- 1. Chapter 16 -Planning the Firms Financing Mix 2005, Pearson
Prentice Hall
2.
3.
4.
Financial Structure 5.
6.
Capital Structure 7. Why is Capital Structure Important?
- 1)Leverage : Higher financial leverage means higher returns to
stockholders, but higher risk due to fixed payments.
- 2)Cost of Capital : Each source of financing has a different
cost. Capital structure affects the cost of capital.
- The Optimal Capital Structureis the one that minimizes the
firms cost of capital and maximizes firm value.
8. What is the Optimal Capital Structure?
- 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 theIndependence hypothesis :firm value is
independent of capital structure .
9. Independence Hypothesis
- Firm value does not depend on capital structure.
10.
- Capital Structure: 100% equity, no debt
- Stock price: $10 per share
- Shares outstanding: 2 million
- Operating income (EBIT): $2,000,000
- With no interest payments and no taxes,
- $2,000,000/2,000,000 shares = $1.00
Independence Hypothesis: Rix Camper Manufacturing Company
11.
- Capital Structure: 100% equity, no debt
- Stock price: $10 per share
- Shares outstanding: 2 million
- Operating income (EBIT): $2,000,000
Independence Hypothesis: Rix Camper Manufacturing Company
12.
- Capital Structure: 100% equity, no debt
- Stock price: $10 per share
- Shares outstanding: 2 million
- Operating income (EBIT): $2,000,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company
13.
- Capital Structure: 100% equity, no debt
- Stock price: $10 per share
- Shares outstanding: 2 million
- Operating income (EBIT): $2,000,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company k=+g=
D 1 P 14.
- Capital Structure: 100% equity, no debt
- Stock price: $10 per share
- Shares outstanding: 2 million
- Operating income (EBIT): $2,000,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company k=+g
=+0= D 1 1.00 P 10.00 15.
- Capital Structure: 100% equity, no debt
- Stock price: $10 per share
- Shares outstanding: 2 million
- Operating income (EBIT): $2,000,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company k=+g
=+0=10% D 1 1.00 P 10.00 16.
- $20 million capitalization
- $8 million in debt issued to retire $8 million in equity.
- Capital Structure: 60% equity, 40% debt
- Shares outstanding: $12 million / $10=1,200,000 shares .
- Interest = $8m x .06 =$480,000
Independence Hypothesis: Rix Camper Manufacturing Company
17.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- $1,520,000/1,200,000 shares = $1.267
Independence Hypothesis: Rix Camper Manufacturing Company
18.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
Independence Hypothesis: Rix Camper Manufacturing Company
19.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Equity:
Independence Hypothesis: Rix Camper Manufacturing Company
20.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Equity:
Independence Hypothesis: Rix Camper Manufacturing Company k=+g =
D 1 P 21.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Equity:
Independence Hypothesis: Rix Camper Manufacturing Company k=+g
=+0=D 1 1.267 P 10.00 22.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Equity:
Independence Hypothesis: Rix Camper Manufacturing Company k=+g
=+0=12.67% D 1 1.267 P 10.00 23.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
Independence Hypothesis: Rix Camper Manufacturing Company
24.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company
25.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company
26.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company
27.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Capital:
Independence Hypothesis: Rix Camper Manufacturing Company
28.
- Capital Structure: 60% equity, 40% debt
- Stock price: $10 per share
- Shares outstanding: 1.2 million
- Net income: $2,000,000 - $480,000 = $1,520,000
- Calculate the Cost of Capital:
- .6 (12.67%) + .4 (6%) = 10%
Independence Hypothesis: Rix Camper Manufacturing Company 29.
Independence Hypothesis Cost of Capital kc 0% debtFinancial
Leverage100% debt . kc = cost of equity kd = cost of debt ko = cost
of capital 30. Independence Hypothesis . Cost of Capital kc kd kd
0% debtFinancial Leverage100% debt 31. Independence Hypothesis .
Cost of Capital kc kd kd 0% debtFinancial Leverage100% debt 32.
Independence Hypothesis Increasing leverage causes the cost of
equity to rise. Cost of Capital kc kd kd 0% debtFinancial
Leverage100% debt 33. Independence Hypothesis Cost of Capital kc kd
kc kd Increasing leverage causes the cost of equity to rise. 0%
debtFinancial Leverage100% debt 34. Independence Hypothesis Cost of
Capital kc kd kc kd Increasing leverage causes the cost of equity
to rise. What willbe the net effect on the overall costof
capital?0% debtFinancial Leverage100% debt 35. Independence
Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes
the cost of equity to rise. What willbe the net effect on the
overall costof capital?0% debtFinancial Leverage100% debt 36.
