Chapter 16 -  Planning the Firm’s Financing Mix    2005, Pearson Prentice Hall
<ul><li>Balance Sheet </li></ul><ul><li>Current  Current  </li></ul><ul><li>Assets  Liabilities </li></ul><ul><li>Debt  an...
<ul><li>Balance Sheet </li></ul><ul><li>Current  Current  </li></ul><ul><li>Assets  Liabilities </li></ul><ul><li>Debt  an...
<ul><li>Balance Sheet </li></ul><ul><li>Current  Current   </li></ul><ul><li>Assets   Liabilities </li></ul><ul><li>Debt  ...
<ul><li>Balance Sheet </li></ul><ul><li>Current  Current  </li></ul><ul><li>Assets  Liabilities </li></ul><ul><li>Debt  an...
<ul><li>Balance Sheet </li></ul><ul><li>Current  Current  </li></ul><ul><li>Assets  Liabilities </li></ul><ul><li>Debt   a...
Why is Capital Structure Important? <ul><li>1)  Leverage : Higher financial leverage means higher returns to stockholders,...
What is the Optimal Capital Structure? <ul><li>In a “perfect world” environment with no taxes, no transaction costs and pe...
Independence Hypothesis <ul><li>Firm value does not depend on capital structure. </li></ul>
<ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>$20 million capitalization </li></ul><ul><li>$8 million in debt issued to retire $8 million in equity. </li></ul><...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
<ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outs...
Independence Hypothesis Cost of Capital kc 0% debt  Financial Leverage  100% debt . kc = cost of equity kd = cost of debt ...
Independence Hypothesis . Cost of Capital kc kd kd 0% debt  Financial Leverage  100% debt
Independence Hypothesis . Cost of Capital kc kd kd 0% debt  Financial Leverage  100% debt
Independence Hypothesis Increasing leverage causes the cost of equity to rise. Cost of Capital kc kd kd 0% debt  Financial...
Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. 0% debt  Financ...
Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will  be t...
Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will  be t...
Independence Hypothesis kc kd Cost of Capital kc ko kd 0% debt  Financial Leverage  100% debt
<ul><li>If we have perfect capital markets,  capital structure is  irrelevant .  </li></ul><ul><li>In other words, changes...
Dependence Hypothesis <ul><li>Increasing leverage does not increase the cost of equity. </li></ul><ul><li>Since debt is le...
Dependence Hypothesis Since the cost of debt is lower than the cost of equity... Cost of Capital kc kd Financial Leverage ...
Dependence Hypothesis Since the cost of debt is lower than the cost of equity… increasing leverage reduces the cost of cap...
Moderate Position <ul><li>The previous hypothesis examines capital structure in a “perfect market.” </li></ul><ul><li>The ...
<ul><li>  unlevered   levered </li></ul><ul><li>EBIT 2,000,000   2,000,000 </li></ul><ul><li>- interest expense   0   (480...
Moderate Position Cost of Capital kc kd Financial Leverage kc kd
Moderate Position Cost of Capital kc kd Financial Leverage kc kd Even if the cost of equity rises as leverage increases, t...
Moderate Position Cost of Capital kc kd Financial Leverage kc kd because of the  tax benefit associated with debt financin...
Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debt  reduces the cost of  capital.
Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debt  reduces the cost of  capital. ko
Moderate Position <ul><li>So, what does the tax benefit of debt financing mean for the value of the firm? </li></ul><ul><l...
Why is 100% Debt Not Optimal? <ul><li>Bankruptcy costs : costs of financial distress. </li></ul><ul><li>Financing  becomes...
<ul><li>Agency costs : costs associated with protecting bondholders. </li></ul><ul><li>Bondholders  (principals) lend mone...
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kd
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kd
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd If a firm borrows too mu...
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko Ideally, a firm shoul...
Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko
Capital Structure Management <ul><li>EBIT-EPS Analysis  - Used to help determine whether it would be better to finance a p...
Capital Structure Management <ul><li>EBIT-EPS Analysis  - Used to help determine whether it would be better to finance a p...
Capital Structure Management <ul><li>EBIT-EPS Analysis  - Used to help determine whether it would be better to finance a p...
EBIT-EPS Example <ul><li>Our firm has  800,000  shares of common stock outstanding, no debt, and a marginal tax rate of  4...
If we expect EBIT to be $2,000,000: <ul><li>Financing    stock  debt  </li></ul><ul><li>EBIT 2,000,000 2,000,000 </li></ul...
<ul><li>Financing    stock  debt  </li></ul><ul><li>EBIT 4,000,000 4,000,000 </li></ul><ul><li>- interest   0   (600,000) ...
<ul><li>If EBIT is $2,000,000,  common   stock   financing is best.  </li></ul><ul><li>If EBIT is $4,000,000,  debt  finan...
If we choose stock financing: EPS EBIT $1m  $2m  $3m  $4m stock  financing 0 3 2 1
If we choose  bond financing: EPS EBIT $1m  $2m  $3m  $4m bond  financing 0 3 2 1
Breakeven EBIT EPS EBIT $1m  $2m  $3m  $4m bond  financing stock  financing 0 3 2 1
Breakeven Point <ul><li>Set two EPS calculations equal to each other and solve for EBIT: </li></ul><ul><li>Stock Financing...
Breakeven Point <ul><li>Stock Financing  Debt Financing </li></ul><ul><li>(EBIT-I)(1-t) - P   =  (EBIT-I)(1-t) - P </li></...
Breakeven Point <ul><li>Stock Financing  Debt Financing  </li></ul><ul><li>.6 EBIT   =  .6 EBIT - 360,000 </li></ul><ul><l...
Breakeven EBIT EPS EBIT $1m  $2m  $3m  $4m bond  financing stock  financing 0 3 2 1 For EBIT up to $3 million, stock  fina...
Breakeven EBIT For EBIT up to $3 million, stock financing is best. For EBIT greater than $3 million,  debt  financing is b...
In-class Problem <ul><li>Plan A:  Sell 1,200,000 shares at $10 per share  ($12 million total). </li></ul><ul><li>Plan B:  ...
Breakeven EBIT <ul><li>Stock Financing  Levered Financing </li></ul><ul><li>(EBIT-I) (1-t) - P   =  (EBIT-I) (1-t) - P   <...
Analytical Income Statement <ul><li>  Stock  Levered </li></ul><ul><li>EBIT 1,080,000 1,080,000 </li></ul><ul><li>I   0   ...
Breakeven EBIT levered  financing stock  financing EPS EBIT $.5m  $1m  $1.5m  $2m 0 .65 .45 .25
Breakeven EBIT For EBIT up to $1.08 m, stock financing is best. levered  financing stock  financing EPS EBIT $.5m  $1m  $1...
Breakeven EBIT For EBIT up to $1.08 m, stock financing is best. For EBIT greater than $1.08 m,  the levered plan is best. ...
In-class Problem <ul><li>Plan A:  Sell 1,200,000 shares at $20 per share  ($24 million total). </li></ul><ul><li>Plan B:  ...
Breakeven EBIT <ul><li>Stock Financing  Levered Financing </li></ul><ul><li>(EBIT-I) (1-t) - P   =  (EBIT-I) (1-t) - P   <...
Analytical Income Statement <ul><li>  Stock    Levered </li></ul><ul><li>EBIT 2,160,000 2,160,000 </li></ul><ul><li>I   0 ...
Breakeven EBIT levered  financing stock  financing EPS EBIT $1m  $2m  $3m  $4m 0 1.5 1.17 .5
Breakeven EBIT levered  financing stock  financing For EBIT up to $2.16 m, stock financing is best. EPS EBIT $1m  $2m  $3m...
Breakeven EBIT levered  financing stock  financing For EBIT greater than $2.16 m,  the levered plan is best. For EBIT up t...
Upcoming SlideShare
Loading in …5
×

Fm10e ch16

933 views

Published on

Published in: Economy & Finance, Business
0 Comments
2 Likes
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total views
933
On SlideShare
0
From Embeds
0
Number of Embeds
2
Actions
Shares
0
Downloads
36
Comments
0
Likes
2
Embeds 0
No embeds

No notes for slide
  • 1
  • 2
  • 3
  • 4
  • 3
  • 3
  • 8
  • 9
  • 10
  • 17
  • 17
  • 17
  • 17
  • 18
  • 18
  • 19
  • 21
  • 21
  • 24
  • 24
  • 23
  • 24
  • 24
  • 25
  • 27
  • 27
  • 31
  • 31
  • 32
  • 34
  • 34
  • 34
  • 35
  • 35
  • 37
  • 37
  • 38
  • 45
  • 45
  • 45
  • 47
  • 48
  • 49
  • 50
  • 51
  • 52
  • 53
  • 54
  • 55
  • 55
  • 56
  • 57
  • 58
  • 59
  • 60
  • 61
  • 62
  • 63
  • Fm10e ch16

    1. 1. Chapter 16 - Planning the Firm’s Financing Mix  2005, Pearson Prentice Hall
    2. 2. <ul><li>Balance Sheet </li></ul><ul><li>Current Current </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>Debt and </li></ul><ul><li>Fixed Preferred </li></ul><ul><li>Assets </li></ul><ul><li>Shareholders’ </li></ul><ul><li>Equity </li></ul>
    3. 3. <ul><li>Balance Sheet </li></ul><ul><li>Current Current </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>Debt and </li></ul><ul><li>Fixed Preferred </li></ul><ul><li>Assets </li></ul><ul><li>Shareholders’ </li></ul><ul><li>Equity </li></ul>
    4. 4. <ul><li>Balance Sheet </li></ul><ul><li>Current Current </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>Debt and </li></ul><ul><li>Fixed Preferred </li></ul><ul><li>Assets </li></ul><ul><li>Shareholders’ </li></ul><ul><li>Equity </li></ul>Financial Structure
    5. 5. <ul><li>Balance Sheet </li></ul><ul><li>Current Current </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>Debt and </li></ul><ul><li>Fixed Preferred </li></ul><ul><li>Assets </li></ul><ul><li>Shareholders’ </li></ul><ul><li>Equity </li></ul>
    6. 6. <ul><li>Balance Sheet </li></ul><ul><li>Current Current </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>Debt and </li></ul><ul><li>Fixed Preferred </li></ul><ul><li>Assets </li></ul><ul><li>Shareholders’ </li></ul><ul><li>Equity </li></ul>Capital Structure
    7. 7. Why is Capital Structure Important? <ul><li>1) Leverage : Higher financial leverage means higher returns to stockholders, but higher risk due to fixed payments. </li></ul><ul><li>2) Cost of Capital : Each source of financing has a different cost. Capital structure affects the cost of capital. </li></ul><ul><li>The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value. </li></ul>
    8. 8. What is the Optimal Capital Structure? <ul><li>In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. </li></ul><ul><li>This is known as the Independence hypothesis : firm value is independent of capital structure . </li></ul>
    9. 9. Independence Hypothesis <ul><li>Firm value does not depend on capital structure. </li></ul>
    10. 10. <ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 2 million </li></ul><ul><li>Operating income (EBIT): $2,000,000 </li></ul><ul><li>Calculate EPS: </li></ul><ul><li>With no interest payments and no taxes, </li></ul><ul><li>EBIT = net income. </li></ul><ul><li>$2,000,000/2,000,000 shares = $1.00 </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    11. 11. <ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 2 million </li></ul><ul><li>Operating income (EBIT): $2,000,000 </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    12. 12. <ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 2 million </li></ul><ul><li>Operating income (EBIT): $2,000,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    13. 13. <ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 2 million </li></ul><ul><li>Operating income (EBIT): $2,000,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company k = + g = D 1 P
    14. 14. <ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 2 million </li></ul><ul><li>Operating income (EBIT): $2,000,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = D 1 1.00 P 10.00
    15. 15. <ul><li>Capital Structure: 100% equity, no debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 2 million </li></ul><ul><li>Operating income (EBIT): $2,000,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = 10% D 1 1.00 P 10.00
    16. 16. <ul><li>$20 million capitalization </li></ul><ul><li>$8 million in debt issued to retire $8 million in equity. </li></ul><ul><li>Equity = $12m / $20m = 60% </li></ul><ul><li>Debt = $8m / $20m = 40% </li></ul><ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Shares outstanding: $12 million / $10 = 1,200,000 shares . </li></ul><ul><li>Interest = $8m x .06 = $480,000 </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    17. 17. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate EPS: </li></ul><ul><li>$1,520,000/1,200,000 shares = $1.267 </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    18. 18. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    19. 19. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Equity: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    20. 20. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Equity: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company k = + g = D 1 P
    21. 21. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Equity: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = D 1 1.267 P 10.00
    22. 22. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Equity: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = 12.67% D 1 1.267 P 10.00
    23. 23. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    24. 24. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    25. 25. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul><ul><li>.6 (12.67%) </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    26. 26. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul><ul><li>.6 (12.67%) + </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    27. 27. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul><ul><li>.6 (12.67%) + .4 (6%) = </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    28. 28. <ul><li>Capital Structure: 60% equity, 40% debt </li></ul><ul><li>Stock price: $10 per share </li></ul><ul><li>Shares outstanding: 1.2 million </li></ul><ul><li>Net income: $2,000,000 - $480,000 = $1,520,000 </li></ul><ul><li>Calculate the Cost of Capital: </li></ul><ul><li>.6 (12.67%) + .4 (6%) = 10% </li></ul>Independence Hypothesis: Rix Camper Manufacturing Company
    29. 29. Independence Hypothesis Cost of Capital kc 0% debt Financial Leverage 100% debt . kc = cost of equity kd = cost of debt ko = cost of capital
    30. 30. Independence Hypothesis . Cost of Capital kc kd kd 0% debt Financial Leverage 100% debt
    31. 31. Independence Hypothesis . Cost of Capital kc kd kd 0% debt Financial Leverage 100% debt
    32. 32. Independence Hypothesis Increasing leverage causes the cost of equity to rise. Cost of Capital kc kd kd 0% debt Financial Leverage 100% debt
    33. 33. Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. 0% debt Financial Leverage 100% debt
    34. 34. Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt Financial Leverage 100% debt
    35. 35. Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt Financial Leverage 100% debt
    36. 36. Independence Hypothesis kc kd Cost of Capital kc ko kd 0% debt Financial Leverage 100% debt
    37. 37. <ul><li>If we have perfect capital markets, capital structure is irrelevant . </li></ul><ul><li>In other words, changes in capital structure do not affect firm value . </li></ul>Independence Hypothesis
    38. 38. Dependence Hypothesis <ul><li>Increasing leverage does not increase the cost of equity. </li></ul><ul><li>Since debt is less expensive than equity, more debt financing would provide a lower cost of capital. </li></ul><ul><li>A lower cost of capital would increase firm value. </li></ul>
    39. 39. Dependence Hypothesis Since the cost of debt is lower than the cost of equity... Cost of Capital kc kd Financial Leverage kc kd
    40. 40. Dependence Hypothesis Since the cost of debt is lower than the cost of equity… increasing leverage reduces the cost of capital. Cost of Capital kc kd Financial Leverage kc kd ko
    41. 41. Moderate Position <ul><li>The previous hypothesis examines capital structure in a “perfect market.” </li></ul><ul><li>The moderate position examines capital structure under more realistic conditions. </li></ul><ul><li>For example, what happens if we include corporate taxes ? </li></ul>
    42. 42. <ul><li> unlevered levered </li></ul><ul><li>EBIT 2,000,000 2,000,000 </li></ul><ul><li>- interest expense 0 (480,000) </li></ul><ul><li>EBT 2,000,000 1,520,000 </li></ul><ul><li>- taxes (50%) (1,000,000) (760,000) </li></ul><ul><li>Earnings available </li></ul><ul><li>to stockholders 1,000,000 760,000 </li></ul><ul><li>Payments to all </li></ul><ul><li>securityholders 1,000,000 1,240,000 </li></ul>Rix Camper example: Tax effects of financing with debt
    43. 43. Moderate Position Cost of Capital kc kd Financial Leverage kc kd
    44. 44. Moderate Position Cost of Capital kc kd Financial Leverage kc kd Even if the cost of equity rises as leverage increases, the cost of debt is very low...
    45. 45. Moderate Position Cost of Capital kc kd Financial Leverage kc kd because of the tax benefit associated with debt financing. Even if the cost of equity rises as leverage increases, the cost of debt is very low...
