Using Greater Amounts of Debt
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".

Tax and Bankruptcy Costs

Related Articles
  1. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  2. Small Business

    Capital Structure

    Capital structure is the combination of the debt and equity a company uses to finance its long-term operations and growth.
  3. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  4. Insights

    The National Debt Explained

    We 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.
  5. Investing

    Lowe's Stock: Capital Structure Analysis (LOW)

    Examine Lowe's Companies' equity capitalization, debt capitalization and enterprise value to analyze trends in the retailer's capital structure.
  6. Investing

    UPS Stock: Capital Structure Analysis

    Analyze UPS' capital structure to determine the relative importance of debt and equity financing. Identify the factors influencing financial leverage trends.
  7. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  8. Investing

    Yahoo Stock: Capital Structure Analysis (YHOO)

    Learn about Yahoo's capital structure, including whether or not a decline in year-over-year earnings is leading the company to use more debt.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center