Post on 03-Jun-2018
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Fall 2005 Dr. Tuftes FIN 4250 Notes 2
What Are the Big FinancingIssues?
Cost of Capital Divisional Hurdles
Capital Structure Leverage Refunding
Dividends
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Fall 2005 Dr. Tuftes FIN 4250 Notes 3
What Is Capital?
Funding for long term investment Two types
Fixed payout Bonds, preferred stock, etc. Variable payout
Common stock, retained earnings
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Fall 2005 Dr. Tuftes FIN 4250 Notes 4
What is the Cost of Capital?
Each type of capital has its own cost(measured as a rate)
The cost of capital is a weighted averageof these rates So, our goal is to calculate WACC the
weighted average cost of capital
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Fall 2005 Dr. Tuftes FIN 4250 Notes 6
How Is the Cost of Capital Used,and How Does It Behave?
A firm uses the cost of capital to figure outhow to finance the marginal investment Marginal in the sense of next or additional
Typically retained earnings are a cheaperway to fill your variable payout category(because there are flotation costs with
issuing new equity) So, most firms WACC is lower for smallinvestments, and higher for large ones
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Fall 2005 Dr. Tuftes FIN 4250 Notes 7
What Is the Difficulty in CalculatingCost of Capital?
Firms have different ways in which theyraise capital
The problems are that: Their costs are quoted in different ways There are idiosyncrasies with each type of
security
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Fall 2005 Dr. Tuftes FIN 4250 Notes 8
What Should Go Into the Cost ofCapital?
Capital is long term Debt Common stock Preferred stock Retained earnings
Other long term items can be added
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Fall 2005 Dr. Tuftes FIN 4250 Notes 9
Is the Cost of Bond Financing theRate On Existing Bonds?
No rates change You want the marginal rate that you would pay on
new financing Note that flotation costs are often ignored because
they are small for bonds The marginal rate is caused by three things
The risk-free rate (which incorporates expectations ofinflation)
The risk premium (determined by the market and yourprospects)
Tax considerations
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Fall 2005 Dr. Tuftes FIN 4250 Notes 10
Is the Earnings/Price Ratio theCost of Common Stock?
Yes if the firm is not expected to grow Of course, in this case you probably wouldnt
be as worried about the cost of capitalanyway
No if the firm is growing
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Fall 2005 Dr. Tuftes FIN 4250 Notes 11
Is the Dividend/Price Ratio the Costof Preferred Stock?
No Preferred stock often has higher
placement costs Most preferred dividends (70%) are non-
taxable
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Fall 2005 Dr. Tuftes FIN 4250 Notes 12
How Do I Calculate the Cost ofBonds?
The current price must equal the PV of thematurity value, plus the PV of the streamof coupons
P = M/(1+k) N + sum{C/(1+k) n} Solve for k
Deflate k by the appropriate tax rate to getthe cost of bonds, k d=k(1-t)
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Fall 2005 Dr. Tuftes FIN 4250 Notes 13
What Are the Pitfalls with the Costof Bonds?
Thin trading Use a bond rating as a proxy
Yield curve extrapolation Is the horizon your costing currently
available? Callability
This is a mess because you have toincorporate how the yield curve might effectyour decision to call but it can be done
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Fall 2005 Dr. Tuftes FIN 4250 Notes 14
How Do I Calculate the Cost ofCommon Stock?
Use the CAPM Use discounted cash flow
Note that you have to use this method toreasonably account for flotation costs on newissues
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Fall 2005 Dr. Tuftes FIN 4250 Notes 15
How Do I Use the CAPM toCalculate the Cost of Equity?
Obtain: A risk-free rate The market risk premium The for your firm
Be aware that all of those must be chosenappropriately for the horizon of your project which might be different than what you woulduse to make a portfolio investment decision
Calculate the cost of capital k s = k rf + (km-krf ) Note that there isnt a reasonable way toincorporate flotation costs
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Fall 2005 Dr. Tuftes FIN 4250 Notes 16
How Do I Use Discounted CashFlow to Calculate the Cost of
Equity? Obtain the:
Current price
Expected future dividends Expected future growth rate
Calculate: kcs = g + D(1+g)/(P-Flotation Costs)
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Fall 2005 Dr. Tuftes FIN 4250 Notes 17
Where Do I Get an ExpectedGrowth Rate to Use for Costing?
Use analysts forecasts Use the product of the retention rate and
the return on equity
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Fall 2005 Dr. Tuftes FIN 4250 Notes 18
How Do I Calculate the Cost ofPreferred Stock?
