1                                        Chapter 12 Part 2  Determining the Financing Mix                              Lec...
2Learning Objectives  Understand the concept of an optimal capital structure.  Explain the main underpinnings of capital...
3Planning the Firm’s Financial MixFinancial Structure and Capital Structure  Financial structure is the mix of all source...
4Planning the Firm’s Financial MixFinancial Structure and Capital Structure  Financial structure is the mix of all source...
5Planning the Firm’s Financial MixFinancial Structure and Capital Structure  Financial structure is the mix of all source...
6Capital Structure Theories  Choose capital structure that minimizes cost of capital   which in turn maximizes stock price
7Capital Structure Theories  Choose capital structure that minimizes cost of capital   which in turn maximizes stock pric...
8Capital Structure Theories  Choose capital structure that minimizes cost of capital   which in turn maximizes stock pric...
9Capital Structure Theories  Choose capital structure that minimizes cost of capital   which in turn maximizes stock pric...
10Capital Structure TheoriesModerate Position  Interest is tax deductible  The use of financial leverage increases the l...
11Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
12Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
13Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
14Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
15Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
16Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
17Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
18Agency Costs and Capital Structure Agency problems arise when management does not  work in the best interests of the cr...
19Capital StructureBasic Tools of Capital Structure Management  The use of financial leverage increases variability of   ...
20Capital StructureBasic Tools of Capital Structure Management  The use of financial leverage increases variability of   ...
21Capital StructureBasic Tools of Capital Structure Management  The use of financial leverage increases variability of   ...
22Capital StructureBasic Tools of Capital Structure Management  The use of financial leverage increases variability of   ...
23EBIT-EPS Analysis Compute EBIT at which EPS will be the same  regardless of financing plan
24EBIT-EPS Analysis Compute EBIT at which EPS will be the same  regardless of financing plan Set EPS for each plan equal...
25EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or st...
26EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or st...
27EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or st...
28EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or st...
29EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or st...
30EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or st...
31Capital Structure in Practice  The majority of financial officers believe there is an   optimal capital structure for t...
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Capital structure

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Capital structure

  1. 1. 1 Chapter 12 Part 2 Determining the Financing Mix Lecture Notes© 1996, Prentice Hall, Inc.
  2. 2. 2Learning Objectives  Understand the concept of an optimal capital structure.  Explain the main underpinnings of capital structure theory.  Distinguish between the independence hypothesis and dependence hypothesis as these concepts relate to capital structure theory theory, and identify the Nobel prize winners in economics who are leading proponents of the independence hypothesis.  Understand and be able to graph the moderate position on capital structure importance.  Incorporate the concepts of agency costs and free cash flow into a discussion on capital structure management.  Use the basic tools of capital structure management.  Familiarize others with corporate financing policies in practice.
  3. 3. 3Planning the Firm’s Financial MixFinancial Structure and Capital Structure Financial structure is the mix of all sources of financing used by the firm Balance Sheet Assets Liabilities Current Liabilities Long Term Liabilities Financial Structure Equity Total Assets
  4. 4. 4Planning the Firm’s Financial MixFinancial Structure and Capital Structure Financial structure is the mix of all sources of financing used by the firm Capital structure is the mix of the long term sources of funds Balance Sheet Assets Liabilities Current Liabilities Long Term Liabilities Capital Structure Equity Total Assets
  5. 5. 5Planning the Firm’s Financial MixFinancial Structure and Capital Structure Financial structure is the mix of all sources of financing used by the firm Capital structure is the mix of the long term sources of funds Capital structure is the focus of this chapter, so current liabilities will not be included. Balance Sheet Assets Liabilities Current Liabilities Long Term Liabilities Capital Structure Equity Total Assets
  6. 6. 6Capital Structure Theories Choose capital structure that minimizes cost of capital which in turn maximizes stock price
  7. 7. 7Capital Structure Theories Choose capital structure that minimizes cost of capital which in turn maximizes stock price There are three theories on choosing the optimal capital structure Independence Theory Dependence Theory Moderate Theory
  8. 8. 8Capital Structure Theories Choose capital structure that minimizes cost of capital which in turn maximizes stock price There are three theories on choosing the optimal capital structure Independence Theory Dependence Theory Moderate Theory For all theories, will use a simple valuation model: D where: P0 = price of stock P0 = kc D = constant dividend Kc = cost of equity capital
  9. 9. 9Capital Structure Theories Choose capital structure that minimizes cost of capital which in turn maximizes stock price There are three theories on choosing the optimal capital structure Independence Theory Dependence Theory Moderate Theory For all theories, will use a simple valuation model: D where: P0 = price of stock P0 = kc D = constant dividend Kc = cost of equity capital If all earnings paid as dividends, so there is no growth: D EPS where: EPS = Earnings per share P0 = kc = kc
  10. 10. 10Capital Structure TheoriesModerate Position Interest is tax deductible The use of financial leverage increases the likelihood of bankruptcy. The costs of equity and debt rise causing a “saucer- shaped” cost of capital function. Firms should choose financial leverage with lowest cost of capital Capital kc Costs kO kd Financial Leverage
  11. 11. 11Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors.
