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
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.
Personal FinanceWithout some basic knowledge, you won't get the job. Find out what you need to know and how to prepare.
InvestingAnalyze UPS' capital structure to determine the relative importance of debt and equity financing. Identify the factors influencing financial leverage trends.
Small BusinessTotal Debt to total assets, also called the debt ratio, is an accounting measurement that shows how much of a company’s assets are funded by borrowing. In business, borrowing is also called leverage.
InvestingLearn why GM's enterprise value increased, and get an update on the company's capital structure, including equity and debt capitalization.
RetirementAs people reach retirement they are carrying more debt than ever before. Why and what to watch for.
InvestingExamine the growth of global debt from 2010 to 2015. Emerging market debt has grown significantly, while advanced economy debt has grown marginally.