The Firm’s Capital Structure
Dr. Sahar Mahran
Associate professor of finance
1
The Firm’s Capital Structure (1 of 27)
• Types of Capital
• All the items on the right-hand side of the firm’s balance
sheet, excluding current liabilities, are sources of capital
13.2 The Firm’s Capital Structure (2 of 27)
• Types of Capital
The cost of debt is lower than the cost of other forms of financing because :
• Debt is the least risk of any contributors of long-term capital (preferred or
common stock)
• Lenders have a higher priority of claim payment than can owners .
• The tax deductibility of interest payments also lowers the debt cost
13.2 The Firm’s Capital Structure (3 of 27)
• Types of Capital
• The two main sources of equity ( with no maturity date )are
(1) preferred stock and (2) common stock and retained
earnings
• Common stock is typically the most expensive form of equity,
followed by retained earnings and then preferred stock
• In general, the more debt a firm uses, the greater will be the
firm’s financial leverage
13.2 The Firm’s Capital Structure (4 of 27)
• Types of Capital
• That leverage makes the claims of common stockholders even more risky, so
the cost of equity increases as debt . In addition, cost of debt rise.
• the cost of equity always exceeds the cost of debt
13.2 The Firm’s Capital Structure (23 of 27)
• Optimal Capital Structure
• Because the value of a firm equals the present value of its future cash flows, it
follows that managers can maximize the value of the firm by minimizing the
cost of capital, holding cash flows constant
• In other words, the present value of future cash flows is at its highest when
the discount rate (the cost of capital) is at its lowest
13.2 The Firm’s Capital Structure (24 of 27)
• Optimal Capital Structure
EBIT (1 − T ) NOPAT
V= = (13.11)
rwacc rwacc
• where:
• EBIT = Earnings before interest and taxes
• T = tax rate
• NOPAT = Net operating profits after taxes, which are the after-tax
operating earnings available to the debt and equity holders, EBIT
* (1−T)
• rwacc = Weighted average cost of capital
Figure 13.4 Cost Functions and Value
13.2 The Firm’s Capital Structure (27 of 27)
• Optimal Capital Structure
• The capital structure at which the weighted average cost of
capital is minimized, thereby maximizing the firm’s value
• Graphical View of Optimal Capital Structure
• The optimal capital structure is the mixture of debt and equity that
minimizes the WACC and maximizes the value of the firm
• In Figure 13.4(a), point M represents the minimum weighted
average cost of capital, the point of optimal financial leverage and
hence of optimal capital structure for the firm
• Figure 13.4(b) is a graph of the value of the firm that results from
substitution of rwacc in Figure 13.4(a) for various levels of financial
leverage into the zero-growth valuation model
• As shown in Figure 13.4(b), at the optimal capital structure, point
M, the value of the firm reaches a maximum at V*
13.3 EBIT–EPS Approach to Capital Structure (6
of 6)
• Basic Shortcomings of EBIT–EPS Analysis
• To select the best capital structure, firms must integrate both return (EPS) and
risk (via the required return, rs) into a valuation framework consistent with
the capital structure theory presented earlier
13.4 Choosing the Optimal Capital Structure (2
of 3)
• Estimating Value
• The value of the firm’s stock associated with alternative
capital structures can be estimated using one of the
standard valuation models
• If, for simplicity, we assume that all earnings are paid out as
dividends, we can use a standard zero growth valuation
model such as that developed in Chapter 7
• By substituting the expected level of EPS and the
associated required return, rs, we can estimate the per-
share value of the firm, P0
EPS
P0 = (13.12)
rs
Figure 13.6 Estimating Value
13.4 Choosing the Optimal Capital Structure (3
of 3)
• Maximizing Value versus Maximizing EPS
• The goal of the financial manager is maximizing owner wealth, not
profit
• Although some relationship exists between expected profit and value,
there is no reason to believe that profit-maximizing strategies
necessarily result in wealth maximization
• It is therefore the wealth of the owners as reflected in the estimated
share value that should serve as the criterion for selecting the best
capital structure
Problem 1 determine the Optimal capital structure
• Medallion Cooling Systems has total assets of $10,000,000, EBIT
of $2,000,000, and preferred dividends of $200,000 and is taxed
at a rate of 40%. In an effort to determine the optimal capital
structure, the firm has assembled data on the cost of debt, the
number of shares of common stock for various levels of
indebtedness, and the overall required return on investment:
Capital Cost of debt, rd Number of Required
structure common return, rs
debt ratio stock shares
0% 0% 200,000 12%
15% 8% 170,000 13%
30% 9% 140.000 14%
45% 12% 110,000 16%
60% 15% 80,000 20%
• a. Calculate earnings per share for each level of
indebtedness.
• b. Use the earnings per share calculated in part a to
calculate a price per share for each level of
indebtedness.
• c. Choose the optimal capital structure. Justify your
choice.
Debt Ratio 0% 15% 30% 45% 60%
EBIT $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000
Less: Interest 0 120,000 270,000 540,000 900,000
EBT $2,000,000 $1,880,000 1,730,000 $1,460,000 $1,100,000
Taxes: 40% of EBT 800,000 752,000 692,000 584,000 440,000
Net profit $1,200,000 $1,128,000 $1,038,000 $ 876,000 $ 660,000
Less: Preferred dividends 200,000 200,000 200,000 200,000 200,000
Profits available to
common stock $1,000,000 $ 928,000 $ 838,000 $ 676,000 $ 460,000
No. of shares outstanding 200,000 170,000 140,000 110,000 80,000
EPS $ 5.00 $ 5.46 $ 5.99 $ 6.15 $ 5.75
Estimated share price (Po) = EPS ÷ required return on common stock (rs)
Debt: 0% Debt: 15% Debt: 60%
$5.00 $5.46 $5.75
P0 = = $41.67 P0 = = $42.00 P0 = = $28.75
0.12 0.13 0.20
Debt: 30% Debt: 45%
$5.99 $6.15
P0 = = $42.79 P0 = = $38.44
0.14 0.16
c. The optimal capital structure would be 30% debt and 70% equity because this debt/equity
mix maximizes the price of the common stock.
