CP

494 CHAPTER 13 Capital Structure Decisions

reserve borrowing capacity. Firms with few profitable investment opportunities

should use high levels of debt and thus have substantial interest payments, which

means imposing managerial constraint through debt.^16

If you find our discussion of capital structure theory imprecise and somewhat dissat-

isfying, you are not alone. In truth, no one knows how to identify precisely a firm’s

optimal capital structure, or how to measure the effects of capital structure on stock

prices and the cost of capital. In practice, capital structure decisions must be made

using a combination of judgment and numerical analysis as shown in the next section.

Why does MM theory with corporate taxes lead to 100 percent debt?

Explain how “asymmetric information” and “signals” affect capital structure

decisions.

What is meant by reserve borrowing capacity,and why is it important to firms?

How can the use of debt serve to discipline managers?

Estimating the Optimal Capital Structure

Managers should choose the capital structure that maximizes shareholders’ wealth.

The basic approach is to consider a trial capital structure, based on the market values

of the debt and equity, and then estimate the wealth of the shareholders under this cap-

ital structure .This approach is repeated until an optimal capital structure is identified.

There are five steps for the analysis of each potential capital structure: (1) Estimate the

interest rate the firm will pay .(2) Estimate the cost of equity .(3) Estimate the weighted

average cost of capital .(4) Estimate the free cash flows and their present value, which

is the value of the firm .(5) Deduct the value of the debt to find the shareholders’

wealth, which we want to maximize .The following sections explain each of these steps,

using the company we considered earlier, Strasburg Electronics.

1. Estimating the Cost of Debt

The CFO asked Strasburg’s investment bankers to estimate the cost of debt at differ-

ent capital structures. The investment bankers began by analyzing industry conditions

and prospects. They appraised Strasburg’s business risk, based on its past financial

statements and its current technology and customer base. The bankers also projected

pro forma statements under various capital structures and analyzed such key ratios as

the current ratio and the times-interest-earned ratio. Finally, they factored in current

conditions in the financial markets, including interest rates paid by firms in Strasburg’s

industry. Based on their analysis and judgment, they estimated interest rates at various

capital structures as shown in Table 13-2, starting with an 8 percent cost of debt if 10

percent or less of its capital is obtained as debt. Notice that the cost of debt goes up as

leverage and the threat of bankruptcy increase.

2. Estimating the Cost of Equity, rs

An increase in the debt ratio also increases the risk faced by shareholders, and this has

an effect on the cost of equity, rs. Recall from Chapter 3 that a stock’s beta is the rele-

vant measure of risk for diversified investors. Moreover, it has been demonstrated,

(^16) Michael J. Barclay and Clifford W. Smith, Jr., “The Capital Structure Puzzle: Another Look at the Evi-
dence,” Journal of Applied Corporate Finance, Vol. 12, no. 1, Spring 1999, 8–20.

490 Capital Structure Decisions