The document discusses capital structure and the tradeoffs between debt and equity financing. It summarizes Modigliani and Miller's seminal work which established that in a perfect capital market without taxes, a firm's value is independent of its capital structure. Specifically, M&M Proposition 1 states that splitting cash flows between debt and equity holders does not change total firm value. Proposition 2 states that the expected return of equity increases with leverage in a way that exactly offsets the reduced risk of debt.
The white paper presents easiest way to understand the mode of choosing a capital structure of Debt versus Equity.
It also talks on the numerical implications of Leverage and Returns. I hope it will be helpful for students, novices and capital markets professionals !
The document discusses capital structure and the advantages and disadvantages of debt versus equity financing. It summarizes Modigliani and Miller's seminal work which established that in a perfect capital market without taxes, a firm's value is independent of its capital structure. When taxes are considered, debt provides a tax shield that increases firm value up to a point, after which additional debt increases financial distress costs. The optimal capital structure balances the tax benefits of debt against the costs of financial distress.
Anıl Sural - Capital Structure and LeverageAnıl Sural
The document discusses business risk versus financial risk and how operating leverage and capital structure impact risk. It provides examples to illustrate:
1) Business risk depends on the uncertainty of a firm's operating income, while financial risk depends on the amount of debt financing used.
2) Operating leverage affects business risk, as high fixed costs mean small sales changes impact profits.
3) Capital structure choices impact total risk to shareholders, as debt increases financial risk despite possibly raising expected returns through tax benefits.
4) An optimal capital structure balances the tax benefits of debt against increasing bankruptcy costs from higher leverage.
The document discusses capital structure and leverage. It defines operating leverage as using fixed costs which increases business risk when sales decline. Financial leverage is using debt which increases financial risk for stockholders. The optimal capital structure balances higher expected returns from debt against increased risk. Signaling theory suggests firms should use less debt than predicted to avoid signaling effects from stock sales that could lower stock prices.
The document discusses capital structure and the various sources of financing available to companies, including debt, equity, hybrid securities, and loan capital. It covers the relative costs and risks of different financing options. The key theories discussed are Modigliani-Miller theory, which establishes that capital structure does not affect firm value under certain assumptions, and the trade-off theory, which recognizes that while debt is cheaper than equity, it also carries higher financial risks. An optimal capital structure balances these costs and risks to minimize the weighted average cost of capital and maximize firm value.
The document discusses the cost of debt and equity financing. It provides an example where the cost of debt is calculated as 10.56% for a company borrowing $600,000 at an annual payment of $100,000 over 10 years. The cost of equity is calculated as 15.51% for a company with a beta of 1.39, risk-free rate of 3%, and market rate of 12%. The weighted average cost of capital is calculated as 13.55% based on the costs of debt and equity and the capital structure.
Types of cost of capital & differential betweenMamta Thakur
This document discusses different types of costs of capital. It defines cost of capital as the minimum rate of return required on investments. The three main types of capital discussed are equity, debt, and preference shares. Cost of debt is the rate expected by lenders and is calculated as interest payments over initial debt amount. Cost of equity represents the compensation demanded by shareholders and can be calculated as dividend payments over share price. Cost of preference shares is the fixed rate payable to preference shareholders and is calculated based on dividend payments and redemption amounts. The document also briefly mentions comparing equity to debt and preference shares.
The white paper presents easiest way to understand the mode of choosing a capital structure of Debt versus Equity.
It also talks on the numerical implications of Leverage and Returns. I hope it will be helpful for students, novices and capital markets professionals !
The document discusses capital structure and the advantages and disadvantages of debt versus equity financing. It summarizes Modigliani and Miller's seminal work which established that in a perfect capital market without taxes, a firm's value is independent of its capital structure. When taxes are considered, debt provides a tax shield that increases firm value up to a point, after which additional debt increases financial distress costs. The optimal capital structure balances the tax benefits of debt against the costs of financial distress.
Anıl Sural - Capital Structure and LeverageAnıl Sural
The document discusses business risk versus financial risk and how operating leverage and capital structure impact risk. It provides examples to illustrate:
1) Business risk depends on the uncertainty of a firm's operating income, while financial risk depends on the amount of debt financing used.
2) Operating leverage affects business risk, as high fixed costs mean small sales changes impact profits.
3) Capital structure choices impact total risk to shareholders, as debt increases financial risk despite possibly raising expected returns through tax benefits.
4) An optimal capital structure balances the tax benefits of debt against increasing bankruptcy costs from higher leverage.
The document discusses capital structure and leverage. It defines operating leverage as using fixed costs which increases business risk when sales decline. Financial leverage is using debt which increases financial risk for stockholders. The optimal capital structure balances higher expected returns from debt against increased risk. Signaling theory suggests firms should use less debt than predicted to avoid signaling effects from stock sales that could lower stock prices.
The document discusses capital structure and the various sources of financing available to companies, including debt, equity, hybrid securities, and loan capital. It covers the relative costs and risks of different financing options. The key theories discussed are Modigliani-Miller theory, which establishes that capital structure does not affect firm value under certain assumptions, and the trade-off theory, which recognizes that while debt is cheaper than equity, it also carries higher financial risks. An optimal capital structure balances these costs and risks to minimize the weighted average cost of capital and maximize firm value.
The document discusses the cost of debt and equity financing. It provides an example where the cost of debt is calculated as 10.56% for a company borrowing $600,000 at an annual payment of $100,000 over 10 years. The cost of equity is calculated as 15.51% for a company with a beta of 1.39, risk-free rate of 3%, and market rate of 12%. The weighted average cost of capital is calculated as 13.55% based on the costs of debt and equity and the capital structure.
Types of cost of capital & differential betweenMamta Thakur
This document discusses different types of costs of capital. It defines cost of capital as the minimum rate of return required on investments. The three main types of capital discussed are equity, debt, and preference shares. Cost of debt is the rate expected by lenders and is calculated as interest payments over initial debt amount. Cost of equity represents the compensation demanded by shareholders and can be calculated as dividend payments over share price. Cost of preference shares is the fixed rate payable to preference shareholders and is calculated based on dividend payments and redemption amounts. The document also briefly mentions comparing equity to debt and preference shares.
