micteach fin

8/3/2019 Micteach Fin

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Chapter 16 -Planning the Firms

Financing Mix

2005, Pearson Prentice Hall


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Balance Sheet

Current Current

Assets Liabilities

Debt and

Fixed Preferred

Assets

Shareholders

Equity

Financial

Structure


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Balance Sheet

Current CurrentAssets Liabilities

Debt and

Fixed Preferred

Assets

Shareholders

Equity

Capital

Structure


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Why is Capital Structure Important?

1) Leverage: Higher financial leveragemeans higher returns to stockholders,but higher risk due to fixed payments.

2) Cost of Capital: Each source offinancing has a different cost. Capitalstructure affects the cost of capital.

TheOptimal Capital Structure is theone that minimizes the firms cost ofcapital and maximizes firm value.


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What is the Optimal CapitalStructure?

In a perfect world environmentwith no taxes, no transaction costs

and perfectly efficient financialmarkets, capital structure does notmatter.

This is known as the Independencehypothesis:firm value is independentof capital structure.


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Firm value does not depend oncapital structure.


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Capital Structure: 100% equity, no debt

Stock price: $10 per share

Shares outstanding: 2 million Operating income (EBIT): $2,000,000

Calculate EPS:

With no interest payments and no taxes,

EBIT = net income.

$2,000,000/2,000,000 shares = $1.00

Independence Hypothesis:Rix Camper Manufacturing

Company


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Capital Structure: 100% equity, no debt


Shares outstanding: 2 million Operating income (EBIT): $2,000,000

Calculate the Cost of Capital:


Company

k = + g = + 0 = 10%D1 1.00

P 10.00


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$20 million capitalization

$8 million in debt issued to retire $8 million inequity.

Equity = $12m / $20m = 60%

Debt = $8m / $20m = 40%

Capital Structure: 60% equity, 40% debt

Shares outstanding: $12 million / $10 =1,200,000 shares.

Interest = $8m x .06 = $480,000


Company


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Shares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000

Calculate EPS:

$1,520,000/1,200,000 shares = $1.267


Company


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Calculate the Cost of Equity:


Company

k = + g = + 0 = 12.67%D1 1.267

P 10.00


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Calculate the Cost of Capital:

.6 (12.67%) + .4 (6%) = 10%


Company


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Cost of

Capital

kc

0% debt Financial Leverage 100% debt

.

kc = cost of equity

kd = cost of debtko = cost of capital

10%

6%


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.

Cost of

Capital

kckd kd


kc = cost of equity


10%

6%


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.

Cost of

Capital

kckd kd


kc = cost of equity


10%

6%


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Increasing leverage causesthe cost of equity (kc)

to rise.Cost of

Capital

kckd kd


kc = cost of equity


10%

6%


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Cost of

Capital

kckd

kc

kd


to rise.


kc = cost of equitykd = cost of debtko = cost of capital

10%

6%


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Cost of

Capital

kckd

kc

kd


to rise.

What will

be the net effect

on the overall cost

of capital?


kc = cost of equity

kd = cost of debt

ko = cost of capital

10%

6%


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Cost of

Capital

kckd

kc

kd


to rise.

What will

be the net effect

on the overall cost

of capital?


kc = cost of equity


10%

6%


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kckd

Cost of

Capital

kc

ko

kd


kc = cost of equity

kd = cost of debt


10%

6%


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Increasing leverage does notincrease the cost of equity (kc).

Since debt (kd) is less expensivethan equity (kc), more debtfinancing would provide a lowercost of capital.

A lower cost of capital wouldincrease firm value.


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Cost of

Capital

kc

kd

kc

kd

Since the cost of debt (kd) is lower

than the cost of equity (kc) ...

kc = cost of equity

kd = cost of debt




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Since the cost of debt (kd) is lower

than the cost of equity (kc)

increasing leverage reduces the

cost of capital (ko).

Cost of

Capital

kc

kd

kc

kdko

kc = cost of equity

kd = cost of debt




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Moderate Position

The previous hypothesisexamines capital structure in aperfect market.

The moderate position examinescapital structure under morerealistic conditions.

For example, what happens if weinclude corporate taxes?


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unlevered leveredEBIT 2,000,000 2,000,000

- interest expense 0 (480,000)

EBT 2,000,000 1,520,000- taxes (50%) (1,000,000) (760,000)

Earnings available

to stockholders 1,000,000 760,000Payments to all

securityholders 1,000,000 1,240,000

Rix Camper example:Tax effects of financing with debt


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Cost of

Capital

kc

kd

kc

kd

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

Even if the cost of equity rises

as leverage increases, the

cost of debt is

very low...