Independence Hypothesis kc kd Cost of Capital kc ko kd 0%
debtFinancial Leverage100% debt 37.
- If we have perfect capital markets,capital structure
isirrelevant .
- In other words, changes in capital structure do not affectfirm
value .
Independence Hypothesis 38. 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.
39. Dependence Hypothesis Since the cost of debt is lower than
the cost of equity... Cost of Capital kc kd Financial Leverage kc
kd 40. Dependence Hypothesis Since the cost of debt is lower than
the cost of equity increasing leverage reduces the cost of capital.
Cost of Capital kc kd Financial Leverage kc kd ko 41. Moderate
Position
- The previous hypothesis examines capital structure in a perfect
market.
- The moderate position examines capital structure under more
realistic conditions.
- For example, what happens if we includecorporate taxes ?
42.
- - interest expense 0 (480,000)
- - taxes (50%) (1,000,000) (760,000)
- to stockholders 1,000,000 760,000
- securityholders 1,000,0001,240,000
Rix Camper example: Tax effects of financing with debt 43.
Moderate Position Cost of Capital kc kd Financial Leverage kc kd
44. Moderate Position Cost of Capital kc kd Financial Leverage kc
kd Even if the cost of equity rises as leverage increases, thecost
of debtisvery low... 45. Moderate Position Cost of Capital kc kd
Financial Leverage kc kd because of thetax benefit associated with
debt financing. Even if the cost of equity rises as leverage
increases, thecost of debtisvery low... 46. Moderate Position Cost
of Capital kc kd Financial Leverage kc kd The low cost of
debtreduces the cost ofcapital. 47. Moderate Position Cost of
Capital kc kd Financial Leverage kc kd The low cost of debtreduces
the cost ofcapital. ko 48. Moderate Position
- So, what does the tax benefit of debt financing mean for the
value of the firm?
- The more debt financing used, the greater thetax benefit , and
the greater thevalue of the firm .
- So, this would mean that all firms should be financed with100%
debt , right?
- Why are firmsnotfinanced with 100% debt?
49. Why is 100% Debt Not Optimal?
- Bankruptcy costs : costs of financial distress.
- Financingbecomes difficult to get.
- Customers leave due to uncertainty.
- Possible restructuring orliquidationcosts if bankruptcy
occurs.
50.
- Agency costs : costs associated with protecting
bondholders.
- Bondholders(principals) lend money to the firm and expect it to
be invested wisely.
- Stockholdersown the firm and elect the board and hire managers
(agents).
- Bond covenantsrequire managers to be monitored.The monitoring
expense is anagency cost , which increases as debt increases.
Why is 100% Debt Not Optimal? 51. Moderate Position with
Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc
kd 52. Moderate Position with Bankruptcy and Agency Costs Cost of
Capital Financial Leverage kc kd kd 53. Moderate Position with
Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc
kd kd 54. Moderate Position with Bankruptcy and Agency Costs Cost
of Capital Financial Leverage kc kd kc kd 55. Moderate Position
with Bankruptcy and Agency Costs Cost of Capital Financial Leverage
kc kd kc kd 56. Moderate Position with Bankruptcy and Agency Costs
Cost of Capital Financial Leverage kc kd kc kd If a firm borrows
too much, the costs of debt and equity will spikeupward, due to
bankruptcy costs and agency costs. 57. Moderate Position with
Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc
kd kc kd 58. Moderate Position with Bankruptcy and Agency Costs
Cost of Capital Financial Leverage kc kd kc kd ko 59. Moderate
Position with Bankruptcy and Agency Costs Cost of Capital Financial
Leverage kc kd kc kd ko 60. Moderate Position with Bankruptcy and
Agency Costs Cost of Capital Financial Leverage kc kd kc kd ko
Ideally, a firm should use leverage to obtain their optimum
capitalstructure, which will minimize the firms cost of capital.
61. Moderate Position with Bankruptcy and Agency Costs Cost of
Capital Financial Leverage kc kd kc kd ko 62. Capital Structure
Management
- EBIT-EPS Analysis- Used to help determine whether it would be
better to finance a project with debt or equity.
63. Capital Structure Management
- EBIT-EPS Analysis- Used to help determine whether it would be
better to finance a project with debt or equity.
EPS=(EBIT - I)(1 - t) - P S 64. Capital Structure Management
- EBIT-EPS Analysis- Used to help determine whether it would be
better to finance a project with debt or equity.
