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					Chapter 15

  Capital Structure Decisions:
              Part I


                                 1
Topics in Chapter
   Overview of capital structure effects
   Business versus financial risk
   The impact of debt on returns
   Capital structure theory, evidence, and
    implications
   Choosing the optimal capital structure:
    An example

                                              2
     Basic Definitions
   V = value of firm
   FCF = free cash flow
   WACC = weighted average cost of capital
   rs and rd = costs of stock and debt
   wce and wd = percentages of the firm that
    are financed with stock and debt

                                                3
  Capital Structure and Firm Value

         ∞        FCFt
 V   =   ∑                    (15-1)


         t=1   (1 + WACC)t

WACC= wd (1-T) rd + wcers     (15-2)




                                       4
Capital Structure Effects
Preview
   The impact of capital structure on
    value depends upon the effect of
    debt on:
     WACC
     FCF




                                         5
The Effect of Debt on WACC
   Debt increases the cost of equity, rs
       Debt holders have a prior claim on cash flows
        relative to stockholders.
       Debtholders’ “fixed” claim increases risk of
        stockholders’ “residual” claim.
   Debt reduces the firm’s taxes
       Firm’s can deduct interest expenses.
       Frees up more cash for payments to investors
       Reduces after-tax cost of debt

                                                        6
The Effect of Debt on WACC
   Debt increases risk of bankruptcy
       Causes pre-tax cost of debt to increase
   Adding debt:
       Increases percent of firm financed with
        low-cost debt (wd)
       Decreases percent financed with high-cost
        equity (wce)
       Net effect on WACC = uncertain
                                                    7
    The Effect of Debt on FCF
    debt   probability of bankruptcy
       Direct costs:
            Legal fees
            “Fire” sales, etc.
       Indirect costs:
            Lost customers
            Reduction in productivity of managers and line
             workers,
            Reduction in credit (i.e., accounts payable)
             offered by suppliers                             8
The Effect of Additional Debt
   Impact of indirect costs
        Sales &  Productivity
            Customers choose other sources
            Workers worry about their jobs
       NOWC 
            Suppliers tighten credit
       NOPAT 
       FCF 

                                              9
    The Effect of Additional Debt
    on Managerial Behavior
   Reduces agency costs:
       Debt reduces free cash flow waste
   Increases agency costs:
       Underinvestment potential




                                            10
    Asymmetric Information
    and Signaling
   “Asymmetric Information” = insiders know
    more than outsiders
        Managers know the firm’s future prospects better
         than investors.
Managers would not issue additional equity if
  they thought the current stock price was less
  than the true value of the stock
= Investors often perceive an additional
  issuance of stock as a negative signal
         Stock price 
                                                            11
Business Risk vs. Financial Risk
   Business risk:
       Uncertainty about 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

                                                   12
 Business risk: Uncertainty about future
 pre-tax operating income (EBIT).

         Probability
                            Low risk


                               High risk


              0   E(EBIT)              EBIT
Note: Business risk focuses on operating
      income, ignoring financing effects.

                                              13
Factors That Influence
Business Risk
1. Demand variability (uncertainty unit sales)
2. Sales price variability
3. Input cost variability
4. Ability to adjust output prices for changes
   input costs
5. Ability to develop new products
6. Foreign risk exposure
7. Degree of operating leverage (DOL)

                                                 14
Operating Leverage
   Operating leverage is the change in
    EBIT caused by a change in quantity
    sold.
   > Fixed costs  > Operating leverage
       The higher the proportion of fixed costs
        within a firm’s overall cost structure, the
        greater the operating leverage.


