Chapter 15

Capital Structure Decisions: Part I

ANSWERS TO END-OF-CHAPTER QUESTIONS

15-1 a. Capital structure is the manner in which a firms assets are financed; that is, the right-
hand side of the balance sheet. Capital structure is normally expressed as the
percentage of each type of capital used by the firm--debt, preferred stock, and
common equity. Business risk is the risk inherent in the operations of the firm, prior
to the financing decision. Thus, business risk is the uncertainty inherent in a total risk
sense, future operating income, or earnings before interest and taxes (EBIT).
Business risk is caused by many factors. Two of the most important are sales
variability and operating leverage. Financial risk is the risk added by the use of debt
financing. Debt financing increases the variability of earnings before taxes (but after
interest); thus, along with business risk, it contributes to the uncertainty of net income
and earnings per share. Business risk plus financial risk equals total corporate risk.

b. Operating leverage is the extent to which fixed costs are used in a firms operations.
If a high percentage of a firms total costs are fixed costs, then the firm is said to have
a high degree of operating leverage. Operating leverage is a measure of one element
of business risk, but does not include the second major element, sales variability.
Financial leverage is the extent to which fixed-income securities (debt and preferred
stock) are used in a firms capital structure. If a high percentage of a firms capital
structure is in the form of debt and preferred stock, then the firm is said to have a high
degree of financial leverage. The breakeven point is that level of unit sales at which
costs equal revenues. Breakeven analysis may be performed with or without the
inclusion of financial costs. If financial costs are not included, breakeven occurs
when EBIT equals zero. If financial costs are included, breakeven occurs when EBT
equals zero.

15-4 Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage has no
effect on EBIT--it only affects EPS, given EBIT.

15-5 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges
will also vary. Such a firm is said to have high business risk. Consequently, there is a
relatively large risk that the firm will be unable to meet its fixed charges, and interest
payments are fixed charges. As a result, firms in unstable industries tend to use less debt
than those whose sales are subject to only moderate fluctuations.

15-8 The tax benefits from debt increase linearly, which causes a continuous increase in the
firms value and stock price. However, financial distress costs get higher and higher as
more and more debt is employed, and these costs eventually offset and begin to outweigh
the benefits of debt.


16-4 The value of a growing tax shield is greater than the value of a constant tax shield.
This means that for a given initial level of debt a growing firm will have more value
from the debt tax shield than a non-growing firm. Thus for a given face value of
debt, D, and unlevered value of equity, U, a growing firm will have a smaller w
D
, a
larger levered cost of equity, r
eL
, and a larger WACC. So the MM model will
underestimate the value of the levered firm and its cost of equity and WACC.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

15-10 a. Present situation (50% debt):

WACC =w
d
r
d
(1-T) +w
ce
r
s

=(0.5)(10%)(1-0.15) +(0.5)(14%) =11.25%.

V =
1125 . 0
) 15 . 0 1 )( 24 . 13 ($
WACC
) T 1 )( EBIT (
WACC
FCF
=

= =$100 million.

70 percent debt:

WACC =w
d
r
d
(1-T) +w
ce
r
s

=(0.7)(12%)(1-0.15) +(0.3)(16%) =11.94%.

V =
1194 . 0
) 15 . 0 1 )( 24 . 13 ($
WACC
) T 1 )( EBIT (
WACC
FCF
=

= =$94.255 million.

30 percent debt:

WACC =w
d
r
d
(1-T) +w
ce
r
s

=(0.3)(8%)(1-0.15) +(0.7)(13%) =11.14%.

V =
1114 . 0
) 15 . 0 1 )( 24 . 13 ($
WACC
) T 1 )( EBIT (
WACC
FCF
=

= =$101.023 million.

15-11 a. BEAs unlevered beta is b
U
=b/(1+(1-T)(D/S))=1.0/(1+(1-0.40)(20/80)) =0.870.

b. b =b
U
(1 +(1-T)(D/S)).

At 40 percent debt: b
L
=0.87 (1 +0.6(40%/60%)) =1.218.
r
S
=6 +1.218(4) =10.872%

c. WACC =w
d
r
d
(1-T) +w
ce
r
s

=(0.4)(9%)(1-0.4) +(0.6)(10.872%) =8.683%.


V =
08683 . 0
) 4 . 0 1 )( 933 . 14 ($
WACC
) T 1 )( EBIT (
WACC
FCF
=

= =$103.188 million.

15-12 Tax rate =40% r
RF
=5.0%
b
U
=1.2 r
M
r
RF
=6.0%

From data given in the problem and table we can develop the following table:

w
d
w
ce
D/S r
d
r
d
(1 T)
Levered
beta
a
r
s
b
WACC
c

0.00 1.00 0.0000 7.00% 4.20% 1.20 12.20% 12.20%
0.20 0.80 0.2500 8.00 4.80 1.38 13.28 11.58
0.40 0.60 0.6667 10.00 6.00 1.68 15.08 11.45
0.60 0.40 1.5000 12.00 7.20 2.28 18.68 11.79
0.80 0.20 4.0000 15.00 9.00 4.08 29.48 13.10

Notes:
a
These beta estimates were calculated using the Hamada equation,
b =b
U
[1 +(1 T)(D/S)].
b
These r
s
estimates were calculated using the CAPM, r
s
=r
RF
+(r
M
r
RF
)b.
c
These WACC estimates were calculated with the following equation:
WACC =w
d
(r
d
)(1 T) +(w
ce
)(r
s
).

