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Ch. 15 - 13ed Capital Structure DecisionsComboMaster
Ch. 15 - 13ed Capital Structure DecisionsComboMaster
Topics in Chapter
Value =
Required investments
in operating capital
FCF1
FCF2
FCF
+
+
+
(1 + WACC)1
(1 + WACC)2
(1 + WACC)
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Firms
debt/equity
mix
Cost of debt
Cost of equity
Thru:
Lowering risk
Increasing CFs
Maximize Op. Profits
Growth Business
Reduce Taxes
5
Business Risk
Debts tax deductibility
Ability to raise capital under adverse terms
Managerial decisions:
Lowering risk
Increasing CFs
Maximize Op. Profits
Growth Business
Reduce Taxes
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
ws and wd are percentages of the firm
that are financed with stock and debt.
7
t=1
FCFt
(1 + WACC)t
WACC
FCF
(Continued)
9
Asymmetric Information
and Signaling
16
Rev.
Rev.
} EBIT
TC
TC
F
QBE
Sales
QBE
Sales
(More...)
18
Operating Breakeven
Business risk:
Financial risk:
Firm U
$20,000
$0
$20,000
40%
$3,000
$1,800
9%
Firm L
$20,000
$10,000 (12% rate)
$10,000
40%
$3,000
$1,800
9%
21
Impact of Leverage on
Returns
EBIT
Interest
EBT
Taxes (40%)
NI
ROIC (NI+Int)/TA]
ROE (NI/Equity)
Firm U
$3,000
0
$3,000
1 ,200
$1,800
Firm L
$3,000
1,200
$1,800
720
$1,080
9.0%
9.0%
11.0%
10.8%
22
Taxes paid:
U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
U: $1,200
L:
$720.
Impact of Leverage on
Returns if EBIT Falls
Firm U
Firm L
EBIT
$2,000
$2,000
Interest
0
1,200
EBT
$2,000
$800
Taxes (40%)
800
320
NI
$1,200
$480
ROIC
6.0%
6.0%
ROE
6.0%
4.8%
Leverage magnifies risk and return!
24
Impact of Leverage on
Returns if EBIT Rises
Firm U
EBIT
$4,000
Interest
0
EBT
$4,000
Taxes (40%)
1,600
NI
$2,400
ROIC
12.0%
ROE
12.0%
Leverage magnifies risk and return!
Firm L
$4,000
1,200
$2,800
1,120
$1,680
14.0%
16.8%
25
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Windows of opportunity
26
Firm L
$3,000
$3,000
1,200
NI
$3,000
$1,800
CF to shareholder
$3,000
$1,800
$1,200
$3,000
$3,000
EBIT
Interest
CF to debtholder
Total CF
VL = VU.
Value of CFU = VU
MM show that the value of rdDT = TD
Therefore, VL = VU + TD.
32
33
Tc = 40%, Td = 30%,
and Ts = 12%.
(1 - 0.40)(1 - 0.12)
VL = VU + 1
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in
debt raises Ls value by $0.25.
34
Trade-off Theory
Value of Firm, V
VL
VU
0
Debt
Distress Costs
37
Signaling Theory
41
42
Windows of Opportunity
Empirical Evidence
46
Volatile sales
High operating leverage
Many potential investment opportunities
Special purpose assets (instead of general
purpose assets that make good collateral)
47
49
50
51
$250
0
$250
0
$250
10
$25.00
52
0%
20%
30%
40%
50%
rd
0.0%
8.0%
8.5%
10.0%
12.0%
53
54
0%
20%
30%
40%
50%
rd
0.0%
8.0%
8.5%
10.0%
12.0%
ws
100%
80%
70%
60%
50%
1.000
1.150
1.257
1.400
1.600
rs
12.00%
12.90%
13.54%
14.40%
15.60%
WACC
12.00%
11.28%
11.01%
11.04%
11.40%
Vop = [FCF(1+g)]/(WACC g)
Vop = [$30(1+0)]/(0.1128 0)
Vop = $265.96 million.
Debt = DNew = wd Vop
Debt = 0.20(265.96) = $53.19 million.
Equity = S = ws Vop
0%
20%
30%
40%
50%
rd
0.0%
8.0%
8.5%
10.0%
12.0%
ws
100%
80%
70%
60%
50%
1.000
1.150
1.257
1.400
1.600
rs
12.00%
12.90%
13.54%
14.40%
15.60%
WACC
12.00%
11.28%
11.01%
11.04%
11.40%
Vop
$250.00
$265.96 $272.48
$271.74
$263.16
$0.00
$53.19
$81.74
$108.70
$131.58
$250.00
$212.77
$190.74
$163.04
$131.58
$250
+ ST Inv.
VTotal
$250
Debt
$250
10
$25.00
Total shareholder
wealth: S + Cash
$250
60
61
After Debt,
Before Rep.
Vop
$250
$265.96
+ ST Inv.
53.19
VTotal
$250
$319.15
Debt
53.19
$250
$265.96
10
10
$25.00
$26.60
$250
$265.96
Total shareholder
wealth: S + Cash
62
63
64
(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).
65
After Debt,
Before Rep.