    46. 46. Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debt reduces the cost of capital.
    47. 47. Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debt reduces the cost of capital. ko
    48. 48. Moderate Position <ul><li>So, what does the tax benefit of debt financing mean for the value of the firm? </li></ul><ul><li>The more debt financing used, the greater the tax benefit , and the greater the value of the firm . </li></ul><ul><li>So, this would mean that all firms should be financed with 100% debt , right? </li></ul><ul><li>Why are firms not financed with 100% debt? </li></ul>
    49. 49. Why is 100% Debt Not Optimal? <ul><li>Bankruptcy costs : costs of financial distress. </li></ul><ul><li>Financing becomes difficult to get. </li></ul><ul><li>Customers leave due to uncertainty. </li></ul><ul><li>Possible restructuring or liquidation costs if bankruptcy occurs. </li></ul>
    50. 50. <ul><li>Agency costs : costs associated with protecting bondholders. </li></ul><ul><li>Bondholders (principals) lend money to the firm and expect it to be invested wisely. </li></ul><ul><li>Stockholders own the firm and elect the board and hire managers (agents). </li></ul><ul><li>Bond covenants require managers to be monitored. The monitoring expense is an agency cost , which increases as debt increases. </li></ul>Why is 100% Debt Not Optimal?
    51. 51. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd
    52. 52. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kd
    53. 53. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kd
    54. 54. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd
    55. 55. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd
    56. 56. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd If a firm borrows too much, the costs of debt and equity will spike upward, due to bankruptcy costs and agency costs.
    57. 57. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd
    58. 58. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko
    59. 59. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko
    60. 60. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital.
    61. 61. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko
    62. 62. Capital Structure Management <ul><li>EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity. </li></ul>
    63. 63. Capital Structure Management <ul><li>EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity. </li></ul>EPS = (EBIT - I)(1 - t) - P S
    64. 64. Capital Structure Management <ul><li>EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity. </li></ul>EPS = (EBIT - I)(1 - t) - P S I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding.
    65. 65. EBIT-EPS Example <ul><li>Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: </li></ul><ul><li>Sell 200,000 shares of common stock at $30 per share, </li></ul><ul><li>Borrow $6,000,000 by issuing 10% bonds. </li></ul>
    66. 66. If we expect EBIT to be $2,000,000: <ul><li>Financing stock debt </li></ul><ul><li>EBIT 2,000,000 2,000,000 </li></ul><ul><li>- interest 0 (600,000) </li></ul><ul><li>EBT 2,000,000 1,400,000 </li></ul><ul><li>- taxes (40%) (800,000) (560,000) </li></ul><ul><li>EAT 1,200,000 840,000 </li></ul><ul><li># shares outst. 1,000,000 800,000 </li></ul><ul><li>EPS $1.20 $1.05 </li></ul>
    67. 67. <ul><li>Financing stock debt </li></ul><ul><li>EBIT 4,000,000 4,000,000 </li></ul><ul><li>- interest 0 (600,000) </li></ul><ul><li>EBT 4,000,000 3,400,000 </li></ul><ul><li>- taxes (40%) (1,600,000) (1,360,000) </li></ul><ul><li>EAT 2,400,000 2,040,000 </li></ul><ul><li># shares outst. 1,000,000 800,000 </li></ul><ul><li>EPS $2.40 $2.55 </li></ul>If we expect EBIT to be $4,000,000:
    68. 68. <ul><li>If EBIT is $2,000,000, common stock financing is best. </li></ul><ul><li>If EBIT is $4,000,000, debt financing is best. </li></ul><ul><li>So, now we need to find a breakeven EBIT where neither is better than the other. </li></ul>
    69. 69. If we choose stock financing: EPS EBIT $1m $2m $3m $4m stock financing 0 3 2 1
    70. 70. If we choose bond financing: EPS EBIT $1m $2m $3m $4m bond financing 0 3 2 1
    71. 71. Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing 0 3 2 1
    72. 72. Breakeven Point <ul><li>Set two EPS calculations equal to each other and solve for EBIT: </li></ul><ul><li>Stock Financing Debt Financing </li></ul><ul><li>(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P </li></ul><ul><li>S S </li></ul>
    73. 73. Breakeven Point <ul><li>Stock Financing Debt Financing </li></ul><ul><li>(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P </li></ul><ul><li>S S </li></ul><ul><li>(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) </li></ul><ul><li>800,000+200,000 800,000 </li></ul>
    74. 74. Breakeven Point <ul><li>Stock Financing Debt Financing </li></ul><ul><li>.6 EBIT = .6 EBIT - 360,000 </li></ul><ul><li>1 .8 </li></ul><ul><li>.48 EBIT = .6 EBIT - 360,000 </li></ul><ul><li>.12 EBIT = 360,000 </li></ul><ul><li>EBIT = $3,000,000 </li></ul>
    75. 75. Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing 0 3 2 1 For EBIT up to $3 million, stock financing is best.
