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1
Chapter 15
Capital Structure Decisions:
Part I
2
Topics in Chapter
Overview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence,
and implications Choosing the optimal capital
structure: An example
3
Basic Definitions
V = value of firm FCF = free cash flow WACC = weighted average cost of
capital rs and rd = costs of stock and debt wce and wd = percentages of the firm
that are financed with stock and debt
4
Capital Structure and Firm Value
V = ∑∞
t=1
FCFt
(1 + WACC)t
WACC= wd (1-T) rd + wcers
(15-1)
(15-2)
5
Capital Structure Effects Preview
The impact of capital structure on value depends upon the effect of debt on: WACC FCF
6
Debt increases the cost of equity, rs
Debt holders have a prior claim on cash flows relative to stockholders.
Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim.
Debt reduces the firm’s taxes Firm’s can deduct interest expenses. Frees up more cash for payments to investors Reduces after-tax cost of debt
The Effect of Debt on WACC
7
The Effect of Debt on WACC
Debt increases risk of bankruptcy Causes pre-tax cost of debt to increase
Adding debt: Increases percent of firm financed with
low-cost debt (wd) Decreases percent financed with high-
cost equity (wce) Net effect on WACC = uncertain
8
The Effect of Debt on FCF
debt probability of bankruptcy Direct costs:
Legal fees “Fire” sales, etc.
Indirect costs: Lost customers Reduction in productivity of managers and
line workers, Reduction in credit (i.e., accounts payable)
offered by suppliers
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The Effect of Additional Debt
Impact of indirect costs Sales & Productivity
Customers choose other sources Workers worry about their jobs
NOWC Suppliers tighten credit
NOPAT FCF
10
The Effect of Additional Debt on Managerial Behavior
Reduces agency costs: Debt reduces free cash flow
waste Increases agency costs:
Underinvestment potential
11
Asymmetric Information and Signaling
“Asymmetric Information” = insiders know more than outsiders Managers know the firm’s future prospects
better than investors.
Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock
= Investors often perceive an additional issuance of stock as a negative signal Stock price
12
Business Risk vs. Financial Risk
Business risk: Uncertainty about future EBIT Depends on business factors such as
competition, operating leverage, etc. Financial risk:
Additional business risk concentrated on common stockholders when financial leverage is used
13
Business risk: Uncertainty about future pre-tax operating income (EBIT).
Probability
EBITE(EBIT)0
Low risk
High risk
Note: Business risk focuses on operating income, ignoring financing effects.
14
Factors That Influence Business Risk
1. Demand variability (uncertainty unit sales)
2. Sales price variability3. Input cost variability4. Ability to adjust output prices for
changes input costs5. Ability to develop new products6. Foreign risk exposure7. Degree of operating leverage (DOL)
15
Operating Leverage
Operating leverage is the change in EBIT caused by a change in quantity sold.
> Fixed costs > Operating leverage The higher the proportion of fixed costs
within a firm’s overall cost structure, the greater the operating leverage.
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Figure 15.1Illustration of Operating Leverage
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Higher operating leverage leads to more business risk: small sales decline causes a larger EBIT decline.
Sales
$ Rev.TC
F
QBE
EBIT}$
Rev.