Cost is the dividend divided by the amountyou clear after flotation, weighted by howmuch is taxable.
kps = (1-.3t)D/(Price-Flotation Cost)
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Fall 2005 Dr. Tuftes FIN 4250 Notes 19
How Do I Value the Cost ofRetained Earnings?
Retained earnings and common stock arecosted in the same ways Use the: CAPM (see above) Discounted cash flow (see above) Construct a guesstimate:
From your current bond yield plus a risk premium
Then make a judgment call combining allof them
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Fall 2005 Dr. Tuftes FIN 4250 Notes 20
How Do I Construct Weighted Costof Capital?
The rates are weighted across the componentsby their share of your capital structure Need to decide whether to use book or market value,
lean towards the latter Usually there are two possibilities:
Bonds, preferred stock, and retained earnings, or Bonds, preferred stock, and new equity issues
The difference is how much the flotation costs ofnew issues effect your choice to retain earnings
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Fall 2005 Dr. Tuftes FIN 4250 Notes 21
What Is a Marginal Cost of CapitalChart?
This shows the rates, as well as the stepat the cutoff where new equity has to beissued for a large enough investment
Generally shown as two flat segments witha step In reality, the rightward segment will
eventually slope upward reflecting limitedability to place large amounts of commonstock
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Fall 2005 Dr. Tuftes FIN 4250 Notes 22
How Is Depreciation Handled?
Depreciation is a source of internal cashflow, just like retained earnings
Therefore, count it as a retained earning inyour calculations
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Fall 2005 Dr. Tuftes FIN 4250 Notes 23
What Factors Effect the Cost ofCapital That A Firm Cant Control?
Interest rates Tax rates
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Fall 2005 Dr. Tuftes FIN 4250 Notes 24
What Factors Effect the Cost ofCapital That A Firm Can Control?
Capital structure Perhaps you can assume more debt to lower
the cost of capital
Dividend policy Perhaps you can reduce your dividends to
reduce the cost of capital
Investment policy Perhaps you can choose less risky projects
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Fall 2005 Dr. Tuftes FIN 4250 Notes 25
What Are the Potential Pitfalls InCalculating the Cost of Capital?
Private ownership less data Small firms less data
Measurement problems What is the risk-free rate What is the expected growth rate? What is the risk premium?
Capital structure may change
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Fall 2005 Dr. Tuftes FIN 4250 Notes 26
What Are the Mistakes to Avoid?
Use the current rather than the historicalcost of debt
Dont mix a historical risk premium with acurrent risk-free rate in the CAPM
Unless the firm has an explicit target, yourshare weights should be based on market
valuations Accounts payable and accruals are notsources of capital
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Fall 2005 Dr. Tuftes FIN 4250 Notes 28
What About Corporate DivisionsWith Different Projects?
Different divisions within a firm will haveinvestment opportunities with different rates ofreturn
But, remember that rates of return are correlated withrisk
A pitfall for a company is that the riskierdivision(s) may have more projects that clear the
investment hurdle so a company that doesnthave divisional hurdles may find itself gettingriskier through time
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Fall 2005 Dr. Tuftes FIN 4250 Notes 29
How Can the Volatility ofDifferent Divisions Be
Measured? You can calculate betas for different divisions
Obviously this will be easiest if the divisions are stand-alone and
have their own equity Alternatively, you can
Look at the betas for firms that have operations similar toyour divisions
Recall that beta is the ratio of the variances of your riskpremium to that of the market, and proxy for those premiumswith earnings
Make an adjustment based on standard deviations ofearnings without reference to beta
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Fall 2005 Dr. Tuftes FIN 4250 Notes 30
How Will Cost of Capital Vary Across Divisions?
This really depends on whether your fixedpayout items are issued for the corporationas a whole or by each division
It doesnt matter as much if common stockis issued by the corporation rather than bythe divisions This is because most divisions have either an
explicit or implicit capability of retainingearnings
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Fall 2005 Dr. Tuftes FIN 4250 Notes 31
How Will Cost of Capital Behave IfDebt Is Corporate But EarningsCan Be Retained at the Division
Level?
The only difference in cost of capital will befrom how beta effects the weight you put oncommon stock or retained earnings
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Fall 2005 Dr. Tuftes FIN 4250 Notes 32
What Are the Pitfalls In Having
Corporate Debt But DivisionalEquity (or Retained Earnings)?
This may still allow the risky division togrow faster as it takes advantage ofcheaper debt available from thecorporation
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Fall 2005 Dr. Tuftes FIN 4250 Notes 33
How Will Cost of Capital Behave If
All Capital Is Raised at the DivisionLevel?
