09Capital+Structure

09Capital+Structure - CapitalStructure...

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Capital Structure
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Summary: Capital Structure Choice
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Optimal Capital Structure (Textbook view) Start with MM Irrelevance Add 2 ingredients that change the size of the pie: Taxes Expected Distress Costs Trading off between the two gives the “static  optimum” capital structure.
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Practical Implications Companies with “low” expected distress costs  should load up on debt to get the tax benefits. Companies with “high” expected distress costs  should be more conservative. 
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Expected Distress Costs Expected Distress costs         = (probability of distress) * (distress  costs) Probability of distress Operating leverage Volatility of cash flows Distress costs  Need external funds to invest in CAPX or market  share Financially strong competitors Customers or suppliers care about your financial  position Assets cannot be easily redeployed.
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Target Capital Structure Check List Taxes Does the company benefit from the debt tax  shield? (i.e. Are they profitable? Do they have  income to offset?) Expected Distress Costs Cash flow volatility Need for external funds for investment Competitive threat if pinched for cash Customers care about distress Hard to redeploy assets
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Recapitalization - Example Here is the sequence of events: Campus Deli announces the recapitalization. New debt is issued. Proceeds are used to repurchase stock. The number of shares repurchased is equal to the  amount of debt issued divided by price per share. Campus Deli has $2,000,000 in total assets and  an unlevered beta of 1.0.  The risk-free rate is 6%, as is the market risk  premium. Campus Deli has a marginal tax rate of 40%. EBIT is $400,000 and they have 80,000 shares  outstanding. Determine the EPS, TIE, and stock price for  various levels of debt in order to determine the  optimal capital structure.
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 Amount       D/V             D/E         Bond borrowed     ratio            ratio        rating      k d $      0    0     0           --     --     250,000 0.125 0.1429       AA    8.0%     500,000 0.2500.3333        A    9.0%     750,000 0.375 0.6000     BBB  11.5%  1,000,000 0.5001.0000       BB  14.0% Cost of debt after the proposed recapitalization Recapitalization - Example
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Recapitalization - Cost of Debt Why do the bond rating and cost of debt depend  upon the amount borrowed?
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09Capital+Structure - CapitalStructure...

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