Chapter 12

Leverage
and Capital
Structure

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The Firm’s Capital Structure

• Capital structure is one of the most complex areas of

financial decision making due to its interrelationship
with other financial decision variables.
• Poor capital structure decisions can result in a high cost
of capital, thereby lowering project NPVs and making
them more unacceptable.
• Effective decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable projects,
thereby increasing the value of the firm.

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Types of Capital

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Capital Structure Theory

• According to finance theory, firms possess a target

capital structure that will minimize its cost of capital.
• Unfortunately, theory can not yet provide financial
mangers with a specific methodology to help them
determine what their firm’s optimal capital structure
might be.
• Theoretically, however, a firm’s optimal capital
structure will just balance the benefits of debt financing
against its costs.

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Capital Structure Theory (cont.)

• The major benefit of debt financing is the tax shield

provided by the federal government regarding interest
payments.
• The costs of debt financing result from:
– the increased probability of bankruptcy caused by debt
obligations,
– the agency costs resulting from lenders monitoring the firm’s
actions, and
– the costs associated with the firm’s managers having more
information about the firm’s prospects than do investors
(asymmetric information).
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Capital Structure Theory:
Tax Benefits

• Allowing companies to deduct interest payments when

computing taxable income lowers the amount of
corporate taxes.
• This in turn increases firm cash flows and makes more
cash available to investors.
• In essence, the government is subsidizing the cost of
debt financing relative to equity financing.

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Capital Structure Theory:
Probability of Bankruptcy

• The probability that debt obligations will lead to

bankruptcy depends on the level of a company’s
business risk and financial risk.
• Business risk is the risk to the firm of being unable to
cover operating costs.
• In general, the higher the firm’s fixed costs relative to
variable costs, the greater the firm’s operating leverage
and business risk.
• Business risk is also affected by revenue and cost
stability.

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• The firm’s capital structure—the mix between debt

versus equity—directly impacts financial leverage.
• Financial leverage measures the extent to which a firm
employs fixed cost financing sources such as debt and
preferred stock.
• The greater a firm’s financial leverage, the greater will
be its financial risk—the risk of being unable to meet
its fixed interest and preferred stock dividends.

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Business Risk
Cooke Company, a soft drink manufacturer, is
preparing to make a capital structure decision. It
has obtained estimates of sales and EBIT from its
forecasting group as show in Table 12.9.

Table 12.9 Sales and Associated EBIT Calculations for Cooke Company ($000)

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Business Risk
When developing the firm’s capital structure, the
financial manager must accept as given these levels
of EBIT and their associated probabilities. These
EBIT data effectively reflect a certain level of business
risk that captures the firm’s operating leverage, sales
revenue variability, and cost predictability.

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk

Let us assume that (1) the firm has no current liabilities,

(2) its capital structure currently contains all equity, and
(3) the total amount of capital remains constant at
$500,000, the mix of debt and equity associated with
various debt ratios would be as shown in Table 12.10.
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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.10
Capital Structures
Associated with
Alternative Debt
Ratios for Cooke
Company

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.11
Level of Debt,
Interest Rate, and
Dollar Amount of
Annual Interest
Associated with
Cooke
Company’s
Alternative
Capital Structures

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company (cont.)

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company (cont.)

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.12
Calculation of
EPS for
Selected Debt
Ratios ($000)
for Cooke
Company

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Table 12.13
Expected EPS,
Standard
Deviation, and
Coefficient of
Variation for
Alternative Capital
Structures for
Cooke Company

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Figure 12.3
Probability
Distributions

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Capital Structure Theory:
Probability of Bankruptcy (cont.)

• Financial Risk
Figure 12.4 Expected EPS and Coefficient of Variation
of EPS

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Capital Structure Theory: Agency Costs
Imposed by Lenders

• When a firm borrows funds by issuing debt, the interest

rate charged by lenders is based on the lender’s
assessment of the risk of the firm’s investments.
• After obtaining the loan, the firm’s stockholders and/or
managers could use the funds to invest in riskier assets.
• If these high risk investments pay off, the stockholders
benefit but the firm’s bondholders are locked in and are
unable to share in this success.