                                                      15
Figure
15.1
Illustration
of
Operating
Leverage




               16
Higher operating leverage leads to more
business risk: small sales decline causes a
larger EBIT decline.


            Rev.                  Rev.
  $                     $
                   TC                } EBIT
                                          TC

                                           F
                   F

      QBE    Sales                       Sales
                            QBE


                                                 17
  Strasburg Electronics Company

Input Data       Plan A       Plan B
                 Low FC      High FC
Price                $2.00        $2.00
Variable costs       $1.50        $1.00
Fixed costs        $20,000     $60,000
Capital           $200,000    $200,000
Tax Rate              40%          40%



                                          18
Strasburg Expected Sales
 Operating Performance
                                  Data Applicable to Both Plans
                                              Units         Dollar
 Demand                     Probability       Sold          Sales
 Terrible                       0.05            0             $0
 Poor                            0.2         40,000        $80,000
 Average                         0.5        100,000       $200,000
 Good                            0.2        160,000       $320,000
 Wonderful                      0.05        200,000       $400,000
 Expected Values:                           100,000       $200,000
 Standard Deviation (SD):                    49,396        98,793
 Coefficient of Variation (CV):               0.49           0.49



                                                                     19
   Strasburg Plan A
                          Plan A: Low Fixed, High Variable Costs
                                 Pre-tax      Net Op Profit    Return on
      Units      Operating     Operating       After Taxes       Invested
       Sold        Costs      Profit (EBIT)     (NOPAT)           Capital
         0        $20,000       ($20,000)       ($12,000)         -6.0%
      40,000      $80,000           $0             $0              0.0%
     100,000     $170,000        $30,000         $18,000           9.0%
     160,000     $260,000        $60,000         $36,000          18.0%
     200,000     $320,000        $80,000         $48,000          24.0%
Exp. Values:     $170,000        $30,000         $18,000           9.0%
Std. Dev.:                       $24,698                           7.4%
Coef. of Var.:                     0.82                            0.82

  Figure 15-1 Lower Panel

                                                                            20
Strasburg Plan B
                            Plan B: High Fixed, Low Variable Costs
                                Pre-tax      Net Op Profit       Return on
       Units      Operating   Operating       After Taxes          Invested
       Sold         Costs    Profit (EBIT)      (NOPAT)             Capital
         0         $60,000     ($60,000)       ($36,000)           -18.0%
      40,000      $100,000     ($20,000)       ($12,000)            -6.0%
     100,000      $160,000      $40,000          $24,000            12.0%
     160,000      $220,000     $100,000          $60,000            30.0%
     200,000      $260,000     $140,000          $84,000            42.0%
 Exp. Values:     $160,000      $40,000          $24,000            12.0%
 Std. Dev.:                     49,396                              14.8%
 Coef. of Var.:                  1.23                                1.23


Figure 15-1 Lower Panel

                                                                              21
Strasburg: Plans A & B
                       Plan A: Low Fixed Costs,                                                             Plan B: High Fixed Costs,
                       Low Operating Leverage                                                               High Operating Leverage


                                                             Revenues
                       $200,000                                                              $200,000
                                                             VC




                                                                        Revenues and costs
                                                                                                                                            Revenues
  Revenues and costs




                       $150,000                              FC                              $150,000                                       VC

                                                                                                                                            FC
                       $100,000                                                              $100,000

                        $50,000
                                                                                              $50,000

                            $0
                                                                                                  $0
                                  0    50000        100000
                                                                                                        0          50000           100000
                                      S ales (units)
                                                                                                                   Sales (units)



Figure 15-1 Upper Panel

                                                                                                                                                       22
Operating Breakeven: QBE
        QBE = F / (P – V)      (15-4)

   QBE    = Operating breakeven quantity
   F      = Fixed cost
   V      = Variable cost per unit
   P      = Price per unit

                                            23
Strasburg Breakeven

             $20 ,000
Q   A
                         40 ,000 units
           $2.00  $1.50
    BE




             $60 ,000
Q   B
                         60 ,000 units
           $2.00  $1.00
    BE




                                           24
Strasburg: Plans A & B
                     Plan A: Low Fixed Costs,                                                             Plan B: High Fixed Costs,
                     Low Operating Leverage                                                               High Operating Leverage


                                                           Revenues
                     $200,000                                                              $200,000
                                                           VC




                                                                      Revenues and costs
                                                                                                                                          Revenues
Revenues and costs




