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Slide 1
Planning the Financing Mix Capital Structure and Firm Value Capital Structure Theories
Independence Hypothesis Dependence Hypothesis Moderate Position
EBIT-EPS Analysis
Slide 2
Balance Sheet Current Current Assets Liabilities
Debt and Fixed Preferred Assets Shareholders’ Equity
FinancialStructure
Financial Structure
Slide 3
Balance Sheet Current Current Assets Liabilities
Debt and Fixed Preferred Assets Shareholders’ Equity
CapitalStructure
Capital Structure
Slide 4
Why is Capital Structure Important? Leverage: Higher financial leverage means higher
returns to stockholders, but higher risk due to interest payments
Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital
The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value
Slide 5
Independence Hypothesis In a “perfect world” environment with no taxes,
no transaction costs and perfectly efficient financial markets, capital structure does not matter
This is known as the Independence hypothesis: firm value is independent of capital structure
Firm value does not depend on capital structure
This is also to say WACC or ko is constant
Slide 6
Cost ofCapital
kcs
kd kd
0% debt financial leverage 100% debt
Independence Hypothesis (Continued)
kcs = cost of common stock
kd = cost of debt
ko = cost of capital
Slide 7
Cost ofCapital
kcs
kd
kcs
kd
Increasing leverage causes thecost of equity to rise.Equity becomesriskier
What will be the net effecton the overall cost of capital?
0% debt financial leverage 100% debt
Independence Hypothesis
Slide 8
kcs
kd
Cost ofCapital
kcs
ko
kd
0% debt financial leverage 100%debt
Independence Hypothesis
Cost of capital stays constant.Increase in cost of equityis proportionate to increase in debt
Slide 9
If we have perfect capital markets, capital structure is irrelevant
In other words, changes in capital structure do not affect firm value
Independence Hypothesis
Slide 10
Dependence Hypothesis
Increasing leverage does not increase the cost of equity
Since debt is less expensive than equity, more debt financing would provide a lower cost of capital
A lower cost of capital would increase firm value
Slide 11
Dependence Hypothesis
Since the cost of debt is lower than the cost of equity…Increasing leverage reduces the cost of capital.
Cost ofCapital
kcs
kd
financial leverage
kcs
kd ko
Slide 12
Moderate Position
The previous hypotheses examines capital structure in a “perfect market”
The moderate position examines capital structure under more realistic conditions
For example, what happens if we include corporate taxes?
Slide 13
Remember this example?Tax effects of financing with debt
with stock with debt
EBIT 400,000 400,000
- interest expense 0 (50,000)
EBT 400,000 350,000
- taxes (34%) (136,000) (119,000)
EAT 264,000 231,000
- dividends (50,000) 0
Retained earnings 214,000 231,000
Slide 14
Moderate Position
Cost ofCapital
kcs
kd
financial leverage
kcs
kd
Because of the tax benefit associated
with debt financing
Even if the cost of equity rises as leverage increases, the cost of debt is very low...
Slide 15
Cost ofCapital
kc
kd
financial leverage
kc
kd
The low cost of debt reduces the cost of capital.
ko
Moderate Position
Slide 16
So, what does the tax benefit of debt financing mean for the value of the firm?
The more debt financing used, the greater the tax benefit, and the greater the value of the firm
So, this would mean that all firms should be financed with 100% debt, right?
Why are firms not financed with 100% debt?
Moderate Position
Slide 17
Why is 100% Debt not Optimal?
Bankruptcy costs: costs of financial distress Financing becomes difficult to get Customers leave due to uncertainty Possible restructuring or liquidation costs if
bankruptcy occurs
Slide 18
Agency costs: costs associated with protecting bondholders
Bondholders (principals) lend money to the firm and expect it to be invested wisely
Stockholders own the firm and elect the board and hire managers (agents)
Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases
Why is 100% Debt not Optimal?
Slide 19
Cost ofCapital
financial leverage
kc
kd
kc
kd
If a firm borrows too much, thecosts of debt and equity will spike upward, due to bankruptcy costsand agency costs
Moderate Positionwith Bankruptcy and Agency Costs
Slide 20
Cost ofCapital
financial leverage
kc
kd
kc
kd
ko
Moderate Positionwith Bankruptcy and Agency Costs
Slide 21
Cost ofCapital
financial leverage
kc
kd
kc
kd
ko
Moderate Positionwith Bankruptcy and Agency Costs
Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital
Slide 22
Capital Structure Management
EBIT-EPS Analysis – used to help determine whether it would be better to finance a project with debt or equity
I = interest expense, t = corporate tax rate P = preferred dividends, S = number of shares of common stock
outstanding
S
P-)t-1)(I-EBIT(=EPS
Slide 23
EBIT-EPS Example
Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: Sell 200,000 shares of common stock at $30 per share Borrow $6,000,000 by issuing 10% bonds
Slide 24
If we expect EBIT to be $2,000,000:
Financing stock debt EBIT 2,000,000 2,000,000- interest 0 (600,000)EBT 2,000,000 1,400,000- taxes (40%) (800,000) (560,000)EAT 1,200,000 840,000# shares outstanding 1,000,000 800,000EPS $1.20 $1.05
Slide 25
Financing stock debt EBIT 4,000,000 4,000,000 - interest 0 (600,000)EBT 4,000,000 3,400,000- taxes (40%) (1,600,000) (1,360,000)EAT 2,400,000 2,040,000# shares outstanding 1,000,000 800,000EPS $2.40 $2.55
If we expect EBIT to be $4,000,000:
Slide 26
If EBIT is $2,000,000, common stock financing is best
If EBIT is $4,000,000, debt financing is best So, now we need to find a crossover EBIT where
neither is better than the other
EBIT-EPS Example
Slide 27
If we choose stock financing:
Stock Financing
0.00
1.00
2.00
3.00
4.00
5.00
0 1 2 3 4 5 6 7 8
EBIT (mil.)
EP
S
Slide 28
If we choose bond financing:
Bond Financing
0.00
1.00
2.00
3.00
4.00
5.00
0 1 2 3 4 5 6 7 8
EBIT (mil.)
EP
S
Slide 29
Crossover EBIT
Breakeven EBIT
0.00
1.00
2.00
3.00
4.00
5.00
0 1 2 3 4 5 6 7 8
EBIT (mil.)
EP
S
Slide 30
Crossover EBIT (Continued)
Set 2 EPS calculations equal to each other and solve for EBIT:
Stock Financing Debt Financing
(EBIT – I)(1 – t) – P = (EBIT – I)(1 – t) – P
S S
Slide 31
Crossover EBIT (Continued)
Stock Financing Debt Financing(EBIT – I)(1 – t ) – P = (EBIT – I )(1 – t ) – P S S (EBIT – 0) (1 – 0.40) = (EBIT – 600,000)(1 – 0.40) 800,000 + 200,000 800,000
0.6 EBIT = 0.6 EBIT – 360,000 1 0.8 0.48 EBIT = 0.6 EBIT – 360,000 0.12 EBIT = 360,000 EBIT = $3,000,000