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 Decisions-B.V.RaghunandanSVS College
This document discusses capital structure and dividend policies. It defines capital structure as the permanent financing of a firm through long-term debt, preferred stock, and equity. It lists factors to consider when planning capital structure and describes the features, benefits, and drawbacks of debt and equity. It also discusses leverage, types of leverage including operating, financial, and combined leverage. Finally, it covers different dividend policies like stable dividend policy and stable dividend payout policy.
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.
Mba 2 fm u 5 capital structure,dividend policyRai University
This document provides an overview of capital structure theory and policy. It discusses different theories on the relationship between capital structure, cost of capital, and firm value, including: the net operating income approach; traditional approach; Modigliani-Miller hypotheses with and without taxes; and the trade-off theory. It also covers how the cost of equity relates to capital structure and financial distress costs. Key points covered include the interest tax shield advantage of debt financing and how the optimal capital structure balances this benefit against financial distress costs.
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.
This document discusses capital structure and various capital structure theories. It begins by defining capital structure as the mix of owned and borrowed capital used to finance a company's assets. The key considerations in planning capital structure are return, cost, risk, control, flexibility, and capacity. It then covers four capital structure theories - net income approach, net operating income approach, Modigliani-Miller model, and traditional approach. The net income approach proposes that firm value increases with more debt due to lower costs. The net operating income approach argues firm value is independent of capital structure. The Modigliani-Miller model supports the net operating income view. The traditional approach finds an optimal capital structure that minimizes costs.
This document discusses capital structure and leverage. It defines capital structure as the mix of long-term financing sources like equity shares, preference shares, debentures, and long-term debt. It notes that the optimal capital structure maximizes shareholder wealth while minimizing costs. Leverage refers to using fixed costs to magnify returns - operating leverage uses fixed operating costs while financial leverage uses fixed financing costs. The document provides formulas for calculating operating, financial, and combined leverage and gives examples of how to compute them based on information about sales, costs, debt, and earnings.
This document discusses capital structure theories, focusing on the Modigliani-Miller approach. It states that the Modigliani-Miller approach from the 1950s advocates that a firm's capital structure is irrelevant to its valuation. The value depends only on operating profits. It lists the assumptions of this approach, including no taxes, costs, or asymmetric information. It also discusses the propositions of this approach both with and without taxes, providing formulas for calculating total firm value.
The document defines capital structure as the composition of a company's long-term financing, including loans, reserves, shares, and bonds. It discusses factors that influence a company's capital structure such as financial leverage, risk, growth, and cost of capital. It also discusses the concept of an optimal capital structure that maximizes firm value. The document then covers related topics like the point of indifference, types of leverage including financial and operating leverage, and how they impact a company's earnings.
Capital Structure Decisions-B.V.RaghunandanSVS College
This document discusses capital structure and dividend policies. It defines capital structure as the permanent financing of a firm through long-term debt, preferred stock, and equity. It lists factors to consider when planning capital structure and describes the features, benefits, and drawbacks of debt and equity. It also discusses leverage, types of leverage including operating, financial, and combined leverage. Finally, it covers different dividend policies like stable dividend policy and stable dividend payout policy.
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.
Mba 2 fm u 5 capital structure,dividend policyRai University
This document provides an overview of capital structure theory and policy. It discusses different theories on the relationship between capital structure, cost of capital, and firm value, including: the net operating income approach; traditional approach; Modigliani-Miller hypotheses with and without taxes; and the trade-off theory. It also covers how the cost of equity relates to capital structure and financial distress costs. Key points covered include the interest tax shield advantage of debt financing and how the optimal capital structure balances this benefit against financial distress costs.
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.
This document discusses capital structure and various capital structure theories. It begins by defining capital structure as the mix of owned and borrowed capital used to finance a company's assets. The key considerations in planning capital structure are return, cost, risk, control, flexibility, and capacity. It then covers four capital structure theories - net income approach, net operating income approach, Modigliani-Miller model, and traditional approach. The net income approach proposes that firm value increases with more debt due to lower costs. The net operating income approach argues firm value is independent of capital structure. The Modigliani-Miller model supports the net operating income view. The traditional approach finds an optimal capital structure that minimizes costs.
This document discusses capital structure and leverage. It defines capital structure as the mix of long-term financing sources like equity shares, preference shares, debentures, and long-term debt. It notes that the optimal capital structure maximizes shareholder wealth while minimizing costs. Leverage refers to using fixed costs to magnify returns - operating leverage uses fixed operating costs while financial leverage uses fixed financing costs. The document provides formulas for calculating operating, financial, and combined leverage and gives examples of how to compute them based on information about sales, costs, debt, and earnings.
This document discusses capital structure theories, focusing on the Modigliani-Miller approach. It states that the Modigliani-Miller approach from the 1950s advocates that a firm's capital structure is irrelevant to its valuation. The value depends only on operating profits. It lists the assumptions of this approach, including no taxes, costs, or asymmetric information. It also discusses the propositions of this approach both with and without taxes, providing formulas for calculating total firm value.
