Chapter 16: Capital Structure Objective To understand how a firm can create value through its capital structure decisions Copyright © Prentice Hall Inc 2000 Author: Nick Bagley, bdellaSoft, Inc Chapter 16 Contents • 16.1 Internal Verses External Financing • 16.2 Equity Financing • 16.3 Debt Financing • 16.4 The Irrelevance of Capital Structure in a Frictionless Environment • 16.5 Creating Value Through Financing Decisions • 16.6 Reducing Costs • 16.7 Dealing with Conflicts of Interest • 16.8 Creating New Opportunities for Stakeholders • 16.9 Financing Decisions in Practice • 16.10 How to Evaluate Leveraged Investments Claimant Classes Nodett Somdett Creditors No Yes Government Yes Yes Shareholders Yes Yes Leverage (Gearing) Equations CFSomdett = Net Earnings + Interest = (EBIT - Interest) * (1 - Tax_Rate) + Interest = EBIT * Tax_Rate + Interest * Tax_Rate = CFNodett + Interest * Tax_Rate Tax_Rate = 34% ⇒ CFSomdett = CFNodett + Interest * 0.34 Market Values of Claims Claimant Nodett Creditors Shareholders Government Somdett $0.0 million $40.0 million $66.0 million $39.6 million $34.0 million $20.4 million Total $100.0 million $100.0 million Stock Price and Leverage (Real Estate Project with High Bankruptcy Costs) $100 $90 $80 Stock Price $70 $60 $50 $40 $30 $20 $10 $0 0% 20% 40% 60% Debt Ratio 80% 100% M&M Equations D ke = k + (k − r ) E E D WACC = ke +r D+E D+E k = the cost of equity w/out leverage r = the risk - free rate of interest D = market value of a firm' s debt E = market value of the firm' s equity V = D + E = market value of the firm