Ch 16 - Chapter16 TheBasics 1 TopicsinChapter...

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  1 Chapter 16 Capital Structure Decisions:  The Basics
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  2 Topics in Chapter Overview and preview of capital  structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence, and  implications for managers Example: Choosing the optimal  structure
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  3 Basic Definitions V = value of firm FCF = free cash flow WACC = weighted average cost of  capital r s  and r are costs of stock and debt w ce  and w d  are percentages of the firm  that are financed with stock and debt.
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  4 How can capital structure  affect value? V = t=1 FCF t (1 + WACC) t WACC= w d  (1-T) r d  + w ce r s
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  5 A Preview of Capital Structure  Effects The impact of capital structure on value  depends upon the effect of debt on: WACC FCF (Continued…)
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  6 The Effect of Additional  Debt on WACC Debtholders have a prior claim on cash flows  relative to stockholders.  Debtholders’ “fixed” claim increases risk of  stockholders’ “residual” claim. Cost of stock, r s , goes up. Firm’s can deduct interest expenses. Reduces the taxes paid Frees up more cash for payments to investors Reduces after-tax cost of debt (Continued…)
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  7 The Effect on WACC  (Continued) Debt increases risk of bankruptcy Causes pre-tax cost of debt, r d , to increase Adding debt increase percent of firm  financed with low-cost debt (w d ) and  decreases percent financed with high- cost equity (w ce ) Net effect on WACC = uncertain. (Continued…)
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  8 The Effect of Additional Debt  on FCF Additional debt increases the probability  of bankruptcy. Direct costs: Legal fees, “fire” sales, etc. Indirect costs: Lost customers, reduction in  productivity of managers and line workers,  reduction in credit (i.e., accounts payable)  offered by suppliers  (Continued…)
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  9 Impact of indirect costs NOPAT goes down due to lost customers  and drop in productivity Investment in capital goes up due to  increase in net operating working capital  (accounts payable goes down as suppliers  tighten credit). (Continued…)
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  10 Additional debt can affect the behavior of  managers. Reductions in agency costs: debt “pre-commits,”  or “bonds,” free cash flow for use in making  interest payments.  Thus, managers are less likely  to waste FCF on perquisites or non-value adding  acquisitions.
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