Capital Structure
FIN 461: Financial Cases & Modeling
George W. Gallinger
Associate Professor of Finance
W. P. Carey School of Business
Arizona State University
Management’s Objective




Maximize firm's value
Firm value = Market
value of debt +
market value of equity
Firm's investments
affect its value
Accept value
enhancing projects.
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Slide 2
Value Eroded; Value Created
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Slide 3
Long-Term Value Index
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Slide 4
Valuation of No-Growth
Unlevered Firm
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Slide 5
Tax Benefit of Debt
Financing
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Slide 6
Valuation of a No-Growth
Levered Firm
×
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Slide 7
Competitive Environments
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Slide 8
PV of Growth Opportunities
Can incorporate growth
in the denominator of
the 1st term
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Slide 9
Contribution of PVGOs
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Slide 10
Calculating the Cost of Debt
Alternatively, you
could use the
CAPM to estimate
the cost of debt.
The problem is
knowing the debt
beta.
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Slide 11
Cost of Preferred Stock
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Slide 12
Cost of Equity Using the
Dividend Growth Model
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Slide 13
Cost of Equity Using the SML
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Slide 14
Cost of Equity from a Beta
Perspective
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Slide 15
Beta & Leverage
Assumes the debt
beta is 0.

In a world with corporate taxes and riskless debt, it
can be shown that the relationship between the beta
of the unlevered firm and the beta of levered equity
is:


Debt
β Equity  1 
 (1  TC ) β Unlevered firm
 Equity



Debt
 Since 1  Equity  (1  TC )  must be more than 1 for a


levered firm, it follows:
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β Equity  β Unleveredfirm
Slide 16
Beta & Leverage …

If the beta of the debt is non-zero (i.e., risky),
then:
β Equity  β Unlevered firm  (1  TC )(β Unlevered firm
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B
 β Debt ) 
SL
Slide 17
Beta & Leverage: No
Corporate Taxes

In a world without corporate taxes, and with riskless corporate
debt, it can be shown that the relationship between the beta of
the unlevered firm and the beta of levered equity is:
β Unlevered 
Equity
 β Equity
Asset
 In a world without corporate taxes, and with risky corporate
debt, it can be shown that the relationship between the beta
of the unlevered firm and the beta of levered equity is:
β Unlevered 
Debt
Equity
 β Debt 
 β Equity
Asset
Asset
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Slide 18
Effect of Debt on Cost of
Equity
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Slide 19
Cost of Equity
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Slide 20
Calculation of Weights &
WACC
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Slide 21
Pertinent Info About
Ethridge Company
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Slide 22
Firm Value & WACC
B
A
C
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Slide 23
Firm Value & WACC …
A
B
C
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Slide 24
Agency Costs & Capital
Structure

A trade-off of debt and equity agency costs suggests that some appropriate mix
of debt and equity financing exists for minimizing total agency costs.
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Slide 25
Costs of Financial Distress

Direct costs of bankruptcy (out-of-pocket cash expenses)

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Indirect costs: Usually much more important

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Impaired ability to conduct business (e.g., lost sales)
Managerial distraction, loss of best (most mobile) personnel
Financial distress also gives managers adverse incentives

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Legal, auditing and administrative costs (include court costs)
Large in absolute amount, but only 1-2% of large firm value
Asset substitution problem: Incentive to take large risks
Under-investment problem: S/Hs refuse to contribute funds
Trade-off Model of Corporate Capital Structure

Trade off tax benefits of debt vs costs of Financial distress:
V L = V U + PV Tax Shields - PV Bankruptcy Costs
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Slide 26
Agency Costs Of Outside
Debt

Issuing debt externally helps minimize agency costs of equity

Gives rise to Agency Costs of Outside Debt

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High debt loads give managers, acting for shareholders,
incentives to play two perverse “games”:



Expropriate bondholder wealth by paying excessive dividends
Bait And Switch: Promise to use borrowed money for safe
investment, then use to buy high/risk, high/return asset
Bondholders understand incentives, protect themselves with
positive and negative covenants in lending contracts


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Costs increase with amount of debt issued
Positive covenants mandate what borrower must do
Negative covenants mandate what borrower must not do
Agency costs of debt are burdensome, but so are solutions.
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Slide 27
Game #1: The Asset
Substitution Problem

