Capital Structure: Finding

the Optimal Mix of Debt

and Equity

Big Picture

Source: Aswath Damodaran

1
 Outline

• Overview of Capital Structure Theories

üModigliani Miller
üPecking Order
• Finding the Optimal Mix of Debt and Equity
1. Cost of Capital Approach
2. Enhanced Cost of Capital Approach
3. Adjusted Present Value Approach
4. Relative Analysis

Modigliani Miller Theorem (Trade-Off Theory)

• We live in a world where there are taxes and bankruptcy costs.
• Interest is tax deductible and when a firm adds debt, it results in tax savings for the
firm. The reduction in taxes increases the cash flow of the firm.
• Increases in debt increases the risk of default for firms.
• (
Remember: Hamada equation: b E = bU + bU - b D )D
E
(1 - t )
übU is the asset b (“unlevered b”) that reflects only the business risk of the firm’s
assets
vbU is unobserved, not impacted from changes in capital structure
übE measures risk of levered equity and depends on financial risk
vChanges in the firm’s capital structure impact bE
übD reflects the risk of firm’s debt
4

2
 M&M Value of Firm
Firms trade off the tax benefits of debt financing against problems caused by potential bankruptcy.

Too much leverage

decreases the value of the
firm because expected
bankruptcy costs offsets the
benefits of debt (tax shield)

Leverage increases the value of

the firm because of the tax
savings of interest

Leverage does not affect the

firm’s business risk and the
value of its business activities
5

M&M – WACC, Cost of Debt, Cost of Equity

As leverage increases:
- Rd increases due to higher
expected bankruptcy costs
and lower rating
- Re also increases
- The WACC initially decreases
b/c tax advantage outweighs
the increase in the probability
of bankruptcy, then increases
b/c at some point, the
probability of bankruptcy
increases enough to outweigh
tax benefit.

3
 Question 1
• A firm recently overhauled its capital structure, by replacing debt with equity:
üBefore the overhaul, it had 20% equity and 80% debt in its capital structure. Its
equity beta was 1.8 and its debt beta was 0.6.
üAfter the overhaul, it has 50% equity and 50% debt in its capital structure.
üAssume tax rate is 35% and also bankruptcy risk exists.

What is the firm’s equity beta after the change? (Assume beta debt does not change)
A. 1.08
B. 1.15
C. 1.23
D. 1.29
E. 1.32

ADDITIONAL QUESTION: What will the firm’s equity beta be if it gets rid of all its debt?

Solution 1

4
 Trade-off Theory of Optimal Leverage
• In the most realistic case of M&M, firms should strike a balance
between the tax benefits of debt and the bankruptcy costs of debt
when determining capital structure
• Do firms actually do this?
üSome evidence suggests Yes:
vIndustries with higher bankruptcy costs tend to have lower
debt
üSome evidence suggests No:
vFirms don’t usually make large shifts in capital structure due
to taxes, and the most profitable companies tend to borrow
the least
• Is there room for other theories?
9

Pecking Order Theory

• Pecking Order Hypothesis: There is an order in raising capital. Firms use internal financing first, then issue debt.
Equity is the last resort.
• Firms raise capital in the following order.
1) Retained Earnings
2) Issue debt
3) Issue new common stock
Why is it logical to follow pecking order theory?
• Internal funds are readily available to the financial manager (“Cheaper”)
ü No public offering or private placement needed
ü No transaction costs
ü No questions from outside investors
ü No need to give up control
• Issuing new common stock is more expensive than issuing debt. What is the exception?
• Issuing new common stock sends a negative signal that stock is overpriced. Therefore, managers are less willing to
issue new common stock.

10

10

5
 Finding the Optimal Mix of Debt and Equity

1. The Cost of Capital Approach: The optimal debt ratio is the one that minimizes the
cost of capital for the firm (WACC).
2. The Enhanced Cost of Capital approach: The optimal debt ratio is the one that
generates the best combination of (low) cost of capital and (high) operating income.
3. The Adjusted Present Value Approach: The optimal debt ratio is the one that
maximizes the overall value of the firm.
4. The Sector Approach: The optimal debt ratio is the one that brings the firm closes to
its peer group in terms of financing mix.
5. The Life Cycle Approach: The optimal debt ratio is the one that best suits where the
firm is in its life cycle.

