The document discusses capital structure decisions and theories. It begins by outlining the goals of maximizing firm value and minimizing the weighted average cost of capital (WACC) through lowering risk, increasing cash flows, and maximizing profits. It then discusses factors that affect capital structure such as business risk, debt tax deductibility, and managerial decisions.
The document goes on to provide definitions related to capital structure and explores how capital structure can impact value using the WACC and free cash flow models. It previews various capital structure theories including Modigliani-Miller with no taxes, corporate taxes, and corporate and personal taxes. Finally, it discusses the trade-off theory and how an optimal capital structure balances the tax
This document summarizes capital structure decisions and theories. It discusses how debt can impact a firm's weighted average cost of capital (WACC) and free cash flow (FCF). The key effects are:
- Debt can lower WACC by reducing the tax burden but increase it by raising financial risk.
- Debt can boost or reduce FCF by lowering costs through interest tax deductions but increasing bankruptcy risk.
- Capital structure theories like MM and trade-off theory examine the optimal debt-equity mix that balances these costs and benefits. Signaling theory notes managers' private information impacts financing choices.
This document provides an overview of capital structure decisions and theories. It discusses how debt can impact a firm's weighted average cost of capital, free cash flows, and risk. Capital structure theories covered include Modigliani-Miller under different tax assumptions, trade-off theory, and signaling theory. Examples are provided to illustrate how leverage can increase returns but also financial risk for stockholders.
This document provides an overview of capital structure decisions and theory. It defines key terms related to capital structure and costs of capital. It discusses how debt can impact the weighted average cost of capital and free cash flows. Capital structure theories covered include Modigliani-Miller with no taxes, corporate taxes, and corporate and personal taxes. The trade-off theory and signaling theory are also introduced.
Fm11 ch 16 capital structure decisions the basicsNhu Tuyet Tran
This document provides an overview of capital structure decisions and theory. It defines key terms related to capital structure and costs of capital. It discusses how debt can impact the weighted average cost of capital and free cash flows. Capital structure theories covered include Modigliani-Miller with no taxes, corporate taxes, and corporate and personal taxes. The trade-off theory and signaling theory are also introduced.
Capital structure decisions impact firm value. While the Modigliani-Miller theories concluded capital structure is irrelevant in perfect markets, other theories recognize costs like bankruptcy and agency costs. An optimal capital structure balances tax benefits of debt against these costs. Managers should consider their firm's risk level and investment opportunities to determine an appropriate capital structure.
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.
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.
This document discusses capital structure and the limits of using debt. It introduces the concept that a firm's value is the sum of its debt and equity values. While increasing leverage can increase firm value by taking advantage of tax benefits, it also increases financial distress costs. There is an optimal capital structure that balances these factors. The document also discusses how signaling and agency costs further complicate determining the optimal structure.
This document summarizes capital structure decisions and theories. It discusses how debt can impact a firm's weighted average cost of capital (WACC) and free cash flow (FCF). The key effects are:
- Debt can lower WACC by reducing the tax burden but increase it by raising financial risk.
- Debt can boost or reduce FCF by lowering costs through interest tax deductions but increasing bankruptcy risk.
- Capital structure theories like MM and trade-off theory examine the optimal debt-equity mix that balances these costs and benefits. Signaling theory notes managers' private information impacts financing choices.
This document provides an overview of capital structure decisions and theories. It discusses how debt can impact a firm's weighted average cost of capital, free cash flows, and risk. Capital structure theories covered include Modigliani-Miller under different tax assumptions, trade-off theory, and signaling theory. Examples are provided to illustrate how leverage can increase returns but also financial risk for stockholders.
This document provides an overview of capital structure decisions and theory. It defines key terms related to capital structure and costs of capital. It discusses how debt can impact the weighted average cost of capital and free cash flows. Capital structure theories covered include Modigliani-Miller with no taxes, corporate taxes, and corporate and personal taxes. The trade-off theory and signaling theory are also introduced.
Fm11 ch 16 capital structure decisions the basicsNhu Tuyet Tran
This document provides an overview of capital structure decisions and theory. It defines key terms related to capital structure and costs of capital. It discusses how debt can impact the weighted average cost of capital and free cash flows. Capital structure theories covered include Modigliani-Miller with no taxes, corporate taxes, and corporate and personal taxes. The trade-off theory and signaling theory are also introduced.
Capital structure decisions impact firm value. While the Modigliani-Miller theories concluded capital structure is irrelevant in perfect markets, other theories recognize costs like bankruptcy and agency costs. An optimal capital structure balances tax benefits of debt against these costs. Managers should consider their firm's risk level and investment opportunities to determine an appropriate capital structure.
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.
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.
This document discusses capital structure and the limits of using debt. It introduces the concept that a firm's value is the sum of its debt and equity values. While increasing leverage can increase firm value by taking advantage of tax benefits, it also increases financial distress costs. There is an optimal capital structure that balances these factors. The document also discusses how signaling and agency costs further complicate determining the optimal structure.
1) Under MM assumptions with no taxes, the WACC is the same for both levered and unlevered firms and is equal to the cost of equity.
2) With taxes, debt lowers the WACC by shifting from high-cost equity to lower-cost debt.
3) Personal taxes further lower the benefits of debt by favoring equity financing over debt. Overall capital structure is less important than under the original MM model.
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.
This document discusses Mark Heath's assignment on corporate finance. It analyzes Modigliani and Miller's theories on capital structure and firm valuation. Specifically:
1) It applies their proposition I that firm value is unaffected by capital structure in a world without taxes to calculate the value of an unlevered and levered firm.
2) It discusses their proposition II that the weighted average cost of capital is also unaffected by capital structure when there are no taxes or transaction costs.
3) It examines how the introduction of corporate and personal taxes impacts firm valuation and the relationship between debt ratios and weighted average cost of capital. Bankruptcy costs are also considered in determining an optimal capital structure.
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.
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.
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
FIN 534 Week 8 Part 2 Capital Structure DecisionsSlide 1Intro.docxssuser454af01
FIN 534 Week 8 Part 2: Capital Structure Decisions
Slide 1
Introduction
Welcome to Financial Management. In this lesson we will discuss capital structure decisions.
Next slide
Slide 2
Topics
The following topics will be covered in this lesson:
A preview of capital structure issues;
Business risk and financial risk;
Capital structure theory;
Capital structure evidence and implications;
Estimating the optimal capital structure; and
Anatomy of recapitalization.
Next slide
Slide 3
A preview of capital structure issues
Managers should make capital structure decisions to maximize the intrinsic value of the firm. The firm’s capital structure is its mixture of debt and equity. While the actual levels of debt and equity may vary over time, most firms try to maintain a financing mix that is close to its target capital structure. Recall, the value of the firm’s operations is the present value of its expected future cash flows, FCF, discounted at the firm’s weighted average cost of capital, WACC. Mathematically, the value of the firm’s operations is given by the following equation:
V sub OP equals summation T equals one through infinity FCF sub T divided by the quantity one plus WACC raised to the tth power;
Where WACC equals w sub D times the quantity one minus T times R sub D plus W sub S times R sub S; and
WACC depends on the percentages of debt and common equity, W sub D and W sub S, the cost of debt, R sub D, the cost of equity, R sub S, and the corporate tax rate T. The only way any decision can change the firm’s value is by changing either FCF or its cost of capital. Debtholders’ claim on the firm’s cash flows rank ahead of the stockholders’ claim because they have a residual claim on the cash flows after debtholders’ are paid.
The fixed claim of debtholders increases the cost of equity, R sub S, because their residual claim becomes riskier. Interest expense is tax deductible which reduces the firm’s taxable income and therefore its tax bill. The tax reduction reduces the after-tax cost of debt which results in more income available to debtholders and other investors.
When the firm increases its debt level the probability of financial distress or bankruptcy increases. This results in an increased pretax cost of debt, R sub D, because debt-holders will require a higher interest rate. The net impact on the WACC is indeterminate because both R sub D and R sub S change because it is a weighted average of relatively low-cost debt and relatively high-cost equity. The risk of bankruptcy can reduce FCF and the value of the firm. When the risk of bankruptcy increases, customers may make purchases from another firm and hence sales decline which reduces net operating profit as well as FCF. Additionally any type of financial distress negatively impacts the productivity of managers and employees and reduces net operating profit after taxes, NOPAT, and FCF. Moreover the firm experiences a reduction in accounts payable and results in an ...
The document discusses several capital structure theories:
- The Modigliani-Miller model establishes that firm value is independent of capital structure under certain restrictive assumptions.
- The trade-off theory recognizes that while debt provides tax benefits, it also increases financial distress costs at higher leverage levels.
