CAPITAL

STRUCTURE
What is the optimal mix of debt and equity for a firm?

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Debt is always cheaper than equity but using debt increases risk in terms
of default risk to lenders and higher earnings volatility for
equity investors. Thus, using more debt can increase value for some firms
and decrease value for others, and for the same firm, debt can be
beneficial up to a point and destroy value beyond that point. We have to
consider ways of going beyond the generalities to specific
ways of identifying the right mix of debt and equity.

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 Four ways to find an optimal mix

The second The third approach,

The first approach
approach is to similar to the second,
begins with a
choose the debt ratio also attempts to
distribution of future The final approach is
that minimizes the maximize firm value,
operating income; we to base the financing
cost of capital. We but it does so by
can then decide how mix on the way
review the role of estimating the
much debt to carry comparable firms
cost of capital in present value of tax
by defining the finance their
valuation and benefits of debt and
maximum possibility operations.
discuss its then netting out the
of default we are
relationship to the expected bankruptcy
willing to bear
optimal debt ratio costs from that debt

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OPERATING INCOME APPROACH

 Simplest Approach

 An approach to find out how much a firm can afford to borrow

 A firm’s maximum acceptable probability of default is the starting point, and based
on the distribution of operating income and cash flows, how much debt the firm can
carry is estimated

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Steps

1. We assess the firm’s capacity to generate operating income based on both current conditions
and history. The result is a distribution for expected operating income, with probabilities attached to
different levels of income.

2. For any given level of debt, we estimate the interest and principal payments that have to be
made over time.

3. Given the probability distribution of operating income and the debt payments, we estimate the
probability that the firm will be unable to make those payments.

4. We set a limit or constraint on the probability of the firm being unable to meet debt payments.
Clearly, the more conservative the management of the firm, the tighter this probability constraint
will be.

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5. We compare the estimated probability of default at a given level of debt to the probability
constraint. If the probability of default is higher than the constraint, the firm chooses a lower level
of debt; if it is lower than the constraint, the firm chooses a higher level of debt.

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Limitations of the Operating Income Approach

1. Estimating a distribution for operating income is not easy, especially for firms in businesses
that are changing and volatile or for firms with short operating histories
2. Even when we can estimate a distribution, the distribution generally will not be normally
distributed, making the statistical computations much more complicated
3. The annual changes in operating income may not reflect the risk of consecutive bad years.
This can be remedied by calculating the statistics based on multiple years of data
4. This approach is also an extremely conservative way of setting debt policy because it
assumes
that debt payments have to be made out of a firm’s operating income and that the firm has no
access to financial markets or pre-existing cash balance
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5. The probability constraint set by management is subjective and may reflect management
concerns more than stockholder interests.
For instance, management may decide that it wants no chance of default and refuse to borrow
money as a consequence

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Refinements on the Operating Income Approach

• We can look at simulations of different possible outcomes for operating income, rather than
looking at historical data; the distributions of the outcomes can be based both on past data and on
expectations for the future.
• Instead of evaluating just the risk of defaulting on debt, we can consider the indirect bankruptcy
costs that can accrue to a firm if operating income drops below a specified level.
• We can compute the present value of the tax benefits fromthe interest payments on the debt,
across simulations, and, thus, compare the expected cost of bankruptcy to the expected tax
benefits from borrowing.
With these changes, we can look at different financing mixes for a firm and estimate the optimal
debt ratio as that mix that maximizes the firm’s value

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COST OF CAPITAL APPROACH

Cost of capital is the weighted average of the costs of the different

components of financing—including debt, equity, and hybrid securities —
used by a firm to fund its investments. By altering the weights of the
different components, firms might be able to change their cost of capital

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In the cost of capital approach, we estimate the costs of debt and equity at different
debt ratios, use these costs to compute the costs of capital, and look for the mix of
debt and equity that yields the lowest cost of capital for the firm. At this cost of
capital, firm value is maximized.

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The value of a firm is a function of its cash flows and its cost of capital.

In the special case where the cash flows to the firm remain constant as the debt/equity mix is
changed, the value of the firm will increase as the cost of capital decreases. If the objective in
choosing the financing mix for the firm is the maximization of firm value, this can be
accomplished, in this case, by minimizing the cost of capital.

