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Income statementSales XXX,XXXLess:variable cost X,XXXContribution XX,XXXFixed cost X,XXXEBIT XX,XXXLess: Interest X,XXXEBT XX,XXXLess: Tax X,XXXEAT X,XXX
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Business risk
Factors influence a firm’s business risk
Uncertainty associated with a firm’s projection of its operating income
Risk faced by shareholders on an all equity firm (business risk does not include financing effects.)
Demand of outputs Price and costs of outputs Competition Amount of operating leverage used by the
firm
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Operating leverage and business risk?
Operating leverage is the extent to which fixed costs are used in the firm’s operationTotal costs = fixed costs + variable costsIf most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.
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More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
Sales
$ Rev.TC
FC
QBE Sales
$ Rev.
TC
FC
QBE
} Profit
Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.
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Degree of operating leverage
EBIT/EBIT Sales/Sales
= Sales – Variable Costs
Sales – Variable Costs – Fixed Costs
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Capital structureBalance sheet
$ $
Assets 100 Share capital ?
Debt ?
100 100
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Financial leverageUse of debt/preference shareFinancial risk is the additional risk concentrated on common stockholders as a result of financial leverage. Use of debt/preference share
Financial leverage expected return
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Degree of financial leverage
EPS/EPS EBIT/EBIT
= Sales – Variable Costs – Fixed Costs
Sales – VC – Fixed Costs - Interests
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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 2 Hypothetical Firms
Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt (capital structure).
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Firm U: Unleveraged
Prob. 0.25 0.50 0.25EBIT $2,000 $3,000 $4,000Interest 0 0 0EBT $2,000 $3,000 $4,000Taxes (40%) 800 1,200 1,600NI $1,200 $1,800 $2,400
Economy Bad Avg. Good
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Firm L: Leveraged
Prob.* 0.25 0.50 0.25EBIT* $2,000 $3,000 $4,000Interest 1,200EBT $ 800Taxes (40%) 320NI $ 480 $1,080 $1,680
*Same as for Firm U.
Economy Bad Avg. Good
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Firm U Bad Avg. Good
ROE 6.0% 9.0% 12.0%
Firm L Bad Avg. Good
ROE 4.8% 10.8% 16.8%
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Degree of total leverage EPS/EPS
Sales/Sales
= Sales – Variable Costs Sales – VC – Fixed Costs - Interests
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Financial Leverage and EPS
(2.00)
EP
S
Debt
No DebtBreak-even
point
EBI in dollars, no taxes
Advantage to debt
Disadvantage to debt EBIT
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Fin Risk & Bus. Risk
DE
Business risk
Financial risk
DDebt/Equity)
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Double-edged sword of leverage use
Things go well when revenue rises but vice versaTherefore, leverage use, either operating or financial, magnifies the original fluctuation in the revenueReaction of investor :Cost of capital stock price
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Business Risk vs. Financial Risk
SUMMARYBusiness risk depends on business factors such as competition, product liability, and operating leverage.Financial risk depends only on the types of securities issued: More debt, more financial risk.
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What types of capital do firms use?
DebtPreferred stockCommon equity
Retained earnings New common stock
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Firm value = Equity + Debt = PV(cash flow from projects)
Company Cost of Capital
Opportunity cost that investors could earn today on capital market securities that have the same risk.
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Stockholders focus on after-tax capital costs, i.e., use after-tax costs in WACC. Only kd (cost of debt) needs adjustment.
Should we focus on before-tax or
after-tax capital costs?
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The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).
Should we focus on historical costs or new (marginal) costs?
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The average Beta of the assets is based on the % of funds in each asset.
Company Cost of Capitalsimple approach (All equity
financed)Company Cost of Capital (COC) is based on the average beta of the assets.
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Discount rateA company’s cost of capital can be compared to the CAPM required return.
Required
return
Project Beta1.26
Company Cost of Capital
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5.5
0
SML
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Two ways to determine cost of common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
2. Dividend model:
ks = D1/P0 + g.
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Component Cost of Debt
Suppose Kd is 10%; Interest is tax deductible, so assuming tax rate of 40%
kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.
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W A C CCOC = rportfolio = rassets
IMPORTANT
E, D, and V are all market values
rassets = WACC = rdebt (D) + requity (E)
(V) (V)Bassets = Bdebt (D) + Bequity (E)
(V) (V)
•requity = rf + Bequity ( rm - rf )
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Cost of capital for new projects
Modify CAPM
(account for proper risk)
Use COC unique to project,
rather than Company COC
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What factors influence a company’s composite WACC?
Market conditions.The firm’s capital structure and dividend policy.The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
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Find the company’s cost of capital based on the CAPM, given
these inputs:
Target debt ratio = 40%.
kd = 12%.
kRF = 7%.
Tax rate = 40%.
Beta of equity = 1.7.
Market risk premium = 6%.
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Beta = 1.7, so it has more market risk than average.
The required return on equity:
ks = kRF + (kM – kRF)bDiv.
=
WACCDiv. = wdkd(1 – T) + wcks
= = 13.2%.
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Capital structureBalance sheet
$ $
Assets 100 Share capital ?
Debt ?
100 100
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The Capital-Structure Question and The Pie Theory
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.V = B + S
Value of the Firm
S B• If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.
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Basic issues (1)Cash flows are generated by assets
• Capital structure is a way of packaging these cash flows and selling them to security holders, i.e. debt and equity
• Should packaging add value?
• Can overall size of pie be affected by the method of slicing it?
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Basic issues (2)• Capital structure is irrelevant to shareholders
wealth maximisation
• The value of the firm (size of pie) is determined by capital budgeting decision
• Capital structure determine only how the pie is sliced.