TC
F
QBESales
18
Strasburg Electronics Company
Input Data Plan A Plan BLow FC High FC
Price $2.00 $2.00Variable costs $1.50 $1.00Fixed costs $20,000 $60,000Capital $200,000 $200,000Tax Rate 40% 40%
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Strasburg Expected Sales
Operating Performance
Units Dollar
Demand Probability Sold Sales
Terrible 0.05 0 $0Poor 0.2 40,000 $80,000Average 0.5 100,000 $200,000Good 0.2 160,000 $320,000Wonderful 0.05 200,000 $400,000
Expected Values: 100,000 $200,000
Standard Deviation (SD): 49,396 98,793
Coefficient of Variation (CV): 0.49 0.49
Data Applicable to Both Plans
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Strasburg Plan A
Pre-tax Net Op Profit Return onUnits Operating Operating After Taxes InvestedSold Costs Profit (EBIT) (NOPAT) Capital
0 $20,000 ($20,000) ($12,000) -6.0%40,000 $80,000 $0 $0 0.0%
100,000 $170,000 $30,000 $18,000 9.0%160,000 $260,000 $60,000 $36,000 18.0%200,000 $320,000 $80,000 $48,000 24.0%
Exp. Values: $170,000 $30,000 $18,000 9.0%Std. Dev.: $24,698 7.4%Coef. of Var.: 0.82 0.82
Plan A: Low Fixed, High Variable Costs
Figure 15-1 Lower Panel
21
Strasburg Plan B
Pre-tax Net Op Profit Return on
Units Operating Operating After Taxes InvestedSold Costs Profit (EBIT) (NOPAT) Capital
0 $60,000 ($60,000) ($36,000) -18.0%40,000 $100,000 ($20,000) ($12,000) -6.0%100,000 $160,000 $40,000 $24,000 12.0%160,000 $220,000 $100,000 $60,000 30.0%200,000 $260,000 $140,000 $84,000 42.0%
Exp. Values: $160,000 $40,000 $24,000 12.0%
Std. Dev.: 49,396 14.8%
Coef. of Var.: 1.23 1.23
Plan B: High Fixed, Low Variable Costs
Figure 15-1 Lower Panel
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Strasburg: Plans A & B
Plan A: Low Fixed Costs, Low Operating Leverage
$0
$50,000
$100,000
$150,000
$200,000
0 50000 100000
Sales (units)
Rev
enue
s an
d co
sts
Revenues
VC
FC
Plan B: High Fixed Costs, High Operating Leverage
$0
$50,000
$100,000
$150,000
$200,000
0 50000 100000
Sales (units)
Rev
enue
s an
d co
sts Revenues
VC
FC
Figure 15-1 Upper Panel
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Operating Breakeven: QBE
QBE = F / (P – V) (15-4)
QBE = Operating breakeven
quantity F = Fixed cost V = Variable cost per unit P = Price per unit
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Strasburg Breakeven
units000,6000.1$00.2$
000,60$Q
units000,4050.1$00.2$
000,20$Q
BBE
ABE
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Strasburg: Plans A & B
Plan A: Low Fixed Costs, Low Operating Leverage
$0
$50,000
$100,000
$150,000
$200,000
0 50000 100000
Sales (units)
Rev
enue
s an
d co
sts
Revenues
VC
FC
Plan B: High Fixed Costs, High Operating Leverage
$0
$50,000
$100,000
$150,000
$200,000
0 50000 100000
Sales (units)
Rev
enue
s an
d co
sts Revenues
VC
FC
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Probability
EBITL
Low operating leverage
High operating leverage
EBITH
Higher operating leverage leads to higher expected EBIT and higher risk.
27
Strasburg & Financial Risk
Strasburg going with Plan B Riskier Higher expected EBIT and ROIC
Financial risk: Additional business risk concentrated
on common stockholders when financial leverage is used
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Strasburg - Extended
To date – no debt Two financing choices:
Remain at 0 debt Move to $100,000 debt and
$100,000 book equity
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Table 15.1Strasburg Electronics – Effects of Financial Leverage
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Strasburg with No DebtDebt $0Book equity $200,000Interest rate n.a.
Demand for Pre-tax Taxes Netproduct Probability EBIT Interest income (40%) income ROE
(1) (2) (3) (4) (5) (6) (7) (8)Terrible 0.05 ($60,000) $0 ($60,000) ($24,000) ($36,000) -18.0%Poor 0.2 (20,000) 0 (20,000) (8,000) (12,000) -6.0%Normal 0.5 40,000 0 40,000 16,000 24,000 12.0%Good 0.2 100,000 0 100,000 40,000 60,000 30.0%Wonderful 0.05 140,000 0 140,000 56,000 84,000 42.0%Expected value: $40,000 $0 $40,000 $16,000 $24,000 12.0%Standard deviation: 14.8%Coefficient of variation: 1.23
Table 15-1 Section I
ROE = Net Income/Book Equity
Expected ROE = ROE under each demand X Probability
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Strasburg with 50% Debt
Debt $100,000Book equity $100,000Interest rate 10%
Demand for Pre-tax Taxes Netproduct Probability EBIT Interest income (40%) income ROE