The firms optimal capital structure is that capital structure which minimizes the firms
WACC. Elliotts WACC is minimized at a capital structure consisting of 40% debt and
60% equity. At that capital structure, the firms WACC is 11.45%.

16-4 a. b
L
=b
U
[1 +(1 - T)(D/S)].

b
U
=
) S / D )( T 1 ( 1
b
L
+
=
) 5 . 0 / 5 . 0 )( 4 . 0 1 ( 1
8 . 1
+
=
6 . 1
8 . 1
=1.125.

b. r
sU
=r
RF
+(r
M
- r
RF
)b
U
=10% +(5%)1.125 =10% +5.625% =15.625%.

c. $2 Million Debt: V
L
=V
U
+TD =$10 +0.25($2) =$10.5 million.

r
sL
=r
sU
+(r
sU
- r
RF
)(1 - T)(D/S)
=15.625% +(15.625% - 10%)(0.75)($2/$8.5)
=15.625 +5.625% (0.75)($2/$8.5) =16.62%.

$4 Million Debt: V
L
=$10 +0.25($4) =$11.0 million.

r
sL
=15.625% +5.625%(0.75)($4/$7) =18.04%.

$6 Million Debt: V
L
=$10 +0.25($6) =$11.5 million.


r
sL
=15.625% +5.625% (0.75)($6/$5.5) =20.23%.

d. $6 Million Debt: V
L
=$8.0 +0.40($6) =$10.4 million.

r
sL
=15.625% +5.625%(0.60)($6/$4.4) =20.23%.

The mathematics of MM result in the required return, and, thus, the same financial
risk premium. However, the market value debt ratio has increased from $6/$11.5 =
52% to $6/$10.4 =58% at the higher tax rate. Hence, a higher tax rate reduces the
financial risk premium at a given market value debt/equity ratio. This is because a
higher tax rate increases the relative benefits of debt financing.

16-5 a. V
U
=
sU
r
EBIT
=
10 . 0
million 2 $
=$20 million.

b. r
sU
=10.0%. (Given)

r
sL
=r
sU
+(r
sU
- r
d
)(D/S) =10% +(10% - 5%)($10/$10) =15.0%.

c. S
L
=
sL
d
r
D r EBIT
=
15 . 0
) 10 ($ 05 . 0 2 $
=$10 million.

S
L
+D =V
L
=V
U
+TD.

$10 +$10 =$20 =V
L
=$20 +(0)$10 =$20 million.


d. WACC
U
=r
sU
=10%.

For Firm L, we know that WACC must equal r
sU
=10% according to Proposition I.
But, we can demonstrate this as follows:

WACC
L
=(D/V)r
d
+(S/V)r
s
=($10/$20)5% +($10/$20)15%
=2.5% +7.5% =10.0%.


e. V
L
=$22 million is not an equilibrium value according to MM. Heres why.
Suppose you owned 10 percent of Firm Ls equity, worth 0.10($22 million - $10
million) =$1.2 million. Your cash flow is equal to 10% of the dividends paid by the
levered firm. Because it is a zero-growth firm, its dividends are equal to its net
income: Dividends =Net income =EBIT r
d
D = $2,000,000 0.05($1,000,000) =
$1,500,000. Your 10% share is 0.10($1,500,000) =$150,000. Therefore, your annual
cash flow is $150,000.
Now consider the following strategy. You could (1) sell your stock in firm L for
0.10($2 million) =$1.2 million. Then you could borrow an amount (at 5%) equal to
10 percent of Firm Ls debt, or 0.10($10 million) =$1 million. You would have $1.2
million +$1 million =$2.2 million. You could spend $2 million of this to buy 10% of
Firm Us stock, and invest the remaining $200,000 in risk-free debt.
Your cash stream would now be: (a) 10 percent of firm Us diviedends, which is
$200,000: 0.10(EBIT
U
) =0.10($2 million) =$200,000; plus (b) the return on the
extra $200,000 profit you invested in risk-free debt, which is $10,000: r
d
(profit) =
0.05($200,000) =$10,000; minus (c) the interest expense on the $1 million you
borrowed, which is $50,000: r
d
(loan) =0.05($1 million)] =$50,000. Your net cash
flow from this strategy is $200,000 +$10,000 - $50,000 =$160,000.
Since the second strategy produces $160,000 annually while your position in L
produces only $150,000, all investors would prefer the second strategy. The pressure
to sell Ls stock would cause its price to fall, and the pressure to buy Us stock would
cause its price to increase. This would continue until V
L
=V
U
.

