EFN412 Lecture 03 - EFN412 Advanced Click to edit Master...

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Click to edit Master subtitle style 9/15/10 EFN412 Advanced Part A Topic 3 (3) Debt Finance 1 Required Reading: PBEHP 10th ed. Ch.12 Alternative Reading: PBEHP 9th ed. Ch.13 Background Reading: RTCWJ 4th ed. Ch.19, 3rd ed. Ch. 20 11
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9/15/10 Reading and Assumed Reading PBEHP 10th ed. Ch. 12 PBEHP 9th ed. Ch. 13 Read notes in Tutorial Documents. 22
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9/15/10 Learning Objectives On completing this topic students should be able to: Explain the impact of financial leverage Differentiate between business risk and financial risk Understand the traditional view on Capital Structure Demonstrate the process of arbitrage using “home made leverage” and “undoing corporate leverage” Explain how corporate taxes, personal taxes, bankruptcy costs and agency costs influence capital structure decisions Review the evidence on the capital structure issue Explain the “pecking order theory” of capital structure 33
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9/15/10 Outline of Lecture Introduction to Capital Structure (CS) Traditional view of CS Neoclassical view: Modigliani and Miller (MM) MM Proposition 1 MM Proposition 2 MM Proposition 3 MM Implications MM Theory with Debt and Taxes Optimal CS with Debt and Taxes 44
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9/15/10 INTRODUCTION TO CAPITAL STRUCTURE 55
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9/15/10 Introduction to Capital Structure The two foundations of financing are (1) EQUITY and (2) DEBT. When a firm undertakes positive NPV investments, it needs to find funds. Q: What type of financing should a company issue to fund the investment? A: It can issue (i) equity or (ii) debt or (iii) both. Even without the need of new funds, a firm can issue new equity and use the funds to repay debt or vice versa to buyout equity. Q: How much Equity finance should a firm have? Q: How much Debt finance should a firm have ? 66
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9/15/10 How much debt should a firm How much debt should a firm have? No debt (debt is bad?) Low level High level (debt is good?) Why could D/E ratio be important for firm value? 77 ( 29 1 1 t t A X V k = = + A E D E D WACC k k k V V = = + In general: kE > kD Notation: kA = RA = WACC kE = RE = Cost of equity kD = RD = Cost of debt Rf = risk free rate
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9/15/10 How much debt ? What happens to cost of capital, kA , and cost of equity, kE , as we increase the proportion of debt? What happens to the value of the firm as we introduce more and more debt? Optimal D/E ratio when kA is minimised and therefore V maximised 88
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9/15/10 The Capital Structure Debate Is there an optimal capital structure? Depends on relationship amongst the value of the firm its cost of capital its capital structure Two Schools of thought Traditional (industry viewpoint) Neoclassical (MM ) 99
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9/15/10 Traditional view of CAPITAL STRUCTURE 10
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9/15/10 Traditional View The Traditional View posits that the cost of capital may be lowered by using moderate
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EFN412 Lecture 03 - EFN412 Advanced Click to edit Master...

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