Ch16 - Chapter 16 Financing Decisions Road Map Part A...

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Unformatted text preview: Chapter 16 Financing Decisions Road Map Part A Introduction to finance. Part B Valuation of assets, given discount rates. Part C Determination of discount rates. Part D Introduction to corporate finance. Ecient Market Hypothesis (EMH). Capital investment decisions (Capital budgeting). Financing decisions. Main Issues Capital Structure without Taxes Effect of Taxes Costs of Financial Distress Optimal Capital Structure 16-2 Financing Decisions Chapter 16 1 Introduction Main Question : How should a firm finance its operations? Is a firms value dependent on its financing? If so, how? Definition : How a firms operations are financed is referred to as its capital structure. With only debt and equity financing, a firms capital structure is given by its debt to equity ratio. Our Objective : Given a firms assets and investment strategy, find a capital structure that increases its value. Balance Sheet (in market value) Assets Debt (D) Growth Equity (E) opportunities Firm Value Firm Value (V) Find the debt/equity ratio, D/E , that maximizes V . 15.407 Lecture Notes Fall 2003 c Jiang Wang Chapter 16 Financing Decisions 16-3 Capital Structure: Some Examples (Source: Grinblatt and Titman) Company Debt Debt + Mkt Equity Debt Total Book Assets AT&T 20% 29% Boeing 15% 13% Boston Edison 49% 42% John Deer 40% 37% Delta Air Lines 53% 32% Disney 9% 20% GM 61% 37% HP 13% 17% McDonalds 15% 31% 3M 6% 12% Philip Morris 27% 35% Raytheon 9% 12% Safeway Stores 55% 53% Texaco 27% 26% Wal-Mart 14% 36% c Jiang Wang Fall 2003 15.407 Lecture Notes 16-4 Financing Decisions Chapter 16 Major factors that might affect target capital structure: 1. Trade-off between risk and return of financing instruments Equity Debt etc. 2. Taxes 3. Costs of financial distress 4. Management incentives 5. Information problems. For most of this lecture, we consider factor 1-3 and assume: 1. Financial market is perfect. 2. A firms investment decisions have been made. They are independent of its financing decisions. 3. Investments are financed by debt and equity. No other financial instruments are used. 15.407 Lecture Notes Fall 2003 c Jiang Wang Chapter 16 Financing Decisions 16-5 Main Conclusions (A Preview): 1. In absence of taxes, a firms value is independent of its capital structure. Financing decisions are irrelevant. 2. In the presence of taxes, when interest-expenses on debt are tax deductible, a firms value increases with its debt/equity ratio. It is better to have more debt financing. 3. When there are costs of financial distress, there is an optimal Capital Structure. c Jiang Wang Fall 2003 15.407 Lecture Notes 16-6 Financing Decisions Chapter 16 2 Capital Structure without Taxes Consider two firms, U and L, with identical assets. Suppose that Firm U is financed by 100% equity (unlevered) Firm L is financed by 50% equity and 50% debt (levered)....
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Ch16 - Chapter 16 Financing Decisions Road Map Part A...

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