                     $150,000                              FC                              $150,000                                       VC

                                                                                                                                          FC
                     $100,000                                                              $100,000

                      $50,000
                                                                                            $50,000

                          $0
                                                                                                $0
                                0    50000        100000
                                                                                                      0          50000           100000
                                    S ales (units)
                                                                                                                 Sales (units)




                                                                                                                                                     25
  Higher operating leverage leads to higher
  expected EBIT and higher risk.


                       Low operating leverage
Probability
                           High operating leverage




               EBITL      EBITH


                                                 26
Strasburg & Financial Risk
   Strasburg going with Plan B
       Riskier
       Higher expected EBIT and ROIC
   Financial risk:
       Additional business risk concentrated on
        common stockholders when financial
        leverage is used


                                                   27
Strasburg - Extended
   To date – no debt
   Two financing choices:
       Remain at 0 debt
       Move to $100,000 debt and $100,000
        book equity




                                             28
Table 15.1
Strasburg
Electronics
– Effects of
Financial
Leverage




               29
                Strasburg with No Debt
Debt                                   $0
Book equity
Interest rate
                                 $200,000
                                     n.a.
                                                                       Table 15-1 Section I

  Demand for                                             Pre-tax        Taxes          Net
    product        Probability   EBIT         Interest   income         (40%)        income           ROE
       (1)              (2)       (3)           (4)        (5)            (6)          (7)             (8)
Terrible               0.05       ($60,000)         $0     ($60,000)     ($24,000)      ($36,000)   -18.0%
Poor                    0.2        (20,000)          0      (20,000)       (8,000)       (12,000)    -6.0%
Normal                  0.5         40,000           0       40,000        16,000         24,000     12.0%
Good                    0.2        100,000           0      100,000        40,000         60,000     30.0%
Wonderful              0.05        140,000           0      140,000        56,000         84,000     42.0%
Expected value:                    $40,000          $0      $40,000       $16,000        $24,000     12.0%
Standard deviation:                                                                                  14.8%
Coefficient of variation:                                                                             1.23



          ROE = Net Income/Book Equity
          Expected ROE = ROE under each demand X Probability

                                                                                                             30
                Strasburg with 50% Debt
Debt                             $100,000
Book equity                      $100,000                                  Table 15-1 Section II
Interest rate                        10%

  Demand for                                                 Pre-tax         Taxes          Net
    product        Probability   EBIT         Interest       income          (40%)        income           ROE
       (1)              (2)       (3)           (4)            (5)             (6)          (7)             (8)
Terrible               0.05       ($60,000)       $10,000      ($70,000)      ($28,000)      ($42,000)   -42.0%
Poor                    0.2        (20,000)         10,000      (30,000)       (12,000)       (18,000)   -18.0%
Normal                  0.5         40,000          10,000       30,000         12,000         18,000     18.0%
Good                    0.2        100,000          10,000       90,000         36,000         54,000     54.0%
Wonderful              0.05        140,000          10,000      130,000         52,000         78,000     78.0%
Expected value:                     $40,000        $10,000       $30,000        $12,000        $18,000    18.0%
Standard deviation:                                                                                       29.6%
Coefficient of variation:                                                                                  1.65




                                                                                                                  31
Section I. Zero Debt
Debt
Book equity
Interest rate

  Demand for                       Net
    product
       (1)
                   Probability
                        (2)
                                 income
                                   (7)
                                                  ROE
                                                   (8)
                                                         Strasburg w/
Terrible               0.05         ($36,000)   -18.0%   Zero Debt
Poor                    0.2          (12,000)    -6.0%
Normal                  0.5           24,000     12.0%
Good                    0.2           60,000     30.0%
Wonderful              0.05           84,000     42.0%
Expected value:                      $24,000     12.0%
Standard deviation:                              14.8%
Coefficient of variation:                         1.23

