Question

Can anyone help me with Damodaran's Optimal Capital Structure explanation? When moving to an optimal WACC by increasing debt, an increase in Firm Value is achieved. However, the increased debt amount seems higher than any increase in Firm Value derived from a lower WACC. Doesn't this result in a lower overall equity value? I can't seem to justify the increased value with an even larger increase in debt.

Answer 1

Hi

Remember, when optimizing the captial structure of an under-leveraged firm, there are potentially 3 ways to increase D / (D+E) :
- Increase the D, without buyback of Equity (balance sheet goes up, assets goes up, presumably on postive NPV projects / assets)
- Increase the D and reduce the Equity at the same time, buy doing a share buyback with the proceeds of debt (balance sheet roughly the same overall size, assets unchanged).
- Shrink the overall balance sheet by selling assets and redeeming Equity (without reducing the D)
Any of these methods can be used to leverage up a firm with a view to optimizing the capital structure, though they are different methods.

The benefit to the Firm Value comes from the tax shield of debt. How this benefit is apportioned between D and E is a financing question.

Which of the 3 scenarios are you interested in, for your question ?

Answer 2

And... yes even if the overall value of equity goes down, the per-share market value of equity could go up in the cases where management do a share buy-back (fewer outstanding shares).

Answer 3

Hi Edward,

Thank you for your response. The scenario I'm referring to is the recapitalization (i.e. a share buyback with the balance sheet remaining the same size).

I'm just struggling to understand that although the per share value increases, is it an issue that the overall value of equity reduces? Maybe I need to undertake a little more research on the mechanics of a share buyback.

Again, thank you kindly for your reply.

Leon

Answer 4

Hi
In my mind it doesn't really matter that the Equity value decreases as the Firm Value increases in this re-leveraging / optimization of the capital structure.
The choice of Equity and Debt on the Liability side of the Balance sheet is a financing question. By increasing D : (D + E) we are reducing the wacc by exploiting the tax shield of debt.
Consider also that even though the Equity value decreased, the equity risk is increased and the potential rewards to the equity are also increased (due to leverage). Let me illustrate:
Firm A) has $5M of Equity and $5M of debt and a Enterprise Value of $10M. This goes up to $12M in year 2.
Firm B) leveraged up, it has $2M of Equity and $8M of debt, and an Enterprise value of $10M. This goes up to $12M in year 2.
The return on equity in Firm A is 40%, but the return on equity in Firm B is magnified, it's 100%. (Of course if the prospects had worsened, Firm B is more likely to go insolvent - it's riskier).

does that help?

I think also we need someone more knowledgeable in "Damodaran's Optimal Capital Structure" to opine on this, since I haven't read through that carefully.

Answer 5

(in the example, to keep it simple I kept both A) and B) at the same Enterprise value - of course the financing optimization should incease the Enterprise Value of B somewhat compared to A).

Answer 6

Hi Edward. I have just returned to Open Study after a long period of inactivity. I was reading our discussion above and wanted to follow up with another question.

In optimizing the capital structure, what if a firm simply recapitalizes by borrowing money and paying out a special dividend, simply to obtain an optimal WACC? In this scenario, the firm will lower its WACC, but the number of shares stays the same. There are no new projects to invest in. The Firm has simply altered its capital structure to the optimal by increasing debt and paying dividends with the cash used to reduce equity- and hence, optimize the capital structure.

I saw an example where increasing debt, by say $10m, and paying out dividends lowers WACC to a point where value is increased by $2m. Given that there's no share buyback, the shares outstanding stays the same. So, my question is, how is the $10 debt increase for only $2m Firm Value increase justified? Is it because there's a more efficient level of equity on the balance sheet now (after being reduced) earning a higher ROE, and this makes the equity more 'valuable' in this respect?

Any thoughts on this scenario of simply increasing debt and paying out dividends to move to an optimal, without reducing the number of shares?