Chapter 16 - Planning the Firm’s

Financing Mix

 2005, Pearson Prentice Hall

 Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’
Equity
 Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’
Equity
 Balance Sheet
Current Current
Assets Liabilities

Debt and Financial

Fixed Preferred Structure
Assets
Shareholders’
Equity
 Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred
Assets
Shareholders’
Equity
 Balance Sheet
Current Current
Assets Liabilities

Debt and
Fixed Preferred Capital
Assets Structure
Shareholders’
Equity
Why is Capital Structure Important?

1) Leverage: Higher financial leverage

means higher returns to stockholders,
but higher risk due to fixed payments.
2) Cost of Capital: Each source of
financing has a different cost. Capital
structure affects the cost of capital.
The Optimal Capital Structure is the
one that minimizes the firm’s cost of
capital and maximizes firm value.
 What is the Optimal Capital
Structure?

 In a “perfect world” environment with

no taxes, no transaction costs and
perfectly efficient financial markets,
capital structure does not matter.
 This is known as the Independence
hypothesis: firm value is independent of
capital structure.
 Independence Hypothesis

Firm value does not depend on

capital structure.
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt

 Stock price: $10 per share
 Shares outstanding: 2 million
 Operating income (EBIT): $2,000,000
 Calculate EPS:
With no interest payments and no taxes,
EBIT = net income.
$2,000,000/2,000,000 shares = $1.00
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt

 Stock price: $10 per share
 Shares outstanding: 2 million
 Operating income (EBIT): $2,000,000
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt

 Stock price: $10 per share
 Shares outstanding: 2 million
 Operating income (EBIT): $2,000,000
 Calculate the Cost of Capital:
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt

 Stock price: $10 per share
 Shares outstanding: 2 million
 Operating income (EBIT): $2,000,000
 Calculate the Cost of Capital:

D1
k = + g =
P
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt

 Stock price: $10 per share
 Shares outstanding: 2 million
 Operating income (EBIT): $2,000,000
 Calculate the Cost of Capital:

D1 1.00
k = + g = + 0 =
P 10.00
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt

 Stock price: $10 per share
 Shares outstanding: 2 million
 Operating income (EBIT): $2,000,000
 Calculate the Cost of Capital:

D1 1.00
k = + g = + 0 = 10%
P 10.00
 Independence Hypothesis:
Rix Camper Manufacturing Company

 $20 million capitalization

 $8 million in debt issued to retire $8 million in
equity.
 Equity = $12m / $20m = 60%
 Debt = $8m / $20m = 40%
 Capital Structure: 60% equity, 40% debt
 Shares outstanding: $12 million / $10 =
1,200,000 shares.
 Interest = $8m x .06 = $480,000
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate EPS:
$1,520,000/1,200,000 shares = $1.267
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Equity:
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Equity:

D1
k = + g =
P
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Equity:

D1 1.267
k = + g = + 0 =
P 10.00
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Equity:

D1 1.267
k = + g = + 0 = 12.67%
P 10.00
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Capital:
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Capital:

.6 (12.67%)
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Capital:

.6 (12.67%) +
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Capital:

.6 (12.67%) + .4 (6%) =
 Independence Hypothesis:
Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt

 Stock price: $10 per share
 Shares outstanding: 1.2 million
 Net income: $2,000,000 - $480,000 = $1,520,000
 Calculate the Cost of Capital:

.6 (12.67%) + .4 (6%) = 10%

 Independence Hypothesis

Cost of
Capital kc = cost of equity
kd = cost of debt
ko = cost of capital

kc .

0% debt Financial Leverage 100% debt

 Independence Hypothesis

Cost of
Capital

kc .
kd kd

0% debt Financial Leverage 100% debt

 Independence Hypothesis

Cost of
Capital

kc .
kd kd

0% debt Financial Leverage 100% debt

 Independence Hypothesis
Increasing leverage causes
Cost of the cost of equity
Capital to rise.

kc
kd kd

0% debt Financial Leverage 100% debt

 Independence Hypothesis
Increasing leverage causes
kc
Cost of the cost of equity
Capital to rise.

kc
kd kd

0% debt Financial Leverage 100% debt

 Independence Hypothesis
Increasing leverage causes
kc
Cost of the cost of equity
Capital to rise.
What will
be the net effect
on the overall cost
kc of capital?

kd kd

0% debt Financial Leverage 100% debt

 Independence Hypothesis
Increasing leverage causes
kc
Cost of the cost of equity
Capital to rise.
What will
be the net effect
on the overall cost
kc of capital?