Section II. $100,000 of Debt
Debt
Book equity
Interest rate

  Demand for                       Net
    product        Probability   income           ROE    Strasburg w/
       (1)              (2)        (7)             (8)   50% Debt
Terrible               0.05         ($42,000)   -42.0%
Poor                    0.2          (18,000)   -18.0%
Normal                  0.5           18,000     18.0%
Good                    0.2           54,000     54.0%
Wonderful              0.05           78,000     78.0%
Expected value:                       $18,000    18.0%   Higher ROE
Standard deviation:                              29.6%
Coefficient of variation:                         1.65   Higher Risk
                                                                        32
Leveraging Increases ROE
   More EBIT goes to investors:
       Total dollars paid to investors:
            I: NI = $24,000
            II: NI + Int = $18,000 + $10,000 = $28,000
       Taxes paid:
            I: $16,000; II: $12,000
   Equity $ proportionally lower than NI


                                                          33
Strasburg’s Financial Risk
   In a stand-alone sense, stockholders
    see much more risk with debt.
       I: σROE = 14.8%
       II: σROE = 29.6%
   Strasburg’s financial risk = σROE - σROIC
    = 29.6% - 14.8% = 14.8%

                                                34
Capital Structure Theory
   Modigliani & Miller theory
       Zero taxes (MM 1958)
       Corporate taxes (MM 1963)
       Corporate and personal taxes (Miller 1977)
   Trade-off theory
   Signaling theory
   Pecking order
   Debt financing as a managerial constraint
   Windows of opportunity
                                                     35
MM Results: Zero Taxes
   If two portfolios (firms) produce the
    same cash flows, then the two
    portfolios must have the same value.

A firm’s value is unaffected by its
 capital structure


                                            36
 MM (1958) Assumptions
1. No brokerage costs
2. No taxes
3. No bankruptcy costs
4. Investors can borrow and lend at the
   same rate as corporations
5. All investors have the same information
6. EBIT is not affected by the use of debt

                                             37
MM Theory: Zero Taxes
                           Firm U         Firm L
EBIT                      $3,000          $3,000
Interest                        0          1,200
NI                        $3,000          $1,800


CF to shareholder         $3,000          $1,800
CF to debt holder               0         $1,200
Total CF                  $3,000          $3,000
Notice that the total CF are identical.
                                                   38
MM Results: Zero Taxes
   MM prove:
       If total CF to investors of Firm U and Firm L are
        equal, then the total values of Firm U and Firm L
        must be equal:
        VL = VU
   Because FCF and values of firms L and U
    are equal, their WACCs are equal
   Therefore, capital structure is irrelevant


                                                            39
    MM (1963): Corporate Taxes
   Relaxed assumption of no corporate
       taxes
   Interest may be deducted, reducing taxes
       paid by levered firms
   More CF goes to investors, less to taxes
       when leverage is used
   Debt “shields” some of the firm’s CF from
       taxes

                                                40
    MM Result: Corporate Taxes
   MM show that the value of a levered firm
    = value of an identical unlevered form +
    any “side effects.”
            VL = VU + TD            (15-7)

   If T=40%, then every dollar of debt adds
    40 cents of extra value to firm


                                               41
    MM relationship between value and debt
    when corporate taxes are considered.
  Value of Firm, V

                                      VL
                                 TD
                                      VU

                                           Debt
    0

Under MM with corporate taxes, the firm’s value
increases continuously as more and more debt is used.
                                                        42
   MM relationship between capital costs and
   leverage when corporate taxes are considered


 Cost of
Capital (%)
                                    rs




                                    WACC
                                    rd(1 - T)
                                        Debt/Value
    0         20   40   60   80   100    Ratio (%)
                                                     43
        Miller (1977): Corporate and
        Personal Taxes
   Personal taxes lessen the advantage of
    corporate debt:
      Corporate taxes favor debt financing

           Interest expenses deductible
       Personal taxes favor equity financing
         No gain is reported until stock is sold
         Long-term gains taxed at a lower rate




                                                    44
Miller’s Model with Corporate
and Personal Taxes

             (1 - Tc)(1 - Ts)
VL = VU + 1−                    D   (15-8)
                  (1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.


