lecture08 Capital Structure
公司金融_Capital Structure (II)
Cost of equity, Re, increases but not by as much as in the
absence of taxes (Similarly for be)
WACC decreases
12
Dividend Airlines is currently an un-levered firm.
E D WACC RE RD 1 TC V V
11
If taxes were the only imperfection, then as leverage increases:
Firm value increases because of the higher interest tax shield
How do we compute the new Re and WACC after a capital
structure change?
Same approach as earlier:
Step 1: un-lever the old/existing capital structure to find the unlevered beta (βU) and cost of capital (RU) Step 2: re-lever using the new target capital structure to find the new beta (βE) and cost of equity (RE) Step 3: calculate WACC under the new target capital structure
capital, Ru
V(U) is obtained by discounting FCFs at the unlevered cost of
CapitalStructure
Capital Structure
Financial Risk
• Leverage increases shareholder risk • Leverage also increases the return on
equity (to compensate for the higher risk)
Question?
• Is the increase in expected return due to financial leverage sufficient to compensate stockholders for the increase in ered
• Leverage in a Tax Free Environment • How Leverage Affects Returns • The Traditional Position
Capital Structure
• When a firm issues debt and equity securities it splits cash flows into two streams:
Modigliani and Miller
• YES • Assuming no taxes, the increase in return
to shock-holders resulting from the use of leverage is exactly offset by the increase in risk – hence no benefit to using financial leverage (and no cost).
【财务管理英文课件】Capital Structure Determination
A Conceptual Look -Relevant Rates of Return
ki = the yield on the company’s debt
I
Annual interest on debt
ki = B = Market value of debt
Assumptions: • Interest paid each and every year • Bond life is infinite • Results in the valuation of a perpetual bond • No taxes (Note: allows us to focus on just
17-2
Capital Structure
Capital Structure -- The mix (or proportion) of a firm’s permanent long-term financing
represented by debt, preferred stock, and common stock equity.
=
common shareholders Market value of common
stock outstanding
Assumptions: • Earnings are not expected to grow • 100% dividend payout • Results in the valuation of a perpetuity • Appropriate in this case for illustrating the
Concerned with the effect of capital market decisions on security prices.
Capital Structure.ppt
Total Value Principle: Modigliani and Miller (M&M)
• Advocate that the relationship between financial leverage and the cost of capital is explained by the NOI approach. • Provide behavioral justification for a constant ko over the entire range of financial leverage possibilities. • Total risk for all security holders of the firm is not altered by the capital structure. • Therefore, the total value of the firm is not altered by the firm’s financing mix.
A Conceptual Look --Relevant Rates of Return
ke = the expected return on the company’s equity Earnings available to E E common shareholders ke = S = Market value of common S stock outstanding
Optimal Capital Structure -- The capital structure that minimizes the firm’s cost of capital and thereby maximizes the value of the firm.
capital structure and leverge
(Difficulty: E = Easy, M = Medium, and T = Tough)1. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price and minimizes the firm’s W ACC.2.An increase in the corporate tax rate and a decrease in the company’s degree of operating leverage/business risk will encourage a company to use more debt in its capital structure.3.you are replacing high cost equity with low cost debt. When there is very little debt in the capital structure, the WACC will actually decrease.Multiple Choice: ConceptualEasy:Business risk Answer: c Diff: E 1. A decrease in the debt ratio will generally have no effect on.a. Financial risk.b. Total risk.c. Business risk.d. Market risk.e. N one of the above is correct. (It will affect each type of risk above.) Business risk Answer: d Diff: E 2. Business risk is concerned with the operations of the firm. Which of thefollowing is not associated with (or not a part of) business risk?a. Demand variability.b. Sales price variability.c. The extent to which operating costs are fixed.d. Changes in required returns due to financing decisions.e. The ability to change prices as costs change.Business risk Answer: d Diff: E N3. Which of the following factors would affect a company’s business risk?a. The level of uncertainty regarding the demand for its product.b. The degree of operating leverage.c. The amount of debt in its capital structure.d. Statements a and b are correct.e. All of the statements above are correct.Chapter 13- Page 1Business and financial risk Answer: d Diff: E4. Which of the following statements is most correct?a. A firm’s business risk is solely determined by the financi alcharacteristics of its industry.b. The factors that affect a firm’s business risk are determined partly byindustry characteristics and partly by economic conditions.Unfortunately, these and other factors that affect a firm’s businessrisk are not subject to any degree of managerial control.c. One of the benefits to a firm of being at or near its target capitalstructure is that financial flexibility becomes much less important.d. The firm’s financial risk may have both market risk and diversifiablerisk components.e. None of the statements above is correct.Optimal capital structure Answer: e Diff: E5. Which of the following statements is most correct?a. As a rule, the optimal capital structure is found by determining thedebt-equity mix that maximizes expected EPS.b. The optimal capital structure simultaneously maximizes EPS andminimizes the WACC.c. The optimal capital structure minimizes the cost of equity, which is anecessary condition for maximizing the stock price.d. T he optimal capital structure simultaneously minimizes the cost of debt,the cost of equity, and the WACC.e. None of the statements above is correct.Optimal capital structure Answer: c Diff: E 6. From the information below, select the optimal capital structure for MinnowEntertainment Company.a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.Optimal capital structure Answer: e Diff: E 7. Which of the following statements best describes the optimal capitalstructure?a. The optimal capital structure is the mix of debt, equity, and preferredstock that maximizes the company’s earnings per share (EPS).b. The optimal capital structure is the mix of debt, equity, and preferredstock that maximizes the company’s stock price.c. The optimal capital structure is the mix of debt, equity, and preferredstock that minimizes the company’s weighted average cost of capital(WACC).d. Statements a and b are correct.e. Statements b and c are correct.Chapter 