BCOR 2200 Chapter 13 - Chapter 13 Leverage and Capital...

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1 Chapter 13 Leverage and Capital Structure
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2 Chapter Overview WACC = W E R E + W D R D (1 - T) (Without preferred stock) W E and W D are the Percentages of Equity and Debt R E and R D are the Costs of Equity and Debt So how much of each should a firm have? What should be the firm’s Capital Structure? Capital Structure is defined by W E and W D Sometimes D/E
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3 Chapter Overview Recall that WACC is the discount rate for all the firm’s projects The lower the rate, the higher the value of the projects The higher the value of the firm So how does WACC (and therefore firm value) change as W E and W D (or D/E) change?
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4 Chapter Overview How does Capital Structure effect Firm Value? Capital Structure means the amount of debt relative to equity (D/E) The firm’s Value is PV of the firm’s CFs Discounted by the WACC So the lower the WACC, the higher the value
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5 Chapter Overview Look at firm Value with and with out Debt First : talk about Taxes Second : talk about the costs of financial distress Increased probability of bankruptcy Results: 1.Taxes are saved by using debt This implies use more debt! 2.But more debt leads to higher probability of default Default has costs This implies use less debt! So look for the look for optimal debt level!
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6 Chapter Overview 1. Look at the effect of leverage on Equity Risk and WACC 2. Look at the effect of leverage on Firm Value Definition of Capital Structure: The portion of debt and equity Usually measured by the Debt-Equity ratio (D/E) If we have D/V and E/V, we can get D/E (See the final slide)
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7 A Quick Note On Leverage: Assume It will cost $2,000 to start my business: 1. I can put up a $1,000 as an owner and get someone else to put up $1,000 as another owner E/V = 100%, D/V = 0%, D/E = 0 1. I can put up $1,000 and borrow $1,000: E/V = 50%, D/V = 50%, D/E = 1 We will compare 1 to 2: All Equity vs. Debt and Equity Should I put up all the money or borrow half?
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8 Recall WACC (w/o Preferred): WACC = W E R E + W D R D (1 - T) W E = E/V W D = D/V R E = The cost of Equity capital From the CAPM or Dividend Discount Model R D = The cost of debt capital The YTM on the firm’s bonds The WACC is the denominator in all the firm’s PV calculation The lower the WACC, the greater the firm’s value
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9 How Leverage changes the risk of the Equity What happens to equity returns if debt is added? Return on equity becomes more volatile: You want to buy $2,000 of assets to start a business You only have $1,000 Should you get the other $1,000 by: 1. Selling a 50% stake in the company Sell stock (or sell Equity) 2. Borrow the other $1,000? Sell $1,000 in Bonds Assume a 10% coupon so interest expense is $100 Borrowing is called Financial Leverage Buy more assets by borrowing This is called levering the equity Lets look at the difference between 1 and 2
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10 How Leverage changes the risk of the Equity If Profits equal $200 Alternative 1: All Stock (Unlevered): Other shareholder gets ½ of $200 = $100
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