16-6 a. V
U
=
sU
r
) T 1 ( EBIT
=
10 . 0
) 4 . 0 1 ( 2 $
=$12 million.

V
L
=V
U
+TD =$12 +(0.4)$10 =$16 million.

b. r
sU
=0.10 =10.0%.

r
sL
=r
sU
+(r
sU
- r
d
)(1 - T)(D/S)
=10% +(10% - 5%)(0.6)($10/$6) =10% +5% =15.0%.

c. S
L
=
sL
d
r
) T 1 )( D r EBIT (
=
15 . 0
6 . 0 )] 10 ($ 05 . 0 2 [$
=$6 million.

V
L
=S
L
+D =$6 +$10 =$16 million.

d. WACC
U
=r
sU
=10.00%.

WACC
L
=(D/V)r
d
(1 - T) +(S/V)r
s
=($10/$16)5%(0.6) +($6/$16)15%
=7.50%.


16-9 a. V
U
=S
U
=
sU
r
EBIT
=
11 . 0
000 , 600 , 1 $
=$14,545,455.

V
L
=V
U
=$14,545,455.

b. At D =$0:

r
s
=11.0%; WACC =11.0%


At D =$6 million:

r
sL
=r
sU
+(r
sU
r
d
)(D/S)
=11% +(11% - 6%) |
.
|

\
|
455 , 545 , 8 $
000 , 000 , 6 $
=11% +3.51% =14.51%.

WACC =(D/V)r
d
+(S/V)r
s

= |
.
|

\
|
455 , 545 , 14 $
000 , 000 , 6 $
6% + |
.
|

\
|
455 , 545 , 14 $
455 , 545 , 8 $
14.51%
=11.0%.

At D =$10 million:

r
sL
=11% +5% |
.
|

\
|
455 , 545 , 4 $
000 , 000 , 10 $
=22.00%.

WACC = |
.
|

\
|
455 , 545 , 14 $
000 , 000 , 10 $
6% + |
.
|

\
|
455 , 545 , 14 $
455 , 545 , 4 $
22%
=11.0%.

Leverage has no effect on firm value, which is a constant $14,545,455 since
WACC is a constant 11%. This is because the cost of equity is increasing with
leverage, and this increase exactly offsets the advantage of using lower cost debt
financing.

c. V
U
=[(EBIT - I)(1 - T)]/r
sU
=[($1,600,000 - 0)(0.6)]/0.11 =$8,727,273.

V
L
=V
U
+TD =$8,727,273 +0.4($6,000,000) =$11,127,273


d. At D =$0:

r
s
=11.0%. WACC =11.0%.

At D =$6 million:

V
L
=V
U
+TD =$8,727,273 +0.4($6,000,000) =$11,127,273.

r
sL
=r
sU
+(r
sU
- r
d
)(1 - T)(D/S)
=11% +(11% - 6%)(0.6)($6,000,000/$5,127,273) =14.51%.

WACC =(D/V)r
d
(1 - T) +(S/V)r
s

=($6,000,000/$11,127,273)(6%)(0.6) +($5,127,273/$11,127,273)(14.51%)
=8.63%.

At D =$10 million:

V
L
=$8,727,273 +0.4($10,000,000) =$12,727,273.

r
sL
=11% +5%(0.6)($10,000,000/$2,727,273) =22.00%.
WACC = ($10,000,000/$12,727,273)(6%)(0.6) +($2,727,273/$12,727,273)(22%)
=7.54%.

Summary: (in millions)

D V D/V r
s
WACC
$ 0 $ 8.73 0% 11.0% 11.0%
6 11.13 53.9 14.5 8.6
10 12.73 78.6 22.0 7.5
15
14
13
12
11
10
9
8
Value (Millions of Dollars)
D/V (%)
25 50 75 100


e. The maximum amount of debt financing is 100 percent. At this level
D =V, and hence

V
L
=V
U
+TD =D
$8,727,273 +0.4D =D
D - 0.4D =$8,727,273
0.6D =$8,727,273
D =$8,727,273/0.6 =$14,545,455 =V.


Since the bondholders are bearing the same risk as the equity holders of the unlevered
firm, r
d
is now 11 percent. Now, the total interest payment is $14,545,455(0.11) =
$1.6 million, and the entire $1.6 million of EBIT would be paid out as interest. Thus,
the investors (bondholders) would get $1.6 million per year, and it would be
capitalized at 11 percent:

V
L
=
11 . 0
000 , 600 , 1 $
=$14,545,455.




















f. (1) Rising interest rates would cause r
d
and hence r
d
(1 - T) to increase, pulling up
WACC. These changes would cause V to rise less steeply, or even to decline.

(2) Increased riskiness causes r
s
to rise faster than predicted by MM. Thus, WACC
would increase and V would decrease.

D/V (%)
25 50 75 100
25
20
15
10
5
Cost of Capital (%)
k
S
WACC
k
d
(1-T)
r
s
r
d
(1-T)