• Determining the optimal capital structure

The tradeoff in using debt raises two related

questions
1) is the higher expected rate of return
associated with debt sufficient to
compensate for the increased risk?
2) what is the optimal amount of debt?
 Optimal Capital Structure
That 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.
 Describe the sequence of events in a
recapitalization.

• Campus Deli announces the

recapitalization.
• New debt is issued.
• Proceeds are used to repurchase stock.

Debt issued
Shares bought =
Price per share
Cost of debt at different debt levels after
recapitalization

Amount D/A D/E Bond

Borrowed(000) ratio ratio rating kd
$ 0 0 0 -- --
250 0.125 0.1429 AA 8%
500 0.250 0.3333 A 9%
750 0.375 0.6000 BBB 11.5%
1,000 0.500 1.0000 BB 14%
Notice that with the increased use of debt the
cost of debt increases. This is because
lenders recognize that other things held
constant, firms with higher debt levels are
more likely to experience financial distress,
so they require higher rates of return.
What would the earnings per share be if
Campus Deli recapitalized and used these
amounts of debt: $0, $250,000, $500,000,
$750,000? Assume EBIT = $400,000, T =
40%, and shares can be repurchased at P0 =
$25.
D = 0: (EBIT – kdD)(1 – T)
EPS0 = Shares outstanding

($400,000)(0.6)
= 80,000 = $3.00.
D = $250, kd = 8%.

Shares $250,000
repurchased = = 10,000.
$25

[$400 – 0.08($250)](0.6)
EPS1 =
80 – 10
= $3.26.

EBIT $400
TIE = = = 20×.
I $20
D = $500, kd = 9%.

Shares $500
repurchased = = 20.
$25

[$400 – 0.09($500)](0.6)
EPS2 =
80 – 20
= $3.55.

EBIT $400
TIE = = = 8.9×.
I $45
D = $750, kd = 11.5%.

Shares $750
repurchased = = 30.
$25

[$400 – 0.115($750)](0.6)
EPS3 =
80 – 30
= $3.77.

EBIT $400
TIE = = = 4.6×.
I $86.25
D = $1,000, kd = 14%.

Shares $1,000
repurchased = = 40.
$25

[$400 – 0.14($1,000)](0.6)
EPS4 =
80 – 40
= $3.90.

EBIT $400
TIE = = = 2.9×.
I $140
• In this example, EPS is maximized at 50%
debt ($1M). Should the firm then issue 50%
debt? The answer is NO.
• The optimal capital structure is the one that
maximizes the firm’s stock price and not the
one that maximizes the firm’s EPS.
• Now we are going to investigate what the
stockholders want. A stock’s beta coefficient
measures its relative volatility or risk compared
to the stock market portfolio. It has been
shown both theoretically and empirically that a
stock’s beta increases as financial leverage
increases.
 Stock Price (Zero Growth)
D1 EPS DPS
P0 = = = .
ks – g ks ks

If payout = 100%, then EPS = DPS and

E(g) = 0.
We just calculated EPS = DPS. To find
the expected stock price (P0), we must
find the appropriate ks at each of the
debt levels discussed.
 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.
The Hamada Equation (cont’d)

bL = bU [1 + (1 – T)(D/E)].

bu : the unlevered beta of a firm, which

represents the business risk of a firm as if
it had no debt.

D/E: debt to equity ratio

EX) 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 total assets were
$2,000,000.
 Calculating Levered Betas
D = $250 ks = kRF + (kM – kRF)bL
bL = bU[1 + (1 – T)(D/E)]
bL = 1.0[1 + (1 – 0.4)($250/$1,750)]
bL = 1.0[1 + (0.6)(0.1429)]
bL = 1.0857.
ks = kRF + (kM – kRF)bL
ks = 6.0% + (6.0%)1.0857 = 12.51%.
 Table for Calculating Levered Betas

Amount D/A D/E Levered

borrowed ratio ratio Beta ks
$ 0 0.00% 0.00% 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
• If we change the capital structure by adding
debt, this would increase the risk
stockholders bear. That, in turn, would
result in an additional risk premium.
• Ks = Krf + Premium for business risk +
Premium for financial risk
 Minimizing the WACC

Amount D/A ratio E/A

borrowed ratio ks kd (1 – T) WACC
0.00%
$ 0 100.00% 12.00% 0.00% 12.00%
12.50
250 87.50 12.51 4.80 11.55
25.00
500 75.00 13.20 5.40 11.25
37.50
750 62.50 14.16 6.90 11.44
50.00
1,000 50.00 15.60 8.40 12.00
• When the firm has no debt, so its capital
structure is 100% equity, WACC is the cost of
equity (12%).
• As the firm begins to use lower cost of debt, the
WACC declines. However, as the debt ratio
increases, the costs of both debt and equity rise,
at first slowly but then at a faster and faster rate.
• Eventually, the increasing costs of the two
components offset the fact that more low-cost
debt is being used. At 25 percent debt, the
WACC hits a minimum of 11.25%.
 P0 = DPS/ks
Amount
Borrowed DPS ks P0
$ 0 $3.00 12.00% $25.00
250,000 3.26 12.51 26.03
500,000 3.55 13.20 26.89*
750,000 3.77 14.16 26.59
1,000,000 3.90 15.60 25.00
*Maximum: Since D = $500,000 and assets
= $2,000,000, optimal D/A = 25%.
What debt ratio maximizes EPS?

