CAPITAL STRUCTURE

DECISIONS

Reference: Brigham and Ehrhardt

and (2020), 16th ed. Chap. 15

D.Duressa revised 2022 1

Topics covered
 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
 Choosing the optimal structure

D.Duressa revised 2022 2

What is goal of the firm?
 Maximize Firm Value
 Maximize Profits
 Minimize WACC
 Maximize ROIC (return on Invested
capital)
 MAXIMIZE SHAREHOLDER WEALTH

D.Duressa revised 2022 3

Goal of the Firm is
 Maximize Firm Value
 Minimize WACC
 by :
 Lowering risk
 Increasing CFs
 Maximize Operating Profits
 Growth of Business
 Reduce Taxes (to increase free cash flows)

D.Duressa revised 2022 4

Capital structure defined
 Capital Structure: The combination of
debt and equity used to finance a firm
 Target Capital Structure: The ideal mix
of debt, preferred stock, and common
equity with which the firm plans to
finance its investments
 Firms establish target capital structure
at which value of the firm is maximized
D.Duressa revised 2022 5
 Factors Affecting Capital
Structure:
 Business Risk
 Debt’s tax deductibility
 Ability to raise capital under adverse terms
 Managerial decisions:
 Conservative vs. Aggressive
 Minimize WACC by
 Lowering risk
 Increasing CFs
 Maximize Operating Profits
 Growth of Business
 Reducing Taxes effects
D.Duressa revised 2022 6
Basic terms

 V = value of the firm

 FCF = free cash flows
 WACC = weighted average cost of
capital
 rs and rd are costs of stock and debt,
respectively
 ws and wd are weight of the firm that
are financed with stock and debt.
D.Duressa revised 2022 7
How can capital structure
affect value?

∞ FCFt
V = ∑
t=1 (1 + WACC)t

WACC= wd (1-T) rd + wsrs

D.Duressa revised 2022 8
A Preview of Capital Structure
Effects
 The impact of capital structure on value
depends upon the effect of debt on:
 WACC
 FCF

(Continued…)
D.Duressa revised 2022 9
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 (less certain)
 As result Cost of stock, rs, goes up.
 Firm’s can deduct interest expenses.
 As result reduces amount of taxes paid
 Frees up more cash for payments to investors
(both debt-holders and stockholders)
 Consequently reduces after-tax cost of debt
D.Duressa revised 2022 10
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. Why?
 WACC= wd (1-T) rd revised
D.Duressa
+ w2022srs 11
Continued, The Effect of Additional Debt
on FCF

 Additional debt increases the probability

of bankruptcy, risk of bankruptcy
reduces free cash flows
 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

D.Duressa revised 2022 12

Continued
 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…)
D.Duressa revised 2022 13
Cont’d, bankruptcy risk affects
agency cost
 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.

D.Duressa revised 2022 14

Cont’d, Asymmetric Information
and Signaling
 Managers know the firm’s future prospects
better than investors.
 Managers would not issue additional equity
if they thought the current stock price was
less than the true value of the stock (given
their inside information).
 Hence, investors often perceive an
additional issuance of stock as a negative
signal, (i.e, there is an overvaluation of
stocks) and the stock price falls*.
D.Duressa revised 2022 15
Business Risk: Uncertainty in
EBIT, NOPAT, and ROIC
 Recall earlier under risk and return, we
defined risk from the perspective stock
investor we identified risk as
 Market risk measured by firms beta

coefficient,
 Stand alone risk which includes elements

both diversifiable, and market risk

 We shall now see two different dimensions of
risk, business risk and financial risk
D.Duressa revised 2022 16
Cont’d
 Business risk is risk of the form’s stock
if it uses no debt
 Financial risk is additional risk placed
on the common stockholders as result
of firms' decision to use debt

D.Duressa revised 2022 17

Cont’d, business risk Uncertainty in EBIT,
NOPAT, and ROIC, causes
 Demand variability, Uncertainty about demand (unit sales).
 Sales price variability, Uncertainty about output prices.
 Input cost variability, Uncertainty about input costs.
 Ability to adjust output prices, can the firm change price to
reflect cost conditions
 Ability to develop new products when product become
obsolete
 Foreign risk exposure (overseas transaction involving
foreign exchange risk)
 Degree of operating leverage (DOL). Degree to which
costs are fixed
D.Duressa revised 2022 18
What is operating leverage, and how
does it affect a firm’s 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.