After Rep.
Vop
$250
$265.96
$265.96
+ ST Inv.
53.19
VTotal
$250
$319.15
$265.96
Debt
53.19
53.19
$250
$265.96
$212.77
10
10
$25.00
$26.60
$26.60
$250
$265.96
$265.9666
Total shareholder
wealth: S + Cash
Key Points
0%
20%
30%
40%
50%
rd
0.0%
8.0%
8.5%
10.0%
12.0%
ws
100%
80%
70%
60%
50%
1.000
1.150
1.257
1.400
1.600
rs
12.00%
12.90%
13.54%
14.40%
15.60%
WACC
12.00%
11.28%
11.01%
11.04%
11.40%
Vop
$250.00
$265.96 $272.48
$271.74
$263.16
$0.00
$53.19
$81.74
$108.70
$131.58
$250.00
$212.77
$190.74
$163.04
$131.58
10
$25.00
$26.60
$27.25
$27.17
$26.32
68
Shortcuts
69
S = (1 wd) Vop
At wd = 20%:
S = (1 0.20) $265.96
S = $212.77.
(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).
70
At wd = 20%:
nPost = nPrior(VopNewDNew)/(VopNewDOld)
nPost = 10($265.96 $53.19)/($265.96 $0)
nPost = 8
71
At wd = 20%:
PPost = (VopNewDOld)/nPrior
nPost = ($265.96 $0)/10
nPost = $26.60
72
wd = 30% gives:
Part B
74
Firm U: Unleveraged
Prob.
EBIT
Interest
EBT
Taxes (40%)
NI
Bad
0.25
$2,000
0
$2,000
800
$1,200
Economy
Avg.
Good
0.50
0.25
$3,000 $4,000
0
0
$3,000 $4,000
1,200
1,600
$1,800 $2,400
Firm L: Leveraged
Prob.*
EBIT*
Interest
EBT
Taxes (40%)
NI
*Same as for Firm U.
Bad
0.25
$2,000
1,200
$ 800
320
$ 480
Economy
Avg.
Good
0.50
0.25
$3,000 $4,000
1,200
1,200
$1,800 $2,800
720
1,120
$1,080 $1,680
Firm U
Bad
Avg.
Good
BEP
10.0%
15.0%
20.0%
ROI*
6.0%
9.0%
12.0%
ROE
6.0%
9.0%
12.0%
TIE
Firm L
Bad
Avg.
Good
BEP
10.0%
15.0%
20.0%
ROI*
8.4%
11.4%
14.4%
ROE
4.8%
10.8%
16.8%
TIE
1.7x
2.5x
3.3x
*ROI = (NI + Interest)/Total financing.
Profitability Measures:
L
15.0%
11.4%
10.8%
ROE
2.12%
4.24%
CVROE
E(TIE)
0.24
0.39
2.5x
E(BEP)
E(ROI)
E(ROE)
Risk Measures:
U
15.0%
9.0%
9.0%
Conclusions
U: ROE = 2.12%.
L: ROE = 4.24%.
For leverage to be positive (increase expected ROE), BEP must be > kd.
If kd > 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.
(More...)
Shares
Bought
Debt issued
=
New price/share
After recapitalization firm would have more debt but fewer common
shares outstanding.
An analysis of several debt levels is given next.
D/E
0
0.142
0.333
0.600
1.000
bL
2.25
2.44
2.70
3.06
3.60
kS
15.00%
15.77
16.80
18.24
20.40
S1
(EBIT - kdD)(1 - T)
ks
=
V1
P1
- 0.1($250)](0.6)
= S1 + D1 =[$500
$1,807
+ $250 = $2,057.
0.1577
=
= $20.57.
$2,057
100
= $1,807.
Shares
repurchased
$250
=
$20.57
Shares
remaining
= $20.57.
S1
n1
= 12.15.
$1,807
87.85
kD
na
10%
11%
13%
16%
Divs
300
285
267
241.5
204
kS
15.00%
15.77
16.80
18.24
20.40
E
2,000
1,807
1,589
1,324
1,000
E
2,000
1,807
1,589
1,324
1,000
Total
Value
2,000
2,057
2,089
2,074
2,000
Price per
Share
$20.00
20.57
20.89
20.74
20.00
Total Value
is Maximized with
500,000 in
debt.
D
$ 0
250
500
750
NI
$300
285
267
242
n
100.00
87.85
76.07
63.84
EPS
$3.00
3.24
3.51
3.78
D
$
0
250
500
750
1,000
e.g. D
WACC
S
$2,000
1,807
1,589
1,324
1,000
V
$2,000
2,057
2,089
2,074
2,000
kd
Ks
WACC
-- 15.00% 15.0%
10%
15.77
14.6
11.0
16.80
14.4
13.0
18.24
14.5
13.0
20.40
15.0
= $250:
= ($250/$2,057)(10%)(0.6)
+ ($1,807/$2,057)(15.77%)
= 14.6%.
Is it possible to do an analysis exactly like the one above for most firms?
What type of analysis should firms conduct to help find their optimal, or
target, capital structure?
What other factors would managers consider when setting the target
capital structure?
Effects on control.