2. 2
Learning Objectives
Understand the concept of an optimal capital structure.
Explain the main underpinnings of capital structure theory.
Distinguish between the independence hypothesis and
dependence hypothesis as these concepts relate to capital
structure theory theory, and identify the Nobel prize
winners in economics who are leading proponents of the
independence hypothesis.
Understand and be able to graph the moderate position on
capital structure importance.
Incorporate the concepts of agency costs and free cash
flow into a discussion on capital structure management.
Use the basic tools of capital structure management.
Familiarize others with corporate financing policies in
practice.
3. 3
Planning the Firm’s Financial Mix
Financial Structure and Capital Structure
Financial structure is the mix of all sources of financing
used by the firm
Balance Sheet
Assets Liabilities
Current Liabilities
Long Term Liabilities Financial
Structure
Equity
Total Assets
4. 4
Planning the Firm’s Financial Mix
Financial Structure and Capital Structure
Financial structure is the mix of all sources of financing
used by the firm
Capital structure is the mix of the long term sources of
funds
Balance Sheet
Assets Liabilities
Current Liabilities
Long Term Liabilities Capital
Structure
Equity
Total Assets
5. 5
Planning the Firm’s Financial Mix
Financial Structure and Capital Structure
Financial structure is the mix of all sources of financing
used by the firm
Capital structure is the mix of the long term sources of
funds
Capital structure is the focus of this chapter, so current
liabilities will not be included.
Balance Sheet
Assets Liabilities
Current Liabilities
Long Term Liabilities Capital
Structure
Equity
Total Assets
6. 6
Capital Structure Theories
Choose capital structure that minimizes cost of capital
which in turn maximizes stock price
7. 7
Capital Structure Theories
Choose capital structure that minimizes cost of capital
which in turn maximizes stock price
There are three theories on choosing the optimal
capital structure
Independence Theory
Dependence Theory
Moderate Theory
8. 8
Capital Structure Theories
Choose capital structure that minimizes cost of capital
which in turn maximizes stock price
There are three theories on choosing the optimal
capital structure
Independence Theory
Dependence Theory
Moderate Theory
For all theories, will use a simple valuation model:
D where: P0 = price of stock
P0 = kc D = constant dividend
Kc = cost of equity capital
9. 9
Capital Structure Theories
Choose capital structure that minimizes cost of capital
which in turn maximizes stock price
There are three theories on choosing the optimal
capital structure
Independence Theory
Dependence Theory
Moderate Theory
For all theories, will use a simple valuation model:
D where: P0 = price of stock
P0 = kc D = constant dividend
Kc = cost of equity capital
If all earnings paid as dividends, so there is no growth:
D EPS where: EPS = Earnings per share
P0 = kc
= kc
10. 10
Capital Structure Theories
Moderate Position
Interest is tax deductible
The use of financial leverage increases the likelihood
of bankruptcy.
The costs of equity and debt rise causing a “saucer-
shaped” cost of capital function.
Firms should choose financial leverage with lowest
cost of capital
Capital kc
Costs kO
kd
Financial Leverage
11. 11
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
12. 12
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
Firms incur agency costs such as paying for outside
monitors to reassure creditors.
13. 13
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
Firms incur agency costs such as paying for outside
monitors to reassure creditors.
The higher the leverage, the higher the agency costs.
Firm
Value
Financial Leverage
14. 14
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
Firms incur agency costs such as paying for outside
monitors to reassure creditors.
The higher the leverage, the higher the agency costs.
Firm
Value
Value of Unlevered Firm
Financial Leverage
15. 15
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
Firms incur agency costs such as paying for outside
monitors to reassure creditors.
The higher the leverage, the higher the agency costs.
Firm
Value
eT heory
en denc ed Firm
I ndep f Lever
o
Value
Financial Leverage
16. 16
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
Firms incur agency costs such as paying for outside
monitors to reassure creditors.
The higher the leverage, the higher the agency costs.
Firm
Value
eT heory
en denc ed Firm
I ndep f Lever
o
Value PV of Tax Shields
Financial Leverage
17. 17
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
Firms incur agency costs such as paying for outside
monitors to reassure creditors.
The higher the leverage, the higher the agency costs.
Firm
Value
eT heory
en denc ed Firm
I ndep f Lever
o
Value
Actual Value
of the Firm
Financial Leverage
18. 18
Agency Costs and Capital Structure
Agency problems arise when management does not
work in the best interests of the creditors.
