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Chapter 16

Capital Structure Decisions: The Basics

ANSWERS TO END-OF-CHAPTER QUESTIONS

16-1 a. Capital structure is the manner in which a firm’s assets are financed; that is, the right- hand side of the balance sheet. Capital structure is normally expressed as the percentage of each type of capital used by the firm--debt, preferred stock, and common equity. Business risk is the risk inherent in the operations of the firm, prior to the financing decision. Thus, business risk is the uncertainty inherent in a total risk sense, future operating income, or earnings before interest and taxes (EBIT). Business risk is caused by many factors. Two of the most important are sales variability and operating leverage. Financial risk is the risk added by the use of debt financing. Debt financing increases the variability of earnings before taxes (but after interest); thus, along with business risk, it contributes to the uncertainty of net income and earnings per share. Business risk plus financial risk equals total corporate risk. b. Operating leverage is the extent to which fixed costs are used in a firm’s operations. If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high degree of operating leverage. Operating leverage is a measure of one element of business risk, but does not include the second major element, sales variability. Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm’s capital structure. If a high percentage of a firm’s capital structure is in the form of debt and preferred stock, then the firm is said to have a high degree of financial leverage. The breakeven point is that level of unit sales at which costs equal revenues. Breakeven analysis may be performed with or without the inclusion of financial costs. If financial costs are not included, breakeven occurs when EBIT equals zero. If financial costs are included, breakeven occurs when EBT equals zero. c. Reserve borrowing capacity exists when a firm uses less debt under “normal” conditions than called for by the tradeoff theory. This allows the firm some flexibility to use debt in the future when additional capital is needed. 16-2 Business risk refers to the uncertainty inherent in projections of future ROEU. 16-3 Firms with relatively high nonfinancial fixed costs are said to have a high degree of operating leverage. 16-4 Operating leverage affects EBIT and, through EBIT, EPS. Financial leverage has no effect on EBIT--it only affects EPS, given EBIT.

. Answers and Solutions: 16 - 1

16-5 If sales tend to fluctuate widely, then cash flows and the ability to service fixed charges will also vary. Such a firm is said to have high business risk. Consequently, there is a relatively large risk that the firm will be unable to meet its fixed charges, and interest payments are fixed charges. As a result, firms in unstable industries tend to use less debt than those whose sales are subject to only moderate fluctuations. 16-6 Public utilities place greater emphasis on long-term debt because they have more stable sales and profits as well as more fixed assets. Also, utilities have fixed assets which can be pledged as collateral. Further, trade firms use retained earnings to a greater extent, probably because these firms are generally smaller and, hence, have less access to capital markets. Public utilities have lower retained earnings because they have high dividend payout ratios and a set of stockholders who want dividends. 16-7 EBIT depends on sales and operating costs. Interest is deducted from EBIT. At high debt levels, firms lose business, employees worry, and operations are not continuous because of financing difficulties. Thus, financial leverage can influence sales and costs, and hence EBIT, if excessive leverage is used. 16-8 The tax benefits from debt increase linearly, which causes a continuous increase in the firm’s value and stock price. However, financial distress costs get higher and higher as more and more debt is employed, and these costs eventually offset and begin to outweigh the benefits of debt. Answers and Solutions: 16 - 2

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

16-1 a. Here are the steps involved: (1) Determine the variable cost per unit at present, V: Profit = P(Q) - FC - V(Q) $500,000 = ($100,000)(50) - $2,000,000 - V(50) 50(V) = $2,500, V = $50,000. (2) Determine the new profit level if the change is made: New profit = P 2 (Q 2 ) - FC 2 - V 2 (Q 2 ) = $95,000(70) - $2,500,000 - ($50,000 - $10,000)(70) = $1,350,000. (3) Determine the incremental profit: Profit = $1,350,000 - $500,000 = $850,000. (4) Estimate the approximate rate of return on new investment: ROI = Profit/Investment = $850,000/$4,000,000 = 21.25%. Since the ROI exceeds the 15 percent cost of capital, this analysis suggests that the firm should go ahead with the change.

. Answers and Solutions: 16 - 3

b. If we measure operating leverage by the ratio of fixed costs to total costs at the expected output, then the change would increase operating leverage: Old: FC V(Q) FC 

=

$ 2 , 000 , 000 $ 2 , 500 , 000 $ 2 , 000 , 000 

= 44.44%.

