MINI CASE: Capital Structure Decisions

As discussed in class, the CFOs of most firms believe that there should be an optimal or target
debt-equity ratio. However, how can they compute such an optimal or target debt-equity ratio?
Trial-and-error method could be a choice. This simple mini-case would shed some light on this
issue.
Background Information:
Assume you are just appointed as a financial manager in a local public firm, ABC. Your
responsibility is to assist the CFO of the firm make value-enhancing financing decisions.
You notice that the companys earnings before interest and tax (EBIT) was $50 million in the
previous year and you expect it will remain at the same level forever. The firm is an all-equity
firm now and its number of shares outstanding is 10 million shares.
Based on the MM Proposition I with tax, you understand that most firms shareholders would be
financially better off if the firms start to borrow some debt and use financial leverage. When you
suggested this to the CFO of the company, he encouraged you to provide in-depth analysis to
convince other senior executives and the board of directors.
As a first step, assume that you obtained the following estimated costs of debt from the firms
investment banker. Specifically, the following table shows the cost of debt at different capital
structures for this ABC company. It also shows the expected number of shares outstanding at
different capital structure.
Debt Ratio (D/V)
0%
20
30
40
50

Rd
N/A
8.0%
8.5%
10.0%
12.0%

# of shares outstanding
10 million shares
8 million shares
7 million shares
6 million shares
5 million shares

If the company were to issue debt, it will use the fund to repurchase/retire part of the equity (i.e.,
so-called recapitalization). ABC has 40% tax rate; its CAPM beta is 1.0 (i.e., unlevered beta =
1.0). Assume the risk-free rate of return is 6% and the market risk premium is 6% too.

a.

Please develop an example which can be presented to ABCs executives to show

the effects of financial leverage by using two hypothetical companies: Firm U,
which uses no debt financing, and Firm L, which uses $131.58 million debt with

12% cost of debt. Both firms have $263.16 firm value in assets, a 40% tax rate,
and an expected EBIT of $50 million.
1. Construct partial income statements, which start with EBIT, for the two firms.
Answer: Here are the fully completed statements:
Assets
Equity

Firm U
$263.16
$263.16

Firm L
$263.16
$131.58

EBIT
$ 50
Debt Interest (12%)
EBT
Taxes (40%)
NI

$ 50

Please complete the highlighted part above.

2. Now calculate ROE for both firms.

ROE = NI / Equity
Answer:

Firm U

Firm L

ROE

Please complete the highlighted part above.

3. What does this example illustrate about the impact of financial leverage on
ROE?
Answer: Conclusions from the analysis:
Please provide your answers here.

b.

To prepare the presentation to the companys senior executives and board of

directors, the CFO suggests that you should briefly introduce the MM
Proposition I with corporate tax. Please briefly introduce why the use of debt
influence firm value based on MM Proposition I (with corporate tax).

Answer:
Please provide your answers here.

c.

The CFO has been persuaded by the above theoretical analysis. The CFO agrees
that the firm should use some debt. Now, he asks a more specific question: If we
are going to use debt, how much debt should we borrow? The CFO thus
encourages you to consider whether there is an optimal capital structure for
ABC that can maximize its firm value.
To conduct the analysis, you should use all the information as described in the
Background Information.
To conduct the optimal capital structure analysis in ( c), please also complete
the Excel Spreadsheet FM_Mini-Case_1_Excel_0Template.xls. Specifically,
please complete the highlighted cells at the end of the Excel Spreadsheet.

To identify the optimal capital structure, use WACC method to evaluate the firm value.
Following symbols should be used to denote different variables.
(1) V = Value of Firm
(2) UCF = (after-tax) Unleveled Cash Flow = EBIT * (1- tax rate) + Depreciation Changes in Working Capital - Capital expenditure. [Footnote 1]
By assumptions in this question, there is no depreciation, changes in
working capital or capital expenditure. Thus, UCF = EBIT * (1- tax rate) for
this case.WACC = Weighted Average Cost Of Capital
(3) rs And rd are costs of stock and debt, respectively.
(4) ws and wd are percentages of the firm that are financed with stock and debt.
(5) n = the number of shares outstanding.
(6) P = stock price per share.

V =
t =1

UCF
(1+WACC )t

Since you expected the EBIT of the firm will stay the same forever, thus you know
the firm value formula can be simplified as follow.
V =

UCF
WACC

A BRIEF SUMMARY OF THE SYMBOLS:

Wd
Rd
ws
b
rs
WACC
V
D
S
n
P

Weightage of debt. wd=D/V

cost of debt
Weightage of equity. ws=S/V
Levered Beta of the firms stock
cost of stock
Weighted average cost of capital: WACC = wd (1-T)
rd + w s rs
Total firm value = D + S
the value or amount of debt
the value of equity or stock
The number of shares outstanding (in million)
Stock price per share

1 In business finance, you should have learned that: EBIT = Sale - COGS - Selling/Admi. Expense
Depreciation.NOTE: another popular name for EBIT * (1- tax rate) is NOPAT. That is, NOPAT (Net operating
profit after taxes) = EBIT * (1- tax rate).

1.For each capital structure under consideration, calculate the levered beta, the cost of
equity, and the WACC.
Answer:

fill below table after calculating levered beta, cost of equity and WACC for given
capital structures.

wd
rd
ws
b
rs
WACC

0%

20%

30%

40%

50%

Please complete the highlighted part above.

2.

Then calculate the firm value (i.e., V). Based on the results, please make your
suggestion on the optimal capital structure that can maximize firm value of
ABC company.

Answer:
Since you expected the EBIT of the firm will stay the same forever, thus you know
the firm value formula can be simplified as follow.
V =

UCF
WACC

Repeating this for all capital structures gives the firm value (i.e., V) in the following
table. In addition, Debt = wd * V and S = ws * V:
wd
rd
ws
b
rs

0%

20%

30%

40%

50%

WACC
V
D
S
n
P

10 mill

8 mill

7 mill

6 mill

5 mill

Please complete the highlighted part above.

Conclusion: What is the optimal capital structure that can maximize firm
value?