Capital Structure

Broadly, a firm can finance its assets with either debt or equity. The proportion of debt loved one to same used, is recognized as the firm"s capital structure (also occasionally referred to together its capital stack).

You are watching: Which one of the following is minimized when the value of a firm is maximized?

A an approach to recognize the best capital structure for a given firm is not known (either in theory or practice).

However an understanding of the implications of provided structures, will allow financial managers to strike a reasonable balance between debt and also equity.


Modifying A resources Structure

Before we talk about the firms an option of funding structure, it is beneficial to understand that firms can adjust their funding structure (known as capital restructuring).

To rise the debt-to-equity ratio, the firm can issue debt, and also use the proceeds come buy earlier stock.

Conversely, to decrease the debt-to-equity ratio, the for sure can worry stock, and use the proceeds come buy back debt.

Note these restructurings do not affect the firm"s assets. This highlights the truth that:

The capital structure decision is live independence of the invest decision.


The goal of gaue won Management

Remember, the goal of financial management is come maximize the worth of the firm"s equity. For this reason the firm should seek a capital structure which does this.

Interestingly, maximizing the value of equity will certainly be equivalent to maximizing the value of the whole firm. We"ll usually state our goal as the latter.

Further, the worth of the firm will be maximized as soon as the firm"s weighted-average price of funding (WACC) is minimized. So main in our discussion will be the impact of changing the firm"s capital structure top top the firm"s cost of financing.


Financial Leverage

Leverage refers come the usage of blame in the firm"s capital structure—the analogy being debt magnifies returns like mechanical leverage magnifies force.

In what complies with we"ll show the result of leverage on the return top top equity.

An example of Leverage

Say your firm, PA Solar, has actually assets through a market value of $10 million. The firm is all equity financed, and also has 50,000 share outstanding, at $200 per share ($10 million / 50,000).

Your certain is considering a restructuring that will include $5 million in debt to the firm"s capital structure. The debt will certainly pay 10%.

The proceeds indigenous issuing $5 million in debt can be offered to buy ago 25,000 share of share ($5 million / $200). There will certainly then be 25,000 share left outstanding.

The firm will be financed with 50% debt, and 50% same after the restructuring. This method the debt-to-equity ratio is 1.

The stock price is the same by the restructuring, `\frac\$5,000,00025,000 = \$200`. Note, we have ignored any affect of the restrucutring ~ above taxes.


Below is a table reflecting the current and also restructured capital structures.

CurrentRestructured
Assets$10,000,000$10,000,000
Equity$10,000,000$5,000,000
Debt$0$5,000,000
Share Price$200$200
Shares Outstanding50,00025,000

The result of capital Structure

Here we investigate the impact of differing funding structures top top the return on equity (ROE) and also earnings per share (EPS). We do so in 3 future scenarios—recession, normal, and also expansion.

In the recession and expansion, EBIT will certainly be 50% and also 150% that the EBIT in the normal scenario respectively.

Current (No Debt)

RecessionNormalExpansion
EBIT$600,000$1,200,000$1,800,000
Interest$0$0$0
Net Income$600,000$1,200,000$1,800,000
ROE6%12%18%
EPS$12$24$36

Restructured

RecessionNormalExpansion
EBIT$600,000$1,200,000$1,800,000
Interest$500,000$500,000$500,000
Net Income$100,000$700,000$1,300,000
ROE2%14%26%
EPS$4$28$52

The effect of Leverage

The over examples display the impact of leverage is to boost the variability of ROE and EPS as a duty of EBIT. The is, leverage magnifies gains and also losses.

In the complying with interactive app, girlfriend can collection the percent that EBIT will be increased/decreased in the expansion/recession scenarios.

It will certainly then calculation ROE and also EPS in each scenario, given EBIT.


EPS, EBIT, and also Debt

The adhering to interactive app will plot EPS as a duty of EBIT in both situations with debt and no debt.

What this application shows is just how EPS services from debt if EBIT is above a certain point, yet is lowered if EBIT is listed below that point. In short, leverage is an excellent on the upside, and bad ~ above the downside.

Does funding Structure Matter?

From the above we check out that leverage magnifies the return to same (on the upside and also downside). Therefore it would seem the the capital structure is necessary for equity investor considering owning the stock?

Interestigly, same investors may view the resources structure as irrelevant. This is because the equity investors deserve to create any capital structure they want for the firm, by borrowing or loan in their own account. This is referred to as homemade leverage.

In the following example we"ll show how an same investor have the right to turn a position in the all-equity stock, right into a place leveraged through a debt-to-equity ratio of 1.


Creating a Leveraged Position

Assume one investor desire to to buy $10,000 that the propose restructured firm (50 shares
$200 per share), however the for sure is presently all-equity. The EPS in the restructured case is $4, $28, and also $52 in the recession, normal, and also expansion cases.

Now assume the investor buys $20,000 of the all-equity certain (100 share
$200 per share), by making use of $10,000 the her own money, and also $10,000 borrowed at 10%.

In this case the investor"s EPS and ROE will match the EPS and also ROE in the restructured case. The investor has replicated the leveraged position herself, and also did not need the certain to do it.

The only assumption needed was the the investor have the right to borrow at the same rate as the company, i m sorry is reasonable (see margin rates on stock brokerage accounts).

In a similar fashion (through lending) an investors can produce an all-equity firm indigenous a leveraged firm.


The Modigliani and also Miller (M&M) Propositions

The idea of homemade leverage was introduced my M&M at an early stage in their well known work (Nobel Memorial compensation winning) on funding structure. Their groundbreaking propositions are worthy of their own presentation. Be sure to inspect out the presentation. Briefly, their propositions are:

No Taxes

The worth of the leveraged and unleveraged firms space equal (capital framework irrelevance).

The price of same is: `R_e = R_u + \fracDE(R_u - R_d)`, where `R_u` and `R_d` are the forced returns top top the unlevered firm, and debt respectively.


M&M v Taxes

Taxes

The worth of the levered certain is same to the value of the unlevered firm plus the current value that the interest taxes shield.

The expense of equity is: `R_e = R_u + \fracDE(R_u - R_d)(1 - \tau)`, where `R_u` and `R_d` are the compelled returns on the unlevered firm, and also debt respectively. `\tau` denotes the taxation rate.


Adding the cost of financial Distress

M&M proposition II through taxes claims that the firm"s WACC is decreasing in the debt-to-equity ratio. However, this doesn"t take right into account that the an ext debt the firm has, the higher the probability of gaue won distress (or can be fried bankruptcy). Remember, interest, unlike dividends, need to be paid.

There are expenses merely to financial distress, also if bankruptcy does no occur, such together employees leaving, caterer demanding up-front payments instead of permitting credit, and NPV positive investments may not be taken to keep cash.

Also, bankruptcy itself, if the occurs, is an extremely costly. Legal and also administrative expenses alone are substantial.


Optimal resources Structure

Balancing the advantage of the debt taxation shield through the expense of financial distress, means the existence of an optimal resources structure. That doesn"t typical we have a formula—only the there is evidence that such a funding structure exists.

This is dubbed the static trade-off concept of resources structure. This firm borrow until the marginal get of the tax advantage equals the cost of the enhanced probability of financial distress.

At this point, the value of the levered for sure is maximized, and simultaneously the WACC is minimized.


Observed funding Structures


Credits and also Collaboration

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