559

560 APPENDIX B

The Capital Structure Question

How should a firm go about choosing its debt-equity ratio? Here, as always, we assume

that the guiding principle is to choose the course of action that maximizes the value of

a share of stock. However, when it comes to capital structure decisions, this is essen-

tially the same thing as maximizing the value of the whole firm, and, for convenience,

we will tend to frame our discussion in terms of firm value.

The WACC (Weighted Average Cost of Capital) tells us that the firm™s overall cost

of capital is a weighted average of the costs of the various components of the firm™s cap-

ital structure. When we described the WACC, we took the firm™s capital structure as

given. Thus, one important issue that we will want to explore is what happens to the cost

of capital when we vary the amount of debt financing, or the debt-equity ratio.

A primary reason for studying the WACC is that the value of the firm is maximized

when the WACC is minimized. The WACC is the discount rate appropriate for the firm™s

overall cash flows. Since values and discount rates move in opposite directions, mini-

mizing the WACC will maximize the value of the firm™s cash flows.

Thus, we will want to choose the firm™s capital structure so that the WACC is mini-

mized. For this reason, we will say that one capital structure is better than another if it

results in a lower weighted average cost of capital. Further, we say that a particular debt-

equity ratio represents the optimal capital structure if it results in the lowest possible

WACC. This optimal capital structure is sometimes called the firm™s target capital

structure as well.

CONCEPT QUESTIONS

• What is the relationship between the WACC and the value of the firm?

• What is an optimal capital structure?

The Effect of Financial Leverage

In this section, we examine the impact of financial leverage on the payoffs to stock-

holders. As you may recall, financial leverage refers to the extent to which a firm relies

on debt. The more debt financing a firm uses in its capital structure, the more financial

leverage it employs.

As we describe, financial leverage can dramatically alter the payoffs to shareholders

in the firm. Remarkably, however, financial leverage may not affect the overall cost of

capital. If this is true, then a firm™s capital structure is irrelevant because changes in cap-

ital structure won™t affect the value of the firm.

THE IMPACT OF FINANCIAL LEVERAGE

We start by illustrating how financial leverage works. For now, we ignore the impact of

taxes. Also, for ease of presentation, we describe the impact of leverage in terms of its

effects on earnings per share, EPS, and return on equity, ROE. These are, of course, ac-

counting numbers and, as such, are not our primary concern. Using cash flows instead

of these accounting numbers would lead to precisely the same conclusions, but a little

more work would be needed.

Leverage and Capital Structure 561

TABLE B.3

Current Proposed

Current and proposed

capital structures for the Assets $8,000,000 $8,000,000

Trans Am Corporation Debt $0 $4,000,000

Equity $8,000,000 $4,000,000

Debt-equity ratio 0 1

Share price $20 $20

Shares outstanding 400,000 200,000

Interest rate 10 % 10 %

Financial Leverage, EPS, and ROE: An Example

The Trans Am Corporation currently has no debt in its capital structure. The CFO, Ms.

Morris, is considering a restructuring that would involve issuing debt and using the pro-

ceeds to buy back some of the outstanding equity. Table B.3 presents both the current

and proposed capital structures. As shown, the firm™s assets have a market value of $8

million, and there are 400,000 shares outstanding. Because Trans Am is an all-equity

firm, the price per share is $20.

The proposed debt issue would raise $4 million; the interest rate would be 10 per-

cent. Since the stock sells for $20 per share, the $4 million in new debt would be used

to purchase $4 million/20 200,000 shares, leaving 200,000 outstanding. After the re-

structuring, Trans Am would have a capital structure that was 50 percent debt, so the

debt-equity ratio would be 1. Notice that, for now, we assume that the stock price will

remain at $20.

To investigate the impact of the proposed restructuring, Ms. Morris has prepared

Table B.4, which compares the firm™s current capital structure to the proposed capital

structure under three scenarios. The scenarios reflect different assumptions about the

firm™s EBIT. Under the expected scenario, the EBIT is $1 million. In the recession sce-

nario, EBIT falls to $500,000. In the expansion scenario, it rises to $1.5 million.

To illustrate some of the calculations in Table B.4, consider the expansion case.

EBIT is $1.5 million. With no debt (the current capital structure) and no taxes, net in-

come is also $1.5 million. In this case, there are 400,000 shares worth $8 million total.

EPS is therefore $1.5 million/400,000 $3.75 per share. Also, since accounting return

on equity, ROE, is net income divided by total equity, ROE is $1.5 million/8 million

18.75%.

With $4 million in debt (the proposed capital structure), things are somewhat differ-

ent. Since the interest rate is 10 percent, the interest bill is $400,000. With EBIT of $1.5

million, interest of $400,000, and no taxes, net income is $1.1 million. Now there are

only 200,000 shares worth $4 million total. EPS is therefore $1.1 million/200,000

$5.5 per share versus the $3.75 per share that we calculated above. Furthermore, ROE

is $1.1 million/4 million 27.5%. This is well above the 18.75 percent we calculated

for the current capital structure.

EPS versus EBIT

The impact of leverage is evident in Table B.4 when the effect of the restructuring on

EPS and ROE is examined. In particular, the variability in both EPS and ROE is much

larger under the proposed capital structure. This illustrates how financial leverage acts

to magnify gains and losses to shareholders.