Capital Structure, Business Risk & financial riskRamesh Pant
This document discusses capital structure, business risk, and financial risk. It defines capital structure as a company's mix of debt and equity used to finance its activities. A higher proportion of debt increases risk exposure. Business risk refers to uncertainty about future operating income and is independent of debt levels. It depends on demand, prices, costs, competition, and other operating factors. Financial risk is the additional risk to shareholders from using debt financing, as debt holders are paid before shareholders if the company fails. Higher debt increases financial risk by concentrating business risk on shareholders.
This document provides an overview of mutual funds, including:
- What a fund is and how it pools shareholder money to invest in securities and distribute returns.
- The key players in a fund like investors, fund managers, custodians and transfer agents.
- How funds make money through income like dividends and interest, and capital gains.
- How the net asset value (NAV) of a fund is calculated based on the value of its holdings and shares outstanding.
- The daily processes involved in fund accounting like trade processing, income accruals, and expense accruals that influence the NAV.
Chapter 2 - The Business, Tax, and Financial Environmentsumarhnasution
This document provides an overview of business environments, tax environments, and financial environments. It discusses different forms of business organizations including sole proprietorships, partnerships, corporations, and limited liability companies. It also covers topics such as corporate income taxes, depreciation, losses and gains, capital gains/losses, personal income taxes, financial markets, risk-return profiles, and factors that influence expected security returns.
This document discusses capital structure and leverage. It provides definitions and examples of business risk, operating leverage, and financial leverage. Business risk depends on uncertainty in demand, prices, costs, and operating leverage. Financial risk depends on the types of securities issued, with more debt increasing financial risk. The document uses an example to show how financial leverage can increase expected return on equity but also increase risk. It discusses calculating a firm's optimal capital structure by minimizing the weighted average cost of capital or maximizing stock price. Signaling effects and other real-world factors are also discussed.
The document discusses capital structure and various capital structure theories. It defines capital structure as the mix of owned and borrowed capital used to finance a firm's assets. The optimal capital structure maximizes firm value by lowering the overall cost of capital. Several capital structure theories are examined, including the net income approach, net operating income approach, and traditional approach. The net income approach argues firm value increases with more debt due to lower costs. The net operating income approach argues firm value is independent of capital structure. The traditional approach finds an optimal capital structure where costs are minimized.
This document summarizes research on the relationship between agency theory and capital structure. Agency theory describes conflicts of interest that can arise between managers, shareholders, and debt holders in a company. These agency costs impact a company's optimal capital structure. The study aims to describe how agency problems influence changes to a company's capital structure and how different financing choices like debt and equity can help optimize capital structure by mitigating agency costs. It discusses how debt can help align manager and shareholder interests while also creating conflicts between managers/shareholders and creditors. The ideal debt level minimizes total agency costs.
Dividend decisions involve determining what proportion of a firm's equity earnings to pay out to shareholders as dividends, and what proportion to retain for reinvestment. There are two main theories on dividend policy - the relevance theory and the irrelevance theory. The relevance theory posits that dividend decisions impact share prices and firm value, while the irrelevance theory argues that dividend policy does not affect these. The document then discusses various dividend theories and models, types of dividend policies, and factors that influence a firm's dividend policy decisions.
This document provides an outline for a presentation on capital structure and the trade off theory. It introduces the presenters and outlines topics to be covered, including definitions of capital structure and firm value, the trade off theory, benefits and costs of leverage, and balancing costs and benefits to find an optimal capital structure. The trade off theory suggests there is an optimal mix of debt and equity that maximizes firm value by balancing the tax shield benefits of debt against the financial distress costs.
This document discusses various topics related to equity valuation and stock markets, including the dividend discount model for valuing stocks, primary and secondary markets, common terminology such as market capitalization and P/E ratio, and different approaches to analyzing stocks like fundamental analysis and the efficient market hypothesis. Key valuation techniques introduced are the dividend discount model under different growth scenarios as well as valuing the present value of growth opportunities.
This document discusses moving away from defined benefit pension plans to defined contribution plans. It notes the shift from guaranteed returns in defined benefit plans to non-guaranteed returns in defined contribution plans. This transfers risk from pension funds to individuals. The document also discusses allowing pension funds to take more investment risk to try and generate higher returns through riskier asset allocations. However, higher risk does not guarantee higher returns and could result in lower returns. The document concludes that interest rate risk becomes more of an investment decision rather than a risk management decision when moving away from defined benefit plans.
This document provides an overview of different types of investments including bonds, stocks, and mutual funds. It discusses bond types like treasury securities, corporate bonds, and zero-coupon bonds. It also covers stock classifications and strategies for analyzing stock performance. The document provides details on mutual funds including their advantages and disadvantages as well as different fund types and fees. It emphasizes the importance of diversification, matching investments to goals, and taking a long-term perspective.
Offshore Reinsurance and Counterparty Credit RiskDonSolow
This document discusses offshore reinsurance and counterparty credit risk. It provides an overview of offshore reinsurance, noting advantages for reinsurers like flexible capital requirements and potential tax benefits. It also discusses potential benefits for ceding insurers, like pricing and capital efficiencies. The document then discusses measuring and managing counterparty credit risk exposure to reinsurers, including defining credit risk events, measuring maximum possible loss, considering reinsurer ratings and collateral, and helpful treaty provisions.
This document discusses different types of non-traditional reinsurance structures. Financial reinsurance aims to improve an insurer's statutory balance sheet by ceding premiums less than reserves released. Reinsurance of run-off blocks allows insurers to transfer non-core legacy business. Variable annuity reinsurance covers risks associated with secondary benefits like guaranteed minimum death benefits. Non-proportional reinsurance includes stop loss, catastrophe covers, and newer pandemic covers that pay based on excess mortality from pandemics.