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Capital Structure Theory: Agency Costs
Imposed by Lenders (cont.)

• To avoid this, lenders impose various

monitoring costs on the firm.
• Examples would of these monitoring
costs would:
– include raising the rate on future debt issues,
– denying future loan requests,
– imposing restrictive bond provisions.

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Capital Structure Theory:
Asymmetric Information

• Asymmetric information results when managers of a

firm have more information about operations and future
prospects than do investors.
• Asymmetric information can impact the firm’s capital
structure as follows:

Suppose management has identified an extremely lucrative

investment opportunity and needs to raise capital. Based on
this opportunity, management believes its stock is
undervalued since the investors have no information about
the investment.
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Capital Structure Theory:
Asymmetric Information (cont.)

• Asymmetric information results when managers of a

firm have more information about operations and future
prospects than do investors.
• Asymmetric information can impact the firm’s capital
structure as follows:

In this case, management will raise the funds using debt

since they believe/know the stock is undervalued
(underpriced) given this information. In this case, the use of
debt is viewed as a positive signal to investors regarding the
firm’s prospects.
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Capital Structure Theory:
Asymmetric Information (cont.)

• Asymmetric information results when managers of a

firm have more information about operations and future
prospects than do investors.
• Asymmetric information can impact the firm’s capital
structure as follows:

On the other hand, if the outlook for the firm is poor,

management will issue equity instead since they
believe/know that the price of the firm’s stock is overvalued
(overpriced). Issuing equity is therefore generally thought of
as a “negative” signal.
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The Optimal Capital Structure

• In general, it is believed that the market value of a company is

maximized when the cost of capital (the firm’s discount rate) is
minimized.
• The value of the firm can be defined algebraically as follows:

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The Optimal Capital Structure

Figure 12.5
Cost Functions
and Value

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EPS-EBIT Approach
to Capital Structure

• The EPS-EBIT approach to capital structure involves selecting

the capital structure that maximizes EPS over the expected range
of EBIT.
• Using this approach, the emphasis is on maximizing the owners
returns (EPS).
• A major shortcoming of this approach is the fact that earnings
are only one of the determinants of shareholder wealth
maximization.
• This method does not explicitly consider the impact of risk.

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EPS-EBIT Approach
to Capital Structure (cont.)

Example

EBIT-EPS coordinates can be found by assuming specific

EBIT values and calculating the EPS associated with them.
Such calculations for three capital structures—debt ratios of
0%, 30%, and 60%—for Cooke Company were presented
earlier in Table 12.2. For EBIT values of $100,000 and
$200,000, the associated EPS values calculated are
summarized in the table with Figure 12.6.

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EPS-EBIT Approach
to Capital Structure (cont.)

Figure 12.6
EBIT–EPS
Approach

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Basic Shortcoming
of EPS-EBIT Analysis

• Although EPS maximization is generally good for the

firm’s shareholders, the basic shortcoming of this
method is that it does not necessary maximize
shareholder wealth because it fails to consider risk.
• If shareholders did not require risk premiums
(additional return) as the firm increased its use of debt,
a strategy focusing on EPS maximization would work.
• Unfortunately, this is not the case.

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Choosing the Optimal Capital Structure

• The following discussion will attempt to create a

framework for making capital budgeting decisions that
maximizes shareholder wealth—i.e., considers both risk
and return.
• Perhaps the best way to demonstrate this is through the
following example:
Cooke Company, using as risk measures the
coefficients of variation of EPS associated with each
of seven alternative capital structures, estimated the
associated returns as shown in Table 12.14
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Choosing the Optimal
Capital Structure (cont.)

Table 12.14 Required Returns for Cooke Company’s

Alternative Capital Structures

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Choosing the Optimal
Capital Structure (cont.)

By substituting the level of EPS and the associated

required return into Equation 12.12, we can
estimate the per share value of the firm, P0.

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Choosing the Optimal
Capital Structure (cont.)

Table 12.15 Calculation of Share Value Estimates

Associated with Alternative Capital Structures for Cooke
Company

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Choosing the Optimal
Capital Structure (cont.)

Figure 12.7
Estimating Value

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Table 12.16 Important Factors to Consider
in Making Capital Structure Decisions

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