- Agency theory suggests that debt can help reduce equity agency costs by limiting free cash flow.
- Signaling theory posits that capital structure decisions signal private information to investors.
- Overall, the optimal capital structure balances these factors and depends on firm-specific characteristics.
This document provides an outline and overview of capital structure and term structure theories. It discusses key concepts related to a firm's capital structure decision, including the net income approach, traditional views, Modigliani-Miller propositions, and theories such as trade-off, agency costs, and pecking order. It also covers term structure theories, including the expectations theory, segmented markets theory, and liquidity premium theory. The document uses examples and diagrams to illustrate how financial leverage, taxes, and bankruptcy costs impact a firm's optimal capital structure and cost of capital.
Working Capital ManagementChapter 15Working Ca.docxdunnramage
Working Capital Management
Chapter 15
Working Capital Terminology
Working capital: current assets.
Net working capital:
current assets - current liabilities.
Net operating working capital:
current assets - (current liabilities - notes payable).
Working capital management:
controlling cash, inventories, and A/R, plus short-term liability management.
2
Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent assets.
Moderate: Match the maturity of the assets with the maturity of the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and temporary assets.
3
Cash Conversion Cycle
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
4
Cash Conversion Cycle
15-5
5
Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or funds available to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual cash management.
6
Cash and Marketable Securities
Currency
Demand Deposit
Marketable Securities
Inventories
Supplies
Raw materials
Work in process
Finished goods
Accounts Receivable: Credit Policy
Credit Period: How long to pay? Shorter period reduces days sales outstanding (DSO) and average A/R, but it may discourage sales.
Cash Discounts: Lowers price. Attracts new customers and reduces DSO.
Credit Standards: Restrictive standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.
Collection Policy: How tough? Restrictive policy will reduce DSO but may damage customer relationships.
9
Accounts Payable: Trade Credit
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit, especially for small firms.
Spontaneous, easy to get, but cost can be high.
10
period
deferral
Payables
period
collection
Average
period
conversion
Inventory
CCC
-
+
=
Capital Structure Policy
Chapter 13
Learning Objectives
Understand the difference between business risk and financial risk.
Use the technique of break-even analysis.
Understand capital structure theories.
Business Risk
Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates.
Determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry
Operating Risk
Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs).
Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.
5
Operating Lev.
This document discusses leverage and capital structure. It defines operating leverage as the use of fixed costs rather than variable costs, which increases business risk when sales decline. Financial leverage refers to the use of debt in the capital structure. While financial leverage can increase expected return on equity if the business' earnings before interest and taxes covers the cost of debt, it also increases risk for equity holders. There is an optimal capital structure that balances the higher expected returns from leverage against the increased financial risk.
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.
The document discusses various factors that influence a company's capital structure and theories around optimal capital structure. It covers factors like financial leverage, growth, costs, and investor requirements. It also discusses reasons for changing capitalization like restoring financial balance or meeting legal needs. Several capital structure theories are examined, including the net income approach, net operating income approach, and MM hypotheses with and without taxes. The document also discusses concepts like indifference points, financial break even points, and how debt-equity mix can impact firm value.
Topic 4 Financial Levarage And Capital Structureshengvn
1) Leverage increases the variability of both EPS and ROE. It amplifies gains in good years but also amplifies losses in bad years.
2) Break-even EBIT is the level of earnings where EPS is the same under the current and proposed capital structures. It indicates whether leverage will increase or decrease stockholder wealth.
3) The optimal capital structure balances the tax benefits of debt against the costs of financial distress and bankruptcy. It occurs when the benefit of an additional dollar of debt is offset by the increased expected bankruptcy costs.
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.
1) The document discusses capital structure theories and the effect of leverage on firm value. It outlines Modigliani-Miller's propositions with and without taxes.
2) According to MM, in a world without taxes, capital structure does not affect firm value but increases risk for shareholders. With taxes, firm value increases with leverage due to interest tax shields.
3) The document also discusses how shareholders can achieve the same returns as a levered firm through "homemade leverage" by borrowing personally.
1) The document discusses capital structure theories and the Modigliani-Miller propositions. It examines how capital structure affects firm value with and without taxes.
2) According to M&M, in a world without taxes, capital structure does not affect firm value. With taxes, firm value increases with leverage due to interest tax shields.
