Lecture_9_-_BA205.pptx

8/9/2019 Lecture_9_-_BA205.pptx

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WEEK 7 LECTURE 9

Capital Structure Policy

1

Financial Management 1


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Capital Restructuring

We are going to loo! at "o# c"anges in capitalstructure a$$ect t"e %alue o$ t"e $irm& all else equal

Capital restructuring in%ol%es c"anging t"e amounto$ le%erage a $irm "as #it"out c"anging t"e $irm's

assets T"e $irm can increase le%erage (y issuing )e(t

an) repurc"asing outstan)ing s"ares

T"e $irm can )ecrease le%erage (y issuing ne#

s"ares an) retiring outstan)ing )e(t

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C"oosing a Capital Structure

W"at is t"e primary goal o$ $inancial managers-

. Ma/imi0e stoc!"ol)er #ealt"

We #ant to c"oose t"e capital structure t"at #ill

ma/imi0e stoc!"ol)er #ealt" We can ma/imi0e stoc!"ol)er #ealt" (y

ma/imi0ing t"e %alue o$ t"e $irm or minimi0ing t"eWCC

2ptimal 3target4 capital structure . )e(t+to+e5uityratio t"at results in lo#est WCC6

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Capital Structure T"eory

Mo)igliani an) Miller 3M8M4 T"eory o$ CapitalStructure

. Proposition . $irm %alue

. Proposition . WCC

T"e %alue o$ t"e $irm is )etermine) (y t"e cas"$lo#s to t"e $irm an) t"e ris! o$ t"e assets

C"anging $irm %alue )ue to:

. C"ange t"e ris! o$ t"e cas" $lo#s. C"ange t"e cas" $lo#s

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Capital Structure T"eory Un)erT"ree Special Cases

Case

.


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Case . Propositions an)

Proposition . T"e %alue o$ t"e $irm is


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Case . Proposition E5uations

WCC @ R1@ 3EAB4RE 3DAB4RD

Rearranging t"e a(o%e gi%es

RE@ R1 3R1. RD43DAE4

. R1is t"e cost o$ t"e $irm's business risk& i6e6&

t"e ris! o$ t"e $irm's assets

. 3R1 . RD43DAE4 is t"e cost o$ t"e $irm's

financial risk& i6e6& t"e a))itional returnre5uire) (y stoc!"ol)ers to compensate $or t"eris! o$ le%erage

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Figure 1*6

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Case + E/ample

Data. Re5uire) return on assets @ 1*H? cost o$ )e(t @ 1IH?

percent o$ )e(t @ ;>H

W"at is t"e cost o$ e5uity-

. RE@ 1* 31* + 1I436;>A6>>4 @ ,I691H Suppose instea) t"at t"e cost o$ e5uity is ,>H& #"at

is t"e )e(t+to+e5uity ratio-. ,> @ 1* 31* + 1I43DAE4

. DAE @ 3,> + 1*4 A 31* + 1I4 @ A, @16>

=ase) on t"is in$ormation& #"at is t"e percent o$e5uity in t"e $irm-. EAB @ , A > @ ;IH

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T"e CPM& t"e SML an)Proposition

Jo# )oes $inancial le%erage a$$ect systematicris!-

CPM: R1@ R$ 13RM. R$4

. W"ere is t"e $irm's asset (eta an) measures t"esystematic ris! o$ t"e $irm's assets

Proposition . RE@ R 3R. RD43DAE4

Replace R#it" t"e CPM a(o%e an) assume t"at t"e)e(t is ris!less 3RD@ R$4 gi%es

RE@ R$ 131DAE43RM. R$4

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=usiness Ris! an)Financial Ris!

RE@ R$ 31DAE43RM. R$4

CPM: RE@ R$ E3RM. R$4

E= A(1 + D/E)

T"ere$ore& t"e systematic ris! o$ t"e stoc!)epen)s on:

. Systematic ris! o$ t"e assets& 3(usiness ris!4. Le%el o$ le%erage& DAE 3$inancial ris!4

RE increases #"en $inancial le%erage increases

#"ile t"e (usiness ris! Rremain unc"ange)6

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Case . Cas" Flo#

nterest is ta/ )e)ucti(le

T"ere$ore& #"en a $irm a))s )e(t& it re)ucesta/es& all else e5ual

T"e re)uction in ta/es increases t"e cas" $lo# o$t"e $irm . a))e) (ene$it o$ )e(t $inancing6

