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Debt issued
Shares bought =
Price per share
Cost of debt at different debt levels after
recapitalization
($400,000)(0.6)
= 80,000 = $3.00.
D = $250, kd = 8%.
Shares $250,000
repurchased = = 10,000.
$25
[$400 – 0.08($250)](0.6)
EPS1 =
80 – 10
= $3.26.
EBIT $400
TIE = = = 20×.
I $20
D = $500, kd = 9%.
Shares $500
repurchased = = 20.
$25
[$400 – 0.09($500)](0.6)
EPS2 =
80 – 20
= $3.55.
EBIT $400
TIE = = = 8.9×.
I $45
D = $750, kd = 11.5%.
Shares $750
repurchased = = 30.
$25
[$400 – 0.115($750)](0.6)
EPS3 =
80 – 30
= $3.77.
EBIT $400
TIE = = = 4.6×.
I $86.25
D = $1,000, kd = 14%.
Shares $1,000
repurchased = = 40.
$25
[$400 – 0.14($1,000)](0.6)
EPS4 =
80 – 40
= $3.90.
EBIT $400
TIE = = = 2.9×.
I $140
• In this example, EPS is maximized at 50%
debt ($1M). Should the firm then issue 50%
debt? The answer is NO.
• The optimal capital structure is the one that
maximizes the firm’s stock price and not the
one that maximizes the firm’s EPS.
• Now we are going to investigate what the
stockholders want. A stock’s beta coefficient
measures its relative volatility or risk compared
to the stock market portfolio. It has been
shown both theoretically and empirically that a
stock’s beta increases as financial leverage
increases.
Stock Price (Zero Growth)
D1 EPS DPS
P0 = = = .
ks – g ks ks
bL = bU [1 + (1 – T)(D/E)].
15 ks
WACC
kd(1 – T)
P0
EPS
D/A
.25 .50
If we discovered that the firm had more/less
business risk than originally estimated, how
would the analysis be affected?
MM without taxes
D/A
0 D1 D2
• Below D1 the probability of bankruptcy is so low
as to be immaterial. Beyond D1, however,
bankruptcy-related costs become increasingly
important, and they reduce the tax benefits of
debt at an increasing rate
• In the range from D1 to D2, bankruptcy-related
costs reduce but do not completely offset the tax
benefits of debt, so the firm’s stock price rises
(but at a decreasing rate) as its debt ratio
increases.
• Beyond D2, bankruptcy related costs exceed the
tax benefits, so from D2 increasing the debt ratio
lowers the value of the stock.
• So D2 is the optimal capital structure.
• Theoretically, the debt rate where the
marginal benefits of the tax shelter equal the
marginal cost of increased bankruptcy risk
dictates the optimal capital structure.
• Empirically, many corporations are found to
have less debt than the trade-off theory of
leverage would suggest.
• The graph shows MM’s tax benefit vs.
bankruptcy cost theory.
• Logical, but doesn’t tell whole capital
structure story. Main problem--assumes
investors have same information as
managers.
Signaling theory, discussed earlier,
suggests firms should use less debt
than MM suggest.
This unused debt capacity helps
avoid stock sales, which depress P0
because of signaling effects.
What are “signaling” effects in capital
structure?
Assumptions: