Professional Documents
Culture Documents
CFA CI Full Ver 021121
CFA CI Full Ver 021121
CFA CI Full Ver 021121
External
Connected
Shareholders Creditors
Loans Interest
Appoint
Internal
Committees Employees
Goods, Goods,
Cash services Cash
services
Suppliers Customers
Taxes
Regulators
6
Stake Interest/Influence
Stake Interest/Influence
Stake Interest/Influence
Stake Interest/Influence
Delegates authority/Hire
(2) Internal
Board of director Senior managers
(3)
Committees Employees
(6)
Customers Suppliers
Regulators
Managers/
Shareholders Conflict of interest
Directors
• The interest of managers When the board is Managers and directors have
and directors is more influenced by more and better information
dependent on firm insiders about the functioning and
performance → managers favor strategic direction of the firm
→ prefer lower of business management than shareholders → manager
risk interests at the may make strategic decisions
• The interest of shareholders expense of that are not necessarily in the
holding diversified portfolios shareholders or best interest of shareholders
is less dependent on the favor one group of → weaken the ability of
firm shareholders at the shareholders to exercise
→ may choose higher expense of another control
business risk to get more
profits
13
Board of
Manager Conflict of interest
director
Controlling Minority
Conflict of interest
shareholders shareholders
Controlling Minority
Conflict of interest
shareholders shareholders
Conflicts between
Mechanism
a. General meetings
• Require board of director to address about the company’s performance and
other matters involved in.
• Enable shareholders to participate in discussions and to vote on major corporate
matters and transactions that are not delegated to the board of directors.
Managers/
Shareholders
Directors
(*)
Proxy voting Cumulative voting
Implications
Mechanism
The board is accountable primarily to shareholders and is responsible for the
proper governance of the company; in this regard, the board is the link between
shareholders and managers.
Shareholders
Board of (1)
Manager
director
(1)
• Guide managers on the company’s strategic direction, oversee and monitor
management’s actions in implementing the strategy.
• Evaluate and rewards or disciplines management performance.
• Supervise the company’s audit, control, and risk management functions
Implications
• Ensure the proper governance of the company → act in the best value for the
shareholders.
• Mitigating agency problems and their associated risks.
22
Mechanism
Implications
Mechanism
Implications
Mechanism
Implications
Mechanism
(*)
• Nonmandatory and nonbinding say on pay systems (e.g., Canada): the board is
required to ask for feedback, rather than their imposition on renumeration
policies and is not required to act upon it.
• Mandatory and nonbinding system: the board is required to enable
shareholders to vote on remuneration plans, but the board does not have to
abide by the result of the vote.
• Mandatory and binding system: the board is required to enable shareholders to
vote on remuneration plans, but the board has to abide by the result of the
vote.
Implications
Mechanism
Implications
Mechanism
• Labor law: The framework that outlines employee rights such as working hours,
hiring and firing, pensions, and other employee benefits.
• Employment contracts: for the individual and outline the employee’s rights and
responsibilities; they are not all-encompassing, leaving some discretion within
the relationship.
• Other items such as the code of ethics and human resources documents are
intended to outline the relationship in order to manage and mitigate any legal
or reputational risks.
Implications
Employers and employees can determine clearly about their rights and
responsibilities:
• A company seeks to comply with employees’ rights and mitigate legal or
reputational risks in violation of these rights
• Ensure that employees are fulfilling their responsibilities toward the company
and are qualified and motivated to act in the company’s best interests
29
Mechanism
Implications
Mechanism
Implications
(1) There is a single board of directors that includes both internal and
external directors.
• Internal (executive) directors: senior managers employed by the
firm.
• External (non-executive) directors: are not company managers,
provide objective decision making, monitoring, and performance
One-tier
assessment.
board
• Independent directors: are non-executive directors who have no
other relationship with the firm regard to employment, ownership
or remuneration.
(2) Lead independent director has the ability to call meetings of the
independent directors, separate from meetings of the full board.
(3) The general practice is for all board member elections to be held at
the same meeting and each election to be for multiple years
Two-tier board
One-tier board
Board of director
Non-executive Executive
directors Direct supervision directors
Report for
monitoring
purpose
Supervisory board/commitee
33
(1) Elections for some board positions are held each year
(2) Board of directors are typically divided into three classes
that are elected separately in consecutive years - one class
every year:
• Negative aspect: need several years to replace a full board
Staggered
→ limit the ability of shareholders to replace board
board
members in any one year → limits their ability to effect a
major change of control at the company.
• Positive aspect: provides continuous implementation of
strategy and oversight without constantly being reassessed
by new board members thereby bringing short-termism into
company strategy.
34
Duty of the board member is to act in the interest of the company and
shareholders → prevent individual board members from acting in their
own interest, or the interest of another individual or group, at the
expense of the company and all shareholders:
• Regular receive reviews and reports from both management and the
company’s risk function
• Review any proposals for corporate transactions or changes, such as
major capital acquisitions, divestures, mergers, and acquisitions, before
they are referred to shareholders for approval, if applicable.
36
Strategy
Internal control
Board of director Management
Risk management
Support (1)
Committees
Management risk
Internal audit
(1)
Internal control
Committees
Audit committee
Governance committee
Nominations committee
Remuneration committee
Risk committee
• Informs the board about appropriate risk policy and risk tolerance of the
organization
• Oversees the enterprise-wide risk management processes of the
organization.
39
Investment committee
Shareholder engagement
Shareholder Activism
The legal environment varies around the world and offers different
protections to the shareholder or creditor:
• Common-law system: judges’ rulings become law in some instances
→ shareholders’ and creditors’ interests are considered to be better
protected
• Civil law system: judges are bound to rule based only on specifically
enacted laws → the rights of creditors are more clearly defined
→ creditors generally have a better protected position
43
Media
Operational efficiency
Improved control
Straight voting structure: one vote per share → any shareholder’s voting
power is equal to the percentage of the company’s outstanding shares
owned by that shareholder.
Dual class structure: common shares may be divided into two classes, one
of which has superior voting rights to the other.
There are two machenism in dual class structure:
• A share class carries one vote per
Each share has equal voting rights, but:
share and is publicly traded
• One share class (held by insiders)
• Another share class (held exclusively
elects a majority of the board
by company insiders or family
• Another share class would be entitled
members) carries several votes per
to elect only a minority of the board
share
For example: Alibaba
For example: Facebook
The founders/insiders can still control The insiders retain substantial power
board elections and all other major over the affairs of the corporation
voting matters even when their because they control a majority of the
ownership level < 50%. board.
50
Sustainable investing
A term used in a similar context to responsible investing, but its key focus is on
factoring in sustainability issues while investing.
Responsible investing
The broadest term used to describe investment strategies that incorporate
environmental, social, and governance (ESG) factors into their approaches.
Socially responsible
ESG investing Impact investing
investing (SRI)
Excluded companies
x x x
59
1. Corporate governance:
A. complies with a set of global standards.
B. is independent of both shareholder theory and stakeholder theory.
C. seeks to minimize and manage conflicting interests between insiders
and external shareholders.
Learning outcomes
28.b. Demonstrate the use of net present value (NPV) and internal rate
of return (IRR) in allocating capital and describe the advantages
and disadvantages of each method.
