Capital Structure, PowerPoint Show

							                                        14 - 1
 Choosing the Optimal Capital Structure:
               Example
Currently is all-equity financed.
Expected EBIT = $500,000.
Firm expects zero growth.
100,000 shares outstanding; rs = 12%;
P0 = $25; T = 40%; b = 1.0; rRF = 6%;
RPM = 6%.
                                   14 - 2

       Estimates of Cost of Debt

    Percent financed
    with debt, wd      rd
          0%           -
         20%           8.0%
         30%           8.5%
         40%          10.0%
         50%          12.0%
If company recapitalizes, debt would be
issued to repurchase stock.
                                  14 - 3

The Cost of Equity at Different Levels
    of Debt: Hamada’s 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/S)]
                                 14 - 4

   The Cost of Equity for wd = 20%

Use Hamada’s equation to find beta:
  bL = bU [1 + (1 - T)(D/S)]
     = 1.0 [1 + (1-0.4) (20% / 80%) ]
     = 1.15
Use CAPM to find the cost of equity:
  rs = rRF + bL (RPM)
     = 6% + 1.15 (6%) = 12.9%
                                    14 - 5

      Cost of Equity vs. Leverage

wd         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%
                                   14 - 6

       The WACC for wd = 20%

WACC = wd (1-T) rd + we rs
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%


Repeat this for all capital structures
 under consideration.
                            14 - 7

      WACC vs. Leverage

wd     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%
                                    14 - 8

     Corporate Value for wd = 20%

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.
                                    14 - 9

     Corporate Value vs. Leverage

wd        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
                                     14 - 10

      Debt and Equity for wd = 20%

The dollar value of debt is:
 D = wd V = 0.2 ($2,659,574) = $531,915.
S = V – D
 S = $2,659,574 - $531,915 = $2,127,659.
                                                   14 - 11

   Debt and Stock Value vs. Leverage

  wd            Debt, D             Stock Value, S
  0%                  $0              $2,500,000
 20%          $531,915                $2,127,660
 30%          $817,439                $1,907,357
 40%       $1,086,957                 $1,630,435
 50%       $1,315,789                 $1,315,789
Note: these are rounded; see Ch 14 Mini Case.xls for full
calculations.
                                14 - 12

       Wealth of Shareholders

Value of the equity declines as more
 debt is issued, because debt is used
 to repurchase stock.
But total wealth of shareholders is
 value of stock after the recap plus
 the cash received in repurchase, and
 this total goes up (It is equal to
 Corporate Value on earlier slide).
                                     14 - 13

         Stock Price for wd = 20%

The firm issues debt, which changes its
 WACC, which changes value.
The firm then uses debt proceeds to
 repurchase stock.
Stock price changes after debt is issued,
 but does not change during actual
 repurchase (or arbitrage is possible).
                                    (More…)
                                 14 - 14

 Stock Price for wd = 20% (Continued)

The stock price after debt is
 issued but before stock is
 repurchased reflects shareholder
 wealth:
  S, value of stock
 Cash paid in repurchase.
                               (More…)
                                    14 - 15

 Stock Price for wd = 20% (Continued)

D0 and n0 are debt and outstanding
 shares before recap.
D - D0 is equal to cash that will be used
 to repurchase stock.
S + (D - D0) is wealth of shareholders’
 after the debt is issued but immediately
 before the repurchase.
                                  (More…)
                                 14 - 16

 Stock Price for wd = 20% (Continued)

P = S + (D – D0)
         n0
 P = $2,127,660 + ($531,915 – 0)
          100,000
 P = $26.596 per share.
                                 14 - 17

   Number of Shares Repurchased

# Repurchased = (D - D0) / P
 # Rep. = ($531,915 – 0) / $26.596
         = 20,000.
# Remaining = n = S / P
  n = $2,127,660 / $26.596
    = 80,000.
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      Price per Share vs. Leverage

                 # shares # shares
wd       P       Repurch. Remaining
 0%     $25.00        0      100,000
20%     $26.60    20,000      80,000
30%     $27.25    30,000      70,000
40%     $27.17    40,000      60,000
50%     $26.32    50,000      50,000
                                  14 - 19

     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.
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What other factors would managers
 consider when setting the target
        capital structure?

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).
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Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible,
 and hence suitable as collateral?
Tax rates.