1. Capital Structure Decisions
Chapter 16
Capital Structure Decisions

2. Basic Definitions V = value of firm FCF = free cash flow
WACC = weighted average cost of capital
rs and rd are required returns of stock and debt
ws and wd are percentages of the capital that are financed with stock and debt.

3. How can capital structure affect value?= ∑ ∞
t=1
FCFt
(1 + WACC)t

4. Operating leverage
Operating leverage is the change in EBIT caused by a change in quantity sold.
High operating leverage implies that a small change in sales results in a large change in EBIT, NOPAT, ROIC, ROA, ROE.
Usually, the higher the proportion of fixed costs relative to variable costs, the greater the operating leverage and business risk (the risk that common stockholders face if no debt).

5. 1. Input Data
Plan A
Plan U
Plan L
Required operating current assets $3
Required long-term assets
$199
Resulting operating current liabilities $2
Total assets
$202
Required capital (TA − Op. CL)
$200
Book equity
$150
Debt $0
$50
Interest rate 8%
Sales price (P)
$2.00
Tax rate (T)
40%
Expected units sold (Q)
110
Fixed costs (F)
$20
$60
Variable costs (V)
$1.50
$1.00
2. Income Statements
Sales revenue (P x Q)
$220.0
Fixed costs
20.0
60.0
Variable costs (V x Q)
165.0
110.0
EBIT
$35.0
$50.0
Interest
0.0
4.0
EBT
$46.0
Tax
14.0
18.4
Net income
$21.0
$30.0
$27.6
3. Key Performance Measures
NOPAT = EBIT(1 − T)
ROIC = NOPAT/Capital
10.5%
15.0%
ROA = NI/Total assets
10.4%
14.9%
13.7%
ROE = NI/Equity
18.4%

6. Operating Breakeven
Q is quantity sold, F is fixed cost, V is variable cost, and P is price per unit.
Operating breakeven = QBE
EBIT= PQ-VQ-F=0; so QBE = F / (P – V)
Plan A: QBE = 20 mil/ (2 – 1.5) = 40 mil unit
Plan U: QBE = 60 mil/ (2 – 1) = 60 mil unit
U has higher business risk

7. Financial leverage and financial risk
Financial leverage: how much capital is financed by debt.
Financial risk is the additional risk placed on common stockholder if there is debt.
If ROIC > rd(1-T), then financial leverage increase ROE but also business risk.

8. 1. Input Data
Plan A
Plan U
Plan L
Required operating current assets $3
Required long-term assets
$199
Resulting operating current liabilities $2
Total assets
$202
Required capital (TA − Op. CL)
$200
Book equity
$150
Debt $0
$50
Interest rate 8%
Sales price (P)
$2.00
Tax rate (T)
40%
Expected units sold (Q)
110
Fixed costs (F)
$20
$60
Variable costs (V)
$1.50
$1.00
2. Income Statements
Sales revenue (P x Q)
$220.0
Fixed costs
20.0
60.0
Variable costs (V x Q)
165.0
110.0
EBIT
$35.0
$50.0
Interest
0.0
4.0
EBT
$46.0
Tax
14.0
18.4
Net income
$21.0
$30.0
$27.6
3. Key Performance Measures
NOPAT = EBIT(1 − T)
ROIC = NOPAT/Capital
10.5%
15.0%
ROA = NI/Total assets
10.4%
14.9%
13.7%
ROE = NI/Equity
18.4%

9. Effect of financial leverage (1)
So, ROE is greater than without debt.
What if unit sales drops?

10. 1. Input Data
Plan A
Plan U
Plan L
Required operating current assets $3
Required long-term assets
$199
Resulting operating current liabilities $2
Total assets
$202
Required capital (TA − Op. CL)
$200
Book equity
$150
Debt $0
$50
Interest rate 8%
Sales price (P)
$2.00
Tax rate (T)
40%
Expected units sold (Q)
110 65
Fixed costs (F)
$20
$60
Variable costs (V)
$1.50
$1.00
2. Income Statements
Sales revenue (P x Q)
$220.0
$130.0
Fixed costs
20.0
60.0
Variable costs (V x Q)
165.0
65.0
EBIT
$35.0
$5.0
Interest
0.0
4.0
EBT
$1.0
Tax
14.0
2.0
0.4
Net income
$21.0
$3.0
$0.6
3. Key Performance Measures
NOPAT = EBIT(1 − T)
ROIC = NOPAT/Capital
10.5%
1.5%
ROA = NI/Total assets
10.4%
0.3%
ROE = NI/Equity
0.4%

11. Effect of financial leverage (2)
So, ROE is lower than without debt.

12. Capital Structure Theory
MM theory: corporate tax
Trade-off theory
Signaling theory
Pecking order

13. 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.
WACC falls as debt is added.

14. 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.

15. Signaling Theory
MM assumed that investors and managers have the same information.
But, managers often have better information. Thus, they would:
issue stock if stock is overvalued.
issue bonds if stock is undervalued.
Investors understand this, so view new stock issue as a negative signal.

16. 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.

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

18. 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

19. 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.

20. Is there an optimal capital structure?

21. Compute WACC WACC = wd (1-T) rd + wce rs
= 0.2 (1 – 0.4) (8%) (12.9%)
= 11.28%
Repeat this for all different capital structures under consideration.
Let’s do in-class practice.

22. Homework assignment Chapter 16 problem: 1.
Review chapter 10 in Business Finance I.