3) The concept of "homemade leverage" shows that investors can replicate the payouts of levered firms through borrowing, supporting the idea that capital structure does not intrinsically affect value.
This document discusses various theories of capital structure and their impact on firm value. It begins by outlining learning objectives around capital structure theories and their relationship to cost of capital and firm value. It then covers the net operating income, traditional, and Modigliani-Miller approaches. It discusses how taxes impact the MM hypotheses and introduces the trade-off theory weighing costs and benefits of leverage. The document also summarizes pecking order theory and approaches to establishing an optimal capital structure.
The document discusses the evolution of thinking around corporate capital structures and optimal debt levels. It notes that early economic models assumed rational behavior and perfect markets in determining optimal capital structure. However, Miller argued that a firm's value will be independent of its capital structure even when accounting for interest tax deductibility. The paper examines how bankruptcy costs, taxes, and market equilibrium impact capital structure decisions. It also notes some of the assumptions in Miller's models, such as personal tax rates on stock and bond income.
1) Under MM assumptions with no taxes, the WACC is the same for both levered and unlevered firms and is equal to the cost of equity.
2) With taxes, debt lowers the WACC by shifting from high-cost equity to lower-cost debt.
3) Personal taxes further lower the benefits of debt by favoring equity financing over debt. Overall capital structure is less important than under the original MM model.
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.
This document discusses Mark Heath's assignment on corporate finance. It analyzes Modigliani and Miller's theories on capital structure and firm valuation. Specifically:
1) It applies their proposition I that firm value is unaffected by capital structure in a world without taxes to calculate the value of an unlevered and levered firm.
2) It discusses their proposition II that the weighted average cost of capital is also unaffected by capital structure when there are no taxes or transaction costs.
3) It examines how the introduction of corporate and personal taxes impacts firm valuation and the relationship between debt ratios and weighted average cost of capital. Bankruptcy costs are also considered in determining an optimal capital structure.
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.
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.
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
FIN 534 Week 8 Part 2 Capital Structure DecisionsSlide 1Intro.docxssuser454af01
FIN 534 Week 8 Part 2: Capital Structure Decisions
Slide 1
Introduction
Welcome to Financial Management. In this lesson we will discuss capital structure decisions.
Next slide
Slide 2
Topics
The following topics will be covered in this lesson:
A preview of capital structure issues;
Business risk and financial risk;
Capital structure theory;
Capital structure evidence and implications;
Estimating the optimal capital structure; and
Anatomy of recapitalization.
Next slide
Slide 3
A preview of capital structure issues
Managers should make capital structure decisions to maximize the intrinsic value of the firm. The firm’s capital structure is its mixture of debt and equity. While the actual levels of debt and equity may vary over time, most firms try to maintain a financing mix that is close to its target capital structure. Recall, the value of the firm’s operations is the present value of its expected future cash flows, FCF, discounted at the firm’s weighted average cost of capital, WACC. Mathematically, the value of the firm’s operations is given by the following equation:
V sub OP equals summation T equals one through infinity FCF sub T divided by the quantity one plus WACC raised to the tth power;
Where WACC equals w sub D times the quantity one minus T times R sub D plus W sub S times R sub S; and
WACC depends on the percentages of debt and common equity, W sub D and W sub S, the cost of debt, R sub D, the cost of equity, R sub S, and the corporate tax rate T. The only way any decision can change the firm’s value is by changing either FCF or its cost of capital. Debtholders’ claim on the firm’s cash flows rank ahead of the stockholders’ claim because they have a residual claim on the cash flows after debtholders’ are paid.
The fixed claim of debtholders increases the cost of equity, R sub S, because their residual claim becomes riskier. Interest expense is tax deductible which reduces the firm’s taxable income and therefore its tax bill. The tax reduction reduces the after-tax cost of debt which results in more income available to debtholders and other investors.
When the firm increases its debt level the probability of financial distress or bankruptcy increases. This results in an increased pretax cost of debt, R sub D, because debt-holders will require a higher interest rate. The net impact on the WACC is indeterminate because both R sub D and R sub S change because it is a weighted average of relatively low-cost debt and relatively high-cost equity. The risk of bankruptcy can reduce FCF and the value of the firm. When the risk of bankruptcy increases, customers may make purchases from another firm and hence sales decline which reduces net operating profit as well as FCF. Additionally any type of financial distress negatively impacts the productivity of managers and employees and reduces net operating profit after taxes, NOPAT, and FCF. Moreover the firm experiences a reduction in accounts payable and results in an ...
The document discusses several capital structure theories:
- The Modigliani-Miller model establishes that firm value is independent of capital structure under certain restrictive assumptions.
- The trade-off theory recognizes that while debt provides tax benefits, it also increases financial distress costs at higher leverage levels.
- Agency theory suggests that debt can help reduce equity agency costs by limiting free cash flow.
- Signaling theory posits that capital structure decisions signal private information to investors.
- Overall, the optimal capital structure balances these factors and depends on firm-specific characteristics.
This document provides an outline and overview of capital structure and term structure theories. It discusses key concepts related to a firm's capital structure decision, including the net income approach, traditional views, Modigliani-Miller propositions, and theories such as trade-off, agency costs, and pecking order. It also covers term structure theories, including the expectations theory, segmented markets theory, and liquidity premium theory. The document uses examples and diagrams to illustrate how financial leverage, taxes, and bankruptcy costs impact a firm's optimal capital structure and cost of capital.
Working Capital ManagementChapter 15Working Ca.docxdunnramage
Working Capital Management
Chapter 15
Working Capital Terminology
Working capital: current assets.
Net working capital:
current assets - current liabilities.
Net operating working capital:
current assets - (current liabilities - notes payable).
Working capital management:
controlling cash, inventories, and A/R, plus short-term liability management.
2
Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent assets.
Moderate: Match the maturity of the assets with the maturity of the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and temporary assets.
3
Cash Conversion Cycle
The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.
4
Cash Conversion Cycle
15-5
5
Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or funds available to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual cash management.
6
Cash and Marketable Securities
Currency
Demand Deposit
Marketable Securities
Inventories
Supplies
Raw materials
Work in process
Finished goods
Accounts Receivable: Credit Policy
Credit Period: How long to pay? Shorter period reduces days sales outstanding (DSO) and average A/R, but it may discourage sales.
Cash Discounts: Lowers price. Attracts new customers and reduces DSO.
Credit Standards: Restrictive standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO.
Collection Policy: How tough? Restrictive policy will reduce DSO but may damage customer relationships.
9
Accounts Payable: Trade Credit
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit, especially for small firms.
Spontaneous, easy to get, but cost can be high.
10
period
deferral
Payables
period
collection
Average
period
conversion
Inventory
CCC
-
+
=
Capital Structure Policy
Chapter 13
Learning Objectives
Understand the difference between business risk and financial risk.
Use the technique of break-even analysis.
Understand capital structure theories.
Business Risk
Business Risk is the variation in the firm’s expected earnings attributable to the industry in which the firm operates.
Determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry
Operating Risk
Operating risk is the variation in the firm’s operating earnings that results from firm’s cost structure (mix of fixed and variable operating costs).
Earnings of firms with higher proportion of fixed operating costs are more vulnerable to change in revenues.
5
Operating Lev.
This document discusses leverage and capital structure. It defines operating leverage as the use of fixed costs rather than variable costs, which increases business risk when sales decline. Financial leverage refers to the use of debt in the capital structure. While financial leverage can increase expected return on equity if the business' earnings before interest and taxes covers the cost of debt, it also increases risk for equity holders. There is an optimal capital structure that balances the higher expected returns from leverage against the increased financial risk.
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.
The document discusses various factors that influence a company's capital structure and theories around optimal capital structure. It covers factors like financial leverage, growth, costs, and investor requirements. It also discusses reasons for changing capitalization like restoring financial balance or meeting legal needs. Several capital structure theories are examined, including the net income approach, net operating income approach, and MM hypotheses with and without taxes. The document also discusses concepts like indifference points, financial break even points, and how debt-equity mix can impact firm value.
Topic 4 Financial Levarage And Capital Structureshengvn
1) Leverage increases the variability of both EPS and ROE. It amplifies gains in good years but also amplifies losses in bad years.
2) Break-even EBIT is the level of earnings where EPS is the same under the current and proposed capital structures. It indicates whether leverage will increase or decrease stockholder wealth.
3) The optimal capital structure balances the tax benefits of debt against the costs of financial distress and bankruptcy. It occurs when the benefit of an additional dollar of debt is offset by the increased expected bankruptcy costs.
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.
1) The document discusses capital structure theories and the effect of leverage on firm value. It outlines Modigliani-Miller's propositions with and without taxes.
