CP

TABLE 13-3 Strasburg’s Optimal Capital Structure

Percent Market After-Tax

Financed Debt/Equity, Cost of Debt, Estimated Cost of Value of

with Debt, wd D/S (1 T) rd Beta, b Equity, rs WACC Firm, V

(1) (2)a (3)b (4)c (5)d (6)e (7)f

0% 0.00% 4.80% 1.00 12.0% 12.00% $200,000

10 11.11 4.80 1.07 12.4 11.64 206,186

20 25.00 4.86 1.15 12.9 11.29 212,540

30 42.86 5.10 1.26 13.5 11.01 217,984

40 66.6 75.40 1.40 14.4 10.80 222,222

50 100.00 6.60 1.60 15.6 11.10 216,216

60 150.00 8.40 1.90 17.4 12.00 200,000

Notes: aThe D/S ratio is calculated as: D/S wd/(1 wd).
bThe interest rates are shown in Table 13-2, and the tax rate is 40 percent.
cThe beta is estimated using Hamada’s formula in Equation 13-8.
dThe cost of equity is estimated using the CAPM formula: rsrRF
(RPM)b, where the risk free rate is 6 percent and the market risk premium is
6 percent.
eThe weighted average cost of capital is calculated using Equation 13-2: WACC wers
wdrd(1 T), where we(1 wd).
fThe value of the firm is calculated using the free cash flow valuation formula in Equation 13-1, modified to reflect the fact that since Strasburg
has zero growth, V FCF / WACC. Strasburg has zero growth, so it requires no investment in capital and its FCF is equal to its NOPAT. Using the
EBIT shown in Table 13-1:
FCF NOPAT
Investment in capital EBIT (1 T)
0
$40,000 (1 0.4) $24,000.

4. Estimating the Firm’s Value

We can estimate Strasburg’s value using Equation 13-1. Because Strasburg has zero

growth, we can use the constant growth version of Equation 13-1:

. (13-1a)

Recall that FCF is net operating profit after taxes (NOPAT) minus the required

net investment in capital. Table 13-1 shows that Strasburg has an expected EBIT

of $40,000. With a tax rate of 40 percent, its expected NOPAT is $24,000 $40,000

(1 0.40). Since Strasburg has zero growth, its future net investments in operating

assets will be zero, so its expected FCF is equal to NOPAT.

With zero debt, Strasburg has a WACC of 12 percent (shown in Column 6 of

Table 13-3) and a value of

.

Column 7 of Table 13-3 shows Strasburg’s value at different capital structures.^18

Notice that the maximum value of $222,222 occurs at a capital structure with 40 per-

cent debt, which is also the capital structure that minimizes the WACC.

V

FCF

WACC



$24,000

0.12

$200,000

V

FCF

WACC

Estimating the Optimal Capital Structure 497

(^18) In this analysis we assume that Strasburg’s expected EBIT and FCF are constant for the various capital
structures. In a more refined analysis we might try to estimate any possible declines in FCF at high levels of
debt in the capital structure as the threat of bankruptcy becomes imminent.

Capital Structure Decisions 493