Definition
The capital allocation process is identifying and evaluating capital projects,
that is, projects where the cash flows to the firm will be received over a
period longer than a year.
The steps typically involved in the capital budgeting process are as follows:
The organization of the profitable proposals that together best fit the
company’s strategy. Financial and real resource constraints mean the
scheduling and prioritizing of capital investments are key considerations.
Project 1 18%
36% Project 3
18%
Project 2
28% Project 4
Post-audit
Conclusion
Investment projects
Investment projects may be sub-divided
into:
• Replacement projects to maintain the
business;
• Replacement projects for cost
reduction
Example:
• Replacing existing equipment with newer
c. New technology
Products • The decision whether to replace a piece
and Services
of equipment becomes obsolete
Expansion projects
Investment projects that expand
business size and often involve greater
uncertainty and management
consideration than replacement
projects.
c. New Example:
Products Vietcombank opens a representative office
and Services in New York (2019).
76
Example:
c. New TH true milk introduces “TH true juice”
Products and product line.
Services
77
c. New
Products and Occasionally, however, the cost of such
Services projects is sufficiently high that the
company would be better off to cease
operating altogether or to shut down
any part of the business that is related to
the project.
Others
Some projects are not easily analyzed
through the capital allocation process.
Example: A senior manager of a architecture firm wants the most qualified designers
to involve in a smart greenhouse project just because he is interested in gardening.
79
Sunk cost
A sunk cost is one that has already been incurred. One cannot change a sunk
cost. Decisions made today, however, should be based on current and future
cash flows and should not be affected by prior, or sunk, costs.
Opportunity cost
An opportunity cost is the value of the next best alternative that is foregone in
making the decision to pursue a particular Project.
For example, if we invest $1 million in a piece of equipment, the opportunity cost
of investing in that piece of equipment is the amount that $1 million would have
earned in its next-most-profitable use. Opportunity costs should be included in
project costs.
Externality
An externality is the effect of an investment on things other than the
investment itself.
An investment affects the cash flows of other parts of the company, and these
externalities can be positive or negative.
A project has a conventional cash flow pattern if the sign on the cash flows
changes only once, with one or more cash outflows followed by only cash
inflows.
Cash inflows
0 1 …
2 3 4 Cash outflows
An unconventional cash flow pattern has more than one sign change.
Cash inflows
0 1 3 …
2 4 Cash outflows
Opportunity costs are cash flows that a firm will lose by undertaking the
project under analysis. These are cash flows generated by an asset the firm
already owns that would be forgone if the project under consideration is
undertaken.
→ Opportunity costs should be included in project costs.
Capital allocation decisions account for the time value of money, which
means that cash flows received earlier are worth more than cash flows to
be received later.
This is true because the money that you have right now can be invested
and earn a return, thus creating a larger amount of money in the future.
Key assumptions
5. Project interactions
Independent projects are capital investments whose cash flows are independent
of each other.
Example:
If projects A and B are independent, and both projects are profitable, the firm
could accept both project.
Mutually exclusive projects compete directly with each other. Multiple projects
are mutually exclusive if only one of them can be accepted so that profitability
must be evaluated a among the projects.
Example:
If Projects A and B are mutually exclusive, either Project A or Project B can be
accepted, but not both. Making a capital allocation decision to select one of two
different stamping machines, each with different costs and outputs, is an example
of ranking two mutually exclusive projects.
86
5. Project interactions
Project sequencing
Many capital projects are sequenced over time, so that investing in a project
creates the option to invest in future projects
Example:
The company might invest in a project today and one year later invest in a second
project:
• If the financial results of the first project or new economic conditions are
favorable, the company would undertake the second project.
• If the results of the first project or new economic conditions are not favorable,
the company would not invest in the second project.
0 t=1
Yes
Invest in project 2
Favorable
Invest in Project 1
result?
Not invest in project 2
No
87
5. Project interactions
Explanation:
If a firm’s profitable project
opportunities exceed the amount of
funds available, the firm must ration,
or prioritize, its capital expenditures
with the goal of achieving the
maximum increase in value for
shareholders, given its available
capital.
88
Net present value (NPV) is the sum of the present values of all the expected
incremental cash flows if a project is undertaken.
n
CF1 CF2 CF3 CFn CFt
NPV = CF0 + + + +…+ =
(1+k)1 (1+k)2 (1+k)3 1+k n (1+k)t
t=0
Where:
CF0 = initial investment outlay (a negative cash flow),
CFt = after-tax cash flow at time t ( can be positive and negative),
k = required rate of return for project.
89
Decision rule:
Because the NPV is the amount by which the company’s wealth increases as a
result of the investment, the decision rule for the NPV is as follows:
Note: In the rare case that NPV turns out to be zero, the project could be
accepted because it meets the required rate of return.
90
CF0 -500
C01 100
F01 1
C02 170
F02 1
C03 230
F03 1
C04 260
F04 1
93
Example: Back to the example calculating the present value of an uneven cashflow
Step 2: Enter the discount rate and calculate the cashflow
• Press
• The screen displays “ I=“
Internal rate of return (IRR) is the discount rate that makes the present
value of the expected incremental after-tax cash inflows just equal to the
present value of the project’s estimated cash outflows.
PV (inflows) = PV (outflows)
Alternatively, the IRR is also the discount rate for which the NPV of a project is
equal to zero: n
CF1 CF2 CF3 CFn CFt
NPV = 0 = CF0 + + + +…+ =
(1+k)1 (1+k)2 (1+k)3 1+k n (1+k)t
t=0
NPV
Discount rate
0
Decision rule:
*The required rate of return for a given project is usually the firm’s cost of capital.
→ The required rate of return is often called the hurdle rate, the rate that a
project’s IRR must exceed for the project to be accepted by the company.
Note: the required rate of return may be higher or lower than the firm’s cost of
capital to adjust for differences between the project’s risk and the average risk of
all of the firm’s projects (which is reflected in the firm’s current cost of capital).
Required rate
of return
Firm’s cost of capital
Projects with higher than avg. risk
Projects with lower than avg. risk
96
Example: Back to the example calculating the present value of an uneven cashflow
Step 1: Entering the cashflows
Action Display Input value
CF0 -500
C01 100
F01 1
C02 170
F02 1
C03 230
F03 1
C04 260
F04 1
99
Example: Back to the example calculating the present value of an uneven cashflow
Step 2: Enter the discount rate and calculate the cashflow
• Press
NPV and IRR criteria will usually indicate the same investment decision for a given
capital investment (Acceptance or rejection of the investment).
Example:
If Project A and Project B were independent projects and the cost of capital were
7%, the company would accept both projects, as they both have positive NPVs
and their IRRs exceed the cost of capital (7%).
10
1
The NPV shows the amount of gain, or wealth increase in company value,
as a currency amount.
The NPV assumes reinvestment of cash flows at the required rate of
return, while the IRR assumes reinvestment at the IRR. The reinvestment
assumption of the NPV is the more economically realistic measure.