13 - Page 28. The firm’s target cap ital structure is consistent with which of thefollowing?a. Maximum earnings per share (EPS).b. Minimum cost of debt (k d).c. Minimum risk.d. Minimum cost of equity (k s).e. Minimum weighted average cost of capital (WACC).Leverage and capital structure Answer: d Diff: E 9. Which of the following is likely to encourage a company to use more debt inits capital structure?a. An increase in the corporate tax rate.b. An increase in the personal tax rate.c. A decrease in the company’s degree of operati ng leverage.d. Statements a and c are correct.e. All of the statements above are correct.Leverage and capital structure Answer: e Diff: E10. Which of the following statements is most correct?a. A reduction in the corporate tax rate is likely to increase the debtratio of the average corporation.b. An increase in the personal tax rate is likely to increase the debtratio of the average corporation.c. If changes in the bankruptcy code make bankruptcy less costly tocorporations, then this would likely reduce the debt ratio of theaverage corporation.d. All of the statements above are correct.e. None of the statements above is correct.Leverage and capital structure Answer: e Diff: E 11. Which of the following statements is likely to encourage a firm to increaseits debt ratio in its capital structure?a. Its sales become less stable over time.b. Its corporate tax rate declines.c. Management believes that the firm’s stock is overvalued.d. Statements a and b are correct.e. None of the statements above is correct.Leverage and capital structure Answer: a Diff: E 12. Which of the following factors is likely to encourage a corporation toincrease the proportion of debt in its capital structure?a. An increase in the corporate tax rate.b. An increase in the personal tax rate.c. An increase in the company’s degree of operating leverage.d. The company’s assets become less liquid.e. An increase in expected bankruptcy costs.Chapter 13- Page 313. Which of the following would increase the likelihood that a company wouldincrease its debt ratio in its capital structure?a. An increase in costs incurred when filing for bankruptcy.b. An increase in the corporate tax rate.c. An increase in the personal tax rate.d. A decre ase in the firm’s business risk.e. Statements b and d are correct.Leverage and capital structure Answer: a Diff: E N 14. Which of the following factors is likely to encourage a company to increaseits debt ratio?a. An increase in the corporate tax rate.b. An increase in the personal tax rate.c. Its assets become less liquid.d. Both statements a and c are correct.e. All of the statements above are correct.Leverage and capital structure Answer: c Diff: E N 15. Jones Co. currently is 100 percent equity financed. The company isconsidering changing its capital structure. More specifically, Jones’ CFO is considering a recapitalization plan in which the firm would issue long-term debt with a yield of 9 percent and use the proceeds to repurchase comm on stock. The recapitalization would not change the company’s total assets nor would it affect the company’s basic earning power, which is currently 15 percent. The CFO estimates that the recapitalization will reduce the company’s WACC and increase its s tock price. Which of the following is also likely to occur if the company goes ahead with the planned recapitalization?a. The company’s net income will increase.b. The company’s earnings per share will decrease.c. The company’s cost of equity will inc rease.d. The company’s ROA will increase.e. The company’s ROE will decrease.Leverage and capital structure Answer: e Diff: E N16. Which of the following statements is most correct?a. When a company increases its debt ratio, the costs of both equity anddebt capital increase. Therefore, the weighted average cost of capital(WACC) must also increase.b. The capital structure that maximizes stock price is generally thecapital structure that also maximizes earnings per share.c. Since debt financing is cheaper than equity financing, increasing acompany’s debt ratio will always reduce the company’s WACC.d. The capital structure that maximizes stock price is generally thecapital structure that also maximizes the company’s WACC.e. None of the statements above is correct.Chapter 13 - Page 417. Which of the following statements is most correct?a. When a company increases its debt ratio, the costs of equity and debtcapital both increase. Therefore, the weighted average cost of capital(WACC) must also increase.b. The capital structure that maximizes stock price is generally thecapital structure that also maximizes earnings per share.c. All else equal, an increase in the corporate tax rate would tend toencourage a company to increase its debt ratio.d. Statements a and b are correct.e. Statements a and c are correct.Capital structure and WACC Answer: e Diff: E18. Which of the following statements is most correct?a. Since debt financing raises the firm’s financial risk, increasing acompany’s debt ratio will always increase the company’s WACC.b. Since debt financing is cheaper than equity financing, increasing acompany’s debt ratio will always reduce the company’s WACC.c. Increasing a company’s debt ratio will ty pically reduce the marginalcosts of both debt and equity financing; however, it still may raisethe company’s WACC.d. Statements a and c are correct.e. None of the statements above is correct.Capital structure, ROA, and ROE Answer: d Diff: E 19. Ridgefield Enterprises has total assets of $300 million. The companycurrently has no debt in its capital structure. The company’s basic earning power is 15 percent. The company is contemplating a recapitalization where it will issue debt at 10 percent and use the proceeds to buy back shares of the company’s common stock. If the company proceeds with the recapitali-zation its operating income, total assets, and tax rate will remain the same.Which of the following will occur as a result of the recapitalization?a. The company’s ROA will decline.b. The company’s ROE will increase.c. The company’s basic earning power will decline.d. Statements a and b are correct.e. All of the statements above are correct.Capital structure, WACC, TIE, and EPS Answer: a Diff: E20. Which of the following statements is most correct?a. The capital structure that maximizes stock price is also the capitalstructure that minimizes the weighted average cost of capital (WACC).b. The capital structure that maximizes stock price is also the capitalstructure that maximizes earnings per share.c. The capital structure that maximizes stock price is also the capitalstructure that maximizes the firm’s times interest earned (TIE) ratio.d. Statements a and b are correct.e. Statements b and c are