(1) (2) (3) (4) (5) (6) (7) (8)Terrible 0.05 ($60,000) $10,000 ($70,000) ($28,000) ($42,000) -42.0%Poor 0.2 (20,000) 10,000 (30,000) (12,000) (18,000) -18.0%Normal 0.5 40,000 10,000 30,000 12,000 18,000 18.0%Good 0.2 100,000 10,000 90,000 36,000 54,000 54.0%Wonderful 0.05 140,000 10,000 130,000 52,000 78,000 78.0%Expected value: $40,000 $10,000 $30,000 $12,000 $18,000 18.0%Standard deviation: 29.6%Coefficient of variation: 1.65
Table 15-1 Section II
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Section I. Zero DebtDebtBook equityInterest rate
Demand for Netproduct Probability income ROE
(1) (2) (7) (8)Terrible 0.05 ($36,000) -18.0%Poor 0.2 (12,000) -6.0%Normal 0.5 24,000 12.0%Good 0.2 60,000 30.0%Wonderful 0.05 84,000 42.0%Expected value: $24,000 12.0%Standard deviation: 14.8%Coefficient of variation: 1.23
Section II. $100,000 of DebtDebtBook equityInterest rate
Demand for Netproduct Probability income ROE
(1) (2) (7) (8)Terrible 0.05 ($42,000) -42.0%Poor 0.2 (18,000) -18.0%Normal 0.5 18,000 18.0%Good 0.2 54,000 54.0%Wonderful 0.05 78,000 78.0%Expected value: $18,000 18.0%Standard deviation: 29.6%Coefficient of variation: 1.65
Strasburg w/ Zero Debt
Strasburg w/ 50% Debt
Higher ROE
Higher Risk
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Leveraging Increases ROE
More EBIT goes to investors: Total dollars paid to investors:
I: NI = $24,000 II: NI + Int = $18,000 + $10,000 = $28,000
Taxes paid: I: $16,000; II: $12,000
Equity $ proportionally lower than NI
34
Strasburg’s Financial Risk
In a stand-alone sense, stockholders see much more risk with debt. I: σROE = 14.8%
II: σROE = 29.6%
Strasburg’s financial risk = σROE -
σROIC = 29.6% - 14.8% = 14.8%
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Capital Structure Theory Modigliani & Miller theory
Zero taxes (MM 1958) Corporate taxes (MM 1963) Corporate and personal taxes (Miller 1977)
Trade-off theory Signaling theory Pecking order Debt financing as a managerial constraint Windows of opportunity
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MM Results: Zero Taxes If two portfolios (firms) produce the
same cash flows, then the two portfolios must have the same value.
A firm’s value is unaffected by its capital structure
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MM (1958) Assumptions
1. No brokerage costs2. No taxes3. No bankruptcy costs4. Investors can borrow and lend at the
same rate as corporations5. All investors have the same
information6. EBIT is not affected by the use of debt
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MM Theory: Zero TaxesFirm U Firm L
EBIT $3,000 $3,000Interest
0 1,200
NI $3,000 $1,800
CF to shareholder
$3,000 $1,800
CF to debt holder
0 $1,200
Total CF $3,000 $3,000
Notice that the total CF are identical.
39
MM Results: Zero Taxes MM prove:
If total CF to investors of Firm U and Firm L are equal, then the total values of Firm U and Firm L must be equal:
VL = VU
Because FCF and values of firms L and U are equal, their WACCs are equal
Therefore, capital structure is irrelevant
40
MM (1963): Corporate Taxes
Relaxed assumption of no corporate taxes
Interest may be deducted, reducing taxes paid by levered firms
More CF goes to investors, less to taxes when leverage is used
Debt “shields” some of the firm’s CF from taxes
41
MM Result: Corporate Taxes
MM show that the value of a levered firm = value of an identical unlevered form + any “side effects.”
VL = VU + TD(15-7)
If T=40%, then every dollar of debt adds 40 cents of extra value to firm
42
Value of Firm, V
0Debt
VL
VU
Under MM with corporate taxes, the firm’s value increases continuously as more and more debt is used.
TD
MM relationship between value and debt when corporate taxes are considered.
43
Cost of Capital (%)
0 20 40 60 80 100Debt/Value Ratio (%)
rs
WACCrd(1 - T)
MM relationship between capital costs and leverage when corporate taxes are considered
44
Miller (1977): Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt: Corporate taxes favor debt financing
Interest expenses deductible Personal taxes favor equity financing
No gain is reported until stock is sold Long-term gains taxed at a lower rate
45
Miller’s Model with Corporate and Personal Taxes
VL = VU + 1− D (15-8)
Tc = corporate tax rate.Td = personal tax rate on debt income.Ts = personal tax rate on stock income.
(1 - Tc)(1 - Ts)
(1 - Td)
46
Tc = 40%, Td = 30%, and Ts = 12%
VL = VU + 1− D
= VU + (1 - 0.75)D
= VU + 0.25D
Value rises with debt; each $1 increase in debt raises Levered firm’s value by $0.25.