(More...)

D.Duressa revised 2022 19

Higher operating leverage leads to more
business risk: small sales decline causes a
larger EBIT decline.

Rev. Rev.
$ $
TC } EBIT
TC

F
F

QBE Sales Sales

QBE
(More...)
D.Duressa revised 2022 20
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...)
D.Duressa revised 2022 21
Compare plans A and B
 leverage calculation.xlsx

D.Duressa revised 2022 22

 Plan A, Fixed cost =Birr 200

Quantity sold Fixed cost , birr Total cost , birr Revenues, birr
20 200 400 300
30 200 500 450
40 200 600 600
60 200 800 900
80 200 1000 1200
100 200 1200 1500
120 200 1400 1800
D.Duressa revised 2022 23
 Plan B, Fixed cost=Birr 400
Total cost,
Quantity Fixed cost, Birr Birr Revenues, birr
20 400 600 300
30 400 700 450
40 400 800 600
60 400 1000 900
80 400 1200 1200
100 400 1400 1500
120 400 1600 1800
D.Duressa revised 2022 24
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.

D.Duressa revised 2022 25

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%

D.Duressa revised 2022 26

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% 11.4%

ROE (NI/Equity) 9.0% 10.8%
D.Duressa revised 2022 27
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.
D.Duressa revised 2022 28
Impact of Leverage on
Returns 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%
D.Duressa revised 2022
4.8% 29
Impact of Leverage on
Returns 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%
D.Duressa revised 2022
16.8% 30
Capital Structure Theory
 MM theory
 Zero taxes
 Corporate taxes
 Corporate and personal taxes
 Trade-off theory
 Signaling theory
 Pecking order
 Debt financing as a managerial constraint
 Windows of opportunity
D.Duressa revised 2022 31
Modigliani-Miller (MM) Theory:
Zero Taxes
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200

NI $3,000 $1,800

CF to shareholder $3,000 $1,800

CF to debtholder 0 $1,200
Total CF $3,000 $3,000
Notice that the total CF are identical for both firms.
D.Duressa revised 2022 32
MM Results: Zero Taxes
 MM assume:
 (1) no transactions costs;
 (2) no restrictions or costs to short sales; and
 (3) individuals can borrow at the same rate as
corporations.
 MM prove that if the total CF to investors of Firm U
and Firm L are equal, then arbitrage is possible
unless the total values of Firm U and Firm L are
equal:
 VL = VU .
 Because FCF and values of firms L and U are equal,
their WACCs are equal.
D.Duressa revised 2022 33
 Therefore, capital structure is irrelevant.
 MM Theory: Corporate Taxes
 Corporate tax laws allow interest to be
deducted, which reduces taxes paid by
levered firms.
 Therefore, more CF goes to investors and
less to taxes when leverage is used.
 In other words, the debt “shields” some
of the firm’s CF from taxes.

D.Duressa revised 2022 34

 MM Result: Corporate Taxes
 MM show that the total CF to Firm L’s investors
is equal to the total CF to Firm U’s investor plus
an additional amount due to interest
deductibility:

CFL = CFU + rdDT.
 What is value of these cash flows?

Value of CFU = VU

MM show that the value of rdDT = TD

Therefore, VL = VU + TD.
 If T=40%, then every dollar of debt adds 40
cents of extra value to firm.
D.Duressa revised 2022 35
 MM relationship between value and debt
when corporate taxes are considered.
Value of Firm, V

VL
TD
VU

Debt
0

Under MM with corporate taxes, the firm’s value

increases continuously as more and more debt is used.
D.Duressa revised 2022 36
Miller’s 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.

D.Duressa revised 2022 37

Miller’s Model with Corporate
and Personal Taxes

(1 - Tc)(1 - Ts)
VL = VU + 1− D
(1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.

