FINANCIAL

MANAGEMENT
BAFB3013
 Topic 2:
Capital Structure

2
Optimal Capital Structure

• Capital structure is a mix of debt, preferred, and

common equity at which P0 is maximized.
• Trades off higher E(ROE) and EPS against higher
risk. The tax-related benefits of leverage are
exactly offset by the debt’s risk-related costs.
• The target capital structure is the mix of debt,
preferred stock, and common equity with which the
firm intends to raise capital.
LO1 Briefly explain what is meant by a firm’s optimal capital structure

• In finance, capital structure is how a firm finances its overall operations and growth by using
different sources of funds either equity, debt, or hybrid securities. A firm's capital structure is
then the composition or 'structure' of its liabilities. For example, a firm that has RM20 billion
in equity and RM80 billion in debt is said to be 20% equity-financed and 80% debt-financed.

• One of the most important issues in corporate finance is responding:

"How do firms choose their capital structure?”

• Determining the optimal capital structure is a critical decision for any organization. This
decision is important not only because of the need to maximize returns, but also because of
the impact such a decision has on an organization’s ability to deal with its competitive
environment.
Finding Optimal Capital Structure

• The firm’s optimal capital structure can be determined

two ways:
• Minimizes WACC.
• Maximizes stock price or maximizes the firm values
• The best debt/equity ratio for a company
• Related to trade-off theory
• The managers of company should find a debt/equity ratio that
balances the risk of bankruptcy with the risk of using too little of
the cheapest form of financing
Table for calculating WACC and determining
the minimum WACC

Amount D/A ratio E/A

borrowed ratio ks kd (1 – T) WACC
$ 0 0.00% 100.00% 12.00% 0.00% 12.00%
250 12.50 87.50 12.51 4.80 11.55
500 25.00 75.00 13.20 5.40 11.25
750 37.50 62.50 14.16 6.90 11.44
1,000 50.00 50.00 15.60 8.40 12.00

* Amount borrowed expressed in terms of thousands of dollars

Table for determining the stock price
maximizing capital structure

Amount
Borrowed DPS ks P0

$ 0 $3.00 12.00% $25.00

250,000 3.26 12.51 26.03
500,000 3.55 13.20 26.89
750,000 3.77 14.16 26.59
1,000,000 3.90 15.60 25.00
LO2 List the reasons why debt financing is preferred

• Financing a business through borrowing is cheaper than using equity.

Why debt financing is cheaper than equity?

• Lenders require a lower rate of return than ordinary shareholders.
• Debt financial securities present a lower risk than shares for the finance
• A profitable business effectively pays less for debt capital than equity for another reason: the
debt interest can be offset against pre-tax profits before the calculation of the corporation tax
bill, thus reducing the tax paid.
• Issuing and transaction costs associated with raising and servicing debt are generally less
than for ordinary shares.
LO3 Illustrate a recapitalization decision process using traditional theory of optimal capital
structure

• The Traditional Theory state that the Optimal Capital Structure is the financing
mix (combination between debt and equity) that:
• maximizes market value (price of the share Po) and
• minimizes the overall cost of finance (WACC = weighted cost of capital)
 Recapitalization - Illustration I
• The following information applies to Lott Enterprises:
Operating income (EBIT) RM300,000 Shares outstanding 120,000
Debt RM100,000 EPS RM1.45
Interest expense RM 10,000 Stock price RM17.40
Tax rate 40%

• The company is considering a recapitalization where it would issue RM348,000 worth of new debt and
use the proceeds to buy back RM348,000 worth of common stock. The buyback will be undertaken at
the pre-recapitalization share price (RM17.40). The recapitalization is not expected to have an effect on
operating income or the tax rate. After the recapitalization, the company’s interest expense will be
RM50,000.

• Assume that the recapitalization has no effect on the company’s P/E ratio. What is the company’s
expected stock price following the recapitalization?
 Before recap. After recap.
EBIT RM300,000 RM300,000
Interest -10,000 -50,000
EBT RM290,000 RM250,000
Tax (40%) 116,000 100,000
NI RM174,000 RM150,000
Shares 120,000 100,000*

EPS RM174,000/120,000. RM150,000/100,000.

= RM1.45 = RM1.50

Price = RM17.40
*120,000 - (RM348,000/RM17.40) = 120,000 – 20,000 = 100,000 shares.

Price/EPS Ratio
P/E = RM17.40/1.45 = 12
As P/E = 12 after the recapitalization (recall the question states that it does not change), we know 12 =
Price/RM1.50;
Price = 12xRM1.50 = RM18.00.

Since the price increases from RM17.40 to RM18.00, the changes in capital structure is accepted.
Recapitalization - Illustration II
• Flood Motors is an all-equity firm with 200,000 shares outstanding. The company’s EBIT is
RM2,000,000, and EBIT is expected to remain constant over time. The company pays out all of its
earnings each year, so its EPS equals its DPS. The company’s tax rate is 40%.

• The company is considering issuing RM2 million worth of bonds (at par) and using the proceeds for a
stock repurchase. If issued, the bonds would have an estimated YTM of 10%. The risk-free rate is
6.6%, and the market risk premium is 6%. The company’s beta is currently 0.9, but investment bankers
say the beta will rise to 1.1 if the recapitalization occurs.

