adv. fine. man. capital structure

adv. fine. man. capital structure - 9‘ WWW L Wdeaqw...

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Unformatted text preview: 9‘ WWW L Wdeaqw W ((33114 H: *W‘flfl's Ciigfifiéf 1 WW) U‘Ff Uri C173) Vertical Submmaniam, Lecture Notes .T : , C Chapter 16 - Capital Structure \J U : \l‘,’ (n o ) ( 6 610+} 0 Elk) *— 13> O B :- 0 Financial Product Markets <0wa “Ad @0" -ondholders . -h 11 1d Chapter 16 — Page I Venkat Subramaniam, Lecture Notes Chapter 16 - Capital Structure MM Proposition I {No Taxes 1: The value of a levered firm is equal to the value of an unlevered firm. VL = VU- i.e., Financing Choices do not add value. . Unlevered Firm vs. a Levered Finn with the same assets. Trans Am Corporation. Same assets -- financed without and with debt. Debt issue of $4,000,000 to buy back equity. Alternatively, you may View them as two companies that differ only in their capital structure. \fu, Vt Current Proposed Assets $8,000,000 8,000,000 Debt 0 4,000,000 "I 9; Equity 8,000,000 4,000,000-1- 3 Shares Outstanding 400,000 200,000 Share price $20 $20 : 8': mil Vt, Trans Am Corporation - without debt b O 8 D at g s 400.00 Recession Expected Boom TC 1 0 1‘1 Earnings: 400,000 1,200,000 2,000,000 “‘2 EB Interest: 0 0 0 Earnings after interest: 400,000 1,200,000 2,000,000 \ Return on N '8 WEED .2; % equity (ROE): 5% 5900' 15% 25% t3; , 0 DO, (DOC) EPS: $1.00 $9033 $3.00 {330,000 $5.00 1'08wa (4 00,003 m 400, DOD “$5 // 25!. : ' . EP3 ‘15 e Chapter 16 — Page 2 . 3‘ t .m‘x Q): Lim ngiol 82%.”) car‘s: 100,00 Venice: S ubramamam Lecture Notes tom? 004,5 Avodbooim DODGVWS (Ltmwo/Q Trans Am Corporation- with debt Recession Ex ected Boom Earnings: 400,000 1,200,000 2,000,000 Interest: 400,000 400,000 400,000 Earnings after interest: 0 0 800,000 1,600,000 ,fi 9 00!”— I. (a m _ ’91,: Return on (7 ngm f] 4, m 7“ ._.——-r— S equity (ROE): 0% 20% 40% Li m i O ”3%; EPS: firm $400 $8 00 L... L" /2023 ”fir-i9 . . ‘ 4; ()on v 10.]. {193 .. sq n6 ‘3 Observation: V“ 92 0']. $5 93‘? /5 T The EPS and ROE of a firm with Debt is more variable (Riskier) than the EPS and ROE of firm Ewithout Debt. , ‘ < 5 L .. FCF EFCFE, Q5? Si, . Q. 0: 09/ ,5 ifiF—i‘fl‘I (”as me In Ufa: es, (‘9‘- g _. 2 Ham 6 dare as 05) 00 56‘9“ , £0( 5.: FCFE. FCFE i P t / Q00“ “(N935 1?, (0T):- (n.0,) —RLW /\ 011310 65 5 1’18 SK- Therisk of equity, increases with debt RS=B+ BIS (R0 d/RB) asses; , .014" e Return on Equity (ROE) of a corporation is proportional to the risk of e ui Hence, a } “dd/1.5m £3 levered firm’ s ROE will be higher than that of an unlevered firm HS 1410' buMMESCS “E. \M {‘6 im V‘tfiz {CL 53 3‘6 Véiiwirij If both Debt and Equity are used, then the cost of capital for the entire firm is a weighted average of the cost of debt and cost of equity. is - WACC = (% of debt)(cost of debt