Now the bond market will also be pricingthe risk of the division, and the higher riskdivision will not have an advantage
On the other hand, what is the point ofhaving a division (as opposed to anindependent firm) in this case?
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Fall 2005 Dr. Tuftes FIN 4250 Notes 34
What Are the Pitfalls In LettingDivisions Have Their Own Debt?
Firms dont know too much about theappropriateness of their own capitalstructure, so how would you know howmuch debt each division could carry?
Who will back up the debt Division: then whats the point of keeping
them as a subsidiary? Corporation: there is a moral hazard for
divisional managers
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Fall 2005 Dr. Tuftes FIN 4250 Notes 35
How Serious a Short-TermProblem Can Differences In
Divisional Risk Be? This problem becomes smaller as:
The firm gets larger The projects get smaller The time frame is shorter
For example, suppose the firm has X% debt. Adopting projects with Y% debt will only slowlymove the overall structure from X% to Y%.
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Fall 2005 Dr. Tuftes FIN 4250 Notes 36
Are There Incentive Problems WithDivisions?
Firms exist because they are better at reducingtransactions costs than markets This is the Coase Theorem
But markets trade off risk for return in a cheapand decentralized way
Financing with divisions is a problem theCoase Theorem says we should go the otherway Incentive problems come about when we do that
incompletely
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Fall 2005 Dr. Tuftes FIN 4250 Notes 37
What Is Capital Structure?
The breakdown of the firms capital (long-term financing) into fixed and variablepayout items And then into finer categories
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Fall 2005 Dr. Tuftes FIN 4250 Notes 38
What Is the Appropriate CapitalStructure?
The short answer is that there isnt one The long answer is that we probably cant
tell what the appropriate capital structureis, so most firms work under theassumption that they shouldnt change theexisting capital structure drastically It worked before, it will work again
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Fall 2005 Dr. Tuftes FIN 4250 Notes 39
Why Should We Care AboutCapital Structure?
Firms have business risk generated by whatthey do
But then firms adopt additional financial riskwhen they finance with debt They trade off access to capital at lower rates for
potential loss of control if they cant make payments In principle, you can measure these with return
on equity A leverage firm will have a higher ROE, but its hard
to demonstrate this because it isnt clear what tocompare it to
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Fall 2005 Dr. Tuftes FIN 4250 Notes 40
What Is the (Nave) Theory ofCapital Structure?
The Modigliani-Miller Theorem says that(in the absence of distortionary taxes) afirm cant improve its profitability bychanging its capital structure This is basically a you- cant -game-the-system
result
The problem with it is that in the real world,we do have distortionary taxes
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Fall 2005 Dr. Tuftes FIN 4250 Notes 41
What Is the (Not-So-Nave) Theoryof Capital Structure?
Our tax system favors debt financingwithout limits
Theoretically then, it is optimal to beinfinitely leveraged This may seem strange, but it follows
because the cost of being overleveraged
(bankruptcy) is not explicit or tangible
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Fall 2005 Dr. Tuftes FIN 4250 Notes 42
What Is An Even Less NaveTheory of Capital Structure?
Marginal tax rates on equity are not as high aswe think Double taxation is a misnomer the rates arent
added theyre compounded Marginal tax rates on debt may be higher than
we think Individual rates are often higher than corporate and
capital gains rates We may be pretty close to the basic Modigliani-
Miller result
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Fall 2005 Dr. Tuftes FIN 4250 Notes 43
Capital Structure
What are the pros and cons?
Is there an ideal one?
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Fall 2005 Dr. Tuftes FIN 4250 Notes 44
What Are the Advantages ofFinancing with Debt?
Tax benefit Because it requires a consistent cash flow,
it disciplines managers
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Fall 2005 Dr. Tuftes FIN 4250 Notes 45
What are the Disadvantages ofFinancing with Debt?
Increased risk of loss of control (throughbankruptcy)
Increased potential for conflict betweenequity holders and debt holders
Loss of flexibility for future financing
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Fall 2005 Dr. Tuftes FIN 4250 Notes 46
What are the Tax Benefits ofDebt?
Tax write-off (100% of interest in the U.S.) Most countries have this
Some try to correct for it Carrot: the U.K. - tax credit on dividends Stick: Germany - tax penalty on retained earnings
Wh I Fi V l P iti l
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Fall 2005 Dr. Tuftes FIN 4250 Notes 47
Why Is Firm Value PositivelyCorrelated with Reasonable Debt
Levels? All firms increase their value by issuing debt,since there is a positive present valueassociated with not paying taxes on interest you
will pay in the future This gain is the tax rate expected on future
earnings times the face value of debt at issue Note that this tax rate is not marginal, since it
covers all the debt not just changes in debt Note that this says nothing about costs of debt
h l d
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Fall 2005 Dr. Tuftes FIN 4250 Notes 48
What Savings Are Realizedfrom Debt Finance?
