Capital Structure Decisions:

Part 1
 Content Highlight
• 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

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Determinants of Intrinsic Value: The Capital Structure Choice

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 Basic Definitions
• V = value of firm
• FCF = free cash flow
• WACC = weighted average cost of capital
• and are costs of stock and debt
• and are percentages of the firm that are financed with stock
and debt.

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Capital Structure Issues

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 Capital Structure Issues
• Debt Increases the Cost of Stock
• Debt Reduces the Taxes a Company Pays
• The Risk of Bankruptcy Increases the Cost of Debt
• The Net Effect on the WACC
• Bankruptcy Risk Reduces Free Cash Flow
• Bankruptcy Risk Affects Agency Costs
• Issuing Equity Conveys a Signal to the Marketplace
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 Business Risk and Financial
Risk
• Business risk: the riskiness of the firm’s stock if it uses no
debt.
• Financial risk: the additional risk placed on the common
stockholders as a result of the firm’s decision to use debt.

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 Business Risk
• Uncertainty about demand (unit sales).
• Uncertainty about output prices.
• Uncertainty about input costs.
• Product and other types of liability.
• Degree of operating leverage (DOL).

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 Business Risk
• Operating leverage is the change in EBIT caused by a change
in quantity sold.
• The higher the proportion of fixed costs relative to variable
costs, the greater the operating leverage.
• Other things held constant, the higher a firm’s operating
leverage, the higher its business risk.

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 Business Risk
• 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 = F / (P – V)
• Example: F = $200, P = $15, and V = $10, calculate QBE.

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 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.
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 Financial Risk
Consider Two Hypothetical Firms Identical Except for Debt

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Financial Risk

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 MM Theory: Zero Taxes

• Notice that the total CF are identical for both firms.

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 MM Theory
• MM assumed:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future
investment opportunities.
6. EBIT is not affected by the use of debt.
NO TAX:
• MM proved that a firm’s value is unaffected by its capital structure
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 MM Theory
CORPORATE TAXES
The value of a levered firm is the value of an identical
unlevered firm plus PV of tax shield.

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 MM Theory

• Under MM with corporate taxes, the firm’s value increases continuously as

more and more debt is used.

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 MM Theory
CORPORATE AND PERSONAL TAXES

Personal taxes lessen the advantage of corporate debt:

– Corporate taxes favor debt financing since corporations can
deduct interest expenses.
– Personal taxes favor equity financing, since no gain is reported
until stock is sold, and long-term gains are taxed at a lower rate.
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 Trade-off Theory
• MM theory ignores bankruptcy (financial distress) costs but
trade-off theory includes it.
• At low leverage levels, tax benefits outweigh bankruptcy
costs. At high levels, bankruptcy costs outweigh tax benefits.
• An optimal capital structure exists that balances these costs
and benefits.

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 Signaling Theory
• MM assumed that investors have the same information about a
firm’s prospects as its managers (symmetric information).
However, signaling theory believes that managers often have
better information than outside investors (asymmetric
information).
• The announcement of a stock offering is generally taken as a
signal that the firm’s prospects as seen by its management are not
bright. Conversely, a debt offering is taken as a positive signal.

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 Pecking Order Theory
• Firms use internally generated funds first, because there are
no flotation costs or negative signals.
• If more funds are needed, firms then issue debt because it
has lower flotation costs than equity and not negative
signals.
• If still more funds are needed, firms then issue equity (last
resort).
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 Agency Theory
• Agency problems may arise if managers and shareholders have different
objectives.
• One agency problem is that managers can use corporate funds for non-value
maximizing purposes.
• The use of financial leverage forces managers to conserve cash by eliminating
unnecessary expenditures.
• Too much debt may overconstrain managers. The more debt the firm has, the
greater the likelihood of financial distress, and thus the greater the likelihood
that managers will forgo risky projects even if they have positive NPVs.
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 Windows of Opportunity
• Managers try to “time the market” when issuing securities.
• They issue equity when the market is “high” and after big
stock price run ups.
• They issue debt when the stock market is “low” and when
interest rates are “low.”
• The issue short-term debt when the term structure is upward
sloping and long-term debt when it is relatively flat.
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 Optimal Capital Structure
Step 1. Estimating the Cost of Debt

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 Optimal Capital Structure
Step 2: Estimating the Cost of Equity (CAPM)

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 Optimal Capital Structure
Step 3: Estimating the WACC
Step 4: Estimating the Firm’s Value

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 Optimal Capital Structure
Example: Beckman Engineering and Associates (BEA) is considering a change in its capital
structure. BEA currently has $20 million in debt carrying a rate of 8 percent, and its stock
price is $40 per share with 2 million shares outstanding. BEA is a zero growth firm and pays
out all of its earnings as dividends. EBIT is $14.933 million, and BEA faces a 40 percent
federal-plus-state tax rate. The market risk premium is 4 percent, and the risk-free rate is 6
percent. BEA is considering increasing its debt level to a capital structure with 40 percent
debt, based on market values, and repurchasing shares with the extra money that it
borrows. BEA will have to retire the old debt in order to issue new debt, and the rate on
the new debt will be 9 percent. BEA has a beta of 1.0.
a. What is BEA’s unlevered beta? Use market value D/S when unlevering.
b. What are BEA’s new beta and cost of equity if it has 40 percent debt?
c. What are BEA’s WACC and total value of the firm with 40 percent debt?

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Optimal Capital Structure

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THANK YOU!