1. Chapter 16 -Planning the Firms Financing Mix 2005, Pearson Prentice Hall

2.

Balance Sheet

CurrentCurrent

AssetsLiabilities

Debtand

FixedPreferred

Assets

Shareholders

Equity

3.

Balance Sheet

CurrentCurrent

AssetsLiabilities

Debtand

FixedPreferred

Assets

Shareholders

Equity

4.

Balance Sheet

CurrentCurrent

Assets Liabilities

Debtand

Fixed Preferred

Assets

Shareholders

Equity

Financial Structure 5.

Balance Sheet

CurrentCurrent

AssetsLiabilities

Debtand

FixedPreferred

Assets

Shareholders

Equity

6.

Balance Sheet

CurrentCurrent

AssetsLiabilities

Debt and

FixedPreferred

Assets

Shareholders

Equity

Capital Structure 7. Why is Capital Structure Important?

1)Leverage : Higher financial leverage means higher returns to stockholders, but higher risk due to fixed payments.

2)Cost of Capital : Each source of financing has a different cost. Capital structure affects the cost of capital.

The Optimal Capital Structureis the one that minimizes the firms cost of capital and maximizes firm value.

8. What is the Optimal Capital Structure?

In a perfect world environment with no taxes, no transaction costs and perfectly efficient financial markets,capital structure does not matter.

This is known as theIndependence hypothesis :firm value is independent of capital structure .

9. Independence Hypothesis

Firm value does not depend on capital structure.

10.

Capital Structure: 100% equity, no debt

Stock price: $10 per share

Shares outstanding: 2 million

Operating income (EBIT): $2,000,000

Calculate EPS:

With no interest payments and no taxes,

EBIT = net income.

$2,000,000/2,000,000 shares = $1.00

Independence Hypothesis: Rix Camper Manufacturing Company 11.

Capital Structure: 100% equity, no debt

Stock price: $10 per share

Shares outstanding: 2 million

Operating income (EBIT): $2,000,000

Independence Hypothesis: Rix Camper Manufacturing Company 12.

Capital Structure: 100% equity, no debt

Stock price: $10 per share

Shares outstanding: 2 million

Operating income (EBIT): $2,000,000

Calculate the Cost of Capital:

Independence Hypothesis: Rix Camper Manufacturing Company 13.

Capital Structure: 100% equity, no debt

Stock price: $10 per share

Shares outstanding: 2 million

Operating income (EBIT): $2,000,000

Calculate the Cost of Capital:

Independence Hypothesis: Rix Camper Manufacturing Company k=+g= D 1 P 14.

Capital Structure: 100% equity, no debt

Stock price: $10 per share

Shares outstanding: 2 million

Operating income (EBIT): $2,000,000

Calculate the Cost of Capital:

Independence Hypothesis: Rix Camper Manufacturing Company k=+g =+0= D 1 1.00 P 10.00 15.

Capital Structure: 100% equity, no debt

Stock price: $10 per share

Shares outstanding: 2 million

Operating income (EBIT): $2,000,000

Calculate the Cost of Capital:

Independence Hypothesis: Rix Camper Manufacturing Company k=+g =+0=10% D 1 1.00 P 10.00 16.

$20 million capitalization

$8 million in debt issued to retire $8 million in equity.

Equity= $12m / $20m =60%

Debt=$8m / $20m =40%

Capital Structure: 60% equity, 40% debt

Shares outstanding: $12 million / $10=1,200,000 shares .

Interest = $8m x .06 =$480,000

Independence Hypothesis: Rix Camper Manufacturing Company 17.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate EPS:

$1,520,000/1,200,000 shares = $1.267

Independence Hypothesis: Rix Camper Manufacturing Company 18.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Independence Hypothesis: Rix Camper Manufacturing Company 19.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Equity:

Independence Hypothesis: Rix Camper Manufacturing Company 20.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Equity:

Independence Hypothesis: Rix Camper Manufacturing Company k=+g = D 1 P 21.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Equity:

Independence Hypothesis: Rix Camper Manufacturing Company k=+g =+0=D 1 1.267 P 10.00 22.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Equity:

Independence Hypothesis: Rix Camper Manufacturing Company k=+g =+0=12.67% D 1 1.267 P 10.00 23.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Independence Hypothesis: Rix Camper Manufacturing Company 24.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Capital:

Independence Hypothesis: Rix Camper Manufacturing Company 25.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Capital:

.6 (12.67%)

Independence Hypothesis: Rix Camper Manufacturing Company 26.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Capital:

.6 (12.67%) +

Independence Hypothesis: Rix Camper Manufacturing Company 27.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Capital:

.6 (12.67%) + .4 (6%) =

Independence Hypothesis: Rix Camper Manufacturing Company 28.