New: FC V (Q )

FC

2 2 2 2 

=

$ 2 , 500 , 000 $ 2 , 800 , 000 $ 2 , 500 , 000 

= 47.17%.

The change would also increase the breakeven point: Old: QBE = P V F 

=

$ 100 , 000 $ 50 , 000 $ 2 , 000 , 000  = 40 units. New: QBE = $ 95 , 000 $ 40 , 000 $ 2 , 500 , 000  = 45.45 units. However, one could measure operating leverage in other ways, say by degree of operating leverage: Old: DOL = Q(P V) F Q(P V )    = 50 ($ 50 , 000 ) $ 2 , 000 , 000 50 ($ 50 , 000 ) 

= 5.0.

New: The new DOL, at the expected sales level of 70, is 70 ($ 55 , 000 ) $ 2 , 500 , 000 70 ($ 95 , 000 $ 40 , 000 )   = 2.85. The problem here is that we have changed both output and sales price, so the DOLs are not really comparable. c. It is impossible to state unequivocally whether the new situation would have more or less business risk than the old one. We would need information on both the sales probability distribution and the uncertainty about variable input cost in order to make this determination. However, since a higher breakeven point, other things held constant, is more risky, the change in breakeven points--and also the higher percentage of fixed costs--suggests that the new situation is more risky. Answers and Solutions: 16 - 4

16-2 a. Expected ROE for Firm C: ROEC = (0.1)(-5.0%) + (0.2)(5.0%) + (0.4)(15.0%)

• (0.2)(25.0%) + (0.1)(35.0%) = 15.0%. Note: The distribution of ROEC is symmetrical. Thus, the answer to this problem could have been obtained by simple inspection. Standard deviation of ROE for Firm C:

40. 1 ( 2020 ) 0 020. 2 ( 1040 ) 00 .. 21 (( 255 ..^0021515 .. 00 ))^200 .. 221 C^2     ^       ^  b. According to the standard deviations of ROE, Firm A is the least risky, while C is the most risky. However, this analysis does not take into account portfolio effects--if C’s ROE goes up when most other companies’ ROEs decline (that is, its beta is negative), its apparent riskiness would be reduced. c. Firm A’s ROE = BEP = 5.5%. Therefore, Firm A uses no financial leverage and has no financial risk. Firm B and Firm C have ROE > BEP, and hence both use leverage. Firm C uses the most leverage because it has the highest ROE - BEP = measure of financial risk. However, Firm C’s stockholders also have the highest expected ROE. 16-3 a. Original value of the firm (D = $0): V = D + S = 0 + ($15)(200,000) = $3,000,000. Original cost of capital: WACC = wd rd(1-T) + wers = 0 + (1.0)(10%) = 10%. With financial leverage (wd=30%): WACC = wd rd(1-T) + wers = (0.3)(7%)(1-0.40) + (0.7)(11%) = 8.96%. Because growth is zero, the value of the company is: V = $^3 ,^348 ,^214.^286.
41. 0896 ($ 500 , 000 )( 1 0. 40 ) WACC (EBIT)( 1 T ) WACC FCF      (^). Increasing the financial leverage by adding $900,000 of debt results in an increase in the firm’s value from $3,000,000 to $3,348,214.286.

. Answers and Solutions: 16 - 5

b. Using its target capital structure of 30% debt, the company must have debt of: D = wd V = 0.30($3,348,214.286) = $1,004,464.286. Therefore, its debt value of equity is: S = V – D = $2,343,750. Alternatively, S = (1-wd)V = 0.7($3,348,214.286) = $2,343,750. The new price per share, P, is: P = [S + (D – D 0 )]/n 0 = [$2,343,750 + ($1,004,464.286 – 0)]/200, = $16.741. c. The number of shares repurchased, X, is: X = (D – D 0 )/P = $1,004,464.286 / $16.741 = 60,000.256  60,000. The number of remaining shares, n, is: n = 200,000 – 60,000 = 140,000. Initial position: EPS = [($500,000 – 0)(1-0.40)] / 200,000 = $1.50. With financial leverage: EPS = [($500,000 – 0.07($1,004,464.286))(1-0.40)] / 140, = [($500,000 – $70,312.5)(1-0.40)] / 140, = $257,812.5 / 140,000 = $1.842. Thus, by adding debt, the firm increased its EPS by $0.342. d. 30% debt: TIE = I EBIT = $ 70 , 312. 5 EBIT . Probability TIE 0.10 ( 1.42) 0.20 2. 0.40 7. 0.20 11. Answers and Solutions: 16 - 6

0.10 15.