kd kd

0% debt Financial Leverage 100% debt

 Independence Hypothesis

kc
Cost of
Capital

kc ko
kd kd

0% debt Financial Leverage 100% debt

 Independence Hypothesis

 If we have perfect capital markets,

capital structure is irrelevant.
 In other words, changes in capital
structure do not affect firm value.
 Dependence Hypothesis
 Increasing leverage does not increase
the cost of equity.
 Since debt is less expensive than equity,
more debt financing would provide a
lower cost of capital.
 A lower cost of capital would increase
firm value.
 Dependence Hypothesis
Since the cost of debt is lower
Cost of than the cost of equity...
Capital

kc kc

kd kd

Financial Leverage
 Dependence Hypothesis
Since the cost of debt is lower
Cost of than the cost of equity…
Capital increasing leverage reduces the
cost of capital.
kc kc

ko
kd kd

Financial Leverage
 Moderate Position

 The previous hypothesis examines

capital structure in a “perfect
market.”
 The moderate position examines
capital structure under more
realistic conditions.
 For example, what happens if we
include corporate taxes?
 Rix Camper example:
Tax effects of financing with debt
unlevered levered
EBIT 2,000,000 2,000,000
- interest expense 0 (480,000)
EBT 2,000,000 1,520,000
- taxes (50%) (1,000,000) (760,000)
Earnings available
to stockholders 1,000,000 760,000
Payments to all
securityholders 1,000,000 1,240,000
 Moderate Position

Cost of kc
Capital

kc

kd kd

Financial Leverage
 Moderate Position
Even if the cost of equity rises
Cost of as leverage increases, the kc
Capital cost of debt is
very low...

kc

kd kd

Financial Leverage
 Moderate Position
Even if the cost of equity rises
Cost of as leverage increases, the kc
Capital cost of debt is
very low...
because
kc
of the tax benefit
associated with debt financing.
kd kd

Financial Leverage
 Moderate Position

The low cost of debt kc

Cost of
reduces the cost of
Capital
capital.

kc

kd kd

Financial Leverage
 Moderate Position
The low cost of debt kc
Cost of
reduces the cost of
Capital
capital.

kc
ko
kd kd

Financial Leverage
 Moderate Position
 So, what does the tax benefit of debt financing
mean for the value of the firm?
 The more debt financing used, the greater the
tax benefit, and the greater the value of the
firm.
 So, this would mean that all firms should be
financed with 100% debt, right?
 Why are firms not financed with 100% debt?
Why is 100% Debt Not Optimal?

Bankruptcy costs: costs of financial

distress.
 Financing becomes difficult to get.
 Customers leave due to uncertainty.
 Possible restructuring or
liquidation costs if bankruptcy
occurs.
Why is 100% Debt Not Optimal?

Agency costs: costs associated with protecting

bondholders.
 Bondholders (principals) lend money to the
firm and expect it to be invested wisely.
 Stockholders own the firm and elect the
board and hire managers (agents).
 Bond covenants require managers to be
monitored. The monitoring expense is an
agency cost, which increases as debt
increases.
 Moderate Position
with Bankruptcy and Agency Costs

Cost of
Capital

kc

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of
Capital

kc

kd
kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of
Capital

kc kd

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of
Capital kc

kc kd

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of kc
Capital

kc kd

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of kc
If a firm borrows too much, the
Capital costs of debt and equity will spike
upward, due to bankruptcy costs
and agency costs.
kc kd

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of kc
Capital

kc kd

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of kc
Capital

kc kd
ko
kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of kc
Capital

ko
kc kd

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of kc
Ideally, a firm should use leverage
Capital
to obtain their optimum capital
structure, which will minimize theko
kc
firm’s cost of capital.
kd

kd

Financial Leverage
 Moderate Position
with Bankruptcy and Agency Costs

Cost of kc
Capital

ko
kc kd

kd

Financial Leverage
Capital Structure Management

EBIT-EPS Analysis - Used to help

determine whether it would be better
to finance a project with debt or
equity.
Capital Structure Management

EBIT-EPS Analysis - Used to help

determine whether it would be better
to finance a project with debt or
equity.
EPS = (EBIT - I)(1 - t) - P
S
Capital Structure Management

EBIT-EPS Analysis - Used to help determine

whether it would be better to finance a
project with debt or equity.