correct.Chapter 13- Page 5Capital structure theory Answer: d Diff: E 21. Which of the following statements about capital structure theory is mostcorrect?a. Signaling theory suggests firms should in normal times maintain reserveborrowing capacity that can be used if an especially good investmentopportunity comes along.b. In general, an increase in the corporate tax rate would cause firms touse less debt in their capital structures.c. According to the “trade-off theory,” an increase in the costs ofbankruptcy would lead firms to reduce the amount of debt in theircapital structures.d. Statements a and c are correct.e. All of the statements above are correct.Miscellaneous capital structure concepts Answer: c Diff: E N22. Which of the following statements is most correct?a. If Congress were to pass legislation that increases the personal taxrate, but decreases the corporate tax rate, this would encouragecompanies to increase their debt ratios.b. If a company were to issue debt and use the money to repurchase commonstock, this action would have no impact on the company’s return onassets. (Assume that the repurchase has no impact on the company’soperating income.)c. If a company were to issue debt and use the money to increase assets,this acti on would increase the company’s return on equity. (Assume thatthe company’s return on assets remains unchanged.)d. Statements a and b are correct.e. Statements b and c are correct.Financial leverage and EPS Answer: a Diff: E 23. Volga Publishing is considering a proposed increase in its debt ratio,which will also increase the company’s interest expense. The plan would involve the company issuing new bonds and using the proceeds to buy back shares of its common stock. The company’s CFO expects that t he plan will not change the company’s total assets or operating income. How-ever, the company’s CFO does estimate that it will increase the company’s earnings per share (EPS). Assuming the CFO’s estimates are correct, which of the following statements is most correct?a. Since the proposed plan increases Volga’s financial risk, the company’sstock price still might fall even though its EPS is expected toincrease.b. If the plan reduces the company’s WACC, the company’s stock price isalso likely to decline.c. Since the plan is expected to increase EPS, this implies that netincome is also expected to increase.d. Statements a and b are correct.e. Statements a and c are correct.Chapter 13 - Page 6Financial leverage and EPS Answer: c Diff: E24. Which of the following statements is most correct?a. Increasing financial leverage is one way to increase a firm’s basicearning power (BEP).b. Firms with lower fixed costs tend to have greater operating leverage.c. The debt ratio that maximizes EPS generally exceeds the debt ratio thatmaximizes share price.d. Statements a and b are correct.e. Statements a and c are correct.Financial leverage and ratios Answer: d Diff: E 25. Company A and Company B have the same tax rate, the same total assets, andthe same basic earning power. Both companies have a basic earning power that exceeds their before-tax costs of debt, k d. However, Company A has a higher debt ratio and higher interest expense than Company B. Which of the following statements is most correct?a. Company A has a lower net income than B.b. Company A has a lower ROA than B.c. Company A has a lower ROE than B.d. Statements a and b are correct.e. None of the statements above is correct.Financial leverage and ratios Answer: b Diff: E 26.Firm U and Firm L each have the same total assets. Both firms also have abasic earning power of 20 percent. Firm U is 100 percent equity financed, while Firm L is financed with 50 percent debt and 50 percent equity. Firm L’s debt has a before-tax cost of 8 percent. Both firms have positive net income. Which of the following statements is most correct?a. The two companies have the same times interest earned (TIE) ratio.b. Firm L has a lower ROA than Firm U.c. Firm L has a lower ROE than Firm U.d. Statements a and b are correct.e. Statements b and c are correct.Medium:Optimal capital structure Answer: d Diff: M27. As a general rule, the capital structure thata. Maximizes expected EPS also maximizes the price per share of commonstock.b. Minimizes the interest rate on debt also maximizes the expected EPS.c. Minimizes the required rate on equity also maximizes the stock price.d. Maximizes the price per share of common stock also minimizes theweighted average cost of capital.e. None of the statements above is correct.Chapter 13- Page 7Operating and financial leverage Answer: e Diff: M28. Which of the following statements is most correct?a. Firms whose sales are very sensitive to changes in the business cycleare more likely to rely on debt financing.b. Firms with large tax loss carry forwards are more likely to rely ondebt financing.c. Firms with a high operating leverage are more likely to rely on debtfinancing.d. Statements a and c are correct.e. None of the statements above is correct.Financial leverage and ratios Answer: c Diff: M 29. Company A and Company B have the same total assets, operating income (EBIT),tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A’s basic earning power (BEP) exceeds its cost of debt financing (k d). Which of the following statements is most correct?a. Company A has a higher return on assets (ROA) than Company B.b. Company A has a higher times interest earned (TIE) ratio than Company B.c. Company A has a higher return on equity (ROE) than Company B, and itsrisk, as measured by the standard deviation of ROE, is also higher thanCompany B’s.d. Statements b and c are correct.e. All of the statements above are correct.Limits of leverage Answer: d Diff: M 30. Which of the following are practical difficulties associated with capitalstructure and degree of leverage analyses?a. It is nearly impossible to determine exactly how P/E ratios or equitycapitalization rates (k s values) are affected by different degrees offinancial leverage.b. Managers’ attitudes toward risk differ and some managers may set atarget capital structure other than the one that would maximize stockprice.c. Managers often have a responsibility to provide continuous service;they must preserve the long-run viability of the enterprise. Thus, thegoal of employing leverage to maximize short-run stock price andminimize capital cost may conflict with long-run viability.d. All of the statements above are correct.e. None of the statements above represents a serious impediment to thepractical application of leverage analysis in capital structuredetermination.Chapter 13 - Page 8Signaling theory Answer: b Diff: M 31. If you know that your firm is facing relatively poor prospects but needsnew capital, and you know that