                                             45
 Tc = 40%, Td = 30%,
 and Ts = 12%

               (1 - 0.40)(1 - 0.12)
VL = VU + 1−                          D
                     (1 - 0.30)
   = VU + (1 - 0.75)D
   = VU + 0.25D

Value rises with debt; each $1 increase in
debt raises Levered firm’s value by $0.25.
                                             46
Trade-off Theory
   MM theory assume no cost to bankruptcy
   The probability of bankruptcy increases as
    more leverage is used
       At low leverage, tax benefits outweigh
        bankruptcy costs.
       At high levels, bankruptcy costs outweigh tax
        benefits.
   An optimal capital structure exists
    (theoretically) that balances costs and
    benefits.
                                                        47
Figure 15.2
Effect of Leverage on Value




                              48
Signaling Theory
   MM assumed that investors and
    managers have the same information.
   Managers often have better information
    and 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.
                                             49
    Pecking Order Theory
   Firms use internally generated funds first (1):
        No flotation costs
        No negative signals
   If more funds are needed, firms then issue
    debt (2)
        Lower flotation costs than equity
        No negative signals
   If more funds are still needed, firms then
    issue equity (3)

                                                      50
Pecking Order Theory

          INTERNAL EXTERNAL
 DEBT                 2
 EQUITY      1        3




                              51
Debt Financing & Agency Costs
   Agency problem #1: Managers use
       corporate funds for non-value
       maximizing purposes
   Financial leverage:
       Bonds commit “free cash flow”
       Forces discipline on managers to avoid
         perks and non-value adding acquisitions.
       LBO = ultimate use of debt controlling
         management actions
                                                    52
    Debt Financing & Agency Costs
   Agency problem #2: “Underinvestment”
     Debt increases risk of financial

      distress
     Managers may avoid risky projects

      even if they have positive NPVs




                                           53
Investment Opportunity Set and
Reserve Borrowing Capacity
   Firms should normally use more
    equity, less debt than optimal
      “Reserve borrowing power”

      Especially important if:

       Many investment opportunities
       Asymmetric information issues cause

        equity issues to be costly

                                              54
  Windows of Opportunity
  Managers try to “time the market” when
             issuing securities.
Issue      When              And
Equity     Market is “high” Stocks have “run up”
Debt       Market is “low”   Interest rates low
S/T Debt      Term structure is upward sloping
L/T Debt            Term structure is flat
                                                   55
Empirical Evidence
   Tax benefits are important
       $1 debt adds  $0.10 to value
       Supports Miller model with personal taxes
   Bankruptcies are costly
       Costs can =10% to 20% of firm value
   Firms don’t make quick corrections
    when Δstock price  Δdebt ratios
       Doesn’t support trade-off model
                                                    56
Empirical Evidence
   After stock price , debt ratio , but firms
    tend to issue equity not debt
       Inconsistent with trade-off model
       Inconsistent with pecking order
       Consistent with windows of opportunity
   Firms tend to maintain excess borrowing
    capacity
       Firms with growth options
       Firms with asymmetric information problems

                                                     57
Implications for Managers
   Take advantage of tax benefits by
    issuing debt, especially if the firm
    has:
     High tax rate
     Stable sales

     Less operating leverage




                                           58
Implications for Managers
   Avoid financial distress costs by
    maintaining excess borrowing capacity,
    especially if the firm has:
       Volatile sales
       High operating leverage
       Many potential investment opportunities
       Special purpose assets (instead of general
        purpose assets that make good collateral)

                                                     59
Implications for Managers
   If manager has asymmetric information
    regarding firm’s future prospects, then:
       Avoid issuing equity if actual prospects are
        better than the market perceives
   Consider impact of capital structure
    choices on lenders’ and rating agencies’
    attitudes

                                                       60
The Optimal Capital Structure
   Maximizes shareholder wealth
   Maximizes firm value
   Maximizes stock price
   Minimizes WACC
   Does NOT maximize EPS