EPS=(EBIT - I)(1 - t) - P S I = interest expense, P = preferred
dividends, S = number of shares of common stockoutstanding. 65.
EBIT-EPS Example
- Our firm has800,000shares of common stock outstanding, no debt,
and a marginal tax rate of40%.We need$6,000,000to finance a
proposed project. We are considering two options:
- Sell200,000shares of common stock at$30per share,
- Borrow$6,000,000by issuing10%bonds.
66. If we expect EBIT to be $2,000,000:
- - taxes (40%)(800,000) (560,000)
- # shares outst. 1,000,000 800,000
67.
- - taxes (40%) (1,600,000) (1,360,000)
- # shares outst. 1,000,000 800,000
If we expect EBIT to be $4,000,000: 68.
- If EBIT is $2,000,000,common stock financing is best.
- If EBIT is $4,000,000,debtfinancing is best.
- So, now we need to find abreakeven EBITwhere neither is better
than the other.
69. If we choose stock financing: EPS EBIT $1m$2m$3m$4m
stockfinancing 0 3 2 1 70. If we choosebond financing: EPS EBIT
$1m$2m$3m$4m bondfinancing 0 3 2 1 71. Breakeven EBIT EPS EBIT
$1m$2m$3m$4m bondfinancing stockfinancing 0 3 2 1 72. Breakeven
Point
- Set two EPS calculations equal to each other and solve for
EBIT:
- Stock FinancingDebt Financing
- (EBIT-I)(1-t) - P =(EBIT-I)(1-t) - P
73. Breakeven Point
- Stock FinancingDebt Financing
- (EBIT-I)(1-t) - P =(EBIT-I)(1-t) - P
- (EBIT-0) (1-.40)=(EBIT-600,000)(1-.40)
74. Breakeven Point
- Stock FinancingDebt Financing
- .6 EBIT =.6 EBIT - 360,000
- .48 EBIT=.6 EBIT - 360,000
75. Breakeven EBIT EPS EBIT $1m$2m$3m$4m bondfinancing
stockfinancing 0 3 2 1 For EBIT up to $3 million, stockfinancing is
best. 76. Breakeven EBIT For EBIT up to $3 million, stock financing
is best. For EBIT greater than $3 million,debtfinancing is best.
EPS EBIT $1m$2m$3m$4m bondfinancing stockfinancing 0 3 2 1 77.
In-class Problem
- Plan A:Sell 1,200,000 shares at $10 per share($12 million
total).
- Plan B:Issue $3.5 million in 9% debt and sell 850,000 shares at
$10 per share($12 million total).
- Assume a marginal tax rate of 50%.
78. Breakeven EBIT
- Stock FinancingLevered Financing
- (EBIT-I) (1-t) - P =(EBIT-I) (1-t) - P
- EBIT-0 (1-.50)=(EBIT-315,000)(1-.50)
79. Analytical Income Statement
80. Breakeven EBIT leveredfinancing stockfinancing EPS EBIT
$.5m$1m$1.5m$2m 0 .65 .45 .25 81. Breakeven EBIT For EBIT up to
$1.08 m, stock financing is best. leveredfinancing stockfinancing
EPS EBIT $.5m$1m$1.5m$2m 0 .65 .45 .25 82. Breakeven EBIT For EBIT
up to $1.08 m, stock financing is best. For EBIT greater than $1.08
m,the levered plan is best. leveredfinancing stockfinancing EPS
EBIT $.5m$1m$1.5m$2m 0 .65 .45 .25 83. In-class Problem
- Plan A:Sell 1,200,000 shares at $20 per share($24 million
total).
- Plan B:Issue $9.6 million in 9% debt and sell shares at $20 per
share($24 million total).
- Assume a 35% marginal tax rate.
84. Breakeven EBIT
- Stock FinancingLevered Financing
- (EBIT-I) (1-t) - P =(EBIT-I) (1-t) - P
- (EBIT-0) (1-.35)=(EBIT-864,000)(1-.35)
85. Analytical Income Statement
86. Breakeven EBIT leveredfinancing stockfinancing EPS EBIT
$1m$2m$3m$4m 0 1.5 1.17 .5 87. Breakeven EBIT leveredfinancing
stockfinancing For EBIT up to $2.16 m, stock financing is best. EPS
EBIT $1m$2m$3m$4m 0 1.5 1.17 .5 88. Breakeven EBIT leveredfinancing
stockfinancing For EBIT greater than $2.16 m,the levered plan is
best. For EBIT up to $2.16 m, stock financingis best. EPS EBIT
$1m$2m$3m$4m 0 1.5 1.17 .5