The interest payment is not covered when TIE < 1.0. The probability of this occurring is 0.10, or 10 percent. 16-4 a. Present situation (50% debt): WACC = wd rd(1-T) + wers = (0.5)(10%)(1-0.15) + (0.5)(14%) = 11.25%. V =

1. 1125 ($ 13. 24 )( 1 0. 15 ) WACC (EBIT)( 1 T ) WACC FCF     (^) = $100 million. 70 percent debt: WACC = wd rd(1-T) + wers = (0.7)(12%)(1-0.15) + (0.3)(16%) = 11.94%. V =
2. 1194 ($ 13. 24 )( 1 0. 15 ) WACC (EBIT)( 1 T ) WACC FCF     (^) = $94.255 million. 30 percent debt: WACC = wd rd(1-T) + wers = (0.3)(8%)(1-0.15) + (0.7)(13%) = 11.14%. V =
3. 1114 ($ 13. 24 )( 1 0. 15 ) WACC (EBIT)( 1 T ) WACC FCF     (^) = $101.023 million. 16-5 a. BEA’s unlevered beta is bU=bL/(1+ (1-T)(D/S))=1.0/(1+(1-0.40)(20/80)) = 0.870. b. bL = bU (1 + (1-T)(D/S)). At 40 percent debt: bL = 0.87 (1 + 0.6(40%/60%)) = 1.218. rS = 6 + 1.218(4) = 10.872% c. WACC = wd rd(1-T) + wers = (0.4)(9%)(1-0.4) + (0.6)(10.872%) = 8.683%.

. Answers and Solutions: 16 - 7

V =

1. 08683 ($ 14. 933 )( 1 0. 4 ) WACC (EBIT)( 1 T ) WACC FCF     (^) = $103.188 million. 16-6 Tax rate = 40% rRF = 5.0% bU = 1.2 rM – rRF = 6.0% From data given in the problem and table we can develop the following table: D/A E/A D/E rd rd(1 – T) Leveraged betaa rsb^ WACCc 0.00 1.00 0.0000 7.00% 4 .20% 1 .20 12 .20% 12 .20% 0.20 0.80 0.2500 8.00 4 .80 1 .38 13 .28 11. 0.40 0.60 0.6667 10.00 6 .00 1 .68 15 .08 11. 0.60 0.40 1.5000 12.00 7 .20 2 .28 18 .68 11. 0.80 0.20 4.0000 15.00 9 .00 4 .08 29 .48 13. Notes: a (^) These beta estimates were calculated using the Hamada equation, b = bU[1 + (1 – T)(D/E)]. b (^) These r s estimates were calculated using the CAPM, rs = rRF + (rM – rRF)b. c (^) These WACC estimates were calculated with the following equation: WACC = wd(rd)(1 – T) + (wc)(rs). The firm’s optimal capital structure is that capital structure which minimizes the firm’s WACC. Elliott’s WACC is minimized at a capital structure consisting of 40% debt and 60% equity. At that capital structure, the firm’s WACC is 11.45%. Answers and Solutions: 16 - 8

SOLUTION TO SPREADSHEET PROBLEM

16-7 The detailed solution for the problem is available both on the instructor’s resource CD- ROM (in the file Solution for FM11 Ch 16 P7 Build a Model.xls ) and on the instructor’s side of the web site, http://brigham.swlearning.com.

. Answers and Solutions: 16 - 9

MINI CASE

Assume you have just been hired as business manager of PizzaPalace, a pizza restaurant located adjacent to campus. The company's EBIT was $500,000 last year, and since the university's enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion capital will be required, PizzaPalace plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock, and the stock is traded in the over-the-counter market. The firm is currently financed with all equity; it has 100,000 shares outstanding; and P 0 = $25 per share. When you took your MBA Corporate Finance course, your instructor stated that most firms' owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures: % Financed With Debt Rd 0% --- 20 8.0% 30 8. 40 10. 50 12. If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. PizzaPalace is in the 40 percent state-plus-federal corporate tax bracket, its beta is 1.0, the risk-free rate is 6 percent, and the market risk premium is 6 percent. a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows. Answer: The basic definitions are: (1) V = Value Of Firm (2) FCF = Free Cash Flow (3) WACC = Weighted Average Cost Of Capital (4) Rs And Rd are costs of stock and debt (5) We And Wd are percentages of the firm that are financed with stock and debt. The impact of capital structure on value depends upon the effect of debt on: WACC and/or FCF. Mini Case: 16 - 10