11

11

1. Cost of Capital Approach

• What is the primary goal of financial managers?

üMaximize stockholder wealth and thus, maximize firm value

𝐹𝐶𝐹𝐹!
𝑉𝑎𝑙𝑢𝑒0 =
𝑊𝐴𝐶𝐶 − 𝑔

• What is the optimal capital structure?

üIf cash flows are held constant and the cost of capital is minimized, the value of the
firm is maximized.
üWe want to choose debt/equity mix that minimizes the weighted average cost of
capital.

12

12

6
 1- Cost of Capital Approach- Example
Assume the firm has $200 million in cash flows, expected to grow 3% a year forever.

13

13

Cost of Capital Estimation at Different Debt Levels

1. Estimate the Cost of Equity at different levels of debt:

• Equity will become riskier -> Beta will increase -> Cost of Equity will increase.
• Estimation will use levered beta calculation
2. Estimate the Cost of Debt at different levels of debt:
• Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt
will increase.
• To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest
expense)
3. Estimate the Cost of Capital at different levels of debt
4. Calculate the effect on Firm Value and Stock Price.

14

14

7
 Example – Disney’s Cost of Capital Calculation
1. Estimate the cost of equity for Disney at different debt levels
STEP 1: Estimate the unlevered beta for Disney
• Regression Beta: If Disney’s regression beta is 1.25 and average Debt to Equity ratio
is 19.44% during the regression period, what is the unlevered beta for Disney?
Assume no bankruptcy risk and Disney’s marginal tax rate is 36.1%.
𝐷
𝛽! = 𝛽" + (𝛽" − 𝛽# )(1 − 𝑡)
𝐸
#
when 𝜷𝑫 = 0; 𝛽! = 𝛽" 1 + 1 − 𝑡 !
→ 1.25 = 𝛽" 1 + 1 − 0.361 0.1944
𝛽" = 1.1119
We ignored the bankruptcy cost 15

15

STEP 1: Estimate the unlevered beta for Disney

Proportion Unlevered The Bottom up Beta: Alternatively, we can find
Business of Disney beta
the unlevered beta for Disney using the
Media Networks 49.27% 1.03
unlevered beta of the businesses Disney is in.
Parks & Resorts 33.81% 0.70

Studio
𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒
Entertainment 13.49% 1.10
= 0.4927 ∗ 1.03 + 0.3381 ∗ 0.70
Consumer + 0.1349 ∗ 1.10 + 0.0218 ∗ 0.68
Products 2.18% 0.68
+ 0.0125 ∗ 1.22 = 𝟎. 𝟗𝟐𝟑𝟗
Interactive 1.25% 1.22

Disney Operations 100.00% 0.9239

16

16

8
 STEP 2: Estimate levered beta and cost of equity for Disney at different debt levels
T-bond rate is 2.75%. Equity risk premium is 5.76%.

Levered Beta = 0.9239 (1 + (1- 0.361) (D/E))

Cost of equity = 2.75% + Levered beta * 5.76%

17

17

2. Estimate cost of debt for Disney at different debt levels

The Ratings Table for Large Manufacturing Firms (Market

cap > $ 5 billion)
You have the following information:
T. Bond rate =2.75%
Market Value of Disney = $137,839 million Interest rate= 2.75% + default spread

EBIT= $10,032 million Interest coverage ratio is Rating is Spread is Interest rate
> 8.50 Aaa/AAA 0.40% 3.15%
Depreciation=$2,485 million 6.5 – 8.5 Aa2/AA 0.70% 3.45%
5.5 – 6.5 A1/A+ 0.85% 3.60%
4.25 – 5.5 A2/A 1.00% 3.75%
At zero debt level, what is the rating of the company? 3 – 4.25 A3/A- 1.30% 4.05%
2.5 -3 Baa2/BBB 2.00% 4.75%
Interest expense= $0 2.25 –2.5 Ba1/BB+ 3.00% 5.75%
2 – 2.25 Ba2/BB 4.00% 6.75%
Interest coverage ratio = EBIT / Interest expense = ∞ 1.75 -2 B1/B+ 5.50% 8.25%
1.5 – 1.75 B2/B 6.50% 9.25%
Likely rating= AAA
1.25 -1.5 B3/B- 7.25% 10.00%
Pre-tax cost of debt= 2.75%+0.40%= 3.15% 0.8 -1.25 Caa/CCC 8.75% 11.50%
0.65 – 0.8 Ca2/CC 9.50% 12.25%
0.2 – 0.65 C2/C 10.50% 13.25%
<0.2 D2/D 12.00% 14.75%
18

