CHAPTER SIXTEEN

Capital StructureBy J.D. Han

Evaluation of Capital StructuresA capital structure that maximizes share prices generally will minimize the firms WACCIf a firm can lower its WACC, shareholders will receive greater returns reflected in increased share pricescapital structure market price per share, WACC market price per share, WACC

Evaluation of Capital StructuresDifferent capital structures results in different levels of financial risk created through leverage.Three trade-off possibilities include:1. Cost equity increases with leverage at a moderate rate so that when combined with debt WACC decreases with increased leverage2. Cost of equity increases at a rate that offsets the benefits gained through cheaper financingWACC remains constant3. Cost of equity increases rapidly with leverage and increase more than offsets any gains from debtWACC increases with leverage

Leverage is measured as the proportion of debt in relation to equity in the capital structure (B/E) With V = B + E, WACC is:

Theory of Capital StructureRelationship Between the WACC, Cost of Equity, and Leverage

Case 1: Capital structure without taxes and bankruptcy costs - costs from equity financing and from bond financing should be the same with each other; capital structure does not matter.denoting keu and keL as the cost of equity for unlevered and levered firms we have:

rearranged we get:

Case 2: Capital Structure with Corporate taxes capital structure matters.levered firms taxes are reduced by the tax shield on interest (IT)VL > Vu

Ignoring bankruptcy, investors would prefer owning debt and equity of L over equity U

Assuming debt outstanding (B) is perpetual and the tax shield generated by interest payments becomes a perpetual annuity of IT then:

Present value of tax savings =

The total value of a levered firm isThe residual value for the equity is

The cost of equity keL increases at a slower rate, which can be seen through the formulas:

How? We will prove it in a separate page.What is the required rate of return of equity for a levered firm?

Note that kb = (1-T) rb or the after-tax interest rate on bonds:

Thus, the Total Cost of Capital is

Two Competing Factors to be Considered

- Debt-Equity Ratio and Bankruptcy Costs: the ability of an enterprise to tolerate higher leverage : As debts rises, the Risk Premium rises.- Agency Problems:when managers fail to act in the best interests of shareholders in the equity financing: As debts rises, this Risk Premium falls.- Which one will be dominating the other?

Evaluation of Capital StructuresConsequences of Different Shareholder Attitudes Toward Risk