Another issue is that when the cash flows are nonconventional (i.e., they
change sign more than once), there are multiple IRRs.*
(*) This is one of IRR problems that will be mentioned in the next slide
If NPV is always preferred over IRR for selecting projects, why do companies
even bother with IRRs?
Answer: The reason is that many people find it easy to understand a rate of return.
10
2
NPV
Advantages Disadvantages
Advantages Disadvantages
One way to approach the question of whether a company is creating value for its
shareholders is to compare the return on the company’s investment in assets to
its cost of capital.
The ROIC measure is often compared with the associated cost of capital
(COC), the required return used in the NPV calculation and the company’s
associated cost of funds.
If a corporation invests in
positive-NPV projects
Example:
Freitag Corporation is investing €600 million in distribution facilities. The present
value of the future after-tax cash flows is estimated to be €850 million.
Freitag has 200 million outstanding shares with a current market price of €32.00
per share. This investment is new information, and it is independent of other
expectations about the company. What should be the investment’s effect on the
value of the company and the stock price?
Solution:
The NPV of the investment = PV of the future after-tax cash flows – Initial outlay
= €850 million − €600 million = €250 million.
The total market value of the company prior to the investment is
€32.00 × 200 million shares = €6,400 million.
→ The value of the company should increase by €250 million, to €6,650 million.
→ The price per share should increase by the NPV per share, or €250 million/200
million shares = €1.25 per share.
→ The share price should increase from €32.00 to €33.25.
10
9
Real options are options that allow companies to make decisions in the
future that alter the value of capital investment decisions made today.
0 t=1
Waiting for
a period of time
Yes
Invest now Take actions
Would the contingent on
Making all capital
future economic events or
investment
information be incurred?
decisions now Reject
No
11
0
Real options are options that allow companies to make decisions in the
future that alter the value of capital investment decisions made today.
0 t=1
a. Timing Options
b. Sizing Options
c. Flexibility Options
d. Fundamental Options
11
2
Abandonment options
0 1 2 … n n+1
… …
If the future financial results are strong , the company can make
additional investments.
Expansion options
11
6
They allow the company to change They offer the operational flexibility
the price of a product. to alter production when demand
varies from what is forecast.
11
7
Fundamental options are projects that are options themselves because the
payoffs depend on the price of an underlying asset
Example:
The payoff for a copper mine is dependent on the market price for copper:
- If copper prices are low, it may not make sense to open a copper mine,
- If copper prices are high, opening the copper mine could be very profitable.
→ The operator has the option to close the mine when prices are low and
open it when prices are high.
11
8
(*) The reasons why should not use only IRR to make investment decisions
are mentioned above in LOS 28.b.
Practice exercises
Practice exercises
1. With regard to capital allocation, an appropriate estimate of the
incremental cash flows from an investment is least likely to include:
A. externalities.
B. interest costs.
C. opportunity costs.
Practice exercises
4. Erin Chou is reviewing a profitable investment that has a conventional
cash flow pattern. If the cash flows for the investment, initial outlay, and
future after-tax cash flows all double, Chou would predict that the IRR
would:
A. increase and the NPV would increase.
B. stay the same and the NPV would increase.
C. stay the same and the NPV would stay the same.
Practice exercises
6. The Bearing Corp. invests only in positive-NPV projects. Which of the
following statements is truef
A. Bearing’s return on invested capital (ROIC) is greater than its cost of
capital (COC).
B. Bearing’s COC is greater than its ROIC.
C. We can’t reach any conclusions about the relationship between the
company’s ROIC and COC.
Practice exercises
7. What is the NPV (C$ millions) of the original project for Bouchard
Industries without considering the production- exibility optionf
A. –C$6.11 million
B. –C$5.66 million
C. C$2.33 million
8. What is the NPV (C$ millions) of the optimal set of investment decisions
for Bouchard Industries including the production- exibility optionf
A. –C$6.34 million
B. C$7.43 million
C. C$31.03 million
Practice exercises
Answer
1. B is correct. Costs to finance the investment are taken into account when
the cash flows are discounted at the appropriate cost of capital; including
interest costs in the cash flows would result in double-counting
the cost of debt.
2. B is correct.
CF1 CF2 CF3 40 80 120
NPV = CF0 + + + = −100 + + + = $58.33
(1+k)1 (1+k)2 (1+k)3 1.20 1.202 1.203
Practice exercises
A more precise IRR of 28.7854% has a total PV closer to zero.
4. B is correct. The IRR would stay the same because both the initial outlay
and the after-tax cash flows double, so the return on each dollar invested
would remain the same. All the cash flows and their present values
double. The difference between the total present value of the future cash
flows and the initial outlay (the NPV) also doubles.
5. C is correct. There are many factors that can affect the stock price,
including whether Ms. Ndereba’s analysis indicates that the project is
more or less profitable than investors expected.
6. A is correct. Since all of Bearing’s projects have a positive NPV, they are all
providing a return that is greater than the opportunity cost of capital.
Therefore, the ROIC must be greater than the COC.
7. B is correct.
If demand is “high,” the NPV is as follows:
10
40
NPV = −190 + = C$55.78 million
1.10t
t=0
13
1
Practice exercises
If demand is “low,” the NPV is
10
20
NPV = −190 + = C$67.11 million
1.10t
t=0
The expected NPV is 0.50(55.78) + 0.50(–67.11) = –C$5.66 million.
Practice exercises
9. C is correct. The project described has a production-flexibility regarding
the level of production. Other flexibility options might be to produce a
different product or to use different inputs at some future date. Including
the value of real options can improve the NPV estimates for individual
projects. (LOS 28.d)
133
Learning outcomes
The risks of each source of capital are diffirent for the company and for the investor:
• Short-term sources include financing from operating activities such as accounts
payable, short-term loans and short-term instruments sold issued in the capital
markets
• Long-term sources include bonds and leases, common shareholders’ equity,
preferred shares and convertible debt
Types of financing
1. Internal financing
Companies
Generate more
Increase working Convert liquid
after-tax operating
capital efficiency (b) assets to cash (c)
cash flows (a)
• Extending payable’s
The higher after-tax Converting
period
operating cash flows receivables,
• Reducing
are, the greater ability inventories and
receivable's period
to internally finance marketable securities
• Shortening asset
itself to cash
conversion cycle
Internal financing
136
1. Internal financing
Dividend
Net income Depreciation
payment
(*) Note that the term “operating cash flow” mentioned here is different from the
“operating cash flow” that appears on the Cash flow statement in the FRA topic.
137
1. Internal financing
The company
(Account payable)
The longer a company delays its payment, the more it can finance its
finance daily purchase
138
1. Internal financing
The company
(Account receivable )
The sooner a company can collect what it is owed, the lesser its need to
finance its operations in some other way
139
1. Internal financing
Shortening
Shortening inventory days
AR days
1. Internal financing
The sooner receivables are collected, the higher liquidity they have
1. Internal financing
Inventories are goods that are waiting to be sold and hold by the
company
1. Internal financing
A line of credit is a preset amount of money that a bank has agreed to lend
company. Company can draw from the line of credit when they need it, up to the
maximum amount and they’ll pay interest on the amount they borrow.
• The main types of bank lines of credit include uncommitted bank lines of
credit, committed bank lines of credit and revolving credit agreements
(revolvers).