Effective interest rates on debt are lower kD = r(1-t) Note that we use the marginal tax rate since
we are talking about new debt Note that this is only a benefit if your actually
making earnings that can be taxed.
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Fall 2005 Dr. Tuftes FIN 4250 Notes 49
What Can We Predict About theRelationship of Taxes and Debt?
Firms that face higher tax rates should havemore leverage We see this with REITs, which dont pay corporate
taxes, and are less leveraged than similar firms
Firms that can shield themselves in other ways say through depreciation should have lessdebt
Changes in tax rates should be correlated withchanges in leverage ratios
Countries with higher taxes should have moreleveraged firms
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Fall 2005 Dr. Tuftes FIN 4250 Notes 50
How Does Debt Discipline a Firm?
Free cash flows those over whichmanagers have some discretion invitemanagement inefficiency
For practical purposes, there has to besome limit to how much you need todiscipline your managers so this isnt an
argument for infinite leverage
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Fall 2005 Dr. Tuftes FIN 4250 Notes 51
What Can We Infer From thePropensity of Debt to Rein In
Management? Managers with a preference for equity financing probably
dont want investors watching them too closely Countries in which shareholders have more power
should also be ones in which leverage is higher Takeover targets are less leveraged than other firms
Operating efficiency is higher in leveraged firms
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Fall 2005 Dr. Tuftes FIN 4250 Notes 52
When Is Bankruptcy More Likely?
Operating cash flows are small relative todebt obligations
Operating cash flows are relatively volatile
h h f
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Fall 2005 Dr. Tuftes FIN 4250 Notes 53
What Are the Direct Costs ofBankruptcy?
Not very high 1% of assets held 5 years prior to bankruptcy 5% of assets at the time of bankruptcy
This reflects slow dissolution of assets prior tofiling
Costs are higher if the firm is holding
assets that are less liquid
h A h di C f
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Fall 2005 Dr. Tuftes FIN 4250 Notes 54
What Are the Indirect Costs ofBankruptcy?
Declining revenue associated withbankruptcy fears on the part of customers
Stricter terms on payables
Wh F A Lik l
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Fall 2005 Dr. Tuftes FIN 4250 Notes 55
What Features Are Likely toLead to Higher Indirect Costs?
Sellers of products with: Long lives Lots of replacement parts Lots of service
Sellers of products whose quality cant bedetermined in advance
Firms producing products with lots ofcomplements
What Sort of Firms Will Use More
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Fall 2005 Dr. Tuftes FIN 4250 Notes 56
What Sort of Firms Will Use MoreDebt Because of the Nature of
Bankruptcy Costs? Stable cash flows Debt payments that can be linked to cash
flows Implicit or explicit government backup Firms whose assets are easily divisible
and marketable Brand names are likely to be associated with
lower debt
Wh I h A P bl i h
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Fall 2005 Dr. Tuftes FIN 4250 Notes 57
What Is the Agency Problem withBorrowing?
Equity holders: Control decision making Prefer riskier projects (since equity is like a
call option) Debt holders
Can end up assuming more risk than they
want to Owning a bond is like selling the company a
put in exchange for a risk-free note
What Aspects of Financial
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Fall 2005 Dr. Tuftes FIN 4250 Notes 58
What Aspects of FinancialManagement Are Affected by this
Agency Problem? Project choice Choice of project financing Cash disbursement
H D h A P bl
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Fall 2005 Dr. Tuftes FIN 4250 Notes 59
How Does the Agency Problem Affect Project Choice?
Managers devise projects and calculate hurdlerates
Bondholders lend money based on hurdle rates
and perceived risk of projects Once money is lent, equity holders have an
incentive to find even riskier projects This transfer wealth from bondholders to equityholder Perversely, equityholders may even be interested in
projects with negative NPV because they are highrisk, and on net are winners for equityholders
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Wh t I th A P bl f
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Fall 2005 Dr. Tuftes FIN 4250 Notes 61
What Is the Agency Problem forProject Finance?