capital) + (% of equity)(c0st of equity capital) QDVS “:— \/ WACC: —B/(B+\’PRB +S/(B+S) *RSL’ A firm’s total risk is unaltered by its financing choice. i.e., WACC does not change with debt. E as compacnus and on (RUDE; WWW \ 5 REV/WM Chapter 16 — Page 3 Venkat Subramaniam, Lecture Notes Two Main Lessons {No Taxes! Prop. I. In a world without taxes, the Value of a Levered Firm is the same as that of an UnLevered firm. Firm Value is affected only by the firm’s product market Operations. VU = VL Also, the WACC of the firm remains unchanged with leverage, i.e., WACC = R0. PropJI. The ROE of a Levered firm is higher than that of an Unlevered firm, because the financial risk is higher for a levered firm. RS = R0 + (R0 - RB)(B/S) MM propositions in a World with Taxes 0 Interest on Debt is Tax Deductible - The cash flows from the IRS are safe cash flows, so, the firm is now safer than before. - (Interest * Tc) is the interest tax shield each year, indefinitely. - PV (Tax Savings) = (EB/’1‘ B * Tc) B = B * '1‘C ° Value of Levered Firm (V L) 2 Value of UnLevered firm (VU) + Int. Tax Shields (B*Tc) . MM: VL = VU + B*TC After-tax cost of Debt Capital Recall that interest on debt is tax deductible. So on each dollar of debt if a firm pays an interest of 10¢ then it may deduct this for tax purposes. So, its tax bill will be lOTc ¢ less than before. Hence the “real” cost of debt is (10 — IOTC). - After tax cost of debt = REG—TC) Chapter 16 — Page 4 A'fwa‘ «at my [gr-W . . 1‘ v $qu (TENW' Venkar Szibrarhaniam, lecture Notes - The ROE of a Levered firm is higher than that of an Unlevered firm, because the financial risk is higher for a levered firm. But this increase is not as high as in the no taxes case, because increased tax shields make equity safer. R5113) + (RD-RB) (BIS) (1 -Tc) , 4’ ,. - (mfg-5 Home. cham‘w 993:5; ms 11 - WACC m (% of debt)(After tax cost of debt) + (% of equitchost of equity) WACC = RS(S/(B+S))+RB(B/(B+S))(1—TC) Two Main Lessons QWith Taxes) fl Prop. 1. In a world with taxes, the Value of a Levered Firm is higher than that of an UnLevered firm, due to the debt tax shields. VL=VU+ (B*Tc) —% MMI - WACC a RS (S/(B+S))) + RB (B/(B+S)) (1 -Tc) Prop. II. R3: R0 + (RD—RB) (BIS) (1 Ire) MM 3: BL = [3U * [1 + 03/3) (1 -Tc)] Chapter 16 — Page 5 WACC ll Venkat Submmaniam, Lecture Notes NOTATION Value of a levered firm, i.e., a firm with debt. Value of an unlevered firm, i.e., a firm with no debt. Rate of return required by the shareholders. This return would compensate them for both business and financial risk faced by them. Rate of return required by the shareholders when they face only business risk (no financial risk). This is the rate of return required by shareholders of an unlevered firm. Rate of return required by bondholders. Weighted Average Cost of Capital. The average of the cost