Chapter 16

Capital Structure
Prepared By : DR. Wael Shams El-Din
Key Concepts
❑ What is capital structure
❑ How dose capital structures affect the value of the firm
❑ Debt increases the Probability of Bankruptcy
❑ Debt can affect the Behavior of Managers ( Agency Cost)
❑ Issuing Debt Convey Positive Signal while Issuing Equity
Convey Negative signal.
❑ Business Risk , Break even point and operating leverage
❑ Financial risk
Capital Structure
❑ Is mix of debt and Equity that maximizes the stock price.

How dose capital structures affect the value of the firm

Value of the Firm = FCF

1+ WACC

❑ The value of a firm is the present value of its expected

future free cash flow (FCFs), discounted at its weighted
average cost of capital (WACC).
ABC Company showing the Following
Capital Structure (Tax Rate 40%)
Ser. Weight of Interest Weight of Cost of WACC
Debt Rate Equity Equity
1 0% 8% 100% 10% 10%
2 10% 8% 90% 10% 9.48%
3 20% 8% 80% 10% 8.96%
4 30% 8% 70% 10% 8.44%
5 40% 8% 60% 10% 7.92%
6 50% 8% 50% 10% 7.40%
7 60% 8% 40% 10% 6.88%
8 70% 8% 30% 10% 6.66%
9 80% 8% 20% 10% 5.84%
10 90% 8% 10% 10% 5.32 %
11 100% 8% 0% 10% 4.80%
The Effect of Debt (On Various Factors)
Capital ( Equity+ Debt) = 10Million
Interest on debt = 10%
Tax Rate = 40%
100% Equity & 50% Equity & 10% Equity &
Zero Debt 50% Debt 90% Debt
A B C
Sales 10,000,000 10,000,000 10,000,000
(-) COGS 5,000,000 5,000,000 5,000,000
EBIT 5,000,000 5,000,000 5,000,000
(-) Interest Zero 500,000 900,000
EBT 5,000,000 4,500,000 4,100,000
TAX @40% 2,000,000 1,800,000 1,640,000
Net Income 3,000,000 2,700,000 2,460,000
ROE 3M/10M = 30% 2.70M/5M= 54% 2.46M/1M= 246%
1.Debt and Its impact on CF
3500000

3,000,000
3000000
2,700,000

2500000 2,460,000

2000000 Interest
Tax
1500000 Cach

1000000

500000

0
❑ Imagine that a company’s cash flows are a pie, and
three different groups get pieces of The pie, the
first sector goes to the government in the form of
taxes, the second goes to debt holders, and the
third to shareholders.

Interest

Cash Interest
Tax
Tax
Cash
2.Debt increases the 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 offered by
suppliers. Therefore lost of customers and drop in productivity
will lead to reduction in net operating Profit after taxes.

❑ Trade off Theory: Modigliani and Miller (MM’s) developed

trade- off theory of capital structure they assume that firm trade
off the benefits of debt (Tax saving) and the bankruptcy cost.
However, in practice bankruptcy can be quite costly. Firms in
bankruptcy have very high legal and accounting expenses, and
they also have a hard time retaining customers, suppliers, and
employees. Moreover, bankruptcy often forces a firm to liquidate
or sell assets for less than they would be worth if the firm were to
continue operating.
3.Debt can affect the Behavior of Managers
( Agency Cost)
❑ When time is good, managers may waste cash flow on
Privileges and Non-necessary expenditures which lead to
increases the agency costs however additional debt will
make manager feel the threat of bankruptcy which makes
them work hard and reduces such wasteful spending, which
mean increases in FCF.
Issuing Debt Convey Positive Signal while
Issuing Equity Convey Negative signal
❑ Managersare in a better position to forecast a company’s free
cash flow than are investors, and academics calling this
informational asymmetry.

