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HUB - Corporate Finance 1
HUB - Corporate Finance 1
CORPORATE FINANCE
(lecture notes)
CORPORATE FINANCE
(lecture notes)
INTRODUCTION
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LEARNING OBJECTIVES
SUBJECT OUTLINE
SCHEDULE
CONTENT DETAILS
1 Chapter 1 Overview of corporate finance
2 Chapter 1 Continued
3 Chapter 2 Overview of time value of money; Interest rate;
3 Chapter 2 Future value
5 Chapter 2 Application
6 Chapter 3 Risk and rate of return
7 Chapter 4 Cost of capital
Financial leverage
8 Chapter 5&6
Theories of capital structure
Review all the content
9 Review Submit group assignments and take individual
tests
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ASSESSMENT
Attendance (10%)
Midterm
Personal Test (20%)
(50%)
ASSESSMENT
(i) Attendance
ASSESSMENT
(ii) Personal Test
Time: 30 minutes;
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ASSESSMENT
(iii) Teamwork
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LEARNING OBJECTIVES
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CHAPTER OUTLINE
1.1. Definition
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1.1. DEFINITION
Corporate finance
Finance is (or Financial
management)
“the system that includes the
circulation of money, the
granting of credit, the making
of investments, and the Areas of
provision of banking facilities” Finance
Capital markets
Webster’s Dictionary, Brigham &
Houston, 2016, p.4
Investments
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1.1. DEFINITION
Corporate finance
Damodaran, 2014, p. 1
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1. Survive
5. Minimize costs.
6. Maximize profits.
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1. Profit maximization
2. Risk control
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Measures of Profits
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EAT
EPS =
Common shares outstanding
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Maximizing
shareholder
value
(in the lorng- term)
Risk Profit
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▪ Investment decisions
▪ Financing decisions
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Debt Equity
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• Cash
• Inventory
• Account receivables
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(1)Proprietorships
(2)Partnerships,
(4)Corporations
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All expenses that are deductible for tax purpose can generate
tax shield.
$1000. It incurs operating costs of $600 and a corporate tax rate of 20%.
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REFERENCES
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CORPORATE FINANCE
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LEARNING OBJECTIVES
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CHAPTER OUTLINE
2.5. Application
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Simple interest
Interest earned only on the original principal amount invested.
Ross et al. 2018, p. 125
Compound interest
Interest earned on both the initial principal and the interest
reinvested from prior periods.
Ross et al. 2018, p. 125
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Simple interest
FV = PV + PV×i×n
FV: the total amount (including the principal and the interest)
received in the future
PV: The initial amount invested at the present
i: interest rate earned per period
n: number of periods
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Compound interest
FVn =PV×(1+i) n
FV: the total amount (including the principal and the interest)
received in the future
n: number of periods
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Approximate formula
Real interest rate ≈ Nominal interest rate − Inflation rate
Example:
a. If the nominal interest rate is 15%, the inflation rate is 7%. What is
the exact real interest rate? The approximate real interest rate?
b. If the real interest rate is 5%, the inflation rate is 7%. What is the
exact nominal interest rate? The approximate nominal interest rate?
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Example 3: Return to example 1, calculate the periodic rate and the amount you have
at the end of year 3 for the following scenarios where The interest rate is
compounded :
a. Semiannually? b. Quarterly?
c. Monthly? d. Daily?
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𝐅𝐕𝐧 = 𝐏𝐕 × (𝟏 + 𝐫)𝐧
FVn: Future value
PV: Present value
r: rate of return earned per period
n: number of periods
(1 + r)n : future value interest factor (or future value factor)
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Annuity
A series of equal payments at fixed intervals for a specified
number of periods.
Ordinary (Deferred) Annuity
An annuity whose payments occur at the end of each period.
Annuity Due
An annuity whose payments occur at the beginning of each
period.
Brigham and Houston, 2019, p. 161
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1+r n −1
⇔FVAn =CF
r
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Previously, we have:
𝐅𝐕𝐧 = 𝐏𝐕 × (𝟏 + 𝐫)𝐧
To find present value, we discount the future value back to the
present:
𝐅𝐕𝐧
𝐏𝐕 =
(𝟏 + 𝐫)𝐧
𝟏
: discount factor
(𝟏+𝐫)𝐧
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Example 14:
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1− 1+r −n
⇔PVAn =CF
r
Where:
1
n: present value factor
1+r
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Example 18
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Return to example 18, suppose the payments continue forever. What is the
present value in this case?
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2.5. APPLICATIONS
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2.5. APPLICATIONS
(i) Finding r, n, and payments
Finding r with a lump sums - Example 20: a given bond has a cost
of $100 and that it will return $150 after 10 years. What is its rate of
return?
(see Brigham and Houston, 2019, p. 160)
Finding r with multiple cashflows - Example 21: An investment
costs $465 and is expected to produce cash flows of $100 at the end of
each of the next 4 years, then an extra lump sum payment of $200 at
the end of the fourth year. What is the expected rate of return on this
investment?
