2.2 Lecture_04_Thurs_23_July

2.2 Lecture_04_Thurs_23_July - FINC 202 2009 Lecture 04...

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Unformatted text preview: FINC 202 2009 Lecture 04 Capital Structure Handout: • Capital Structure Case 1 OPTIMAL CAPITAL STRUCTURE Capital structure is exact mixture of : • • • • Debt Ordinary Equity Preferred Shares Convertible Debt weights of these ingredients used in WACC What debt/equity mix should firm use ? • Debt in capital structure is also called: Gearing Leverage Managers will be influenced by all of the factors contributing to: • ________________________________ 2 • ________________________________ How Managers have said they choose their How Firms’ Capital Structures Firms’ A hierarchy of sources of funds appears to exist: (in ranked order most down to least desirable): • • • 1Retained Earnings 2Debt 3External Common Equity But to switch around means _______________________________ 3 Trade-off Model (Of Capital Structure) Trade­off Model focuses on 3 factors • Tax advantages of debt (a Return item) • Agency costs of debt (a Risk item) • Costs of ____________________________ (a Risk item) 4 Tax advantage of debt interest payments on firm debt are tax­ deductible • as firm’s debt level rises, more of EBIT escapes taxation and flows to investors Creditors are investors too! levered firm will be worth more to investors than ________________________________ So why don’t firms use 100% debt ? 5 Agency costs of debt Shareholders of debt­laden firms have incentive to pursue strategies harmful to lenders • • • take large risks underinvest milk the firm Lender’s try to protect themselves by: • raising cost of debt • imposing restrictive covenants Actions of lenders _________________ 6 Costs of financial distress Debt laden firms more likely to run into financial distress Costs of financial distress include • legal/administration fees • loss of key employees/customers • deferral of maintenance/new projects • _________________________________ Costs of financial distress reduce value of firm 7 2. Trade-off Model Optimal capital structure contains: This occurs where; • • Optimal debt, equity etc mix Tax benefit of last $ of debt = extra costs of agency and financial distress at optimal debt/equity mix: • value of firm (or share price) is maximised • WACC ___________________________ 8 Cost of Capital % rs re rd(1­tC) Debt as % of capital Structure Share Price $ Share Price Debt as % of capital Structure 9 Capital Structure, Share Price and EPS Does EPS at maximum coincide with maximum share price? • EPS was not explored on diagram Capital Structure Handout fits here! We start with Equity­only capital structure Then we look at three levels of debt in capital structure We will compare Debt % with: • Share price, WACC and • EPS • The $10m debt level (40% debt) is done for you • Give the company a name You choose a name for it 10 Major handout fits here 11 Solution to T20-4: Capital Structure Example rs = rRF + β (rs ­ rRF) Where rRF = 8% and rM ­ rRF = RPM = 5% (a) 8 + (1.6)(5) = (b) 8 + (1.8)(5) = (c) 8 + (2)(5) = (d) 8 + (2.8)(5) = Amt. borrowed (a) $0 (b) $5m (c ) $10m (d) $15m ­ 10% rd Beta of Stock 16% 17% 1.6 1.8 11% 2.0 16.2% 2.80 rs 18% 22% 12 Calculations for Debt = $5m Shares repurchased = ∆ N = Debt Issued / Initial Share Price = Debt / P0 …where P0 is $25m / 1.25m shares = $20 = $5,000,000 / $20 = New Interest = I = (rd)(debt) = (0.1)($5m) = $500,000 New EPS = (EBIT ­ I)(1 ­ tC) / (N0 ­ ∆ N) = ($6,666,667 ­ $0.5m)(1 ­ 0.4) / (1.25m ­ 0.25m) = = New P = New EPS / rs = 0 13 Calculations for Debt = $15m Shares repurchased = ∆ N = Debt Issued / Initial Share Price = Debt / P0 …where P0 is $25m / 1.25m shares = $20 = $15,000,000 / $20 = New Interest = I = (rd)(debt) = (0.162)($15m) = New EPS = (EBIT ­ I)(1 ­ tC) / (N0 ­ ∆ N) = ($6,666,667 ­ $2.43m)(1 ­ 0.4) / (1.25m ­ 0.75m) = = New P = New EPS / rS = 0 14 T20.6 Capital Structure Table & Calculation (a) Calculation @$10m debt: @$15m debt: (b) Table: $$ Debt D/A $0 $5m $10m $15m r d r S EPS 16% 17% 18% 22% P 0 WACC $20 16% 0 20% 10/25=40% 15/25=60% ­ 10% 11% 16.2% 3.20 Therefore price maximised at ________________________ when WACC =________ 15 Solution to T20-7a Calculations when debt = $5m Prob. Of sales 0.25 0.5 0.25 EBIT ($m) $1,030,000 $6,666,667 $12,300,000 Interest expense (500,000) (500,000) (500,000) Taxable income 530,000 6,166,667 11,800,000 Taxes (40%) (212,000) (2,466,667) (4,720,000) Net Income EPS (N=1m shares) E(EPS) = = ≈ σ EPS = = = 16 Solution to T20-7a Calculations when debt = $10m Prob. Of sales 0.25 0.5 0.25 EBIT ($m) $1,030,000 $6,666,667 $12,300,000 Interest expense (1,100,000) (1,100,000) (1,100,000) Taxable income (70,000) 5,566,667 11,200,000 Taxes (40%) +28,000 (2,226,667) (4,480,000) Net Income EPS (N=0.75m shares) E(EPS) = = ≈ σ EPS = = = ≈ 17 Summary of results Percentage of Debt Market or Intrinsic Price of Share Expected EPS Standard Deviation of EPS 0% $20.00 20% 40% 60% $23.11 $3.20 $1.91 $5.08 $4.78 18 ...
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