2) According to MM, in a world without taxes, capital structure does not affect firm value but increases risk for shareholders. With taxes, firm value increases with leverage due to interest tax shields.
3) The document also discusses how shareholders can achieve the same returns as a levered firm through "homemade leverage" by borrowing personally.
1) The document discusses capital structure theories and the Modigliani-Miller propositions. It examines how capital structure affects firm value with and without taxes.
2) According to M&M, in a world without taxes, capital structure does not affect firm value. With taxes, firm value increases with leverage due to interest tax shields.
3) The concept of "homemade leverage" shows that investors can replicate the payouts of levered firms through borrowing, supporting the idea that capital structure does not intrinsically affect value.
This document discusses various theories of capital structure and their impact on firm value. It begins by outlining learning objectives around capital structure theories and their relationship to cost of capital and firm value. It then covers the net operating income, traditional, and Modigliani-Miller approaches. It discusses how taxes impact the MM hypotheses and introduces the trade-off theory weighing costs and benefits of leverage. The document also summarizes pecking order theory and approaches to establishing an optimal capital structure.
The document discusses the evolution of thinking around corporate capital structures and optimal debt levels. It notes that early economic models assumed rational behavior and perfect markets in determining optimal capital structure. However, Miller argued that a firm's value will be independent of its capital structure even when accounting for interest tax deductibility. The paper examines how bankruptcy costs, taxes, and market equilibrium impact capital structure decisions. It also notes some of the assumptions in Miller's models, such as personal tax rates on stock and bond income.
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THE SACRIFICE HOW PRO-PALESTINE PROTESTS STUDENTS ARE SACRIFICING TO CHANGE T...indexPub
The recent surge in pro-Palestine student activism has prompted significant responses from universities, ranging from negotiations and divestment commitments to increased transparency about investments in companies supporting the war on Gaza. This activism has led to the cessation of student encampments but also highlighted the substantial sacrifices made by students, including academic disruptions and personal risks. The primary drivers of these protests are poor university administration, lack of transparency, and inadequate communication between officials and students. This study examines the profound emotional, psychological, and professional impacts on students engaged in pro-Palestine protests, focusing on Generation Z's (Gen-Z) activism dynamics. This paper explores the significant sacrifices made by these students and even the professors supporting the pro-Palestine movement, with a focus on recent global movements. Through an in-depth analysis of printed and electronic media, the study examines the impacts of these sacrifices on the academic and personal lives of those involved. The paper highlights examples from various universities, demonstrating student activism's long-term and short-term effects, including disciplinary actions, social backlash, and career implications. The researchers also explore the broader implications of student sacrifices. The findings reveal that these sacrifices are driven by a profound commitment to justice and human rights, and are influenced by the increasing availability of information, peer interactions, and personal convictions. The study also discusses the broader implications of this activism, comparing it to historical precedents and assessing its potential to influence policy and public opinion. The emotional and psychological toll on student activists is significant, but their sense of purpose and community support mitigates some of these challenges. However, the researchers call for acknowledging the broader Impact of these sacrifices on the future global movement of FreePalestine.
2. 2
Goal of the Firm is
Maximize Firm Value
Minimize WACC
Thru:
Lowering risk
Increasing CFs
Maximize Op. Profits
Growth Business
Reduce Taxes
3. 3
Factors Affecting Capital
Structure:
Business Risk
Debt’s tax deductibility
Ability to raise capital under adverse terms
Managerial decisions:
Conservative vs. Aggressive
Minimize WACC
Thru:
Lowering risk
Increasing CFs
Maximize Op. Profits
Growth Business
Reduce Taxes
4. 4
Basic Definitions
V = value of firm
FCF = free cash flow
WACC = weighted average cost of
capital
rs and rd are costs of stock and debt
ws and wd are percentages of the firm
that are financed with stock and debt.
5. 5
How can capital structure
affect value?
V = ∑
∞
t=1
FCFt
(1 + WACC)t
WACC= wd (1-T) rd + wsrs
6. 6
A Preview of Capital Structure
Effects
The impact of capital structure on value
depends upon the effect of debt on:
WACC
FCF
(Continued…)
7. 7
The Effect of Additional
Debt on WACC
Debtholders have a prior claim on cash flows
relative to stockholders.
Debtholders’ “fixed” claim increases risk of
stockholders’ “residual” claim.