Fm11 ch 18 distributions to shareholders dividends and repurchasesNhu Tuyet Tran
This document discusses distributions to shareholders, including dividends and stock repurchases. It covers theories of investor preferences for dividends, the residual model for setting dividend policy, and factors managers consider like signaling effects and maintaining a target capital structure. Stock repurchases, dividends, splits and dividend reinvestment plans are also summarized. The optimal use of these strategies depends on forecasted capital needs, target payout and maintaining stable growth rates over time.
How Do Convertible Notes Work For Early-stage FinancingEquidam
What is the definition of convertible debt and how to use it in early-stage startup financing. You can also see the calculations we made using our Convertible Note Calculator.
To read more take a look at this article: https://www.equidam.com/practical-advice-pricing-convertible-note/
Compute your company valuation for free at https://www.equidam.com/
This document discusses the cost of capital for entrepreneurs. It explains that lenders require compensation for alternative costs, time value of money, and risk when providing capital. For time value, money is worth more today than in the future due to lock-in and inflation effects. Risk premium interest is charged to offset potential defaults, with more risky borrowers requiring higher interest rates. The cost of capital considers both the risk-free interest rate and additional risk premium charged for the likelihood of default.
This document provides an introduction to finance concepts for a business principles course. It discusses key topics like the importance of cash over profit, debt versus equity sources of funding, and the working capital cycle. The learning outcomes are to explain the difference between cash and profit, compare debt and equity, evaluate financing options, and understand the importance of cash flow to a business. The document also outlines different sources of funding like loans, leasing, overdrafts, and shares, and how their costs vary based on risk level.
The document discusses capital structure and its impact on firm value. It covers the following key points:
1) Modigliani and Miller's proposition that in perfect capital markets, firm value is independent of capital structure. Leverage does not affect total firm value but impacts the riskiness of equity.
2) When corporate taxes are considered, an optimal capital structure exists where tax benefits of debt balance costs of financial distress, maximizing firm value.
3) Traditional views held that the weighted average cost of capital declines with leverage, incentivizing high debt. However, equity risk rises with leverage per M&M proposition two.
4) Real-world capital structures involve a trade-off between
The document discusses corporate financing and capital structure policies. It covers:
1. The Modigliani-Miller propositions on capital structure irrelevance with and without taxes. With taxes, debt increases firm value up to an optimal level due to interest tax shields.
2. Bankruptcy costs reduce firm value at high debt levels due to financial distress costs. There is an optimal capital structure that balances tax benefits of debt against bankruptcy costs.
3. Criticisms of the static tradeoff theory include that profitable firms use little debt contrary to predictions. The pecking order theory explains this by suggesting firms prefer internal then debt financing over new equity issues.
1) The document discusses how a company's capital structure and use of debt can impact its value and shareholder returns. It considers how debt can lower the weighted average cost of capital but also increase bankruptcy risk.
2) An example is provided showing how debt can increase earnings per share but also expose shareholders to more risk in economic downturns. The optimal level of debt depends on factors like a company's fixed costs and risk of bankruptcy.
3) Tax benefits of debt are discussed, as interest expenses are tax deductible. However, higher debt also increases financial risk and the required return on equity. The overall impact on the weighted average cost of capital from debt is uncertain and depends on specific company and economic conditions
jimmy stepanian | Capital structure | Financial Structure | decisions | Jimmy Stepanian
Capital structure is the combination of long term capital and debt resources. Examine your balance sheet and you will find that there will be three main sources of capital.
Capital structure can affect firm value due to market imperfections like taxes, financial distress costs, and information asymmetry. The static tradeoff theory posits that firms choose an optimal debt ratio that balances the tax benefits of debt against the costs of financial distress. While the perfect capital markets assumptions of Miller and Modigliani imply capital structure is irrelevant, real world frictions mean capital structure decisions can create or destroy value. Empirical evidence generally supports theories like pecking order that see capital structure changing dynamically in response to financing needs rather than a fixed target.
Capital Structure, Business Risk & financial riskRamesh Pant
This document discusses capital structure, business risk, and financial risk. It defines capital structure as a company's mix of debt and equity used to finance its activities. A higher proportion of debt increases risk exposure. Business risk refers to uncertainty about future operating income and is independent of debt levels. It depends on demand, prices, costs, competition, and other operating factors. Financial risk is the additional risk to shareholders from using debt financing, as debt holders are paid before shareholders if the company fails. Higher debt increases financial risk by concentrating business risk on shareholders.
This document provides an overview of mutual funds, including:
- What a fund is and how it pools shareholder money to invest in securities and distribute returns.
- The key players in a fund like investors, fund managers, custodians and transfer agents.
- How funds make money through income like dividends and interest, and capital gains.
- How the net asset value (NAV) of a fund is calculated based on the value of its holdings and shares outstanding.
- The daily processes involved in fund accounting like trade processing, income accruals, and expense accruals that influence the NAV.
Chapter 2 - The Business, Tax, and Financial Environmentsumarhnasution
This document provides an overview of business environments, tax environments, and financial environments. It discusses different forms of business organizations including sole proprietorships, partnerships, corporations, and limited liability companies. It also covers topics such as corporate income taxes, depreciation, losses and gains, capital gains/losses, personal income taxes, financial markets, risk-return profiles, and factors that influence expected security returns.
This document discusses capital structure and leverage. It provides definitions and examples of business risk, operating leverage, and financial leverage. Business risk depends on uncertainty in demand, prices, costs, and operating leverage. Financial risk depends on the types of securities issued, with more debt increasing financial risk. The document uses an example to show how financial leverage can increase expected return on equity but also increase risk. It discusses calculating a firm's optimal capital structure by minimizing the weighted average cost of capital or maximizing stock price. Signaling effects and other real-world factors are also discussed.