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

becauseof the tax benefit

associated with debt financing.

Even if the cost of equity rises

as leverage increases, the

cost of debt is

very low...



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Cost of

Capital

kc

kd

kc

kd

The low cost of debtreduces the cost of

capital.

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

The low cost of debtreduces the cost of

capital.

ko

kc = cost of equity




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Moderate Position

So, what does the tax benefit of debtfinancing mean for the value of thefirm?

The more debt financing used, thegreater the tax benefit, and the greaterthe value of the firm.

So, this would mean that all firmsshould be financed with 100% debt,right?

Why are firms not financed with 100%


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Why is 100% Debt NotOptimal?

Bankruptcy costs: costs offinancial distress.

Financing becomes difficult toget.

Customers leave due touncertainty.

Possible restructuring or

liquidation costs if bankruptcy


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Agency costs: costs associated withprotecting bondholders.

Bondholders (principals) lend money

to the firm and expect it to be investedwisely.

Stockholders own the firm and elect

the board and hire managers (agents). Bond covenants require managers to

be monitored. The monitoring

expense is an agency cost, whichincreases as debt increases.

Why is 100% Debt NotOptimal?


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Cost of

Capital

kc

kd


kc = cost of equity

kd = cost of debt



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Cost of

Capital

kc

kdkd

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kd

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

If a firm borrows too much, the

costs of debt and equity will spike

upward, due to bankruptcy costsand agency costs.



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Cost of

Capital

kc

kd

kc

kd

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

ko

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

ko

kc = cost of equity

kd = cost of debt




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Cost of

Capital

kc

kd

kc

kd

ko

Ideally, a firm should use leverage

to obtain their optimum capital

structure, which will minimize thefirms cost of capital.



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EBIT-EPS Analysis - Used to help determinewhether it would be better to finance aproject with debt or equity.

EPS = (EBIT - I)(1 - t) - P

S

I = interest expense, P = preferred dividends,

S = number of shares of common stock

outstanding.


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EBIT-EPS Example

Our firm has 800,000 shares of common stockoutstanding, no debt, and a marginal tax rate of40%. We need $6,000,000 to finance a proposedproject. We are considering two options:

Sell 200,000 shares of common stock at $30 per

share,

Borrow $6,000,000 by issuing10% bonds.


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Financing stock debtEBIT 2,000,000 2,000,000

- interest 0 (600,000)

EBT 2,000,000 1,400,000- taxes (40%) (800,000) (560,000)

EAT 1,200,000 840,000

# shares outst. 1,000,000 800,000EPS $1.20 $1.05


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Financing stock debtEBIT 4,000,000 4,000,000

- interest 0 (600,000)

EBT 4,000,000 3,400,000- taxes (40%) (1,600,000) (1,360,000)

EAT 2,400,000 2,040,000

# shares outst. 1,000,000 800,000EPS $2.40 $2.55


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If EBIT is $2,000,000, common

stock financing is best. If EBIT is $4,000,000, debt

financing is best. So, now we need to find a

breakevenEBIT where neither

is better than the other.


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EPS

EBIT$1m $2m $3m $4m

stock

financing

0

3

2

1

bond


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EPS

EBIT$1m $2m $3m $4m

bond

financing

0

3

2

1

bond


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EPS

EBIT$1m $2m $3m $4m

bond

financing

stock

financing

0

3

2

1


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Set two EPS calculations equal to eachother and solve for EBIT:

Stock Financing Debt

Financing(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P

S S


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Stock Financing Debt Financing(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P

S S

(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40)

800,000+200,000 800,000


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Stock Financing Debt Financing.6 EBIT = .6 EBIT - 360,000

1 .8

.48 EBIT = .6 EBIT - 360,000

.12 EBIT = 360,000

EBIT = $3,000,000

bond


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EPS

EBIT$1m $2m $3m $4m

bond

financing

stock

financing

0

3

2

1

For EBIT up to $3 million,

stock financing is best.

bond


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EPS

EBIT$1m $2m $3m $4m

bond

financing

stock

financing

0

3

2

1

For EBIT up to $3 million,

stock financing is best.

For EBIT greater

than $3 million,

debt financing

is best.

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