(1 - 0.40)(1 - 0.12)(1 - 0.30)
47
Trade-off Theory MM theory assume no cost to bankruptcy The probability of bankruptcy increases
as more leverage is used At low leverage, tax benefits outweigh
bankruptcy costs. At high levels, bankruptcy costs outweigh tax
benefits. An optimal capital structure exists
(theoretically) that balances costs and benefits.
48
Figure 15.2 Effect of Leverage on Value
49
Signaling Theory
MM assumed that investors and managers have the same information.
Managers often have better information and would: Sell stock if stock is overvalued Sell bonds if stock is undervalued
Investors understand this, so view new stock sales as a negative signal.
50
Pecking Order Theory Firms use internally generated funds
first (1): No flotation costs No negative signals
If more funds are needed, firms then issue debt (2) Lower flotation costs than equity No negative signals
If more funds are still needed, firms then issue equity (3)
51
Pecking Order Theory
INTERNAL EXTERNAL
DEBT 2
EQUITY 1 3
52
Debt Financing & Agency Costs
Agency problem #1: Managers use corporate funds for non-value maximizing purposes
Financial leverage: Bonds commit “free cash flow” Forces discipline on managers to
avoid perks and non-value adding acquisitions.
LBO = ultimate use of debt controlling management actions
53
Agency problem #2: “Underinvestment” Debt increases risk of financial
distress Managers may avoid risky
projects even if they have positive NPVs
Debt Financing & Agency Costs
54
Investment Opportunity Set and Reserve Borrowing Capacity
Firms should normally use more equity, less debt than optimal “Reserve borrowing power” Especially important if:
Many investment opportunities Asymmetric information issues
cause equity issues to be costly
55
Windows of Opportunity
Issue When And
Equity Market is “high”
Stocks have “run up”
Debt Market is “low”
Interest rates low
S/T Debt Term structure is upward sloping
L/T Debt Term structure is flat
Managers try to “time the market” when issuing securities.
56
Empirical Evidence Tax benefits are important
$1 debt adds $0.10 to value Supports Miller model with personal taxes
Bankruptcies are costly Costs can =10% to 20% of firm value
Firms don’t make quick corrections when Δstock price Δdebt ratios Doesn’t support trade-off model
57
Empirical Evidence
After stock price , debt ratio , but firms tend to issue equity not debt Inconsistent with trade-off model Inconsistent with pecking order Consistent with windows of opportunity
Firms tend to maintain excess borrowing capacity Firms with growth options Firms with asymmetric information problems
58
Implications for Managers
Take advantage of tax benefits by issuing debt, especially if the firm has: High tax rate Stable sales Less operating leverage
59
Implications for Managers
Avoid financial distress costs by maintaining excess borrowing capacity, especially if the firm has: Volatile sales High operating leverage Many potential investment opportunities Special purpose assets (instead of general
purpose assets that make good collateral)
60
Implications for Managers
If manager has asymmetric information regarding firm’s future prospects, then: Avoid issuing equity if actual prospects
are better than the market perceives Consider impact of capital structure
choices on lenders’ and rating agencies’ attitudes
61
The Optimal Capital Structure
Maximizes shareholder wealth Maximizes firm value Maximizes stock price Minimizes WACC Does NOT maximize EPS
62
Estimating the Optimal Capital Structure: 5 Steps
1. Estimate the interest rate the firm will pay (cost of debt)
2. Estimate the cost of equity3. Estimate the WACC4. Estimate the free cash flows and
their present value (value of the firm)
5. Deduct the value of debt to find Shareholder Wealth Maximize
63
Choosing the Optimal Capital Structure: Strasburg Example
Currently all-equity financed Expected EBIT = $40,000 10,000 shares outstanding
rs = 12% P0 = $25
T = 40% b = 1.0
rRF = 6% RPM = 6%
64
TABLE 15.2
Step 1:Estimates of Cost of Debt
65
The Cost of Equity at Different Levels of Debt: Hamada’s Equation
MM theory beta changes with leverage
bU = the beta of a firm with NO debt Unlevered beta
b = bU [1 + (1 - T)(D/S)]
D = Market value of firm’s debtS = Market value of firm’s
equityT = Firm’s corporate tax rate
66
Step 2:The Cost of Equity for wd = 50%
Use Hamada’s equation to find beta: b = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (50% / 50%) ] = 1.60
Use CAPM to find the cost of equity: rs= rRF + bL (RPM)
= 6% + 1.60 (6%) = 15.6%
67
TABLE 15.3Strasburg’s optimal Capital Structure
68
Step 3: Strasburg’s WACC & Optimal Capital Structure
Note: The Capital Structure that MAXIMIZES firm value is the one that MINIMIZES WACC
Table 15-3 Strasburg's Optimal Capital Structure
Percent Market After-tax Value offinanced Debt/Equity, cost of debt, Estimated Cost of operations,
with debt, wd D/S (1-T) rd beta, b equity, rs WACC Vop
(1) (2) (3) (4) (5) (6) (7)0% 0.00% 4.80% 1.00 12.0% 12.00% $200,000
10% 11.11% 4.80% 1.07 12.4% 11.64% $206,18620% 25.00% 4.86% 1.15 12.9% 11.29% $212,54030% 42.86% 5.10% 1.26 13.5% 11.01% $217,98440% 66.67% 5.40% 1.40 14.4% 10.80% $222,22250% 100.00% 6.60% 1.60 15.6% 11.10% $216,21660% 150.00% 8.40% 1.90 17.4% 12.00% $200,000
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Notes to Table 15-3
Notes: a The D/S ratio is calculated as: D/S = wd / (1-wd).b The interest rates are shown in Table 15-2, and the tax rate is 40%.c The beta is estimated using Hamada’s formula in Equation 15-8.