The document discusses capital structure and various capital structure theories. It defines capital structure as the mix of owned and borrowed capital used to finance a firm's assets. The optimal capital structure maximizes firm value by lowering the overall cost of capital. Several capital structure theories are examined, including the net income approach, net operating income approach, and traditional approach. The net income approach argues firm value increases with more debt due to lower costs. The net operating income approach argues firm value is independent of capital structure. The traditional approach finds an optimal capital structure where costs are minimized.
This document summarizes research on the relationship between agency theory and capital structure. Agency theory describes conflicts of interest that can arise between managers, shareholders, and debt holders in a company. These agency costs impact a company's optimal capital structure. The study aims to describe how agency problems influence changes to a company's capital structure and how different financing choices like debt and equity can help optimize capital structure by mitigating agency costs. It discusses how debt can help align manager and shareholder interests while also creating conflicts between managers/shareholders and creditors. The ideal debt level minimizes total agency costs.
Dividend decisions involve determining what proportion of a firm's equity earnings to pay out to shareholders as dividends, and what proportion to retain for reinvestment. There are two main theories on dividend policy - the relevance theory and the irrelevance theory. The relevance theory posits that dividend decisions impact share prices and firm value, while the irrelevance theory argues that dividend policy does not affect these. The document then discusses various dividend theories and models, types of dividend policies, and factors that influence a firm's dividend policy decisions.
This document provides an outline for a presentation on capital structure and the trade off theory. It introduces the presenters and outlines topics to be covered, including definitions of capital structure and firm value, the trade off theory, benefits and costs of leverage, and balancing costs and benefits to find an optimal capital structure. The trade off theory suggests there is an optimal mix of debt and equity that maximizes firm value by balancing the tax shield benefits of debt against the financial distress costs.
This document discusses various topics related to equity valuation and stock markets, including the dividend discount model for valuing stocks, primary and secondary markets, common terminology such as market capitalization and P/E ratio, and different approaches to analyzing stocks like fundamental analysis and the efficient market hypothesis. Key valuation techniques introduced are the dividend discount model under different growth scenarios as well as valuing the present value of growth opportunities.
This document discusses moving away from defined benefit pension plans to defined contribution plans. It notes the shift from guaranteed returns in defined benefit plans to non-guaranteed returns in defined contribution plans. This transfers risk from pension funds to individuals. The document also discusses allowing pension funds to take more investment risk to try and generate higher returns through riskier asset allocations. However, higher risk does not guarantee higher returns and could result in lower returns. The document concludes that interest rate risk becomes more of an investment decision rather than a risk management decision when moving away from defined benefit plans.
This document provides an overview of different types of investments including bonds, stocks, and mutual funds. It discusses bond types like treasury securities, corporate bonds, and zero-coupon bonds. It also covers stock classifications and strategies for analyzing stock performance. The document provides details on mutual funds including their advantages and disadvantages as well as different fund types and fees. It emphasizes the importance of diversification, matching investments to goals, and taking a long-term perspective.
Offshore Reinsurance and Counterparty Credit RiskDonSolow
This document discusses offshore reinsurance and counterparty credit risk. It provides an overview of offshore reinsurance, noting advantages for reinsurers like flexible capital requirements and potential tax benefits. It also discusses potential benefits for ceding insurers, like pricing and capital efficiencies. The document then discusses measuring and managing counterparty credit risk exposure to reinsurers, including defining credit risk events, measuring maximum possible loss, considering reinsurer ratings and collateral, and helpful treaty provisions.
This document discusses different types of non-traditional reinsurance structures. Financial reinsurance aims to improve an insurer's statutory balance sheet by ceding premiums less than reserves released. Reinsurance of run-off blocks allows insurers to transfer non-core legacy business. Variable annuity reinsurance covers risks associated with secondary benefits like guaranteed minimum death benefits. Non-proportional reinsurance includes stop loss, catastrophe covers, and newer pandemic covers that pay based on excess mortality from pandemics.
Fm11 ch 18 distributions to shareholders dividends and repurchasesNhu Tuyet Tran
This document discusses distributions to shareholders, including dividends and stock repurchases. It covers theories of investor preferences for dividends, the residual model for setting dividend policy, and factors managers consider like signaling effects and maintaining a target capital structure. Stock repurchases, dividends, splits and dividend reinvestment plans are also summarized. The optimal use of these strategies depends on forecasted capital needs, target payout and maintaining stable growth rates over time.
How Do Convertible Notes Work For Early-stage FinancingEquidam
What is the definition of convertible debt and how to use it in early-stage startup financing. You can also see the calculations we made using our Convertible Note Calculator.
To read more take a look at this article: https://www.equidam.com/practical-advice-pricing-convertible-note/
Compute your company valuation for free at https://www.equidam.com/
This document discusses the cost of capital for entrepreneurs. It explains that lenders require compensation for alternative costs, time value of money, and risk when providing capital. For time value, money is worth more today than in the future due to lock-in and inflation effects. Risk premium interest is charged to offset potential defaults, with more risky borrowers requiring higher interest rates. The cost of capital considers both the risk-free interest rate and additional risk premium charged for the likelihood of default.
This document provides an introduction to finance concepts for a business principles course. It discusses key topics like the importance of cash over profit, debt versus equity sources of funding, and the working capital cycle. The learning outcomes are to explain the difference between cash and profit, compare debt and equity, evaluate financing options, and understand the importance of cash flow to a business. The document also outlines different sources of funding like loans, leasing, overdrafts, and shares, and how their costs vary based on risk level.
The document discusses capital structure and its impact on firm value. It covers the following key points:
1) Modigliani and Miller's proposition that in perfect capital markets, firm value is independent of capital structure. Leverage does not affect total firm value but impacts the riskiness of equity.
2) When corporate taxes are considered, an optimal capital structure exists where tax benefits of debt balance costs of financial distress, maximizing firm value.
3) Traditional views held that the weighted average cost of capital declines with leverage, incentivizing high debt. However, equity risk rises with leverage per M&M proposition two.
4) Real-world capital structures involve a trade-off between
The document discusses corporate financing and capital structure policies. It covers:
1. The Modigliani-Miller propositions on capital structure irrelevance with and without taxes. With taxes, debt increases firm value up to an optimal level due to interest tax shields.
