Cf Financing 7
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Cf Financing 7







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Cf Financing 7 Cf Financing 7 Presentation Transcript

    • To guess is cheap. To guess wrong is expensive.
  • In 2000, Philip Morris generated in cash $11billion. It paid 4.5b as dividends, repurchased shares for 3.6b & 2.9b was reinvested in business. The company borrowed 10.9b and raised 100m thru equity.
  • Financing
    • Independence of Financing & Investment decisions
    • Reversible
    • NPVs of Financing
    • Vast variety of Financing Instruments
    • Dividend / Debt vs Equity
    • Should the firm retain most of its earnings in the business, or should it pay them out as dividends?
    • If the firm needs more money, should it issue more stock or should it borrow?
    • Should it borrow short-term or long-term?
    • Should it borrow by issuing a normal long-term bond or a convertible bond.
  • Capital Structure
    • Debt equity mix
    • Fixed & residual claims
    • Impact on value/ cost of capital
  • Efficient Markets
    • Stock prices fully reflect available information
    • Future price changes are random
    • Implications
    • Investors can expect only normal returns
    • Firms receive fair value for securities that they sell
    • Value addition from financing activity? Positive NPV financing options?
  • Cost of Capital
    • Hurdle rate for projects
    • Valuation of companies
    • Finding economic value added
  • Weighted Average Cost of Capital
    • Funding thru debt and equity
    • WACC is a weighted average cost of debt and equity
    • Weights for debt and equity are targetted capital structure, in terms of market values
    • The component cost of capital are investor-required rates of return.
  • Weighted Average Cost of Capital
    • Coc = r D (1-t)(D/ (D+E)) + r E ( E/ (D+E))
    • r D = Cost of Debt
    • r E = Cost of Equity
    • r A = Operating Income/ Market Value of the Firm
    • Market value of the firm = value of debt + value of equity
  • Our cost of capital is calculated using the approximate market value weightings of debt and equity used to finance the company. The cost of debt is simply our after-tax, long-term debt rate, which is around 5.7%. The cost of equity is approximately 11.4%. - The Quaker Oats Company, 1992 Annual Report.
  • WACC numerical
    • Cost of debt = 8%
    • Cost of equity = 14.6%
    • Corporate tax =35%
    • Debt ratio = 0.4
    • Equity ratio = 0.6
  • Weighted Average Cost of Capital
    • WACC = .08 (1-.35)*0.4 + .146* 0.6
    • = 10.84%
  • Miller Modigilliani Hypothesis
    • Signals the start of modern finance
    • A formal theory of capital structure
    • Nobel laureates
  • Principles
    • Comparison of levered & unlevered firm.
    • Law of conservation of value. Value additivity.
    • The value of a pie is independent of how it is sliced.
    • Value created on the right hand side of BS.
  • Proposition
    • The value of a firm equals its expected operating income divided by the discount rate applicable to its risk class. The value is independent of its capital structure.
  • Implications of Debt Irrelevence
    • Value of the firm unaffected by changes in leverage.
    • Independence of the investment decision from the financing decision
  • Impact of Debt
    • Tax benefits
    • Added discipline
    • Bankruptcy cost
    • Agency cost
    • Loss of flexibility
    • Marketing conditions
    • Dilution of control
  • Patterns of Financing
    • Internally generated cashflow predominant source of financing. (Typically 70 to 90%)
    • Financial deficit covered by borrowing and equity. Net new equity insignificant. Even negetive
  • Empirical Capital structure
    • Most corporations have low debt equity ratios
    • Many firms use no debt
    • There are differences in the capital structure of different industries
    • Most corporations employ target debt equity ratios
  • Capital Structure Determinants
    • Taxes
    • Types of assets
    • Uncertainty of operating income
  • Concept
    • Component cost of capital are investor required rates of return.
    • Current cost of debt and equity
    • Target Capital Structure determine weights for WACC
    • Capital Components are funds that come from investors