D.Duressa revised 2022 38

 Tc = 40%, Td = 30%,
and Ts = 12%.

(1 - 0.40)(1 - 0.12)
VL = VU + 1− D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.

Value rises with debt; each $1 increase in

debt raises L’s value by $0.25.
D.Duressa revised 2022 39
Conclusions with Personal
Taxes
 Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.
 Firms should still use 100% debt.
 Note: However, Miller argued that in
equilibrium, the tax rates of marginal
investors would adjust until there was
no advantage to debt.

D.Duressa revised 2022 40

Trade-off Theory
 MM theory ignores bankruptcy (financial
distress) costs, which increase as more
leverage is used.
 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.

D.Duressa revised 2022 41

 Tax Shield vs. Cost of Financial
Distress
Tax Shield
Value of Firm, V

VL
VU

0 Debt

Distress Costs
D.Duressa revised 2022 42
Signaling Theory
 MM assumed that investors and managers
have the same information.
 But, managers often have better information.
Thus, they would:
 Sell stock if stock is overvalued.
 Sell bonds if stock is undervalued.
 Investors understand this, so view new stock
sales as a negative signal.
 Implications for managers?

D.Duressa revised 2022 43

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 more funds are needed, firms then
issue equity.
D.Duressa revised 2022 44
Debt Financing and Agency
Costs
 One agency problem is that managers
can use corporate funds for non-value
maximizing purposes.
 The use of financial leverage:
 Bonds “free cash flow.”
 Forces discipline on managers to avoid
perks and non-value adding acquisitions.
(More...)
D.Duressa revised 2022 45
Cont’d
 A second agency problem is the
potential for “underinvestment”.
 Debt increases risk of financial distress.
 Therefore, managers may avoid risky
projects even if they have positive NPVs.

D.Duressa revised 2022 46

Investment Opportunity Set and
Reserve Borrowing Capacity
 Firms with many investment
opportunities should maintain reserve
borrowing capacity, especially if they
have problems with asymmetric
information (which would cause equity
issues to be costly).

D.Duressa revised 2022 47

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.”
 They issue short-term debt when the term
structure is upward sloping and long-term
debt when it is relatively flat.
D.Duressa revised 2022 48
Empirical Evidence
 Tax benefits are important– $1 debt
adds about $0.10 to value.
 Bankruptcies are costly– costs can be
up to 10% to 20% of firm value.
 Firms don’t make quick corrections
when stock price changes cause their
debt ratios to change– doesn’t support
trade-off model.
D.Duressa revised 2022 49
Empirical Evidence (Continued)
 After big stock price run ups, debt ratio falls,
but firms tend to issue equity instead of
debt.
 Inconsistent with trade-off model.
 Inconsistent with pecking order.
 Consistent with windows of opportunity.
 Many firms, especially those with growth
options and asymmetric information
problems, tend to maintain excess
borrowing capacity.
D.Duressa revised 2022 50
Implications for Managers
 Take advantage of tax benefits by
issuing debt, especially if the firm has:
 High tax rate
 Stable sales
 Low operating leverage

D.Duressa revised 2022 51

Implications for Managers
(Continued)
 Avoid financial distress costs by
maintaining excess borrowing capacity,
especially if the firm has:
 Volatile sales
 High operating leverage
 Many potential investment opportunities
 Special purpose assets (instead of general
purpose assets that make good collateral)
D.Duressa revised 2022 52
Implications for Managers
(Continued)
 If manager have asymmetric
information regarding firm’s future
prospects, then avoid issuing equity if
actual prospects are better than the
market perceives.
 Always consider the impact of capital
structure choices on lenders’ and rating
agencies’ attitudes
D.Duressa revised 2022 53
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%.

D.Duressa revised 2022 54

Current Value of Operations
 Expected FCF = $30 million.
 Firm expects zero growth: g = 0.
 Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.12 − 0)
Vop = $250 million.

D.Duressa revised 2022 55

Other Data for Valuation
Analysis
 Company has no Short Term
investments (ST investment).
 Company has no preferred stock.
 100,000 shares outstanding

D.Duressa revised 2022 56

Current Valuation Analysis
Vop $250
+ ST Inv. 0
VTotal $250
− Debt 0
S $250
÷n 10
P $25.00

D.Duressa revised 2022 57

 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.

