CHAPTER 15Capital Structure Decisions:The Basics
Impact of leverage on returns
Business versus financial risk
Capital structure theory
Perpetual cash flow example
Setting the optimal capital structure in practice
Why does leveraging increase return?
Total dollar return to investors:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Difference = $480.
Taxes paid:
U: $1,200; L: $720.
Difference = $480.
More EBIT goes to investors in Firm L.
Equity $ proportionally lower than NI.
What is business risk?
Factors That Influence Business Risk
Uncertainty about demand (unit sales).
Uncertainty about output prices.
Uncertainty about input costs.
Product and other types of liability.
Degree of operating leverage (DOL).
What is operating leverage, and how does it affect a firm’s business risk?
Operating leverage is the use of fixed costs rather than variable costs.
The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.
Higher operating leverage leads to more business risk, because a small sales decline causes a larger profit decline.
Business Risk versus Financial Risk
Business risk:
Uncertainty in future EBIT.
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.
From a shareholder’s perspective, how are financial and business risk measured in the stand-alone sense?
Conclusions
Basic earning power = BEP = EBIT/Total assets is unaffected by financial leverage.
L has higher expected ROI and ROE because of tax savings.
L has much wider ROE (and EPS) swings because of fixed interest charges. Its higher expected return is accompanied by higher risk.
In a stand-alone risk sense, Firm L’s stockholders see much more risk than Firm U’s.
U and L: sROE(U) = 2.12%.
U: sROE = 2.12%.
L: sROE = 4.24%.
L’s financial risk is sROE - sROE(U) = 4.24% - 2.12% = 2.12%. (U’s is zero.)
Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Debt financing as a managerial constraint
MM Theory: Zero Taxes
MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix.
Therefore, capital structure is irrelevant.
Any increase in ROE resulting from financial leverage is exactly offset by the increase in risk.
MM Theory: Corporate Taxes
Corporate tax laws favor debt financing over equity financing.
With corporate taxes, the benefits of financial leverage exceed the risks: More EBIT goes to investors and less to taxes when leverage is used.
Firms should use almost 100% debt financing to maximize value.
MM Theory: Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing.
Personal taxes favor equity financing.
Use of debt financing remains advantageous, but benefits are less than under only corporate taxes.
Firms should still use 100% debt.
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.
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?
Debt Financing As a Managerial Constraint
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.
However, it also increases risk of financial distress.
Debt kd ks P
$250 10% 15.5% $20.89
500 11 16.5 21.18
750 13 18.0 20.92

$500,000 of debt produces the highest stock price and thus is the best of the debt levels considered.
Calculate EPS at debt of $0, $250K, $500K, and $750K, assuming that the firm begins at zero debt and recap-italizes to each level in a single step.
EPS continues to increase beyond the $500,000 optimal debt level.
Does this mean that the optimal debt level is $750,000, or even higher?
The WACC is minimized at D = $500,000, the same debt level that maximizes stock price.
Since the value of a firm is the present value of future operating income, the lowest discount rate (WACC) leads to the highest value.
At any debt level, the firm’s probability of financial distress would be higher. Both kd and ks would rise faster than before. The end result would be an optimal capital structure with less debt.
Lower business risk would have the opposite effect.
No. The analysis above was based on the assumption of zero growth, and most firms do not fit this category.
Further, it would be very difficult, if not impossible, to estimate ks with any confidence.
Financial forecasting models can help show how capital structure changes are likely to affect stock prices, coverage ratios, and so on.
Forecasting models can generate results under various scenarios, but the financial manager must specify appropriate input values, interpret the output, and eventually decide on a target capital structure.
In the end, capital structure decision will be based on a combination of analysis and judgment.
Debt ratios of other firms in the industry.
Pro forma coverage ratios at different capital structures under different economic scenarios.
Lender and rating agency attitudes(impact on bond ratings).
Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible, and hence suitable as collateral?
Tax rates.
Default Design

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