The document defines capital structure as the composition of a company's long-term financing, including loans, reserves, shares, and bonds. It discusses factors that influence a company's capital structure such as financial leverage, risk, growth, and cost of capital. It also discusses the concept of an optimal capital structure that maximizes firm value. The document then covers related topics like the point of indifference, types of leverage including financial and operating leverage, and how they impact a company's earnings.
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.
The document defines capital structure as the permanent long-term financing of a company, including long-term debt, common stock, preferred stock, and retained earnings. It discusses the concept of optimal capital structure, which minimizes a firm's cost of capital. The document also outlines various approaches to establishing capital structure, including EBIT-EPS analysis and cash flow analysis. It evaluates capital structure based on factors like flexibility, risk, return, and control.
This document discusses capital structure decisions and optimal capital structure. It defines capital structure as the mix of long-term financing sources like debt and equity. An optimal capital structure minimizes costs while maximizing firm value. It balances financial risk from debt against non-employment of debt capital risk. The optimal structure achieves the lowest weighted average cost of capital.
This document assesses the capital structure of Hutchison Whampoa based on its future financing needs. It analyzes Hutchison Whampoa's current capital structure ratios and compares them to industry averages. It also models how different ratios would be impacted by raising $500 million through various combinations of debt and equity. Overall, the analysis finds that Hutchison Whampoa's current capital structure ratios are healthy but could be optimized further to improve profitability and cash flow while maintaining financial stability.
The document discusses capital structure, which is the mix of debt and equity used to finance a firm. The value of a firm is equal to the value of its debt plus the value of its equity. The optimal capital structure maximizes firm value by balancing the debt-equity ratio. Factors that influence the capital structure decision include business risk, taxes, financial flexibility, growth opportunities, and market conditions. Leverage increases risk for shareholders but also increases potential returns, as interest payments are tax deductible. Higher debt leads to greater financial risk.
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.
Capital structure and its DeterminantsMinhas Azeem
This document discusses capital structure and its determinants. It defines capital structure as the mix of different securities used to finance a firm's operations, including bonds, loans, ordinary shares, and preferred shares. It then lists and describes various determinants that must be considered when determining a firm's optimal capital structure, including financial leverage, growth and stability of sales, cost of capital, cash flow ability, nature and size of the firm, control, flexibility, requirements of investors, capital market conditions, assets structure, purpose and period of financing, costs of floating securities, personal considerations, corporate tax rates, and legal requirements. Finally, it briefly outlines four major capital structure theories: the net income approach, net operating income approach, Modig
The document discusses various concepts related to financial management including cost of capital. It defines controller and treasurer roles, and explains that in the Indian context, the controller typically takes on treasury responsibilities as well. It then provides examples of calculating present value of cash flows, rates of interest for loan repayment installments, weighted average cost of capital, and analyzing leverage and risk positions for different companies.
This document contains 5 questions related to corporate finance concepts. Question 1 asks about corporate investment and financial decisions or goals of good corporate governance. Question 2 provides income statement data and asks to calculate economic value added. Question 3 asks about value-based management or criteria for good corporate governance in India. Question 4 asks to calculate share price using Walter's or Gordon's model based on given financial data. Question 5 asks to define and discuss corporate restructuring in terms of reasons, areas, expansion techniques, or disinvestment techniques.
capital structure
,
goals and significance of capital structure
,
target capital structure
,
does capital structure matter
,
modigliani and miller theory
The document discusses capital structure and leverage. It defines capital structure and discusses questions to consider when making financing decisions, such as determining the optimal financing mix. Appropriate capital structures should have features like profitability, solvency, flexibility, capacity, and control. Capital structure is determined by factors like taxes, flexibility, industry norms, and investor requirements. Firms can use different forms of capital structure involving various proportions of equity, debt, and preference shares. Financial leverage refers to using debt financing to magnify returns, and it can be measured using ratios like debt ratio and interest coverage. Capital structure theories address whether firm value depends on capital structure.
This document analyzes the capital structure of SC SADELLI PRODCOM SRL, an agricultural company in Romania. It discusses theories of optimal capital structure and the costs and benefits of debt versus equity. It also provides a case study of SC SADELLI PRODCOM SRL, including its financial statements from 2010-2012, ratios analyzing profitability and leverage, and working capital over time. It concludes that the company has generally performed well but should reduce its high leverage ratios to avoid liquidity issues that could lead to bankruptcy.
This document provides an overview of cost of capital, including:
1. Definitions of capital, cost of capital, and the significance of calculating cost of capital for capital budgeting and other decisions.
