Capital Structure - Capital structure Decision Financing...

This preview shows page 1 out of 37 pages.

Unformatted text preview: Capital structure Decision / Financing Decision How do we want to finance our firm’s assets? Balance Sheet Current Current Assets Liabilities Fixed Assets Debt and Preferred Shareholders’ Equity Balance Sheet Current Current Assets Liabilities Fixed Assets Debt and Preferred Shareholders’ Equity Balance Sheet Current Current Assets Liabilities Fixed Assets Debt and Preferred Shareholders’ Equity Financial Structure Balance Sheet Current Current Assets Liabilities Fixed Assets Debt and Preferred Shareholders’ Equity Balance Sheet Current Current Assets Liabilities Fixed Assets Debt and Preferred Shareholders’ Equity Capital Structure Why is Capital Structure Important? 1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments. 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. 3) The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value. OPTIMUM CAPITAL STRUCTURE Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby the value of the firm is maximum. Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads to the maximum value of the firm. Objectives of Capital Structure Maximize the value of the firm. Minimize the overall cost of capital. Capital Structure Theories There is a relationship among the capital structure, cost of capital and value of the firm. The aim of effective capital structure is to maximize the value of the firm and to reduce the cost of capital. There are two major theories explaining the relationship between capital structure, cost of capital and value of the firm. Net Income (NI) Approach suggested by the Durand. The capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital structure leads to a corresponding change in the overall cost of capital as well as the total value of the firm. According to this approach, use more debt finance to reduce the overall cost of capital and increase the value of firm. Net income approach is based on the following three important assumptions: 1. There are no corporate taxes. 2. The cost debt is less than the cost of equity. 3. The use of debt does not change the risk perception of the investor. Net Income Approach Cost of Capital The low cost of debt reduces the cost of capital. kc kc ko kd kd financial leverage Net Operating Income (NOI) Approach Capital Structure decision is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital structure changes. According to this approach, the change in capital structure will not lead to any change in the total value of the firm and market price of shares as well as the overall cost of capital. NI approach is based on the following important assumptions; The overall cost of capital remains constant; There are no corporate taxes; NOI approach kc The cost of capital does kc not change. Leverage has no effect on the cost of capital and therefore, it has no effect on the value of the firm. ko kd kd Cost of Capital financial leverage Modigliani and Miller Approach Modigliani and Miller approach states that the financing decision of a firm does not affect the market value of a firm in a perfect capital market. In other words MM approach maintains that the average cost of capital does not change with change in the debt weighted equity mix or capital structures of the firm. Modigliani and Miller approach is based on the following important assumptions: • There is a perfect capital market. • There are no retained earnings. • There are no corporate taxes. • The investors act rationally. • The dividend payout ratio is 100%. • The business consists of the same level of business risk. 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 Capital Structure Management EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS EPS == (EBIT (EBIT -- I)(1 I)(1 -- t)t) -- PP SS I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding. EBIT-EPS Example Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: Sell 200,000 shares of common stock at $30 per share, Borrow $6,000,000 by issuing 10% bonds. If we expect EBIT to be $2,000,000: Financing stock debt EBIT 2,000,000 2,000,000 - interest 0 (600,000) EBT 2,000,000 1,400,000 - taxes (40%) (800,000) (560,000) EAT1,200,000 840,000 # shares outst. 1,000,000 800,000 EPS $1.20 $1.05 If we expect EBIT to be $4,000,000: Financing stock debt EBIT 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) EAT2,400,000 2,040,000 # shares outst. 1,000,000 800,000 EPS $2.40 $2.55 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 breakeven EBIT where neither is better than the other. EPS 3 If we choose stock financing: stock financing 2 1 0 EBIT $1m $2m $3m $4m EPS 3 If we choose bond financing: bond financing 2 1 0 EBIT $1m $2m $3m $4m Breakeven EBIT EPS 3 bond financing stock financing 2 1 0 EBIT $1m $2m $3m $4m Breakeven Point: Set 2 EPS calculations equal to each other and solve for EBIT: Stock Financing (EBIT-I)(1-t) - P S = Debt Financing (EBIT-I)(1-t) - P S Breakeven Point: Stock Financing (EBIT-I)(1-t) - P = S Debt Financing (EBIT-I)(1-t) - P S (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800,000+200,000 800,000 To refresh your algebra…. Stock Financing .6 EBIT = 1 .48 EBIT = .12 EBIT = Debt Financing .6 EBIT - 360,000 .8 .6 EBIT - 360,000 360,000 EBIT = $3,000,000 Breakeven EBIT EPS 3 bond financing For EBIT up to $3 million, stock financing is best. stock financing 2 1 0 EBIT $1m $2m $3m $4m Breakeven EBIT EPS 3 bond financing For EBIT up to $3 million, stock financing is best. 2 stock financing For EBIT greater than $3 million, debt financing is best. 1 0 EBIT $1m $2m $3m $4m Team Problem: Plan A- all equity: We will start a new firm by selling 1,200,000 shares at $10 per share. Plan B- levered: issue $3.5 million in 9% debt and finance the rest with equity at $10 per share. a) Breakeven EBIT: Stock Financing (EBIT-I) (1-t) - P = S EBIT-0 (1-.50) 1,200,000 Levered Financing (EBIT-I) (1-t) - P S = (EBIT-315,000)(1-.50) 850,000 EBIT = $1,080,000 Analytical Income Statement Stock Levered EBIT 1,080,000 1,080,000 I 0 (315,000) EBT 1,080,000 765,000 Tax (540,000) (382,500) NI 540,000 382,500 Shares 1,200,000 EPS .45 .45 850,000 b) Breakeven EBIT levered financing EPS .65 stock financing .45 .25 0 EBIT $.5m $1m $1.5m $2m Breakeven EBIT For EBIT up levered to $1.08 m, stock EPS financing stock financing .65 financing is best. .45 .25 0 EBIT $.5m $1m $1.5m $2m Breakeven EBIT For EBIT up levered to $1.08 m, stock EPS financing stock financing .65 financing is best. For EBIT greater than $1.08 m, .45 the levered plan is best. .25 0 EBIT $.5m $1m $1.5m $2m ...
View Full Document

{[ snackBarMessage ]}

Get FREE access by uploading your study materials

Upload your study materials now and get free access to over 25 million documents.

Upload now for FREE access Or pay now for instant access
Christopher Reinemann
"Before using Course Hero my grade was at 78%. By the end of the semester my grade was at 90%. I could not have done it without all the class material I found."
— Christopher R., University of Rhode Island '15, Course Hero Intern

Ask a question for free

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern