5.13 The Importance of Capital Structure in the Firm’s Valuation

We have demonstrated that leverage affects EPS and ROE; it should not be a tall order to connect these data with the firm’s valuation via the dividend discount model or some alternate rubric. However, we have not been able to answer (universally) what the optimal firm leverage ought to be. We know that too much leverage increases default risk; that is not good. We also know that too little leverage does not offer favorable results in terms of increases in EPS and ROE – and share price!

We also know that if EBIT is expected to come in to the right of the crossover point that some degree is leverage is warranted. That still does not inform us how much leverage we should take. It turns out, once again, that the degree of leverage a firm chooses depends on four qualitative factors.

Much will depend on industry characteristics, including the stability of the industry’s operating cash flows, which go to paying debt. For example, electric utility companies have captive and regular customers, and hence very stable operating earnings; these companies can tolerate high debt levels, which they need to finance costly power plants and thus will manifest “thin” TIE ratios.

Still more depends on management’s risk profile.  Can management tolerate aggressive solvency ratios in the pursuit of higher earnings? What about shareholders? If the company’s leverage is too aggressive, or not aggressive enough, will shareholders sell, and subsequently buy shares in companies more suited to their respective personal risk profiles?

We may also ask whether leverage indeed matters at all? Must capital structure match the investor’s personal risk profile and, if not, does capital structure really matter at all to a firm’s worth?  (Initially, we may think that leverage matters, because it affects the firm’s WACC, its bonds’ respective yields, its equity capital costs, and thus, via the numerous valuation models the firm’s very worth!)

It can be shown, however, that an individual himself can emulate, in his investment portfolio, the capital structure of a company in which s/he is invested, by borrowing (or lending) money within his personal portfolio. For example, an individual may purchase stock in an un-leveraged company (i.e., a company with no debt, or 100% equity) and leverage his investment by buying the stock on margin. “Buying on Margin” means paying for as little as half the cost and borrowing the rest from one’s stockbroker.

After accounting for the cost of borrowing (i.e., interest), but ignoring taxes, it will be shown that the earnings to the investor are the same. It will also be assumed that the investor’s marginal borrowing rate is the same as the corporation’s.) If so, arguably, leverage may not matter; the investor can create his/her own leverage, the result of which is the same EPS and ROE, and hence value (or valuation), to the shareholder! We’ll see all this soon!


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Corporate Finance Copyright © 2023 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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