Capital Structure
BUS ADM 775

Back to the concept…
The concept of a corporation
Investors

Corporation

Projects

A bit more realistic…
Shareholders
Corporation
Creditors

Capital structure
How should firms decide whether to issue debt the amount of debt to issue?
Does capital structure “matter”? for firm value?
Through CFs?
Through WACC?

Projects

The Balance Sheet
Balance sheet
Assets

Liabilities

Shareholders' equity

Recall…
Balance Sheet Identity

Assets = Liabilities + Stockholders’
Equity
Left-hand side reflects investment decisions
Right-hand side reflects financing decisions
Capital invested and retained by owners
(equity)
Additional capital raised from creditors
(debt)

Equity financing
Stockholders are owners of the company
Stockholders are residual claimants
Stockholders vote for the board of directors and other issues Periodic payments to stockholders (dividend payments) are not contractual not a liability of the firm not considered a cost of doing business not tax deductible

Debt financing
Creditors (or debtholders) are not owners of the company Creditors do not have voting rights
Payments to creditors (interest and principal payments) are contractually specified, and creditors have legal recourse if missed missed payments may lead to financial distress and bankruptcy interest is considered a cost of doing business and is tax deductible

Equity vs debt
Differ in
What happens if payments are missed
Debtholders can demand payment and seize assets Tax deductibility of periodic payments
Interest is tax deductible

Cost
Debt payments have priority
Debt is less risky, and thus costs less

Types of long-term debt
Bonds – public issue of long-term debt
Private issues
Bank credit
Private placements
Easier to renegotiate than public issues
Lower costs than public issues

The effect of debt on cash flows
How does leverage affect the EPS and ROE?
Cost of debt is lower than cost of equity
When we increase the amount of debt financing, we increase the fixed interest expense
In a good year, we pay our fixed cost and have more left over for our stockholders
In a bad year, we still have to pay our fixed costs and we have less left over for our stockholders
Debt increases the average level of both EPS and ROE
Debt amplifies the variation in both EPS and ROE
So, debt increases riskiness of equity

The effect of debt on cash flows
Current Capital Structure: No Debt, $8M
Recession Expected
$500,000 $1,000,000
0
0
$500,000 $1,000,000
6.25%
12.50%
$1.25
$2.50

EBIT
Interest
Net Income
ROE
EPS

equity
Expansion
$1,500,000
0
$1,500,000
18.75%
$3.75

Proposed Capital Structure: Debt = $4M , Equity = $4M
Recession
Expected
Expansion
$500,000
$1,000,000
$1,500,000
400,000
400,000
400,000
$100,000
$600,000
$1,100,000
2.50%
15.00%
27.50%
$0.50
$3.00
$5.50

EBIT
Interest
Net Income
ROE
EPS

Average

St dev

12.50%
$2.50

6.25%
$1.25

Average

St dev

15.00%
$3.00

12.50%
$2.50

Trade-off theory
Interest is tax deductible
When a firm adds debt, it reduces taxes, all else equal The reduction in taxes increases the cash flow of the firm
Consider bankruptcy costs
As the D/E ratio increases, the probability of bankruptcy increases
This increased probability will increase the expected bankruptcy costs
At some point, the additional value of the interest tax shield will be offset by the expected bankruptcy cost

Example
Unlevered Firm
EBIT

Levered Firm

5000

Interest

5000

0

500

Taxable Income

5000

4500

Taxes (34%)

1700

1530

Net Income

3300

2970

CFFA

3300

3470

Interest tax shield
Annual interest tax shield
Tax rate times interest payment
6250 in 8% debt = 500 in interest expense
Annual tax shield = .34(500) = 170
Present value of annual interest tax shield
Assume perpetual debt for