13: Capital StructureThe proposed 50% debt/50% equity capital structure yields a debt-to-equity ratio of 1.0. We can
use Equation 13.2 to calculate that the return on levered equity must be 14%, just as Ms Kelly had
calculated previously:
r 0.10 (0.1 00 .06)
$5,000, 000
$5,000, 000
l=+−× =+==0.10 0.04 0.14 14%Proposition II has another important interpretation. Let’s rearrange the equation so that r, the return
on assets, appears by itself, on the left-hand side. This results in the following expression:
rr
E
DEr
D
DE
al= d
+
+
+
Does this look familiar? It should. It’s the expression introduced in Chapter 11 for a company’s
weighted average cost of capital (WACC), if we ignore the tax deductibility of interest on debt. We have
already said the value of ra depends on a company’s business risk and is independent of the company’s
capital structure. This equation might appear to contradict that claim, because it might seem that
changing the values of E and D on the right-hand side might change ra. But remember, Proposition II
says that as leverage increases, the required return on equity also increases. If a company replaces equity
with debt in its capital structure, the term E ÷ (D + E) falls and the term D ÷ (D + E) rises. However,
rl goes up because of the added financial risk borne by shareholders. The net effect of all this is to leave
the WACC unchanged. For example, when HTMC uses all equity, we know that the required return on
equity is 10%, so the WACC is 10%, too:
ra = 10%(1.0) + 6%(0) = 10%
If HTMC recapitalises, then pays 6% to bondholders, shareholders demand a 14% return and the
WACC remains unchanged at 10%:
ra = 14%(0.50) + 6%(0.50) = 10%
If capital structure is irrelevant (i.e. if Proposition I holds), Proposition II tells us what the required
return on levered equity must be to maintain the same total company value (or the same WACC). As
Figure 13.2 shows, the cost of equity will rise continuously as companies substitute debt for equity, but
the WACC remains the same.
Remember that the value of a company equals all of its future cash flows discounted by its cost
of capital. If managers could adjust capital structure to achieve a lower overall WACC (while leaving
cash flows unchanged), then that would also increase the value of the company. Propositions I and II
illustrate why this can’t happen in perfect markets. Proposition I says that there is no capital structure
that maximises the value of a company, while Proposition II says that there is no capital structure that
minimises the WACC.
13-2c DOES DEBT POLICY MATTER?
In the previous section we learned that, in a perfect market, companies’ capital structure choices do not
matter. That finding stands at odds with what CFOs tell us – namely, that capital structure decisions
are extremely important and can have as much influence on the value of a company as investment
decisions. If financial managers believe that capital structure is important, it must be because markets
are imperfect in some important way. One of our goals in this chapter is to understand how market
imperfections influence capital structure choices and affect company value.
See the concept explained
step by step on the
CourseMate website.SMART
CONCEPTS