Cf Financing 7

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Cf Financing 7

  1. 1. <ul><li>To guess is cheap. To guess wrong is expensive. </li></ul>
  2. 2. 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.
  3. 3. Financing <ul><li>Independence of Financing & Investment decisions </li></ul><ul><li>Reversible </li></ul><ul><li>NPVs of Financing </li></ul><ul><li>Vast variety of Financing Instruments </li></ul><ul><li>Dividend / Debt vs Equity </li></ul>
  4. 4. <ul><li>Should the firm retain most of its earnings in the business, or should it pay them out as dividends? </li></ul><ul><li>If the firm needs more money, should it issue more stock or should it borrow? </li></ul><ul><li>Should it borrow short-term or long-term? </li></ul><ul><li>Should it borrow by issuing a normal long-term bond or a convertible bond. </li></ul>
  5. 5. Capital Structure <ul><li>Debt equity mix </li></ul><ul><li>Fixed & residual claims </li></ul><ul><li>Impact on value/ cost of capital </li></ul>
  6. 6. Efficient Markets <ul><li>Stock prices fully reflect available information </li></ul><ul><li>Future price changes are random </li></ul><ul><li>Implications </li></ul><ul><li>Investors can expect only normal returns </li></ul><ul><li>Firms receive fair value for securities that they sell </li></ul><ul><li>Value addition from financing activity? Positive NPV financing options? </li></ul>
  7. 7. Cost of Capital <ul><li>Hurdle rate for projects </li></ul><ul><li>Valuation of companies </li></ul><ul><li>Finding economic value added </li></ul>
  8. 8. Weighted Average Cost of Capital <ul><li>Funding thru debt and equity </li></ul><ul><li>WACC is a weighted average cost of debt and equity </li></ul><ul><li>Weights for debt and equity are targetted capital structure, in terms of market values </li></ul><ul><li>The component cost of capital are investor-required rates of return. </li></ul>
  9. 9. Weighted Average Cost of Capital <ul><li>Coc = r D (1-t)(D/ (D+E)) + r E ( E/ (D+E)) </li></ul><ul><li>r D = Cost of Debt </li></ul><ul><li>r E = Cost of Equity </li></ul><ul><li>r A = Operating Income/ Market Value of the Firm </li></ul><ul><li>Market value of the firm = value of debt + value of equity </li></ul>
  10. 10. 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.
  11. 11. WACC numerical <ul><li>Cost of debt = 8% </li></ul><ul><li>Cost of equity = 14.6% </li></ul><ul><li>Corporate tax =35% </li></ul><ul><li>Debt ratio = 0.4 </li></ul><ul><li>Equity ratio = 0.6 </li></ul>
  12. 12. Weighted Average Cost of Capital <ul><li>WACC = .08 (1-.35)*0.4 + .146* 0.6 </li></ul><ul><li>= 10.84% </li></ul>
  13. 13. Miller Modigilliani Hypothesis <ul><li>Signals the start of modern finance </li></ul><ul><li>A formal theory of capital structure </li></ul><ul><li>Nobel laureates </li></ul>
  14. 14. Principles <ul><li>Comparison of levered & unlevered firm. </li></ul><ul><li>Law of conservation of value. Value additivity. </li></ul><ul><li>The value of a pie is independent of how it is sliced. </li></ul><ul><li>Value created on the right hand side of BS. </li></ul>
  15. 15. Proposition <ul><li>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. </li></ul>
  16. 16. Implications of Debt Irrelevence <ul><li>Value of the firm unaffected by changes in leverage. </li></ul><ul><li>Independence of the investment decision from the financing decision </li></ul>
  17. 17. Impact of Debt <ul><li>Tax benefits </li></ul><ul><li>Added discipline </li></ul><ul><li>Bankruptcy cost </li></ul><ul><li>Agency cost </li></ul><ul><li>Loss of flexibility </li></ul><ul><li>Marketing conditions </li></ul><ul><li>Dilution of control </li></ul>
  18. 18. Patterns of Financing <ul><li>Internally generated cashflow predominant source of financing. (Typically 70 to 90%) </li></ul><ul><li>Financial deficit covered by borrowing and equity. Net new equity insignificant. Even negetive </li></ul>
  19. 19. Empirical Capital structure <ul><li>Most corporations have low debt equity ratios </li></ul><ul><li>Many firms use no debt </li></ul><ul><li>There are differences in the capital structure of different industries </li></ul><ul><li>Most corporations employ target debt equity ratios </li></ul>
  20. 20. Capital Structure Determinants <ul><li>Taxes </li></ul><ul><li>Types of assets </li></ul><ul><li>Uncertainty of operating income </li></ul>
  21. 21. Concept <ul><li>Component cost of capital are investor required rates of return. </li></ul><ul><li>Current cost of debt and equity </li></ul><ul><li>Target Capital Structure determine weights for WACC </li></ul><ul><li>Capital Components are funds that come from investors </li></ul>

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