Firms incur agency costs such as paying for outside
monitors to reassure creditors.
The higher the leverage, the higher the agency costs.
Firm
Value
eT heory
en denc ed Firm
ndep f Lever PV of Agency and
I
Value
o } Bankruptcy Costs
Actual Value
of the Firm
Financial Leverage
19. 19
Capital Structure
Basic Tools of Capital Structure Management
The use of financial leverage increases variability of
EPS (as seen by DFL in Chapter 13)
20. 20
Capital Structure
Basic Tools of Capital Structure Management
The use of financial leverage increases variability of
EPS (as seen by DFL in Chapter 13)
The use of financial leverage also changes EPS at any
given EBIT.
21. 21
Capital Structure
Basic Tools of Capital Structure Management
The use of financial leverage increases variability of
EPS (as seen by DFL in Chapter 13)
The use of financial leverage also changes EPS at any
given EBIT.
EBIT-EPS Analysis
Graphically demonstrates the impact of leverage on EPS
at different levels of EBIT.
EPS 50% Leverage
40% Leverage
EBIT
22. 22
Capital Structure
Basic Tools of Capital Structure Management
The use of financial leverage increases variability of
EPS (as seen by DFL in Chapter 13)
The use of financial leverage also changes EPS at any
given EBIT.
EBIT-EPS Analysis
Graphically demonstrates the impact of leverage on EPS
at different levels of EBIT.
EPS 50% Leverage
40% Leverage
Indifference Point
EBIT
24. 24
EBIT-EPS Analysis
Compute EBIT at which EPS will be the same
regardless of financing plan
Set EPS for each plan equal to each other
At the EBIT indifference level:
EPS50% debt = EPS40% debt
(EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t)
=
S50% S40%
where: I = Interest cost of plan
S = # of shares of plan
25. 25
EBIT-EPS Analysis
Example:
$1 million of financing are currently needed. Can raise the money
with debt costing 8%, or stock at $10/share. Tax rate = 40%
26. 26
EBIT-EPS Analysis
Example:
$1 million of financing are currently needed. Can raise the money
with debt costing 8%, or stock at $10/share. Tax rate = 40%
At the EBIT indifference level:
EPS50% debt = EPS40% debt
(EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t)
=
S50% S40%
27. 27
EBIT-EPS Analysis
Example:
$1 million of financing are currently needed. Can raise the money
with debt costing 8%, or stock at $10/share. Tax rate = 40%
At the EBIT indifference level:
EPS50% debt = EPS40% debt
(EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t)
=
S50% S40%
I = $500,000 x 8% = $40,000
S = $500,000/$10 = 50,000
28. 28
EBIT-EPS Analysis
Example:
$1 million of financing are currently needed. Can raise the money
with debt costing 8%, or stock at $10/share. Tax rate = 40%
At the EBIT indifference level:
EPS50% debt = EPS40% debt
(EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t)
=
S50% S40%
I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000
S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000
29. 29
EBIT-EPS Analysis
Example:
$1 million of financing are currently needed. Can raise the money
with debt costing 8%, or stock at $10/share. Tax rate = 40%
At the EBIT indifference level:
EPS50% debt = EPS40% debt
(EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t)
=
S50% S40%
I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000
S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000
(EBIT - $40,000)(1 - .40) (EBIT - $32,000)(1 - .40)
=
50,000 60,000
30. 30
EBIT-EPS Analysis
Example:
$1 million of financing are currently needed. Can raise the money
with debt costing 8%, or stock at $10/share. Tax rate = 40%
At the EBIT indifference level:
EPS50% debt = EPS40% debt
(EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t)
=
S50% S40%
I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000
S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000
(EBIT - $40,000)(1 - .40) (EBIT - $32,000)(1 - .40)
=
50,000 60,000
Solve for EBIT: EBIT = $80,000
31. 31
Capital Structure in Practice
The majority of financial officers believe there is an
optimal capital structure for their company.
Managers adapt financial leverage to the business
cycle, taking advantage of debt when it is less
expensive.
The most important factor in determining leverage is a
firm’s business risk.
Managers’ optimal choice to finance new projects is to
use retained earnings.
Only after internal funds are exhausted, managers’
choice of leverage is consistent with the Moderate
Theory of financial leverage.