Capital Structure: 60% equity, 40% debt

Stock price: $10 per share

Shares outstanding: 1.2 million

Net income: $2,000,000 - $480,000 = $1,520,000

Calculate the Cost of Capital:

.6 (12.67%) + .4 (6%) = 10%

Independence Hypothesis: Rix Camper Manufacturing Company 29. Independence Hypothesis Cost of Capital kc 0% debtFinancial Leverage100% debt . kc = cost of equity kd = cost of debt ko = cost of capital 30. Independence Hypothesis . Cost of Capital kc kd kd 0% debtFinancial Leverage100% debt 31. Independence Hypothesis . Cost of Capital kc kd kd 0% debtFinancial Leverage100% debt 32. Independence Hypothesis Increasing leverage causes the cost of equity to rise. Cost of Capital kc kd kd 0% debtFinancial Leverage100% debt 33. Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. 0% debtFinancial Leverage100% debt 34. Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What willbe the net effect on the overall costof capital?0% debtFinancial Leverage100% debt 35. Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What willbe the net effect on the overall costof capital?0% debtFinancial Leverage100% debt 36. Independence Hypothesis kc kd Cost of Capital kc ko kd 0% debtFinancial Leverage100% debt 37.

If we have perfect capital markets,capital structure isirrelevant .

In other words, changes in capital structure do not affectfirm value .

Independence Hypothesis 38. Dependence Hypothesis

Increasing leverage does not increase the cost of equity.

Since debt is less expensive than equity, more debt financing would provide a lower cost of capital.

A lower cost of capital would increase firm value.

39. Dependence Hypothesis Since the cost of debt is lower than the cost of equity... Cost of Capital kc kd Financial Leverage kc kd 40. Dependence Hypothesis Since the cost of debt is lower than the cost of equity increasing leverage reduces the cost of capital. Cost of Capital kc kd Financial Leverage kc kd ko 41. Moderate Position

The previous hypothesis examines capital structure in a perfect market.

The moderate position examines capital structure under more realistic conditions.

For example, what happens if we includecorporate taxes ?

42.

unlevered levered

EBIT 2,000,000 2,000,000

- interest expense 0 (480,000)

EBT 2,000,000 1,520,000

- taxes (50%) (1,000,000) (760,000)

Earnings available

to stockholders 1,000,000 760,000

Payments to all

securityholders 1,000,0001,240,000

Rix Camper example: Tax effects of financing with debt 43. Moderate Position Cost of Capital kc kd Financial Leverage kc kd 44. Moderate Position Cost of Capital kc kd Financial Leverage kc kd Even if the cost of equity rises as leverage increases, thecost of debtisvery low... 45. Moderate Position Cost of Capital kc kd Financial Leverage kc kd because of thetax benefit associated with debt financing. Even if the cost of equity rises as leverage increases, thecost of debtisvery low... 46. Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debtreduces the cost ofcapital. 47. Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debtreduces the cost ofcapital. ko 48. Moderate Position

So, what does the tax benefit of debt financing mean for the value of the firm?

The more debt financing used, the greater thetax benefit , and the greater thevalue of the firm .

So, this would mean that all firms should be financed with100% debt , right?

Why are firmsnotfinanced with 100% debt?

49. Why is 100% Debt Not Optimal?

Bankruptcy costs : costs of financial distress.

Financingbecomes difficult to get.

Customers leave due to uncertainty.

Possible restructuring orliquidationcosts if bankruptcy occurs.

50.

Agency costs : costs associated with protecting bondholders.

Bondholders(principals) lend money to the firm and expect it to be invested wisely.

Stockholdersown the firm and elect the board and hire managers (agents).

Bond covenantsrequire managers to be monitored.The monitoring expense is anagency cost , which increases as debt increases.

Why is 100% Debt Not Optimal? 51. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd 52. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kd 53. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kd 54. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd 55. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd 56. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd If a firm borrows too much, the costs of debt and equity will spikeupward, due to bankruptcy costs and agency costs. 57. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd 58. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko 59. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko 60. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko Ideally, a firm should use leverage to obtain their optimum capitalstructure, which will minimize the firms cost of capital. 61. Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko 62. Capital Structure Management

EBIT-EPS Analysis- Used to help determine whether it would be better to finance a project with debt or equity.

63. Capital Structure Management

EBIT-EPS Analysis- Used to help determine whether it would be better to finance a project with debt or equity.

EPS=(EBIT - I)(1 - t) - P S 64. Capital Structure Management

EBIT-EPS Analysis- Used to help determine whether it would be better to finance a project with debt or equity.

EPS=(EBIT - I)(1 - t) - P S I = interest expense, P = preferred dividends, S = number of shares of common stockoutstanding. 65. EBIT-EPS Example

Our firm has800,000shares of common stock outstanding, no debt, and a marginal tax rate of40%.We need$6,000,000to finance a proposed project. We are considering two options:

Sell200,000shares of common stock at$30per share,

Borrow$6,000,000by issuing10%bonds.

66. If we expect EBIT to be $2,000,000:

Financingstockdebt

EBIT 2,000,000 2,000,000

- interest 0 (600,000)

EBT 2,000,000 1,400,000

- taxes (40%)(800,000) (560,000)

EAT 1,200,000 840,000

# shares outst. 1,000,000 800,000

EPS $1.20 $1.05

67.

