Fundamentals of Financial Management (Concise 6th Edition)

Chapter 13 Capital Structure and Leverage 417

value because of the feedback effects of debt on the costs of debt and equity. For
example, if Bigbee used more than 40% debt (say, 50%), it would have more of the
cheaper capital; but this bene! t would be more than offset by the fact that the ad-
ditional debt raises the costs of debt and equity.
These thoughts were echoed in a statement made by the Georgia-Paci! c
Corporation:

On a market-value basis, our debt-to-capital ratio is 47%. By employing this capi-
tal structure, we believe that our weighted average cost of capital is minimized, at
approximately 10%. Although reducing debt would reduce our marginal cost of
debt, this action would likely increase our weighted average cost of capital because
we would then have to use more higher-cost equity.
Finally, and very importantly, recall that the capital structure that minimizes
the WACC is also the capital structure that maximizes the! rm’s stock price. Bigbee
pays out all of its earnings as dividends, so it plows zero earnings back into the
business, which leads to an expected growth rate in earnings and dividends of zero.
Thus, in Bigbee’s case, we can use the zero growth stock price model developed in
Chapter 9 to estimate the stock price at each different capital structure. These esti-
mates are shown in Column 7 of Table 13-3. Here we see that the stock price! rst

10 20 60

14

12

8

6

4

0

Required

Return on

Equity

(%)

18

2

10

16

30 40 50

rs

rRF = (^) r
RF
Debt Ratio (%)
Risk-Free Rate:
Time Value of
Money Plus
Expected
In#ation
Premium for
Business Risk
Premium for
Financial Risk
Bigbee’s Required Rate of Return on Equity
F I G U R E 1 3! 7 at Di" erent Debt Levels