                                   61
Estimating the Optimal Capital
Structure: 5 Steps
1. Estimate the interest rate the firm will
     pay (cost of debt)
2.   Estimate the cost of equity
3.   Estimate the WACC
4.   Estimate the free cash flows and their
     present value (value of the firm)
5.   Deduct the value of debt to find
     Shareholder Wealth  Maximize
                                          62
Choosing the Optimal Capital
Structure: Strasburg Example
   Currently all-equity financed
   Expected EBIT = $40,000
   10,000 shares outstanding
       rs    = 12%     P0   = $25
       T     = 40%     b    = 1.0
       rRF   = 6%      RPM = 6%

                                    63
      Step 1:
      Estimates of Cost of Debt




TABLE 15.2



                                  64
The Cost of Equity at Different Levels
of Debt: Hamada’s Equation

   MM theory  beta changes with
    leverage
   bU = the beta of a firm with NO debt
       Unlevered beta
   b = bU [1 + (1 - T)(D/S)]
       D = Market value of firm’s debt
       S = Market value of firm’s equity
       T = Firm’s corporate tax rate
                                           65
    Step 2:
    The Cost of Equity for wd = 50%
   Use Hamada’s equation to find beta:
     b = bU [1 + (1 - T)(D/S)]
        = 1.0 [1 + (1-0.4) (50% / 50%) ]
        = 1.60
   Use CAPM to find the cost of equity:
      rs= rRF + bL (RPM)
       = 6% + 1.60 (6%) = 15.6%
                                           66
TABLE 15.3
Strasburg’s optimal Capital Structure




                                        67
           Step 3: Strasburg’s WACC &
           Optimal Capital Structure
Table 15-3 Strasburg's Optimal Capital Structure

    Percent        Market        After-tax                                         Value of
   financed      Debt/Equity,   cost of debt,   Estimated    Cost of              operations,
 with debt, wd       D/S          (1-T) rd       beta, b    equity, rs   WACC        Vop
      (1)             (2)            (3)            (4)        (5)         (6)        (7)
      0%            0.00%          4.80%           1.00      12.0%       12.00%    $200,000
     10%           11.11%          4.80%           1.07      12.4%       11.64%    $206,186
     20%           25.00%          4.86%           1.15      12.9%       11.29%    $212,540
     30%           42.86%          5.10%           1.26      13.5%       11.01%    $217,984
     40%           66.67%          5.40%           1.40      14.4%       10.80%    $222,222
     50%          100.00%          6.60%           1.60      15.6%       11.10%    $216,216
     60%          150.00%          8.40%           1.90      17.4%       12.00%    $200,000



    Note: The Capital Structure that MAXIMIZES firm value is
          the one that MINIMIZES WACC
                                                                                                68
         Notes to Table 15-3
         a
Notes:       The D/S ratio is calculated as: D/S = wd / (1-wd).
         b
             The interest rates are shown in Table 15-2, and the tax rate is 40%.
         c
             The beta is estimated using Hamada’s formula in Equation 15-8.
         d
          The cost of equity is estimated using the CAPM formula: rs = rRF + (RPM)b,
         where the risk free rate is 6 percent and the market risk premium is 6 percent.
         e
          The weighted average cost of capital is calculated using Equation 15-2: WACC =
         wce rs + wd rd (1-T), where wce = (1-wd).


         f
          The value of the firm's operations is calculated using the free cash flow valuation formula in
         Equation 14-1, modified to reflect the fact that Strasburg has zero growth: Vop = FCF / WACC.
         Since Strasburg has zero growth, it requires no investment in capital, and its FCF is equal to its
         NOPAT. Using the EBIT shown in Table 15-1:
                              FCF = NOPAT + Investment in capital = EBIT(1-T) + 0
                                    = $40,000 (1-0.4) = $24,000.