• The reliability of each lines of credit is shown in the diagram below:
Reliability
Is a legal Is an agreement
Is a form of bank agreement that permits an
borrowing in
outlining the account holder to
which a bank
conditions of the borrow money
extends an offer
credit line between repeatedly up to a
of credit for an
Definition a bank & the set money limit
extended period
borrower, and while repaying a
of time but may
cannot be portion of the
refuse to lend if
circumstances suspended without current balance
change notifying the due in regular
borrower payments
Is the bank
committed Uncommitted Committed Committed
or not?
• Require • Similar to
compensation, committed lines
usually in the of credit with
form of a respect to
commitment fee borrowing rates,
Do not require to the lender. compensation.
any • The fee is a • Revolving credit
Cost
compensation fractional percent can come with
than interest. of the full amount variable interest
or unused rate that may be
amount of the adjusted and
line, depending typically higher
on bank-company than regular
negotiations. lines of credit.
Can be
listed in the
No Yes Yes
footnotes
or not?
146
• Revolving credit: When payments are made on the revolving credit account,
those funds become available to borrow again. The credit limit may be used
repeatedly as long as you do not exceed the credit limit.
• Line of credit: The pool of available credit does not replenish after payments
are made.
147
Secured loans
Secured loans are loans in which the lender requires the company to provide
collateral in the form of an asset.
Provide collateral
Company Lender
Lend money
Factoring
Factoring refers to the actual sale of receivables at a discount from their face
value. It is an arrangement to have debts collected by a factor company, which
advances a proportion of the money it is due to collect.
Factor
In a factoring arrangement, the company shifts the credit granting and collection
process to the factor. The cost of this credit (i.e., the amount of the discount)
depends on the credit quality of the accounts and the costs of collection.
149
Non-bank lenders also lend to businesses, but unlike typical banks, which make
loans and take deposits, these lenders only make loans.
150
2. External financing
The company can finance funds on capital markets by using three kinds
of financial instruments.
Capital markets
Convertible debts
Long-term debts and convertible
preferreds stocks
151
2. External financing
2. External financing
2. External financing
Note:
• Debt payments have priority over payments to equity holders and
the interest paid on debt is typically tax deductible;
154
2. External financing
2. External financing
Shareholders Company
2. External financing
2. External financing
Debt Equity
2. External financing
Debt Equity
2. External financing
2. External financing
Convertible instruments
They are similar to preferred equity or
debt but provide the owner with an
Debt Equity
option to convert to common stock
component component
2. External financing
2. External financing
Leasing Obligations
The lease is a debt instrument where the asset owner (the lessor) gives
another party (the lessee) the right to use the asset.
The leasing might offer lower joint costs for the company and for
suppliers of capital than buying and financing separately.
163
d. Monetary policy
The company
c. Government policy
a. Taxation
b. Inflation
Borrower Lender
c. Government Policy
a. Company size
Large companies with strong operating cash flows can rely more heavily
on internal financing,
Smaller companies, especially those that are younger and faster growing,
or without cash flow, cannot satisfy their capital needs internally and
must rely more on external financing—in particular, private equity.
170
• Real property and equipment are good collateral for mortgages and
asset-backed bonds.
• Assets that are unique, highly specialized, and intangible might not
be valuable as collateral.
If interest rates on short-term debt are less than those on long-term debt,
the company would be to finance with short-term debt and continually
refinance with new short-term debt whenever current debt matures.
174
The possibility of bankruptcy and the costs of financial distress can also
affect customers, suppliers, managers, employees, and the community
177
A publicly traded company incurs flotation costs when it issues new debt
or equity securities. Flotation costs include various expenses that are
company specific:
• legal fees,
• registration fees,
• audit fees,
• Underwriting fees
Lotation costs as a percentage of the capital raised are generally lower for
debt offerings than for equity offerings.
Flotation costs increase the cost of financing and can affect a company’s
financing decisions.
178
1. Managing liquidity
Cash balances
1. Managing liquidity
1. Managing liquidity
1. Managing liquidity
1. Managing liquidity
Short-term funds
Short-term funds include items such as:
• Trade credit,
• Bank lines of credit,
• Short-term investment portfolios.
1. Managing liquidity
Liquidating assets
Liquidating assets are both short-term and long-term assets can be
liquidated and converted into cash without substantial loss in value
1. Managing liquidity
A drag on liquidity occurs when there is a delay in cash coming into the
company, creating pressure from the decreased available funds
Company
A pull on liquidity occurs when cash leaves the company too quickly,
requiring companies to expend funds before they receive funds from
sales that could cover the liability.
185
1. Managing liquidity
A drag on liquidity
Major drags on receipts involve pressures from credit management and
deterioration in other assets and include the following:
1. Managing liquidity
A pull on liquidity
Major pulls on payments include the following:
2. Liquidity ratios
Liquidity ratios
• Measure a company’s ability to meet short-term obligations to
creditors as they mature or come due,
• Analyze the relationship between:
o Current assets and current liabilities;
o The rapidity with which receivables and inventory can be
converted into cash
Liquidity ratios
Liquidity
If liquidity is low, there are the risk that company will suffer financial
distress or, in the extreme case, insolvency or bankruptcy
If liquidity is too higher, that means the company have too much
invested in low- and non-earning assets low earning relative to the
long-term
Contributes to
Creditworthiness
2. Liquidity ratios
Current assets
Current ratio =
Current liabilities
Current Usage: Expresses current assets in relation to current liabilities.
ratio
Interpretation: A high current ratio is desirable as it indicates a
higher level of liquidity.
Cash+Short−term investment
Cash ratio =
Current liabilities
Usage: Represents a reliable measure of an entity’s liquidity in a
Cash ratio crisis situation. Only highly marketable short-term investments
and cash are included.
Interpretation: A high cash ratio is desirable as it indicates greater
liquidity.
190
2. Activity ratios
Activity ratios measure how well key current assets are managed over time
Purchases Sales
Days of inventory on hand Days of sales outstanding
2. Activity ratios
Activity ratios measure how well current assets are managed over time
• Usage: The number of DSO represents the elapsed time between a sale and cash
collection, reflecting how fast the company collects cash from customers.
• Interpretation:
o A high receivables turnover might indicate that the company’s credit
collection are highly efficient or result from overly stringent credit or
collection policies, which can hurt sales if competitors offer more lenient
credit terms to customers and vice versa
o A high DSO means that the company’s credit collection are highly inefficient.
192
2. Activity ratios
Activity ratios measure how well current assets are managed over time
Number of Days of
Payables
Purchases Pay cash Sales Receipt cash
• Usage: The number of days of payables reflects the average number of days the
company takes to pay its suppliers, and the payables turnover ratio measures
how many times per year the company theoretically pays off all its creditors.
