A B C D E

1 Tool Kit Chapter 15

2
3 Capital Structure Decisions
4
5
6 15-2 Business Risk and Financial Risk
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8
9 Operating Leverage reflects the amount of fixed costs embedded in a firm's operations. Thus, if a high percentage of a firm's costs are fixed,
continue even if sales decline, then the firm is said to have high operating leverage. High operating leverage produces a situation where a sm
10 in sales can result in a large change in operating profit. The following example compares two operational plans with different degrees of ope
11 leverage.
12
13
14 Figure 15-1
15 Illustration of Operating and Financial Leverage (Millions of Dollars and
16 Millions of Units, Except Per Unit Data)
17 1. Input Data Plan A Plan U Plan L
18 Required operating current assets $3 $3 $3
19 Required long-term assets $199 $199 $199
20 Resulting operating current liabilities $2 $2 $2
21 Total assets $202 $202 $202
22 Required capital (TA − Op. CL) $200 $200 $200
23 Book equity $200 $200 $150
24 Debt $0 $0 $50
25 Interest rate 8% 8% 8%
26 Sales price (P) $2.00 $2.00 $2.00
27 Tax rate (T) 40% 40% 40%
28 Expected units sold (Q) 110 110 110
29 Fixed costs (F) $20 $60 $60
30 Variable costs (V) $1.50 $1.00 $1.00
31 2. Income Statements Plan A Plan U Plan L
32 Sales revenue (P x Q) $220.0 $220.0 $220.0
33 Fixed costs 20.0 60.0 60.0
34 Variable costs (V x Q) 165.0 110.0 110.0
35 EBIT $35.0 $50.0 $50.0
36 Interest 0.0 0.0 4.0
37 EBT $35.0 $50.0 $46.0
38 Tax 14.0 20.0 18.4
Net income $21.0 $30.0 $27.6
39
40 3. Key Performance Measures Plan A Plan U Plan L
41 NOPAT = EBIT(1 − T) $21.0 $30.0 $30.0
42 ROIC = NOPAT/Capital 10.5% 15.0% 15.0%
43 ROA = NI/Total assets 10.4% 14.9% 13.7%
44 ROE = NI/Equity 10.5% 15.0% 18.4%
45
46 Note: ROA is not exactly equal to ROE for the Plan L or Plan U because total assets is not quite
47 equal to equity for these plans. This is because the operating current liabilities, such as accounts
48 payable and accruals, reduce the required capital investment of equity.
49
50 We can use the following formula to find the exact break-even quantity.
51 QBE = F ÷ (P-V)
52 Plan A
 A B C D E
53 QBE = F ÷ (P −
54 QBE = $20 ÷ $2.00 −
55 QBE = 40 Units.
56
57 Plan U
58 QBE = F ÷ (P −
59 QBE = $60 ÷ $2.00 −
60 QBE = 60 Units.
61
62
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64
65
66
67 Figure 15-2
68 Operating Leverage and Financial Leverage
69
70 Panel a: Operating Leverage Panel b: Finacial Leverage
71 ROE
ROA
72
73
40.0% 40.0%
74
75
76 30.0% Crossover at 80 30.0% Crossover at 76
77 Million Units Million Units
78
79 20.0% 20.0%
80
81 Plan A Plan U
82 10.0% Break-even Q 10.0%
Break-even Q
83
84
85 0.0% 0.0%
86 Units Sold
Units Sold
87 (Millions) -10.0% (Millions)
-10.0%
88
89 Plan U Plan L
Break-even Q Break-even Q
90 -20.0% -20.0%
91
92
93 -30.0% -30.0%
94 0 20 40 60 80 100 120 140 0 20 40 60 80 100 120 140
95
96
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 A B C D E
98 FINANCIAL RISK AND LEVERAGE
99
100 Leverage magnifies the ROE. See Panel b of Figure 15-2 above.
101
102
103 15-5 Estimating the Optimal Capital Structure
104
105
106 Figure 15-4
107 Strasburg’s Current Value and Capital Structure (Millions of Dollars Except
108 Per Share Data)
109 Input Data: Capital Structure:
110 Tax rate 40.00% Market value of equity (S = P x n) $200
111 Debt (D) $50.00 Total value (V = D + S) $250
112 # of shares (n) 10.00 % financed with debt (wd = D/V) 20%
113 Stock price (P) $20.00 % financed with stock (ws = S/V) 80%
114 NOPAT $30.00
115 Free Cash Flow (FCF)a $30.00
116 Growth rate in FCFa 0.00%
117 Cost of Capital: Estimated Intrinsic Value:
118 Cost of debt (rd) 8.00% Value of operations:
119 Beta (b) 1.25 Vop = [FCF(1+g)]/(WACC−g) $250.00
120 Risk-free rate (rRF) 6.30% + Value of ST investments $0.00
121 Mkt. risk prem. (RPM) 6.00% Estimated total intrinsic value $250.00
122 Cost of equity: − Debt $50.00
