498 CHAPTER 13 Capital Structure Decisions
5. Estimating Shareholder Wealth and Stock Price
Strasburg should now recapitalize,meaning that it should issue debt and use the pro-
ceeds to repurchase stock. The shareholder’s wealth after the recap,as it is commonly
called, would be equal to the payment they receive from the share repurchase plus
the remaining value of their equity. To find the remaining value of equity, we need
to specify how much debt is issued in the new capital structure. Since we know the
percent of debt in the capital structure and the resulting value of the firm, we can find
the dollar value of debt as follows:
.
For example, at the optimal capital structure of 40 percent debt, the dollar value of
debt is about $88,889 0.40($222,222).
The market value of the remaining equity, S, is equal to the total value minus the
value of the debt. At the optimal capital structure, the market value of equity is
$133,333 $222,222 $88,889. Column 4 in Table 13-4 shows the market value of
equity under the various capital structures. Notice that the value of equity declines as
the percent financed with debt increases. At first glance, it looks like increasing lever-
age hurts shareholders. But keep in mind that the shareholders also receive cash equal
to the amount of new debt when the company repurchases the stock:
Cash raised by issuing debtDD 0.
DwdV
FIGURE 13-4 Strasburg’s Required Rate of Return on Equity
at Different Debt Levels
10 20 60
14
12
8
6
4
0
Required
Return on
Equity
(%)
18
2
10
16
30 40 50
rs
rRF = rRF
Percent Financed with Debt (%)
Risk-Free Rate:
Time Value of
Money Plus
Expected
Inflation
Premium for
Financial Risk
Premium for
Business Risk
494 Capital Structure Decisions