In the more general case where the cash flows to the firm themselves change as the debt
ratio changes, the optimal financing mix is the one that maximizes firm value

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To use the cost of capital approach in its simplest form, where the cash flows are fixed and
only the cost of capital changes, we need estimates of the cost of capital at every debt
ratio. In making these estimates, the one thing we cannot do is keep the costs of debt and
equity fixed, while changing the debt ratio. In addition to being unrealistic in its assessment
of risk as the debt ratio changes, this analysis will yield the unsurprising conclusion that
the cost of capital is minimized at a 100% debt ratio.

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As the debt ratio increases, each of the components in the cost of capital will change. Let us start
with the equity component. Equity investors are entitled to the residual earnings and cash flows in a
firm, after interest and principal payments have been made. As that firm borrows more money to
fund a given level of assets, debt payments will increase, and equity earnings will become more
volatile.
This higher earnings volatility, in turn, will translate into a higher cost of equity. In the CAPM and
multifactor models, the beta or betas we use for equity should increase as the debt ratio goes up.
The debt holders will also see their risk increase as the firm borrows more. Holding operating income
constant, a firm that contracts to pay more to debt holders has a greater chance of defaulting, which
will result in a higher cost of debt. As an added complication, the tax benefits of interest expenses
can be put at risk, if these expenses become greater than the earnings.
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The key to using the cost of capital approach is coming up with realistic estimates of the cost
of equity and debt at different debt ratios.
The optimal financing mix for a firm is trivial to compute if one is provided with a schedule that
relates the costs of equity and debt to the debt ratio of the firm.

Computing the optimal debt ratio then becomes purely mechanical .

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The choice of an optimal financing mix seem trivial, and it obscures some
real problems that may arise in its application. First, we typically do not have the benefit of
having the entire schedule of costs of financing, before an analysis. In most cases, the only
level of debt about which there is any certainty about the cost of financing is the current
level. Second, the analysis assumes implicitly that the level of cash flows to the firm is
unaffected by the financing mix of the firm and, consequently, by the default risk (or bond
rating) for the firm. Although this may be reasonable in some cases, it might not in others.
For instance, a firm that manufactures consumer durables (cars, televisions, etc.) might find
that its sales and operating income drop if its default risk increases
because investors are reluctant to buy its products.

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MINIMIZING COST OF CAPITAL AND MAXIMIZING FIRM VALUE
A lower cost of capital will lead to a higher firm value only if
a. the operating income does not change as the cost of capital declines.
b. the operating income goes up as the cost of capital goes down.
c. any decline in operating income is offset by the lower cost of capital.

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The Standard Cost of Capital Approach

In the standard cost of capital approach, we keep the operating income and cash flows fixed,
while changing the cost of capital. Not surprisingly, the optimal debt ratio is the one that minimizes
the cost of capital.

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In this approach, the effect of changing the capital structure, on firm value, is isolated, by
keeping the operating income fixed and varying only the cost of capital. In practical terms, this
requires us to make two assumptions. First, the debt ratio is decreased by raising new equity
and retiring debt; conversely, the debt ratio is increased by borrowing money and buying back
stock. This process is called recapitalization. Second, the pretax operating income is assumed
to be unaffected by the firm’s financing mix and, by extension, its bond rating

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If the operating income changes with a firm’s default risk, the basic analysis will not
change, but minimizing the cost of capital may not be the optimal course of action,
because the value of the firm is determined by both the cash flows and the cost of
capital. The value of the firm will have to be computed at each debt level, and the optimal
debt ratio will be that which maximizes firm value.

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The cost of capital approach that we have described is unconstrained, because our only
objective is to minimize the cost of capital. There are several reasons why a firm may
choose not to view the debt ratio that emerges from this analysis as optimal. First, the firm’s
default risk at the point at which the cost of capital is minimized may be high enough to put
the firm’s survival at jeopardy. Stated in terms of bond ratings, the firm may have a below-
investment grade rating. Second, the optimal debt ratio was computed using the
operating income from the most recent financial year.