2. Bankruptcy costs reduce firm value at high debt levels due to financial distress costs. There is an optimal capital structure that balances tax benefits of debt against bankruptcy costs.
3. Criticisms of the static tradeoff theory include that profitable firms use little debt contrary to predictions. The pecking order theory explains this by suggesting firms prefer internal then debt financing over new equity issues.
1) The document discusses how a company's capital structure and use of debt can impact its value and shareholder returns. It considers how debt can lower the weighted average cost of capital but also increase bankruptcy risk.
2) An example is provided showing how debt can increase earnings per share but also expose shareholders to more risk in economic downturns. The optimal level of debt depends on factors like a company's fixed costs and risk of bankruptcy.
3) Tax benefits of debt are discussed, as interest expenses are tax deductible. However, higher debt also increases financial risk and the required return on equity. The overall impact on the weighted average cost of capital from debt is uncertain and depends on specific company and economic conditions
jimmy stepanian | Capital structure | Financial Structure | decisions | Jimmy Stepanian
Capital structure is the combination of long term capital and debt resources. Examine your balance sheet and you will find that there will be three main sources of capital.
Capital structure can affect firm value due to market imperfections like taxes, financial distress costs, and information asymmetry. The static tradeoff theory posits that firms choose an optimal debt ratio that balances the tax benefits of debt against the costs of financial distress. While the perfect capital markets assumptions of Miller and Modigliani imply capital structure is irrelevant, real world frictions mean capital structure decisions can create or destroy value. Empirical evidence generally supports theories like pecking order that see capital structure changing dynamically in response to financing needs rather than a fixed target.
The document discusses capital structure, which refers to the mix of debt and equity used by a company to finance its long-term operations. It covers definitions of capital structure, forms of capital, the difference between capital structure and financial structure, theories of capital structure including net income, net operating income, and Modigliani-Miller approaches. The document also discusses the concept of optimal capital structure, which maximizes firm value and minimizes the weighted average cost of capital.
This document discusses capital structure and theories of capital structure. It defines capital structure as the composition of long-term sources of funds, including debt, preference shares, and equity. The optimal capital structure maximizes firm value and shareholder wealth while minimizing costs. Several theories are described, including the net income approach, net operating income approach, and Modigliani-Miller approach. The net income approach suggests firms should use debt financing to reduce costs until business risk outweighs tax benefits. The document also outlines essential features of a sound capital mix.
This document discusses capital structure and the determinants of a firm's mix of debt and equity financing. It first examines Modigliani-Miller's proposition that capital structure is irrelevant under certain assumptions, such as no taxes, bankruptcy costs, or asymmetric information. It then explores how factors like taxes, risk, financial slack, asset characteristics, and costs of financial distress influence a firm's optimal capital structure. Specific examples are provided to illustrate how these various determinants impact capital structure decisions.
The document discusses various capital structure theories including the net income approach, traditional approach, and irrelevance theories like the net operating income approach and MM approach. It provides definitions of key terms like capital structure and optimal capital structure. It also lists the assumptions and formulas used in different theories. Several factors that determine a firm's capital structure are outlined along with examples of calculating a firm's value and WACC under different approaches.
This document discusses Modigliani and Miller's propositions regarding capital structure. It summarizes:
1) MM's Proposition I states that the market value of a firm is independent of its capital structure in perfect capital markets.
2) Proposition II states that the expected return on equity increases with leverage, but this is offset by a higher risk so shareholders are indifferent to leverage.
3) The weighted average cost of capital remains unchanged with leverage according to MM's theory, contradicting the traditional view that firms should minimize their WACC through leverage.
The document discusses various concepts related to corporate finance and leverage. It defines financial leverage as using fixed financial charges to magnify the effects of changes in EBIT on earnings per share. It also defines operating leverage as a company's ability to use fixed operating costs to magnify the effects of sales changes on earnings before interest and taxes. Combined leverage is when a company uses both financial and operating leverage to magnify changes in sales into larger changes in earnings per share. The document also discusses capital structure theories including the net income approach, traditional approach, and Modigliani-Miller approach.
Chapter 14 Capital Structure and Leverage version1Mikee Bylss
This document covers capital structure and leverage. It discusses the differences between book value, market value, and target capital structures. It also explains business risk versus financial risk and how debt financing can affect both. The optimal capital structure balances the positive effects of increased earnings per share from using debt against the negative effects of increased risk for stockholders. Finally, the document discusses different theories about capital structure, including the trade-off theory and signaling theory.
Financial leverage involves using debt to finance a firm's assets in order to increase expected earnings per share. While it increases expected returns, it also increases risk. There is no unique optimal capital structure, as changing leverage simply redistributes risk between shareholders and bondholders without changing firm value. According to the Modigliano-Miller propositions, capital structure is irrelevant in perfect markets with no taxes or bankruptcy costs.
The document discusses capital structure and financial leverage. It defines capital structure as a firm's mix of debt and equity. Firms can alter their capital structure through activities like paying off debt with stock proceeds. Financial leverage refers to the extent a firm relies on debt financing. While debt provides a tax shield, it also increases the risks of bankruptcy costs if the firm cannot meet its debt obligations. The optimal capital structure balances the tax benefits of debt against the costs of financial distress.
1. The document discusses capital structure decisions and provides an overview of key theories on capital structure, including the trade-off theory, pecking order theory, and signaling theory.
2. It examines empirical evidence on factors like industry patterns, leverage, profitability, taxes, and bankruptcy costs as they relate to capital structure decisions.
3. The theories weigh the costs and benefits of debt versus equity for firms, including tax benefits, bankruptcy costs, agency costs, and implications for firm value.
This document provides an overview of capital structure. It defines sources of capital including equity and debt capital. It discusses the costs of equity, debt, and preferred shares. It introduces the weighted average cost of capital (WACC) and how it is used to determine a firm's target capital structure. The document also covers financial leverage and how it impacts earnings per share, return on equity, and risk. Break-even analysis and operating leverage are also summarized.