Debt holders have a prior claim on cash flows relative to stockholders. Debt holders’ “fixed” claim increases risk of stockholders’ “residual” claim, so the cost of stock, rs, goes up. Firm’s can deduct interest expenses. This reduces the taxes paid, frees up more cash for payments to investors, and reduces after-tax cost of debt Debt increases the risk of bankruptcy, causing pre-tax cost of debt, rd, to increase. Adding debt increase the percent of firm financed with low-cost debt (wd) and decreases the percent financed with high-cost equity (we). The net effect on WACC is uncertain, since some of these effects tend to increase WACC and some tend to decrease WACC. Additional debt can affect FCF. The additional debt increases the probability of bankruptcy. The direct costs of financial distress are legal fees, “fire” sales, etc. The indirect costs are lost customers, reductions in productivity of managers and line workers, reductions in credit (i.e., accounts payable) offered by suppliers. Indirect costs cause NOPAT to go down due to lost customers and drop in productivity and causes the investment in capital to go up due to increases in net operating working capital (accounts payable goes up as suppliers tighten credit). Additional debt can affect the behavior of managers. It can cause reductions in agency costs, because debt “pre-commits,” or “bonds,” free cash flow for use in making interest payments. Thus, managers are less likely to waste FCF on perquisites or non-value adding acquisitions. But it can cause increases in other agency costs. Debt can make managers too risk- averse, causing “underinvestment” in risky but positive NPV projects. There are also effects due to asymmetric information and signaling. Managers know the firm’s future prospects better than investors. Thus, managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls. b. (1) What is business risk? What factors influence a firm's business risk? Answer: Businsess risk is uncertainty about EBIT. Factors that influence business risk include: uncertainty about demand (unit sales); uncertainty about output prices; uncertainty about input costs; product and other types of liability; degree of operating Mini Case: 16 - 11

leverage (DOL). b. (2) what is operating leverage, and how does it affect a firm's business risk? Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10. Answer: Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage. Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline. Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit. Operating Breakeven = QBE QBE = F / (P – V) Example: F=$200, P=$15, AND V=$10: QBE = $200 / ($15 – $10) = 40. c. Now, to develop an example which can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: firm U, which uses no debt financing, and firm L, which uses $10,000 of 12 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000.

1. Construct partial income statements, which start with EBIT, for the two firms. Answer: Here are the fully completed statements: Firm U Firm L Assets $20,000 $20, Equity $20,000 $10, EBIT $ 3,000 $ 3, INT (12%) 0 1, EBT $ 3,000 $ 1, Taxes (40%) 1,200 720 NI $ 1,800 $ 1, Mini Case: 16 - 12

c. 2. Now calculate roe for both firms. Answer: Firm U Firm L BEP 15.0% 15.0% ROI 9.0% 11.4% ROE 9.0% 10.8% TIE  2.5 c. 3. What does this example illustrate about the impact of financial leverage on ROE? Answer: Conclusions from the analysis:  The firm’s basic earning power, BEP = EBIT/total assets, is unaffected by financial leverage.  Firm L has the higher expected ROI because of the tax savings effect: o ROIU = 9.0%. o ROIL = 11.4%.  Firm L has the higher expected roe: o ROEU = 9.0%. o ROEL = 10.8%. Therefore, the use of financial leverage has increased the expected profitability to shareholders. The higher roe results in part from the tax savings and also because the stock is riskier if the firm uses debt.  At the expected level of EBIT, ROEL > ROEU.  The use of debt will increase roe only if ROA exceeds the after-tax cost of debt. Here ROA = unleveraged roe = 9.0% > rd(1 - t) = 12%(0.6) = 7.2%, so the use of debt raises roe.  Finally, note that the TIE ratio is huge (undefined, or infinitely large) if no debt is used, but it is relatively low if 50 percent debt is used. The expected tie would be larger than 2.5 if less debt were used, but smaller if leverage were increased. Mini Case: 16 - 13

d. Explain the difference between financial risk and business risk. Answer: Business risk increases the uncertainty in future EBIT. It depends on business factors such as competition, operating leverage, etc. Financial risk is the additional business risk concentrated on common stockholders when financial leverage is used. It depends on the amount of debt and preferred stock financing. e. **Now consider the fact that EBIT is not known with certainty, but rather has the following probability distribution: Economic State Probability EBIT Bad 0.25 $2, Average 0.50 3, Good 0.25 4, Redo the part A analysis for firms U and L, but add basic earning power (BEP), return on investment (ROI), [defined as (net income + interest)/(debt