❑ Suppose a company’s stock price is $50 per share. If

managers are willing to issue new stock at $50 per share,
investors reason that no one would sell anything for less than
its true value. Therefore, the true value of the shares as seen
by the managers with their superior information must be less
than $50. Thus, investors perceive an equity issue as a
negative signal, and this usually causes the stock price to fall.
Business Risk
❑ Business risk occurs when sales are Reduced and costs are
Increased, in both cases EBIT will negatively affect.
The higher the Operating Leverage the higher the business risk
Break Even Point
EBIT = Zero
Total Sale = Total Cost
Price X Quantity = Variable Cost X Quantity + Fixed Cost
P XQ = VXQ + FC

PQ –VQ = FC
Q (P-V) = FC
QBE = FC
P-V
Example

Good Year Bad Year

Price $2.00 $2.00
Variable costs $1.50 $1.00
Fixed costs $20,000 $60,000
Tax rate 40% 40%
Answer
Good Year
QBE = FC
P-V
QBE = 20,000 = 40,000 units
2 - 1.50
Bad Year
QBE = 60,000 = 60,000 units
2-1
Answer
Good Year Bad Year
Sales @ Break Even 40,000X2 = 80,000 60,000X2 = 120,000
(-) VC 60,000 60,000
(-) FC 20,000 60,000
EBIT ZERO ZERO
Operating Leverage 20/80 X 100 = 25% 60/120 X 100 = 50%
Fixed Cost /Total High Business Risk
Cost X 100

The higher the operating Leverage the higher the business risk
Financial Risk
❑ Financial risk is the additional risk placed on the Common
stockholders as a result of The decision to finance the firm
with debt.

❑ Suppose ten people decide to form a corporation there is a

certain amount of business risk in the operation. If the firm
is capitalized only with common equity, and if each person
buys 10 % of the stock, then each investor shares equally in
the business risk.
Financial Risk
❑ Suppose the firm is capitalized with 50% debt and 50%
Equity, with five of the investors putting up their capital as
debt and the other five putting up their money as equity. In
this case, the five investors who put up the equity will have
to bear all of the business risk, so the common stock will be
twice as risky as it would have been had the firm been
financed only with equity.

❑ Thus, the use of debt, or financial leverage, concentrates the

firm’s business risk on its stockholders. This concentration of
business risk occurs because debt holders, who receive fixed
interest payments, bear none of the business risk.
Example
Schweser Satellites Inc. Produces satellite earth stations that sell for
$100,000 each. The firm’s fixed costs (F), are $2 Million; 50 earth stations
are produced and sold each year; Profits total $500,000; and the firm’s
assets (all equity financed) are $5 Million. The firm estimates that it can
change its production process, adding $4 Million to investment and
$500,000 to fixed operating costs. This change will
❑ Reduce variable costs per unit by $10,000
❑ increase output by 20 units
❑ But the sales price on all units will have to be lowered to $95,000 to
permit sales of the additional output.
❑ The firm has tax loss carry-forwards that cause its tax rate to be zero, its
cost of equity is 15 percent, and it uses no debt.

A. Should the firm make the change?

B. Would the firm’s operating leverage increase or decrease if it made the
change? What about its breakeven point?
C. Would the new situation expose the firm to more or less business risk
than the old one?
Answer
OLD NEW
Asset (Equity ) 5,000,000 9,000,000
Fixed Cost 2,000,000 2,500,000
Variable Cost ? X Reduction by 10,000
No. of Units 50 70
Price per Unit 100,000 95,000
Profit $ 500,000 ?
WACC 15%
Answer
(1) Determine the variable cost per unit at present
Profit = Sales - (FC + VC)
$500,000 = ($100,000) (50) - ($2,000,000 + V (50)
50(V) = $2,500,000
VC Per unit = $50,000
VC for New = 50,000 -10,000 =40,000
(2) Determine the new profit level if the change is made:
New profit = Sales - (FC +VC)
= $95,000(70) – ($2,500,000 + 40,000X70) = $1,350,000
(3) Determine the change in Profit (incremental profit)
Profit = $1,350,000 – $500,000 = $850,000
Answer
Estimate the approximate rate of return on new investment:
Return = Profit X 100
Investment
Return = $850,000/$4,000,000 = 21.25%

❑ Since the return exceeds WACC, therefore this analysis suggests that the
firm should go ahead with the change.
Return > WACC
21.25% > 15%
The change would increase the breakeven point
Old Break Even = FC = 2,000,000 = 40 Units
P- V 100,000 -50,000

New: Break Even = 2,500,000 = 45.45 Units

95,000 -40,000
Answer
Since breakeven point increased , while other factors held constant,
therefore the new situation is more risky, specially when the percentage of
fixed costs increased by 25% .

❑ Operating Leverage (OL) = Fixed Cost ÷ Total Cost

OL Old = 2,000,000 ÷ 4,500,000 = 44.44%
OL New = 2,500,000÷ 5,300,000 = 47.17%

The change will cause, increase in breakeven points , higher percentage

of fixed costs and high Operating Leverage, so the new situation is more
risky.
Thank You