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2201AFE VW Week 11 Financial Leverage & Capital Structure Policy
2201AFE VW Week 11 Financial Leverage & Capital Structure Policy
Week 11: Financial Leverage and Capital Structure Policy Readings: Chapter 19
Agenda
Last Week Financial Leverage and Capital Structure Policy
Key Concepts and Skills
Next Week
Approved list of deferred exam sitting is published on Learning@GU > Assessment
Last Lecture
Cost of Equity Cost of Preferred Stock Cost of Debt Proportion or weight of each form of financing Cost of Capital = WACC
Unadjusted/Adjusted When should we use WACC? Other approaches: pure play and subjective
Flotation Costs
Chapter 19
2. Time Value of Money 9. Return, Risk & the Security Market Line
11. Financial Leverage & Capital Structure Policy 12. Dividends & Dividend Policy
Capital Restructuring
Financial leverage = the extent to which a firm relies on debt financing. Capital restructuring involves changing the amount of leverage a firm has without changing the firms assets.
The firm can increase leverage by issuing debt and repurchasing outstanding shares. The firm can decrease leverage by issuing new shares and retiring outstanding debt.
Current
Assets Debt Equity Debt/Equity Ratio Share Price Shares Outstanding $5,000,000 $0 $5,000,000 0 $10 500,000
Proposed
$5,000,000 $2,500,000 $2,500,000 1 $10 250,000
ROE
EPS
6.00%
$0.60
13.00%
$1.30
20.00%
$2.00
Interest Rate
N/A
10%
Expected
$250,000 $400,000
Expansion
$250,000 $750,000
$650,000 $1,000,000
ROE
EPS
2.00%
$0.20
16.00%
$1.60
30.00%
$3.00
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Break-Even EBIT
Break-Even EBIT where: EPS debt = EPS no debt If expected EBIT > break-even EBIT, then leverage is beneficial to our stockholders. If expected EBIT < break-even EBIT, then leverage is detrimental to our stockholders.
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The value of the firm is determined by the cash flows to the firm and the risk of the assets. Changing firm value.
Change the risk of the cash flows. Change the cash flows.
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Case II Assumptions:
With taxes No bankruptcy costs
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Case I No Taxes
Proposition I:
The value of the firm is NOT affected by changes in the capital structure. The cash flows of the firm do not change; therefore, value doesnt change.
Proposition II:
Cost of Equity increases as Debt increases. The WACC of the firm is NOT affected by capital structure.
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RA is the cost of the firms business risk, i.e., the risk of the firms assets. (RA RD)(D/E) is the cost of the firms financial risk, i.e., the additional return required by stockholders to compensate for the risk of leverage (D/E).
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E 1 V 1 D/E
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CAPM: RE = Rf + E(RM Rf) for equity CAPM: RA = Rf + A(RM Rf) for assets Where A is the firms asset beta and measures the systematic risk of the firms assets, also called unlevered beta the risk of the assets if the firm would have no debt ( in essence E = A if no debt)
RE = RA + (RA RD)(D/E) RE = RA + (RA Rf)(D/E) assume RD = Rf
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The CAPM, Business Risk, Financial Risk and Proposition II Proposition II As we introduce debt in the firm: RE = Rf + A(1+D/E)(RM Rf) E = A(1 + D/E)
Therefore, the systematic risk of the stock depends on: Systematic risk of the assets, A, (Business risk) Level of leverage, D/E, (Financial risk)
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Quick Quiz
Under Case I, what are the values of the firm with debt (levered) and without debt (unlevered)?
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How should an increase in cash flows affect the value of the firm?
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VU = EBIT(1-T) / RU
with no debt RU = RA= RE and VU = E
VL = VU + DTC E = VL - D
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RE = RU + (RU RD)(D/E)(1-TC)
WACC decreases as D/E increases
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RE = RU + (RU RD)(D/E)(1-TC)
RE = 0.12 + (0.12-0.09)(0.87)(1-0.35) = 13.69%
What will happen to the cost of equity under the new capital structure? (previously 13.69%) RE = 0.12 + (0.12 0.09)(1)(1-0.35) = 13.95% What will happen to the weighted average cost of capital?
(previously 10.05%)
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Quick Quiz
Under Case II, it is beneficial and should firms take on more debt?
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Bankruptcy Costs
Direct costs
Legal and administrative costs.
Indirect costs
Larger than direct costs & more difficult to measure and estimate.
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Conclusions
Case I no taxes or bankruptcy costs.
No optimal capital structure.
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Managerial Recommendations
The tax benefit is only important if the firm has a large tax liability. Risk of financial distress:
The greater the risk of financial distress, the less debt will be optimal for the firm. The cost of financial distress varies across firms and industries and as a manager you need to understand the cost for your industry.
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CDO101
What is a CDO? An arbitrage cash flow Collateralised Debt Obligation (or CDO) is a structured pool of below investment grade corporate loan and bond assets The Fund, which is a special purpose entity (SPV), issues various tranches of debt and equity to fund its purchase of corporate loans and bonds This pool of loans and bonds acts as collateral for the Funds liabilities Because the majority of these liabilities are rated investment grade, the Fund equity benefits from the difference between the income generated by the collateral pool and the Funds liability costs CDO funds issued today are generally $300-500 million in size. The underlying collateral typically represents 100-200 obligors in 20-30 industries. Below is a typical CDO structure:
The Funds indenture governs the order in which cash generated by the Fund is paid to the various tranches
Generally, the higher the tranches rating, the higher its position in the Funds cash flow waterfall
Residual cash generated by the collateral assets after paying the Funds required principal and interest payment to the liabilities and the management fee is distributed to the holders of the Fund equity
Source: http://www.octagoncredit.com/cdo-basics.htm
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Next Week
Next week we look at the role of dividends and how firms set dividend policy.
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