Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

The shareholder suggests that this strategy will increase the expected return to HTMC’s shareholders,

as measured by EPS. Though initially dubious about this proposal, Ms Kelly creates Tables 13.2 and

13.3 to test the shareholder’s prediction. As noted, she thinks that HTMC’s earnings before interest and

taxes (EBIT) will be $1,000,000 next year, if the economy continues to grow at a normal rate.^1 However,

if the country falls into a recession next year, High-Tech’s sales will fall, and EBIT will be only $500,000.

On the other hand, if the economy booms, HTMC will enjoy rising sales, and EBIT will be $1,500,000.

Ms Kelly believes that the probability of each outcome is one-third, and that any change of capital

structure will not affect earnings from operations, so the expected value of EBIT equals $1,000,000:

Expected EBIT =

1

3









$1,500,000 +

1

3









$1,000,000 +

1

3









$500,000 = $1,000,000

Table 13.3 summarises HTMC’s current and proposed capital structures, assuming that the

economy grows at a normal rate and that EBIT equals $1,000,000. If the current capital structure is

retained, earnings per share (EPS) will be $5.00. Because HTMC shares are currently worth $50 per

share and the company pays out all net profits as dividends, HTMC’s shareholders will earn a return

on equity of 10% ($5.00 ÷ $50.00) over the coming year. If HTMC instead adopts the proposed

recapitalisation, the company will have to pay $300,000 interest on the $5,000,000 debt (0.06 ×

$5,000,000), leaving $700,000 in net income ($1,000,000 EBIT – $300,000 interest). Only 100,000

shares remain outstanding after the recapitalisation, so EPS will be $7.00. In this scenario, the return on

equity enjoyed by shareholders is 14% ($7 ÷ $50).

TABLE 13.3 EXPECTED CASH FLOWS TO SHAREHOLDERS AND BONDHOLDERS UNDER THE CURRENT

AND PROPOSED CAPITAL STRUCTURES FOR HTMC

Assuming EBIT = $1,000,000

Current capital structure:

all-equity financing

Proposed capital structure:

50% debt, 50% equity

EBIT $1,000,000 $1,000,000

• Interest (6.0%) $0 $(300,000)
  Net income $1,000,000 $700,000
  Shares outstanding 200,000 100,000
  EPS $5.00 $7.00
  Return on equity 10.0% 14.0%
  (P 0 = $50.00/share)

So far, the recapitalisation plan seems to look rather attractive. But what happens if a recession or a

boom occurs? Table 13.4 shows the payoffs to HTMC’s investors under those economic scenarios. If

the economy booms, High-Tech’s EBIT will be $1,500,000. With the existing capital structure, EPS will

be $7.50, and ROE will be 15.0%. If the economy booms and HTMC recapitalises, EPS will be $12.00,

and ROE will be an impressive 24.0%! It would seem that the recapitalisation is particularly good for

shareholders in this scenario.

1 For now, we assume that there are no taxes. Therefore, there is no difference between EBIT and net income for an unlevered company like

HTMC. We relax this no-tax assumption in Section 13-3.