Chapter 14: Capital Structure and Leverage
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Campus Deli Inc.
Optimal Capital Structure
Assume that you have just been hired as business manager of Campus Deli
(CD), which is located adjacent to the campus. Sales were $1,100,000 last
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A. (1) What is business risk? What factors influence a firm’s business
risk?
Answer: [Show S14-1 through S14-3 here.] Business risk is the riskiness
inherent in the firm’s operations if it uses no debt. A firm’s
A. (2) What is operating leverage, and how does it affect a firm’s
business risk?
Answer: [Show S14-4 through S14-6 here.] Operating leverage is the
extent to which fixed costs are used in a firm’s operations. If a
A. (3) What is the firm’s return on invested capital (ROIC)?
Answer: [Show S14-7 here.]
ROIC =
capital invested Total
)T 1(EBIT −
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B. (1) What do the terms financial leverage and financial risk mean?
Answer: [Show S14-8 here.] Financial leverage refers to the firm’s decision
B. (2) How does financial risk differ from business risk?
Answer: [Show S14-9 here.] As we discussed above, business risk depends
C. To develop an example that can be presented to CD’s management
as an illustration, consider two hypothetical firms: Firm U with
zero debt financing and Firm L with $10,000 of 12% debt. Both
firms have $20,000 in invested capital and a 40% federal-plus-
state tax rate, and they have the following EBIT probability
distribution for next year:
Probability EBIT
0.25 $2,000
0.50 3,000
0.25 4,000
(1) Complete the partial income statements and the firms’ ratios in
Table IC 14.1.
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Table IC 14.1. Income Statements and Ratios
Firm U Firm L
Total capital $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Equity $20,000 $20,000 $20,000 $10,000 $10,000 $10,000
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Answer: [Show S14–10 through S14–14 here.] Here are the fully completed
statements:
Firm U Firm L
Total capital $20,000 $20,000 $20,000 $20,000 $20,000 $20,000
Equity $20,000 $20,000 $20,000 $10,000 $10,000 $10,000
C. (2) Be prepared to discuss each entry in the table and to explain how
this example illustrates the effect of financial leverage on expected
rate of return and risk.
Answer: [Show S14–15 and S14–16 here.] Conclusions from the analysis:
1. The firm’s ROIC, ROIC = EBIT(1 – T)/Total invested capital, is
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D. After speaking with a local investment banker, you obtain the
following estimates of the cost of debt at different debt levels (in
thousands of dollars):
Amount Debt/Capital Debt/Equity Bond
Borrowed Ratio Ratio Rating rd
$ 0 0.000 0.0000 — —
250 0.125 0.1429 AA 8.0%
500 0.250 0.3333 A 9.0
750 0.375 0.6000 BBB 11.5
1,000 0.500 1.0000 BB 14.0
Now consider the optimal capital structure for CD.
(1) To begin, define the terms optimal capital structure and target
capital structure.
Answer: [Show S14–17 here.] The optimal capital structure is the capital
structure at which the tax-related benefits of leverage are exactly
D. (2) Why does CD’s bond rating and cost of debt depend on the amount
of money borrowed?
Answer: [Show S14-18 here.] Financial risk is the additional risk placed on the
common stockholders as a result of the decision to finance with debt.
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D. (3) Assume that shares could be repurchased at the current market price
of $25 per share. Calculate CD’s expected EPS and TIE at debt levels
of $0, $250,000, $500,000, $750,000, and $1,000,000. How many
shares would remain after recapitalization under each scenario?
Answer: [Show S14–19 through S14–25 here.] The analysis for the debt
levels being considered (in thousands of dollars and shares) is
shown below:
At D = $0:
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(Note: EPS and TIE calculations are in thousands of dollars.)
D. (4) Using the Hamada equation, what is the cost of equity if CD
recapitalizes with $250,000 of debt? $500,000? $750,000?
$1,000,000?
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Answer: [Show S14–26 through S14–30 here.]
rRF = 6.0% rM – rRF = 6.0%
D. (5) Considering only the levels of debt discussed, what is the capital
structure that minimizes CD’s WACC?
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Answer: [Show S14-31 and S14–32 here.]
Amount
Borroweda
Debt/Capital
Ratiob
Equity/Capital
Ratioc
Debt/Equity
Ratiod
Levered
Betae
rsf
rda
rd(1 – T)
WACCg
$ 0
0.00%
100.00%
0.00%
1.00
12.00%
0.0%
0.0%
12.00%
1.09
12.51
1.20
13.20
1.36
14.16
11.5
1.60
15.60
14.0
D. (6) What would be the new stock price if CD recapitalizes with
$250,000 of debt? $500,000? $750,000? $1,000,000? Recall that
the payout ratio is 100%, so g = 0.
Answer: [Show S14-33 and 14–34 here.] We can calculate the price of a
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D. (7) Is EPS maximized at the debt level that maximizes share price?
Why or why not?
Answer: [Show S14–35 here.] We have seen that EPS continues to increase
D. (8) Considering only the levels of debt discussed, what is CD’s optimal
capital structure?
Answer: [Show S14–36 here.] A capital structure with $500,000 of debt
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D. (9) What is the WACC at the optimal capital structure?
Answer: Initial debt level:
Debt/Total capital = 0%, so Total capital = Initial equity = $25
E. Suppose you discovered that CD had more business risk than you
originally estimated. Describe how this would affect the analysis.
How would the analysis be affected if the firm had less business
risk than originally estimated?
Answer: [Show S14–37 here.] If the firm had higher business risk, then, at any
F. What are some factors a manager should consider when
establishing his or her firm’s target capital structure?
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Answer: [Show S14–38 here.] Since it is difficult to quantify the capital
structure decision, managers consider the following judgmental
factors when making capital structure decisions:
1. The average debt-to-capital ratio for firms in their industry.
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Optional Question
Modigliani and Miller proved, under a very restrictive set of assumptions, that
the value of a firm will be maximized by financing almost entirely with debt.
Why, according to MM, is debt beneficial?
Answer: MM argued that using debt increases the value of the firm because
interest is tax deductible. The government, in effect, pays part of the
Optional Question
What assumptions underlie the MM theory? Are these assumptions realistic?
Answer: MM’s key assumptions are as follows:
1. There are no brokerage costs.
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Figure IC 14.1. Relationship Between Capital Structure and Stock Price
G. Put labels on Figure IC 14.1 and then discuss the graph as you might
use it to explain to your boss why CD might want to use some debt.
Answer: [Show S14–39 and S14–40 here.] The use of debt permits a firm to
obtain tax savings from the deductibility of interest. So the use of
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H. How does the existence of asymmetric information and signaling
affect capital structure?
Answer: [Show S14–41 through S14–43 here.] The asymmetric information
concept is based on the premise that management’s choice of
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Optional Question
You might expect the price of a mature firm’s stock to decline if it announces a
stock offering. Would you expect the same reaction if the issuing firm were a
young, rapidly growing company?
Answer: If a mature firm sells stock, the price of its stock would probably
decline. A mature firm should have other financing alternatives, so