Cost of stock, rs, goes up.
Firm’s can deduct interest expenses.
Reduces the taxes paid
Frees up more cash for payments to investors
Reduces after-tax cost of debt
(Continued…)
8. 8
The Effect on WACC
(Continued)
Debt increases risk of bankruptcy
Causes pre-tax cost of debt, rd, to increase
Adding debt increase percent of firm
financed with low-cost debt (wd) and
decreases percent financed with high-
cost equity (ws)
Net effect on WACC = uncertain.
(Continued…)
9. 9
The Effect of Additional Debt
on FCF
Additional debt increases the probability
of bankruptcy.
Direct costs: Legal fees, “fire” sales, etc.
Indirect costs: Lost customers, reduction in
productivity of managers and line workers,
reduction in credit (i.e., accounts payable)
offered by suppliers
(Continued…)
10. 10
What is operating leverage, and how
does it affect a firm’s business risk?
Operating leverage is the change in
EBIT caused by a change in quantity
sold.
The higher the proportion of fixed costs
relative to variable costs, the greater
the operating leverage.
(More...)
11. 11
Higher operating leverage leads to more
business risk: small sales decline causes a
larger EBIT decline.
(More...)
Sales
$ Rev.
TC
F
QBE
EBIT
}
$
Rev.
TC
F
QBE
Sales
12. 12
Consider Two Hypothetical Firms
Identical Except for Debt
Firm U Firm L
Capital $20,000 $20,000
Debt $0 $10,000 (12% rate)
Equity $20,000 $10,000
Tax rate 40% 40%
EBIT $3,000 $3,000
NOPAT $1,800 $1,800
ROIC 9% 9%
13. 13
Impact of Leverage on
Returns
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROIC (NI+Int)/TA] 9.0% 11.0%
ROE (NI/Equity) 9.0% 10.8%
14. 14
Why does leveraging increase
return?
More cash goes to investors of Firm L.
Total dollars paid to investors:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
Taxes paid:
U: $1,200
L: $720.
In Firm L, fewer dollars are tied up in
equity.
15. 15
Impact of Leverage on
Returns if EBIT Falls
Firm U Firm L
EBIT $2,000 $2,000
Interest 0 1,200
EBT $2,000 $800
Taxes (40%) 800 320
NI $1,200 $480
ROIC 6.0% 6.0%
ROE 6.0% 4.8%
Leverage magnifies risk and return!
16. 16
Impact of Leverage on
Returns if EBIT Rises
Firm U Firm L
EBIT $4,000 $4,000
Interest 0 1,200
EBT $4,000 $2,800
Taxes (40%) 1,600 1,120
NI $2,400 $1,680
ROIC 12.0% 14.0%
ROE 12.0% 16.8%
Leverage magnifies risk and return!
17. 17
Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Windows of opportunity
18. 18
Modigliani-Miller (MM) Theory:
Zero Taxes
Firm U Firm L
EBIT $3,000 $3,000
Interest 0 1,200
NI $3,000 $1,800
CF to shareholder $3,000 $1,800
CF to debtholder 0 $1,200
Total CF $3,000 $3,000
Notice that the total CF are identical for both firms.
19. 19
MM Results: Zero Taxes
MM assume: (1) no transactions costs; (2) no
restrictions or costs to short sales; and (3) individuals
can borrow at the same rate as corporations.
MM prove that if the total CF to investors of Firm U
and Firm L are equal, then arbitrage is possible
unless the total values of Firm U and Firm L are
equal:
VL = VU.
Because FCF and values of firms L and U are equal,
their WACCs are equal.
Therefore, capital structure is irrelevant.
20. 20
MM Theory: Corporate Taxes
Corporate tax laws allow interest to be
deducted, which reduces taxes paid by
levered firms.
Therefore, more CF goes to investors and
less to taxes when leverage is used.
In other words, the debt “shields” some
of the firm’s CF from taxes.
21. 21
MM Result: Corporate Taxes
MM show that the total CF to Firm L’s investors
is equal to the total CF to Firm U’s investor plus
an additional amount due to interest
deductibility:
CFL = CFU + rdDT.
What is value of these cash flows?
Value of CFU = VU
MM show that the value of rdDT = TD
Therefore, VL = VU + TD.
If T=40%, then every dollar of debt adds 40
cents of extra value to firm.
