Chapter 16

Capital Structure
Capital Structure

Is mix of debt and Equity that

maximizes the stock price.
How dose capital structures affect
the value of the firm
 Value of the Firm= FCF
1+ WACC
 The value of a firm is the present
value of its expected future free cash
flow (FCFs), discounted at its
weighted average cost of capital
(WACC).
ABC Company showing the Following
Capital Structure (Tax Rate 40%)
Ser. Weight of Interest Weight of Cost of WACC
Debt Rate Equity Equity
1 0% 8% 100% 10% 10%
2 10% 8% 90% 10% 9.48%
3 20% 8% 80% 10% 8.96%
4 30% 8% 70% 10% 8.44%
5 40% 8% 60% 10% 7.92%
6 50% 8% 50% 10% 7.40%
7 60% 8% 40% 10% 6.88%
8 70% 8% 30% 10% 6.66%
9 80% 8% 20% 10% 5.84%
10 90% 8% 10% 10% 5.32 %
11 100% 8% 0% 10% 4.80%
The Effect of Debt (On Various Factors)
Capital 10Million – Int.10% - Tax
40%
100% Equity 50% & 50% 100% Debt

A B C
Sales 10,000,000 10,000,000 10,000,000

(-) COGS 5,000,000 5,000,000 5,000,000

EBIT 5,000,000 5,000,000 5,000,000

(-) Interest Zero 500,000 1,000,000

EBT 5,000,000 4,500,000 4,000,000

TAX @40% 2,000,000 1,800,000 1,600,000

Net Income 3,000,000 2,700,000 2,400,000

ROE 30% 54% ∞
1.Debt and Its impact on CF
 Imagine that a company’s cash
flows are a pie, and three different
groups get pieces of The pie, the
first sector goes to the government
in the form of taxes, the second
goes to debt holders, and the third
to shareholders.
 B A
500K
INT.

2.70 M 1.80 M 2M
Cash TAX Interest 3M TAX Interest

Flow Tax
Cash Cash
Tax
cash

Flow

C
1M
INT.
2.40 M
Cash Interest

Flow 1.60M Tax

Cash

TAX
2. Debt increases the Probability of
Bankruptcy.
A. Direct costs: Legal Fees, “Fire” Sales, etc.
B. Indirect costs: Lost customers, Reduction
in productivity of managers and line
workers, reduction in credit offered by
suppliers. Therefore lost of customers and
drop in productivity will lead to reduction in
net operating Profit after taxes.
2. Debt increases the Probability of
Bankruptcy - Cont’d
C. Trade off Theory
 Modigliani and Miller (MM’s) developed trade- off
theory of capital structure they assume that firm trade
off the benefits of debt (Tax saving) and the
bankruptcy cost.
 However, in practice bankruptcy can be quite costly.
Firms in bankruptcy have very high legal and
accounting expenses, and they also have a hard time
retaining customers, suppliers, and employees.
Moreover, bankruptcy often forces a firm to liquidate
or sell assets for less than they would be worth if the
firm were to continue operating.
3.Debt can affect the Behavior of
Managers ( Agency Cost)
 When time is good, managers may
waste cash flow on Privileges and Non-
necessary expenditures which lead to
increases the agency costs however
additional debt will make manager feel
the threat of bankruptcy which makes
them work hard and reduces such
wasteful spending, which mean
increases in FCF.
Issuing debt Convey Positive Signal while
issuing Equity Convey Negative signal
 Managers are in a better position to forecast a
company’s free cash flow than are investors, and
academics calling this informational asymmetry.
Suppose a company’s stock price is $50 per share.
If managers are willing to issue new stock at $50
per share, investors reason that no one would sell
anything for less than its true value. Therefore, the
true value of the shares as seen by the managers
with their superior information must be less than
$50. Thus, investors perceive an equity issue as a
negative signal, and this usually causes the stock
price to fall.
Business Risk
 Business risk occurs when sales are
Reduced and costs are Increased, in
both cases EBIT will negatively
affect.(The higher the Operating
Leverage the higher the business risk )
Break Even Point
EBIT = Zero
Price XQ – Variable XQ – FC = 0
PQ –VQ = FC
Q (P-V) = F
QBE = FC
P-V
Example

Good Year Bad Year

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%
Answer
Good Year
QBE = FC
P-V
QBE = 20,000 = 40,000 units
2-1.50
Bad Year
QBE = 60,000 = 60,000 units
2-1
Answer
Good Year Bad Year

Sales @ Break Even 80,000 120,000

(-) VC 60,000 60,000

(-)FC 20,000 60,000

EBIT ZERO ZERO

The higher the operating Leverage the higher the

business risk
Financial Risk
 Financial risk is the additional risk placed on the
Common stockholders as a result of The decision
to finance the firm with debt.

 Suppose ten people decide to form a corporation

there is a certain amount of business risk in the
operation. If the firm is capitalized only with
common equity, and if each person buys 10 % of
the stock, then each investor shares equally in the
business risk.
 Suppose the firm is capitalized with 50% debt and 50%
Equity, with five of the investors putting up their capital
as debt and the other five putting up their money as
equity. In this case, the five investors who put up the
equity will have to bear all of the business risk, so the
common stock will be twice as risky as it would have
been had the firm been financed only with equity.
 Thus, the use of debt, or financial leverage, concentrates
the firm’s business risk on its stockholders. This
concentration of business risk occurs because debt
holders, who receive fixed interest payments, bear none
of the business risk.
Thank You