Financing decisions

Optimal Capital Structure

Capital structure theories

13-1
 Optimal Capital Structure

• The capital structure (mix of debt, preferred, and common

equity) at which P0 is maximized.
• Trades off higher E(ROE) and EPS against higher risk.
The tax-related benefits of leverage are exactly offset by
the debt’s risk-related costs.
• The target capital structure is the mix of debt, preferred
stock, and common equity with which the firm intends to
raise capital.

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 Why do the bond rating and cost of debt depend upon the
amount of debt borrowed?

• As the firm borrows more money, the firm increases its

financial risk causing the firm’s bond rating to decrease
and its cost of debt to increase.

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 Sequence of Events in a Recapitalization

• Firm announces the recapitalization.

• New debt is issued.
• Proceeds are used to repurchase stock.
–The number of shares repurchased is equal to the
amount of debt issued divided by price per share.

13-4
Cost of Debt at Different Debt Ratios

Amount D/Cap. D/E Bond

Borrowed Ratio Ratio Rating rd
(’000)
$ 0 0 0 -- --
250 AA
0.125 0.143 8.0%
500 A
0.250 0.333 9.0%
750 BBB
0.375 0.600 11.5%
13-5
1,000 BB
 Analyze the Recapitalization at Various Debt Levels and
Determine the EPS and TIE at Each Level
Amount D/Cap. D/E Bond
Borrowed Ratio Ratio Rating rd
(’000)
$ 0 0 0 -- --
250 AA
0.125 0.143 8.0%
500 A
0.250 0.333 9.0%
750 BBB
0.375 0.600 11.5%
1,000
EBIT= $ 400,000, and tax rate= 40%. Current share outstanding =BB
80,000. Share price is $25 13-6
What do you observe? 0.500 1.000 14.0%
 D = $0

(EBIT  rdD)(1  T)
EPS 
Shares outstandin g
($400,000) (0.6)

80,000
 $3.00

13-7
 D = $250,000 and rd = 8%

$250,000
Shares repurchase d   10,000
$25

(EBIT  rdD)(1  T)
EPS 
Shares outstandin g
[$400,000  (0.08)($250,000)](0.6)

80,000  10,000
 $3.26
EBIT $400,000
TIE    20x
Int. Exp. $20,000
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 D = $500,000 and rd = 9%

$500,000
Shares repurchased   20,000
$25

(EBIT  rdD)(1  T)
EPS 
Shares outstandin g
[$400,000  (0.09)($500,000)](0.6)

80,000  20,000
 $3.55
EBIT $400,000
TIE    8 .9 x
Int. Exp. $45,000
13-9
D = $750,000 and rd = 11.5%

$750,000
Shares repurchased   30,000
$25

(EBIT  rdD)(1  T)
EPS 
Shares outstandin g
[$400,000  (0.115 )($750,000 )](0.6)

80,000  30,000
 $3.77

EBIT $400,000
TIE    4 .6 x
Int. Exp. $86,250

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D = $1,000,000 and rd = 14%

$1,000,000
Shares repurchase d   40,000
$25

(EBIT  rdD)(1  T)
EPS 
Shares outstandin g
[$400,000  (0.14 )($1,00 0,000 )](0.6)

80,000  40,000
 $3.90
EBIT $400,000
TIE    2.9x
Int. Exp. $140,000
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What effect does more debt have on a firm’s cost of equity?

• If the level of debt increases, the firm’s risk increases.

• We have already observed the increase in the cost of debt.
• However, the risk of the firm’s equity also increases,
resulting in a higher rs.

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 The Hamada Equation

• Because the increased use of debt causes both the costs of

debt and equity to increase, we need to estimate the new
cost of equity.
• The Hamada equation attempts to quantify the increased
cost of equity due to financial leverage.
• Uses the firm’s unlevered beta, which represents the
firm’s business risk as if it had no debt.

13-13
 The Hamada Equation

bL = bU[1 + (1 – T)(D/E)]

• Suppose, the risk-free rate is 6%, as is the market risk

premium. The unlevered beta of the firm is 1.0. We were
previously told that invested capital was $2,000,000.
• Calculate the Levered Betas and Costs of Equity.

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Calculating Levered Betas and Costs of Equity

If D = $250,

bL = 1.0[1 + (0.6)($250/$1,750)]
= 1.0857

rs = rRF + (rM – rRF)bL

= 6.0% + (6.0%)1.0857
= 12.51%
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Table for Calculating Levered Betas and Costs of Equity

Amount D/Cap. D/E Levered

Borrowed Ratio Ratio Beta rs

$ 0 0% 0% 1.00 12.00%
250 12.50 14.29 1.09 12.51
500 25.00 33.33 1.20 13.20
750 37.50 60.00 1.36 14.16
1,000 50.00 100.00 1.60 15.60
13-16
 Finding Optimal Capital Structure

• The firm’s optimal capital structure can be determined

two ways:
–Minimizes WACC (use tax rate as 40%).
–Maximizes stock price.
• Both methods yield the same results.

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Table for Calculating Levered Betas and Costs of Equity

Amount D/Cap. E/Cap.