When a firm falls into financial distress, management
has incentive to substitute assets


Assume Firm Substitute has debt with a face value of
$12,000,000 million outstanding, matures 1 month
$10,000,000 of cash on hand

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
Firm still controls investment policy until default actually occurs
If firm defaults, bondholders take over all remaining assets
(including cash on hand)
Substitute’s managers offered two projects, both requiring
$10,000,000 cash investment & both paying off in 30 days:

Safe promises a certain $10,200,000 payoff (2% monthly

Lottery offers a 25% chance of $13,000,000 payoff, and a 75%
return)
chance of $7,500,000: expected value = $8,875,000.
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Slide 28
Game #1: Asset Substitution
Problem …

Safe has positive NPV and is preferred by bondholders


But stockholders and managers rationally choose Lottery
If gamble is successful

Payoff = $13,000,000 million

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If gamble unsuccessful

Stockholders are no worse off


Pay maturing debt, keep remaining $1,000,000
Bondholders will take firm’s remaining assets in 30 days
Game is important because shareholders (through managers)
have incentive to gamble with bondholders’ money



Would not accept Lottery if all-equity financed firm
Would not accept Lottery if company was a partnership
Limited liability means bondholders have no recourse to
shareholders.
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Slide 29
Game # 2: The UnderInvestment Problem

Shareholders refuse to contribute funds for positive NPV projects


Assume firm has $10,000,000 cash on hand and a bond worth
$12,000,000 million maturing in 30 days



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Occurs if shareholders must contribute cash, but all project’s benefits
accrue to bondholders.
Firm is offered chance to purchase a competitor at a discount price
of $11,000,000  offer open only 30 days
Merger would maximize firm value, and bondholders would accept
Shareholders control firm’s investment policy until default occurs
Firm’s managers, acting for the shareholders, would reject
merger


Even though value-maximizing, shareholders have to contribute
additional $1,000,000 cash  yet firm will still default in 30 days
If firm all-equity financed, shareholders would invest additional cash.
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Slide 30
Theoretical Optimal Capital
Structure

Optimal capital
structure



Point where the
value of the firm
is maximized
WACC is
minimized
Management
trades off benefits
realized from the
interest tax shield
against financial
distress and
agency costs.
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Slide 31
Maximize Value of the Firm
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Slide 32
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Slide 33
Coverage Ratios
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Slide 34
Median Value by Rating
Category
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Slide 35
Industry Debt-to-Asset
Ratios
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Slide 36
Market Value Debt Ratios,
July 2002
Company
Microsoft
Intel
ExxonMobil
Procter & Gamble
Boeing
Walt Disney
AEP
Georgia Pacific
Delta Air Lines
General Motors
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Debt to total
assets
L-T debt to
total capital
Market to
book ratio
0
0
0.04
0.12
0.27
0.27
0.54
0.69
0.77
0.84
0
0
0.03
0.07
0.24
0.25
0.36
0.55
0.75
0.83
5.54
4.03
3.72
10.13
3.65
1.92
1.62
1.19
0.82
4.12
Slide 37
Financial Relationships



Earnings before
interest and taxes
represent the
operating income
(before taxes)
generated by the
firm's assets
Interest expense is
the (accounting)
cost of debt
financing
If you define ROA
as net
income/assets, you
are mixing the
earning power of
the assets with a
financing cost.
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Slide 38
Trading on the Equity
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Slide 39
EBIT-Profitability Analysis


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When EBIT is below
the level of $80, the
firm will be more
profitable if
management finances
with an all-equity
capital structure
Above the indifference
point, a combination of
debt and equity
financing improves
profitability.
Slide 40
EBIT Indifference Levels for
Different Capital Structures
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Slide 41
Indifference Levels …
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Slide 42
Choice Among Different
Capital Structures

The capital structure choice is to use no debt if EBIT is below $90, use $300 of
debt and $700 of equity financing if EBIT is in the range between $90 to $104,
and use $600 of debt and $400 of equity financing if EBIT is above $104.
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Slide 43
Calculating Financial
Leverage
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Slide 44
Breakeven Sales Level
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Slide 45
Managing Total Risk
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The End
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