investors do not have this information, signaling theory would predict that you woulda. Issue debt to maintain the returns of equity holders.b. Issue equity to share the burden of decreased equity returns betweenold and new shareholders.c. Be indifferent between issuing debt and equity.d. P ostpone going into capital markets until your firm’s prospects improve.e. Convey your inside information to investors using the media toeliminate the information asymmetry.Capital structure and WACC Answer: d Diff: M32. Which of the following statements is most correct?a. The optimal capital structure minimizes the WACC.b. If the after-tax cost of equity financing exceeds the after-tax cost ofdebt financing, firms are always able to reduce their WACC byincreasing the amount of debt in their capital structure.c. Increasing the amount of debt in a firm’s capital structure is likelyto increase the costs of both debt and equity financing.d. Statements a and c are correct.e. Statements b and c are correct.Capital structure and WACC Answer: b Diff: M33. Which of the following statements is most correct?a. A firm can use retained earnings without paying a flotation cost.Therefore, while the cost of retained earnings is not zero, the cost ofretained earnings is generally lower than the after-tax cost of debtfinancing.b. The capital structure that minimizes the firm’s weighted average costof capital is also the capital structure that maximizes the firm’sstock price.c. The capital structure that minimizes the firm’s weighted average costof capital is also the capital structure that maximizes the firm’searnings per share.d. If a firm finds that the cost of debt financing is currently less thanthe cost of equity financing, an increase in its debt ratio will alwaysreduce its weighted average cost of capital.e. Statements a and b are correct.Chapter 13- Page 9Miscellaneous capital structure concepts Answer: a Diff: M34. Which of the following statements is most correct?a. In general, a firm with low operating leverage has a small proportionof its total costs in the form of fixed costs.b. An increase in the personal tax rate would not affect firms’ capitalstructure decisions.c. A firm with high business risk is more likely to increase its use offinancial leverage than a firm with low business risk, assuming allelse equal.d. Statements a and b are correct.e. All of the statements above are correct.Miscellaneous capital structure concepts Answer: c Diff: M35. Which of the following statements is correct?a. “Business risk” is differentiated from “financial risk” by the factthat financial risk reflects only the use of debt, while business riskreflects both the use of debt and such factors as sales variability,cost variability, and operating leverage.b. If corporate tax rates were decreased while other things were heldconstant, and if the Modigliani-Miller tax-adjusted tradeoff theory ofcapital structure were correct, this would tend to cause corporationsto increase their use of debt.c. If corporate tax rates were decreased while other things were heldconstant, and if the Modigliani-Miller tax-adjusted tradeoff theory ofcapital structure were correct, this would tend to cause corporationsto decrease their use of debt.d. The optimal capital structure is the one that simultaneously(1) maximizes the price of the firm’s stock, (2) minimizes its WACC,and (3) maximizes its EPS.e. None of the statements above is correct.Tough:Variations in capital structures Answer: d Diff: T36. Which of the following is correct?a. Generally, debt to total assets ratios do not vary much among differentindustries although they do vary for firms within a particular industry.b. Utilities generally have very high common equity ratios due to theirneed for vast amounts of equity-supported capital.c. The drug industry has a high debt to common equity ratio because theirearnings are very stable and thus, can support the large interest costsassociated with higher debt levels.d. Wide variations in capital structures exist between industries and alsobetween individual firms within industries and are influenced by uniquefirm factors including managerial attitudes.e. Since most stocks sell at or around their book values, using accountingvalues provides an accurate picture of a fir m’s capital structure.Chapter 13 - Page 10Multiple Choice: ProblemsEasy:Determining price from EBIT Answer: e Diff: E 37. The Price Company will produce 55,000 widgets next year. Variable costswill equal 40 percent of sales, while fixed costs will total $110,000. At what price must each widget be sold for the company to achieve an EBIT of $95,000?a. $2.00b. $4.45c. $5.00d. $5.37e. $6.21Breakeven price Answer: a Diff: E 38. Texas Products Inc. has a division that makes burlap bags for the citrusindustry. The division has fixed costs of $10,000 per month, and it expects to sell 42,000 bags per month. If the variable cost per bag is $2.00, what price must the division charge in order to break even?a. $2.24b. $2.47c. $2.82d. $3.15e. $2.00Medium:New financing Answer: a Diff: M 39. The Altman Company has a debt ratio of 33.33 percent, and it needs to raise$100,000 to expand. Management feels that an optimal debt ratio would be16.67 percent. Sales are currently $750,000, and the total assets turnoveris 7.5. How should the expansion be financed so as to produce the desired debt ratio?a. 100% equityb. 100% debtc. 20 percent debt, 80 percent equityd. 40 percent debt, 60 percent equitye. 50 percent debt, 50 percent equityChapter 13- Page 11Net operating income Answer: b Diff: M 40. The Congress Company has identified two methods for producing playingcards. One method involves using a machine having a fixed cost of $10,000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the selling price per deck of cards will be the same under each method, at what level of output will the two methods produce the same net operating income?a. 5,000 decksb. 10,000 decksc. 15,000 decksd. 20,000 deckse. 25,000 decksChange in breakeven volume Answer: b Diff: M 41. Hensley Corporation uses breakeven analysis to study the effects ofexpansion projects it considers. Currently, the fi rm’s plastic bag business segment has fixed costs of $120,000, while its unit price per carton is $1.20 and its variable unit cost is $0.60. The firm is considering a new bag machine and an automatic carton folder as modifications to its existing production lines. With the expansion, fixed costs would rise to $240,000, but variable cost would drop to $0.41 per unit. One key benefit is that Hensley can lower its wholesale price to its distributors to $1.05 per carton (that is, its selling price), and this would likely more than double its market share, as it will become the lowest cost producer. What is the change in the breakeven volume with the proposed project?a. 100,000 unitsb. 