Topics in Chapter 16: Capital
Structure
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Business risk & financial risk
Impact of financial leverage on returns
Analyzing alternative capital structures
Optimal capital structure
1
Capital Structure
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To minimize the complexity of capital
structure analysis, we simplify:
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No preferred stock financing: the firm’s
capital consists of common equity and debt
No financial assets (no nonoperating
assets)
100% dividend payout, so g = 0
2
Capital Structure
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We saw in Chapter 15 that the value of
the firm is the PV of expected FCFs,
discounted at the WACC (plus
marketable securities, if any).
Now, we consider how changes in the
firm’s capital structure affects WACC,
and hence the firm value.
3
Business Risk

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Business risk: the risk facing a firm’s
shareholders if it has no debt financing.
Business risk is the risk associated with
firm’s assets and the nature of the
products it produces and sells.
4
Business Risk

Measures of business risk include the
standard deviation of EBIT and the
standard deviation of basic earning
power (BEP).
BEP = EBIT / Total Assets
5
Financial Risk
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Financial risk: the risk that results from
debt financing.
Measures of fin’l risk include debt ratio,
debt/equity, s of ROE, etc.
If a firm relies heavily on debt
financing, it has high financial leverage
and high financial risk.
Why expose the firm to financial risk?
6
Consider Two Hypothetical
Firms
Firm U
No debt
Firm L
$10,000 of 12% debt
$20,000 in assets
$20,000 in assets
40% tax rate
40% tax rate
Both firms have same operating leverage,
business risk, and EBIT of $3,000. They differ
only with respect to use of debt.
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Impact of Leverage on
Returns
EBIT
Interest
EBT
Taxes (40%)
NI
ROE
Firm U
$3,000
0
$3,000
1 ,200
$1,800
Firm L
$3,000
1,200
$1,800
720
$1,080
9.0%
10.8%
8
Why does leveraging increase
return?

More cash flow goes to investors and
less is paid in taxes in Firm L.
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Total dollars paid to investors:
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U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Taxes paid:
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U: $1,200; L: $720.
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Why Does Debt Financing
Increase ROE?
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Firm L’s ROE is higher because its basic
earning power (BEP) > interest rate.
BEP = EBIT / (Total Assets)
= 3,000 / 20,000 = .15
Firm L is borrowing at 12% and
investing in assets that earn 15%.
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Conclusions
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L has higher expected ROE due to tax
savings and smaller equity base.
L has more volatile returns because of
fixed interest charges.
Higher expected return is accompanied
by higher risk.
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Capital Structure
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As a firm increases its use of debt:
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rs and rd increase
WACC initially decreases, then increases
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Trade-off Theory of Capital
Structure
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At low leverage levels, tax benefits of
debt 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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Implications for Managers
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Use less debt financing if firm has:
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High business risk
Special use assets
Use more debt financing if firm has:
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High tax rate
Low business risk
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Optimal Capital Structure
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The optimal capital structure results in
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Highest firm value
Highest stock price per share
Lowest WACC
15