2. Methods for calculating the cost of different sources of capital such as equity, preferred stock, debt.
3. Factors that affect the cost of capital for a firm.
4. The weighted average cost of capital (WACC) and how it is calculated based on a firm's target capital structure.
Capital structure refers to the combination of capital (equity, debt, preference shares) used to finance a company. There are various theories on how capital structure affects a company's value and cost of capital. The net income approach argues that leverage always increases value by lowering the overall cost of capital. The net operating income and MM approaches argue capital structure is irrelevant as the costs of equity and debt offset each other. The traditional approach finds an optimal capital structure that minimizes costs up to a point, after which more debt increases risks.
This document contains an assignment with multiple questions related to financial management for an Amity MBA program. It includes questions on topics like capital budgeting techniques, weighted average cost of capital calculation, dividend policy analysis, capital structure, working capital management, and inventory management. The assignment requires calculations to be shown and opinions or recommendations to be provided on issues like suitable investment options, capital budgeting project rankings, and analysis of capital structure impacts.
Financial management unit 3 Financing and Dividend DecisionGanesha Pandian
This document provides an overview of financial management topics including leverages, capital structure, and dividend decisions. It begins with definitions and types of operating and financial leverages, and how to calculate their degrees. It then discusses capital structure theories including the Net Income, Net Operating Income, and Modigliani-Miller approaches. Finally, it covers factors influencing dividend policy decisions and different types of dividend policies and payouts. In summary, the document is a lecture on financing and dividend decisions, analyzing leverage, capital structure optimization, and dividend policies.
Net operating approach in financial managementKumarrebal
The Net Operating Income approach is a capital structure theory that suggests the total value of a firm is independent of the firm's capital structure or use of financial leverage. According to this approach, the market value of a firm depends only on the firm's operating income and business risk, not on financial leverage. While financial leverage can impact distributions to debt holders and equity holders, it cannot impact the firm's operating income or total value. The Net Operating Income is a measure of real estate profitability calculated by subtracting operating expenses from revenues to examine underlying cash flows before taxes and financing costs.
Objective questions and answers of financial managementVineet Saini
- The document contains questions and answers related to financial management concepts like ratio analysis, financial planning, and capital budgeting.
- It includes true/false and multiple choice questions testing understanding of various financial ratios, their calculations and interpretations. Key ratios covered include liquidity, activity, profitability and solvency ratios.
- Multiple choice questions also assess knowledge of financial planning techniques like budgeting, cash budgeting and projected financial statements. Key concepts tested include percentage of sales method and assumptions in projections.
- Capital budgeting questions examine understanding of concepts like evaluation criteria, relevant costs, cash flows and techniques like payback period, NPV and IRR.
Traditional and MM approach in capital structureMERIN C
The document discusses traditional and Modigliani-Miller (MM) approaches to capital structure.
The traditional approach argues that a company's value and cost of capital can be optimized through a judicious mix of debt and equity, up to a certain level of debt. Beyond this, increased financial risk from more debt outweighs the benefits of cheaper debt.
The MM approach argues that a company's value depends only on its operating income and risk, not its capital structure. It proposes that markets will equalize any differences in value or cost of capital through arbitrage. The cost of equity rises in line with debt, keeping the weighted average cost of capital constant.
While influential, the MM approach makes
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.
The document discusses capital structure decisions and financial management concepts like operating leverage, financial leverage, and theories of capital structure. It provides examples and solutions to calculate leverage, break-even point, return on equity, debt service coverage ratio, and optimal capital structure for different companies based on their capital structure and financial details.
This document discusses operating and financial leverage. It defines operating leverage as the use of fixed operating costs, which can increase sensitivity to sales changes. Financial leverage refers to the use of fixed financing costs. The document explains how to calculate break-even points, degrees of operating and financial leverage, and use EBIT-EPS analysis to evaluate financing alternatives.
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.
The document defines capital structure as the permanent long-term financing of a company, including long-term debt, common stock, preferred stock, and retained earnings. It discusses the concept of optimal capital structure, which minimizes a firm's cost of capital. The document also outlines various approaches to establishing capital structure, including EBIT-EPS analysis and cash flow analysis. It evaluates capital structure based on factors like flexibility, risk, return, and control.
This document discusses capital structure decisions and optimal capital structure. It defines capital structure as the mix of long-term financing sources like debt and equity. An optimal capital structure minimizes costs while maximizing firm value. It balances financial risk from debt against non-employment of debt capital risk. The optimal structure achieves the lowest weighted average cost of capital.
This document assesses the capital structure of Hutchison Whampoa based on its future financing needs. It analyzes Hutchison Whampoa's current capital structure ratios and compares them to industry averages. It also models how different ratios would be impacted by raising $500 million through various combinations of debt and equity. Overall, the analysis finds that Hutchison Whampoa's current capital structure ratios are healthy but could be optimized further to improve profitability and cash flow while maintaining financial stability.