18

9
 Iteration – Cost of Debt
Iteration 1 (Debt at AAA Iteration 2 (Debt at AA
Rating) Rating)
Debt/(Debt + Equity) 30% 30%
Debt / Equity 30/70 = 42.86%
$ Debt 0.30 * $137,839 = $41,352
EBIT $10,032
Interest Expense $41,352*0.0315 = $1,302 $41,352*0.0345 = $1,427
Interest Coverage Ratio $10,032/$1,302 = 7.7 $10,032/$1,427 = 7.03
Likely Rating AA AA
Pretax Cost of Debt 2.75% + 0.70% = 3.45% 2.75% + 0.70% = 3.45%

Market Value of Disney = $137,839 million

EBIT stays the same 19

19

Cost of Debt after Iterations

Interest expenses above the EBIT of $10,032 million are tax deductible only to the level of $10,032

Maximum Tax Benefit = EBIT * Marginal Tax Rate = $10,032 million * 0.361 = $ 3,622 million
Adjusted Marginal Tax Rate = Maximum Tax Benefit/Interest Expenses = $3,622/$11,096 = 32.64%

20

20

10
 3. Estimate cost of capital for Disney at different debt levels and find
the optimal
Optimal ratio is 40%.

21

21

Disney: Cost of Capital Chart and Optimal

As a manager, pick the

optimal debt ratio of 40%!

Source: Aswath Damodaran

22

22

11
 What does Cost of Capital Approach Tell Disney to
Do?
• Disney currently has $15.96 billion in debt. The optimal dollar debt (at 40%) is
roughly $55.1 billion.
• Excess debt capacity = $55.1 bio - $15.96 bio = $39.14 billion.
• To move to its optimal, Disney should borrow $ 39.14 billion and buy back stock.
QUESTIONS
A. Why should we do it?
B. What if something goes wrong?
C. What if we don’t want (or cannot) buyback stock and we want to make
additional investments with the excess debt capacity?

23

23

A. Why? Effect on Value (Incremental Approach)

• We isolate the effect of changing the capital structure on the cash flow and the resulting value.
Market Value of Disney is $137,839 mio and cash is $3,931 mio. At the current debt level of $15,961 mio,
Disney has cost of capital of 7.81%. Assume Disney has a constant growth of 2.75% (consistent with risk
free rate) in perpetuity. What is the value of Disney if it moves to its optimal WACC of 7.16%?
Enterprise Value before the change = MV of Disney – Cash = $137,839 mio - $3,931 mio = $133,908 million

Cost of financing Disney at existing debt ratio = $ 133,908 mio * 0.0781 = $10,458 million
Cost of financing Disney at optimal debt ratio = $ 133,908 mio * 0.0716 = $ 9,592 million
Annual savings in cost of financing = $10,458 million – $9,592 million = $866 million

Annual Savings next year $866

Increase in Value= = = $19, 623 million
(Cost of Capital - g) (0.0716 - 0.0275)

Enterprise value after recapitalization = Existing enterprise value + PV of Savings

= $133,908 + $19,623 = $153,531 million 24

24

12
 A. What Price Should Disney Pay to Buyback?
What is the maximum price they should pay to buy back the stocks?
• Given that Disney has total number of shares outstanding of 1,800 million and Disney is
currently trading at $67.71:
• Increase in Value per Share = $19,623/1800 = $ 10.90
• New Stock Price = $67.71 + $10.90= $78.61
• Disney should buy back @ $78.61 (it leaves investors indifferent between selling back
their shares and holding on to them).
• If Disney buys back @ less than $78.61 (the remaining shareholders, who do not sell, will
be better off than the ones selling their shares).
• If Disney buys back @ more than $78.61 (the remaining shareholders, who do not sell,
will be worse off than the ones selling their shares).

