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Capital Structure
FINC 3630 - Yost
Capital Structure
Optimal Capital Structure What is capital structure? How should a firm choose a debt-to-
equity ratio? The goal: _________________________
Which is done by: __________________
Which is done by: __________________
Capital Structure
FINC 3630 - Yost
Financial LeverageScenario
A B CMarket Value of Debt $0 $50 $75Market Value of Equity $100 $50 $25Market Value of AssetsDebt-to-Equity RatioNumber of Shares ($1 each) 100 50 25
Financial LeverageScenario
A B CCorporate Borrowing Rate 8% 8% 8%EBIT $20 $20 $20Interest Expense $0 $4 $6Taxes (assume 0%) $0 $0 $0Net Income
Capital Structure
FINC 3630 - Yost
Financial LeverageScenario
A B CROAROEEPS e (assume A= 1) 1.0 2.0 4.0
Asset Betas and Equity Betas
EquityC
Asset Debt])T-[(1 Equity
Equity
Equity
DebtT-11 CAssetEquity
Capital Structure
FINC 3630 - Yost
Financial Leverage What is financial leverage? What are the effects of financial leverage? What is meant by “homemade leverage”?
The use of ________________ to change the overall amount of financial leverage to which an individual is exposed.
Homemade Leverage Assume the firm in the previous
example has no debt (Scenario A).
Also assume you personally prefer to have the leverage in Scenario C.
How could you do this on your own?
Capital Structure
FINC 3630 - Yost
The M&M Propositions Why is Keven obsessed with M&Ms? Franco Modigliani and Merton Miller won Nobel
prizes for the following (irrelevance) propositions. Consider a world of no taxes (we will consider the
role of taxes later), no bankruptcy costs, and perfect, efficient capital markets. People can borrow and lend at the same rate as the firm.
Capital Structure
FINC 3630 - Yost
M&M Proposition I (no taxes) Does capital structure
matter?
In our world of no taxes, bankruptcy costs, and perfect, efficient markets, is an individual firm’s capital structure important?
M&M Proposition I (no taxes) The value of the firm is _____________
the firm’s capital structure. VL = VU
Capital Structure
FINC 3630 - Yost
M&M Proposition II (no taxes) What happens to the risk
shareholders face when the firm increases its use of debt?
What happens to beta? What happens to the
cost of equity?
M&M Proposition II (no taxes) The firm’s cost of equity capital is a
positive linear function of the firm’s debt-to-equity ratio.
E
DRRRR DAAE
Capital Structure
FINC 3630 - Yost
M&M Proposition II (no taxes)Cost of Capital
Debt-to-Equity Ratio
RD
RE
WACCRA •
An Example (no taxes)Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market value of $10 per share. It now announces that it intends to issue $160 million of debt and use the proceeds to buy back common stock. The firm’s current cost of equity is 10 percent. The cost of debt is 8 percent.
Capital Structure
FINC 3630 - Yost
An Example (no taxes) -- continued
How many shares can the company buy back? What is the market value of the firm after the
change in capital structure? What is the firm’s new debt-to-equity ratio? After the repurchase, what will be the firm’s
new cost of equity? New cost of capital?
Capital Structure
FINC 3630 - Yost
Agree or Disagree? The assumption of no taxes is a fair and
realistic assumption.
Agree or Disagree
Capital Structure:The Sequel
Capital Structure
FINC 3630 - Yost
Review Financial Leverage:
1. Magnifies the gains and losses to shareholders.
2. Increases the risk (e) to shareholders.
e = A [1 + (1 - t)(D/E)]
Review In our happy
financial world world of no taxes, perfect, efficient financial markets, and no costs of financial distress, with homemade leverage…
Capital Structure
FINC 3630 - Yost
M&M Proposition I (no taxes)
The value of the firm is ____________ the firm’s capital structure.
_______________
M&M Proposition II (no taxes) The firm’s cost of equity capital is a positive
linear function of the firm’s debt-to-equity ratio.
