Capital Structure DecisionsCHAPTER 15© 2020 Cengage Learning.docx

Capital Structure Decisions
CHAPTER 15
© 2020 Cengage Learning. All Rights Reserved. May not be
copied, scanned, or duplicated, in whole or in part, except for
use as permitted in a license distributed with a certain product
or service or otherwise on a password-protected website for
classroom use.
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
classroom use.
Determinants of Intrinsic Value:
The Capital Structure Choice
classroom use.

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.
classroom use.
How can capital structure affect value?
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A Preview of Capital Structure Effects
The impact of capital structure on value depends upon the effect
of debt on:
WACC
FCF
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The 2017 Tax Cuts and Jobs Act (TCJA)
Corporate tax rate:
TCJA rate is flat 21%.
Previous rate was graduated, with top rate of 35%.
Limits on interest expense deductions:
Interest/EBITDA < 30% for 2018-2021
Interest/EBIT < 30% for subsequent years
Excess carried forward indefinitely.
Should cause firms to reduce debt.
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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).
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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.

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Higher operating leverage leads to more business risk: small
sales decline causes a larger EBIT decline.
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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.
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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.
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Consider Two Hypothetical Firms Identical
Except for DebtFirm UFirm LCapital$20,000 $20,000
EBIT$2,400 $2,400 Tax Rate25%25%Equity$20,000 $16,000
Debt$0 $4,000 rd =8%
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Impact of Leverage on Income StatementsFirm UFirm
LEBIT$2,400 $2,400 Interest$0 $320 EBT$2,400 $2,080
Taxes$600 $520 NI$1,800 $1,560
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NOPAT, ROIC, and ROEFirm UFirm LEBIT =$2,400 $2,400
NOPAT = EBIT(1 − T) =$1,800 $1,800 Operating capital
=$20,000 $20,000 ROIC = NOPAT/Op. Cap. =9.0%9.0%Equity
=$20,000 $16,000 Net income =$1,800 $1,560 ROE = NI/Equity

=9.0%9.8%
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What does this example illustrate about the impact of financial
leverage?
ROIC wasn’t affected by financial leverage.
ROE went up, increasing the expected return to shareholders.
ROEL was greater than ROEU.
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Why did leverage increase ROE in this example?
More total dollars paid to L’s investors:
U: NI = $1,800.
L: NI + Int = $1,560 + $320 = $1,880.
Lower taxes paid by L:
U: $600
L: $520.
Less equity tied up in L:
U: $20,000
L: $16,000
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Impact of Leverage on Returns if
EBIT Falls to $1,600Firm UFirm LEBIT$1,600 $1,600 Interest
$0 $320 EBT$1,600 $1,280 Taxes (40%)$400 $320 NI $1,200
$960 ROIC6.0%6.0%ROE6.0%6.0%
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Impact of Leverage on Returns if
EBIT Falls to $1,200Firm UFirm LEBIT$1,200 $1,200 Interest
$0 $320 EBT$1,200 $880 Taxes (40%)$300 $220 NI $900 $660
ROIC4.5%4.5%ROE4.5%4.1%
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Leverage only adds value if ROIC is greater than the after-tax
cost of debt.EBITEBITEBIT$2,400 $1,600 $1,200
ROIC9.0%6.0%4.5%rd(1-T)6.0%6.0%6.0%ROE9.8%6.0%4.1%
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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
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MM Theory: Zero TaxesFirm UFirm
LEBIT$3,000$3,000Interest 0 1,000NI
$3,000$2,000CF to shareholder$3,000$2,000CF to debtholder
0$1,000Total CF$3,000$3,000
Notice that the total CF are identical for both firms.
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MM Results for Zero Taxes: VL = VU
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:
VL = VU.
Because FCF and values of firms L and U are equal, their
WACCs are equal.

Therefore, capital structure is irrelevant.
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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.
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MM Result for Corporate Taxes: VL = VU + TD
MM show that the total CF to Firm L’s investors is equal to the
total CF to Firm U’s investor plus 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.

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MM relationship between value and debt when corporate taxes
are considered.
Under MM with corporate taxes, the firm’s value increases
continuously as more and more debt is used.
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Impact of the TCJA on the MM Result:
VL = VU + TD
The TCJA cut the federal corporate tax rate to 21%, reducing
the combined federal-plus-state tax rate from about 40% to
about 25%.
This significantly reduces the tax shield of TD.
The slope of the graph on the previous slide is lower since the
TCJA took effect.
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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.