25

25

What if buy shares back

What if buy shares back at at the fair price
the old price ($67.71)? ($78.61)?
1. Compute # of shares outstanding after buyback: 1. Compute # of shares outstanding after buyback:
Debt issued = $ 55,136 - $15,961 = $39,175 Debt issued = $ 55,136 - $15,961 = $39,175
# Shares = 1800 - $39,175/$67.71 = 1221.43 # Shares = 1800 - $39,175/$78.61 = 1301.65
2. Compute equity value after buyback: 2. Compute equity value after buyback:
@ optimal debt level, enterprise value = $153,531 @ optimal debt level, enterprise value = $153,531
Equity value after buyback = EV+ cash – debt@optimal Equity value after buyback = EV+ cash – debt@optimal
= $153,531 + $3,931– $55,136 = $102,326 = $153,531 + $3,931– $55,136 = $102,326
3. Compute value of shares after buyback 3. Compute value of shares after buyback
Value per share after buyback = $102,326/1221.43 = Value per share after buyback = $102,326/1301.65=
$83.78 (remaining shareholders are better off) $78.61 (remaining shareholders are equally well of as the
ones selling)

26

26

13
 B. What if Something Goes Wrong? Downside Risk
A) “What If” Analysis: Look at history of the company and see what a bad year looks like.
üFocus on the downside and decide whether your optimal ratio is still valid for the
downside.
• EXAMPLE: If the worst year for Disney had been a 30% drop in its EBIT, what debt level
will you target for Disney? Based on prior example, at an EBIT of $10,032 for Disney, 40%
was the optimal debt ratio.

27

27

B. What if Something Goes Wrong? Downside Risk

B) “Economic Scenario” Analysis: Develop possible scenarios (boom economy,

regular economy, recession)

C) Constraint on Bond Ratings: Management specifies a “desired rating” below

which they do not want to fall.
üPutting this constraint could reduce the exposure to downside risk.
üEvery rating constraint has a cost.
vThe cost of a rating constraint is the difference between the
unconstrained value and the value of the firm with the constraint.

28

28

14
 B. What if Something Goes Wrong? Downside Risk
Disney Example: Constraint on Bond Ratings: At its optimal debt ratio of 40%, Disney
has an estimated rating of A.
• If managers insisted on a AA rating, the optimal debt ratio for Disney is then 30% and the
cost of the ratings constraint is :
Cost of AA Rating Constraint = Value at 40% Debt – Value at 30% Debt
= $153,531 m – $147,937 m = $ 5,594 million
• If managers insisted on a AAA rating, the optimal debt ratio would drop to 20% and the
cost of the ratings constraint would rise:
Cost of AAA rating constraint = Value at 40% Debt – Value at 20% Debt
= $153,531 m – $141,452 m = $ 12,079 million
• Given the tradeoff in optimal debt ratio, your company is worth more as a single A
rated company than a AA or AAA rated company. 29

29

C. What if company does not buy back stock?

• The optimal debt ratio is ultimately a function of the underlying riskiness of the
business in which company operates and company’s tax rate.
• Will the optimal be different if you invested in projects instead of buying back
stock?
üNo. As long as the projects financed are in the same business mix that the
company has always been in and company tax rate does not change
significantly.
üYes, if the projects are in entirely different types of businesses or if the tax
rate is significantly different.

30

30

15
 Limitations of the Cost of Capital approach

• The most critical number in the entire analysis is the operating income (EBIT).
üIf EBIT changes, the optimal debt ratio will change.
• The EBIT is assumed to stay fixed as the debt ratio and the bond rating changes.
üIn effect, it ignores indirect bankruptcy costs and overestimates the optimal
debt ratio.

31

31

2. Enhanced Cost of Capital Approach

• In the enhanced cost of capital approach, the indirect costs of bankruptcy are built
into the expected operating income (EBIT).
üRather than look at a single number for operating income, you adjust the operating
income to a company’s bond rating. We quantify how much the operating income
would decline if a bond rating declines from AA to A or from A to BBBB.
üAcross sectors, the effect of distress on operating income will vary based on how
customers, suppliers, and employees react to the perception of default risk.
vIt is higher for firms that produce long lived assets (customers are dependent on long
term service or equipment parts such as automobile sector)
• We modify the cost of capital approach and we look for the debt ratio that delivers
the highest value rather than looking for the debt ratio that minimizes WACC.
32

32

16
 Example – Estimating the Distress Effect on Disney
Rating Drop in EBITDA Drop in EBITDA Drop in EBITDA
(Low) (Medium) (High)
To A No effect No effect 2.00%
To A- No effect 2.00% 5.00%
To BBB 5.00% 10.00% 15.00%
To BB+ 10.00% 20.00% 25.00%
To B- 15.00% 25.00% 30.00%
To C 25.00% 40.00% 50.00%
To D 30.00% 50.00% 100.00%

• To derive the table, look at other firms in the same sector that got downgraded
and analyze changes in their EBIT in the next year.
33

33

Disney - Optimal Debt Ratio with Indirect Bankruptcy Costs

Cost of Bond Interest rate Cost of Debt Enterprise
Debt Ratio Beta Equity Rating on debt Tax Rate (after-tax) WACC Value
0% 0.9239 8.07% Aaa/AAA 3.15% 36.10% 2.01% 8.07% $122,633
10% 0.9895 8.45% Aaa/AAA 3.15% 36.10% 2.01% 7.81% $134,020
20% 1.0715 8.92% Aaa/AAA 3.15% 36.10% 2.01% 7.54% $147,739
30% 1.1769 9.53% Aa2/AA 3.45% 36.10% 2.20% 7.33% $160,625
40% 1.3175 10.34% A2/A 3.75% 36.10% 2.40% 7.16% $172,933
50% 1.5573 11.72% Caa/CCC 11.50% 31.44% 7.88% 9.80% $35,782
60% 1.9946 14.24% C2/C 13.25% 22.74% 10.24% 11.84% $25,219
70% 2.6594 18.07% C2/C 13.25% 19.49% 10.67% 12.89% $21,886
80% 3.9892 25.73% C2/C 13.25% 17.05% 10.99% 13.94% $19,331
90% 7.9783 48.72% C2/C 13.25% 15.16% 11.24% 14.99% $17,311

• The optimal debt ratio stays at 40% but the cliff becomes much steeper.
üNeed a buffer! Pick a capital structure below 40% debt (30% or 35% debt ratio)
• Bankruptcy cost is embedded into the beta of equity computation through beta of debt.
• Interest coverage ratio is re-adjusted with the decline in EBIT. Then, the bond rating is recomputed
with the re-adjusted interest coverage ratio. With the decline in rating, cost of debt increases.
34

34

17
 Determinants of optimal debt ratios
• Lower operating income, as a percent of firm value, makes it difficult to make debt payments. Thus, the optimal
debt ratio will be lower
• Firms with greater uncertainty in operations (higher variance in operating income) will have lower optimal debt
ratio than firms with more predictable operations.
ü Higher variance results in higher unlevered beta (higher cost of equity and higher WACC), pushing lower
debt usage.
ü Ratings drop off and bankruptcy probability increases with higher variance, pushing lower debt usage.
• The lower the marginal tax rate, the lower the tax benefit, and the lower the optimal debt ratio. With the U.S.
Tax Reform Act of 2017:
ü The marginal federal tax rate for US companies on US income has been lowered from 35% to 21%,
resulting in a decline in tax savings.
ü Companies can deduct interest expenses only up to 30% of EBITDA (until 2022) and 30% of EBIT (after
2022). This adds a constraint to the tax savings from debt and lowers the marginal tax rate.