(see Brigham and Houston, 2019, p. 175)
Finding r with annuity - Example 22: Your uncle named you
beneficiary of his life insurance policy. The insurance company gives
you a choice of $100,000 today or a 12-year annuity of $12,000 at the
end of each year. What rate of return is the insurance company
offering?
(see Brigham and Houston, 2019, p. 175)
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2.5. APPLICATIONS
(i) Finding r, n, and payments
Finding n with a lump sums
FVn =PV×(1+r) n
FV
ln( )
⇔n= PV
ln(1+r)
Example 23: (see Brigham and Houston, 2019, p. 161) How long
would it take $1,000 to double if it was invested in a bank that paid
6% per year? How long would it take if the rate was 10%?
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2.5. APPLICATIONS
(i) Finding r, n, and payments
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2.5. APPLICATIONS
(ii) Amortized loans
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
CF1 CFn
NPV=−CF0 + +…+
1+r 1 1+r n
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
CF1 CFn
NPV=−CF0+ +…+ =0
1+IRR 1 1+IRR n
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iii) Capital budgeting criteria
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2.5. APPLICATION
(iv) Stock and bond valuation
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2.5. APPLICATION
(iv) Stock and bond valuation
Bond valuation
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2.5. APPLICATION
(iv) Stock and bond valuation
Bond valuation
Types of bond:
• Fixed rate bonds
• Floating rate bonds
• Zero-coupon bonds Denotation:
•FV: Face value (par value)
•i: Coupon rate
•C: Coupon payment (C = FV*i)
•n: maturity of bond
•rd: required rate of return
•Pt: bond price at time t
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2.5. APPLICATION
(iv) Stock and bond valuation
At t = 0:
1−(1+rd ) −n 1
P0 =C +FV
rd (1+rd )n
At time t:
1−1−(1+rd ) −(n−t) 1
Pt =C +FV
rd (1+rd )n−t
n-t: the remaining years of bonds until maturity
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2.5. APPLICATION
(iv) Stock and bond valuation
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2.5. APPLICATION
(iv) Stock and bond valuation
Stock valuation
Dividend Discount Model (DDM)
Dt: Dividend at time t
Re: stockholder’s required rate of return
P0: Stock price at the current
Pt: Stock price at time t
D1 D2 D∞
P0 = + +…+
(1+re ) 1 (1+re ) 2 (1+re ) ∞
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2.5. APPLICATION
(iv) Stock and bond valuation
D0(1+g)
⇔P0 =
re −g
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2.5. APPLICATION
(iv) Stock and bond valuation
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2.5. APPLICATION
(iv) Stock and bond valuation
g = (1 – payout ratio)*ROE
Example 36: Firm B has a 12% ROE. Other things held constant,
what would its expected growth rate be if it paid out 25% of its
earnings as dividends? 75%?
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REFERENCES
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LEANING OBJECTIVES
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CHAPTER OUTLINE
3.1. Returns
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3.1. RETURNS
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3.1. RETURNS
(i) Dollar Returns
Returns are what you earn from an investment. There are two
components:
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3.1. RETURNS
(ii) Percentage Returns
D + Pt+1 −Pt
Rate of returns (R)= t+1
Pt
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3.1. RETURNS
(iii) Average returns
R1 +R2 +…+Rn
ഥ
R=
n
Geometric average return
The average compound return earned per year over a
multiyear period.
(Ross et al., 2018, p. 404)
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3.1. RETURNS
(iii) Average returns
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3.1. RETURNS
(iv) Expected return
⇔E R = σn
i=1 P(Ri )Ri
E(R): Expected returns of asset
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3.1. RETURNS
(iv) Expected return
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(i) Definition
(ii) Measures of risk
(iii) The relationship between risk and expected return
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(i) Definition
Risk is the chance that some unfavorable event will occur.
Brigham and Houston, 2019, p. 274
(ii) Measures of risk
If using forecasting data or a subjective probability distribution
Variance
σ2 =E [R−E R ]2
n
⇔σ2 = P(Ri )[Ri −E R ]2
i=1
Standard deviation
σ= σ2
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Example 6:
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σ
CV=
E(R)
CV is used when the expected return of the two assets are
not the same.
→ Calculate CV of Rate of return of stock A and B in the
example 6.
