Topic 7 Capital Structure - Topic 7 Capital Structure...

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Topic 7 Capital Structure Overview This topic is concerned with the issue of whether there exists an “Optimal Capital Structure”, one that maximizes the value of the firm. In order to address the issue one needs to first examine the effect on equity holders of introducing “Financial Leverage” into the firms capital structure Financial Leverage refers to the extent to which a firm relies on debt.
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Returns Returns RETURN AVAILABLE TO SHAREHOLDERS reflects the earning capacity of the firms assets REQUIRED RATE OF RETURN TO SHAREHOLDERS the minimum return demanded by shareholders given the investment risk reflects trade- off between risk and return
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Firm’s Cash Flows Firm’s Cash Flows REVENUE Fixed operating costs Fixed operating costs Variable operating costs Variable operating costs Interest Interest NET INCOME [NI] less less equals equals NET OPERATING INCOME NET OPERATING INCOME [NOI] [NOI] less less equals equals
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Example Assume that there are 3 identical firms, a , b and c. Identical in all respects apart from the way in which the firm is financed. We are initially neglecting the effects of corporate taxation In each case the firm has total assets of $400,000 and but the mix of debt and equity used to finance these assets differ We assume that the return that the firm can earn on its assets in each case is the case, 15% Therefore Net operating Income of all 3 firms is the same at $60,000 The firms that use debt pay 10% interest
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(a) All equity $ (b) 50% debt 50% equity (c) 75% debt 25 % equity Equity 400,000 200,000 100,000 Debt 200,000 300,000 Total Assets 400,000 400,000 400,000 Debt/Equity ratio 0 1:1 3:1 Net operating Income 60,000 60,000 60,000 Interest (at 10%) 20,000 30,000 Net Income 60,000 40,000 30,000 Return on Assets 15% 15% 15% Available Return on Equity 15% 20% 30%
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The previous analysis can be captured in algebraic form Let = return available to equity holders = return provided by the firms assets ae r af r ( 29 E D r E D r r d af ae - + = ( 29 E D r r r r d af af ae - + = = ae r Net cash flow - interest from firms assets payments equity investments =
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What happens to the available return to equity holders as result of the return earned on the firms assets decreasing? Initially the return on the firms assets of $400,000 was 15% giving a NOI of $60,000. We now assume the return on assets falls to 9% giving a NOI of $36,000 It will be shown that the greater is the D/E ratio the greater the drop in the available rate of return to equity holders
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(a) All equity $ (b) 50% debt 50% equity (c) 75% debt 25 % equity Equity 400,000 200,000 100,000 Debt 200,000 300,000 Total Assets 400,000 400,000 400,000 Debt/Equity ratio 0 1:1 3:1 Net operating Income 36,000 36,000 36,000 Interest (at 10%) 20,000 30,000 Net Income 36,000 16,000 6,000 Return on Assets 9% 9% 9% Available Return on Equity 9% 8% 6% Change in available return on equity -40% -60% -80%
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Financing package Different levels of NOI ($000) 0 20 40 60 80 (a) All equity 0% 5% 10% 15% 20% (b) 50% debt, 50% equity -10% 0% 10% 20% 30% (c) 75% debt, 25% equity -30% -10% 10% 30% 50% The below table shows the greater the debt to equity ratio the greater the change in the available return to equity holders as a result of a change in the level of Net Operating Income (NOI)
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Effects Of Financial Leverage
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