• Interpretation:
o A high payables turnover might indicate that the company is not making full
use of available credit facilities and repaying creditors too soon or company
making payments early to avail early payment discounts
o A low number of days of payables means that the company repaying
creditors too soon
193
2. Activity ratios
Activity ratios measure how well current assets are managed over time
2. Activity ratios
Activity ratios measure how well current assets are managed over time
• Usage: Indicates the amount of time that elapses from the point when a
company invests in working capital until the point at which the company collects
cash
• Interpretation: A short cycle is desirable, as it indicates greater liquidity
195
30.b. Describe how taxes affect the cost of capital from different capital
sources
30.c. Calculate and interpret the cost of debt capital using the yield-
tomaturity approach and the debt-rating approach
30.e. Calculate and interpret the cost of equity capital using the capital
asset pricing model approach and the bond yield plus risk premium
approach
Cost of capital is the rate of return that the suppliers of capital (lenders
and owners) require as compensation for their contribution of capital.
Hybrid instrument
(Having characteristics
Equity Debt
of both debt and
equity)
Corporate capital
Corporate capital
Hybrid instrument
(Having characteristics
Equity Debt
of both debt and
equity)
The weights are the proportions of the various sources of capital that
the company uses to support its investment program.
Debt 1/3
Now suppose the new investment will be financed by issuing more debt
so that capital structure changes.
Target capital structure
Source of capital Proportions
Where:
wd = the target proportion of debt in the capital structure when the
company raises new funds
rd = the before-tax marginal cost of debt
t = the company’s marginal tax rate
wp = the target proportion of preferred stock in the capital structure
when the company raises new funds
rp = the marginal cost of preferred stock
we = the target proportion of common stock in the capital structure
when the company raises new funds
re = the marginal cost of common stock
The marginal cost of debt financing is the cost of debt after considering
the allowable deduction for interest on debt based on the tax law
If interest cannot
The effective marginal cost of debt = rd
be deducted
If interest can be
The effective marginal cost of debt = rd .(1 − t)
deducted in full
The tax deductibility of debt reduces the
effective marginal cost of debt to reflect the
income shielded from taxation
Note: There may be reasons why additional interest expense is not tax
deductible. In other words, if the limit on tax deductibility is reached, the
marginal cost of debt is the cost of debt without any adjustment for a tax
shield.
READING 30: Cost of Capital-Foundational Topics
[LOS 30.b] Describe how taxes affect the cost of capital from
different capital sources
0.04(1-0.48) =
Solution to 2 48% 6%
2.08%
Weighted average
2. Cost of Preferred stock
cost of capital
[LOS 30d]
(WACC)
1. Cost of debt
affected by
• unstable profit
• high debt in capital structure
HOW to estimate?
YTM is the annual return that an investor earns on a bond if the investor
purchases the bond today and holds it until maturity.
In other words, it is the yield, rd, that equates the present value of the
bond’s promised payments to its market price:
211
READING 30: Cost of Capital-Foundational Topics
[LOS 30.c] calculate and interpret the cost of debt capital
using the yield-to-maturity and the debt-rating approach
20 N = 20
-1,025 PV = -1,025
25 PMT = 25
1,000 FV = 1,000
212
21
21
33
b. Debt-rating approach
b. Debt-rating approach
Considerations
• Debt ratings are ratings of the debt issue itself, with the issuer being
only one of the considerations.
• Debt seniority and security (*), also affect ratings and yields
Note:
• Debt security means that a debt (i.e. bond) is secured by a form of
collateral.
• Seniority ranking is the systematic way in which lenders are repaid in
case of bankruptcy or liquidation.
Reference: Please refer to Reading 39: Fixed-income Securities: Defining
elements
READING 30: Cost of Capital-Foundational Topics
[LOS 30.c] calculate and interpret the cost of debt capital
using the yield-to-maturity and the debt-rating approach
Nonrated Debt
Ratings: The grade assigned to a corporation or its debt instrument
showing rating agency's predictions of how well a firm can make as
promised to pay periodic interest and repay the principal.
For nonrated bonds (small company unable to pay rating fees):
Estimating acompany’s “synthetic” debt rating based on financial ratios,
even offerred by researchers, are imprecise because debt ratings
incorporate not only financial ratios but also information about the
particular bond issue and the issuer that are not captured in
215
financial
ratios.
READING 30: Cost of Capital-Foundational Topics
[LOS 30.c] calculate and interpret the cost of debt capital
using the yield-to-maturity and the debt-rating approach
218
READING 30: Cost of Capital-Foundational Topics
[LOS 30.c] calculate and interpret the cost of debt capital
using the yield-to-maturity and the debt-rating approach
219
READING 30: Cost of Capital-Foundational Topics
[LOS 30.c] calculate and interpret the cost of debt capital
using the yield-to-maturity and the debt-rating approach
Leases
220
READING 30: Cost of Capital-Foundational Topics
[LOS 30.d] Calculate and interpret the cost of noncallable,
nonconvertible preferred stock
The cost of preferred stock is the cost that a company has committed to
pay preferred stockholders as a preferred dividend when it issues
preferred stock.
The value of noncallable, nonconvertible preferred stock, with fixed
dividend rate and no maturity date (fixed-rate perpetual stock) will be
Dp
Pp = where: Pp : the current preferred stock price per share
rp
Dp : the preferred stock dividend per share
rp : the cost of preferred stock
Effects of tax
Considerations
adjustable-rate dividends
222
READING 30: Cost of Capital-Foundational Topics
[LOS 30.d] Calculate and interpret the cost of noncallable,
nonconvertible preferred stock
Solution:
The current terms indicate the most current actual cost of the preferred
stock.
Therefore, the cost of preferred stock for De Gouden Tulip is, 6.5%.
Because preferred dividends offer no tax shield, there is no adjustment
made on the basis of the marginal tax rate.
223
224
HOW to estimate?
Capital asset pricing Bond yield plus risk
model (CAPM) premium (BYPRP)
225
We use the capital asset pricing model theory that the expected return
on a stock, E(Ri ), is the sum of the risk-free rate of interest, RF , and a
premium for bearing the stock’s market risk, βi E RM −RF .
This premium incorporates the stock’s return sensitivity to changes in
the market return, or market-related risk, known as βi
E Ri = RF + βi E RM −RF
where:
βi = the return sensitivity of stock i to changes in the market return
RF = the risk-free rate of interest
E(RM ) = the expected return on the market
E(RM ) - RF = the expected market risk premium
226
1. Overview on Beta
Beta estimation
Used as
A critical component of CAPM
A component of calculation of WACC
229
• In US: S&P 500 Index and The most common choice is five
NYSE Composite years of monthly data, yielding
• In Japan: Nikkei 225 Index 60 observations.
231
b. Adjusted beta
Adjusted “Raw”
2/3 1/3 1.0
beta beta
232
Solution:
Adjusted beta = (2/3) (0.4) + (1/3) (1.0) = 0.6
233
Not reflect
Beta is
underlying changes
understated
in value
234
Step 1:
Choose Peer/Comparable company
peer
company Publicly traded Similar business risk
Unlevered
Asset beta
Re-levered
Solution (continued):
Step 3: Unlevered peer company’s beta to estimate beta of asset
Since Merck is 40% funded by debt, it is 60% funded by equity
→ Merck’s D/E = 4/6
1 1
βAsset = βEquity (Merck Co.) x = 0.7 x 4 = 0.46
1+ 1−t D
E 1+ 1−0.21
6
2% - 7%
Flotation cost
241
Treatment 1 Treatment 2
a. Treatment 1
b. Treatment 2
Required:
Calculate the NPV of the project using the 2 treatments of flotation costs
and discuss how the result of this method differs from the result
obtained from these treatments of flotation costs.
