05 Lecture5 - Capital Structure Decisions- Part I Overview...

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Capital Structure Decisions- Part I Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory Example: Choosing the optimal structure Setting the capital structure in practice
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Basic Definitions V = value of firm FCF = free cash flow WACC = weighted average cost of capital r s and r d are costs of stock and debt r e and w d are percentages of the firm that are financed with stock and debt.
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How can capital structure affect value? = + = 1 t t t ) WACC 1 ( FCF V (Continued…) WACC = w d (1-T) r d + w e r s
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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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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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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 e ) Net effect on WACC = uncertain. (Continued…)
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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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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 up as suppliers tighten credit). (Continued…)
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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. Increases in agency costs: debt can make managers too risk-averse, causing “underinvestment” in risky but positive NPV projects. (Continued…)
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Asymmetric Information and Signaling Managers know the firm’s future prospects better than investors. Managers would not issue additional equity if they thought the current stock price was less than the true value of the stock (given their inside information). Hence, investors often perceive an additional issuance of stock as a negative signal, and the stock price falls.
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Uncertainty about future pre-tax operating income (EBIT).
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This note was uploaded on 05/12/2010 for the course BUSINESS BS525 taught by Professor Matthews during the Winter '10 term at Drexel.

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05 Lecture5 - Capital Structure Decisions- Part I Overview...

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