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HOW CHANGING CAPITAL STRUCTURE AFFECTS EXPECTED RETURNS

We will illustrate how changes in capital structure affect expected returns by focusing on the simplest possible case, where the corporate tax rate Tc is zero. Think back to our earlier example of Geothermal. Geothermal, you may remember, has the following market-value balance sheet:

Geothermal`s debtholders require a return of 8 percent and the shareholders require a return of 14 percent. Since we assume here that Geothermal pays no corporate tax, its weighted-average cost of capital is simply the expected return on the firm`s assets:

WACC = rassets = (.3 ГЧ 8%) + (.7 ГЧ 14%) = 12.2%

This is the return you would expect if you held all Geothermal`s securities and therefore owned all its assets.

Now think what will happen if Geothermal borrows an additional $97 million and uses the cash to buy back and retire $97 million of its common stock. The revised market- value balance sheet is

If there are no corporate taxes, the change in capital structure does not affect the total cash that Geothermal pays out to its security holders and it does not affect the risk of those cash flows. Therefore, if investors require a return of 12.2 percent on the total package of debt and equity before the financing, they must require the same 12.2 percent return on the package afterward. The weighted-average cost of capital is therefore unaffected by the change in the capital structure.

Although the required return on the package of the debt and equity is unaffected, the change in capital structure does affect the required return on the individual securities. Since the company has more debt than before, the debt is riskier and debtholders are likely to demand a higher return. Increasing the amount of debt also makes the equity riskier and increases the return that shareholders require.

WHAT HAPPENS WHEN THE CORPORATE TAX RATE IS NOT ZERO

We have shown that when there are no corporate taxes the weighted-average cost of capital is unaffected by a change in capital structure. Unfortunately, taxes can complicate the picture.7 For the moment, just remember

The weighted-average cost of capital is the right discount rate for average risk capital investment projects.

The weighted-average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders.

If the firm increases its debt ratio, both the debt and the equity will become more risky. The debtholders and equity holders require a higher return to compensate for the increased risk.

There`s nothing wrong with our formulas and examples, provided that the tax deductibility of interest payments doesn`t change the aggregate risk of the debt and equity investors. However, if the tax savings from deducting interest are treated as safe cash flows, the formulas get more complicated. If you really want to dive into the tax-adjusted formulas showing how WACC changes with capital structure, we suggest later in R. A. Brealey and S. C. Myers, Principles of Corporate Finance, 6th ed. (New York: Irwin/McGraw-Hill, 2000).