Solution:
Calculation:
Treatment 1 Treatment 2
Solution (continued)
Treatment 1 Treatment 2
Solution (continued)
Treatment 1 Treatment
Solution (continued)
Discussion:
1. Using these 2 treatments results in different assessments of value:
Compare with treatment 2:
• The cost of equity in treatment 1 would have increased from 10.55%
(treatment 2) to 10.82% (treatment 1) → increase the WACC from
7.39% (treatment 2) to 7.53% (treatment 1)
• NPV is higher than NPV in treatment 2
2. Adjusting the flotation cost from the initial cash outflow (treatment 2)
is the correct approach because it provides the most accurate
assessment of the project’s value once all cash costs, and their timing,
are considered.
248
2. At the time of valuation, the estimated betas for JPMorgan Chase & Co.
and the Boeing Company were 1.50 and 0.80, respectively. The risk-free
rate of return was 4.35%, and the equity risk premium was 8.04%. Based
on these data, calculate the required rates of return for these two stocks
using the CAPM.
A. $25.00
B. $26.92
C. 37.31
The estimated equity beta for the private company is closet to:
A. 1.029
B. 1.104
C. 1.877
252
1. C is correct.
FV= $1,000; PMT = $40; N = 5 x 2 = 10; PV = $900
Use financial calculator (see slide 15), solve for i = 0.053149 or 5.3149%
→ rd = 5.3149% x 2 = 10.6298%.
The after-tax cost = rd (1-t) = 10. 6298%(1-0.38) = 6.5905%
2. For JPMorgan Chase, the required return is
re = RF + β E RM − RF = 4.35% + 1.5(8.04%) = 4.35% + 12.06% = 16.41%
3. B is correct.
The company can issue preferred stock at 6.5%. Therefore, the calculation
of the preferred stock's current value is
PP = $1.75/0.065 = $26.92
254
5. B is correct. Asset risk does not change with a higher debt-to-equity ratio.
Equity risk rises with higher debt.
6. C is correct.
We have:
Flotation
NPV of the project using external equity
cost
NPV of the project using external equity = NPV of the project using
internal equity – Flotation cost = 5,000,000 – 1,450,000 = 3,550,000
Flotation costs reduce NPV by £1,450,000 and the NPV using external
equity would be £3,550,000 B is correct and C is incorrect
A is incorrect because adjusting the cost off capital to reflect the flotation
cost is not a preferred way to account for flotation costs.
25
7
Learning outcomes
28.a. Describe how a company’s capital structure may change over its
life cycle
Introduction
This reading reviews some of the key factors affecting capital structure,
including the following:
Company life Companies typically evolve over time from cash consumers to
cycle cash generators, with decreasing business risk and increasing
debt capacity. (Refer to los 31.a)
+ Revenue
Cashflow
0
Time
-
Stage in life cycle Start-up (a) Growth (b) Mature (c)
Financial management
Revenue growth Beginning Rising Slowing
Cash flow Negative Improving Positive/Predictable
Business risk High Medium Low
Debt capital/leverage
Availability Very limited Limited/improving High
Cost High Medium Low
Typical cases N/A Secured Unsecured
Typical % of capital Close to 0% 0%–20% 20% +
structure
READING 31: CAPITAL STRUCTURE
[LOS 31.a] Describe how a company’s capital structure may
change over its life cycle
2. Capital structure during company life cycle
a. Start-up stage
• Sales are just beginning and operating earnings and cash flows tend to be
low or negative.
• Business risk is relatively high.
• Company debt is quite risky and, if issued, would require high interest
rates.
• Assets, both accounts receivable and fixed assets, typically are low and
therefore not available as collateral for debt.
→ Start-up companies are financed almost exclusively with equity.
b. Growth stage
• Revenue and cash flow are rising and business risk is reduced.
• Debt financing cost is reduced and investors may be willing to lend to the
company, often with the loans secured by fixed assets or accounts
receivable.
• There may be assets that can be used to secure debt, such as receivables,
inventory, or fixed assets.
→ Depending on the company, debt issuance may be as much as26020% of the
firm’s capital structure (and secured debts are the typical cases).
READING 31: CAPITAL STRUCTURE
[LOS 31.a] Describe how a company’s capital structure may
change over its life cycle
c. Mature stage
261
READING 31: CAPITAL STRUCTURE
[LOS 31.a] Describe how a company’s capital structure may
change over its life cycle
Cyclical Industries
Revenues and cash flows vary
Debt capacity is Use low level
widely through the economic
limited of debt.
cycle.
“Capital-Light” Businesses
These companies have minimal fixed Have little debt in their capital
investments or working capital needs structures
263
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
1. Modigliani–Miller assumptions
In 1958, Nobel laureates Franco Modigliani and Merton Miller (we will refer
to them as MM) published their seminal work on capital structure theory.
Modigliani and Miller (MM) used simplifying assumptions to show the
irrelevance of capital structure to firm value.
3. Risk-free rate: Investors can borrow and lend at the risk-free rate.
265
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
share share
Arbitrage profit
Conclusion, the value of the levered company (VL) is equal to the value of
the unlevered company (Vu ),
Vu = VL
Results:
• Managers cannot create firm value simply by changing the company’s
capital structure
• The value of a company is determined solely by its cash flows, not by its
relative reliance on debt and equity capital.
269
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Demonstration:
(1) According to MM Proposition I, Weighted average cost of capital (WACC)
is unaffected by capital structure.
WACC = constant = r0
(2) M&M also give theory on the assumption that:
• There is no financial distress and agency costs
• Ability to borrow and lend at the risk-free rate
rd = constant
(3) To understand the M&M view, we go back with WACC formula:
E.re + D.rd (1 − t)
WACC =
E+D
In M&M view without tax, we ignore the impact of tax, so t = 0
270
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Demonstration:
• Buiding cost of equity linear function:
From (3), we have:
E.re + D.rd
WACC =
E+D
D D
⇒ r0 = ( )r +( )r
E+D d E+D e
r (E + D) − D.rd
⇒ re = 0
E
D
Linear function: re = r0 + (r0 − rd)
E
271
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
The proportions of debt versus equity in the firm’s capital structure do not
affect the firm’s overall cost of capital or the value of the firm
Cost of D
re = r0 + (r0 − rd )
capital E
E.re + D.rd (1 − t)
r0 WACC =
E+D
rd rd =constant
273
Gearing D/E
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Example:
Unlevered capital structure
Leverkin Company, which currently has an all-equity capital structure.
Leverkin has expected annual cash flows to equityholders (which we denote
as “CFe”) of $5,000 and a cost of equity, which is also its WACC, of 10%.
For simplicity, we assume that all cash flows are perpetual. Therefore,
Leverkin’s value is equal to
CFe $5,000
V= = = $50,000
WACC 10%
Levered capital structure
Now suppose that Leverkin plans to issue $15,000 in debt at a cost of 5%
and use the proceeds to buy back $15,000 worth of its equity.
