CP

478 CHAPTER 13 Capital Structure Decisions

As seen in Chapters 11 and 12, all firms need operating capital to support their sales.

To acquire that operating capital, funds must be raised, usually as a combination of eq-

uity and debt. The mixture of debt and equity that a firm uses is called its capital

structure.Although a firm’s actual levels of debt and equity may vary somewhat over

time, most seek to keep their financing mix close to a target capital structure.The

capital structure decisionsinclude a firm’s choice of a target capital structure, the

average maturity of its debt, and the specific source of financing it chooses at any par-

ticular time it raises new funding. Similar to operating decisions, managers should

make capital structure decisions designed to maximize the firm’s value.

A Preview of Capital Structure Issues

Recall from Chapter 12 that the value of a firm is the present value of its expected fu-

ture free cash flow (FCFs), discounted at its weighted average cost of capital

(WACC):^2

. (13-1)

The WACC depends on the percentages of debt and equity (wdand we), the cost of

debt (rd), the cost of stock (rs), and the corporate tax rate (T):

. (13-2)

As these equations show, the only way that any decision can change a firm’s value is

if it affects either free cash flows or the cost of capital. We discuss below some of the

ways that a higher proportion of debt can affect WACC and/or FCF.

Debt Increases the Cost of Stock, rs

Debtholders have a prior claim on the company’s cash flows relative to shareholders,

who are entitled only to any residual cash flow after debtholders have been paid .As we

show later in a numerical example, the “fixed” claim of the debtholders causes the

“residual” claim of the stockholders to become less certain, and this increases the cost

of stock, rs.

Debt Reduces the Taxes a Company Pays

Imagine that a company’s cash flows are a pie, and three different groups get pieces of

the pie. The first piece goes to the government in the form of taxes, the second goes

to debtholders, and the third to shareholders. Companies can deduct interest expenses

when calculating taxable income, which reduces the government’s piece of the pie and

leaves more pie available to debtholders and investors. This beneficial impact of taxes

reduces the after-tax cost of debt, as shown in Equation 13-2 above.

The Risk of Bankruptcy Increases the Cost of Debt, rd

As debt increases, the probability of financial distress, or even bankruptcy, goes up.

With higher bankruptcy risk, debtholders will insist on a higher promised return,

which increases the pre-tax cost of debt, rd.

WACCwd (1T)rd
Wers

V a

t 1

FCFt

(1
WACC)t

The textbook’s web site

contains an Excelfile that

will guide you through the

chapter’s calculations. The

file for this chapter is Ch 13

Tool Kit.xls,and we encour-

age you to open the file and

follow along as you read the

chapter.

(^2) For simplicity, we assume that the firm has no nonoperating assets.

474 Capital Structure Decisions