Equityholders have the authority to giveissuers of new debt priority (in bankruptcy)over existing debt This transfers some of the wealth of old
debtholders to equityholders
How Do Bondholders Protect
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Fall 2005 Dr. Tuftes FIN 4250 Notes 62
How Do Bondholders ProtectThemselves from Being
Disprioritized? Write a put clause into the bond contract
This allows the bonds to be sold back to thefirm - at the holders discretion and at facevalue
What Is the Agency Problem
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Fall 2005 Dr. Tuftes FIN 4250 Notes 63
What Is the Agency Problemwith Cash Disbursement?
In the absence of viable projects,equityholders usually want to either: Pay out cash as dividends, or
Use it to repurchase stock
Debtholders prefer that cash be retainedto ensure that they get paid There is evidence that bond prices go down
after dividend announcements
How Do Debtholder Protect
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Fall 2005 Dr. Tuftes FIN 4250 Notes 64
Themselves Against Poor Use of
Cash? Covenants that restrict dividend rates Hybrid securities like convertible bonds
What Are the Implications of the
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Fall 2005 Dr. Tuftes FIN 4250 Notes 65
What Are the Implications of the Agency Cost Problems?
Bond prices will be higher due toexpectations of abuse
Direct costs of monitoring covenants willpush bond prices higher
Indirect costs of foregone opportunitiesthat covenants restrict
a re e mp ca ons o
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Fall 2005 Dr. Tuftes FIN 4250 Notes 66
a re e mp ca ons oLoss of Flexibility from Debt
Finance? How do we value this? Flexibility is more valuable when:
You have more potential projects You have better potential projects Your projects will yield more volatile cash
flows This is consistent with why Microsoft or Intel
uses little (long-term) debt but holds much cash
What Is the EBIT EPS
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Fall 2005 Dr. Tuftes FIN 4250 Notes 67
What Is the EBIT-EPSTradeoff?
EBIT and EPS are positively correlated Assuming a standard strategy of issuing
debt to buy stock, A graph of the two will be steeper as the firm
becomes more leveraged
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What Happens to Modigliani-Miller
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Fall 2005 Dr. Tuftes FIN 4250 Notes 70
pp gWith Taxes and Interest Write-
Offs? Allowing for taxes with a write-off of
interest - makes the optimal capitalstructure 100% debt
What Happens to (Modigliani)-
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Fall 2005 Dr. Tuftes FIN 4250 Notes 71
pp ( g )Miller with Realistic Taxes On All
Parties? Capital structure wont matter if:
All tax rates are zero Tax rates on debt and equity are the same Taxes on personal income (which is the
relevent rate for debt) are substantially higher
than on corporations making up for thedouble taxation of equity
What Is the Practical Implication of
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Fall 2005 Dr. Tuftes FIN 4250 Notes 72
What Is the Practical Implication ofthe Modigliani-Miller Theorem?
They were the first to point out that therewere tradeoffs worth thinking about Up to this time you determined you capital
structure through imitation It implies that a firm is made or broken on
the basis of project choice
Bad choices cant be fixed with finance Good choices cant be ruined with finance
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Fall 2005 Dr. Tuftes FIN 4250 Notes 73
How Is Modigliani-Miller Helpful?
Its really saying that the cost of capital doesntchange when you change your capital structure
How is this possible?
As you shift more towards an asset with a low rate,you increase the costs associated with that methodas well
Its a zero profit condition for capital structure
changes Project decisions canand should be made on the
merits of the project, not on how it is financed
What Are the Two Practical
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Fall 2005 Dr. Tuftes FIN 4250 Notes 74
What Are the Two PracticalViews On Debt?
There is no optimal level of debt Debt is preferable up to some threshold
level
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Does Financing Mix Change
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Fall 2005 Dr. Tuftes FIN 4250 Notes 76
Does Financing Mix Change Across the Firms Life Cycle?
On net, the costs of debt appear to declineas the business grows to maturity (andinto decline)
Increasing factors: Tax benefits Added discipline
Declining factors
Bankruptcy costs Agency costs Need for flexibility
Does Financing Mix Depend On
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Fall 2005 Dr. Tuftes FIN 4250 Notes 77
Does Financing Mix Depend OnYour Industry?
There is strong empirical evidence tosupport this
This doesnt mean this is evidence of amanagement strategy Each firm may be drawn to a similar capital
structure by the costs and benefits of debt
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What Is the Significance of the
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What Is the Significance of theFinancing Hierarchy?
The street seems to use this ranking as anindicator of financial strength If you are issuing convertible preferred, it is a
sign of weakness More extremely, issuing securities at all isa sign of weakness If you prefer retained earnings, and you have
to issue securities, it is a sign you arent doingwell enough to support the projects comingyour way