See preceding slide. Maximum EPS =

$3.90 at D = $1,000,000, and D/A = 50%.
Risk is too high at D/A = 50%.
What is Campus Deli’s optimal capital
structure?

P0 is maximized ($26.89) at D/A =

$500,000/$2,000,000 = 25%, so
optimal D/A = 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).
 %

15 ks
WACC
kd(1 – T)

0 .25 .50 .75 D/A

$

P0
EPS

D/A
.25 .50
 If we discovered that the firm had 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. On the other hand,
lower business risk would lead to an
optimal capital structure of more debt.
 Long-term Debt Ratios for
Selected Industries

Industry Long-Term Debt Ratio

Pharmaceuticals 20.00%
Computers 25.93
Steel 39.76
Aerospace 43.18
Airlines 56.33
Utilities 56.52
Source: Dow Jones News Retrieval. Data
collected through December 17, 1999.
• Capital structure theory
Under a very restrictive set of assumptions
Modigliani and Miller (M&M) proved that
the value of a firm is unaffected by its capital
structure. Thus, capital structure is
irrelevant.
This means that in a no tax world, the firm’s
WACC is constant and the firm’s capital
structure does not influence the firm’s stock
price.
Assumptions: No brokerage costs, no taxes, no
bankruptcy costs, investors can borrow at the
same rate as corporations, symmetric
information.
• The effect of taxes
M&M relaxed the assumption of no corporate
taxes. The tax code allows firms to deduct
interest payments as an expense but dividend
payments to stockholders are not deductible.

This differential tax treatment encourages firms

to use more debt in their capital structures.
The more the firm borrows the greater the
tax benefits that will accrue to the remaining
stockholders. M&M demonstrate that if their
other assumptions hold, the optimal capital
structure in a tax world will be 100% debt.
• The effect of bankruptcy costs
Relaxing M&M’s assumptions even more by
introducing bankruptcy costs change the
analysis dramatically. M&M assumed a
constant cost of borrowing.
In the real world, however, as the debt ratio
increases lenders get nervous. The more
nervous the lenders get the higher the rate of
return they expect to get. So in an M&M
world with taxes and bankruptcy, the WACC
will fall at first as small amounts of debt are
added to the capital structure.
As the firm continues to add debt to the capital
structure the lender’s threshold level of risk is
hit and they start to raise interest rates slowly
at first and then more rapidly.
So, in a world with taxes and bankruptcy costs
there is an optimal structure where the
WACC is minimized and the stock price is
maximized.
Value of Stock
MM with taxes

MM with taxes and bank

-ruptcy costs

MM without taxes

D/A
0 D1 D2
• Below D1 the probability of bankruptcy is so low
as to be immaterial. Beyond D1, however,
bankruptcy-related costs become increasingly
important, and they reduce the tax benefits of
debt at an increasing rate
• In the range from D1 to D2, bankruptcy-related
costs reduce but do not completely offset the tax
benefits of debt, so the firm’s stock price rises
(but at a decreasing rate) as its debt ratio
increases.
• Beyond D2, bankruptcy related costs exceed the
tax benefits, so from D2 increasing the debt ratio
lowers the value of the stock.
• So D2 is the optimal capital structure.
• Theoretically, the debt rate where the
marginal benefits of the tax shelter equal the
marginal cost of increased bankruptcy risk
dictates the optimal capital structure.
• Empirically, many corporations are found to
have less debt than the trade-off theory of
leverage would suggest.
• 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.
Signaling theory, discussed earlier,
suggests firms should use less debt
than MM suggest.
This unused debt capacity helps
avoid stock sales, which depress P0
because of signaling effects.
 What are “signaling” effects in capital
structure?

Assumptions:

• Managers have better information about a

firm’s long-run value than outside
investors.
• Managers act in the best interests of
current stockholders.
• If managers are supposed to behave as if they are
maximizing current shareholders’ wealth by
maximizing stock prices, then the announcement
of a stock offering will generally be taken as a
signal that the firm’s prospects (as seen by its
management) are not good.
• Assume a firm that has a new product that will
increase its profitability but to go into production
the firm needs to raise capital.
• If the firm sells new stock, then as the profits
from the new product start flowing into the firm,
the price of the stock will rise.
• The current shareholders will do well but not as
well as they would have done if the company
would not have had to share the benefits of the
new product with the new shareholders.
• Therefore, one would expect a firm with very
favorable prospects to try to avoid selling new
stock and, rather, to raise any required new capital
by other means, including new debt.
 Therefore, managers can be expected to:
• issue stock if they think stock is overvalued.
• issue debt if they think stock is undervalued.
• Investors view a common stock offering as a negative
signal--managers think stock is overvalued.
• As a result, firms try to avoid having to issue stock by
maintaining a reserve borrowing capacity, and this
means using less debt in normal times than the MM
theory would suggest.
 Conclusions on Capital Structure
1. Need to make calculations as we did, but
should also recognize inputs are
“guesstimates.”
2. As a result of imprecise numbers, capital
structure decisions have a large
judgmental content.
3. We end up with capital structures varying
widely among firms, even similar ones in
same industry.