The document discusses capital structure, which is the mix of debt and equity used to finance a firm. The value of a firm is equal to the value of its debt plus the value of its equity. The optimal capital structure maximizes firm value by balancing the debt-equity ratio. Factors that influence the capital structure decision include business risk, taxes, financial flexibility, growth opportunities, and market conditions. Leverage increases risk for shareholders but also increases potential returns, as interest payments are tax deductible. Higher debt leads to greater financial risk.
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.
Capital structure and its DeterminantsMinhas Azeem
This document discusses capital structure and its determinants. It defines capital structure as the mix of different securities used to finance a firm's operations, including bonds, loans, ordinary shares, and preferred shares. It then lists and describes various determinants that must be considered when determining a firm's optimal capital structure, including financial leverage, growth and stability of sales, cost of capital, cash flow ability, nature and size of the firm, control, flexibility, requirements of investors, capital market conditions, assets structure, purpose and period of financing, costs of floating securities, personal considerations, corporate tax rates, and legal requirements. Finally, it briefly outlines four major capital structure theories: the net income approach, net operating income approach, Modig
The document discusses various concepts related to financial management including cost of capital. It defines controller and treasurer roles, and explains that in the Indian context, the controller typically takes on treasury responsibilities as well. It then provides examples of calculating present value of cash flows, rates of interest for loan repayment installments, weighted average cost of capital, and analyzing leverage and risk positions for different companies.
This document contains 5 questions related to corporate finance concepts. Question 1 asks about corporate investment and financial decisions or goals of good corporate governance. Question 2 provides income statement data and asks to calculate economic value added. Question 3 asks about value-based management or criteria for good corporate governance in India. Question 4 asks to calculate share price using Walter's or Gordon's model based on given financial data. Question 5 asks to define and discuss corporate restructuring in terms of reasons, areas, expansion techniques, or disinvestment techniques.
capital structure
,
goals and significance of capital structure
,
target capital structure
,
does capital structure matter
,
modigliani and miller theory
The document discusses capital structure and leverage. It defines capital structure and discusses questions to consider when making financing decisions, such as determining the optimal financing mix. Appropriate capital structures should have features like profitability, solvency, flexibility, capacity, and control. Capital structure is determined by factors like taxes, flexibility, industry norms, and investor requirements. Firms can use different forms of capital structure involving various proportions of equity, debt, and preference shares. Financial leverage refers to using debt financing to magnify returns, and it can be measured using ratios like debt ratio and interest coverage. Capital structure theories address whether firm value depends on capital structure.
This document analyzes the capital structure of SC SADELLI PRODCOM SRL, an agricultural company in Romania. It discusses theories of optimal capital structure and the costs and benefits of debt versus equity. It also provides a case study of SC SADELLI PRODCOM SRL, including its financial statements from 2010-2012, ratios analyzing profitability and leverage, and working capital over time. It concludes that the company has generally performed well but should reduce its high leverage ratios to avoid liquidity issues that could lead to bankruptcy.
This document provides an overview of cost of capital, including:
1. Definitions of capital, cost of capital, and the significance of calculating cost of capital for capital budgeting and other decisions.
2. Methods for calculating the cost of different sources of capital such as equity, preferred stock, debt.
3. Factors that affect the cost of capital for a firm.
4. The weighted average cost of capital (WACC) and how it is calculated based on a firm's target capital structure.
Capital structure refers to the combination of capital (equity, debt, preference shares) used to finance a company. There are various theories on how capital structure affects a company's value and cost of capital. The net income approach argues that leverage always increases value by lowering the overall cost of capital. The net operating income and MM approaches argue capital structure is irrelevant as the costs of equity and debt offset each other. The traditional approach finds an optimal capital structure that minimizes costs up to a point, after which more debt increases risks.
This document contains an assignment with multiple questions related to financial management for an Amity MBA program. It includes questions on topics like capital budgeting techniques, weighted average cost of capital calculation, dividend policy analysis, capital structure, working capital management, and inventory management. The assignment requires calculations to be shown and opinions or recommendations to be provided on issues like suitable investment options, capital budgeting project rankings, and analysis of capital structure impacts.
Financial management unit 3 Financing and Dividend DecisionGanesha Pandian
This document provides an overview of financial management topics including leverages, capital structure, and dividend decisions. It begins with definitions and types of operating and financial leverages, and how to calculate their degrees. It then discusses capital structure theories including the Net Income, Net Operating Income, and Modigliani-Miller approaches. Finally, it covers factors influencing dividend policy decisions and different types of dividend policies and payouts. In summary, the document is a lecture on financing and dividend decisions, analyzing leverage, capital structure optimization, and dividend policies.
