Reading: Adjusting the Capital Structure

Let us now consider the unlevered firm from the previous section. Remember that the firm generates an annual EBIT of 600, is exposed to a tax rate of 35%, and consequently earns an operating net income (NOPLAT) of 390.

Current valuation

Given our assumptions (investments equal depreciation charges; no changes in the net working capital), this operating net income also corresponds to the cash flow the firm generates for its providers of capital, the so-called free cash flow. We have also seen that the firm's overall cost of capital (k_A) is 12%. Based on this information, we have derived an unlevered value of the firm (V_U) of 3'250 [= 390/0.12]. Since the firm has no debt outstanding, this 3'250 is also the equity value of the company. With 500 shares outstanding, the current stock price is 6.5 [= 3'250/500]. 

Adjusting the capital structure

Now suppose the firm wants to change its capital structure to achieve the same tax benefits as the levered firm from before.

• We assume that it can borrow 2'500 at a (pre-tax) cost of debt (k_D) of 10%.
• We also assume, for the moment, that the firm will keep the amount of debt outstanding constant at 2'500 (target debt level), so that the riskiness of the future interest tax savings is comparable to that of the firm's debt.
• To make sure the firm's activities do not change, the firm will not retain the proceeds of the debt financing. Instead, it will pay them out to the shareholders.

In the sequence of events, three points in time are now relevant for our analysis:

• Before the announcement: This is the situation we have described above;

• Right after the announcement of the change in the financing policy;

• After the transaction has actually been carried out.

Announcing the levered recapitalization

Let's have a look at what happens when the firm announces that it will borrow 2'500 and return the proceeds to  shareholders. In what follows, we denote all variables that refer to time of the announcement with the prime modifier (') and all variables that reflect the situation after the recapitalization with the asterisks modifier (*).

• Upon the announcement of the recapitalization, shareholders learn that the firm's future tax burden will be reduced by 87.5 per year because of debt financing (i.e, 35% of the annual interest expenses of 250). Maintaining the assumption that the relevant discount rate for these tax savings is the cost of debt (k_D), the present value of these future tax savings is 875 (DTS'). Therefore, at the time of the announcement, the value of the company will increase by 875 to 4'125: 
   
  \( V_L' = V_U + DTS' = 3'250 + 875 = 4'125 \).  
   

• Note that, at the time of the announcement, the firm has not yet borrowed any money (D' = D = 0). It has simply announced that it will do so in the future. Consequently, the value of the equity at the time of the announcement corresponds to the firm value of 4'125: 

• Therefore, the share price increases from 6.5 to 8.25 at the time of the announcement: 

Put differently, the share price increases by 1.75, which is the value of the additional tax savings (875) divided by the firm's number of shares (500).

The following table summarizes the situation before and after the announcement of the recapitalization:

After the transaction

Now let's have a look how the picture changes when the firm actually carries out the transaction and borrows money to return it to its shareholders. We denote all variables that refer to the time after the transaction with the asterisks modifier (*). In principle, the payout to shareholders can take two forms: The firm can either pay a dividend or it can repurchase shares. Let's consider these alternatives separately.