This document discusses various methods for valuing stocks, including discounted cash flow models like the dividend discount model and free cash flow models. It compares the cash flows to bond investors versus equity investors. Key valuation methods covered include relative valuation using price-earnings ratios and multiples of book value per share. The document also provides examples of calculating stock values using these various approaches.
The document discusses various aspects of capital structure including:
1) Capital structure refers to the combination of debt and equity used to finance a company's operations and growth. The capital structure decision considers factors like control, risk, and cost.
2) Several capital structure theories are described including the net income approach, traditional approach, and Modigliani-Miller approach. The net income approach suggests maximizing debt to minimize costs while the traditional approach finds an optimal debt level.
3) Worked examples demonstrate calculating a firm's value, cost of equity, and weighted average cost of capital under different capital structure assumptions.
- Capital structure refers to the proportion of different types of capital (equity, debt, preference shares) that make up a company's total financing. It influences the value of a firm.
- Three main approaches to capital structure are the net income approach, net operating income approach, and traditional approach. The Modigliani-Miller approach argues that the value and cost of capital of a firm are unaffected by its capital structure under certain assumptions.
- The net income approach suggests that increasing debt lowers the weighted average cost of capital and increases firm value. The net operating income approach argues that leverage does not affect total firm value. The traditional approach proposes an optimal debt-equity mix that maximizes firm value.
This document summarizes key concepts regarding capital structure analysis:
1) EBIT/EPS analysis examines how different capital structures affect earnings available to shareholders and risk based on different levels of EBIT. Leverage increases EPS at high EBIT levels but decreases it at low levels.
2) Debt provides a tax shield benefit as interest payments reduce taxable income. This increases overall returns to investors compared to an unlevered firm.
3) There is a trade-off between the tax benefits of debt and the financial distress and agency costs of debt as leverage increases. Optimal capital structure balances these factors.
4) Practical considerations like industry standards, creditor requirements, maintaining borrowing capacity, and manager
The Capital Asset Pricing Model (CAPM) was developed in the 1960s as a way to determine the expected return of an asset based on its risk. CAPM assumes that investors will be compensated only based on an asset's systematic or non-diversifiable risk as measured by its beta. The model builds on Markowitz's portfolio theory and introduces the security market line, which plots the expected return of an asset against its beta. According to CAPM, the expected return of an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset's beta.
This study investigated the relationship between macroeconomic uncertainty, corporate governance, and changes in firms' financial leverage. The researchers hypothesized that both macroeconomic uncertainty and corporate governance would significantly impact firms' financing decisions. Using data on over 1,000 US manufacturing firms from 1990-2006, the study found that both macroeconomic uncertainty and measures of corporate governance, such as governance indexes, influenced how firms adjusted their leverage over time. In particular, there were interaction effects between uncertainty and governance, such that the impact of one factor depended on the level of the other. The findings supported the conclusion that considering both macroeconomic conditions and corporate governance is important for understanding determinants of corporate capital structure decisions.
This document summarizes a study that examines how household portfolio diversification varies with financial literacy and financial advice. The study finds that households with below-median financial literacy that do not seek financial advice incur the largest losses from failing to properly diversify their portfolios. Specifically, these households have portfolios that provide significantly lower expected returns given the amount of risk taken, compared to households that have higher financial literacy or seek advice. The results suggest that both increasing financial literacy and the uptake of financial advice could help reduce welfare losses from suboptimal investment strategies among households.
The Combined Code is the primary document outlining principles of corporate governance in the UK. It consolidates recommendations from several earlier reports, including the Cadbury, Greenbury, Hampel, Turnbull, Higgs, and Smith Reports. These reports responded to corporate scandals and provided guidance on board responsibilities and composition, executive compensation, internal controls, audit functions, and shareholder rights. The Combined Code establishes 14 governance principles and is updated annually with new recommendations to maintain best practices.
Organizational Behavior Case Study of Mirror PlantRana Faisal Ali
The document discusses the Engstrom Auto Mirror Plant which manufactures mirrors for trucks and automobiles. It had 200 employees working at its Indiana plant. In 2006, 46 employees had to be laid off due to declining productivity, management issues, and a depressed economy. To address these problems, the plant considered closing down altogether or modifying its Scanlon Plan, which related employee bonuses to productivity but had become too complicated. It was proposed to simplify the Scanlon Plan payout calculations, improve communication with employees, and introduce new goals to increase productivity and motivation.
Bank Alfalah is a private commercial bank headquartered in Lahore, Pakistan. It was established in 1997 and provides personal, corporate, and consumer banking services according to Islamic principles. The bank aims to be a premier financial services organization locally and internationally by delivering innovative products and high quality customer service. It holds regular meetings for employees to provide feedback and discuss ways to improve operations and achieve organizational goals. Bank Alfalah's adherence to Islamic banking principles is both a strength in attracting Muslim customers and an opportunity to expand, but it also faces threats from competitors.
The chapter discusses the Capital Asset Pricing Model (CAPM). It introduces the efficient frontier and capital market line. The CAPM hypothesizes that the expected return of an asset is determined by its sensitivity to non-diversifiable risk, as represented by beta. All rational investors will hold the market portfolio and use leverage/borrowing according to their risk tolerance. The CAPM is used to determine the required rate of return for assets and their cost of equity.
Basel III is an international regulatory accord that introduced a series of reforms to regulate banks' capital adequacy and stress testing. It was implemented in response to the deficiencies exposed by the global financial crisis. The key changes introduced by Basel III include stronger capital and liquidity requirements, a leverage ratio to monitor financial leverage, and measures to promote the build-up of capital buffers. Basel III aims to improve the banking sector's ability to absorb shocks from financial and economic stress and reduce risks.
