UV3929

Rev. Jun. 30, 2011

CAPITAL STRUCTURE AND VALUE

The underlying principle of valuation is that the discount rate must match the risk of the
cash flows being valued. Furthermore, when we include the possibility that cash flows are
financed with debt capital, valuations must acknowledge the tax deductibility of interest
payments. This note presents a series of calculations that illustrate these two essential points and
the relations between them. The results provide important insights into the following capital
structure questions: How does debt financing affect equity holders? Does debt financing create
value for a firm? What is the right amount of debt financing?
The context for this analysis is a very simple firm valuation in which the firm experiences
no growth and lasts indefinitely. In other words, we assume that the firms operating cash flows
are a perpetuityan infinite stream of identical cash flows. This allows for an extremely
tractable valuation calculationthe value of a perpetuity is the cash flow divided by the discount
rate.1 This simple context is chosen to focus on the underlying principles, though these principles
are quite general. We will focus on the value of the whole firm, which is the sum of debt and
equity values and is referred to as enterprise value.
The analysis is divided into four parts. First, we examine the effects of debt financing on
equity cash flow variability. The analysis justifies a common calculation, which is to adjust
capital asset pricing model (CAPM) betas for leverage. The term leverage, in this context, refers
to the use of debt financing (financial leverage). Second, the note considers the effects of debt
financing where there are no taxes. While unrealistic, this analysis establishes an important
benchmark that makes later results easier to understand. Third, the note calculates enterprise
value using a variety of methods. The use of differing methods helps illustrate underlying
1

This is a simplification of the ubiquitous constant growth formula shown below, but with zero growth. In the
constant growth formula, V0 is the value now (time zero), CF1 is the cash flow one period in the future (time one), k
is the discount rate per period, and g is the growth rate of cash flows from time one onward.
CF1
V0
kg
With zero growth, the formula reduces to V0 = CF k, where there is no longer a need to subscript CF since all cash
flows are the same. To understand this formulas logic, consider the case where you put $100,000 in a bank account
that pays 5% forever. You will receive 0.05 $100,000 = $5,000 a year, every year. Now turn this around: If your
discount rate were 5%, and you were promised $5,000 a year forever, that would be the same as having $100,000 in
the bank today. In other words, at a 5% discount rate, $5,000 a year is worth $5,000 0.05 = $100,000.
This technical note was prepared by Associate Professor Marc Lipson. Copyright 2009 by the University of
Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.

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principles. Finally, the note considers explicitly how a financing change would affect stock
prices. This last analysis demonstrates quite clearly how the benefits associated with debt
financing (the tax deductibility of interest payments) benefit shareholders.

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Financial Risk
Our simple firm generates an expected EBIT of $104,000 a year, every year; however,
this cash flow is not certain. The calculation below explores the effects of a 20% decrease in
EBIT on the cash flow to equity holders. Consider this effect when the firm has zero debt and
when the firm has debt equal to $380,000 on which it pays 6.0%. Assume furthermore that the
firm pays taxes of 30%. Fill out the table below. Note that given the simple structure of the firm,
net income will be paid each year to equity holders.

No Debt
Base Case
20% Decrease
EBIT
Interest
Earnings Before Tax
Tax
Net Income

104,000
0
104,000
31,200
72,800

83,200
0
83,200

Percentage Change in Net Income

Debt Equal to $380,000
Base Case
20% Decrease
EBIT
Interest
Earnings Before Tax
Tax
Net Income

104,000

83,200

Percentage Change in Net Income

Given the resulting changes in equity cash flows, it is clear that the existence of debt
financing magnifies changes in equity cash flows. As you might expect, this variation also
influences the beta of a firms equity. In fact, we can describe that effect with Equation 1, which
you will use for the remainder of these calculations:
L = U (1 + (1 t) D E)

(1)

where L is the leveraged beta (beta given debt financing), U is the unleveraged beta (beta of
firm without debt, also called an asset beta), t is the marginal corporate tax rate, D is the market
value of debt, and E is the market value of equity.

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Valuation without TaxesWeighted Average Cost of Capital (WACC) Approach

To better understand the effects of debt, which are related to the existence of tax deductibility,
it is useful to consider first a world with a zero marginal tax rate. The usual formulas still apply, but
the tax rate is set to zero. We will assume that given the risks of our simple firm, and assuming the
firm was entirely financed with equity, the beta of the equity would equal 0.80. This is the
unleveraged beta referred to in Equation 1. Furthermore, we will assume the risk-free rate of return is
equal to 6.0%. This is the same as the interest rate on debt, which implies that the debt is riskless.2
Finally, assume that the market risk premium is equal to 5.5%.
Fill out the table below, assuming first that there is no debt and then assuming debt, as
described earlier, equal to $380,000. We will value the company using the WACC approach
discounting free cash flow by the WACC. To do this, you must have a measure of the proportion
of debt financing based on market values, but the firms market value (enterprise value) is
unknown. A proportion is assumed below, and you will verify it is consistent with the results.
You will also calculate the difference in enterprise values between the Debt and No Debt cases.

