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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 Tradeoff 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. Tradeoff 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 T204: 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 T207a
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 T207a
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
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 Spring '09
 WarwickAnderson

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