Chapter 14 - Capital structure decisions, Part 1

Chapter 14 - Capital structure decisions, Part 1 - Brigham...

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Brigham and Daves (2004) , Intermediate Financial Management Chapter 14 - Capital Structure decisions:Part 1 A preview of capital structure issues Value of a firm is the PV of its expected FCFs, discounted at the weighted average cost of capital (WACC) WACC depends on the percentages of debt and equity, the cost of debt and equity and the corporate tax rate The only way to change the value of the firm is the affect the free cash flows or the cost of capital Debt increase the cost of stock r s Debtholders have a prior claim on the company’s cash flows relative to shareholders → fixed claim of the debtholders causes the residual claim to become less certain → r s Debt reduces the taxes a company pays Due to the interest expense deductibility when calculating taxable income → reduces government’s share and leaves more of the pie to share- and bondholders → after-tax cost of debt ↓ The risk of bankruptcy increases the cost of debt r d As debt increases, the probability of financial distress and bankruptcy increases → increases the required return on corporate debt → pre-tax cost of debt ↑ The net effect on the WACC The WACC is a weighted average of relatively low-cost debt and high-cost equity If we increase the proportion of debt relative to equity, then the WACC should fall and the value of the firm should increase However, the cost of debt and equity increase with higher leverage Bankruptcy risk affects agency costs As the risk of bankruptcy increases, some customers may buy from other companies which decreases NOPAT (also decrease productivity and tightening of credit standards) Risk of bankruptcy can reduce the value of the firm Bankruptcy affects agency costs Threat of bankruptcy may reduce the wasteful spending of managers But also high debt leads to underinvestment (reject positive NPVs) since managers are not as well diversified (reputation, PV of future income, stock options) Issuing equity conveys a signal to the marketplace Informational asymmetry – managers are in a better position to forecast a company’ FCFs Investors perceive an equity issue as a negative signal which causes the stock price to fall Business risk and financial risk Market risk – measured by the firm’s beta coefficient Stand-alone risk – includes market risk and an element of risk that can be eliminated by diversification Business risk – riskiness of the firm’s stock if it uses no debt - 1 -
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Brigham and Daves (2004) , Intermediate Financial Management Chapter 14 - Capital Structure decisions:Part 1 Financial risk – which is the additional risk placed on common stockholders as a result of the firm’s decision to use debt o Leveraged firm’s stockholders will demand more compensation for bearing additional financial risk → required return on common equity will increase with the use of debt Business risk Arises from uncertainty in projections about a firm’s cash flows which in turn means
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This note was uploaded on 11/16/2009 for the course F 3033 taught by Professor Hh during the Spring '09 term at Maastricht.

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Chapter 14 - Capital structure decisions, Part 1 - Brigham...

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