Net operating approach in financial managementKumarrebal
The Net Operating Income approach is a capital structure theory that suggests the total value of a firm is independent of the firm's capital structure or use of financial leverage. According to this approach, the market value of a firm depends only on the firm's operating income and business risk, not on financial leverage. While financial leverage can impact distributions to debt holders and equity holders, it cannot impact the firm's operating income or total value. The Net Operating Income is a measure of real estate profitability calculated by subtracting operating expenses from revenues to examine underlying cash flows before taxes and financing costs.
Objective questions and answers of financial managementVineet Saini
- The document contains questions and answers related to financial management concepts like ratio analysis, financial planning, and capital budgeting.
- It includes true/false and multiple choice questions testing understanding of various financial ratios, their calculations and interpretations. Key ratios covered include liquidity, activity, profitability and solvency ratios.
- Multiple choice questions also assess knowledge of financial planning techniques like budgeting, cash budgeting and projected financial statements. Key concepts tested include percentage of sales method and assumptions in projections.
- Capital budgeting questions examine understanding of concepts like evaluation criteria, relevant costs, cash flows and techniques like payback period, NPV and IRR.
Traditional and MM approach in capital structureMERIN C
The document discusses traditional and Modigliani-Miller (MM) approaches to capital structure.
The traditional approach argues that a company's value and cost of capital can be optimized through a judicious mix of debt and equity, up to a certain level of debt. Beyond this, increased financial risk from more debt outweighs the benefits of cheaper debt.
The MM approach argues that a company's value depends only on its operating income and risk, not its capital structure. It proposes that markets will equalize any differences in value or cost of capital through arbitrage. The cost of equity rises in line with debt, keeping the weighted average cost of capital constant.
While influential, the MM approach makes
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.
The document discusses capital structure decisions and financial management concepts like operating leverage, financial leverage, and theories of capital structure. It provides examples and solutions to calculate leverage, break-even point, return on equity, debt service coverage ratio, and optimal capital structure for different companies based on their capital structure and financial details.
This document discusses operating and financial leverage. It defines operating leverage as the use of fixed operating costs, which can increase sensitivity to sales changes. Financial leverage refers to the use of fixed financing costs. The document explains how to calculate break-even points, degrees of operating and financial leverage, and use EBIT-EPS analysis to evaluate financing alternatives.
Capital structure decisions and profitabilitybappykazi
Group G is analyzing the capital structure and profitability of Square Pharmaceuticals Ltd. The group members are Kazi Tanvirul Islam, S.M. Zayed Siraj, Jannatul Ferdows, Md. Tajmilur Rahman, and Umma Kulsum. Square Pharmaceuticals gets financing from equity, debt, retained earnings and borrowed funds. Its average debt ratio from 2006-2010 was 29% and debt increased 20% while equity increased 80%. Square Pharmaceuticals maintains low debt levels and has sound financial performance with average debt-equity ratio of 0.4. The company has stable profit margins around 18% on average.
The document discusses capital structure decisions and financial management. It defines capital structure as the combination of capital used by a firm. An optimal capital structure minimizes costs while managing risks. The document then discusses theories of capital structure, the risks associated with leverage, and the tradeoff between debt and equity financing. It provides an example problem analyzing different capital structure options.
The document discusses different models and theories of dividend policy, including:
- Walter's theory, which uses a mathematical model to show that a company's dividend policy impacts its valuation. The model relates market price to factors like dividend payout, internal rate of return, and cost of capital.
- Gordon's theory, another mathematical model that explicitly links market value to dividend policy. It determines value based on perpetual dividends, cost of capital, and growth rate.
- Modigliani-Miller theory, which argues that dividends are "irrelevant" for valuation as investors will value companies based on earnings and investment policy rather than dividend history. Dividends and capital gains are considered equivalent sources of
Measures of cost of capital
The cost of capital is the cost of obtaining funds, through debt or equity, in order to finance an investment.
The cost of capital represents the overall cost of financing to the firm.
The chapter discusses dividend policy and its importance as a financing decision for corporations. It defines dividend policy as the board of director's decision regarding how much of the company's residual earnings to distribute to shareholders. The mechanics of dividend payments are also outlined, including the declaration date, holder of record date, ex-dividend date, and payment date. Key assumptions and theories around dividend policy such as M&M's dividend irrelevance theorem and the "bird in the hand" argument are introduced.
Capital structure and cost of equity pdfDavid Keck
This document discusses capital structure and cost of equity. It begins by outlining learning objectives around basic corporate finance concepts like capital structure, cost of equity, and dividend policy. It then provides assumptions for calculating rates of return, including that free cash flow is a perpetuity. The document uses an example firm to demonstrate calculating unlevered and levered costs of equity and the effects of leverage on firm value under the assumptions of Miller and Modigliani's propositions.
Cost of capital is the minimum rate of return that a company must earn on its investments to maintain its market value and attract funds. It is used to evaluate investment projects and determine the company's capital structure. Cost of capital can be calculated for specific sources like equity, debt, preference shares, and retained earnings using various methods. The overall cost of capital is the weighted average of the costs of each source based on their proportion in the company's capital structure. It is an important concept in financial management for capital budgeting, valuation, and performance evaluation.
