CHAPTER 16

Capital Structure Decisions

Value:
The Capital Structure Choice

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Optimal Capital Structure
• Highest corporate value
• Lowest WACC
• Highest stock price per share

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Choosing a Capital Structure
Cost of Capital (%)

Value of Firm (V)

D* = Optimal amount of Debt
Total Debt (D)

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Tax Shield vs. Cost of
Financial Distress

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Capital Restructuring
• We are going to look at how changes in capital
structure affect the value of the firm, all else
equal.
• Capital restructuring involves changing the
amount of leverage a firm has without changing
the firm’s assets.
• The firm can increase leverage by issuing debt
and repurchasing outstanding shares.
• The firm can decrease leverage by issuing new
shares and retiring outstanding debt.

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Choosing a Capital Structure
What is the primary goal of financial
managers?
 Maximize stockholder wealth

We want to choose the capital structure

that will maximize stockholder wealth.

We can maximize stockholder wealth by

maximizing the value of the firm or
minimizing the WACC.
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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%.

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Current Value of Operations
• Expected FCF $30 million.
• Firm expects zero growth: g 0.

• Vop [FCF(1 g)]/(WACC g)

[$30(1 0)]/(0.12 0)
$250 million.

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Other Data for Valuation
Analysis
• Company has no ST investments.
• Company has no preferred stock.
• 10 million shares outstanding

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

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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)]

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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%
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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.

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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%
%
WAC 12.00 11.28% 11.01% 11.04% 11.40%
C WACC%is minimized for wd 30%. This
The
is the optimal capital structure.
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Corporate Value for wd 20%

• Vop [FCF(1 g)]/(WACC g)

[$30(1 0)]/(0.1128 0)
$265.96 million.

• Debt DNew wd Vop

0.20(265.96) $53.19 million.

• Equity S ws Vop
0.80(265.96) $212.77 million.
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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%
%
WAC 12.00 11.28% 11.01% 11.04% 11.40%
C %
Vop $250.0 $265.9 $272.4 $271.7 $263.1
0 6 8 4 6
Value of operations is maximized at wd
D $0.00 $53.19 $81.74 $108.7 $131.5
30%. 0 818
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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
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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.
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Anatomy of a Recap: After
Debt, but Before Repurchase
Before After Debt,
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 S/H
Wealth: S Cash $250 $265.96
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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.

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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:
• n
© 2019 CengagePost n
Learning.Prior
(D D )/P
New May notOld
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Anatomy of a Recap: After
Repurchase
After Debt,
Before Before
Debt 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
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 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.
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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 $250.0 $265.96 $272.48 $271.74 $263.16
0
D $0.00 $53.19 $81.74 $108.70 $131.58
S $250.0 $212.77 $190.74 $163.04 $131.58
0
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5
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26
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.

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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.

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Number of Shares after a
Repurchase, nPost

• At wd 20%:

nPost nPrior(VopNew DNew)/(VopNew DOld)

10($265.96 $53.19)/($265.96 $0)
8

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Calculating PPost, the Stock
Price after a Recap
At wd 20%:

PPost (VopNew DOld)/nPrior

($265.96 $0)/1
$26.60

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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.

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