• Increased the debt will increase both the risk and expected return to equity.
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When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.
M&M (Debt Policy Doesn’t Matter)Independent hypothesis
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Assumptions
M&M (Debt Policy Doesn’t Matter)
• Homogeneous expectations
• Homogeneous business risk classes
• Perpetual cash flows
• Perfect capital market
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Assumptions- Perfect capital market
Perfect competition– Corporate leverage is replicable by individual
investors (firms and investors can borrow/lend at the same rate)
– No taxes– No bankruptcy costs– Symmetric information– No growth, i.e. EPS = DPS
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No Magic in Financial Leverage
MM'S PROPOSITION I (no tax)
Firm value is not affected by leverage
Valuation is independent of the debt ratio i.e. VL = VU
= Value of debt + Value of levered equity
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Value of a firm• The total market value of the firm is the
net present value of the income stream. For a firm with a constant perpetual income stream: C1V = –––––––
WACC
SdWACC rED
Er
ED
D
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WACC (Traditional)
DV
rE
rE =WACC
Cost of capital
rD
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M&M Proposition II
15.000,10
1500securities all of uemarket val
income operating expectedr r AE
E dooe rr
Drr
E
20%or 20.
10.15.5000
500015.
Er
Leverage increases risk and return to shareholders
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Cost of capitalWACC
DV
rE
WACC is constant
rD
The WACC is constant because the cost of equity capital rises to exactly offset the effect of cheaper debt
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X
X
EDA
ED
EED
D
DAAE ED
Leverage and Returns
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M&M Proposition II (no tax)
Leverage increases risk and return to shareholders
Shareholders require compensation for increased use of debt which exactly offsets the cheaper cost of debt financing.
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Proposition I (with corporate taxes)
Firm value increases with leverage
Value of leveraged firm = Value of unleveraged firm + PV(tax shield on interest)
i.e. VL = VU + TCD
Dependence hypothesis
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Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.
S G S G
B
All-equity firm Levered firm
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MM Proposition II (with taxes)
WACC
r
Sd rED
Er
ED
D(1 - Tc)
E doos rr
Drr
E(1 - Tc)
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Tax shield of interest payment
PV of Tax Shield = (assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
D = 1000 rD = 10% Tc = 20%
Tax benefit = 1000 x (.10) x (.20) = $20
PV of $20 perpetuity = 20 / .10 = $200
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Implications• With corporate tax, leverage create value
due to tax shield created by debt• Part of the cost and risk is shared by
government• It suggests firm should be 100% financed
by debt. In reality, no such firm. Why?
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100 % financed by debtNot exist because
Unable to use up tax shieldPersonal tax favour equity as capital gains tax can be deferred but tax on interest income cannot.Cost of financial distressAgency problems created by excessive debt
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Other views on capital structure
• Agency theory
• Trade-off theory
• Signalling Approach
• Pecking order theory
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Agency theory• Incentive to take large risks
• Incentive to under investment
• Milking the project
• Stockholders have incentives to play games. These games lead to poor investment and operating decisions.
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Trade-off theory
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity financed + PV Tax Shield - PV Costs of Financial Distress
A trade-off between costs of financial distress and tax savings
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Integration of Tax Effects and Financial Distress Costs
Debt (B)
Value of firm (V)
0
Present value of taxshield on debt
Present value offinancial distress costs
Value of firm underMM with corporatetaxes and debt
VL = VU + TCB
V = Actual value of firm
VU = Value of firm with no debt
B*
Maximumfirm value
Optimal amount of debt
Value ofunlevered
firm
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Costs of financial distress
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Trade-off theory: Implications
• Firms with low bankruptcy costs will have greater debt e.g. hotel (not care after sale services)
• Firms with tangible assets will borrow more than firms with specialised, intangible assets or valuable growth opportunities.
• Cannot explain why the more successful firms generally have the most conservative capital structure.
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1. Stock-for-debt Stock price exchange offers falls
Debt-for-stock Stock price exchange offers rises
Signalling approach
2. Issuing common stock drives down stock prices; repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
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1. If changes in capital structure can alter the market’s perception, the firm’s financial structure is no longer relevant.
2. A signal of management provides clues to investors how management views the firm’s prospects.
Managers think that the shares are “overpriced”
Managers know more and that they try to time issues
Investors interpret decision to issue new equity as bad news so price declineFirms, being unable to sell equity at fair price may sacrifice +ve NPV projects
Signalling approachAsymmetric information
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Pecking order theoryTheory stating that firms prefer to issue debt r
ather than equity if internal finance is insufficient.
Priority in funds raising Internally generated cash flowCash and marketable securities in
businessDebtEquity
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Pecking order theory•Firms prefer internal finance since funds can be raised without sending adverse signals.•If external finance is required, firms issue debt first and equity as a last resort. (Asymmetric information).•The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.•Financial slack is valuable (avoid given up +ve NPV projects due to low issue price of common stock).
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How Firms Establish Capital Structure
Most Corporations Have Low Debt-Asset Ratios.
Changes in Financial Leverage Affect Firm Value.
Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes.
Another interpretation is that firms signal good news when they lever up.
There are Differences in Capital Structure Across Industries.
There is evidence that firms behave as if they had a target Debt to Equity ratio.
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Factors in Target D/E RatioTaxes
If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt.
Types of AssetsThe costs of financial distress depend on the types of assets the firm has.
Uncertainty of Operating IncomeEven without debt, firms with uncertain operating income have high probability of experiencing financial distress.
Pecking Order and Financial SlackTheory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.