Capital Structure

Benefits of Using Other People’s Money

Debt
→Financial leverage is the ability that owners
have, to use other people’s money at fixed
rates to make higher rates of return than would
have been possible by using all of their own
money. It represents one of the main benefits
of taking on debt.  
→Firms that take on debt as part of their capital
structure are therefore known as leveraged
firms while those that do not are known as
unlevered firms.
How does the mechanism work?
 Earnings per Share as a Measure of the
Benefits of Borrowing
® One way to measure the benefits of leverage
is to compare the EPS of firms with different
capital structures under good and bad
economic conditions.
® Let us consider 3 equal-sized firms: one with
no debt, one with 50% debt, and one with
99.75% debt.
 Earnings per Share as a Measure of the
Benefits of Borrowing
Capital Structure
Three Identical Firms
Company needs to raise $10,000 capital, its shares are sold @ $25
 Earnings per Share as a Measure of the
Benefits of Borrowing
→ Assuming a cost of debt of 10% for all firms and identical EBIT
($2000), EPS is calculated and shown
→ Earnings per Share of Firms with Different Capital Structures

→ If the firm’s EBIT covers its interest cost, higher leverage benefits
the stockholders resulting in higher EPS
 Earnings per Share as a Measure of the
Benefits of Borrowing
→ However, if the firm’s EBIT does not cover its interest cost,
the reverse is true, as shown
Earnings per Share of Firms with Different Capital Structures

Bottom-line
Leverage is a two-edged sword; benefiting firms in
good times and hurting them in bad times
® The search continues for seeking that level
of EBIT that makes the capital structure
decision irrelevant, resulting in similar EPS
® The Break Even EBIT has an answer
 Break-Even Earnings for Different
Capital Structures
To calculate the break-even EBIT, we use the following method: 
1. We first calculate the EPS of two firms, Company 1 and
Company 2; set them equal; and solve for the EBIT:
EPS = (EBIT – I)/no: of shares
EPS* =( EBIT – 0)/400 = (EBIT -$500)/200
400(EBIT-$500) = 200(EBIT-0)
2EBIT-$1000 = EBIT
EBIT = $1000
2. Next, we calculate each firm’s EPS at the break-even EBIT,
i.e., $1000: 
Company 1’s EPS = 1000/400 = $2.50
Company 2’s EPS = (1000-500)/200 = $2.50
Company 3’s EPS = (1000-997.5)/1= $2.50
 Break-Even Earnings for Different
Capital Structures
→At a certain level of EBIT, known as the break-even
EBIT, all three firms will have the same EPS, as
shown  
→Earnings per Share of Firms with Different Capital
Structures
 Break-Even Earnings for Different
Capital Structures
→Below an EBIT of $1000, e.g., $800, leverage hurts
and vice-versa, as shown

Earnings per share and

earnings for three different
capital structures.
 Bottom line
® At an EBIT of $1,000, capital structure of
the firm becomes irrelevant, justified by
the fact at the different capital structure
leads to the same EPS value
1. In order to meet its financing requirements, Google is
contemplating at two possible capital structures.
Presently the firm is an all equity firm with a $12
million in assets and 2 million shares outstanding. The
market value of each stock is $6.0. the CEO is thinking
of leveraging the firm by selling 6 million of debt
financing and retiring the stock in debt for equity swap.
The annual cost of debt is 8%. What is the break – even
EBIT for Google with the two possible capital
structures.
EBIT = $960,000, EPS = 0.48
2. Which capital structure should the company choose if
the anticipated EBIT for the coming year is $1,000,000?
EPS = $0.50, $0.52
The intriguing question
®How much debt should a company
carry and from whom
®Basis for “Pecking order Hypothesis”
 Firm Value in Miller – Modigliani Framework

® Firm E is an all equity firm with a required rate of

return on its assets of 8%. Firm L is a leveraged
firm and can borrow in the debt market @6%,
what is the cost of equity as the firm L borrows
more and more in the debt markets? Solve for
each of the three different capital structures:
A. 100% equity
B. 50% equity, 50% debt
C. 10% equity and 90% debt
The firm earn $100,000 every year forever
Steps
1. Find Cost of Equity of the firm at each capital
structure
2. Find WACC of the firm at each capital
structure
3. Find the value of the firm using the
appropriate discount rate
 “Our performance in 2000 was a success by any measure…The
company’s net income reached a record in 2000. We are laser-
focused on earnings per share, and we expect to continue strong
earnings performance.”

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 Debt and the Tax Shield
EBIT Distribution to Claimants under Different Funding Structures

Effect of increasing debt levels on the distribution of a firm’s EBIT

As the firm’s debt level goes from 0% to 90%, with EBIT staying
constant at $100,000, government’s share of EBIT (taxes) dwindles
from $25,000 to $2,500. The equity holders’ share also gets smaller
and smaller as the debt holders receive their interest payments.
Impact of Capital Structure on Firm Value
® Does Debt / Equity policy affect the overall
firm value?
® Does Minimizing WACC always result in
maximizing value?