Under MM Proposition I, VL = VU, so the value of Leverkin must remain the
same at $50,000. Under MM Proposition II, the cost of Leverkin’s equity
when it has $15,000 debt and $35,000 equity is
$15,000
re = 10% + 10% − 5% ≈ 12.143%
$35,000
274
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Example:
Furthermore, the value of Leverkin must equal the sum of the present value
of cash flows to debtholders and equityholders. With $15,000 debt at a cost
of 5%, Leverkin makes annual interest payments of $750 to debtholders,
leaving $5,000 − $750 = $4,250 for equityholders. Therefore, the total value
of the company is:
$750 $4,250
V=D+E= + = $15,000 + $34,999.59 ≈ $50,000
5% 12.413%
The more debt the company uses, the greater the cost of equity, but the
total value of the company does not change and neither does the weighted
average cost of capital.
With its new capital structure, the company’s WACC remains at 10%:
$15,000 $35,000
WACC = 5%+ 12.143%=10%
$50,000 $50,000
275
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Example:
We can summary the impact of change in capital structure as the following
graph:
Cost of capital D
re = 10% + 5%
E
12.413%
10% WACC
rd = 5%
276
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Now let’s explore what happens when we take a more realistic assumption,
that of corporate taxes.
279
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Demonstration:
From MM position I with corporate taxes, we have
V1 = V1U + tD1
Furthermore:
• V1 = E1 + D1 = E0 (1 + re ) + D0 (1 + rd );
• V1U = (1 + r0 )V0U; (with r0 is cost of capital for a unlevered company),
• D1 = D0 (1 + rd )
Thus, (1 + r0 )V0U + D0 (1 + rd )t = E0 (1 + re ) + D0 (1 + rd )
⇒ E0 (1 + re ) = (1 + r0 )V0U - D0 (1 + rd )(1 – t)
V D
⇒ (1 + re ) = (1 + r0) 0U − (1 + rd )(1 – t) 0
E0 E0
With V0 = V0U + tD0
V − tD0 D
⇒ (1 + re ) = (1 + r0 ) 0 − (1 + rd )(1 – t) 0
E0 E0
E0 + D0 − tD0 281 D
Since V0 = E0 + D0 ⇒ (1 + re ) = (1 + r0 ) − (1 + rd )(1 – t) 0
E0 E0
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Demonstration:
E + (1 − t)D0 D
⇒ (1 + re ) = (1 + r0 ) 0 − (1 + rd )(1 – t) 0
E0 E0
D0 D
⇒ (1 + re ) = (1 + r0 )+(1 + r0 )(1 − t) − (1 + rd )(1 – t) 0
E0 E0
D0
⇒ (1 + re ) = (1 + r0 )+(1 + r0 − 1 − rd )(1 − t)
E0
D0
⇒ re = r0 + (r0 − rd )(1 − t)
E0
282
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Demonstration:
E + (1 − t)D0 D
⇒ (1 + re ) = (1 + r0 ) 0 − (1 + rd )(1 – t) 0
E0 E0
D0 D
⇒ (1 + re ) = (1 + r0 )+(1 + r0 )(1 − t) − (1 + rd )(1 – t) 0
E0 E0
D0
⇒ (1 + re ) = (1 + r0 )+(1 + r0 − 1 − rd )(1 − t)
E0
D0
⇒ re = r0 + (r0 − rd )(1 − t)
E0
283
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
When t is not zero, the term (1 − t) is less than 1 and serves to reduce the
cost of levered equity
The cost of equity rises as the company increases the amount of debt in its
capital structure, but it rises at a slower rate than in the no-tax case
The increase in re does not offset the benefit of the cheaper debt finance
and therefore the WACC falls.
284
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
the WACC decreases when the company raise the debt proportion in capital
structure, and move toward rd (= rd when company using 100% debt)
D
Cost of re = r0 + (r0 − rd )(1 − t)
E
capital
r0 E.re + D.rd (1 − t)
WACC =
E+D
rd (1−t)
rd (1−t) = constant
285
Gearing D/E
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Example:
Let us return to the example of the Leverkin Company. Recall that annual
cash flows to equityholders are $5,000 and the WACC is 10%. As before,
Leverkin is planning to issue $15,000 of 5% debt in order to buy back an
equivalent amount of equity. Now, however, assume that Leverkin pays
corporate taxes at a rate of 25%.
Since the company does not currently have debt, the after-tax cash flows
are $5,000(1 – 0.25) or $3,750.
Because the cash flows are assumed to be perpetual, the value of the
company at 10% is $37,500, considerably less than it was when there were
no taxes. Now suppose Leverkin issues $15,000 of debt and uses the
proceeds to repurchase common stock.
According to MM Proposition I with corporate taxes, the value of the
company is:
VL = VU + tD = $37,500 + 0.25($15,000) = $41,250
286
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
Example:
Since the value of the debt is $15,000, the value of the equity (after the
buyback) must be ($41,250 − $15,000) = $26,250. According to MM
Proposition II with corporate taxes, the cost of the levered equity is:
D $15,000
re = r0 + (r0 − rd )(1 − t) = 10% + (10% −50%)(1 − 25%) = 12.413%
E $26,250
Note that the value of the company must also equal the present value of
cash flows to debt and to equity:
re D (CFe − rd D)(1 − t)
VL = D + E = +
rd re
$750 ($5,000 − $750)(1 − 25%)
= +
0.05 12.413%
≈ $41,250
which is the same result that we got from MM Proposition I with corporate
taxes. As a further check, using Equation 5, the WACC for the levered
Leverkin is:
$15,000 $35,000
WACC= 5%(1 − 25%)+ 12.143% = 9.091%
41,250 $41,250
287
As expected, this is lower than the unlevered WACC of 10%.
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
One type of cost that can be expected to increase at higher levels of debt
financing is costs of financial distress.
Costs of financial distress are the increased costs a company faces when
earnings decline to the point where the firm has trouble paying its fixed
financing costs (interest on debt).
288
READING 31: CAPITAL STRUCTURE
[LOS 31.b] Explain the Modigliani–Miller propositions
regarding capital structure
We consider only the tax shield provided by debt and the costs of financial
distress. As a result, we can write the value of a leveraged company as
VL = VU + tD − PV of costs of financial distress
The static trade-off theory seeks to balance the costs of financial distress
with the tax shield benefits from using debt
This point represents the optimal capital structure for a firm, where the WACC
is minimized and the value of the firm is maximized.
Note: each firm’s optimal capital structure depends on its business risk
(operating risk and sales risk), tax rate, corporate governance, industry
291
influences, and other factors.
