BCOR 2200 Chapter 13 - Chapter 13 Leverage and Capital...

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1 Chapter 13 Leverage and Capital Structure
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2 Chapter Overview WACC = W E R E + W D R D (1 - T) (Without preferred stock) W E and W D are the Percentages of Equity and Debt R E and R D are the Costs of Equity and Debt So how much of each should a firm have? What should be the firm’s Capital Structure? Capital Structure is defined by W E and W D Sometimes D/E WACC is the discount rate for all the firm’s projects The lower the rate, the higher the value of the projects The higher the value of the firm So how does WACC (and therefore firm value) change as W E and W D (or D/E) change?
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3 Chapter Overview How does Capital Structure effect Firm Value? Capital Structure means the amount of debt relative to equity (D/E) The firm’s Value is PV of the firm’s CFs Discounted by the WACC So the lower the WACC, the higher the value Look at firm Value with and with out Debt First talk about Taxes Second talk about the costs of financial distress Increased probability of bankruptcy Results: 1. Tax savings from debt So more debt! 2. But more debt leads to higher probability of default So less debt! So look for the look for optimal debt level
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4 Chapter Overview 1. Look at the effect of leverage on Equity Risk and WACC 2. Look at the effect of leverage on Firm Value Definition of Capital Structure: The portion of debt and equity Usually measured by the Debt-Equity ratio (D/E) If we have D/V and E/V, we can get D/E See the last slide
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5 Recall WACC (w/o Preferred): WACC = W E R E + W D R D (1 - T) W E = E/V W D = D/V R E = The cost of Equity capital From the CAPM or Dividend Discount Model R D = The cost of debt capital The YTM on the firm’s bonds So the WACC is the denominator in the firm’s PV calculation The lower the WACC, the greater the firm’s value
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6 Effect of Leverage on Equity Risk Return on equity is more volatile if debt is added: You want to buy $2,000 of assets to start a business You only have $1,000 Should you get the other $1,000 by: 1. Selling a 50% stake in the company Sell stock (or sell Equity) 1. Borrow the other $1,000? Sell $1,000 in Bonds Assume a 10% coupon so interest expense is $100 Borrowing is called Leverage levering your equity investment by borrowing to get more assets Lets look at the difference
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7 The Effect of Leverage on Equity Risk If Profits equal $200 Alternative 1: All Stock (Unlevered): Other shareholder gets ½ of $200 = $100 You get ½ of $200 = $100 Alternative 2 – $1,000 10% Bond (Levered): Bond Holders get $10% x $1,000 = $100 You get $200 - $100 = $100 If Profits equal $250 Alternative 1: All Stock (Unlevered): Other shareholder gets ½ of $250 = $125 You get ½ of $250 = $125 Alternative 2: $1,000 10% Bond (Levered): Bond Holders get $10% x $1,000 = $100 You get $250 - $100 = $150 If Profits equal $150 Alternative 1: All Stock (Unlevered): Other shareholder gets ½ of $150 = $75 You get ½ of $150 = $75 Alternative 2: $1,000 10% Bond (Levered): Bond Holders get $10% x $1,000 = $100 You get $150 - $100 = $50
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8 The Effect of Leverage on Equity Risk
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