                                                                                                              69
Figure 15.3
Strasburg’s Required Rate of Return on Equity




                                          70
Figure 15-4: Effects of Capital
Structure on Cost of Capital
    20%                                            Cost of Equity




    15%

                                                          WACC


    10%



                                                        After-T ax
     5%                                                 Cost of Debt




     0%
          0%   10%   20%         30%        40%   50%          60%
                     Percent Financed with Debt


                                                                       71
Step 4:
Corporate Value for wd = 0%
   Vop = FCF(1+g) / (WACC-g)
   g=0, so investment in capital is zero
       FCF = NOPAT = EBIT (1-T)
   NOPAT = ($40,000)(1-0.40) = $24,000
   Vop = $24,000 / 0.12 = $200,000



                                            72
        Step 4: Strasburg’s Firm Value
Table 15-3 Strasburg's Optimal Capital Structure

    Percent        Market        After-tax                                         Value of
   financed      Debt/Equity,   cost of debt,   Estimated    Cost of              operations,
 with debt, wd       D/S          (1-T) rd       beta, b    equity, rs   WACC        Vop
      (1)             (2)            (3)            (4)        (5)         (6)        (7)
      0%            0.00%          4.80%           1.00      12.0%       12.00%    $200,000
     10%           11.11%          4.80%           1.07      12.4%       11.64%    $206,186
     20%           25.00%          4.86%           1.15      12.9%       11.29%    $212,540
     30%           42.86%          5.10%           1.26      13.5%       11.01%    $217,984
     40%           66.67%          5.40%           1.40      14.4%       10.80%    $222,222
     50%          100.00%          6.60%           1.60      15.6%       11.10%    $216,216
     60%          150.00%          8.40%           1.90      17.4%       12.00%    $200,000




Note: The Capital Structure that MAXIMIZES firm value is
      the one that MINIMIZES WACC
                                                                                                73
Implications for Strasburg
   Firm should recapitalize (“recap”)
   Issue debt
   Use funds to repurchase equity
   Optimal debt = 40%
       WACC = 10.80%
       Maximizes Firm Value


                                         74
Anatomy of Strasburg’s Recap:
Before Issuing Debt
         Value of Operations     $200,000
    + Short Term investments            0
      Total Value of the Firm    $200,000
      − Market Value of Debt            0
           Value of equity (S)   $200,000
            Number of shares       10,000
        Stock Price per Share      $20.00

              Value of stock     $200,000
       + Cash distributed in
                  repurchase            0
      Wealth of shareholders     $200,000
                                            75
Issue Debt (wd = 40%), But
Before Repurchase
   WACC decreases to 10.80%
   Vop increases to $222,222
   Short-term funds = $88,889
       Temporary until it uses these funds to
        repurchase stock
   Debt is now $88,889


                                                 76
Anatomy of a Recap: After
Debt, but Before Repurchase
                                              After Debt Issue,
                             Before Debt         But Before
                                Issue           Repurchase
                                 (1)                 (2)
     Value of Operations          $200,000             $222,222   Vop  $222,222
+ Short Term investments                  0              88,889
  Total Value of the Firm         $200,000             $311,111
  − Market Value of Debt                  0              88,889
                                                                  Debt      = $88,889
       Value of equity (S)        $200,000             $222,222   S/T funds = $88,889
        Number of shares             10,000              10,000
    Stock Price per Share            $20.00              $22.22   Stock Price  $22.22

          Value of stock          $200,000            $222,222
   + Cash distributed in
              repurchase                 0                   0
  Wealth of shareholders
                                                                  Shareholder wealth 
                                  $200,000            $222,222
                                                                       $222.222
                                                                                         77
    The Repurchase:
    No Effect on Stock Price
   Announcement of intended repurchase might
    send a signal that affects stock price
   The repurchase itself has no impact on stock
    price.
      If investors think the repurchase would:

