Estimating the Optimal Capital Structure 501
Strasburg used the entire debt proceeds to repurchase stock, which means the
number of repurchased shares is equal to the debt, D, divided by the repurchase price,
P. Given 10,000 shares outstanding prior to the repurchase, the number of remaining
shares after the repurchase, n, is
At the optimal capital structure, Strasburg will repurchase $88.889/$22.22 4,000
shares of stock, leaving 6,000 shares outstanding (see Column 6 of Table 13-4).
The expected EBIT is $40,000, from Table 13-1. Using the appropriate interest
rate, amount of debt, and tax rate we can calculate the net income (Column 7 in Table
13-4) and the earnings per share (Column 8).
Analyzing the Results
We summarize the results graphically in Figure 13-5. Notice that the cost of equity
and the cost of debt both increase as debt increases. The WACC initially falls, but the
rapidly increasing costs of equity and debt cause WACC to increase when the debt
ratio goes above 40 percent. As indicated earlier, the minimum WACC and maximum
corporate value occur at the same capital structure.
Now look closely at the curve for the value of the firm, and notice how flat it is
around the optimal level of debt. Thus, it doesn’t make a great deal of difference
whether Strasburg’s capital structure has 30 percent debt or 50 percent. Also, notice
that the maximum value is about 11 percent greater than the value with no debt. Al-
though this example is for a single company, the results are typical: The optimal capi-
tal structure can add 10 to 20 percent more value relative to zero debt, and there is a
fairly wide region (from about 20 percent debt to 55 percent) over which value
changes very little.
In the last chapter we looked at value-based management and saw how companies
can increase their value by improving their operations. There is good news and bad
news regarding this. The good news is that small improvements in operations can lead
to huge increases in value. But the bad news is that it’s often very hard to improve
operations, especially if the company is already well managed.
If instead you seek to increase a firm’s value by changing its capital structure, we
again have good news and bad news. The good news is that changing capital structure
is very easy—just call an investment banker and issue debt (or the reverse if the firm
has too much debt). The bad news is that this will add only a relatively small amount
of value. Of course, any additional value is better than none, so it’s hard to understand
why there are some mature firms with zero debt.
Finally, Figure 13-5 shows that Strasburg’s EPS steadily increases with leverage,
while its stock price reaches a maximum and then begins to decline. For some compa-
nies there is a capital structure that maximizes EPS, but this is generally not at the
same capital structure that maximizes stock price. This is one additional reason we
focus on cash flows and value rather than earnings.
What happens to the costs of debt and equity when the leverage increases?
Explain.
Using the Hamada equation, show the effect of financial leverage on beta.
Using a graph and illustrative data, identify the premiums for financial risk and
business risk at different debt levels. Do these premiums vary depending on the
debt level? Explain.
Is expected EPS maximized at the optimal capital structure?
n 0 (D/P).
n Number of outstanding shares remaining after the repurchase
Capital Structure Decisions 497
