321Class14-Leverage%2c%20Beta%2c%20%26%20WACC

321Class14-Leverage%2c%20Beta%2c%20%26%20WACC - 49.35...

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Leverage, Beta, & WACC
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Debt Policy Firm capital structure does not matter Law of Conservation of Value
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ROA ROE ROE is positively related to leverage
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Cost of Equity 1. DDM 2. CAPM 3. MM Prop II
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The “Lever”
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MM Proposition II MM Proposition II with Debt
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Beta Levered & Unlevered
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When Things Go Wrong Financial Distress V F = V E + PV( tax shield ) – PV ( cost of financial distress ) Bankruptcy
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Who borrows? Trade-off Theory Balance of benefits and costs of financial distress Firms with liquid assets borrow more Firms with higher cash flows borrow less Pecking Order Theory Asymmetric information No well defined target debt/equity ratio
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The Unlevered Firm Industry D/MV HIGH LEVERAGE Air transport 59.67 57.78 Paper mills 53.61 RE operators / lessors
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Unformatted text preview: 49.35 Building construction 40.39 LOW LEVERAGE Electronics 7.09 Drugs 5.81 Biological products 4.44 Computers 3.77 Software 2.27 Opportunity Cost of Capital -+ + + = ) 1 ( * * c d e T r E D D r E D E WACC WACC Unlevered β • Using debt/equity mix Unlevered β • But Corporation MUST pay tax Unlevered β Rebalancing WACC • Risk changes with D/E ratio • Three step process to rebalance beta 1. Calculate the Opportunity Cost of Capital: Rebalancing WACC 2. Calculate K d & K e at NEW debt ratio: – Estimate new K d Rebalancing WACC 3. Recalculate WACC at the NEW weights: Rebalanced Beta • Asset Beta changes— • Equity Beta also changes:...
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321Class14-Leverage%2c%20Beta%2c%20%26%20WACC - 49.35...

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