FCF = NOPAT + Investment in capital = EBIT(1-T) + 0= $40,000 (1-0.4) = $24,000.
f The value of the firm's operations is calculated using the free cash flow valuation formula in Equation 14-1, modified to reflect the fact that Strasburg has zero growth: Vop = FCF / WACC. Since Strasburg has zero growth, it requires no investment in capital, and its FCF is equal to its NOPAT. Using the EBIT shown in Table 15-1:
d The cost of equity is estimated using the CAPM formula: rs = rRF + (RPM)b, where the risk free rate is 6 percent and the market risk premium is 6 percent.e The weighted average cost of capital is calculated using Equation 15-2: WACC = wce rs + wd rd (1-T), where wce = (1-wd).
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Figure 15.3Strasburg’s Required Rate of Return on Equity
71
Figure 15-4: Effects of Capital Structure on Cost of Capital
0%
5%
10%
15%
20%
0% 10% 20% 30% 40% 50% 60%
Percent Financed with Debt
Cost of Equity
WACC
After-Tax Cost of Debt
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Step 4:Corporate Value for wd = 0%
Vop = FCF(1+g) / (WACC-g) g=0, so investment in capital is
zero FCF = NOPAT = EBIT (1-T)
NOPAT = ($40,000)(1-0.40) = $24,000
Vop = $24,000 / 0.12 = $200,000
73
Step 4: Strasburg’s Firm Value
Table 15-3 Strasburg's Optimal Capital Structure
Percent Market After-tax Value offinanced Debt/Equity, cost of debt, Estimated Cost of operations,
with debt, wd D/S (1-T) rd beta, b equity, rs WACC Vop
(1) (2) (3) (4) (5) (6) (7)0% 0.00% 4.80% 1.00 12.0% 12.00% $200,000
10% 11.11% 4.80% 1.07 12.4% 11.64% $206,18620% 25.00% 4.86% 1.15 12.9% 11.29% $212,54030% 42.86% 5.10% 1.26 13.5% 11.01% $217,98440% 66.67% 5.40% 1.40 14.4% 10.80% $222,22250% 100.00% 6.60% 1.60 15.6% 11.10% $216,21660% 150.00% 8.40% 1.90 17.4% 12.00% $200,000
Note: The Capital Structure that MAXIMIZES firm value is the one that MINIMIZES WACC
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Implications for Strasburg
Firm should recapitalize (“recap”)
Issue debt Use funds to repurchase equity Optimal debt = 40%
WACC = 10.80% Maximizes Firm Value
75
Anatomy of Strasburg’s Recap: Before Issuing Debt
$200,000
0
$200,000
0
Value of equity (S) $200,000
Number of shares 10,000 $20.00
Value of stock $200,000
0Wealth of shareholders $200,000
Stock Price per Share
Value of Operations
+ Short Term investments
Total Value of the Firm
− Market Value of Debt
+ Cash distributed in repurchase
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Issue Debt (wd = 40%), But Before Repurchase
WACC decreases to 10.80% Vop increases to $222,222 Short-term funds = $88,889
Temporary until it uses these funds to repurchase stock
Debt is now $88,889
77
Anatomy of a Recap: After Debt, but Before Repurchase
Before Debt Issue
After Debt Issue, But Before Repurchase
(1) (2)$200,000 $222,222
0 88,889
$200,000 $311,111
0 88,889
Value of equity (S) $200,000 $222,222
Number of shares 10,000 10,000 $20.00 $22.22
Value of stock $200,000 $222,222
0 0Wealth of shareholders $200,000 $222,222
Stock Price per Share
Value of Operations
+ Short Term investments
Total Value of the Firm
− Market Value of Debt
+ Cash distributed in repurchase
Vop $222,222
Debt = $88,889S/T funds = $88,889
Stock Price $22.22
Shareholder wealth $222.222
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The Repurchase: No Effect on Stock Price
Announcement of intended repurchase might send a signal that affects stock price
The repurchase itself has no impact on stock price. If investors think the repurchase would:
stock price, they would purchase stock the day before, which would drive up its price.