EBIT
Tax
NOPAT
Change in Net PPE
Change in NWC
Free Cash Flow
Unleveraged Beta
Proportion of Debt
Debt to Equity
Leveraged Beta
Cost of Equity (use CAPM)

No Debt

Debt = $380,000

104,000
0
104,000
0
0
104,000

104,000
0
104,000
0
0
104,000

0.80
0.00
0.00
0.80

0.80
0.38

WACC
Enterprise Value
Difference in Enterprise Values
Calculate Ratio of Debt to Enterprise Value
Provide an intuitive explanation for your results regarding the difference in enterprise values.
2

The analysis can be adjusted to accommodate risky debt, but assuming riskless debt is another simplification
that allows a focus on underlying principals.

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Valuation with TaxesWACC Approach

In contrast to a world with no taxes, we now consider the more realistic case where the
firm pays taxes and interest payments are tax deductible. Assume that the tax rate, as in the first
calculations, is equal to 30%.

EBIT
Tax
NOPAT
Change in Net PPE
Change in NWC
Free Cash Flow
Unleveraged Beta
Proportion of Debt
Debt to Equity
Leveraged Beta
Cost of Equity (use CAPM)

No Debt

Debt = $380,000

104,000
31,200
72,800
0
0
72,800

104,000
31,200
72,800
0
0
72,800

0.80
0.00
0.00
0.80

0.80
0.46683

WACC
Enterprise Value
Difference in Enterprise Values
Calculate Ratio of Debt to Enterprise Value
The results above regarding the enterprise values are quite different from those in a world with
no taxes. Provide an intuitive explanation for the results.

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Valuation with TaxesValue of Claims

It should be noted that the logic behind the WACC approach is that the operating
decisions of the firm are reflected in the cash flows, while all the financing decisions are
reflected in the discount rate. But the central logic of valuationdiscount cash flows at an
appropriate ratecan be applied to more than just this one case. In fact, we can view the firm in
a number of different ways and value the firm accordingly.
In this section, rather than valuing the whole firm using the WACC approach, we will
value each of the claims (debt and equity) on the firm separately. The sum of these claims will be
equal to the enterprise value.
In this analysis you will use the cost of equity from the prior calculations.

No Debt
EBIT
Interest Payments
Income Before Taxes
Tax
Net Income (Cash to Equity)
Cost of Equity
Value of Equity
Cash to Debt (Interest)
Cost of Debt
Value of Debt
Enterprise Value

104,000
0
104,000

Debt = $380,000
104,000

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Valuation with TaxesValue of Assets

Another valuation approach would be to consider the firm as a collection of assets and to
value each of these assets separately. The sum of these assets would equal enterprise value. For
our simple firm, there are just two assets. The first is the operating capability of the firm
(operating assets). The second is the tax shield provided by debt financing.

No Debt
EBIT
Tax
NOPAT
Change in Net PPE
Change in NWC
Free Cash Flow

104,000
31,200
72,800
0
0
72,800

Debt = $380,000
104,000
31,200
72,800
0
0
72,800

Beta of Operating Cash Flow

Discount Rate
Value of Operations
Interest Payment
Annual Taxes Shield
Discount Rate
Value of Tax Shield
Enterprise Value
Note that in all three approaches, the value of the firm is identical. This must be the case, of
course, since it cannot matter how we slice up the firm. The value of the whole firm (WACC
approach) must equal the sum of the claims on the firm (claims approach), which must equal the
sum of the value of all assets (asset approach). Assuming debt is permanent and unchanging, and
given that the appropriate discount rate would be the cost of debt (since it correctly reflects the
risk of debt cash flows), a simple formula for the value of the tax shield is t D.

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Per Share Effects

One striking result above is that the value of equity is markedly lower when we include
debt. This raises an important question: Are the equity holders better or worse off as a result of
adding debt? To understand the effects on equity holders, the following table examines the
change in per share prices as our simple firm adds debt. In effect, we consider the same analysis
as before, but we cast the results in terms of a recapitalization: The firm issues the debt and uses
the proceeds to repurchase shares in the market.
Fill out the table below, where the table is divided into a No Debt column (the market
assumes the firm will have no debt) and a recapitalized column (the firm has competed the
recapitalization). The analysis employs the asset valuation approach. The No Debt column asks
you to calculate the price per share that reflects the anticipated value of the tax shield provided
by the new debt. For this analysis, assume the firm has 20,000 shares outstanding initially and
repurchases shares at a fair price when implementing the recapitalization.

No Debt
Free Cash Flow
Discount rate for Operations
Value of Operations

72,800

Recapitalized
72,800

Value of Tax Shield (t D)

Enterprise Value
Debt Outstanding
Equity Value
Price Without Tax Shield
Value of Tax Shield
Per Share Value of Tax Shield
Price Reflecting Value
Shares Repurchased
New Shares Outstanding
Price Post-Recapitalization
What does your analysis suggest would be the stock price (market) reaction to the announcement
that the firm will be issuing $380,000 in debt?