1) The capital structure of a firm refers to how it finances its operations and growth through different sources of funds, including debt, equity, and retained earnings.
2) Several factors influence a firm's capital structure decisions, including business risk, tax exposure, financial flexibility, management style, growth rate, and market conditions.
3) Business risk, tax rates, financial flexibility, management aggressiveness, growth needs, and market access all impact the optimal mix of debt and equity financing for firms.
The document discusses dividend policy and various models that attempt to explain the relationship between a firm's dividend policy and its stock price. It describes the Traditional Model, Walter Model and Gordon Model. The Traditional Model links stock price to dividends through a multiplier. The Walter Model examines how dividend policy impacts stock price under different scenarios where return on equity is greater than, less than, or equal to the cost of capital. The Gordon Model uses a dividend discount approach and suggests firms with returns exceeding their cost of capital should retain more earnings.
determinants of corporate dividend policyArfan Afzal
Determinants of Corporate Dividends Policy: Evidence from an Emerging Economy, the attributes of non-financial companies listed on Abu Dhabi Securities Exchange (ADX). panel data for the period between 2010 and 2012 were collected from the listed companies annual reports published on ADX website.
The document discusses capital structure and cost of capital. It defines financing decisions as raising funds to meet investment needs, mostly through borrowing. A company must determine its optimal debt-equity ratio or capital structure when making financing decisions. The cost of capital is also an important consideration, as the company must pay back funds in the future. Different capital structure theories, such as the net income approach and net operating income approach, provide different perspectives on optimizing capital structure and minimizing cost of capital.
This document outlines the key aspects of dividend policy, including:
- The mechanics of declaring and paying cash dividends, including declaration date, record date, ex-dividend date, and payment date.
- Stock dividends involve issuing additional shares to shareholders, while stock splits decrease the share price without changing shareholder wealth.
- The board of directors has discretion over dividend decisions, and shareholders cannot force the board to declare dividends.
DEFINITION of 'Operating Leverage'
A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs.
1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability.
2. A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage. Those businesses with lower fixed costs and higher variable costs are said to employ less operating leverage.
Financial Leverage:
Financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share.
Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company.
This document is a presentation on inflation that defines inflation as a rise in prices over time and discusses its measurement and causes. It examines quality and quantity theories of inflation and how inflation is measured using price indices like the consumer price index. The presentation also outlines different types of inflation and explores the effects of inflation on areas like production, income distribution, and foreign trade. It analyzes the negative effects of inflation and costs like money losing value. The presentation concludes by considering measures that can be used to control inflation such as monetary policy, wage and price controls, and cost of living allowances.
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.
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 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
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.
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
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 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
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 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 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.
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 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 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.
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.
This presentation is an overview of Capital Structure Theories.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata
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.
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.
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.
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2. Capital Structure Decisions
• Overview and preview of capital structure effects
• Business versus financial risk
• The impact of debt on returns
• Capital structure theory
• Example: Choosing the optimal structure
• Setting the capital structure in practice
3. 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
• re and wd are percentages of the firm that
are financed with stock and debt.
4. How can capital structure affect value?
∑
∞
= +
=
1t
t
t
)WACC1(
FCF
V
(Continued…)
WACC = wd (1-T) rd + we rs
5. A Preview of Capital Structure Effects
• The impact of capital structure on value
depends upon the effect of debt on:
– WACC
– FCF
(Continued…)
6. 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…)
7. 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 (we)
• Net effect on WACC = uncertain.
(Continued…)
8. 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…)
9. • Impact of indirect costs
– NOPAT goes down due to lost customers and
drop in productivity
– Investment in capital goes up due to increase
in net operating working capital (accounts
payable goes up as suppliers tighten credit).
(Continued…)
10. • Additional debt can affect the behavior of
managers.
– Reductions in agency costs: debt “pre-
commits,” or “bonds,” free cash flow for use in
making interest payments. Thus, managers are
less likely to waste FCF on perquisites or non-
value adding acquisitions.
– Increases in agency costs: debt can make
managers too risk-averse, causing
“underinvestment” in risky but positive NPV
projects.
(Continued…)
11. Asymmetric Information and Signaling
• Managers know the firm’s future prospects better
than investors.
• Managers would not issue additional equity if they
thought the current stock price was less than the
true value of the stock (given their inside
information).
• Hence, investors often perceive an additional
issuance of stock as a negative signal, and the stock
price falls.
12. Uncertainty about future pre-tax operating
income (EBIT).
Note that business risk focuses on operating
income, so it ignores financing effects.
What is business risk?
Probability
EBITE(EBIT)0
Low risk
High risk
13. Factors That Influence Business Risk
• Uncertainty about demand (unit sales).
• Uncertainty about output prices.