In Figure B.3, we take a closer look at the effect of the proposed restructuring. This

figure plots earnings per share, EPS, against earnings before interest and taxes, EBIT,

562 APPENDIX B

TABLE B.4

Current Capital Structure: No Debt

Capital structure

scenarios for the Trans Recession Expected Expansion

Am Corporation

EBIT $500,000 $1,000,000 $1,500,000

Interest 0 0 0

Net income $500,000 $1,000,000 $1,500,000

ROE 6.25 % 12.50 % 18.75%

EPS $1.25 $2.50 $3.75

Proposed Capital Structure: Debt $4 million

Recession Expected Expansion

EBIT $500,000 $1,000,000 $1,500,000

Interest 400,000 400,000 400,000

Net income $100,000 $ 600,000 $1,100,000

ROE 2.50 % 15.00 % 27.50 %

EPS $.50 $3.00 $5.50

for the current and proposed capital structures. The first line, labeled “No debt,” repre-

sents the case of no leverage. This line begins at the origin, indicating that EPS would

be zero if EBIT were zero. From there, every $400,000 increase in EBIT increases EPS

by $1 (because there are 400,000 shares outstanding).

The second line represents the proposed capital structure. Here, EPS is negative if

EBIT is zero. This follows because $400,000 of interest must be paid regardless of the

firm™s profits. Since there are 200,000 shares in this case, the EPS is “$2 per share as

shown. Similarly, if EBIT were $400,000, EPS would be exactly zero.

The important thing to notice in Figure B.2 is that the slope of the line in this sec-

ond case is steeper. In fact, for every $400,000 increase in EBIT, EPS rises by $2, so

the line is twice as steep. This tells us that EPS is twice as sensitive to changes in EBIT

because of the financial leverage employed.

Another observation to make in Figure B.2 is that the lines intersect. At that point,

EPS is exactly the same for both capital structures. To find this point, note that EPS is

equal to EBIT/400,000 in the no-debt case. In the with-debt case, EPS is (EBIT “

$400,000)/200,000. If we set these equal to each other, EBIT is:

EBIT/400,000 (EBIT “ $400,000)/200,000

EBIT 2 (EBIT “ $400,000)

EBIT $800,000

When EBIT is $800,000, EPS is $2 per share under either capital structure. This is

labeled as the break-even point in Figure B.2; we could also call it the indifference

point. If EBIT is above this level, leverage is beneficial; if it is below this point, it is

not.

There is another, more intuitive, way of seeing why the break-even point is $800,000.

Notice that, if the firm has no debt and its EBIT is $800,000, its net income is also

$800,000. In this case, the ROE is $800,000/8,000,000 10%. This is precisely the

same as the interest rate on the debt, so the firm earns a return that is just sufficient to

pay the interest.

EXAMPLE: BREAK-EVEN EBIT

The MPD Corporation has decided in favor of a capital restructuring. Currently, MPD

uses no debt financing. Following the restructuring, however, debt will be $1 million.

Leverage and Capital Structure 563

FIGURE B.2 Earnings per

share ($)

Financial leverage: EPS

and EBIT for the Trans

Am Corporation

4 No debt

With debt

3 Advantage

to debt

2 Break-even point

Disadvantage

to debt

1

Earnings before

interest and

0

taxes ($)

400,000 800,000 1,200,000

“1

“2

The interest rate on the debt will be 9 percent. MPD currently has 200,000 shares out-

standing, and the price per share is $20. If the restructuring is expected to increase EPS,

what is the minimum level for EBIT that MPD™s management must be expecting? Ig-

nore taxes in answering.

To answer, we calculate the break-even EBIT. At any EBIT above this the increased fi-

nancial leverage will increase EPS, so this will tell us the minimum level for EBIT.

Under the old capital structure, EPS is simply EBIT/200,000. Under the new capital

structure, the interest expense will be $1 million .09 $90,000. Furthermore, with

the $1 million proceeds, MPD will repurchase $1 million/20 50,000 shares of stock,

leaving 150,000 outstanding. EPS is thus (EBIT “ $90,000)/150,000.

Now that we know how to calculate EPS under both scenarios, we set them equal to

each other and solve for the break-even EBIT:

EBIT/200,000 (EBIT “ $90,000)/150,000

EBIT (4/3) (EBIT “ $90,000)

EBIT $360,000

Verify that, in either case, EPS is $1.80 when EBIT is $360,000. Management at MPD

is apparently of the opinion that EPS will exceed $1.80.

Section 6

Mergers, Acquisitions, and Corporate

Control

International Financial Management

MERGERS, ACQUISITIONS,

AND CORPORATE

CONTROL

Evaluating Mergers

The Market for Corporate

Control Mergers Financed by Cash

Method 1: Proxy Contests Mergers Financed by Stock

Method 2: Mergers and Acquisitions A Warning

Method 3: Leveraged Buyouts Another Warning

Method 4: Divestitures and Spin-offs

Merger Tactics

Sensible Motives for Mergers Who Gets the Gains?

Economies of Scale

Leveraged Buyouts

Economies of Vertical Integration

Barbarians at the Gate?

Combining Complementary Resources

Mergers and the Economy

Mergers as a Use for Surplus Funds

Merger Waves

Dubious Reasons for Mergers

Do Mergers Generate Net Benefits?

Diversification

Summary

The Bootstrap Game

A merger is consummated.

These two managers are clearly delighted, but why do companies decide to merge?

Reuters/Peter Morgan/Archive Photos

567

n recent years the scale and pace of merger activity have been remark-

I able. For example, Table 6.1 lists just a few of the important mergers of

1998 and 1999. Notice that the United States does not have a monopoly

on merger activity. In recent years many of the largest mergers have involved

European firms.

The mergers listed in Table 6.1 involved big money. During periods of intense

merger activity financial managers spend considerable time either searching for firms

to acquire or worrying whether some other firm is about to take over their company.

When one company buys another, it is making an investment, and the basic princi-

ples of capital investment decisions apply. You should go ahead with the purchase if it

makes a net contribution to shareholders™ wealth. But mergers are often awkward trans-

actions to evaluate, and you have to be careful to define benefits and costs properly.