175,000 unitsc. 75,000 unitsd. 200,000 unitse. 0 unitsBreakeven and expansion Answer: c Diff: M 42. Martin Corporation currently sells 180,000 units per year at a price of$7.00 per unit; its variable cost is $4.20 per unit; and fixed costs are $400,000. Martin is considering expanding into two additional states, which would increase its fixed costs to $650,000 and would increase its variable unit cost to an average of $4.48 per unit. If Martin expands, it expects to sell 270,000 units at $7.00 per unit. By how much will Martin’s breakeven sales dollar level change?a. $ 183,333b. $ 456,500c. $ 805,556d. $ 910,667e. $1,200,000Chapter 13 - Page 12Breakeven Answer: d Diff: M 43. Elephant Books sells paperback books for $7 each. The variable cost perbook is $5. At current annual sales of 200,000 books, the publisher is j ust breaking even. It is estimated that if the authors’ royalties are reduced, the variable cost per book will drop by $1. Assume authors’ royalties are reduced and sales remain constant; how much more money can the publisher put into advertising (a fixed cost) and still break even?a. $600,000b. $466,667c. $333,333d. $200,000e. $175,225Operating decision Answer: d Diff: M 44. Musgrave Corporation has fixed costs of $46,000 and variable costs that are30 percent of the current sales price of $2.15. At a price of $2.15,Musgrave sells 40,000 units. Musgrave can increase sales by 10,000 units by cutting its unit price from $2.15 to $1.95, but variable cost per unit won’t change. Should it cut its price?a. No, EBIT decreases by $6,000.b. No, EBIT decreases by $250.c. Yes, EBIT increases by $11,500.d. Yes, EBIT increases by $8,050.e. Yes, EBIT increases by $5,050.Capital structure and stock price Answer: c Diff: M 45. The following information applies to Lott Enterprises:Operating income (EBIT) $300,000 Shares outstanding 120,000 Debt $100,000 EPS $1.45 Interest expense $ 10,000 Stock price $17.40 Tax rate 40%The company is considering a recapitalization where it would issue $348,000 worth of new debt and use the proceeds to buy back $348,000 worth of common stock. The buyback will be undertaken at the pre-recapitalization share price ($17.40). The recapitalization is not expected to have an effect on operating income or the tax rate. After the recapitalization, the company’s interest expense will be $50,000.Assume that the recapitalization has no effect on the company’s price earnings (P/E) ratio. What is the expected price of the company’s stock following the recapitalization?a. $15.30b. $17.75c. $18.00d. $19.03e. $20.48Chapter 13- Page 13。
ICF-lec8-Capital Structure I 2013
Most
important question: Is there an optimal capital structure - defined as the relation between long-term debt and equity – and, if yes, how is it determined? Capital structure leads to WACC
13
McDonalds example
On December 31, 2010 the book value of debt of McDonalds was US $11,505 million. Based on book values: Debt-equity ratio = 11,505/14,630 = 0.79 Debt-to-value ratio = 11,505/(11,505+14,630) = 0.44 Assume market value of debt = book value of debt Based on market values: Debt-equity ratio = 11,505/80,905 = 0.14 Debt-to-value ratio = 11,505/(11,505+80,905) = 0.12
For
directors For important decisions
7
The capital structure question (15.1)
Balance sheet of McDonalds Corporation: Assets Liabilities ___________________________ Fixed Long term: - equity - debt Current Current
资本结构Capital Structure
Capital structure integrates capital with different components,ownerships,time span and levels
2018/11/30
Teaching Team of Advanced Financial Management
5
Capital structure is a relative independent system with quality and quantity integrated
Each capital component,cost and risk should harmonize
Each capital component should maintain rational and balanced proportion
3
Concept of Capital Structure
Broad Sense
?Proportion of equity capital to debt capital
资本结构与资本成本【英文】
D = $2.5 mil
Interest = Net Income = EPS =
(D/E = 1)
/250,000 =
EBIT $300,000
D = $0
Interest = 0, Net Income = $300,000 EPS = $300,000/500,000 = $0.60
Cost of Debt
YTM isБайду номын сангаасgood estimate
Cost of Common Stock
Derived from current market data – Beta Cost has 2 factors
Business or Asset Risk Financing or Leverage Risk (Leverage increases common stock risk)
Ex: Break-Even EBIT
EPSAll Equity EPSWith Debt
Proposed
$5,000,000
Debt
Equity D/E Share $ # Shares
$0
$5,000,000 0 $10 500,000
$2,500,000
$2,500,000 1 $10 250,000
Int. Rate
N/A
10%
EBIT $650,000
D = $0
Interest = 0, Net Income = $650,000 EPS = $650,000/500,000 = $1.30
Capital-Structure-and-Cost-of-Equity资本结构与资金成本-英文版课件)
arbitrageurs would seek to buy the
cheaper security and sell (short) the more expensive one.
• Trading by arbitragef the cheaper security
at the same rate – Equal access to all relevant
information – No transaction costs, no cost of
bankruptcy – No taxes
4
Arbitrage
• Suppose two ‘identical’ securities
Corporate Finance (Econ 906)
Lecture Capital Structure
Read: Hillier, Grinblatt & Titman Chapters 14-17 Copeland/Weston – Chapter 15 Brealey and Myers Chapter 16-19
(with the same expected return and
risk characteristics) trade at different market prices.
• Then there would be an arbitrage opportunity: intelligent
of debt of levered firm.
Initial Cost of Investment
Expected Return
Debt: (0.1)D
(0.1)rdD
Equity: (0.1)E
清华五道口金融学院公司金融内部课件 考研必备 4.Capital Structure
Leverage and Financial Risk
• A new
business requires $100,000 investment. The project can either be entirely equity financed, or ½ of the investment can be funded by a 10 year bank loan at 8%. The corporate tax rate is 43%. EBIT is expected to be $25,000, but it could be as high as $45,000, or as low as $5,000. Calculate ROE for all 6 scenarios. Comment.
• Operating leverage – Fixed costs of production. Arises from fixed cost associated with production • Measure % change in EBIT for a given % change in sales or revenue. The greater the operating leverage, the greater the change in EBIT as sales / revenues change. • Operating leverage is the degree to which a company’s costs of operation are fixed as opposed to variable costs. • Operating leverage increases as fixed costs rise and as variable costs fall. • Financial leverage – Fixed costs of finance. Arises from the debt/equity mix in a firm. • Measure % change in EPS (or ROE) for a given % change in EBIT. (EPS is earnings available to common shareholders and is after interest and taxes.) • Extent to which a firm relies on debt. • Financial leverage = long term debt / (long term debt + equity).
CapitalStructure
What is Business Risk?
Uncertainty about future operating income (EBIT). How well can we predict operating income?