D.Duressa revised 2022 58

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)]

D.Duressa revised 2022 59

 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%
D.Duressa revised 2022 60
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.
D.Duressa revised 2022 61
 Beta, rs, and WACC
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%

The WACC is minimized for wd = 30%. This is the optimal

capital structure.

D.Duressa revised 2022 62

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.
D.Duressa revised 2022 63
 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%.

D.Duressa revised 2022 64
 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
D.Duressa revised 2022 65
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.

D.Duressa revised 2022 66

 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 revised 2022
D.Duressa $265.96 67
After Issuing Debt, Before
Repurchasing Stock
 Stock price increases from $25.00 to
$26.60.
 Wealth of shareholders (due to
ownership of equity) increases from
$250 million to $265.96 million.

D.Duressa revised 2022 68

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.

D.Duressa revised 2022 69

 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).
D.Duressa revised 2022 70
 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 revised 2022
D.Duressa $265.96 $265.96 71
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.

D.Duressa revised 2022 72

 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
D.Duressa revised 2022 73
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.

D.Duressa revised 2022 74

 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).
D.Duressa revised 2022 75
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

D.Duressa revised 2022 76

Calculating PPost, the Stock
Price after a Recap
 At wd = 20%:
 PPost = (VopNew−DOld)/nPrior
nPost = ($265.96 −$0)/10
nPost = $26.60

D.Duressa revised 2022 77

 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.

D.Duressa revised 2022 78

 Firm U: Unleveraged

Economy
Bad Avg. Good
Prob. 0.25 0.50 0.25
EBIT $2,000 $3,000 $4,000
Interest 0 0 0
EBT $2,000 $3,000 $4,000
Taxes (40%) 800 1,200 1,600
NI $1,200 $1,800 $2,400
 Firm L: Leveraged

Economy
Bad Avg. Good
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
D.Duressa revised 2022 80
 Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%

8
8

8
TIE
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROI* 8.4% 11.4% 14.4%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
*ROI = (NI + Interest)/Total financing.
D.Duressa revised 2022 81
Profitability Measures:
U L
E(BEP) 15.0% 15.0%
E(ROI) 9.0% 11.4%
E(ROE) 9.0% 10.8%
Risk Measures:
ROE 2.12% 4.24%
CVROE 0.24 0.39
8
E(TIE) 2.5x
D.Duressa revised 2022 82
Conclusions
 Basic earning power = BEP = EBIT/Total
assets is unaffected by financial leverage.
 L has higher expected ROI and ROE
because of tax savings.
 L has much wider ROE (and EPS) swings
because of fixed interest charges. Its
higher expected return is accompanied
by higher risk.
(More...)
D.Duressa revised 2022 83
 In a stand-alone risk sense, Firm L’s
stockholders see much more risk than
Firm U’s.
 U and L: ROE(U) = 2.12%.
 U: ROE = 2.12%.
 L: ROE = 4.24%.
 L’s financial risk is ROE - ROE(U) = 4.24%
- 2.12% = 2.12%. (U’s is zero.)
(More...)
D.Duressa revised 2022 84
 Cont’d
 For leverage to be positive (increase
expected ROE), BEP must be > kd.
 If kd > BEP, the cost of leveraging will be
higher than the inherent profitability of the
assets, so the use of financial leverage will
depress net income and ROE.
 In the example, E(BEP) = 15% while interest
rate = 12%, so leveraging “works.”