35

35

Some Applications
• Cyclical and commodity firms
ü cyclical firms during recessions will have lower optimal debt ratios.
ü commodity firms with declining commodity prices will have lower optimal debt ratios.
ü It is better to normalize the earnings during those periods.
• When a company is part of a family group, its optimal structure can be skewed by the health of the
family group of companies
ü A distressed company that is part of a healthy family group of companies may borrow at a lower
rate than an otherwise similar standalone company and would have higher optimal debt ratio.
ü A healthy company that is part of a distressed group may borrow at a higher rate than an
otherwise similar standalone company and would have lower optimal debt ratio.
• Young and high growth companies have a lower debt ratio.

36

36

18
 3. Adjusted Present Value (APV) Approach
Tax shield
• Based on APV approach, Value of Business
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 + 𝑇𝑎𝑥 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑜𝑓 𝐷𝑒𝑏𝑡 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐵𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑐𝑦 𝐶𝑜𝑠𝑡 𝑓𝑟𝑜𝑚 𝐷𝑒𝑏𝑡

• Optimal debt level is the one that maximizes firm value and expressed as $ value
rather than debt ratio.
• APV is preferred over cost of capital approach when debt ratio changes frequently.
üWACC approach reflects the tax shield of debt in rd (1-t) and bankruptcy costs in
cost of equity and pre-tax cost of debt.
• Many analysis ignore the expected bankruptcy cost because it is difficult to estimate
it. This leads them to conclude firm value increases as firm borrows money and
optimal debt ratio is 100% debt.
37

37

Implementing the APV Approach

• Step 1: Estimate the unlevered firm value. How?

üEstimate the cost of equity based on the unlevered beta and discount the expected cash
flows using this cost of equity (which is also the cost of capital for an unlevered firm)
üAlternatively, back out the unlevered firm value from the market value of the firm
Unlevered Firm Value = Current Market Value of Firm - Tax Benefits of Current Debt +
Expected Bankruptcy cost from Current Debt
• Step 2: Estimate the tax benefits at each debt level. If we assume the savings are perpetual:
Tax benefits = (Dollar Debt * Interest Rate * Tax Rate) / Interest Rate
üTax Benefits = Dollar Debt * Tax rate

38

38

19
 Implementing the APV Approach

• Step 3: Estimate the expected bankruptcy cost by multiplying probability of

bankruptcy at each debt level with the cost of bankruptcy (including both direct and
indirect costs)
üEstimate probability of bankruptcy corresponding to either bond ratings or
synthetics rating (i.e. Altman default probabilities)
üBased on empirical studies, direct bankruptcy cost is generally between 5-10%
of firm value.
üIndirect bankruptcy costs is tougher to estimate. It is higher for sectors where
customers are dependent on long term service or equipment parts.

39

39

Altman Default
Probabilities
Rating Likelihood of Default

AAA 0.07%
AA 0.51%
A+ 0.60%
A 0.66%
Altman estimated these
A- 2.50% probabilities by looking at bonds in
BBB 7.54% each ratings class ten years prior
BB 16.63% and then examining the proportion
B+ 25.00% of these bonds that defaulted over
B 36.80% the ten years.
B- 45.00%
CCC 59.01%
CC 70.00%
C 85.00%
D 100.00%
40

40

20
 Example on APV Approach - Disney

Use the APV approach to estimate the value of unlevered firm for Disney. The current
market value of equity for Disney is $121,878 million and the current debt level is $15,961
million. The marginal tax rate for Disney is 36.1%. The interest payment on debt constitutes
a perpetuity. Based on Disney’s current rating of A, the probability of bankruptcy is 0.66%
(Altman’s probability of default). Bankruptcy cost is 25% of firm value.

Current Value of firm = $121,878+ $15,961 = $ 137,839

- Tax Benefit on Current Debt = $15,961 * 0.361 =$ 5,762
+ Expected Bankruptcy Cost = 0.66% * (0.25 * 137,839) = $ 227
Unlevered Value of Firm = $ 132,304
41