Prob Low risk
High risk
0
E(EBIT)
EBIT
Factors Affecting Business Risk
Stock Price and Cost of Capital Estimates with Different Debt/Assets (D/A) Ratios
D/A Expected Estimated ks = [kRF + EPS Beta (kM – kRF)s] 0% $2.40 1.50 12.0% 10 8.0% 2.56 1.55 12.2 20 8.3 2.75 1.65 12.6 30 9.0 2.97 1.80 13.2 40 10.0 3.20 2.00 14.0 50 12.0 3.36 2.30 15.2 60 15.0 3.30 2.70 16.8 kd Estimated Resulting WACC Price P/E Ratio $20.00 8.33 12.00% 20.98 8.20 11.46 21.83 7.94 11.08 22.50 7.58 10.86 22.86 7.14 10.80 22.11 6.58 11.20 19.64 5.95 12.12
The Effect of Capital Structure on Stock Prices and the Cost of Capital The optimal capital structure is the one that maximizes the price of a firm’s stock, and this always calls for a debt/assets ratio that is lower than the one that maximizes expected EPS
Lecture11CapitalStructure（II）公司金融教学课件
MM and the Real WorldIn perfect capital markets,MM made it clear thatfirm value and the average cost of capital are independent of thefirm’s capital structure.Why MM results are important if,after all,capital markets are not perfect in the real world. While it is true that capital markets are not prefect,all scientific theories begin with a set of idealized assumptions from which conclusions can be drawn. When we apply the theory,we must then evaluate how closely the assumptions hold,and consider the consequences of any important deviations.Recall that the a perfect market exists under the following assumptions: Investors andfirms can trade the same set of securities at competitivemarket prices equal to the present value of their future cashflows.There are no taxes,transaction costs,or issuance costs associated withsecurity trading.Afirm’sfinancing decisions do not change the cashflows generated by its investments,nor do they reveal new information about them.Thus,we must look to market imperfections to explain why capital structure matters in the real world.Corporations pay taxes on their profits after interest payments are deducted. Thus,interest expense reduces the amount of corporate taxes.This creates an incentive to use debt.Consider an unleveredfirm,U.Its after-tax cashflows to all its investors(i.e., equity holders)are given byEBIT−τ×EBITConsider a leveredfirm,L.Its after-tax cashflows to all its investors(i.e.,equity holders and debt holders)are given byEBIT−τ×(EBIT−Interest Payment)The gain to investors of the leveredfirm is given byτ×Interest Payment,and it results from the tax deductibility of interest payments and is referred toas the interest tax shield.11.2012327Valuing the Interest Tax ShieldWhen afirm uses debt,the interest tax shield provides a corporate tax benefit each year.This benefit is the computed as the present value of the stream of future interest tax shields thefirm will receive.The cashflows a leveredfirm pays to investors will be higher than they wouldbe without leverage by the amount of the interest tax shield.Cash Flows to Investorswith Leverage=Cash Flows to Investorswithout Leverage+(Interest Tax Shield)The MM Proposition IThe total value of the leveredfirm exceeds the value of thefirm without leverage due to the present value of the tax savings from debt.V L=V U+PV(Interest Tax Shield)The above calculation assumes the debt is risk free and the risk-free interestrate is constant.However,these assumptions are unnecessary.If the debt is fairly priced,no arbitrage implies that its market value mustequal the present value of the future interest payments.Market Value of Debt=D=PV(Future Interest Payments)If thefirm’s marginal tax rate is constant,then:PV(Interest Tax Shield)=PV(τc×Future Interest Payments)=τc×PV(Future Interest Payments)=τc×D11.2012727The WACC with and without Corporate TaxesFinance(SHUFE)Lec11.Capital Structure(II)Spring20129/27Example:Recapitalizing to Capture the Tax ShieldAssume that Midco Industries wants to boost its stock price.The company currently has20million shares outstanding with a market price of$15pershare and no debt.Midco has had consistently stable earnings,and pays a35%tax rate.Management plans to borrow$100million on a permanent basis and they will use the borrowed funds to repurchase outstanding shares.Without leverageV U=20×15=300millionIf Midco borrows$100million using permanent debt,the present value of thefirm’s future tax savings isPV(Interest Tax Shield)=τc×D=0.35×100=35millionThus the total value of the leveredfirm will beV L=V U+τc D=300+35=335millionwith debt worth100and equity worth235million.Although the value of the shares outstanding drops to$235million, shareholders will also receive the$100million that Midco will pay out through the share repurchase.In total,they will receive the full$335million,a gain of$35million over the value of their shares without leverage.The value of the Midco’s equity will rise immediately from$300million to$335million after the repurchase announcement.With20million shares outstanding,the share price will rise to$16.75per share.With a repurchase price of$16.75,the shareholders who tender their sharesand the shareholders who hold their shares both gain$1.75per share as aresult of the transaction.The benefit of the interest tax shield goes to all20million of the originalshares outstanding for a total benefit of$35million($1.75×20).When securities are fairly priced,the original shareholders of afirm capture the full benefit of the interest tax shield from an increase in leverage.11.20121127Market Value Balance Sheet after Harrison’s Leveraged RecapitalizationIn the presence of corporate taxes,we must include the interest tax shield as one of thefirm’s assets.The share price rises at the announcement of the recap,reflecting thepresent value of the interest tax shield.Why we do not see all debtfirms?It is due to the cost offinancial distressThe possibility of bankruptcy has a negative effect on the value of thefirm.However,it is not the risk of bankruptcy itself that lowers value.Rather it is the costs associated with bankruptcy.It is the stockholders who bear these costs.Types offinancial distress costDirect costsLegal and administrative costs(tend to be a small percentage offirmvalue).Indirect costsImpaired ability to conduct business(e.g.,lost sales)Agency costs of debtIncentive to take large risks—risk shiftingIncentive toward underinvestmentMilking the property11.20121327Expected cashflow from the new investmentTo bondholders:300×0.10+$0=$30To stockholders:($1000−$300)×0.10+$0=$70PV of bonds without the investment=$200PV of stocks without the investment=$0PV of bonds with the investment=$30/1.5=$20PV of stocks with the investment=$70/1.5=$47Thus,the manager,acting in the best interest of shareholders,will choose to accept the investment.Shareholders enjoy the upside benefits,while bondholders bear the downside losses.Aware of the selfish strategy,rational bondholders will require a higher rate of return,so the cost is ultimately borne by shareholders.Expected cashflow from the government sponsored projectTo bondholders:300To stockholders:(350−300)=50PV of bonds without the project=200PV of stocks without the project=0PV of bonds with the project=300/1.1=272.73PV of stocks with the project=50/1.1−100=−54.55From the stockholders’perspective,the NPV on