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Risk premium
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Portfolio variance
n m
σ2 2
P = wi ∗wj∗σij
i=1 j=1
σP = σ2
P
σ2
ij = Cov(Ri, Rj): Covariance of returns of assets i and j
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Stock A Stock B
Stock A w2A. σ2
A wA.wB. σ2
AB
Stock B wA.wB.σ2
AB wb.wb. σ2
B
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Covariance (𝛔𝟐𝐀𝐁 )
If using forecasting data (or a probability distribution)
n
σ2
AB = pi RAi −E RA ∗[RBi −E RB ]
i=1
(pi : probability that scenario i occurs)
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Correlation coefficient
ρAB = 1: perfectly positive correlation => no benefits in
terms of reducing risk by diversification
ρAB = -1: perfectly negative correlation => highest benefits
in terms of reducing risk by diversification
ρAB = 0: independent relation => some benefits in terms of
reducing risk by diversification
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Example 9:
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Example 10:
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1 2 3 … n
w1.w2.𝛔12 w1.w3.𝛔13
1 w12 . 𝛔12 2 2 … w1.wn.𝛔1n2
w2.w1.𝛔12 w2.w3.𝛔23
2 2 w22 . 𝛔22 2 … w2.wn.𝛔2n2
w3.w1.𝛔13 w3.w2.𝛔23
3 2 2 w32. 𝛔32 … w3.wn.𝛔3n2
… … … … … …
wn.w1.𝛔1n wn.w2.𝛔2n wn.w3.𝛔3n
n 2 2 2 … wn 2. 𝛔n2
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Diversification (by
adding more partially
correlated stocks) can
reduce unsystematic
risk but cannot
reduce systematic
(market) risk.
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REFERENCES
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CORPORATE FINANCE
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LEARNING OBJECTIVES
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CHAPTER OUTLINE
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Capital Components
One of the types of capital used by firms to raise funds.
Brigham and Houston, 2019, p. 359
Cost of Capital
The expected return on a portfolio of all the company’s
outstanding debt and equity securities.
Brealey et al., 2020, p. 229
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Dp
rp =
Pp
rp: cost of preferred stock
Dp: preferred dividend
Pp: current price of preferred dividend
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Cost of equity
The return that equity investors require on their investment
in the firm.
Ross et al., 2018, p. 460
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D0 (1 + g) 𝐷1
P0 = =
re − g re − g
𝐷1
⇔ re = +𝑔
P0
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Advantages Disadvantages
Only applicable for
companies that pay
dividends
Simple to apply Sensitive to the estimated
growth rate
Does not explicitly consider
risks Ross et al., 2018, p. 462
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Example 5: Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk
premium is 7 percent, and the risk-free rate is 6 percent. Alpha’s last dividend was $2
per share, and the dividend is expected to grow at 8 percent indefinitely. The stock
currently sells for $30. What is Alpha’s cost of equity capital?
(see Ross et al., 2018, p. 463)
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Advantages Disadvantages
Adjust for risks The estimate of market risk
premium and the beta
coefficient might not be
correct
Applicable to most of Use data in the past
companies
Ross et al., 2018, p. 463
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Example 7: The B.B. Lean Co. has 1.4 million shares of stock
outstanding. The stock currently sells for $20 per share. The firm’s
debt is publicly traded and was recently quoted at 93 percent of
face value. It has a total face value of $5 million, and it is currently
priced to yield 11 percent. The risk-free rate is 8 percent, and the
market risk premium is 7 percent. You’ve estimated that Lean has
a beta of 0.74. If the corporate tax rate is 21 percent, what is the
WACC of Lean Co.?
(see Ross et al., 2018, p. 467)
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Flotation costs
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Example 9:
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REFERENCES
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CORPORATE FINANCE
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LEARNING OBJECTIVES
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CHAPTER OUTLINE
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The use of fixed financing costs by the firm. For example, interest
on debt, preferred dividend on preferred stock.
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Method 1 Method 2
What is EPS of each financing
Assets 100 billions 100 billions
method under each following
Debt 0 50 billions
scenarios?
Equity 100 billions 50 billions a. EBIT is 6.25 billions
Debt to Equity ratio 0 1 b. EBIT is 15 billions
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6000
EPS1 =EPS2
EBIT 3000
⇔ =EBIT−5
2
⇔EBIT=2EBIT−10
2000
⇔EBIT=10 billions
1000
0
0 10 20 30 40
EBIT
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REFERENCES
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CORPORATE FINANCE
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LEARNING OBJECTIVES
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CHAPTER OUTLINE
6.1. Overview
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4.1. OVERVIEW
Capital Structure
The mix of debt, preferred stock, and common equity that is
used to finance the firm’s assets.
Brigham and Houston, 2019, p. 476
Measures of Capital Structure
Debt to Equity ratio = Debt/Equity
Debt ratio = Debt/Total Assets
Equity ratio = Equity/Total Assets
Equity multiplier = Total Assets/Equity
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4.1. OVERVIEW
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E D
WACC= ×RE + ×RD
V V
E D
⇔RA = ×RE + ×RD
V V
D
⇔RE =RA +(RA−RD)×
E
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Example 1:
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VL = VU + TC × D
EBIT×(1−TC )
VU =
RU
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Example 5: (see Ross et al., 2018, p. 549) You are given the following
information for the Format Co.:
EBIT = $126.58
TC = 0.21
D = $500
RU = 0.20
The cost of debt capital is 10 percent. What is the value of Format’s
equity? What is the cost of equity capital for Format? What is the WACC?
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The theory that a firm borrows up to the point where the tax
benefit from an extra dollar in debt is exactly equal to the cost
that comes from the increased probability of financial distress.
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REFERENCES
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