           stock price, they would purchase stock the
           day before, which would drive up its price.
           stock price, they would all sell short the stock
           the day before, which would drive down the
           stock price.
                                                                78
Remaining Number of Shares
After Repurchase
   D0 = original amount of debt
   D = amount after issuing new debt
   If all new debt is used to repurchase shares,
    then total dollars used equals:
       (D – D0) = ($88,889 - $0) = $88,889
   n0 = number of shares before repurchase,
   n = number after repurchase.
       n = n0 – (D – D0)/P = 10,000 - $88,889/$22.22
       n = 10,000 – 4,000 = 6,000
                                                        79
Anatomy of Strasburg’s Recap:
After Repurchase
                                               After Debt Issue,
                              Before Debt         But Before         After
                                 Issue           Repurchase        Repurchase
                                  (1)                 (2)             (3)
      Value of Operations          $200,000             $222,222       $222,222
 + Short Term investments                  0              88,889               0
   Total Value of the Firm         $200,000             $311,111       $222,222
   − Market Value of Debt                  0              88,889          88,889
        Value of equity (S)        $200,000             $222,222       $133,333
         Number of shares             10,000              10,000      $6,000.00
     Stock Price per Share            $20.00              $22.22          $22.22

           Value of stock          $200,000            $222,222        $133,333
    + Cash distributed in
               repurchase                 0                   0          88,889
   Wealth of shareholders          $200,000            $222,222        $222,222

                                                                                   80
Strasburg after Recapitalization
Key Points
   Short Term investments used to
    repurchase stock
   Stock price is unchanged
   Value of stock falls to $133,333
       Firm no longer owns the short-term
        investments
   Wealth of shareholders remains at
    $222,222
                                             81
Shortcuts
   The corporate valuation approach will
    always give the correct answer
   There are some shortcuts for finding
    S, P, and n
   Shortcuts on next slides



                                            82
Calculating S, the Value of
Equity after the Recap
   S = (1 – wd) Vop                 (15-13)

   At wd = 40%:
       SPrior = S + (D – D0)        (15-14)

       S = (1 – 0.40) $222,222
       S = $133,333
       SPrior = $133,333 + (88,889 – 0)
       SPrior = $222,222

                                               83
Calculating P, the Stock Price
after the Recap

P = [S + (D – D0)]/n0      (15-15)

P = $133,333 + ($88,889 – 0)
         10,000
P = $22.22 per share


                                     84
Number of Shares after a
Repurchase, n
   # Repurchased = (D - D0) / P
   n = n0 - (D - D0) / P
   # Rep. = ($88,889 – 0) / $22.22
   # Rep. = 4,000
   n = 10,000 – 4,000
   n = 6,000


                                      85
TABLE 15.5
Strasburg’s Stock Price & EPS




                                86
            Analyzing the Recap
   Percent       Value of      Market        Market                    Number of                   Earnings
  financed      operations,      value        value        Stock      shares after   Net income,   per share,
with debt, wd      Vop        of debt, D   of equity, S   price, P   repurchase, n        NI          EPS
     (1)            (2)           (3)           (4)         (5)           (6)             (7)         (8)
     0%          $200,000         $0        $200,000      $20.00        $10,000       $24,000        $2.40
    10%           206,186       20,619       185,567      $20.62         9,000         23,010        $2.56
    20%           212,540       42,508       170,032      $21.25         8,000         21,934        $2.74
    30%           217,984       65,395       152,589      $21.80         7,000         20,665        $2.95
    40%           222,222       88,889       133,333      $22.22         6,000         19,200        $3.20
    50%           216,216      108,108       108,108      $21.62         5,000         16,865        $3.37
    60%           200,000      120,000        80,000      $20.00         4,000         13,920        $3.48


    Table 15-5




                                                                                                           87
FIGURE 15.5   Effects of Capital Structure on Firm Value, Price and EPS




                                                                          88
Effects of Capital Structure on
Price and EPS

     Stock Price
                                                        EPS

    $25                                                    $6
     Price
    $20
                                                           $4
    $15
                                     EPS
    $10
                                                           $2
     $5

     $0                                                    $0
          0%   10%      20%    30%         40%    50%   60%

                     Percent Financed with Debt


                                                                89
Optimal Capital Structure
   wd = 40% gives:
     Highest corporate value
     Lowest WACC

     Highest stock price per share

     Does NOT maximize EPS




                                      90

				
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