A Preview of Capital Structure Issues 479The Net Effect on the Weighted Average Cost of Capital
As Equation 13-2 shows, the WACC is a weighted average of relatively low-cost debt
and high-cost equity .If we increase the proportion of debt, then the weight of low-cost
debt (wd) increases and the weight of high-cost equity (we) decreases .If all else
remained the same, then the WACC would fall and the value of the firm in Equation
13-1 would increase .But the previous paragraphs show that all else doesn’t remain the
same: both rdand rsincrease .While it should be clear that changing the capital struc-
ture affects all the variables in the WACC equation, it’s not easy to say whether those
changes increase the WACC, decrease it, or balance out exactly and leave the WACC
unchanged .We’ll return to this issue later, when we discuss capital structure theory.Bankruptcy Risk Reduces Free Cash Flow
As the risk of bankruptcy increases, some customers may choose to buy from another
company, which hurts sales. This, in turn, decreases net operating profit after taxes
(NOPAT), thus reducing FCF. Financial distress also hurts the productivity of work-
ers and managers, as they spend more time worrying about their next job rather than
their current job. Again, this reduces NOPAT and FCF. Finally, suppliers tighten their
credit standards, which reduces accounts payable and causes net operating working
capital to increase, thus reducing FCF. Therefore, the risk of bankruptcy can decrease
FCF and reduce the value of the firm.Bankruptcy Risk Affects Agency Costs
Higher levels of debt may affect the behavior of managers in two opposing ways. First,
when times are good, managers may waste cash flow on perquisites and nonnecessary
expenditures. This is an agency cost, as described in Chapter 12. The good news is that
the threat of bankruptcy reduces such wasteful spending, which increases FCF.
But the bad news is that a manager may become gun-shy and reject positive NPV
projects if they are risky. From the stockholder’s point of view it would be unfortunate if
a risky project caused the company to go into bankruptcy, but note that other compa-
nies in the stockholder’s portfolio may be taking on risky projects that turn out success-
fully. Since most stockholders are well diversified, they can afford for a manager to take
on risky but positive NPV projects. But a manager’s reputation and wealth are generally
tied to a single company, so the project may be unacceptably risky from the manager’s
point of view. Thus, high debt can cause managers to forego positive NPV projects un-
less they are extremely safe. This is called the underinvestment problem,and it is an-
other type of agency cost. Notice that debt can reduce one aspect of agency costs
(wasteful spending) but may increase another (underinvestment), so the net effect on
value isn’t clear.Issuing Equity Conveys a Signal to the Marketplace
Managers are in a better position to forecast a company’s free cash flow than are in-
vestors, and academics call this informational asymmetry.Suppose a company’s
stock price is $50 per share. If managers are willing to issue new stock at $50 per share,
investors reason that no one would sell anything for less than its true value. Therefore,
the true value of the shares as seen by the managers with their superior information
must be less than $50. Thus, investors perceive an equity issue as a negative signal, and
this usually causes the stock price to fall.^3(^3) An exception to this rule is any situation with little informational asymmetry, such as a regulated utility.
Also, some companies, such as startups or high-tech ventures, are unable to issue debt and so simply must
issue equity; we discuss this later in the chapter.