    76. 76. Breakeven EBIT For EBIT up to $3 million, stock financing is best. For EBIT greater than $3 million, debt financing is best. EPS EBIT $1m $2m $3m $4m bond financing stock financing 0 3 2 1
    77. 77. In-class Problem <ul><li>Plan A: Sell 1,200,000 shares at $10 per share ($12 million total). </li></ul><ul><li>Plan B: Issue $3.5 million in 9% debt and sell 850,000 shares at $10 per share ($12 million total). </li></ul><ul><li>Assume a marginal tax rate of 50%. </li></ul>
    78. 78. Breakeven EBIT <ul><li>Stock Financing Levered Financing </li></ul><ul><li>(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P </li></ul><ul><li>S S </li></ul><ul><li>EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) </li></ul><ul><li>1,200,000 850,000 </li></ul><ul><li>EBIT = $1,080,000 </li></ul>
    79. 79. Analytical Income Statement <ul><li> Stock Levered </li></ul><ul><li>EBIT 1,080,000 1,080,000 </li></ul><ul><li>I 0 (315,000) </li></ul><ul><li>EBT 1,080,000 765,000 </li></ul><ul><li>Tax (540,000) (382,500) </li></ul><ul><li>NI 540,000 382,500 </li></ul><ul><li>Shares 1,200,000 850,000 </li></ul><ul><li>EPS .45 .45 </li></ul>
    80. 80. Breakeven EBIT levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m 0 .65 .45 .25
    81. 81. Breakeven EBIT For EBIT up to $1.08 m, stock financing is best. levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m 0 .65 .45 .25
    82. 82. Breakeven EBIT For EBIT up to $1.08 m, stock financing is best. For EBIT greater than $1.08 m, the levered plan is best. levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m 0 .65 .45 .25
    83. 83. In-class Problem <ul><li>Plan A: Sell 1,200,000 shares at $20 per share ($24 million total). </li></ul><ul><li>Plan B: Issue $9.6 million in 9% debt and sell shares at $20 per share ($24 million total). </li></ul><ul><li>Assume a 35% marginal tax rate. </li></ul>
    84. 84. Breakeven EBIT <ul><li>Stock Financing Levered Financing </li></ul><ul><li>(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P </li></ul><ul><li>S S </li></ul><ul><li>(EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) </li></ul><ul><li>1,200,000 720,000 </li></ul><ul><li>EBIT = $2,160,000 </li></ul>
    85. 85. Analytical Income Statement <ul><li> Stock Levered </li></ul><ul><li>EBIT 2,160,000 2,160,000 </li></ul><ul><li>I 0 (864,000) </li></ul><ul><li>EBT 2,160,000 1,296,000 </li></ul><ul><li>Tax (756,000) (453,600) </li></ul><ul><li>NI 1,404,000 842,400 </li></ul><ul><li>Shares 1,200,000 720,000 </li></ul><ul><li>EPS 1.17 1.17 </li></ul>
    86. 86. Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m 0 1.5 1.17 .5
    87. 87. Breakeven EBIT levered financing stock financing For EBIT up to $2.16 m, stock financing is best. EPS EBIT $1m $2m $3m $4m 0 1.5 1.17 .5
    88. 88. Breakeven EBIT levered financing stock financing For EBIT greater than $2.16 m, the levered plan is best. For EBIT up to $2.16 m, stock financing is best. EPS EBIT $1m $2m $3m $4m 0 1.5 1.17 .5

    ×