• Uncertainty about input costs.
• Product and other types of liability.
• Degree of operating leverage (DOL).
14. 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
within a firm’s overall cost structure, the
greater the operating leverage.
(More...)
15. • Higher operating leverage leads to more
business risk, because a small sales decline
causes a larger EBIT decline.
(More...)
Sales
$ Rev.
TC
F
QBE Sales
$ Rev.
TC
F
QBE
EBIT}
16. Operating Breakeven
• Q is quantity sold, F is fixed cost, V is
variable cost, TC is total cost, and P is price
per unit.
• Operating breakeven = QBE
QBE = F / (P – V)
• Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
(More...)
18. Business Risk versus Financial Risk
• Business risk:
– Uncertainty in future EBIT.
– Depends on business factors such as competition,
operating leverage, etc.
• Financial risk:
– Additional business risk concentrated on common
stockholders when financial leverage is used.
– Depends on the amount of debt and preferred stock
financing.
19. Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Consider Two Hypothetical Firms
Both firms have same operating
leverage, business risk, and EBIT of
$3,000. They differ only with respect to
use of debt.
20. Impact of Leverage on Returns
EBIT $3,000 $3,000
Interest 0 1,200
EBT $3,000 $1,800
Taxes (40%) 1 ,200 720
NI $1,800 $1,080
ROE 9.0% 10.8%
Firm U Firm L
21. Why does leveraging increase
return?
• More EBIT goes to investors in 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.
• Equity $ proportionally lower than NI.
22. Now consider the fact that EBIT is not
known with certainty. What is the
impact of uncertainty on stockholder
profitability and risk for Firm U and
Firm L?
Continued…
24. Firm L: Leveraged
Prob.* 0.25 0.50 0.25
EBIT* $2,000 $3,000 $4,000
Interest 1,200 1,200 1,200
EBT $ 800 $1,800 $2,800
Taxes (40%) 320 720 1,120
NI $ 480 $1,080 $1,680
*Same as for Firm U.
Economy
Bad Avg. Good
25. Firm U Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 6.0% 9.0% 12.0%
TIE n.a. n.a. n.a.
Firm L Bad Avg. Good
BEP 10.0% 15.0% 20.0%
ROIC 6.0% 9.0% 12.0%
ROE 4.8% 10.8% 16.8%
TIE 1.7x 2.5x 3.3x
27. Conclusions
• Basic earning power (EBIT/TA) and ROIC
(NOPAT/Capital = EBIT(1-T)/TA) are
unaffected by financial leverage.
• L has higher expected ROE: tax savings and
smaller equity base.
• L has much wider ROE swings because of
fixed interest charges. Higher expected
return is accompanied by higher risk.
(More...)
28. • In a stand-alone risk sense, Firm L’s
stockholders see much more risk than Firm
U’s.
– U and L: σROIC = 2.12%.
– U: σROE = 2.12%.
– L: σROE = 4.24%.
• L’s financial risk is σROE - σROIC = 4.24% - 2.12%
= 2.12%. (U’s is zero.)
(More...)
29. For leverage to be positive (increase
expected ROE), BEP must be > rd.
If rd > BEP, the cost of leveraging will
be higher than the inherent
profitability of the assets, so the use
of financial leverage will depress net
income and ROE.
In the example, E(BEP) = 15% while
interest rate = 12%, so leveraging
“works.”
30. Capital Structure Theory
• MM theory
– Zero taxes
– Corporate taxes
– Corporate and personal taxes
• Trade-off theory
• Signaling theory
• Debt financing as a managerial constraint
31. MM Theory: Zero Taxes
• MM prove, under a very restrictive set of
assumptions, that a firm’s value is unaffected by its
financing mix:
– VL = VU.
• Therefore, capital structure is irrelevant.
• Any increase in ROE resulting from financial leverage
is exactly offset by the increase in risk (i.e., rs), so
WACC is constant.
32. MM Theory: Corporate Taxes
• Corporate tax laws favor debt financing over
equity financing.
• With corporate taxes, the benefits of financial
leverage exceed the risks: More EBIT goes to
investors and less to taxes when leverage is used.
• MM show that: VL = VU + TD.
• If T=40%, then every dollar of debt adds 40 cents
of extra value to firm.
33. Value of Firm, V
0
Debt
VL
VU
MM relationship between value and debt
when corporate taxes are considered.
Under MM with corporate taxes, the firm’s value
increases continuously as more and more debt is used.
TD
34. Cost of
Capital (%)
0 20 40 60 80 100
Debt/Value
Ratio (%)
MM relationship between capital costs
and leverage when corporate taxes are
considered.
rs
WACC
rd(1 - T)
35. 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.
36. 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)
37. 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)
38. 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.
39. 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.
40. Signaling Theory
• MM assumed that investors and managers have
the same information.
• But, managers often have better information.