41

Disney: APV at Debt Ratios

• What is the value of Disney at a debt ratio of 20% of current market value of firm ($27,568 million), an
expected rating of AAA and tax rate of 36.1%? You are given the following Altman default probabilities; AAA:
0.07%; AA: 0.51%; A+: 0.60%; A: 0.66%; A-: 2.50%; BBB: 7.54%; BB: 16.63%
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 + 𝑇𝑎𝑥 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑜𝑓 𝐷𝑒𝑏𝑡 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐵𝑎𝑛𝑘𝑟𝑢𝑝𝑡𝑐𝑦 𝐶𝑜𝑠𝑡 𝑓𝑟𝑜𝑚 𝐷𝑒𝑏𝑡
= 132,304 + 0.361 ∗ 27,568 − 0.0007 ∗ 0.25 ∗ 132,304 + (0.361 ∗ 27,568) = $142,231

Unlevered Probability of Expected Value of

Debt Ratio $ Debt Tax Rate Firm Value Tax Benefits Bond Rating Default Bankruptcy Cost Levered Firm
0% $0 36.10% $132,304 $0 AAA 0.07% $23 $132,281
10% $13,784 36.10% $132,304 $4,976 Aaa/AAA 0.07% $24 $137,256
20% $27,568 36.10% $132,304 $9,952 Aaa/AAA 0.07% $25 $142,231
30% $41,352 36.10% $132,304 $14,928 Aa2/AA 0.51% $188 $147,045
40% $55,136 36.10% $132,304 $19,904 A2/A 0.66% $251 $151,957
50% $68,919 36.10% $132,304 $24,880 B3/B- 45.00% $17,683 $139,501
60% $82,703 36.10% $132,304 $29,856 C2/C 59.01% $23,923 $138,238
70% $96,487 32.64% $132,304 $31,491 C2/C 59.01% $24,164 $139,631
80% $110,271 26.81% $132,304 $29,563 Ca2/CC 70.00% $28,327 $133,540
90% $124,055 22.03% $132,304 $27,332 Caa/CCC 85.00% $33,923 $125,713

The optimal debt ratio is 40%, which is the point at which firm value is maximized. 42

42

21
 4. Relative Analysis

• Pick a debt ratio that is close to the industry average

• Take industry average as your basis and adjust it based on the below firm
characteristics, to arrive at the right debt ratio.
üHigher tax rates -> Higher debt ratios (Tax benefits)
üLower insider ownership -> Higher debt ratios (Greater discipline)
üMore stable income -> Higher debt ratios (Lower bankruptcy costs)
üMore intangible assets -> Lower debt ratios (More agency problems)

43

43

How can we Apply Relative Analysis?

• Look at the determinants of Debt to Capital ratio using “regression”. For instance,
Debt Ratio = a + b (Tax rate) + c (Earnings Variability) + d (EBITDA/Firm Value)
üCheck this regression for statistical significance (t statistics)
• Regression is applied to the historical data of other companies either in the same
sector as the firm is in or in the entire market.
• Estimate the predicted debt ratio by plugging into the regression outcome the
characteristics of the company you are analyzing.
• Compare the actual debt ratio to the predicted debt ratio to see whether the
company is over or under levered.

44

44

22
 Question - Disney
• Using 2014 data for US listed firms, we looked at the determinants of the market debt to capital ratio.
The regression provides the following results
DFR = 0.27 + 0.24 ETR – 0.10 g + 0.065 INST – 0.338 CVOI + 0.59 E/V
(15.79) (9.00) (2.71) (3.55) (3.10) (6.85)

DFR = Debt / ( Debt + Market Value of Equity)

ETR = Effective tax rate in most recent twelve months (tax benefit)
g = Revenue growth (expected growth possibilities and need for flexibility)
INST = % of Shares held by institutions (discipline from debt)
CVOI = Std dev in OI in last 10 years/ Average OI in last 10 years (business uncertainty ---bankruptcy
risk)
E/V = EBITDA/ (Market Value of Equity + Debt- Cash) (cash flows and ability to make debt payments)

45

45

Question - Disney
• If Disney has the following values for these inputs, what is the optimal debt ratio using
the debt regression?
Effective Tax Rate (ETR) = 31.02%
Expected Revenue Growth = 6.45%
Institutional Holding % (INST) = 70.2%
Coefficient of Variation in OI (CVOI) = 0.0296
EBITDA/Value of firm (E/V) = 9.35%

• What does this optimal debt ratio tell you if Disney’s actual debt ratio is 12%?

46

46

23