels of debt
(D = $750,000 and rd = 11.5%)
$750,000
Shares repurchase d   30,000
$25
( EBIT - rdD )( 1 - T )
EPS 
Shares outstandin g
($400,000 - 0.115($750,000))(0.6)

80,000 - 30,000
 $3.77

EBIT $400,000
TIE    4.6x
Int Exp $86,250

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Determining EPS and TIE at different levels of debt
(D = $1,000,000 and rd = 14%)

$1,000,000
Shares repurchase d   40,000
$25
( EBIT - rdD )( 1 - T )
EPS 
Shares outstandin g
($400,000 - 0.14($1,000,000))(0.6)

80,000 - 40,000
 $3.90

EBIT $400,000
TIE    2.9x
Int Exp $140,000

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 The Hamada Equation
Because the increased use of debt causes both the
costs of debt and equity to increase, we need to
estimate the new cost of equity.
The Hamada equation attempts to quantify the
increased cost of equity due to financial leverage.
Uses the unlevered beta of a firm, which represents
the business risk of a firm as if it had no debt.

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 The Hamada Equation

bL = bU[ 1 + (1 – T) (D/E)]

Suppose, the risk-free rate is 6%, as

is the market risk premium. The
unlevered beta of the firm is 1.0 and
the total assets are $2,000,000.

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Calculating levered betas and costs of
equity
If D = $250,

bL = 1.0 [ 1 + (0.6)($250/$1,750) ]
bL = 1.0857

rs = rRF + (rM – rRF) bL

rs = 6.0% + (6.0%) 1.0857
rs = 12.51%

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 Trade-off Theory of Capital Structure
Developed Modigliani and Miller (M&M) and their
followers.
They showed that debt is useful because interest is tax
deductible, but also that debt brings with it costs
associated with actual or potential bankruptcy.
Under MM’s theory, the optimal capital structure
strikes a balance between the tax benefits of debt and
the costs associated with bankruptcy.

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 The Signaling Theory
Investor receive signals from a firm’s decision to use
debt versus stock to raise new capital.
A stock issue sets off a negative signal, while using
debt is a positive, or at least a neutral, signal.
As a result, companies try to avoid having to issue
stock by maintaining a reserve borrowing capacity,
and this means using less debt in “normal” times than
a MM trade-off theory would suggest.

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 Debt: A force to Discipline Managers
A firm’s owners may have it use a relatively large
amount of debt to constrain the managers.
A high debt ration raises the threat of bankruptcy,
which carries a cost but which also forces managers to
be more careful and less wasteful with shareholder’s
money.
Many of the corporate takeovers and leveraged
buyouts in recent years were designed to improve the
efficiency by reducing the free cash flow available to
managers.

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Checklist for Capital Structure Decisions
1. Sales stability: Utility companies vs. industrial firms.
2. Asset structure: General purpose assets make good collateral. Real estate
companies vs. Companies involved in technical research.
3. Operating leverage.
4. Growth rate: High growth rate would encourage reliance on debt.
5. Profitability: Firms with high rate of ROI like Microsoft, Intel, Coca-Cola use
relatively little debt.
6. Taxes
7. Management attitude: Aggressive or conservative.
8. Lender or rating agency attitude
9. Market conditions: Availability of debt at reasonable cost.
10. The firm’s internal condition: Asymmetric information (Managers have
different (better) information about firm’s prospects than to investors.

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 END OF LECTURE

QUESTIONS & ANSWERS

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