• equity)], and the times-interest-earned (TIE) ratio to the outcome measures. Find the values for each firm in each state of the economy, and then calculate the expected values. Finally, calculate the standard deviation and coefficient of variation of ROE. What does this example illustrate about the impact of debt financing on risk and return? Answer:** Here are the pro forma income statements: Firm U Firm L Bad Avg. Good Bad Avg. Good Prob. 0.25 0.50 0.25 0.25 0.50 0. EBIT $2,000 $3,000 $4,000 $2,000 $3,000 $4, Interest 0 0 0 1,200 1,200 1, EBT $2,000 $3,000 $4,000 $ 800 $1,800 $2, Taxes (40%) 800 1,200 1,600 320 720 1, NI $1,200 $1,800 $2,400 $ 480 $1,080 $1, BEP 10 .0% 15 .0% 20 .0% 10 .0% 15 .0% 20 .0% ROIC 6 .0% 9 .0% 12 .0% 6 .0% 9 .0% 12 .0% ROE 6 .0% 9 .0% 12 .0% 4 .8% 10 .8% 16 .8% TIE    1 .7 2 .5 3 .3 E(BEP) 15 .0% 15 .0% E(ROIC) 9 .0% 9 .0% E(ROE) 9 .0% 10 .8% σROIC 2 .12% 2 .12% Mini Case: 16 - 14

σROE 2 .12% 4 .24% This example illustrates that financial leverage can increase the expected return to stockholders. But, at the same time, it increases their risk.  Firm L has a wider range of ROEs and a higher standard deviation of ROE, indicating that its higher expected return is accompanied by higher risk. To be precise: ROE (Unleveraged) = 2.12%, and ROE (Leveraged) = 4.24%. Thus, in a stand-alone risk sense, firm L is twice as risky as firm U--its business risk is 2.12 percent, but its stand-alone risk is 4.24 percent, so its financial risk is 4.24% - 2.12% = 2.12%. f. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models. Answer: MM theory begins with the assumption of zero taxes. MM prove, under a very restrictive set of assumptions, that a firm’s value is unaffected by its financing mix: VL = VU. Therefore, capital structure is irrelevant. Any increase in roe resulting from financial leverage is exactly offset by the increase in risk (i.e., rs), so WACC is constant. MM theory later includes corporate taxes. Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks because more EBIT goes to investors and less to taxes when leverage is used. MM show that: VL = VU + TD. If T=40%, then every dollar of debt adds 40 cents of extra value to firm. Miller later included personal taxes. Personal taxes lessen the advantage of corporate debt. Corporate taxes favor debt financing since corporations can deduct interest expenses, but personal taxes favor equity financing, since no gain is reported until stock is sold, and long-term gains are taxed at a lower rate. Miller’s conclusions with personal taxes are that the use of debt financing remains advantageous, but benefits are less than under only corporate taxes. Firms should still use 100% debt. Note: however, miller argued that in equilibrium, the tax rates of marginal investors would adjust until there was no advantage to debt. MM theory ignores bankruptcy (financial distress) costs, which increase as more leverage is used. At low leverage levels, tax benefits outweigh bankruptcy costs. At high levels, bankruptcy costs outweigh tax benefits. An optimal capital structure exists that balances these costs and benefits. This is the trade-off theory. Mini Case: 16 - 15

MM assumed that investors and managers have the same information. But managers often have better information. Thus, they would sell stock if stock is overvalued, and sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal. This is signaling theory. One agency problem is that managers can use corporate funds for non-value maximizing purposes. The use of financial leverage bonds “free cash flow,” and forces discipline on managers to avoid perks and non-value adding acquisitions. A second agency problem is the potential for “underinvestment”. Debt increases risk of financial distress. Therefore, managers may avoid risky projects even if they have positive NPVs. g. With the above points in mind, now consider the optimal capital structure for PizzaPalace. g. (1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Answer: MM theory implies that beta changes with leverage. Bu is the beta of a firm when it has no debt (the unlevered beta.) Hamada’s equation provides the beta of a levered firm: BL = BU [1 + (1 - T)(D/S)]. For example, to find the cost of equity for wd = 20%, we first use Hamada’s equation to find beta: BL = BU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.4) (20% / 80%)] = 1. Then use CAPM to find the cost of equity: RS = RRF + BL (RPM) = 6% + 1.15 (6%) = 12.9% We can repeat this for the capital structures under consideration. WD D/S BL RS 0% 0.00 1.000 12.00% 20% 0.25 1.150 12.90% 30% 0.43 1.257 13.54% 40% 0.67 1.400 14.40% 50% 1.00 1.600 15.60% Mini Case: 16 - 16

