Capital Structure Decisions: The Basics
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 P0 = $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
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.
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.
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.
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,...
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