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Enhanced Cost of Capital Approach

A key limitation of the standard cost of capital approach is that it keeps operating income fixed,
while bond ratings vary. In effect, we are ignoring indirect bankruptcy costs, when computing
the optimal debt ratio. In the enhanced cost of capital approach, we bring these indirect
bankruptcy costs into the expected operating income. As the rating of the company declines,
the operating income is adjusted to reflect the loss in operating income that will occur when
customers, suppliers, and investors react.

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Determinants of Optimal Debt Ratio

Firm-Specific Factors

Firm’s tax rate: In general, the tax benefits from debt increase as the tax rate goes up. In
relative terms, firms with higher tax rates will have higher optimal debt ratios than do firms with
lower tax rates, other things being equal. It also follows that a firm’s optimal debt ratio will
increase as its tax rate increases. However, higher marginal tax rates do make debt more
attractive but only to the extent that the firm has the operating income to cover its interest
expenses.

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Pre tax Returns on the Firm (in Cash Flow Terms) The most significant determinant
of the optimal debt ratio is a firm’s earnings capacity. In fact, the operating income as a
percentage of the market value of the firm (debt plus equity) is usually good indicator of
the optimal debt ratio. When this number is high (low), the optimal debt ratio will also be
high (low). A firm with higher pre tax earnings can sustain much more debt as a proportion
of the market value of the firm, because debt payments can be met much more easily
from prevailing earnings.

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Variance in Operating Income The variance in operating income enters the base case
analysis in two ways. First, it plays a role in determining the current beta: Firms with high (low)
variance in operating income tend to have high (low) unlevered betas. Second, the volatility in
operating income can be one of the factors determining bond ratings at different levels of debt:
Ratings drop off much more dramatically for higher variance firms as debt levels are increased. It
follows that firms with higher (lower) variance in operating income will have lower (higher) optimal
debt ratios. The variance in operating income also plays a role in the constrained analysis,
because higher variance firms are much more likely to register significant drops in operating
income.
Consequently, the decision to increase debt should be made much more cautiously for these
firms.

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Macroeconomic Factors

In good economic times, firms will generate higher earnings and be able to service more debt.
In recessions, earnings will decline and with it the capacity to service debt. That is why prudent
firms borrow based on normalized earnings rather than current earnings. Holding operating
income constant, macroeconomic variables can still affect optimal debt ratios. In fact, both the
level of risk-free rate and the magnitude of default spreads can affect optimal debt ratios.

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Level of Rates: As interest rates decline, the conventional wisdom is that debt should
become cheaper and more attractive for firms. Though this may seem intuitive, the effect is
muted by the fact that lower interest rates also reduce the cost of equity. In fact, changing the
risk-free rate has a surprisingly small effect on the optimal debt ratio as long as interest rates
move within a normal range. When interest rates exceed normal levels, optimal debt ratios do
decline partly because we keep operating income fixed. The higher interest payments at
every debt ratio lower bond ratings and affect the capacity of firms to borrow more.

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Default Spreads: The default spreads for different ratings classes tend to increase during
recessions and decrease during economic booms. Keeping other things constant, as the
spreads increase (decrease) optimal debt ratios decrease (increase), for the simple
reason that higher spreads penalize firms that borrow more money and have lower
ratings.

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ADJUSTED PRESENT VALUE APPROACH

In the adjusted present value (APV) approach, we begin with the value of the firm
without debt. As we add debt to the firm, we consider the net effect on value by
considering both the benefits and the costs of borrowing. The value of the levered firm
can then be estimated at different levels of the debt, and the debt level that maximizes
firm value is the optimal debt ratio.

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Steps

In the APV approach, we assume that the primary benefit of borrowing is a tax benefit and that the
most significant cost of borrowing is the added risk of bankruptcy. To estimate the value of the firm
with these assumptions, we proceed in three steps. We begin by estimating the value of the firm with
no leverage. We then consider the present value of the interest tax savings generated by borrowing a
given amount of money. Finally, we evaluate the effect of borrowing the amount on the probability
that the firm will go bankrupt and the expected cost of bankruptcy.

