Chapter 15

Capital Structure Decisions

By:
Prof. Saad Abdel-Hamid Abdel-Hamid Metawa
(Full Professor of Investment & Financet)
(Faculty of Commerce - Mansoura University))

2021
1
 Topics in Chapter
• 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

2
 Determinants of Intrinsic Value:
The Capital Structure Choice
Net operating Required
−
profit after investments
taxes in operating capital
Free cash
=
flow
(FCF)

FCF1 FCF2 FCF

Value = + + ··· + ∞
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted Firm’s
average debt/
cost of capital equity
(WACC)
mix
Market interest Cost of debt
rates
Cost of
Market risk equity Firm’s business 3
aversion risk
 Basic Definitions
• V = value of firm
• FCF = free cash flow
• WACC = weighted average cost of capital
• rs and rd are costs of stock and debt
• ws and wd are percentages of the firm that are
financed with stock and debt.

4
How can capital structure affect
?value

∞ FCFt
V = ∑
t=1 (1 + WACC)t

WACC= wd (1-T) rd + wsrs

5
 A Preview of Capital Structure
Effects
• The impact of capital structure on value
depends upon the effect of debt on:
• WACC
• FCF

6
 The Effect of Additional
Debt on WACC
• Debtholders have a prior claim on cash flows relative
to stockholders.
• Debtholders’ “fixed” claim increases risk of stockholders’
“residual” claim.
• Cost of stock, rs, goes up.
• Firm’s can deduct interest expenses.
• Reduces the taxes paid
• Frees up more cash for payments to investors
• Reduces after-tax cost of debt

7
 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 (w s)
• Net effect on WACC = uncertain.

8
 The Effect of Additional Debt on
FCF
• Additional debt increases the probability of
bankruptcy.
• 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

(Continued…) 9
• 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).

10
• 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.
 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, and the stock
price falls.

12
 Business Risk: Uncertainty in
EBIT, NOPAT, and ROIC
• Uncertainty about demand (unit sales).
• Uncertainty about output prices.
• Uncertainty about input costs.
• Product and other types of liability.
• Degree of operating leverage (DOL).

13
 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.

14
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

15
 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.

16
 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.

17
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%
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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 9.0% 9.0%

ROE (NI/Equity) 9.0% 10.8%
19
 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.

20
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% 4.8%
Leverage magnifies risk and return! 21
 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

22
 MM Theory: Zero Taxes
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200

NI $3,000 $1,800

CF to $3,000 $1,800
shareholder
CF to 0 $1,200
debtholder
23
Total CF $3,000 $3,000
 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:
• V L = V U.
 Because FCF and values of firms L and U are equal, their
WACCs are equal.
 Therefore, capital structure is irrelevant.

24
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.
25
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.
26
 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.
27
 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.

28
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. 29
 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.
30
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.

31
 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.

32
Tax Shield vs. Cost of Financial Distress

Tax Shield
Value of Firm, V

VL
VU

0 Debt

Distress Costs
33
 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?

34
 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.
35
 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.

36
 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.

37
 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).

38
 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.

39
 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.

40
 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.

41
 Implications for Managers
 Take advantage of tax benefits by issuing
debt, especially if the firm has:
• High tax rate
• Stable sales
• Low operating leverage

42
 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)

43
 Implications for Managers
(Continued)
• If manager has 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

44
 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%.

45
 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.

46
 Other Data for Valuation
Analysis
• Company has no ST investments.
• Company has no preferred stock.
• 100,000 shares outstanding

47
Current Valuation Analysis

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

48
Investment bankers provided estimates of r d
.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.

49
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)]

50
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% 51
 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.

52
 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.

53
 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.

54
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%.

55
 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 56

wealth: S +
 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.

57
 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 $265.96 58
 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.

59
 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.

60
 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). 61
 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 $265.96 $265.96 62
 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.

63
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
64
 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.

65
 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). 66
 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

67
 Calculating PPost, the Stock
Price after a Recap
• At wd = 20%:
• PPost = (VopNew−DOld)/nPrior
• nPost = ($265.96 −$0)/10
• nPost = $26.60

68
 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.

69