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 Effect on Operations
Business Operating Interest Cash to
Outcome cash flow shareholders
Bad $ 80 $ 60 $ 20
Expected $ 100 $ 60 $ 40
Good $120 $ 60 $ 60

• Business risk is 20%

• Financial risk is 50%

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 Impact of leverage on firm’s cost of
capital
Case 1
® Firm uses equal levels of debt & equity in its
capital structure
® Given tax rate is 40%
® Kd is 10%
® KE is 16%
® WACC is {D/(D+E)} Kd(1-t) + (E/D+E) KE
® WACC = 11%

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Case 2
® Firm uses 60 % debt – 40 % equity in its capital
structure
® Tax rate is 40%
® KE is 18%
® Kd is 10%
® WACC = 10.8%
Case 3
® All else being equal, KE changes to 20%
® New WACC is 11.6%
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 Let us examine
Should I
® Pick the financing mix that maximizes firm value
® Rely on ROE & EPS as appropriate measures of
value
® No, they only measure the returns & ignores
the all important element of risk
® So, increased earnings does not necessarily
increase firm value if it comes at a cost of
increased debt levels

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 Value

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 The Epicenter of value
® Value that eventually goes to all the claimants
® Earnings Before Interest & Tax (EBIT)
Government
Tax

EBIT
Debt holders Shareholders
Interest Dividends

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® Investment decision decides the Size of the pie
® The Financing decisions decides how the slice
is to be cut
® Can firms increase the slice of residual claims
by restricting the outflow in the form of
corporate taxes?

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 Unlevered Firm Levered Firm
$ 3,000* @ 10 %
Earnings before Interest & 1,000 1000
Taxes - EBIT
Interest on Debt 0 300
Pretax profits 1,000 700
Tax rate @ 40 % 400 280
Profits after taxes 600 420
Payments made to debt & 600 720
equity
®Maintaining a target capital structure
®Entire PAT paid out as dividends

The levered firm’s increase in value to the extent of 120 is in

essence exactly the amount arising out of tax shield on interest
0.10(3,000)(0.4)

Thus Government’s tax revenues decline by 120 (600 – 480)

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 Capital Structure in a World of
Corporate Taxes and no Bankruptcy
Value of firms in world of corporate taxes

As the firm issues more debt, its tax shield increases, and the
government’s share of the pie decreases, increasing the value of the
equity-holders.
→All debt financing is optimal.
→The WACC of the firm falls as more debt is added.
® So, can we safely say
® VL = VUL + Present value of Tax shield on Debt
® VL = VUL + DT
Case
® Given: EBIT = 1,000
® Tax rate (T) = 40 %
® So, Post tax EBIT = 1,000(0.4) = 600
® KD = 10%, KEU 12%
® V denotes firm value &
® CFD & CFE denotes cash floes to debt and equity
holders respectively
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Financial Policy Cash Flows Values
Unlevered Firm CFD = 0 D = CFD / KD =0
CFE = 600 E = CFE / KEU = 600 / 0.12 =
Taxes = 400 5,000
Value (V) = D+E= 0+5,000 =
5,000
Levered Firm CFD = 300 D = CFD / KD =300 / 0.10 =
3,000 Debt CFE = 420 3,000
issues Taxes = 280 VL = VUL + DT = 5,000 +
(120) / 0.10
VL = 6,200
Since, VL = D + E
6,200 = 3,000 +E
So, E = 3,200

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 The Benefit – Cost Tradeoff
Value of the Firm

VL
VU

D*
Leverage
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Leverage and tax benefits & its implication on firm value
and investors’ cost of capital
• With added leverage, the KE for the levered firm
changes, but the question is to what extent
From our earlier calculations,
• Market value of equity was $ 3,200
• Expected cash flow to equity holders was $ 420
• So, the implied cost of equity for the levered firm
(KEL) is,
• E = CFE/KEL, 3,200 = 420/KEL, KEL = 13.125
• So, the additional debt has altered the KE from 12%
to 13.125%
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® The additional 1.125% (13.125 – 12) is the
additional risk premium for financial risk and
increases directly with the D/E ratio
Recall,
® KEL = Rf + Rbus + Rfin
® Where, Rfin denotes financial risk
® Thus: KEL = KEU + Rfin
In this case,
® 13.125% = 12% + 1.125%

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 Inference
® The value of the firms, either levered of
unlevered can be estimated by discounting its
Post tax EBIT with the appropriate WACC
® Value of the firm will be maximum where the
WACC is minimum
® Challenge is to estimate the minimum WACC
that maximizes the firm value

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 Cost of Capital & Debt Policy

Debt Cost of Equity Cost of WACC

(D) Debt (KD) Equity (KE )

Unlevered 0 10% $5,000 12% 12%

Firm

Levered Firm $3,000 10% $3,200 13.125% 9.68%

WACC = (D/D+E)*KD(1-t) + (E/D+E)(KE )

 Final Thoughts
® Financial leverage magnifies the variability of operating
income, thus increasing the riskiness of the return o equity
® As financial leverage, the risk & return required by the
equity holders increases
® Financial leverage affects the value of the firm because the
tax deductibility of interest acts as a subsidy to the firm
® offsetting the benefits of tax are the costs of financial
distress, agency problem and reduced flexibility
® In principal, an optimum debt level exists beyond which
the tax benefits of additional debt are outweighed by its
costs

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