  12. 12. 12Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors. Firms incur agency costs such as paying for outside monitors to reassure creditors.
  13. 13. 13Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors. Firms incur agency costs such as paying for outside monitors to reassure creditors. The higher the leverage, the higher the agency costs. Firm Value Financial Leverage
  14. 14. 14Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors. Firms incur agency costs such as paying for outside monitors to reassure creditors. The higher the leverage, the higher the agency costs. Firm Value Value of Unlevered Firm Financial Leverage
  15. 15. 15Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors. Firms incur agency costs such as paying for outside monitors to reassure creditors. The higher the leverage, the higher the agency costs. Firm Value eT heory en denc ed Firm I ndep f Lever o Value Financial Leverage
  16. 16. 16Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors. Firms incur agency costs such as paying for outside monitors to reassure creditors. The higher the leverage, the higher the agency costs. Firm Value eT heory en denc ed Firm I ndep f Lever o Value PV of Tax Shields Financial Leverage
  17. 17. 17Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors. Firms incur agency costs such as paying for outside monitors to reassure creditors. The higher the leverage, the higher the agency costs. Firm Value eT heory en denc ed Firm I ndep f Lever o Value Actual Value of the Firm Financial Leverage
  18. 18. 18Agency Costs and Capital Structure Agency problems arise when management does not work in the best interests of the creditors. Firms incur agency costs such as paying for outside monitors to reassure creditors. The higher the leverage, the higher the agency costs. Firm Value eT heory en denc ed Firm ndep f Lever PV of Agency and I Value o } Bankruptcy Costs Actual Value of the Firm Financial Leverage
  19. 19. 19Capital StructureBasic Tools of Capital Structure Management The use of financial leverage increases variability of EPS (as seen by DFL in Chapter 13)
  20. 20. 20Capital StructureBasic Tools of Capital Structure Management The use of financial leverage increases variability of EPS (as seen by DFL in Chapter 13) The use of financial leverage also changes EPS at any given EBIT.
  21. 21. 21Capital StructureBasic Tools of Capital Structure Management The use of financial leverage increases variability of EPS (as seen by DFL in Chapter 13) The use of financial leverage also changes EPS at any given EBIT. EBIT-EPS Analysis Graphically demonstrates the impact of leverage on EPS at different levels of EBIT. EPS 50% Leverage 40% Leverage EBIT
  22. 22. 22Capital StructureBasic Tools of Capital Structure Management The use of financial leverage increases variability of EPS (as seen by DFL in Chapter 13) The use of financial leverage also changes EPS at any given EBIT. EBIT-EPS Analysis Graphically demonstrates the impact of leverage on EPS at different levels of EBIT. EPS 50% Leverage 40% Leverage Indifference Point EBIT
  23. 23. 23EBIT-EPS Analysis Compute EBIT at which EPS will be the same regardless of financing plan
  24. 24. 24EBIT-EPS Analysis Compute EBIT at which EPS will be the same regardless of financing plan Set EPS for each plan equal to each otherAt the EBIT indifference level: EPS50% debt = EPS40% debt (EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t) = S50% S40% where: I = Interest cost of plan S = # of shares of plan
  25. 25. 25EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or stock at $10/share. Tax rate = 40%
  26. 26. 26EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or stock at $10/share. Tax rate = 40%At the EBIT indifference level: EPS50% debt = EPS40% debt (EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t) = S50% S40%
  27. 27. 27EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or stock at $10/share. Tax rate = 40%At the EBIT indifference level: EPS50% debt = EPS40% debt (EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t) = S50% S40% I = $500,000 x 8% = $40,000 S = $500,000/$10 = 50,000
  28. 28. 28EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or stock at $10/share. Tax rate = 40%At the EBIT indifference level: EPS50% debt = EPS40% debt (EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t) = S50% S40% I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000 S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000
  29. 29. 29EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or stock at $10/share. Tax rate = 40%At the EBIT indifference level: EPS50% debt = EPS40% debt (EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t) = S50% S40% I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000 S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000 (EBIT - $40,000)(1 - .40) (EBIT - $32,000)(1 - .40) = 50,000 60,000
  30. 30. 30EBIT-EPS Analysis Example: $1 million of financing are currently needed. Can raise the money with debt costing 8%, or stock at $10/share. Tax rate = 40%At the EBIT indifference level: EPS50% debt = EPS40% debt (EBIT - I50%)(1 - t) (EBIT - I40%)(1 - t) = S50% S40% I = $500,000 x 8% = $40,000 I = $400,000 x 8% = $32,000 S = $500,000/$10 = 50,000 S = $600,000/$10 = 60,000 (EBIT - $40,000)(1 - .40) (EBIT - $32,000)(1 - .40) = 50,000 60,000 Solve for EBIT: EBIT = $80,000
  31. 31. 31Capital Structure in Practice The majority of financial officers believe there is an optimal capital structure for their company. Managers adapt financial leverage to the business cycle, taking advantage of debt when it is less expensive. The most important factor in determining leverage is a firm’s business risk. Managers’ optimal choice to finance new projects is to use retained earnings. Only after internal funds are exhausted, managers’ choice of leverage is consistent with the Moderate Theory of financial leverage.
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