• Assume that the shares are repurchased at a price equal to the stock market price prior to the
recapitalization. What would be the company’s stock price following the recapitalization?
Solution:
First, find the company’s current cost of capital, DPS, and stock price:
Cost of Capital: CAPM: kr = krf + (km- krf)β = 0.066 + (0.06)0.9 = 12%.

To find the stock price, you still need the DPS = (RM2,000,000(1 - 0.4))/200,000 =
RM6.00.

EBIT 2,000,000
Less: Interest 0 (no debt)
EBT 2,000,000
Less: Tax 40% 800,000
Earning 1,200,000

DPS = Dividend / no of shares: 1,200,000 / 200,000 = 6.00

All earnings are paid out as dividend.
Thus, the stock price is P0 = DPS/kr = RM6.00/0.12 = RM50.00.

Thus, by issuing RM2,000,000 in new debt the company can repurchase

RM2,000,000/RM50.00 = 40,000 shares.
Now after recapitalization, the new cost of capital, DPS, and
stock price can be found:
Cost of Capital: kr = krf + (km- krf)β = 0.066 + (0.06)1.1 =
13.20%.
DPS for the remaining (200,000 - 40,000) = 160,000 shares
EBIT 2,000,000
Less: Interest 200,000 (RM2,000,000 x 10% debt)
EBT 1,800,000
Less: Tax 40% 720,000
Earning 1,080,000

DPS = Dividend / no of shares: 1,080,000 / 160,000 = 6.75

And, finally, P0 = RM6.75/0.132 = RM51.14.

Since the price of the share increases from RM50 to

RM51.14, increasing the debt is acceptable.
Stock Price, with zero growth

D1 EPS DPS
P0   
ks - g ks ks

• If all earnings are paid out as dividends, E(g)

= 0.
• EPS = DPS
• To find the expected stock price (P0), we
must find the appropriate ks at each of the
debt levels discussed.
Recapitalization - Illustration III
A consultant has collected the following information regarding Young Publishing:
Total assets $3,000 million Tax rate 40%
Operating income (EBIT) $800 million Debt ratio 0%
Interest expense $0 million WACC 10%
Earning $480 million M/B ratio 1.00×
Share price $32.00 EPS = DPS $3.20

• The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS =
DPS). Young’s stock price can be calculated by simply dividing earnings per share by the required return on equity
capital, which currently equals the WACC because the company has no debt.

• The consultant believes that the company would be much better off if it were to change its capital structure to 40
percent debt and 60 percent equity. After meeting with investment bankers, the consultant concludes that the
company could issue $1,200 million of debt at a before-tax cost of 7 percent, leaving the company with interest
expense of $84 million. The $1,200 million raised from the debt issue would be used to repurchase stock at $32 per
share. The repurchase will have no effect on the firm’s EBIT; however, after the repurchase, the cost of equity will
increase to 11 percent. If the firm follows the consultant’s advice, what will be its estimated stock price after the
capital structure change?
 Solution:

Determine the current number of shares outstanding:

Determine the number of shares after the repurchase:
Determine the new EPS after the repurchase:
Determine the new stock price:

Capital structure and stock price

Step 1: Find the current number of shares outstanding:

Shares = NI/EPS = $480 million/$3.20 = 150 million shares.
Step 2: Find the number of shares after the repurchase:
New shares = 150 – $1,200/$32 = 150 – 37.5 = 112.5 million shares.
Step 3: Find the new EPS after the repurchase:
EPS = [(EBIT – INT)(1 - T)]/New shares
= [($800 – $84)  0.6]/112.5 = $3.818667.
Step 4: Find the new stock price:
Stock price = EPS/New WACC
= $3.818667/0.11 = $34.72.
LO4 List the Motivations for Share Buybacks

• To Signal to the Market the Shares are Undervalued

• To Manage Earnings per Share
• To Reduce Dilution from Employee Stock Options
• To Increase Financial Leverage.
LO5 List the factors influencing decision on capital

• 1. Business risk
Risk associated with the nature of the industry the business operates and if the business risk is higher the optimal
capital structure is required.
•
2. Tax position
Debt capital is regarded as cheaper because interest payable is deductible for tax purposes.
•
3. Financial flexibility
Depends on how easy a business can arrange finance on reasonable terms under adverse conditions. Flexibility in
raising finance will be influenced by the economic environment (availability of savers and interest rates) and the
financial position of the business.
•
4. Managerial style
How much to borrow also depend on managers approach to finance risk. Conservative managers will usual try to
keep the debt equity ratio low.
 Other factors to consider when establishing the
firm’s target capital structure

1. Industry average debt ratio

2. TIE ratios under different scenarios
3. Lender/rating agency attitudes
4. Reserve borrowing capacity
5. Effects of financing on control
6. Asset structure
7. Expected tax rate
Conclusions on Capital Structure
• Need to make calculations as we did, but should also recognize
inputs are “guesstimates.”
• As a result of imprecise numbers, capital structure decisions have
a large judgmental content.
• We end up with capital structures varying widely among firms,
even similar ones in same industry.
End of topic 2

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