Borrowed Ratio Ratio rs rd(1 – T) WACC

$ 0 0% 100% --
12.00% 12.00%
250 12.50 87.50 12.51 4.80%
11.55
500 25.00 75.00 13.20 5.40%
11.25
750 37.50 62.50 14.16 6.90%
11.44 13-18
Stock Price with Zero Growth (earning is shared as dividend)

D1 EPS DPS
P̂0   
rs  g rs rs

• If all earnings are paid out as dividends, E(g) = 0.

• EPS = DPS.
• To find the expected stock price (P̂ ), we must find the
0

appropriate rs at each of the debt levels discussed.

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Determining the Stock Price Maximizing Capital Structure

Amount
Borrowed DPS rs P0
$ 0 12.00%
$3.00 $25.00
250 3.26
12.51 26.03
500 3.55
13.20 26.89
750 3.77
14.16 26.59
1,000 3.90
15.60 25.00 13-20
 What debt ratio maximizes EPS?

• Maximum EPS = $3.90 at D = $1,000,000, and D/Cap. =

50%. (Remember DPS = EPS because payout = 100%.)
• Risk is too high at D/Cap. = 50%.

13-21
 What is optimal capital structure?

• P0 is maximized ($26.89) at
D/Cap. = $500,000/$2,000,000 = 25%, so optimal D/Cap.
= 25%.
• EPS is maximized at 50%, but primary interest is stock
price, not E(EPS).
• The example shows that we can push up E(EPS) by using
more debt, but the risk resulting from increased leverage
more than offsets the benefit of higher E(EPS).
13-22
 What if there were more/less business risk than
originally estimated, how would the analysis be affected?

• If there were higher business risk, then the probability of

financial distress would be greater at any debt level, and the
optimal capital structure would be one that had less debt.
• However, lower business risk would lead to an optimal
capital structure with more debt.

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How would these factors affect the target capital structure?

1. Sales stability?
2. High operating leverage?
3. Increase in the corporate tax rate?
4. Increase in the personal tax rate?
5. Increase in bankruptcy costs?
6. Management spending lots of money on lavish perks?
7. Financial flexibility?
8. Firm’s growth rate?
13-24
Theories of Capital Structure

13-25
 Modigliani-Miller Irrelevance Theory

• Modern capital structure theory began in 1958 when

Professors Franco Modigliani and Merton Miller
(hereafter, MM) published what has been called the most
influential finance article ever written.
• MM’s results suggest that it does not matter how a firm
finances its operations—hence, that capital structure is
irrelevant.

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MM Assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management
about the firm’s future investment opportunities.
6. EBIT is not affected by the use of debt.
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• The graph shows MM’s tax benefit vs. bankruptcy cost
theory.
• Logical, but doesn’t tell whole capital structure story.
Main problem: assumes investors have same information
as managers.

13-28
 MM Theory-The Effect of Taxes

• MM’s original 1958 paper was criticized harshly, and

they published a follow-up in 1963 that relaxed the
assumption of no corporate taxes.
• MM demonstrated that if all their other assumptions hold,
this differential treatment leads to an optimal capital
structure of 100% debt.
• MM’s 1963 work was modified several years later by
Merton Miller (this time without Modigliani), when he
brought in the effects of personal taxes.
13-29
 The Effect of Potential Bankruptcy

• MM’s irrelevance results also depend on the assumption

that firms don’t go bankrupt and hence that bankruptcy
costs are irrelevant.
• However, in practice, bankruptcy exists, and it can be
quite costly.

13-30
 Trade-off Theory

• The preceding arguments led to the development of what

is called “the trade-off theory of leverage” or trade off
theory of capital structure.
• It states that firms trade off the tax benefits of debt
financing against problems caused by potential
bankruptcy.

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13-32
 Signaling Theory

• An action taken by a firm’s management that provides

clues to investors about how management views the
firm’s prospects.
• Signaling theory suggests firms should use less debt than
MM suggest.
• This unused debt capacity helps avoid stock sales, which
depress stock price because of signaling effects.

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• Assumptions:
–Managers have better information about a firm’s long-
run value than outside investors.
–Managers act in the best interests of current
stockholders.
• What can managers be expected to do?
–Issue stock if they think stock is overvalued.
–Issue debt if they think stock is undervalued.
–As a result, investors view a stock offering negatively; 13-34

managers think stock is overvalued.

 Pecking Order Hypothesis

• The sequence in which firms prefer to raise capital: first

spontaneous credit, then retained earnings, then other
debt, and finally new common stock.
• Their first source of funds is accounts payable and
accruals. Retained earnings generated during the current
year would be the next source. Then, if the amount of
retained earnings is not sufficient to cover capital
requirements, firms issue debt. Finally, and only as a last
resort, they issue new common stock.
13-35
 Windows of Opportunity

• The occasion where a company’s managers adjust its

firm’s capital structure to take advantage of certain
market situations.

13-36
 Conclusions on Capital Structure

• Need to make calculations as we did, but should also

recognize inputs are “guesstimates.”
• As a result of imprecise numbers, capital structure
decisions have a large judgmental content.
• We end up with capital structures varying widely among
firms, even similar ones in same industry.

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13-38