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Miller’s Model with Corporate and Personal Taxes
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
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Tc = 25%, Td = 30%, and Ts = 12%.
Value rises with debt; each $1 increase in debt raises L’s value
by about $0.06.
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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.
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Impact of the TCJA on the Miller
Model (1 of 2)
Cut the combined federal-plus-state Tc from about 40% to about
25%.
Did not significantly affect the personal tax rate on stocks, Ts.
The TCJA cut the top personal rate from 39.6% to 35%
(although the changes to the personal rates will revert back to
the pre-TCJA values after 2025). The result is relatively small
changes in Td.
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Impact of the TCJA on the Miller
Model (2 of 2)
The TCJA significantly reduced the numerator, (1 − Tc)
(1 − Ts), because Tc is much smaller now.
The TCJA made small changes to the denominator, (1 − Td).
The net effect is that the term in brackets is much
smaller now.
This means that debt adds much less value than before
the TCJA.

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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.
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Tax Shield vs. Cost of Financial Distress
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Impact of the TCJA on the Trade-off Theory
The slope of the tax shield line in the previous graph is less
steep due to the reduction in corporate taxes.
The TCJA did not affect financial distress costs.
The net affect is that the curved line for VL is much lower and
flatter now.

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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?
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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.
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Debt Financing and Agency Costs
(1 of 2)
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.
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Debt Financing and Agency Costs
(2 of 2)
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.
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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).

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Market Timing Theory
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.
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Empirical Evidence (1 of 4)
Tax benefits are important
At optimal capital structure, $1 debt adds about $0.10 to $0.20
to value on average.
For average firm financed with 25% to 30% debt, this adds
about 3% to 6% to the total value.
Warning! These results were for periods before the TCJA and
may now overstate the benefits of debt.
Bankruptcies are costly– costs can be up to 10% to 20% of firm
value.

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Firms have targets, but don’t make quick corrections when stock
price changes cause their debt ratios to change.
Average speed of adjustment from current capital structure is
about 30% per year.
Speed is about 50% per year for firms with high cash flow.
Speed is about 70% for firms with high cash flow that are above
target.
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Lost value from being above target is bigger than lost value
from being below target.
When above target, distress costs rise very rapidly.
Sometimes companies will deliberately increase debt to above
target to take advantage of unexpected investment opportunity.
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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.
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Implications for Managers (1 of 3)
Take advantage of tax benefits by issuing debt, especially if the
firm has:
High tax rate
Stable sales
Low operating leverage
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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)

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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
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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 = 25%.
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Current Value of Operations
Expected FCF = $90 million.
Firm expects zero growth: g = 0.
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$90(1+0)]/(0.12 − 0)
Vop = $750 million.

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Other Data for Valuation Analysis
Company has no ST investments.
Company has no preferred stock.
10 million shares outstanding
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Current Valuation Analysis Vop$750 + ST Inv. 0
VTotal$750 − Debt 0S$750 ÷ n 10 P$75.00
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Investment bankers provided estimates of rd for different
capital
structures.wd0%20%30%40%50%rd0.0%8.0%8.5%10.0%12.0%
If company recapitalizes, it will use proceeds from debt
issuance to repurchase stock.

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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)]
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The Cost of Equity for wd = 20%
Use Hamada’s equation to find beta:
b = bU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.25) (20% / 80%) ]
= 1.188
Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% + 1.188 (6%) = 13.13%
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The WACC for wd = 20%
WACC = wd (1-T) rd + ws rs
WACC =
0.2 (1 – 0.25) (8%) + 0.8 (13.13%)
WACC = 11.7%
Repeat this for all capital structures under consideration.

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Beta, rs, and
WACCwd0%20%30%40%50%rd0.0%8.0%8.5%10.0%12.0%ws1
00%80%70%60%50%b1.001.1881.321.501.75rs12.00%13.13%1
3.93%15.00%16.50%WACC12.00%11.70%11.66%12.00%12.75
%
The WACC is minimized for wd = 30%. This is the optimal
capital structure.
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Corporate Value for wd = 20%
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$90(1+0)]/(0.117 − 0)
Vop = $769.23 million.
Debt = DNew = wd Vop
Debt = 0.20($769.23) = $153.85 million.
Equity = S = ws Vop
Equity = 0.80($769.23) = $615.38 million.
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Value of Operations, Debt, and

Equitywd0%20%30%40%50%rd0.0%8.0%8.5%10.0%12.0%ws1
00%80%70%60%50%b1.001.1881.321.501.75rs12.00%13.13%1
3.93%15.00%16.50%WACC12.00%11.70%11.66%12.00%12.75
%Vop$750.00$769.23$771.70$750.00$705.88D$0.00$153.85$2
31.51$300.00$352.94S$750.00$615.38$540.19$450.00$352.94
The WACC is minimized for wd = 30%. This is the optimal
capital structure.
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Anatomy of a Recap: Before Issuing DebtBefore Debt
Vop$750.00 + ST Inv. 0 VTotal$750.00 − Debt
0S$750.00 ÷ n$10.00 P$75.00 Total shareholderwealth: S +
Cash$750
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Issue Debt (wd = 20%), But Before Repurchase
WACC decreases to 11.70%.
Vop increases to $771.70.
Firm temporarily has short-term investments of $153.85 (until it
uses these funds to repurchase stock).
Debt is now $153.85.

