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Principles of Finance

17.5 Optimal Capital Structure

Principles of Finance17.5 Optimal Capital Structure

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

By the end of this section, you will be able to:

  • Explain how increased use of leverage increases the possibility of financial distress.
  • Explain how the possibility of financial distress impacts the cost of capital.
  • Discuss the trade-offs a firm faces as it increases its leverage.
  • Explain the concept of an optimal capital structure.

Debt and Financial Distress

The more debt a company uses in its capital structure, the larger the dollar value of the interest tax shield. Why, then, do we not see firms using a capital structure composed 100% of debt to maximize this interest tax shield?

The answer to this question lies in the fact that as a company increases its debt, there is a greater chance that the firm will be unable to make its required interest payments on the debt. If the firm has difficulty meeting its debt obligations, it is said to be in financial distress.

A firm in financial distress incurs both direct and indirect costs. The direct costs of financial distress include fees paid to lawyers, consultants, appraisers, and auctioneers. The indirect costs include loss of customers and suppliers.

Trade-Off Theory

Trade-off theory weighs the advantages and disadvantages of using debt in the capital structure. The advantage of using debt is the interest tax shield. The disadvantage of using debt is that it increases the risk of financial distress and the costs associated with financial distress.

A company has an incentive to increase leverage to exploit the interest tax shield. However, too much debt will make it more likely that the company will default and incur financial distress costs. Calculating the precise balance between these two is difficult if not impossible.

For companies with a low level of debt, the risk of default is low, and the main impact of an increase in leverage will be an increase in the interest tax shield. At some point, however, the tax savings that result from increasing the amount of debt in the capital structure will be just offset by the increased probability of incurring the costs of financial distress. For firms that have higher costs of financing distress, this point will be reached sooner. Thus, firms that face higher costs of financial distress have a lower optimal level of leverage than firms that face lower costs of financial distress.

Figure 17.4 demonstrates how the value of a levered firm varies with the level of debt financing used. Vu is the value of the unlevered firm, or the firm with no debt. As the firm begins to add debt to its capital structure, the value of the firm increases due to the interest tax shield. The more debt the company takes on, the greater the tax benefit it receives, up until the point at which the company’s interest expense exceeds its earnings before interest and taxes (EBIT). Once the interest expense equals EBIT, the firm will have no taxable income. There is no tax benefit from paying more interest after that point.

A line graph shows the Maximum Value of a Levered Firm. It shows how at first as the firm adds debt, the PV of interest tax shields rises at a similar rate to the debt. As debt increases, the lines diverge. The maximum value of the firm occurs at the optimal debt level. After this point, the magnitude of the costs of financial distress increase as the debt level of the company rises.
Figure 17.4 Maximum Value of a Levered Firm

As the firm increases debt and increases the value of the tax benefit of debt, it also increases the probability of facing financial distress. The magnitude of the costs of financial distress increases as the debt level of the company rises. To some degree, these costs offset the benefit of the interest tax shield.

The optimal debt level occurs at the point at which the value of the firm is maximized. A company will use this optimal debt level to determine what the weight of debt should be in its target capital structure. The optimal capital structure is the target. Recall that the market values of a company’s debt and equity are used to determine the costs of capital and the weights in the capital structure. Because market values change daily due to economic conditions, slight variations will occur in the calculations from one day to the next. It is neither practical nor desirable for a firm to recalculate its optimal capital structure each day.

Also, a company will not want to make adjustments for minor differences between its actual capital structure and its optimal capital structure. For example, if a company has determined that its optimal capital structure is 22.5% debt and 77.5% equity but finds that its current capital structure is 23.1% debt and 76.9% equity, it is close to its target. Reducing debt and increasing equity would require transaction costs that might be quite significant.

Table 17.7 shows the average WACC for some common industries. The calculations are based on corporate information at the end of December 2020. A risk-free rate of 3% and a market-risk premium of 5% are assumed in the calculations. You can see that the capital structure used by firms varies widely by industry. Companies in the online retail industry are financed almost entirely through equity capital; on average, less than 7% of the capital comes from debt for those companies. On the other hand, companies in the rubber and tires industry tend to use a heavy amount of debt in their capital structure. With a debt weight of 63.62%, almost two-thirds of the capital for these companies comes from debt.

Industry Name Equity Weight Debt Weight Beta Cost of Equity Tax Rate After-Tax
Cost of Debt
WACC
Retail (online) 93.33% 6.67% 1.16 8.82% 2.93% 2.19% 8.38%
Computers/peripherals 91.45% 8.55% 1.18 8.92% 3.71% 1.88% 8.32%
Household products 87.07% 12.93% 0.73 6.65% 5.06% 2.19% 6.07%
Drugs (pharmaceutical) 84.62% 15.38% 0.91 7.54% 1.88% 2.19% 6.72%
Retail (general) 82.41% 17.59% 0.90 7.49% 12.48% 1.88% 6.51%
Beverages (soft) 82.24% 17.76% 0.79 6.96% 3.32% 2.19% 6.11%
Tobacco 76.74% 23.26% 0.72 6.61% 8.69% 1.88% 5.51%
Homebuilding 75.34% 24.66% 1.46 10.29% 15.91% 2.19% 8.30%
Food processing 75.18% 24.82% 0.64 6.18% 8.56% 2.19% 5.19%
Restaurants/dining 74.79% 25.21% 1.34 9.72% 3.19% 2.19% 7.82%
Apparel 71.74% 28.26% 1.10 8.49% 4.75% 2.19% 6.71%
Farming/agriculture 68.94% 31.06% 0.87 7.37% 6.45% 1.88% 5.67%
Packaging & containers 64.47% 35.53% 0.92 7.61% 15.67% 1.88% 5.57%
Food wholesalers 64.10% 35.90% 1.03 8.17% 0.52% 2.19% 6.02%
Hotels/gaming 63.60% 36.40% 1.56 10.82% 2.02% 2.19% 7.68%
Telecom. services 54.60% 45.40% 0.66 6.30% 3.93% 1.40% 4.07%
Retail (grocery and food) 51.46% 48.54% 0.24 4.21% 13.52% 2.19% 3.23%
Air transport 38.26% 61.74% 1.61 11.04% 6.00% 2.19% 5.58%
Rubber & tires 36.38% 63.62% 1.09 8.47% 5.30% 1.88% 4.28%
Table 17.7 Capital Structure, Cost of Debt, Cost of Equity, and WACC for Selected Industries (data source: Aswath Damodaran Online)

Industries that have high betas, such as hotels/gaming and air transport, have high equity costs of capital. More recession-proof industries, such as food processing and household products, have low betas and low equity costs of capital. The WACC for each industry ends up being influenced by the weights of equity and debt the company chooses, the riskiness of the industry, and the tax rates faced by companies in the industry.

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