123 rs = rRF + b(RPM ) 13.80% Estimated intrinsic value of equity $200.00
124 WACC 12.00% ÷ Number of shares 10.00
125 Estimated intrinsic price per share $20.00
126 Note:
127 a
Strasburg's sales, earnings, and assets are not growing, so it does not need investments in
128 operating capital. Therefore, FCF = NOPAT(1 −T). The growth in FCF also is 0.
129
130
131
132
The optimal capital structure is the one that maximizes the value of the company. Also, that same capital structure minimizes the WACC.
133 We begin by estimating how capital structure affects the costs of debt and equity. The effects on debt are usually estimated by talking
134 with bankers and investment bankers. Discussions with its bankers indicate that Strasburg can borrow different amounts, but the more
135 it borrows, the higher the cost of its debt. Note: the percentages are based on market values.
136
137
138 Figure 15-5
139 Estimating Strasburg's Optimal Capital Structure (Millions of Dollars)
140 Percent of Firm Financed with Debt (w
141 0% 10% 20% 30%
142 1. ws 100.00% 90.00% 80.00% 70.00%
143 2. rd 7.70% 7.80% 8.00% 8.50%
144 3. b 1.09 1.16 1.25 1.37
145 4. rs 12.82% 13.26% 13.80% 14.50%
146 5. rd (1−T) 4.62% 4.68% 4.80% 5.10%
147 6. WACC 12.82% 12.40% 12.00% 11.68%
 A B C D E
148 7. Vop $233.98 $241.96 $250.00 $256.87
149 8. Debt $0.00 $24.20 $50.00 $77.06
150 9. Equity $233.98 $217.76 $200.00 $179.81
151 10. # Shares 12.72 11.34 10.00 8.69
152 11. Stock price $18.40 $19.20 $20.00 $20.69
153 12. Net income $30.00 $28.87 $27.60 $26.07
154 13. EPS $2.36 $2.54 $2.76 $3.00
155
156 Notes: 1. The percent financed with equity is: w s = 1 − wd
157 2. The interest rate on debt, rd, is obtained from investment bankers.
158 3. The levered beta is estimated using Hamada's formula, and unlevered beta of b
159 and a tax rate of 40%: b = bU [1 + (1-T) (wd/ws)].
160 4. The cost of equity is estimated using the CAPM formula with a risk-free
161 rate of 6. 3% and a market risk premium of 6%: r s = rRF + (RPM)b.
162 5. The after-tax cost of debt is r d (1−T), where T = 40%.
163 6. The weighted average cost of capital is calculated as:
164 WACC = ws rs + wd rd (1-T).
165 7. The value of the firm's operations is calculated as:
166 Vop = [FCF(1+g)] / (WACC − g), where FCF = $30 million and g = 0.
167 8. Debt = wd x Vop
168 9. The equity after the recap & repurchase is S Post = Vop − Debt = ws x Vop
169 10. The number of shares after the recap has been completed is found using:
170 nPost = nPrior [(VopNew - DNew) / (VopNew-DOld)]. The subscript "Old" indicates values
171 from the original capital structure where w d = 20%, the subscript "New" indicates values
172 at the current capital structure after the recap & repurchase, and the subscript "Post"
173 indicates values after the recap & repurchase.
174 11. The price after the recap & repurchase is: P Post = SPost/nPost. But we can also find the
175 price as: PPost = (VopNew − DOld)/nPrior.
176 12. EBIT is $50 million; see Figure 15-1. Net income is: NI = (EBIT − r dD)(1 − T).
177 13. Earnings per share is: EPS = NI/nPost.
178
179
180
181
182
183 THE HAMADA EQUATION
184 Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different am
185 financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. He
186 Hamada equation:
 A B C D E
187
188 b = bU x [1 + (1-T) x (D/S)]
189 b = bU x [1 + (1-T) x (wd/ws)]
190 bU = b / [1 + (1-T) x (wd/ws)]
191
192 Here b is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax rate, D is the market value of the
193 is the market value of the equity.
194
195 Levered beta, b 1.25
196 Current wd 20%
197 Current w s 80%
198 Tax rate 40%
199
200 bU 1.0870
201
202 As shown above, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity.
203
204
205 Data for Figure 15-6
206 wd 0% 10% 20% 30%
207 rRF 6.30% 6.30% 6.30% 6.30%
208 rUnlevered-rRF 6.52% 6.52% 6.52% 6.52%
209 rs-rUnlevered-rRF 0.00% 0.43% 0.98% 1.68%
210 For graph 0.00% 0.00% 0.00% 0.00%
211
212 Figure 15-6
213 Strasburg’s Required Rate of Return on Equity at Different Debt Levels
214
215 Required
216 Return on
217 Equity
218 20%
219
220 18% rs
221 Premium for
222 16%
Financial Risk:
223 14%
224 (b − bU) x RPM
225 12%
226
227 10% Premium for
228 Business Risk:
229 8% bU x RPM = 6.52%
230 6%
231
232 4%
233
234 2%
235
236 0%
237 0% 10% 20% 30% 40% 50% 60%
238 Percent Financed with Debt
239
 4%
2%
0%
0% 10% 20% 30% 40% 50% 60%
Percent Financed with Debt
A B C D E
240
241
242
243
244 Figure 15-7
245 Effects of Capital Structure on Cost of Capital
246
247
248 Cost of Capital
249 20%
250
251
252
253 15%
254
255
256
257 10%
258
259
260
261 5%
262
263
264
265 0%
266 -10% 0% 10% 20% 30% 40% 50% 60%
267
268 Percent Financed with Debt
269
270
271
272
273
274 Data for Figure below
275 wd 0% 10% 20% 30%
276 Vop $233.98 $241.96 $250.00 $256.87
277 Debt $0.00 $24.20 $50.00 $77.06
278 Equity (S) $233.98 $217.76 $200.00 $179.81
279 V for chart $0.00 $0.00 $0.00 $0.00
280
281
282 Figure 15-8
283 Effects of Capital Structure on the Value of Operations
284
285
286
287
288 $275
289
290 $250
291 $225
292
$200
$175
$150
$125
$100
$75
$50
$25
$0
0% 10% 20% 30% 40% 50% 60%
Percent Financed with Debt
 $275
$250
$225
A B C D E
$200
293
294 $175
295 $150
296
297 $125
298 $100
299 $75
300
301 $50
302 $25
303
$0
304
305 0% 10% 20% 30% 40% 50% 60%
306 Percent Financed with Debt
307
308
309
310
311 15-6 Anatomy of a Recapitalization
312
313
314 Strasburg will issue additional debt and use the proceeds to repurchase stock. This is a recapitalization, often called a "recap." When
315 Strasburg announces its planned recapitalization, investors realize that the company will be worth more after the recap because it will
316 have a lower cost of capital. Therefore, the stock price will increase when the plans are announced, even though the actual repurchase
has not yet occurred. If the stock price did not increase until after the actual repurchase, it would be possible for an investor to buy the
317 stock immediately prior to the repurchase, and then reap a reward the next day when the repurchase occurred. Curent stockholders
318 realize this, and refuse to sell the stock unless they are paid the price that is expected immediately after the repurchase occurs.
319
320
321 Figure 15-9
322 Anatomy of a Recapitalization (Millions, Except Per Share Data)
323
324
325 Before Issuing After Debt Issue, but Post
326 Additional Debt Prior to Repurchase Repurchase
327 (1) (2) (3)
328
329 Percent financed with debt: wd 20% 40% 40%
330
331 Value of operations $250.00 $257.86 $257.86
332 + Value of ST investments 0.00 53.14 0.00
333 Estimated total intrinsic value $250.00 $311.00 $257.86
334 − Debt 50.00 103.14 103.14
335 Estimated intrinsic value of equity $200.00 $207.86 $154.72
336 ÷ Number of shares 10.00 10.00 7.44
337 Estimated intrinsic price per share $20.00 $20.79 $20.79
338
339 Value of stock $200.00 $207.86 $154.72
340 + Cash distributed in repurchase 0.00 0.00 53.14
341 Wealth of shareholders $200.00 $207.86 $207.86
342
343 Notes: 1. The value of ST investments in Column 2 is equal to the amount of cash raised by
344 issuing additional debt but that has not been used to repurchase shares:
ST investments = DNew − DOld.
 1. The value of ST investments in Column 2 is equal to the amount of cash raised by
A B additional debt
issuing C but that has not been
D used to repurchase E shares:
345 ST investments = DNew − DOld.
346 2. The value of ST investments in Column 3 is zero because the funds have been
347 used to repurchase shares of stock.
348 3. The number of shares in Column 3 reflects the shares repurchased:
349 nPost = nPrior − (CashRep/PPrior) = nPrior − ([DNew − DOld]/PPrior).
350
351
352 Figure 15-10
353 Effect of Capital Structure on Intrinsic Stock Price and Earnings per Share
354
355
356
357
358 Stock Price EPS
359 $25 Price $6
360
361
362 $20
363 $4
364 $15
365
366 $10
367 EPS $2
368 $5
369
370
