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Capital Structure Slides Plus Questions
Capital Structure Slides Plus Questions
16-1
Relevance of capital structure–
Net Income Approach
Traditional Approach
16-2
Assumptions: Only two source of capital (E&D), perpetual life,
No Taxes, Constant cost of capital (E&D both), Homogeneous
operating risk, perfect capital market, Constant total financing
The way of financing can only change the way in which net
operating income is distributed.
Since in same business risk class, the expected net operating income will not
change with financial leverage, the WACC or opportunity cost of capital would
not change with financial leverage.
Thus: levered firm cost of capital = Unlevered firm cost of capital
∴ WACCL = WACCU
16-4
16-5
Additional assumption: Firms and investors can borrow/lend at
the same rate
Investor can create a levered or unlevered position by adjusting the
trading in his own personal account.
This homemade leverage or personal leverage, suggests that capital
structure is irrelevant in determining the value of the firm:
V L = VU
MM Proposition I: For the firm in same business risk class value will
be independent to Debt Equity mix & will be determined by
capitalizing Net Operating Income with opportunity cost of capital.
VL = VU
16-6
Financial leverage does not affect the Net Operating Income and
business operating risk. But it does affect shareholders risk.
And if, Shareholders risk ↑ -> Shareholders required rate return will ↑
16-7
A levered firm will have higher required rate on equity as
compensation for financial risk, thus Ke > Ka.
Ke should be equals to constant Ka + financial risk premium.
16-8
ke
Cost of capital
WACCL or kaL =
WACCU or kaU
kd
Leverage
16-9
MM Proposition II (No Taxes) : Under extreme leverage : Excessive use of
debt will increase the risk of default, hence Kd will increase and Ke will
increase at decreasing rate.
ke
Cost of capital
kd
Leverage
16-10
Proposition I (with Corporate Taxes)
◦ Firm value increases with leverage
VL = VU + PV of tax shield or [PV of (Tax rate * Int on debt)]
16-11
Vl
Value of the firm
Vu
Leverage
16-12
Proposition II (with Corporate Taxes)
◦ Some of the increment in equity risk and return is offset by the
interest tax shield. Thus, WACC will decrease with financial
leverage.
16-13
Cost of capital
Ke
Ke
WACC
Kd
Leverage
16-14
Advantages of all equity
Higher solvency due to no interest payment
Low chances of bankruptcy
Low finance cost due to less risk – higher profits
Attract more investors and results in higher share value
Advantages of leverage
Personal tax on interest income
Disadvantages of leverage
Increase chances of financial distress : leads to impaired ability to conduct
business, thus; VL = VU + PV of tax shield – PV of financial distress cost)
Operating risk could be exaggerated
Debt is a fixed cost which increases BEP of the firm.
16-15
Trade off Theory :Trade off between tax
shield advantage and financial distress cost)
Signaling Theory : Equity is a bad signal and
debt is a good signal for market
Agency Theory: Based on free cash flow
hypothesis
The Pecking-Order Theory: Fund raising
hierarchy – first internal funds(RE) after that
debt and lastly equity.
10.00 Debt
8.00 No Debt
6.00 Advantage
EPS
Break-even to debt
4.00 point
2.00
0.00
1,000 2,000 3,000
(2.00) Disadvantage EBIT in dollars
to debt
16-17
Q8) Star inc. a prominent consumer product firm, is debating whether or not to convert it's all
equity capital structure to one that is 35% debt. Currently there are 6000 shares outstanding and
the price per share is $58. EBIT is expected to remain at $39600 per year forever. The interest rate
on new debt is 7% and there are no Taxes.
a. Ms. Brown, a shareholder of the firm, own 100 shares of stock. What is her cash flow under
the current capital structure, assuming the firm has a dividend payout rate of 100%?
b. What will Ms. Brown’s cash flow be under the proposed capital structure of the firm? Assume
that she keeps all 100 of her shares.
c. Suppose the company does convert, but Ms. Brown prefers the current all equity capital
structure. Show how she could unlever her share of stock to recreate the original capital
structure.
d. Using your answer to part C, explain why company’s choice of capital structure is irrelevant
Ans:a. EPS $ 6.60
Shareholder's cash flow $ 660.00
b. V $ 3,48,000
D $ 1,21,800
Shares bought 2,100
NI $ 31,074
EPS $ 7.97
Shareholder's cash flow $ 796.77
16-19
Q6) Kolby Corp. is comparing two different capital structure. Plan I would
result in the 1300 shares of stock and $80640 in debt. Plan II would result in
2900 shares of stock and $19,200 in debt. The interest rate on the debt is
10%.
a. Ignoring taxes, compare both of these plan to all equity plan assuming that
EBIT will be $10,500. The all-equity plan will result in 3400 shares of stock
outstanding. Which of three plans has the highest EPS? the lowest?
b. In part (a) what are the breakeven levels of EBIT for each plan as compared
to that for an all equity plan? Is one higher than the other? Why?
c. Ignoring Taxes, when will EPS be identical fore plan I and plan II?
d. Repeat part A B & C assuming that the corporate tax rate is 40%. Are the
breakeven levels of EBIT different from the before? why or why not?
16-20
a. I II All-Equity
EBIT $ 10,500 $ 10,500 $ 10,500
Interest 8,064 1,920 -
NI $ 2,436 $ 8,580 $ 10,500
EPS $ 1.87 $ 2.96 $ 3.09
EBIT
b. Plan I vs. all equity $ 13,056
Plan II vs. all equity $ 13,056
The break even levels of EBIT are the same because of M&M Proposition I.
d. I II All-equity
EBIT $ 10,500 $ 10,500 $ 10,500
Interest 8,064 1,920 -
Taxes 974 3,432 4,200
NI $ 1,462 $ 5,148 $ 6,300
EPS $ 1.12 $ 1.78 $ 1.85
Breakeven EBIT
Plan I vs. all-equity $ 13,056
Plan II vs. all-equity $ 13,056
PLanI vs. Plan II $ 13,056
The break-even levels of EBIT do not change because of additions of taxes reduces
the income of all three plans by the same percentage; therefore they do not change
relative to one another. 16-21