22. 22
Value of Firm, V
0
Debt
VL
VU
Under MM with corporate taxes, the firm’s value
increases continuously as more and more debt is used.
TD
MM relationship between value and debt
when corporate taxes are considered.
23. 23
Miller’s Theory: Corporate and
Personal Taxes
Personal taxes lessen the advantage of
corporate debt:
Corporate taxes favor debt financing since
corporations can deduct interest expenses.
Personal taxes favor equity financing, since
no gain is reported until stock is sold, and
long-term gains are taxed at a lower rate.
24. 24
Miller’s Model with Corporate
and Personal Taxes
VL = VU + 1− D
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
(1 - Tc)(1 - Ts)
(1 - Td)
25. 25
Tc = 40%, Td = 30%,
and Ts = 12%.
VL = VU + 1− D
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in
debt raises L’s value by $0.25.
(1 - 0.40)(1 - 0.12)
(1 - 0.30)
26. 26
Conclusions with Personal
Taxes
Use of debt financing remains
advantageous, but benefits are less
than under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in
equilibrium, the tax rates of marginal
investors would adjust until there was
no advantage to debt.
27. 27
Trade-off Theory
MM theory ignores bankruptcy (financial
distress) costs, which increase as more
leverage is used.
At low leverage levels, tax benefits outweigh
bankruptcy costs.
At high levels, bankruptcy costs outweigh tax
benefits.
An optimal capital structure exists that
balances these costs and benefits.
28. 28
Tax Shield vs. Cost of Financial
Distress
Value of Firm, V
0 Debt
VL
VU
Tax Shield
Distress Costs
29. The Optimal Capital Structure
Calculate the cost of equity at each level of
debt.
Calculate the value of equity at each level
of debt.
Calculate the total value of the firm (value
of equity + value of debt) at each level of
debt.
The optimal capital structure maximizes
the total value of the firm.
30. Calculation of Point of
Indifference | Capital
Structure
The EPS, earnings per share, ‘equivalency point’ or ‘point of indifference’ refers
to that EBIT, earnings before interest and tax, level at which EPS remains the
same irrespective of different alternatives of debt-equity mix At this level of
EBIT, the rate of return on capital employed is equal to the cost of debt and this
is also known as break-even level of EBIT for alternative financial plans.
The equivalency or point of indifference can be
calculated algebraically, as below:
Where, X = Equivalency Point or Point of Indifference or Break Even EBIT Level.
I1 = Interest under alternative financial plan 1.
I2 = Interest under alternative financial plan 2.
T = Tax Rate
PD = Preference Dividend
S1 = Number of equity shares or amount of equity share capital under
alternative 1.
S2 = Number of equity shares or amount of equity share capital under 30
31. Illustration 1:
A project under consideration by your company requires a
capital investment of BDT. 60 lakhs. Interest on term
loan is 10% p.a. and tax rate is 50% Calculate the point
of indifference for the project, if the debt-equity ratio
insisted by the financing agencies is 2:1
As the debt equity ratio insisted by the
financing agencies is 2:1, the company has two
alternative financial plans:
(i) Raising the entire amount of BDT. 60 lakhs by the
issue of equity shares, thereby using no debt, and
(ii) Raising BDT. 40 lakhs by way of debt and BDT.
20 lakh by issue of equity share capital.
31
32. Calculation of point of
Indifference:
32
Where, X = Point Indifference
I1 = Interest under alternative 1, i.e. .0
I2 = Interest under alternative 2, i.e. 10/100 × 40 = 4
T = Tax rate, i.e. 50% or .5
PD = Preference Divided, i.e. O as there are no preference shares.
S1 = Amount of equity capital under alternative 1, i.e. 60.
S2 = Amount of equity capital under alternative 2, i.e. 20.
Substituting the values:
33. Thus, EBIT, earnings before interest and tax, at point of
indifference is BDT 6 lakhs. At this level (6 lakh) of EBIT, the
earnings on equity after tax will be 5% p.a. irrespective of
alternative debt-equity mix when the rate of interest on debt is
10% p, a.
From the figure given on next page, we find that the
equivalency point (point of indifference) or the break-even level
of EBIT is BDT. 6 lakhs. In case, the firm has EBIT level below
BDT. 6 lakhs then equity financing is preferable to debt
financing; but if the EBIT is higher than BDT. 6 lakhs then debt
financing; but if the EBIT is higher than BDT. 6 lakhs then debt
financing is better.
33