371 $0 $0
372 -10% 0% 10% 20% 30% 40% 50% 60%
373 Percent Financed with Debt
374
375
376
377
378
379 Shortcut Formulas Applied to Change in Capital Structure: w d Prior = 20%, wd Post = 40%
380
381 Inputs:
382 wd = 40%
383 V opNew
= $257.86
384 nPrior = 10.00
385 DNew = $103.14
386 DOld = $50.00
387
388
389 Shortcuts:
390 SPost = VopNew (1-wd) = $154.72
391 nPost
= n Prior
(V opNew
- D New
) / (VopNew - DOld) = 7.44
392 PPost = (VopNew - DOld) / nPrior = $20.79
 F G H I
1 12/9/2012
2
ructure Decisions 3
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rm's operations. Thus, 9
if a high percentage of a firm's costs are fixed, hence
ing leverage. High operating leverage produces a situation where a small change
10
example compares two operational plans with different degrees of operating
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y. 50
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 F G H I
53 V)
54 $1.50
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58 V)
59 $1.00
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69
70Leverage
Panel b: Finacial
ROE
71
72
73
40.0%
74
75
30.0% 76 Crossover at 76
77 Million Units
78
20.0% 79
80
81
Plan U
10.0% 82 Q
Break-even
83
84
0.0% 85
86 Units Sold
-10.0%
87 (Millions)
88
89 Plan L
Break-even Q
-20.0% 90
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-30.0% 93
0 20 94 40 60 80 100 120 140
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 F G H I
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132
e company. Also, that same capital structure minimizes the WACC.
and equity. The effects133
on debt are usually estimated by talking
134borrow different amounts, but the more
dicate that Strasburg can
sed on market values.135
136
137
138
139
of Firm Financed with140
Debt (w d)
141 40% 50% 60%
142 60.00% 50.00% 40.00%
143 9.90% 12.00% 16.00%
144 1.52 1.74 2.07
145 15.43% 16.73% 18.69%
146 5.94% 7.20% 9.60%
147 11.63% 11.97% 13.24%
 F G H I
148 $257.86 $250.68 $226.65
149 $103.14 $125.34 $135.99
150 $154.72 $125.34 $90.66
151 7.44 6.25 5.13
152 $20.79 $20.07 $17.66
153 $23.87 $20.98 $16.95
154 $3.21 $3.36 $3.30
155
156
157
mada's formula, and unlevered 158 beta of b U = 1.09,
(wd/ws)]. 159
e CAPM formula with a160 risk-free
m of 6%: r s = rRF + (RPM161 )b.
162
calculated as: 163
164
culated as: 165
F = $30 million and g =166 0.
167
e is S Post = Vop − Debt = w 168
s
x Vop
169
as been completed is found using:
The subscript "Old" indicates170 values
e w d = 20%, the subscript 171"New" indicates values
recap & repurchase, and 172the subscript "Post"
chase. 173
is: P Post = SPost/nPost. But174
we can also find the
175
t income is: NI = (EBIT176 − r dD)(1 − T).
177
178
179
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181
182
183
iani-Miller model. We184 use the model to determine beta at different amount of
bt ratios to find the cost 185
of equity associated with those debt ratios. Here is the
186
 F G H I
187
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192
it used no debt, T is the marginal tax rate, D is the market value of the debt, and S
193
194
195
196
197
198
199
200
201
d, we can determine the 202
effects of leverage on the cost of equity.
203
204
205
206 40% 50% 60%
207 6.30% 6.30% 6.30%
208 6.52% 6.52% 6.52%
209 2.61% 3.91% 5.87%
210 0.00% 0.00% 0.00%
211
212
213
214
215
216
217
218
219
220
221 Premium for
222 Financial Risk:
223
224 (b − bU) x RPM
225
226
227 Premium for
228 Business Risk:
229 bU x RPM = 6.52%
230
231
232
233 Risk-Free
234 Rate: rRF =
235
236 6.3%
0% 50% 60%
237
Financed with Debt 238
239
0% 50% 60%
Financed with Debt
F G H I
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50% 60%
266
267
anced with Debt 268
269
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272
273
274
275 40% 50% 60%
276 $257.86 $250.68 $226.65
277 $103.14 $125.34 $135.99
278 $154.72 $125.34 $90.66
279 $0.00 $0.00 $0.00
280
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292