Thus, they would:
– Sell stock if stock is overvalued.
– Sell bonds if stock is undervalued.
• Investors understand this, so view new stock sales
as a negative signal.
• Implications for managers?
41. Debt Financing and Agency Costs
• One agency problem is that managers can
use corporate funds for non-value
maximizing purposes.
• The use of financial leverage:
– Bonds “free cash flow.”
– Forces discipline on managers to avoid perks
and non-value adding acquisitions.
(More...)
42. • A second agency problem is the potential
for “underinvestment”.
– Debt increases risk of financial distress.
– Therefore, managers may avoid risky projects
even if they have positive NPVs.
43. Choosing the Optimal Capital
Structure: Example
Currently is all-equity financed.
Expected EBIT = $500,000.
Firm expects zero growth.
100,000 shares outstanding; rs = 12%;
P0 = $25; T = 40%; b = 1.0; rRF = 6%;
RPM = 6%.
44. Estimates of Cost of Debt
Percent financed
with debt, wd rd
0% -
20% 8.0%
30% 8.5%
40% 10.0%
50% 12.0%
If company recapitalizes, debt would be
issued to repurchase stock.
45. The Cost of Equity at Different
Levels of Debt: Hamada’s Equation
• MM theory implies that beta changes with
leverage.
• bU is the beta of a firm when it has no debt
(the unlevered beta)
• bL = bU [1 + (1 - T)(D/S)]
46. The Cost of Equity for wd = 20%
• Use Hamada’s equation to find beta:
bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
• Use CAPM to find the cost of equity:
rs = rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%
48. The WACC for wd = 20%
• WACC = wd (1-T) rd + we rs
• WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
• WACC = 11.28%
• Repeat this for all capital structures under
consideration.
50. Corporate Value for wd = 20%
• V = FCF / (WACC-g)
• g=0, so investment in capital is zero; so FCF =
NOPAT = EBIT (1-T).
• NOPAT = ($500,000)(1-0.40) = $300,000.
• V = $300,000 / 0.1128 = $2,659,574.
51. Corporate Value vs. Leverage
wd WACC Corp. Value
0% 12.00% $2,500,000
20% 11.28% $2,659,574
30% 11.01% $2,724,796
40% 11.04% $2,717,391
50% 11.40% $2,631,579
52. Debt and Equity for wd = 20%
• The dollar value of debt is:
D = wd V = 0.2 ($2,659,574) = $531,915.
• S = V – D
S = $2,659,574 - $531,915 = $2,127,659.
53. Debt and Stock Value vs. Leverage
wd Debt, D Stock Value, S
0% $0 $2,500,000
20% $531,915 $2,127,660
30% $817,439 $1,907,357
40% $1,086,957 $1,630,435
50% $1,315,789 $1,315,789
Note: these are rounded; see Ch 14 Mini Case.xls for full
calculations.
54. Wealth of Shareholders
• Value of the equity declines as more debt is
issued, because debt is used to repurchase
stock.
• But total wealth of shareholders is value of
stock after the recap plus the cash received in
repurchase, and this total goes up (It is equal
to Corporate Value on earlier slide).
55. Stock Price for wd = 20%
• The firm issues debt, which changes its WACC,
which changes value.
• The firm then uses debt proceeds to repurchase
stock.
• Stock price changes after debt is issued, but
does not change during actual repurchase (or
arbitrage is possible).
(More…)
56. Stock Price for wd = 20% (Continued)
• The stock price after debt is issued but
before stock is repurchased reflects
shareholder wealth:
– S, value of stock
–Cash paid in repurchase.
(More…)
57. Stock Price for wd = 20%
(Continued)
• D0 and n0 are debt and outstanding shares
before recap.
• D - D0 is equal to cash that will be used to
repurchase stock.
• S + (D - D0) is wealth of shareholders’ after the
debt is issued but immediately before the
repurchase. (More…)
58. Stock Price for wd = 20% (Continued)
• P = S + (D – D0)
n0
P = $2,127,660 + ($531,915 – 0)
100,000
P = $26.596 per share.
59. Number of Shares Repurchased
• # Repurchased = (D - D0) / P
# Rep. = ($531,915 – 0) / $26.596
= 20,000.
• # Remaining = n = S / P
n = $2,127,660 / $26.596
= 80,000.
61. Optimal Capital Structure
• wd = 30% gives:
–Highest corporate value
–Lowest WACC
–Highest stock price per share
• But wd = 40% is close. Optimal range is
pretty flat.
62. • Debt ratios of other firms in the industry.
• Pro forma coverage ratios at different
capital structures under different
economic scenarios.
• Lender and rating agency attitudes
(impact on bond ratings).
What other factors would managers
consider when setting the target
capital structure?
63. • Reserve borrowing capacity.
• Effects on control.
• Type of assets: Are they tangible, and
hence suitable as collateral?
• Tax rates.