Professional Documents
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Chapter 15
Capital Structure
Decisions
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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
We and wd are percentages of the
firm that are financed with stock and
debt.
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t 1
FCFt
t
(1 WACC)
WACC = wd (1-T) rd + we rs
(Continued)
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(Continued)
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investors
Reduces after-tax cost of debt
(Continued)
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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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Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate
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EBIT
Interest
EBT
Taxes (40%)
NI
ROE
Firm U
Firm L
$3,000
0
$3,000
1 ,200
$1,800
$3,000
1,200
$1,800
720
$1,080
9.0%
10.8%
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Capital Structure
Theory
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Trade-off theory
Signaling theory
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rs
20
40
60
80
WACC
rd(1 - T)
Debt/Value
100
Ratio (%)
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(1 - Tc)(1 - Ts)
VL = VU + 1 (1 - Td)
]D.
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(1 - 0.40)(1 - 0.12)
VL = VU + 1 D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
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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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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.
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D/S
bL
rs
0%
0.00
1.000
12.00%
20%
0.25
1.150
12.90%
30%
0.43
1.257
13.54%
40%
0.67
1.400
14.40%
50%
1.00
1.600
15.60%
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rd
rs
WACC
0%
0.0%
12.00%
12.00%
20%
8.0%
12.90%
11.28%
30%
8.5%
13.54%
11.01%
40%
10.0%
14.40%
11.04%
50%
12.0%
15.60%
11.40%
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V = FCF / (WACC-g)
g=0, so investment in capital is zero;
so FCF = NOPAT = EBIT (1-T).
NOPAT = ($500,000)(1-0.40) = $300,000.
V = $300,000 / 0.1128 = $2,659,574.
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WACC
Corp. Value
0%
12.00%
$2,500,000
20%
11.28%
$2,659,574
30%
11.01%
$2,724,796
40%
11.04%
$2,717,391
50%
11.40%
$2,631,579
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wd = 30% gives:
Highest corporate value
Lowest WACC
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