READING 31: CAPITAL STRUCTURE
[LOS 31.c] describe the use of target capital structure in
estimating WACC, and calculate and interpret target capital
structure weights
2. Static Trade-Off Theory
Value of
levered firm
Firm value Cost of financial
Maximum firm distress
value Value of Levered Firm
PV of tax shield with Financial Distress
Value of
Unlevered Firm
rd (1−t)
cost increases reduce or
even negate the cost savings
Optimal capital Gearing D/E
stucture
The result is a U-shaped
weighted average cost of
capital curve
293
READING 31: CAPITAL STRUCTURE
[LOS 31.c] describe the use of target capital structure in
estimating WACC, and calculate and interpret target capital
structure weights
2. Application of Static trade-off theory in capital management
Company may adopt its optimal capital structure as Target capital structure
A company’s capital structure at any point in time may differ from the target
due to:
• Management may exploit short-term opportunities in one or another
financing source
• Market-value fluctuations continuously affect the company’s capital
structure
294
READING 31: CAPITAL STRUCTURE
[LOS 31.c] describe the use of target capital structure in
estimating WACC, and calculate and interpret target capital
structure weights
2. Determine what WACC weights to use
Ideally, we want to use the proportion of each source of capital that the
company would use in the project or company
Example: suppose a company has the following market values for its capital:
Weights
Bonds outstanding $5 million 25%
Preferred stock $1 million 5%
Common stock $20 million 70% 296
READING 31: CAPITAL STRUCTURE
Capital structure
policies and
targets (1)
Asymmetric
information (4)
297
READING 31: CAPITAL STRUCTURE
Company
298
READING 31: CAPITAL STRUCTURE
a. Debt Ratings
Implication:
Debt ratings reflects a company’s level of leverage as well as financial risks
→ Debt ratings are an important consideration in the practical management
of leverage, and maintaining the company’s rating at a certain level may
also be an explicit policy target for management.
For example: A company might target an S&P debt rating of A or higher.
2. For management, the primary concern is the amount and types of capital
invested by the company, not in the company.
2. Match the cash flows and maturity structure of the assets and debt.
Asset liability misalignment increases the risk of default and cost
of capital for companies:
• A company financing long-term assets with short-term obligations faces
rollover risk, which may threaten profitability if short-term financing
costs go up over the financing period.
• A company financing short-term assets with long-term financing beyond
the term needed faces the risk that the company overpays in financing
cost. 301
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Explain factors affecting capital structure decisions
3. Market conditions
• Macro-economics
• Country’s specific factors
• Credit market conditions
Asymmetric information
303
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Explain factors affecting capital structure decisions
Asymmetric information
A hierarchy to managers’
selection of methods for
financing – pecking order
theory (next slide) 304
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Explain factors affecting capital structure decisions
Internal financing
information content
Level of potential
Prefencces of
managers
Debt
Equity *
* Public equity offerings are, in general, closely scrutinized because investors are
typically skeptical that existing owners would share ownership of a company with a
great future with other investors 305
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Explain factors affecting capital structure decisions
• Agency costs are the incremental costs arising from conflicts of interest
when an agent makes decisions for a principal.
• In the context of a corporation, agency costs arise from conflicts of
interest between managers, shareholders, and bondholders.
The smaller The less their share The less their Agency
the stake in bearing the cost of desire to give their cost
managers excessive perquisite best efforts in increases
have consumption running the company
306
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Explain factors affecting capital structure decisions
307
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Describe competing stakeholder interests in capital
structure decisions
Share-
Stakeholders Other stakeholders
holders
308
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Describe competing stakeholder interests in capital
structure decisions
Equityholders Debtholders
3. Preferred Stockholders
The conflict of interest between common stock holders and preferred stock
holders is similar to the conflict of interest between the conflict of interest
between common stock holders and debt holder.
(*) • Holder of preferred stock are entitled to receive a fixed amount of dividends
before dividends are paid to common stock holder.
• If the firm cannot make the promised payments on its debt, preferred stock
310
dividends will not be paid.
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Describe competing stakeholder interests in capital
structure decisions
311
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Describe competing stakeholder interests in capital
structure decisions
The risk varies between Bank and private lenders and Public debt holder
312
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Describe competing stakeholder interests in capital
structure decisions
Customers
Customers of specialized products have an interest in the financial health
and survival of firms that are their key suppliers, similar to the interest of
debt holder.
Suppliers
• Suppliers typically are short-term creditors of a firm and thus have an
interest in the firm’s continuing ability to meet its obligation.
• Some suppliers have invested time and capital in developing specialized
products for a firm and will lose significant revenue if that firm fails.
313
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Describe competing stakeholder interests in capital
structure decisions
6. Employees
315
READING 31: CAPITAL STRUCTURE
[LOS 31.d] Describe competing stakeholder interests in capital
structure decisions
316
317
32.a. Define and explain leverage, business risk, sales risk, operating risk,
and financial risk and classify a risk
A ($) B ($)
A ($) B ($)
1. Business risk
(1) Revenue (prices and quantity of (2) The greater the fixed operating
sales) is affected by economic costs relative to variable operating
conditions, industry dynamics, costs → difficult to adjust its
government regulation, and operating costs to changes in sales
demographics. → the greater the operating risk.
2. Financial risk
Financial risk refers to the additional risk that the firm’s common
stockholders must bear when a firm uses fixed cost (debt) financing.
a. DOL formula
a. DOL formula
a. DOL formula
∆EBIT × Q ∆Q × (P −AVC) × Q
= =
EBIT× ∆Q Q × P −AVC − F × ∆Q
Q × (P −AVC)
=
Q × P −AVC − F
Q × (P −AVC)
DOL =
Q × P −AVC − F
329
a. DOL formula
Answer:
A ($) B ($)
The higher the proportion of fixed operating costs in a company’s cost structure,
the more sensitive its operating income is (the higher DOL) to changes in units sold
→ the higher the company’s operating risk.
332
a. DFL formula
% change
→ DFL = 40%/20% = 2
333
a. DFL formula
a. DFL formula
DFL 2 4
The higher the use of fixed financing sources by a company, the greater
the sensitivity of net income to changes in operating income (higher DFL)
→ the higher the financial risk of the company.
Q × (P −AVC) [Q × (P −AVC) − F]
= DOL × DFL = ×
Q × P −AVC − F [Q × P −AVC − F − C]
Q × (P −AVC)
=
[Q × P −AVC − F − C]
337
Calculate Beta’s Net income and ROE if its EBIT changes by 10% in 2
cases?
Case 2: equity = debt = $250,000 EBIT less 10% Expected EBIT EBIT plus 10%
Using financial leverage reduce net income due to increasing fixed costs,
but increase ROE as well as the variability of ROE compared to without
financial leverage.
341
Breakeven point
Units sold
QBE
F+C
QBE =
P − AVC
343
F
QOBE =
P − AVC
344
Atom Beta
Price 4 4
Answer:
F+C
1. QBE (Atom) = = (10,000 + 30,000)/(4 – 3) = 40,000 units
P − AVC
F+C
QBE (Beta) = = (80,000 + 40,000)/(4 – 2) = 60,000 units
P − AVC
Revenue/ Revenue/
Revenue
Expense Expense
Net income
Revenue Total
Net income cost
Net loss
Total
Net loss cost Fixed costs
Fixed costs = 120,000
= 40,000
40,000 Units sold 60,000 Units sold
Atom Beta
346
Answer:
Conclusion
• A firm that choose operating and financial structure that result in
greater total fixed cost (level of leverage) will have a higher breakeven
point.
• Leverage can magnify the effects of changes in sales on net income
(illustrated by charts in Example 10)
• The further the units of sold are from the breakeven point, the greater
the net income → the greater the magnifying effects of leverage on
net income