40% 50% 60%

ent Financed with Debt
 F G H I
293
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302
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304
40% 50% 305 60%
ent Financed with Debt 306
307
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314
e stock. This is a recapitalization, often called a "recap." When
at the company will be315
worth more after the recap because it will
hen the plans are announced, even though the actual repurchase
316 be possible for an investor to buy the
actual repurchase, it would
317
e next day when the repurchase occurred. Curent stockholders
318 after the repurchase occurs.
hat is expected immediately
319
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343
2 is equal to the amount of cash raised by
en used to repurchase344shares:
 F G H I
345
346 have been
3 is zero because the funds
347
348
cts the shares repurchased:
w
− DOld]/PPrior). 349
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 J K L M N O
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69 Data Table for Figure
70 x-axis for both ROA for Panel a ROE for panel b
71 panels. Plan A Plan U Plan U Plan L
72 Q 10.4% 14.9% 15.0% 18.4%
73 0 -18.0% -25.6%
74 20 -12.0% -17.6%
75 40 -6.0% -9.6%
76 60 0.0% -1.6%
77 64 1.2% 0.0%
78 76 4.8% 4.8%
79 80 6.0% 6.4%
80 100 12.0% 14.4%
81 120 18.0% 22.4%
82 140 24.0% 30.4%
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SECTION 15-2
SOLUTIONS TO SELF-TEST

A firm has fixed operating costs of $100,000 and variable costs of $4 per unit. If it sells the
product for $6 per unit, what is the breakeven quantity?

F= $100,000
V= $4
P= $6

QBE 50,000
SECTION 15-5
SOLUTIONS TO SELF-TEST

Use the Hamada equation to calculate the unlevered beta for JAB Industries, assuming the
following data: bL = 1.4; T = 40%; wd = 45%.

bL 1.4
Tax rate 40%
wd 45%

Equity ratio 0.55

bU 0.9390

Suppose rRF = 6% and RPM = 5%. What would the cost of equity be for JAB Industries if it has
no debt? If wd is 45%?

rRF 6%
RPM 5%

No debt:
From 5, bu = 0.9390
rs,U 10.70%

Debt 1.00
From 5, bL = 1.40
rs,L 13.00%
SECTION 15-6
SOLUTIONS TO SELF-TEST

A firm’s value of operations is equal to $800 million after a recapitalization (the firm had no
debt before the recap). It raised $200 million in new debt and used this to buy back stock. The
firm had no short-term investments before or after the recap. After the recap, w d = 25%. The
firm had 10 million shares before the recap. What is S (the value of equity after the recap)?
What is P (the stock price) after the recap? What is n (the number of remaining shares) after
the recap?

Vop $800
D $200
wd 25%
n0 10

S= $600

P= $80.00

n= 7.5