This document summarizes capital structure decisions and theories. It discusses how debt can impact a firm's weighted average cost of capital (WACC) and free cash flow (FCF). The key effects are:
- Debt can lower WACC by reducing the tax burden but increase it by raising financial risk.
- Debt can boost or reduce FCF by lowering costs through interest tax deductions but increasing bankruptcy risk.
- Capital structure theories like MM and trade-off theory examine the optimal debt-equity mix that balances these costs and benefits. Signaling theory notes managers' private information impacts financing choices.
3. How can capital structure affect value? (Continued…) WACC = w d (1-T) r d + w e r s
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18. Firm U Firm L No debt $10,000 of 12% debt $20,000 in assets $20,000 in assets 40% tax rate 40% tax rate Consider Two Hypothetical Firms Both firms have same operating leverage, business risk, and EBIT of $3,000. They differ only with respect to use of debt .
19. Impact of Leverage on Returns EBIT $3,000 $3,000 Interest 0 1,200 EBT $3,000 $1,800 Taxes (40%) 1 ,200 720 NI $1,800 $1,080 ROE 9.0% 10.8% Firm U Firm L
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21. Now consider the fact that EBIT is not known with certainty. What is the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L? Continued…
23. Firm L: Leveraged Prob.* 0.25 0.50 0.25 EBIT* $2,000 $3,000 $4,000 Interest 1,200 1,200 1,200 EBT $ 800 $1,800 $2,800 Taxes (40%) 320 720 1,120 NI $ 480 $1,080 $1,680 *Same as for Firm U. Economy Bad Avg. Good
24. Firm U Bad Avg. Good BEP 10.0% 15.0% 20.0% ROIC 6.0% 9.0% 12.0% ROE 6.0% 9.0% 12.0% TIE n.a. n.a. n.a. Firm L Bad Avg. Good BEP 10.0% 15.0% 20.0% ROIC 6.0% 9.0% 12.0% ROE 4.8% 10.8% 16.8% TIE 1.7x 2.5x 3.3x
32. Value of Firm, V 0 Debt V L V U MM relationship between value and debt when corporate taxes are considered. Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used. TD
33. Cost of Capital (%) 0 20 40 60 80 100 Debt/Value Ratio (%) MM relationship between capital costs and leverage when corporate taxes are considered. r s WACC r d (1 - T)
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35. Miller’s Model with Corporate and Personal Taxes V L = V U + [ 1 - ] D. T c = corporate tax rate. T d = personal tax rate on debt income. T s = personal tax rate on stock income. (1 - T c )(1 - T s ) (1 - T d )
36. T c = 40%, T d = 30%, and T s = 12%. V L = V U + [ 1 - ] D = V U + (1 - 0.75)D = V U + 0.25D. Value rises with debt; each $1 increase in debt raises L’s value by $0.25. (1 - 0.40)(1 - 0.12) (1 - 0.30)
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42. Choosing the Optimal Capital Structure: Example Currently is all-equity financed. Expected EBIT = $500,000. Firm expects zero growth. 100,000 shares outstanding; r s = 12%; P 0 = $25; T = 40%; b = 1.0; r RF = 6%; RP M = 6%.
43. Estimates of Cost of Debt Percent financed with debt, w d r d 0% - 20% 8.0% 30% 8.5% 40% 10.0% 50% 12.0% If company recapitalizes, debt would be issued to repurchase stock.