EPS = (EBIT - I)(1 - t) - P

S
I = interest expense, P = preferred dividends,
S = number of shares of common stock
outstanding.
 EBIT-EPS Example
Our firm has 800,000 shares of common stock
outstanding, no debt, and a marginal tax rate
of 40%. We need $6,000,000 to finance a
proposed project. We are considering two
options:
 Sell 200,000 shares of common stock at $30
per share,
 Borrow $6,000,000 by issuing 10% bonds.
 If we expect EBIT to be $2,000,000:

Financing stock debt

EBIT 2,000,000 2,000,000
- interest 0 (600,000)
EBT 2,000,000 1,400,000
- taxes (40%) (800,000) (560,000)
EAT 1,200,000 840,000
# shares outst. 1,000,000 800,000
EPS $1.20 $1.05
 If we expect EBIT to be $4,000,000:
Financing stock debt
EBIT 4,000,000 4,000,000
- interest 0 (600,000)
EBT 4,000,000 3,400,000
- taxes (40%) (1,600,000) (1,360,000)
EAT 2,400,000 2,040,000
# shares outst. 1,000,000 800,000
EPS $2.40 $2.55
 If EBIT is $2,000,000, common
stock financing is best.
 If EBIT is $4,000,000, debt
financing is best.
 So, now we need to find a
breakeven EBIT where neither is
better than the other.
 If we choose stock financing:
EPS
3
stock
financing
2

0 EBIT
$1m $2m $3m $4m
 If we choose bond
bond financing: financing
EPS
3

0 EBIT
$1m $2m $3m $4m
 Breakeven EBIT bond
financing
EPS
3
stock
financing
2

0 EBIT
$1m $2m $3m $4m
 Breakeven Point
Set two EPS calculations equal to each
other and solve for EBIT:
Stock Financing Debt Financing
(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P
S S
 Breakeven Point

Stock Financing Debt Financing

(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P
S S

(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40)

800,000+200,000 800,000
 Breakeven Point
Stock Financing Debt Financing
.6 EBIT = .6 EBIT - 360,000
1 .8

.48 EBIT = .6 EBIT - 360,000

.12 EBIT = 360,000

EBIT = $3,000,000
 Breakeven EBIT bond
financing
EPS
3
For EBIT up to $3 million, stock
stock financing is best. financing
2

0 EBIT
$1m $2m $3m $4m
 Breakeven EBIT bond
financing
EPS
3
For EBIT up to $3 million, stock
stock financing is best. financing
2
For EBIT greater
than $3 million,
1 debt financing
is best.
0 EBIT
$1m $2m $3m $4m
 In-class Problem
 Plan A: Sell 1,200,000 shares at $10
per share ($12 million total).
 Plan B: Issue $3.5 million in 9% debt
and sell 850,000 shares at $10 per
share ($12 million total).
 Assume a marginal tax rate of 50%.
 Breakeven EBIT
Stock Financing Levered Financing
(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
S S
EBIT-0 (1-.50) = (EBIT-315,000)(1-.50)
1,200,000 850,000

EBIT = $1,080,000
Analytical Income Statement
Stock Levered
EBIT 1,080,000 1,080,000
I 0 (315,000)
EBT 1,080,000 765,000
Tax (540,000) (382,500)
NI 540,000 382,500

Shares 1,200,000 850,000

EPS .45 .45
 Breakeven EBIT
levered stock
EPS
financing financing
.65

.45

.25

0 EBIT
$.5m $1m $1.5m $2m
 For EBIT up Breakeven EBIT
to $1.08 m, levered stock
EPS
stock financing financing
.65
financing is
best.
.45

.25

0 EBIT
$.5m $1m $1.5m $2m
 For EBIT up Breakeven EBIT
to $1.08 m, levered stock
EPS
stock financing financing
.65
financing is
best. For EBIT greater
than $1.08 m,
.45
the levered plan
is best.
.25

0 EBIT
$.5m $1m $1.5m $2m
 In-class Problem
 Plan A: Sell 1,200,000 shares at $20
per share ($24 million total).
 Plan B: Issue $9.6 million in 9% debt
and sell shares at $20 per share
($24 million total).
 Assume a 35% marginal tax rate.
 Breakeven EBIT
Stock Financing Levered Financing
(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
S S
(EBIT-0) (1-.35) = (EBIT-864,000)(1-.35)
1,200,000 720,000

EBIT = $2,160,000
 Analytical Income Statement

Stock Levered
EBIT 2,160,000 2,160,000
I 0 (864,000)
EBT 2,160,000 1,296,000
Tax (756,000) (453,600)
NI 1,404,000 842,400
Shares 1,200,000 720,000
EPS 1.17 1.17
 Breakeven EBIT
levered stock
EPS financing
1.5 financing

1.17

.5

0 EBIT
$1m $2m $3m $4m
 For EBIT up Breakeven EBIT
to $2.16 m, levered stock
EPS financing
stock financing
1.5
financing is
best.

1.17

.5

0 EBIT
$1m $2m $3m $4m
 For EBIT up Breakeven EBIT
to $2.16 m, levered stock
EPS financing
stock financing
1.5
financing
is best. For EBIT greater
than $2.16 m,
1.17
the levered plan
is best.
.5

0 EBIT
$1m $2m $3m $4m