2. Advantages of Debt
• Interest is tax deductible (lowers the
effective cost of debt)
• Debt-holders are limited to a fixed return –
so stockholders do not have to share
profits if the business does exceptionally
well
• Debt holders do not have voting rights
3. Disadvantages of Debt
• Higher debt ratios lead to greater risk and
higher required interest rates (to
compensate for the additional risk)
4. What is the optimal debt-equity
ratio?
• Need to consider two kinds of risk:
– Business risk
– Financial risk
5. Business Risk
• Standard measure is beta (controlling for
financial risk)
• Factors:
– Demand variability
– Sales price variability
– Input cost variability
– Ability to develop new products
– Foreign exchange exposure
– Operating leverage (fixed vs variable costs)
6. Financial Risk
• The additional risk placed on the common
stockholders as a result of the decision to
finance with debt
7. Example of Business Risk
• Suppose 10 people decide to form a
corporation to manufacture disk drives.
• If the firm is capitalized only with common
stock – and if each person buys 10% --
each investor shares equally in business
risk
8. Example of Relationship Between
Financial and Business Risk
• If the same firm is now capitalized with
50% debt and 50% equity – with five
people investing in debt and five investing
in equity
• The 5 who put up the equity will have to
bear all the business risk, so the common
stock will be twice as risky as it would
have been had the firm been all-equity
(unlevered).
9. Business and Financial Risk
• Financial leverage concentrates the firm’s
business risk on the shareholders
because debt-holders, who receive fixed
interest payments, bear none of the
business risk.
10. Financial Risk
• Leverage increases shareholder risk
• Leverage also increases the return on
equity (to compensate for the higher risk)
11. Question?
• Is the increase in expected return due to
financial leverage sufficient to compensate
stockholders for the increase in risk?
12. Modigliani and Miller
• YES
• Assuming no taxes, the increase in return
to shock-holders resulting from the use of
leverage is exactly offset by the increase
in risk – hence no benefit to using financial
leverage (and no cost).
13. Topics To Be Covered
• Leverage in a Tax Free Environment
• How Leverage Affects Returns
• The Traditional Position
14. Capital Structure
• When a firm issues debt and equity
securities it splits cash flows into two
streams:
– Safe stream to bondholders
– Risky stream to stockholders
15. Capital Structure
• Modigliani and Miller (1958) show that
financing decisions don’t matter in perfect
capital markets
• M&M Proposition 1:
– Firms cannot change the total value of their
securities by splitting cash flows into two
different streams
– Firm value is determined by real assets
– Capital structure is irrelevant
16. M&M (Debt Policy Doesn’t Matter)
• Modigliani & Miller
– When there are no taxes and capital markets
function well, it makes no difference whether
the firm borrows or individual shareholders
borrow. Therefore, the market value of a
company does not depend on its capital
structure.
17. M&M (Debt Policy Doesn’t Matter)
Assumptions
• By issuing 1 security rather than 2, company
diminishes investor choice. This does not
reduce value if:
– Investors do not need choice, OR
– There are sufficient alternative securities
• Capital structure does not affect cash flows
e.g...
– No taxes
– No bankruptcy costs
– No effect on management incentives
18. An Example of the Effects of
Leverage
• D and E are market values of debt and
equity of Wapshot Marketing Company.
Wapshot has issued 1000 shares and
these are currently selling at $50 a share.
Wapshot has borrowed $25,000 so
Wapshot’s stock is “levered equity”.
• E = 1000 x $50 = $50,000
• D= $25,000
• V = E + D = $75,000
19. Effects of Leverage
• What happens if WPS “levers up” again by
borrowing an additional $10,000 and at the
same time paying out a special dividend of $10
per share, thereby substituting debt for equity?
• This should have no impact on WPS assets or
total cash flows:
– V is unchanged
– D= $35,000
– E= $75,000 - $35,000 = $40,000
• Stockholders will suffer a $10,000 capital loss
which is exactly offset by the $10,000 special
dividend.
20. Effects of Leverage
• What if instead of assuming V is
unchanged we allow V it rise to $80,000
as a result of the change in capital
structure?
• Then E = $80,000 - $35,000 = $45,000
• Any increase or decrease in V as a result
of the change in capital structure accrues
to the shareholders
21. Effects of Leverage
• What if the new borrowing increases the
risk of bankruptcy?
• This would suggest that the risk of the “old
debt” is higher (and the value of the old
debt is lower)
• If this is the case, then shareholders would
gain from the increase in leverage at the
expense of the original bondholders.
22. Modigliani and Miller
• Any combination of securities is as good
as any other.
• Example:
– Two Firms with the same operating income
who differ only in capital structure
• Firm U is unlevered: VU=EU
• Firm L is levered: EL= VL-DL
23. Modigliani and Miller
• Four Strategies
• Strategy 1
– Buy 1% of Firm U’s Equity
• Dollar investment = .01VU
• Dollar Return= .01 Profits
• Strategy 2
– Buy 1% of Firm L’s Equity and Debt
• Dollar investment= .01DL + .01EL = .01VL
• Dollar Return=
• From owning .01 DL .01 interest
• From owning .01 EL .01 (Profits – interest)
• Total .01 Profits
• Both Strategies give the same payoff
24. Modigliani and Miller
• Strategy 3
– Buy 1% of Firm L’s Equity
• Dollar investment = .01EL= .01(VL-DL)
• Dollar Return= .01 (Profits – interest)
• Strategy 4
– Buy 1% of Firm U’s Equity and borrow on your own
account .01DL (home-made leverage)
• Dollar investment= .01(Vu – DL)
• Dollar Return=
• From borrowing .01DL -.01 interest
• From owning .01 EU .01 (Profits)
• Total .01 (Profits – interest)
• Both Strategies give the same payoff
25. Modigliani and Miller
• It does not matter what risk preferences
are for investors.
• Just need that investors have the ability to
borrow and lend for their own account
(and at the same rate as firms) so that
they can “undo” any changes in firm’s
capital structure
• M&M Proposition 1: the value of a firm is
independent of its capital structure.