RE = RA + (RA – RD)(D/E)
Capital Structure
FINC 3630 - Yost
M&M Proposition II (no taxes)Cost of Capital
Debt-to-Equity Ratio
RD
RE
WACCRA •
But then the IRS said, “Let there be taxes.”
And there were.
Capital Structure
FINC 3630 - Yost
Features of Debt Two features of debt that we ignored
in our “perfect” financial world in the previous lecture:
1. ____________________________
2. ____________________________
Back to our previous example…Scenario
A B CCorporate Borrowing Rate 8% 8% 8%EBIT $20 $20 $20Interest Expense $0 $4 $6Taxes (assume 50%) $10 $8 $7Net Income
Capital Structure
FINC 3630 - Yost
Back to our previous example…Scenario
A B CCash Flow to StockholdersCash Flow to DebtholdersTotal Cash Flow from Assets
What, then, should happen to firm value?
Firm Value with Debt and Taxes
Capital Structure
FINC 3630 - Yost
M&M Proposition I (with taxes) VL = VU + ______ How do we calculate the value of the firm? VU = [EBIT x (1 – tc)] / RA
Assume that the cost of equity for the firm in scenario A is 10%. Complete the following balance sheet:
Back to our previous example…Scenario
A B CMarket Value of Debt $0 $50 $75Market Value of EquityMarket Value of AssetsDebt-to-Equity RatioROE (assume $1 per share)
Capital Structure
FINC 3630 - Yost
M&M Proposition I (with taxes)Value of the Firm (V)
Debt-to-Equity Ratio
VL = VU + (tc x D)
VU
Tc x D
VU
M&M Proposition II (with taxes) The firm’s cost of equity capital is a
positive linear function of the firm’s debt-to-equity ratio.
RE = RA + (RA – RD)(D/E)(1 - tc)
Capital Structure
FINC 3630 - Yost
M&M Proposition II (with taxes)
Assume that the cost of equity for the firm in scenario A is 10%. What is the required rate of return on equity for each scenario?
M&M Proposition II (with taxes) What is the WACC in each scenario?
Capital Structure
FINC 3630 - Yost
M&M Proposition II (with taxes)Cost of Capital
Debt-to-Equity Ratio
RD
RE
WACC
RA •
Therefore… What is the optimal capital structure?
Why don’t we see this?
Capital Structure
FINC 3630 - Yost
Let’s take another look…Executive Chalk is financed solely by common stock and has outstanding 25 million shares with a market value of $10 per share. It now announces that it intends to issue $160 million of debt and use the proceeds to buy back common stock. The firm’s current cost of equity is 10 percent. The cost of debt is 8 percent. The tax rate is 35 percent. Assume a M&M world, where all assumptions hold.
Capital Structure
FINC 3630 - Yost
Let’s take another look… What is the market value of the firm after
the announcement? How many shares can the company buy
back? What is the firm’s new debt-to-equity ratio? After the repurchase, what will be the firm’s
new cost of equity? New cost of capital?
Optimal Capital Structure(with taxes and bankruptcy costs)
Why do different firms have different capital structures?
____________________ greater for some firms.
____________________ greater for some firms.
Capital Structure
FINC 3630 - Yost
The Costs of Financial Distress _________ Costs
Legal expenses Administrative expenses
_________ Costs Lost sales Lost time Loss of morale and employees
Optimal Capital Structure(with taxes and bankruptcy costs)
Trade-Off Theory of Capital Structure:The firm borrow up to the point where the tax benefits from an extra dollar of debt is _______________ the cost that comes from the increased probability of financial distress.
Capital Structure
FINC 3630 - Yost
Optimal Capital Structure(with taxes and bankruptcy costs)Value of the Firm (V)
Debt-to-Equity Ratio
VL = VU + (tc x D)
VU
Tc x D
VU
ActualValue
PV of Financial Distress Costs
D*
Suggested Problems Questions:
16-1(a - b), 16-4, 16-5, 16-8 17-2
Problems: 16-9, 16-10, and 16-11 17-6 and 17-7
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