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Estimate the value of the firm with no debt

This can be accomplished by valuing the firm as if it had no debt, i.e., by

discounting the expected after-tax operating cash flows at the unlevered cost of
equity. In the special case where cash flows grow at a constant rate in perpetuity,
Value of Unlevered Firm = FCFF1∕(𝜌u − g)

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Estimate the present value of tax benefits from debt:

This tax benefit is a function of the tax rate of the firm and is discounted at the cost of debt
to reflect the riskiness of this cash flow. If the tax savings are viewed as a perpetuity,
Value of Tax Benefits = (Tax Rate × Cost of Debt × Debt) ∕Cost of Debt
= Tax Rate × Debt
= tcD

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Estimate the expected bankruptcy costs as a result of
the debt

The third step is to evaluate the effect of the given level of debt on the default risk of the firm and on
expected bankruptcy costs. In theory, at least, this requires the estimation of the probability of
default with the additional debt and the direct and indirect cost of bankruptcy. If 𝜋a is the probability
of default after the additional debt and BC is the present value of the bankruptcy cost, the
present value of expected bankruptcy cost can be estimated:

PV of Expected Bankruptcy Cost = Probability of Bankruptcy × PV of Bankruptcy Cost = 𝜋aBC

This step of the APV approach poses the most significant estimation problem, because neither the
probability of bankruptcy nor the bankruptcy cost can be estimated directly.

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There are two ways the probability of bankruptcy can be estimated indirectly. One is to
estimate a bond rating, as we did in the cost of capital approach, at each level of debt,
and look at past history to estimate the default probabilities for a given rating.

The other is to use a statistical approach, such as a probit, to estimate the probability of
default, based on the firm’s observable characteristics, at each level of debt.

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The net effect of adding debt can be calculated by aggregating the costs and the
benefits at each level of debt.
Value of Levered Firm = FCFF1∕(𝜌u − g) + tcD − 𝜋aBC
We compute the value of the levered firm at different levels of debt. The debt level that
maximizes the value of the levered firm is the optimal debt ratio.

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Benefits and Limitations of the APV Approach

The advantage of the APV approach is that it separates the effects of debt into different
components and allows an analyst to use different discount rates for each component. In this
approach, we do not assume that the debt ratio stays unchanged forever, which is an implicit
assumption in the cost of capital approach.
These advantages have to be weighed against the difficulty of estimating probabilities of default
and the cost of bankruptcy. In fact, many analyses that use the APV approach ignore the expected
bankruptcy costs, leading them to the conclusion that firm value increases as firms borrow money.
Not surprisingly, they conclude that the optimal debt ratio for a firm is 100% debt.

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 Costs of Financial Distress

Indirect Costs such as

Direct Costs such as cost of management time in warding
litigation and administration, off the creditors, managing by
loss due to distress sale, crisis rather than planning,
reduction in value of assets faulty decision making in
due to non-use, etc. choosing right business
opportunities, etc.

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COMPARATIVE ANALYSIS

The most common approach to analyzing the debt ratio of a firm is to compare its leverage to
that of similar firms. A simple way to perform this analysis is to compare a firm’s debt ratio to
the average debt ratio for the industry in which the firm operates. A more complete analysis
would consider the differences between a firm and the rest of the industry, when determining
debt ratios. We will consider both ways below.

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Comparing to Industry Average
Firms sometimes choose their financing mixes by looking at the average debt ratio of other firms
in the industry in which they operate. The underlying assumptions in this comparison are that
firms within the same industry are comparable and that, on average, these firms are operating
at or close to their optimal. Both assumptions can be questioned, however. Firms within the
same industry can have different product mixes, different amounts of operating risk, different tax
rates, and different project returns.

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Controlling for Differences between Firms
Firms within the same industry can exhibit wide differences on tax rates, capacity to generate
operating income and cash flows, and variance in operating income. Consequently, it can be
dangerous to compare a firm’s debt ratio to the industry and draw conclusions about the optimal
financing mix. The simplest way to control for differences across firms, while using the maximum
information available in the market, is to run a regression, regressing debt ratios against these
variables, across the firms in a industry:
Debt Ratio = 𝛼0 + 𝛼1Tax Rate + 𝛼2Pretax Returns + 𝛼3Variance in Operating Income

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THANKS!

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