Next, find the WACC. For example, the WACC for wd = 20% is: WACC = wd (1-T) rd + we rs WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%) WACC = 11.28% Then repeat this for all capital structures under consideration. wd rd rs WACC 0% 0.0% 12.00% 12.00% 20% 8.0% 12.90% 11.28% 30% 8.5% 13.54% 11.01% 40% 10.0% 14.40% 11.04% 50% 12.0% 15.60% 11.40% g. (2) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity. Answer: For example the corporate value for wd = 20% is: V = FCF / (WACC-G) G=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). In this example, NOPAT = ($500,000)(1-0.40) = $300,000. Using these values, V = $300,000 / 0.1128 = $2,659,574. Repeating this for all capital structures gives the following table: wd WACC Corp. Value 0% 12.00% $2,500, 20% 11.28% $2,659, 30% 11.01% $2,724, 40% 11.04% $2,717, 50% 11.40% $2,631, As this shows, value is maximized at a capital structure with 30% debt. Mini Case: 16 - 17

g. (3) Calculate the resulting price per share, the number of shares repurchased, and the remaining shares. Answer: First, find the dollar value of debt and equity. For example, for wd = 20%, the dollar value of debt is: d = wd V = 0.2 ($2,659,574) = $531,915. We can then find the dollar value of equity: S = V – D S = $2,659,574 - $531,915 = $2,127,659. We repeat this process for all the capital structures. wd Debt, D Stock Value, S 0% $0 $2,500, 20% $531,915 $2,127, 30% $817,439 $1,907, 40% $1,086,957 $1,630, 50% $1,315,789 $1,315, Note: these are rounded; see FM11 Ch 16 mini case.xls for full calculations. Notice that the value of the equity declines as more debt is issued, because debt is used to repurchase stock. But the total wealth of shareholders is the value of stock after the recap plus the cash received in repurchase, and this total goes up (it is equal to corporate value on earlier slide). The firm issues debt, which changes its WACC, which changes value. The firm then uses debt proceeds to repurchase stock. The stock price changes after debt is issued, but does not change during actual repurchase (or arbitrage is possible). The stock price after debt is issued but before stock is repurchased reflects shareholder wealth, which is the sum of the stock and the cash paid in repurchase. For example, to find the stock price for wd = 20%, let D 0 and N 0 denote debt and outstanding shares before the recap. D - D 0 is equal to cash that will be used to repurchase stock. S + (D - D 0 ) is the wealth of shareholders’ after the debt is issued but immediately before the repurchase. We can express the stock price per share prior to the repurchase, P, for wd = 20%, as: P = [S + (D – D 0 )]/N 0. P = [$2,127,660 + ($531,915 – 0)] / 100, P = $26.596 per share. Mini Case: 16 - 18

The number of shares repurchased is:

repurchased = (D - D 0 ) / P

rep. = ($531,915 – 0) / $26.

= 20,000. The number of remaining shares after the repurchase is:

remaining = N = S / P

N = $2,127,660 / $26. = 80,000. We can apply this same procedure to all the capital structures under consideration.

Shares # Shares

Wd P Repurch. Remaining 0% $25.00 0 100, 20% $26.60 20,000 80, 30% $27.25 30,000 70, 40% $27.17 40,000 60, 50% $26.32 50,000 50, h. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure? Answer: The optimal capital structure is for wd = 30%. This gives the highest corporate value, the lowest WACC, and the highest stock price per share. But notice that wd = 40% is very similar to the optimal solution; in other words, the optimal range is pretty flat. i. What other factors should managers consider when setting the target capital structure? Answer: Managers should also consider the debt ratios of other firms in the industry, pro forma coverage ratios at different capital structures under different economic scenarios, lender and rating agency attitudes (i.e., the impact on bond ratings), reserve borrowing capacity, the effects on control (i.e., does the capital structure make it easier of harder for an outsider to take over the firm), the firm’s types of assets (i.e., are they tangible, and hence suitable as collateral?, and the firm’s projected tax rates. Mini Case: 16 - 19