D.Duressa revised 2022 85

The Optimal Capital Structure
 Calculate the cost of equity at each level of
debt.
 Calculate the value of equity at each level
of debt.
 Calculate the total value of the firm (value
of equity + value of debt) at each level of
debt.
 The optimal capital structure maximizes
the total value of the firm.
D.Duressa revised 2022 86
Cost of Equity at Zero Debt
 Since the firm has 0 growth, its current
value, $2,000,000, is given by

Dividends/kS = (EBIT)(1-T)/kS
= 500,000 (1 - 0.40)/k S

 kS = 15.0% = unlevered cost of equity.

 bU = (kS - kRF)/RPM = (15 - 6)/4 = 2.25

D.Duressa revised 2022 87
Cost of Equity at Each Debt
Level
 Hamada’s equation says that
bL = bU (1 + (1-T)(D/E))

Debt(000s) D/E bL kS
0 0 2.25 15.00%
250 0.142 2.44 15.77
500 0.333 2.70 16.80
750 0.600 3.06 18.24
1,000 1.000 3.60 20.40
D.Duressa revised 2022 88
Value of Equity at Each Debt
Level
 Equity Value = Dividends/kS

Debt(000s) kD Divs kS E
0 na 300 15.00% 2,000
250 10% 285 15.77 1,807
500 11% 267 16.80 1,589
750 13% 241.5 18.24 1,324
1,000 16% 204 20.40 1,000

D.Duressa revised 2022 89

 Total Value of Firm

Debt Total Price per

(000s) E Value Share
0 2,000 2,000 $20.00
250 1,807 2,057 20.57 Total Value
500 1,589 2,089 20.89 is Max-
750 1,324 2,074 20.74 imized with
1,000 1,000 2,000 20.00
500,000 in
debt.
D.Duressa revised 2022 90
Calculate EPS at debt of $0, $250K, $500K, and
$750K, assuming that the firm begins at zero
debt and recapitalizes to each level in a single
step.

Net income = NI = [EBIT - kd D](1 - T).

EPS = NI/n.

D NI n EPS
$ 0 $300 100.00 $3.00
250 285 87.85 3.24
500 267 76.07 3.51
750 242 63.84 3.78
D.Duressa revised 2022 91
 EPS continues to increase beyond the
$500,000 optimal debt level.
 Does this mean that the optimal debt
level is $750,000, or even higher?

D.Duressa revised 2022 92

 Find the WACC at each debt level.
D S V kd Ks WACC
$ 0 $2,000 $2,000 -- 15.00% 15.0%
250 1,807 2,057 10% 15.77 14.6
500 1,589 2,089 11.0 16.80 14.4
750 1,324 2,074 13.0 18.24 14.5
1,000 1,000 2,000 13.0 20.40 15.0
e.g. D = $250:
WACC = ($250/$2,057)(10%)(0.6)
+ ($1,807/$2,057)(15.77%)
= 14.6%.

D.Duressa revised 2022 93

 The WACC is minimized at D =
$500,000, the same debt level that
maximizes stock price.
 Since the value of a firm is the present
value of future operating income, the
lowest discount rate (WACC) leads to
the highest value.

D.Duressa revised 2022 94

 How would higher or lower
business risk affect
the optimal capital structure?

 At any debt level, the firm’s probability of

financial distress would be higher. Both kd
and ks would rise faster than before. The
end result would be an optimal capital
structure with less debt.
 Lower business risk would have the
opposite effect.
D.Duressa revised 2022 95
Is it possible to do an analysis exactly like the one above for most firms?

 No. The analysis above was based on

the assumption of zero growth, and
most firms do not fit this category.
 Further, it would be very difficult, if not
impossible, to estimate ks with any
confidence.

D.Duressa revised 2022 96

What type of analysis should firms conduct to help find their optimal, or
target, capital structure?

 Financial forecasting models can help

show how capital structure changes
are likely to affect stock prices,
coverage ratios, and so on.

(More...)
D.Duressa revised 2022 97
 Forecasting models can generate
results under various scenarios, but the
financial manager must specify
appropriate input values, interpret the
output, and eventually decide on a
target capital structure.
 In the end, capital structure decision
will be based on a combination of
analysis and judgment.

D.Duressa revised 2022 98

What other factors would managers consider when setting the target
capital structure?

 Debt ratios of other firms in the

industry.
 Pro forma coverage ratios at different
capital structures under different
economic scenarios.
 Lender and rating agency attitudes
(impact on bond ratings).
D.Duressa revised 2022 99
 Reserve borrowing capacity.
 Effects on control.
 Type of assets: Are they tangible, and
hence suitable as collateral?
 Tax rates.

D.Duressa revised 2022 100