Choosing the Optimal Capital Structure: Example

Company is all-equity financed. Expected EBIT = $500,000. Firm expects zero growth. 100,000 shares outstanding; Re = 12%; P0 = $25; T = 40%; b = 1.0; RRF = 6%; RPM = 6%.

Choosing the Optimal Capital Structure

Company has decided to recapitalize its capital structure by borrowing and repurchasing its shares

Estimates of Cost of Debt

% financed with debt, wd 0% 20% Rd 8.0%

30%
40%

8.5%
10.0%

50% 12.0% Debt would be issued to repurchase stock, but the cost of debt will increase as the financial risk increases

Question 1
(1.) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation: bL = bU [1 + (1 - T)(D/E)]

The Cost of Equity at Different Levels of Debt: Hamadas Equation

MM theory implies that beta changes with leverage. bU is the beta of a firm when it has no debt (the unlevered beta) bL = bU [1 + (1 - T)(D/E)]

The Cost of Equity for wd = 20%

Use Hamadas equation to find beta: bL= bU [1 + (1 - T)(D/E)] = 1.0 [1 + (1-0.4) (20% / 80%) ] = 1.15 Use CAPM to find the cost of equity: Re= RRF + bL (RPM) = 6% + 1.15 (6%) = 12.9%

Cost of Equity vs. Leverage

wd 0% 20% 30% D/E 0.00 0.25 0.43 bL 1.000 1.150 1.257 Re 12.00% 12.90% 13.54%

40% 50%

0.67 1.00

1.400 1.600

14.40% 15.60%

The WACC for wd = 20%

WACC = wd (1-T) Rd + we Re WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%) WACC = 11.28% Repeating this procedure for all capital structures, then:

WACC vs. Leverage

wd 0% 20% Rd 0.0% 8.0% Re 12.00% 12.90% WACC 12.00% 11.28%

30%
40% 50%

8.5%
10.0% 12.0%

13.54%
14.40% 15.60%

11.01%
11.04% 11.40%

Cost of Equity vs. Leverage

Cost of Equity and Leverage
65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 0% 10% 20% 30% 40% 50% 60% 70% 80%

Returns

Leverage Effect

90%

100%

Debt-to- Value

RL

RU

Effects of Leverage on Cost of Equity and WACC

Effects of Leverage on WACC and cost of Equity
65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Debt-to Value

Returns

RL

WACC

Question 2
(2.) What is the corporate value, the value of the debt that will be issued, and the resulting market value of equity.

Calculating Corporate Value and Equity

As the table shows, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity and then on the WACC. We know the EBIT for each capital structure, so we can calculate the free cash flow. Since growth is zero, there will be no required investment in capital, and the FCF is equal to NOPAT. Free cash flow (FCF) =$300,000 With the estimated FCF and WACC, we can find the corporate value, V. Since growth is zero, V:

Corporate Value at Different WACC

wd rd rs WACC V

0%

0.0%

12.00%

12.00%

2,500,000

20%

8.0%

12.90%

11.28%

2,659,574

30%

8.5%

13.54%

11.01%

2,724,796

40%

10.0%

14.40%

11.04%

2,717,391

50%

12.0%

15.60%

11.40%

2,631,579

Corporate Value for wd = 20%

Vop = FCF(1+g) / (WACC-g) g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). NOPAT = ($500,000)(1-0.40) = $300,000. Vop = $300,000 / 0.1128 = $2,659,574.

Effects of Leverage: The Trade-Off Models

Effects of Leverage: The Trade-Off Models $3,000,000
Frim Value

$2,000,000 $1,000,000 $0

25.00% 20.00% 15.00% 10.00% 5.00% 0.00%

D/V
wd Value WACC

WACC

Question 3- What is the dollar value of debt?

Debt for wd = 20% D = wd V = 0.2 ($2,659,574) = $531,915.

Value of Debt
wd 0% 20% 30% 40% Debt, D $0 $531,915 $817,439 $1,086,957

50%

$1,315,789

Question 4
Calculate the market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is the optimal capital structure?

Anatomy of a Recap: Before Issuing Debt

Before Debt
Vop + ST Inv. VTotal Debt S n $2,500,000 0 $2,500,000 0 $2,500,000 100,000

P
Total shareholder wealth: S + Cash

$25.00
$2,500,000

Issue Debt (wd = 20%), But Before Repurchase

WACC decreases to 11.28%. Vop increases to $2,659,574. Firm temporarily has short-term investments of $531,915 (until it uses these funds to repurchase stock). Debt is now $531,915.

Anatomy of a Recap: After Debt, but Before Repurchase

Before Debt
Vop + ST Inv. VTotal Debt S n $2,500,000 0 $2,500,000 0 $2,500,000 100,000 After Debt, Before Rep. $2,659,574 531,915 $3,191,489 531,915 $2,659,574 100,000

P
Total shareholder wealth: S + Cash

$25.00
$2,500,000

$26.60
$2,659,574

After Issuing Debt, Before Repurchasing Stock

Stock price increases from $25.00 to $26.60. Wealth of shareholders (due to ownership of equity) increases from $2,500,000 to $2,659,574.

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.

Remaining Number of Shares After Repurchase

D0 is amount of debt the firm initially has, D is amount after issuing new debt. If all new debt is used to repurchase shares, then total dollars used equals
(D D0) = ($531,915 - $0) = $531,915.

n0 is number of shares before repurchase, n is number after. Total shares remaining:

n = n0 (D D0)/P = 100,000 - $531,915/$26.60 n = 80,000

Anatomy of a Recap: After Rupurchase

Before Debt Vop + ST Inv. $2,500,000 0

After Debt, Before Rep.

$2,659,574 531,915

After Rep. $2,659,574 0

VTotal
Debt S n P Total shareholder wealth: S + Cash

$2,500,000
0 $2,500,000 100,000 $25.00 $2,500,000

$3,191,489
531,915 $2,659,574 100,000 $26.60 $2,659,574

$2,659,574
531,915 $2,127,660 80,000 $26.60 $2,659,574

Key Points
ST investments fall because they are used to repurchase stock. Stock price is unchanged. Value of equity falls from $2,659,574 to $2,127,660 because firm no longer owns the ST investments. Wealth of shareholders remains at $2,659,574 because shareholders now directly own the funds that were held by firm in ST investments.

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.

Calculating S, the Value of Equity after the Recap

S = (1 wd) Vop At wd = 20%: S = (1 0.20) $2,659,574 S = $2,127,660.

Calculating P, the Stock Price after the Recap

P = [S + (D D0)]/n0 P = $2,127,660 + ($531,915 0) 100,000 P = $26.596 per share.

Number of Shares after a Repurchase, n

# Repurchased = (D - D0) / P n = n0 - (D - D0) / P # Rep. = ($531,915 0) / $26.596 # Rep. = 20,000. n = 100,000 20,000 n = 80,000.

Price per Share vs. Leverage

wd 0% S $2,500,000 P $25.00 n 100,000

20%
30%

$2,127,660
$1,907,357

$26.60
$27.25

80,000
70,000

40%
50%

$1,630,435
$1,315,789

$27.17
$26.32

60,000
50,000

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.