Financingstockdebt

EBIT 4,000,000 4,000,000

- interest 0 (600,000)

EBT 4,000,000 3,400,000

- taxes (40%) (1,600,000) (1,360,000)

EAT 2,400,000 2,040,000

# shares outst. 1,000,000 800,000

EPS $2.40 $2.55

If we expect EBIT to be $4,000,000: 68.

If EBIT is $2,000,000,common stock financing is best.

If EBIT is $4,000,000,debtfinancing is best.

So, now we need to find abreakeven EBITwhere neither is better than the other.

69. If we choose stock financing: EPS EBIT $1m$2m$3m$4m stockfinancing 0 3 2 1 70. If we choosebond financing: EPS EBIT $1m$2m$3m$4m bondfinancing 0 3 2 1 71. Breakeven EBIT EPS EBIT $1m$2m$3m$4m bondfinancing stockfinancing 0 3 2 1 72. Breakeven Point

Set two EPS calculations equal to each other and solve for EBIT:

Stock FinancingDebt Financing

(EBIT-I)(1-t) - P =(EBIT-I)(1-t) - P

SS

73. Breakeven Point

Stock FinancingDebt Financing

(EBIT-I)(1-t) - P =(EBIT-I)(1-t) - P

SS

(EBIT-0) (1-.40)=(EBIT-600,000)(1-.40)

800,000+200,000800,000

74. Breakeven Point

Stock FinancingDebt Financing

.6 EBIT =.6 EBIT - 360,000

1.8

.48 EBIT=.6 EBIT - 360,000

.12 EBIT=360,000

EBIT = $3,000,000

75. Breakeven EBIT EPS EBIT $1m$2m$3m$4m bondfinancing stockfinancing 0 3 2 1 For EBIT up to $3 million, stockfinancing is best. 76. Breakeven EBIT For EBIT up to $3 million, stock financing is best. For EBIT greater than $3 million,debtfinancing is best. EPS EBIT $1m$2m$3m$4m bondfinancing stockfinancing 0 3 2 1 77. In-class Problem

Plan A:Sell 1,200,000 shares at $10 per share($12 million total).

Plan B:Issue $3.5 million in 9% debt and sell 850,000 shares at $10 per share($12 million total).

Assume a marginal tax rate of 50%.

78. Breakeven EBIT

Stock FinancingLevered Financing

(EBIT-I) (1-t) - P =(EBIT-I) (1-t) - P

SS

EBIT-0 (1-.50)=(EBIT-315,000)(1-.50)

1,200,000850,000

EBIT = $1,080,000

79. Analytical Income Statement

StockLevered

EBIT 1,080,000 1,080,000

I 0 (315,000)

EBT 1,080,000 765,000

Tax (540,000) (382,500)

NI 540,000 382,500

Shares 1,200,000 850,000

EPS .45 .45

80. Breakeven EBIT leveredfinancing stockfinancing EPS EBIT $.5m$1m$1.5m$2m 0 .65 .45 .25 81. Breakeven EBIT For EBIT up to $1.08 m, stock financing is best. leveredfinancing stockfinancing EPS EBIT $.5m$1m$1.5m$2m 0 .65 .45 .25 82. Breakeven EBIT For EBIT up to $1.08 m, stock financing is best. For EBIT greater than $1.08 m,the levered plan is best. leveredfinancing stockfinancing EPS EBIT $.5m$1m$1.5m$2m 0 .65 .45 .25 83. In-class Problem

Plan A:Sell 1,200,000 shares at $20 per share($24 million total).

Plan B:Issue $9.6 million in 9% debt and sell shares at $20 per share($24 million total).

Assume a 35% marginal tax rate.

84. Breakeven EBIT

Stock FinancingLevered Financing

(EBIT-I) (1-t) - P =(EBIT-I) (1-t) - P

SS

(EBIT-0) (1-.35)=(EBIT-864,000)(1-.35)

1,200,000720,000

EBIT = $2,160,000

85. Analytical Income Statement

StockLevered

EBIT 2,160,000 2,160,000

I 0 (864,000)

EBT 2,160,000 1,296,000

Tax (756,000) (453,600)

NI 1,404,000 842,400

Shares 1,200,000 720,000

EPS 1.17 1.17

86. Breakeven EBIT leveredfinancing stockfinancing EPS EBIT $1m$2m$3m$4m 0 1.5 1.17 .5 87. Breakeven EBIT leveredfinancing stockfinancing For EBIT up to $2.16 m, stock financing is best. EPS EBIT $1m$2m$3m$4m 0 1.5 1.17 .5 88. Breakeven EBIT leveredfinancing stockfinancing For EBIT greater than $2.16 m,the levered plan is best. For EBIT up to $2.16 m, stock financingis best. EPS EBIT $1m$2m$3m$4m 0 1.5 1.17 .5