stock price, they would all sell short the stock the day before, which would drive down the stock price.
79
Remaining Number of Shares After Repurchase D0 = original amount of debt D = amount after issuing new debt If all new debt is used to repurchase
shares, then total dollars used equals: (D – D0) = ($88,889 - $0) = $88,889
n0 = number of shares before repurchase, n = number after repurchase.
n = n0 – (D – D0)/P = 10,000 - $88,889/$22.22 n = 10,000 – 4,000 = 6,000
80
Anatomy of Strasburg’s Recap: After Repurchase
Before Debt Issue
After Debt Issue, But Before Repurchase
After Repurchase
(1) (2) (3)$200,000 $222,222 $222,222
0 88,889 0
$200,000 $311,111 $222,222
0 88,889 88,889
Value of equity (S) $200,000 $222,222 $133,333
Number of shares 10,000 10,000 $6,000.00 $20.00 $22.22 $22.22
Value of stock $200,000 $222,222 $133,333
0 0 88,889Wealth of shareholders $200,000 $222,222 $222,222
Stock Price per Share
Value of Operations
+ Short Term investments
Total Value of the Firm
− Market Value of Debt
+ Cash distributed in repurchase
81
Strasburg after RecapitalizationKey Points
Short Term investments used to repurchase stock
Stock price is unchanged Value of stock falls to $133,333
Firm no longer owns the short-term investments
Wealth of shareholders remains at $222,222
82
Shortcuts
The corporate valuation approach will always give the correct answer
There are some shortcuts for finding S, P, and n
Shortcuts on next slides
83
Calculating S, the Value of Equity after the Recap
S = (1 – wd) Vop (15-13)
At wd = 40%: SPrior = S + (D – D0) (15-14)
S = (1 – 0.40) $222,222 S = $133,333 SPrior = $133,333 + (88,889 – 0)
SPrior = $222,222
84
Calculating P, the Stock Price after the Recap
P = [S + (D – D0)]/n0 (15-
15)
P = $133,333 + ($88,889 – 0)
10,000
P = $22.22 per share
85
Number of Shares after a Repurchase, n
# Repurchased = (D - D0) / P n = n0 - (D - D0) / P # Rep. = ($88,889 – 0) / $22.22 # Rep. = 4,000 n = 10,000 – 4,000 n = 6,000
86
TABLE 15.5 Strasburg’s Stock Price & EPS
87
Analyzing the Recap
Percent Value of Market Market Number of Earnings financed operations, value value Stock shares after Net income, per share,
with debt, wd Vop of debt, D of equity, S price, P repurchase, n NI EPS
(1) (2) (3) (4) (5) (6) (7) (8)0% $200,000 $0 $200,000 $20.00 $10,000 $24,000 $2.40
10% 206,186 20,619 185,567 $20.62 9,000 23,010 $2.5620% 212,540 42,508 170,032 $21.25 8,000 21,934 $2.7430% 217,984 65,395 152,589 $21.80 7,000 20,665 $2.9540% 222,222 88,889 133,333 $22.22 6,000 19,200 $3.2050% 216,216 108,108 108,108 $21.62 5,000 16,865 $3.3760% 200,000 120,000 80,000 $20.00 4,000 13,920 $3.48
Table 15-5
88
FIGURE 15.5 Effects of Capital Structure on Firm Value, Price and EPS
89
Effects of Capital Structure on Price and EPS
$0
$5
$10
$15
$20
$25
0% 10% 20% 30% 40% 50% 60%
Percent Financed with Debt
Stock Price
$0
$2
$4
$6
EPS
EPS
Price
90
Optimal Capital Structure
wd = 40% gives: Highest corporate value Lowest WACC Highest stock price per
share Does NOT maximize EPS