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Chapter 14: Capital Structure Decisions
Chapter 14: Capital Structure Decisions
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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
re and wd are percentages of the firm
that are financed with stock and
debt.
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t 1
FCFt
t
(1 WACC )
WACC = wd (1-T) rd + we rs
(Continued)
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(Continued)
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(Continued)
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High risk
E(EBIT)
EBIT
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Rev.
} EBIT
TC
TC
F
F
QBE
Sales
QBE
Sales
(More...)
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Operating Breakeven
Q is quantity sold, F is fixed cost, V
is variable cost, TC is total cost, and
P is price per unit.
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Probability
EBITL
EBITH
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Financial risk:
Additional business risk concentrated on
common stockholders when financial leverage
is used.
Depends on the amount of debt and preferred
stock financing.
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Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate
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EBIT
Interest
EBT
Taxes (40%)
NI
ROE
Firm U
Firm L
$3,000
0
$3,000
1 ,200
$1,800
$3,000
1,200
$1,800
720
$1,080
9.0%
10.8%
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Continued
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Firm U: Unleveraged
Bad
Prob.
0.25
EBIT
$2,000
Interest
0
EBT
$2,000
Taxes (40%)
800
NI
$1,200
Economy
Avg.
Good
0.50
$3,000
0
$3,000
1,200
$1,800
0.25
$4,000
0
$4,000
1,600
$2,400
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Firm L: Leveraged
Bad
Prob.*
0.25
EBIT*
$2,000
Interest
1,200
EBT
$ 800
Taxes (40%)
320
NI
$ 480
*Same as for Firm U.
Economy
Avg.
0.50
$3,000
1,200
$1,800
720
$1,080
Good
0.25
$4,000
1,200
$2,800
1,120
$1,680
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Firm U
BEP
ROIC
ROE
TIE
Bad
10.0%
6.0%
6.0%
n.a.
Avg.
15.0%
9.0%
9.0%
n.a.
Good
20.0%
12.0%
12.0%
n.a.
Firm L
BEP
ROIC
ROE
TIE
Bad
10.0%
6.0%
4.8%
1.7x
Avg.
15.0%
9.0%
10.8%
2.5x
Good
20.0%
12.0%
16.8%
3.3x
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Profitability Measures:
E(BEP)
E(ROIC)
E(ROE)
U
15.0%
9.0%
9.0%
L
15.0%
9.0%
10.8%
Risk Measures:
ROIC
ROE
2.12%
2.12%
2.12%
4.24%
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Conclusions
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MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes
Trade-off theory
Signaling theory
Debt financing as a managerial
constraint
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rs
20
40
60
80
WACC
rd(1 - T)
Debt/Value
100
Ratio (%)
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(1 - Tc)(1 - Ts)
VL = VU + 1 (1 - Td)
]D.
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(1 - 0.40)(1 - 0.12)
VL = VU + 1 D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
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Trade-off Theory
MM theory ignores bankruptcy (financial
distress) costs, which increase as more
leverage is used.
At low leverage levels, tax benefits
outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh
tax benefits.
An optimal capital structure exists that
balances these costs and benefits.
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Signaling Theory
MM assumed that investors and managers
have the same information.
But, managers often have better
information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
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wd
D/S
bL
rs
0%
0.00
1.000
12.00%
20%
0.25
1.150
12.90%
30%
0.43
1.257
13.54%
40%
0.67
1.400
14.40%
50%
1.00
1.600
15.60%
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WACC = wd (1-T) rd + we rs
WACC = 0.2 (1 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%
Repeat this for all capital structures
under consideration.
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wd
rd
rs
WACC
0%
0.0%
12.00%
12.00%
20%
8.0%
12.90%
11.28%
30%
8.5%
13.54%
11.01%
40%
10.0%
14.40%
11.04%
50%
12.0%
15.60%
11.40%
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V = FCF / (WACC-g)
g=0, so investment in capital is zero;
so FCF = NOPAT = EBIT (1-T).
NOPAT = ($500,000)(1-0.40) = $300,000.
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wd
WACC
Corp. Value
0%
12.00%
$2,500,000
20%
11.28%
$2,659,574
30%
11.01%
$2,724,796
40%
11.04%
$2,717,391
50%
11.40%
$2,631,579
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Debt, D
Stock Value, S
0%
$0
$2,500,000
20%
$531,915
$2,127,660
30%
$817,439
$1,907,357
40%
$1,086,957
$1,630,435
50%
$1,315,789
$1,315,789
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Wealth of Shareholders
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P = S + (D D0)
n0
P = $2,127,660 + ($531,915 0)
100,000
P = $26.596 per share.
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# Repurchased = (D - D0) / P
# Rep. = ($531,915 0) / $26.596
= 20,000.
# Remaining = n = S / P
n = $2,127,660 / $26.596
= 80,000.
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wd
# shares
# shares
Repurch. Remaining
0%
$25.00
100,000
20%
$26.60
20,000
80,000
30%
$27.25
30,000
70,000
40%
$27.17
40,000
60,000
50%
$26.32
50,000
50,000
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wd = 30% gives:
Highest corporate value
Lowest WACC
Highest stock price per share
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