their100investment is−54.55.Rational stockholders will choose to forego this positive NPV project.As in the previous selfish strategy,the leveredfirms chooses a distorted investment policy:Whereas the all-equityfirm always chooses projects with positive NPV,the leveredfirm may deviate from this policy.Aware of the selfish strategy,rational bondholders will charge a higher interset rate,leaving shareholders to bear the ultimate cost.Agency costs of debt3:Milking the PropertyShareholders have incentive to capture some of thefirm’s value in times offinancial distressLiquidating dividends:Suppose ourfirm paid out a$200dividend to theshareholders.This leaves thefirm insolvent,with nothing for thebondholders,but plenty for the former shareholders.Increase perquisites to shareholders and/or managementBond covenants are used to protect bondholders from shareholders’selfish strategies and thus help reduce the agency costs of debt.11.20121927Protective CovenantsAgreements to protect bondholdersNegative covenants limit or prohibit actions that the company may take.Limitations are placed on the amount of dividends a company may pay.Thefirm may not pledge any of its assets to other lenders.Thefirm may not merge with anotherfirm.Thefirm may not issue additional long-term debt.Thefirm may not sell or lease its major assets without approval by thelender.Positive covenants specify an action that the company agrees to take or a condition the company must abide by.Use proceeds from sale of assets for other assets.Allow redemption in event of merger or spinoff.Maintain its working capital at a minimum level.Provide auditedfinancial information.Segregate and maintain specific assets as security for debt.There also exist conflicts of interest between managers and shareholders.A manager will work harder for afirm if he is one of the owners than if heis one of the“hired help.”A manager has incentive to pursue personal satisfaction by,e.g.,shirking,consuming perquisites.While managers may have motive to pursue personal interests,they also need opportunity.Free cashflow provides this opportunity.The free cashflow hypothesis says that an increase in dividends should benefit the stockholders by reducing the ability of managers to pursue wasteful activities.The free cashflow hypothesis also argues that an increase in debt will reducethe ability of managers to pursue wasteful activities more effectively than dividend increases.The above analysis indicates a potential agency benefits of debt:Reducing the opportunities for managers to waste resources.11.20122127 There is a trade-offbetween the tax advantage of debt and the costs associated with debtfinancing(includingfinancial distress costs and theagency costs of debt).The optimal capital structure is achieved by trading offthe tax benefits of debt and the distress and agency costs of debt.It is difficult to express this with a precise and rigorous formula.But the logic can be expressed as follows.V L=V U+PV(Interest Tax Shield)−PV(Financial Distress Costs)−PV(Agency Costs of Debt)+PV(Agency Benefits of Debt).11.20122227Optimal Leverage with Taxes,Financial Distress,and Agency CostsFinance(SHUFE)Lec11.Capital Structure(II)Spring201223/27TheoryWhen a seller has private information about the value of a good,buyers will discount the price they are willing to pay.In capital markets with asymmetric information,new securities issued by a firm are likely to be perceived by investors as overvalued.The pecking-order theory states thatfirms prefer to issue debt rather than equity if internalfinance is insufficient.Rule1:Use internalfinancingfirst.Rule2:Issue debt next,equity last.The pecking-order theory is at odds with the trade-offtheory:There is no target D/E ratio.Profitablefirms use less debt.Companies likefinancial slackFinance(SHUFE)Lec11.Capital Structure(II)Spring201224/27Factors affecting target D/E ratioTaxes:There is a tax advantage to debt.Types of assets:The costs offinancial distress are smaller(larger)for intangible(tangible) assets,since they have lower(higher)resale value.Uncertainty of operating income:Firms with uncertain operating income have high probability ofexperiencingfinancial distress.Corporate Finance(SHUFE)Lec11.Capital Structure(II)Spring201226/27The MM Proposition I with corporate taxesV U=V L+PV(Interest Tax Shield)Costs offinancial distress causefirms to restrain their issuance of debt.Direct costsIndirect costsAgency Costs of DebtRisk shiftingUnderinvestmentMilking the propertyAgency Cost of EquityManagerial perksFree cashflow hypothesesTrade-offtheory and pecking-order theory of capital structureFactors affecting target capital structure offirms11.20122727。
CapitalStructureTheory
CapitalStructureTheoryCAPITAL STRUCTURE THEORYCost of capital is the discount rate used for NPV calculations. A lower discount rate means a higher NPV, thus higher company valuation. Whether introducing debt capital will reduce the cost of capital (WACC) and increase company’s value is subject to a series of conflicting theories.Traditional View1)Cost of debt (kd) is unaffected by gearing/debt level. Debt holders interest income is notdependent on the firm’s profitability. Besides, debt holders are protected by liquidationrights. As such, debt holders risk is unaffected by gearing level, kd remains constant.2)Cost of equity (ke) is higher than cost of debt. Shareholders dividend depends onprofitability and do not have liquidation right. The shareholders have higher risk than thedebt holders and thus require higher return.3)The higher the level of gearing, the risk suffered by shareholders will increase (financial risk).This is because the increased in interest cost will reduce the dividend available toshareholders and also increased in liquidation right of the debtholders.4)At early level of introducing debt, WACC reduces when gearing increases. The firm benefitsfrom the lower cost of debt. However, as gearing continue to increase, cost of equity alsoincreases. Up to certain level of gearing, the increase in ke offset the benefit enjoyed fromthe lower kd, WACC will start to rise.5)Conclusion: an optimal capital structure (gearing level) which minimizes the WACC does exist.M&M (NO TAX)M&M takes a different view. A firm’s value and thus it’s cost of capital depends on it’s future earnings potential and not capital structure. Two companies with the same future earnings should have the same cost of capital regardless of it’s capital structure.Even if they might have different values, arbitrage process will make them the sameConclusion: WACC is unaffected by capital structure.M&M (WITH TAX)However, the above theory ignores tax implications on earnings. When a company uses debt capital, it would enjoy tax relief on interest cost but no such relief for dividend payment. Thus, even though two companies may have same earnings, the company that used debt capital will have better value than a fully equity financed firm.Conclusion: debt capital therefore reduces the WACC due to the tax relief on interest cost.。
Capital structure_Ch_2003
◦ Suppose ALCO plans to pay $60 million in interest each year for the next 8 years, and then repay the principal of $1 billion in year 8.