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Anatomy of a Recap: After Debt,
but Before RepurchaseBefore DebtAfter Debt, Before Rep.
Vop$750.00 $769.23 + ST Inv. 0$153.85
VTotal$750.00 $923.08 − Debt 0$153.85 S$750.00
$769.23 ÷ n10.00 10.00 P$75.00 $76.92 Total
shareholderwealth: S + Cash$750 $769.23
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After Issuing Debt, Before Repurchasing Stock
Stock price increases from $75.00 to $76.92.
Wealth of shareholders (due to ownership of equity) increases
from $750 million to $769.23 million.
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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.
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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) = ($153.85 - $0) = $153.85.
nPrior is number of shares before repurchase, nPost is number
after. Total shares remaining:
nPost = nPrior – (DNew – DOld)/P
nPost = 10 – ($153.85/$26.60)
nPost = 8 million.
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Anatomy of a Recap: After RepurchaseBefore DebtAfter Debt,
Before Rep.After Rep. Vop$750.00 $769.23 $769.23 + ST Inv.
0$153.85 0 VTotal$750.00 $923.08 $769.23 − Debt
0$153.85 153.85 S$750.00 $769.23 $615.38 ÷ n10.00 10.00
8.00 P$75.00 $76.92 $76.92 Total shareholderwealth: S +
Cash$750 $769.23 $769.23

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Key Points
ST investments fall because they are used to repurchase stock.
Stock price is unchanged.
Value of equity falls from $769.23 to $615.38 because firm no
longer owns the ST investments.
Wealth of shareholders remains at $769.23 because shareholders
now directly own the funds that were held by firm in ST
investments.
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Intrinsic Stock Price Maximized at Optimal
Capital
Structurewd0%20%30%40%50%rd0.0%8.0%8.5%10.0%12.0%w
s100%80%70%60%50%b1.001.1881.321.501.75rs12.00%13.13
%13.93%15.00%16.50%WACC12.00%11.70%11.66%12.00%12.
75%Vop$750.00$769.23$771.70$750.00$705.88D$0.00$153.85
$231.51$300.00$352.94S$750.00$615.38$540.19$450.00$352.9
4n10.08.07.06.05.0P$75.00$76.92$77.17$75.00$70.59
classroom use.
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.
classroom use.
Calculating S, the Value of Equity after the Recap
S = (1 – wd) Vop
At wd = 20%:
S = (1 – 0.20) $769.23
S = $615.38.
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Number of Shares after a Repurchase, nPost
At wd = 20%:
nPost = nPrior(VopNew−DNew)/(VopNew−DOld)
nPost = 10($769.23 −$153.85)/($769.23 −$0)
nPost = 8
classroom use.
Calculating PPost, the Stock Price after a Recap
At wd = 20%:
PPost = (VopNew−DOld)/nPrior
nPost = ($769.23 −$0)/10

nPost = $76.92
classroom use.
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.
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Equity as an Option on the Firm’s Value
For highly levered firms there is a relatively high probability of
default.
Equity holders make the decision on whether or not to make a
required interest or principal payment on the debt.
If they do make the payment, they own the total value of the
firm minus the amount due to debtholders.
If they default because the total value of the firm is less than
the amount owed to debtholders, then they own nothing.
The equity owners’ position looks like an option to buy the firm
with an exercise price equal to the value of the debt.

classroom use.
Example of Equity as an Option: Liu Industries
Liu Industries is a highly levered firm with the following
data:Total Value of Firm4.00Face Value of Debt2.00Risk Free
rate6.0%Maturity of debt (years)1.00Standard Dev. of Total
Value0.60
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Equity as an option
P = underlying value of firm:
P = $4 million
X = exercise price = value of debt:
X = $2 million
t = time to maturity
t = 1 year
rRF = 6%
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Use Black-Scholes to price this option

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Black-Scholes
Solution
(1 of 2)
classroom use.
Black-Scholes

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