Jo# s"oul) an increase in cas" $lo#s a$$ect t"e%alue o$ t"e $irm-

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Case + E/ample

Unlevered Firm Levered Firm

EBIT 1&III 1&III

Ineres I GITa!ableInc"me

1&III 9,I

Ta!es (#$%) II ,7*

&e Inc"me 7II *;;

'as Fl"Fr"m Asses

7II 7,;

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nterest Ta/ S"iel)

nnual interest ta/ s"iel). Ta/ rate times interest payment

. 1&III in GH )e(t @ GI in interest e/pense

.nnual ta/ s"iel) @ 6I3GI4 @ ,;

Present %alue o$ annual interest ta/ s"iel)

.ssume perpetual )e(t $or simplicity

. PB @ ,; A 6IG @ II

. PB @ D3RD43TC4 A RD@ DTC@ 1&III36I4 @ II

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Case . Proposition

T"e %alue o$ t"e $irm increases (y t"e present%alue o$ t"e annual interest ta/ s"iel)

. Balue o$ a le%ere) $irm @ %alue o$ an unle%ere)$irm PB o$ interest ta/ s"iel)

. Balue o$ e5uity @ Balue o$ t"e le%ere) $irm .Balue o$ )e(t

ssuming perpetual cas" $lo#s

. BU@ E=T31+T4 A RU

. BL@ BU DTC

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E/ample: Case . Proposition

Data

. E=T @ 1&III? Ta/ rate @ IH? De(t @ 1&III?Cost o$ )e(t @ GH? Unle%ere) cost o$ capital @1IH

BU@ 1&III31+6I4 A 61I @ 7&III

BL@ BUDTC@ 7&III 3I6I / 1&III4 @

7&II E @ 7&II + 1&III @ *&II

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Figure 1*6;

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Case . Proposition

T"e WCC )ecreases as DAE increases (ecause o$t"e go%ernment su(si)y on interest payments

. R1@ 3EAB4RE 3DAB43RD431 . TC4

. RE@ RU 3RU. RD43DAE431 . TC4

E/ample. RE@ 1I 31I+G431&IIIA*&II431 .6I4 @ 1$*%

E is ta!en $rom t"e %alue o$ e5uity un)erproposition

. R1@ 3*&IIA7&II431I6,,4 31&IIIA7&II43G431 . 6I4

R1@ ,*-%

WAo )e(t& WCC @ 1IH? WA )e(t& WCC @ 96*H1*+1G


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E/ample: Case .Proposition

Suppose t"at t"e $irm c"anges its capital structure sot"at t"e )e(t+to+e5uity ratio (ecomes 16

W"at #ill "appen to t"e cost o$ e5uity un)er t"e ne#capital structure-

. RE@ RU 3RU. RD43DAE431 . TC4

. RE@ 1I 31I . G431431 . 6I4 @ 11*.%

W"at #ill "appen to t"e #eig"te) a%erage cost o$capital-

. R@ 3EAB4RE 3DAB43RD431 . TC4

. R@ 6>3116;4 6>3G431 . 6I4 @ *0%

T"e amount o$ le%erage in t"e $irm increase)& so t"ecost o$ e5uity increase)6 =ut& t"e o%erall cost o$ capital

)ecrease)6 1*+19


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Figure 1*6>

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Case


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=an!ruptcy Costs

Direct costs. Legal an) a)ministrati%e costs

. Ultimately cause (on)"ol)ers to incur a))itionallosses

. Disincenti%e to )e(t $inancing Financial )istress

. Signi$icant pro(lems in meeting )e(t o(ligations

. Firms t"at e/perience $inancial )istress )o not

necessarily $ile $or (an!ruptcy. Cost o$ a%oi)ing $ile $or (an!ruptcy : in)irect

(an!ruptcy cost A $inancial )istress cost

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More =an!ruptcy Costs

n)irect (an!ruptcy costs

. Larger t"an )irect costs& (ut more )i$$icult tomeasure an) estimate

. Stoc!"ol)ers #ant to a%oi) a $ormal (an!ruptcy $iling

. =on)"ol)ers #ant to !eep e/isting assets intact so

t"ey can at least recei%e t"at money.ssets lose %alue as management spen)s time

#orrying a(out a%oi)ing (an!ruptcy instea) o$running t"e (usiness

. T"e $irm may also lose sales& e/perience interrupte)operations an) lose %alua(le employees

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Figure 1*6*

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Figure 1*67

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Conclusions

Case . no ta/es or (an!ruptcy costs.


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Figure 1*6G

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Step"en 6R& Ran)olp" W6W& =ra)$or) D6N6&

Lim& N6 an) Tan& R6 3,I1,46 Fun)amentals o$Corporate Finance& McOra# Jill6

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