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Lecture_18_student - Lecture 18 Capital Structure Decision...

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Lecture 18: Capital Structure Decision: I BD Chapter 15
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Topics Preview of effects of debt Business risk versus Financial risk Capital Structure Theories MM Theory Tradeoff Theory Pecking Order Theory
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How to choose capital structure In early 2006, Tyco International, Ltd., was planning to break up into three separate companies: electronics, health care, and fire and security services. Tyco’s shareholders will receive shares of the three new companies. But Tyco had $12.5 billion total debt to allocate. How should Tyco split debt among the three new companies? How should a company choose a capital structure for itself, or in Tyco’s case, for its offspring? How does capital structure affect firm value and shareholders value?
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Review: 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 – w ce and w d are percentages of the firm that are financed with stock and debt. The impact of capital structure on value depends upon the effect of debt on WACC and FCF
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Preview: Effects of Debt on WACC Additional debt increases cost of equity Debtholders have a prior claim on cash flows relative to stockholders. Debtholders’ “fixed” claim increases risk of stockholders’ “residual” claim. Cost of stock, rs, goes up. Additional debt reduces taxes a company pays Interest payment is tax deductible. Reduces after-tax cost of capital
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Preview: Effects of Debt on WACC Additional debt increases risk of bankruptcy Causes pre-tax cost of debt, r d , to increase Adding debt increases percent of firm financed with low-cost debt (w d ) and decreases percent financed with high-cost equity (w ce ) Net effect on WACC = uncertain.
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Preview: Effects of 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 Impact of indirect costs NOPAT goes down due to lost customers and drop in productivity Require more net operating working capital (e.g., accounts payable goes down as suppliers tighten credit), leading to lower efficiency.
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