28. M&M Proposition 2
• Bonds are almost risk-free at low debt levels
– rD is independent of leverage
– rE increases linearly with debt-equity ratios and the
increase in expected return reflects increased risk
• As firms borrow more, the risk of default rises
– rD starts to increase
– rE increases more slowly (because the holders of risky
debt bear some of the firm’s business risk)
29. The Return on Equity
• The increase in expected equity return
reflects increased risk
• The increase in leverage increases the
amplitude of variation in cash flows
available to share-holders (the same
change in operating income is now
distributed among fewer shares)
• We can understand the increase in risk in
terms of Betas
31. The Traditional Position
• What did financial experts think before
M&M?
• They used the concept of WACC
(weighted average cost of capital)
– WACC is the expected return on the portfolio
of all the company’s securities
34. WACC
Example - A firm has $2 mil of debt and
100,000 of outstanding shares at $30
each. If they can borrow at 8% and the
stockholders require 15% return what is
the firm’s WACC?
D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
35. WACC
Example - A firm has $2 mil of debt and 100,000 of
outstanding shares at $30 each. If they can borrow at
8% and the stockholders require 15% return what is the
firm’s WACC? D = $2 million
E = 100,000 shares X $30 per share = $3 million
V = D + E = 2 + 3 = $5 million
12.2%or122.
15.
5
3
08.
5
2
=
×+
×=
×+
×= ED r
V
E
r
V
D
WACC
36. The Traditional Position
• The return on equity (rE) is constant
• WACC declines with increasing leverage
because rD<rE
• Given the two assumptions above, a firm
will minimize the cost of capital by issuing
almost 100% debt
• This can’t be correct!
38. An intermediate position
• A moderate degree of financial leverage may
increase the return on equity (but less than
predicted by M&M proposition 2)
• A high degree of financial leverage increases the
return on equity (but by more than predicted by
M&M proposition 2)
• WACC then declines at first, then rises with
increasing leverage (U-shape)
• Its minimum point is the point of “optimal capital
structure”.
40. The intermediate position
• Investors don’t notice risk of “moderate”
borrowing
• They wake up with debt is “excessive”
• The problem with this view is that it confuses
default risk with financial risk.
– Default risk may not be serious for moderate amounts
of leverage
– Financial risk (in terms of increased volatility of return
and higher beta) will increase with leverage even with
no risk of default
41. Modigliani and Miller Revisited
• M&M proposition 1: A firm’s total value is
independent of its capital structure
• Assumptions needed for Prop 1 to hold:
1. Capital markets are perfect and complete
2. Before-tax operating profits are not affected by
capital structure
3. Corporate and personal taxes are not affected by
capital structure
4. The firm’s choice of capital structure does not
convey important information to the market
42. Modigliani and Miller Revisited
• M&M Proposition 2: The return on equity
will rise as the debt-equity ratio rises in
order to compensate equity holders for the
additional (financial) risk.
• Note: Proposition 2 does not rely on
default risk – rE rises because of the rise in
financial risk
44. Financial Risk - Risk to shareholders resulting
from the use of debt.
Financial Leverage - Increase in the variability of
shareholder returns that comes from the use of
debt.
Interest Tax Shield- Tax savings resulting from
deductibility of interest payments.
Capital Structure and Corporate
Taxes
45. Example - You own all the equity in a company.
The company has no debt. The company’s
annual cash flow is $1,000, before interest and
taxes. The corporate tax rate is 40%. You have
the option to exchange 1/2 of your equity
position for 10% bonds with a face value of
$1,000.
Should you do this and why?
Capital Structure and Corporate
Taxes
46. All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
Capital Structure and Corporate
Taxes
Total Cash Flow
All Equity = 600
*1/2 Debt = 640*1/2 Debt = 640
(540 + 100)
47. Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400
48. Capital Structure
Firm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
Firm Value with 1/2 Debt = $6,400
49. U.S. Tax Code
• Allows corporations to deduct interest
payments on debt as an expense
• Dividend payments to stockholders are not
deductible
• Differential treatment results in a net
benefit to financial leverage (debt)
50. U.S. Tax Code
• Personal taxes bias the other way (toward equity)
• Income from bonds generally comes as interest and
is taxed at the personal income tax rate
• Income from equity comes partly from dividends and
partly from capital gains
• Capital gains are often taxed at a lower rate and the
tax is deferred until the stock is sold and the gain
realized.
• If the owner of the stock dies – no capital gain tax is
paid
• On balance, common stock returns are taxed at
lower rates than debt returns
51. U.S. Tax Rates
• Top bracket (over $250,000 for a married
couple)
– Personal rates: 35%
– Capital gains: 18% (holding period of 18mos)
• If stock is held for less than 1 year capital gain is
taxed at the personal rate
• If stock is held for over 1 year but less than 18mos
the capital gains tax is between 18-35%
52. Capital Structure and Financial
Distress
Costs of Financial Distress - Costs arising from
bankruptcy or distorted business decisions before
bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
53. Weighted Average Cost of Capital
without taxes (traditional view)
r
D
E
rD
rE
Includes Bankruptcy Risk
WACC
55. M&M with taxes and bankruptcy
• WACC now is more hump-shaped (similar
to the traditional view – though for different
reasons).
• The minimum WACC occurs where the
stock price is maximized.
• Thus, the same capital structure that
maximizes stock price also minimizes the
WACC.
56. Financial Choices
Trade-off Theory - Theory that capital structure is
based on a trade-off between tax savings and
distress costs of debt.
Pecking Order Theory - Theory stating that firms
prefer to issue debt rather than equity if internal
finance is insufficient.
57. Pecking Order Theory
The announcement of a stock issue drives down the stock
price because investors believe managers are more likely to
issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be
raised without sending adverse signals.
If external finance is required, firms issue debt first and equity
as a last resort.
The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.
58. Pecking Order Theory
Some Implications:
Internal equity may be better than external
equity.
Financial slack is valuable.
If external capital is required, debt is better.
(There is less room for difference in opinions
about what debt is worth).