Interest Tax Shield Corporate Tax Rate Interest Payments
The interest payments provided a tax savings of: 35% × $400 million = $140 million.
➢ The cash flows a levered firm pays to investors will be higher than they would be without leverage by the amount of the interest tax shield.
Debt-toValue Ratio [D/(E + D)] for Selected Industries in US.
Sources of finance – country comparison (2005)
100.0 80.0 60.0 40.0 20.0 0.0 Euro USA Japan UK area
Dr. K.Niemczak
CORPORATE FINANCE
I. Sources of Finance II. Patterns of Financing III. Why is Capital Structure Choice Important? IV. Capital Structure Theories
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EBIT Interest Net income EPS ROA ROE
Shares outstanding = 240 shares
Leverage and EPS
Earnings per share（EPS） share 12.00 10.00 8.00 6.00 4.00 2.00 0.00 1,000 (2.00) 2,000 Break-even point
10% × 100 − 5 = $5 million
Example
• 10% of equity in L is worth $5 million Market value of equity of firm L: $50 million • Market value of firm L: value of equity + value of debt = $50 million + $50 million = $100 million • Therefore, market value of firm L equal market value of firm U. • Otherwise there will be arbitrage opportunities.
E D
Firm value
Why Maximizing Firm Value?
• Why should the manager maximize firm value? Perhaps he should maximize shareholders’ value? • We shall show that shareholders gain from changes in capital structure only when those changes increase firm value.
Homemade Leverage
EPS of Unlevered Firm Earnings for 40 shares Less interest on $800 (8%) Net Profits ROE (Net Profits / $1,200) Recession $2.50 $100 $64 $36 3% Expected $5.00 $200 $64 $136 11% Expansion $7.50 $300 $64 $236 20%
Example
• Firm U: Unlevered (100% equity financed) EBIT (dividends): $10 million Market capitalization rate: 10% Market value: $100 million • Firm L (otherwise identical to firm U) Levered Market value of debt: $50 million Risk free rate: 8% Interest payment: $4 million; dividends: $6 million • Market value of firm L?
MM Proposition I
• MM Proposition I: In a frictionless world, the value of the firm is unaffected by its choice of capital structure, VL = VU • The total market value of all securities issued by the firm is determined by the earning power and risk of its underlying real assets • MM Proposition I allows complete separation of investment and financing decisions
Why Maximizing Firm Value?
100 shares, $10 per share E0 = 1000 No leverage D0 = 0 Firm value V0 = 1000 + 0 = 1000 · With leverage： Borrow $500 D1 = 500 Pay dividends of $5 per share Suppose this changes the value of the firm, and the new value V1 is: 1250, 1000, or 750
Leverage, EPS and ROE
Suppose an all-equity firm is considering doing a debtequity swap.
Assets Debt Equity Debt/Equity ratio Interest rate Shares outstanding Share price
Financial Management
Lecture 8 Capital Structure
What We Try to Answer
• Investing in projects with positive NPV will increase firm value. • We have learned that there are many ways to finance the firm. • So do financing tools matter?
Why Maximizing Firm Value?
• The answer is that maximizing firm value will maximize shareholders’ value. • What we are interested in is that if and how leverage affects firm value.
Value of Debt and Equity under Leverage
V0 = 1,000 V1=1,250 V1=1,000 Value of debt 0 500 500 Value of equity 1,000 750 500 Capital gain to shareholders Dividends Changes in shareholders’ value -250 500 250 -500 500 0 V1=750 500 250 -750 500 -250
Current $20,000 $0 $20,000 0 n/a 400 $50
Proposed $20,000 $8,000 $12,000 2/3 8% 240 $50
EPS and ROE without Leverage
Recession $1,000 0 $1,000 $2.50 5% 5% Expected Expansion $2,000 $3,000 0 0 $2,000 $3,000 $5.00 $7.50 10% 15% 10% 15%
E
$1 ,200
3
Homemade (Un)Leverage
EPS of Levered Firm Earnings for 24 shares Plus interest on $800 (8%) Net Profits ROE (Net Profits / $2,000) Recession $1.50 $36 $64 $100 5% Expected Expansion $5.67 $9.83 $136 $64 $200 10% $236 $64 $300 15%
ห้องสมุดไป่ตู้
Example
• Portfolio A: 10% of equity in firm L - Dividends: $0.6 million • Portfolio B: borrowing $5 million and 10% of equity in firm U - Dividends: $1 million - Interest payments: $0.4 million - Net payoff: $0.6 million • As portfolio A and portfolio B offer the same payoff, they must have the same value. Which is:
Debt No Debt
Gains to leverage
Losses to leverage
3,000
EBIT in dollars, no taxes EBI
MM Proposition I: Assumptions
• No taxes • No transaction costs of issuing debt/equity • Stakeholders are able to resolve conflicts of interest costlessly • Investors can borrow on the same terms as the firm
Capital Structure and the Pie
• The value of the firm is the sum of the value of its equity and debt: V = E + D • If the manager’s aim is to maximize firm value, then he should choose the best mix of debt and equity for this aim.
We buy 24 shares of a levered firm, and lend $800 at 8%. We will get the same ROE as the unlevered firm.