Introduction to Corporate Finance

13: Capital Structure

Mitchell Petersen,

Northwestern University

‘When firms structure

their business, they

need to think about

trading off operating and

financial leverage.’

See the entire interview on

the CourseMate website.

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object, debt financing magnifies the impact of a change in EBIT on earnings per share. If High-Tech’s

realised EBIT comes in next year above $600,000, employing debt financing will increase earnings per

share for the company’s shareholders. However, the reverse also holds true. If EBIT falls below $600,000,

HTMC’s earnings per share will be lower than they would have been with an all-equity capital structure.

This yields a basic and important result, the fundamental principle of financial leverage: substituting debt for

equity increases expected returns to shareholders, but also increases the risk that equity investors bear.

Because adding debt to the capital structure makes shareholders’ claims more risky, they should

demand a higher return. Therefore, whether the addition of debt to HTMC’s capital structure increases

the company’s share price depends on the relative importance of two offsetting effects: (1) the increase

in expected EPS as opposed to (2) the increased discount rate that shareholders will apply to these

earnings. In one special (but important) case, these forces offset each other exactly, which would mean

that changing a company’s capital structure neither raises nor lowers its value.

13 -1c LEVERAGE INCREASES EXPECTED RETURN – BUT DOES IT

INCREASE VALUE?

Though we have demonstrated the effect that financial leverage should have on HTMC’s shareholders,

we have not yet helped Ms Kelly decide whether to adopt the 50% debt/50% equity recapitalisation or

retain the company’s existing all-equity capital structure. In Tables 13.1 and 13.2, and in Figure 13.1,

she documents that employing debt can increase expected EPS and ROE for HTMC’s shareholders, but

the added risk associated with debt makes her uncertain about the net benefit of the recapitalisation

(change of debt-equity ratio).

In creating Table 13.2, we assumed that immediately after HTMC’s recapitalisation, the remaining

shares would still sell for $50. If that assumption is valid, then the total market value of HTMC equals

$10 million, whether the company finances with all equity or with some debt and some equity. Recall

that if HTMC recapitalises, its expected EPS increases from $5 to $7. Likewise, expected ROE increases

from 10% to 14%. Because of the added risk that they must bear, suppose HTMC shareholders increase

their required return from 10% to 14%. If shareholders believe that HTMC’s earnings will be $7 per

share in perpetuity, then the share price will remain at $50 and the recapitalisation will have no net

impact on HTMC’s total value:

P

$7

0.14

==$50

From this analysis, Ms Kelly concludes that there is no unique, optimal capital structure for her

company that maximises company value. Substituting debt for equity will increase expected EPS, but

only at the cost of higher variability. With higher EPS volatility, shareholders will expect a higher return,

meaning that they will discount future earnings at a higher rate. These two effects essentially cancel each

other out, so shareholders are just as happy with a capital structure that includes no debt as they are with

one that consists of equal proportions of debt and equity.^2

2 This result holds for any other mix of debt and equity under the assumptions used in this example. The total market value of HTMC is the

same whether the company uses 100% equity, 75% equity and 25% debt, or any other capital structure.

fundamental principle of

financial leverage

Substituting debt for equity

increases expected returns

to shareholders, but also

increases the risk that equity

investors bear

What impact would you expect

on a company’s earnings if it

raises its debt-to-equity ratio?

thinking cap

question

LO 13.1

Source: Cengage Learning