Recall that the main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer is no.
With an increased debt load the following occurs:
Interest expense rises and cash flow needs to cover the interest expense also rise.
Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing.
Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all.
In our previous examples, EPS increased with every increase in our debt-to-equity ratio. However, in our prior discussions, an optimal capital structure is some combination of both equity and debt that maximizes not only earnings but also stock price. Recall that this is best implied by the capital structure that minimizes the company's WACC.
The following is Newco's cost of debt at various capital structures. Newco has a tax rate of 40%. For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in determining stock prices, assume Newco pays out all of its earnings as dividends.
Figure 11.15: Newco's cost of debt at various capital structures
At each level of debt, calculate Newco's WACC, assuming the CAPM model is used to calculate the cost of equity.
At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50
At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19
At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29
Recall that the minimum WACC is the level where stock price is maximized. As such, our optimal capital structure is 40% debt and 60% equity. While there is a tax benefit from debt, the risk to the equity can far outweigh the benefits - as indicated in the example.
Company vs. Stock Valuation
The value of a company's stock is but one part of the company's total value. The value of a company comprises the total value of the company's capital structure, including debtholders, preferred-equity holders and common-equity holders. Since both debtholders and preferred-equity holders have first rights to a company's value, common-equity holders have last rights to a company value, also known as a "residual value".
InvestingWeighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
InvestingLearn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
InvestingAn optimal capital structure shows the best balance of debt to equity a company can have in order to minimize its cost of capital.
InvestingLearn to use the composition of debt and equity to evaluate balance sheet strength.
Small BusinessCapital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
InvestingLearn about the importance of capital structure, and what equity and debt capitalization measures can tell us about the performance of McDonald's Corporation.
Small BusinessCost of capital is the cost of funds used to finance a business.
Personal FinanceWithout some basic knowledge, you won't get the job. Find out what you need to know and how to prepare.
InsightsWe know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
InvestingBorrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.