of debt and equity capital. Chapter 16 «— Page 6 ”Wax Venkat Subramaniam, Lecture Notes 14"” 5V \ ( In-Class Example Eb W A L W M s = - - mum (m \DCCOMSC «\3 41 " EBIT $4 H111. per year (perpetuuy) 'WWJC 15‘ (MAO? \50W§%\U° R0 = 15%, Tax rate = 34%, RB = 10%, B ‘= 1011111. \fl¢\ a) What is theFirmValue? ‘ ‘ O I. 7’ 3 . . . ,. .. _ dl'h-Y‘ Will—LE: VL = VU + (B*Tc) EWC- Eemf Hans“ ... ' 1‘ (muvow'xmom VU = EBITCI- c)/R{) 06%“) = 4 mil. (1 — 0.34)]0.15 CF _ . \Ifi [1-11.1.1] 7 3 -1715 1. if < CF; wflCC S HCL= " 4—. _ = 3.411111. W 25 F$+5 LFQBXO Rig—12% (B * Tc) = (10 mfl.)(0.34) VL = 17.6+3.4mil = 21 mil. 5:8 " WW ‘4 b) What is the company’s required rate of eturn on Equity? R5 = R0 + (R0- R3) (BIS) (1 -Tc) FirmValue = 2111111., B = 1011111., Hence, 5 = 1111111. me vume = 6 " 5 2", 1 [0" S R3 = 15+(15-10)(10111)(1—0.34) 5: u 7. = 18% 95 M I 42' t8 / c) What is the company’s WACC? 2.1 21 *0 OLLwni' _ ‘ (”Afis “(fl-W; \JL- QOSM‘W * 18 1/21)+10(10/21)(1-0.34) ‘0‘ “9““ :87. w M c. = 12511 W q - 305104-qu : 9.43 + 3.14 - 115': With taxes: WACC = RS (SN) + RB (BN) (1 -Tc) 13,1 mu 12.57% NM @1114 may, 1”: W (middlg 11% low, 0. . ' . + f.— . Mai-:1 31%.:33 {Cb‘vul‘ L91 D CWSC *0 [1,75 /. (ufiej +0“ bfiflfl) L 3/ Notczlnaworld with taxes WACC < R0. 15, 5“?“ ‘3 “WOW income $11“:ij we‘ve shame. (-vaxiedm Mail @ng aw" “AVG“W‘CUEJC me “‘3‘” Chapter16—Page7 _ . being \‘uxed 0h infamy. q - q (.54): 9.11M.“ \l 1 w‘ra 1; (MPH m 11 (F d w a (an L L 53 aux \va “CL :14th .5 1 WE“ Offlq choose. 0.15) 2 m V .1151 Venkat Subramaniam, Lecture Notes Supplemental Problem 7 ( Suppose the total firm value of a corporation is.. Also suppose that this firm has® of debt in its capital structure. Other relevant in o - ation is provided below. R0 = 15%, RB = 10%. TC = 35% Q KEVETEd. V = B *5 What is the company’s required rate of return on Equity? 5 ”— 5: ‘ + 5 f f f I V 2 Rs = R0 + (RD-RBMB/SXI- c) 5 “* FirmValue = 5mil., B =1mil., S = 4mi1. RS = 15 + (15 - 10)(1/4)(1-(l.I35) .8I59 COMPe/T‘SO‘hOn {or “newt/mm n‘suc Clow become 10‘; dem is LOW ‘fliflL- need lithe LDM‘G ens od-f On) 15.813% W What is the company’s WACC? J v '/ ‘/ . s _ Ll , 07. % WACC = RS(SN)+RB(BN)(1-Tc) V - g y g FEW”) , b _ \ , ZU‘A C1315" ( = (15.813)(4/5) + 10(1/5)(0.65) ”\7 5 S = 12.65+ 1.3 = 13.95% What would have been the value of this company if it did not use any debt? i.e. What is V ? = ’ U know @mvuzcfl 9’ 07‘ 4W . . L9 loo m3 repmx ed u.) om e%u\’\‘\j w Ps CC would Charge. 0 5'1-) But the Value of the firm when it is levered is given to be $5 mil. i.e., VL= $5 mil. ~ {086 4716i '7 +O‘X “(We ‘06ch — the, tow M Therefore VU [email protected] BarTc adv garage “’6 had VL = VU + B*TC - '3 => VU = 5mil. - 1mi1. (0.35) {rem W MW VU = $4.65 mil. (lost +0997"gmfxexo).__.-i_- or ”fly... ' W? up: 5 Ba Vb = L} B5 9: D (‘ \l ‘ $37“ Venkat Subramaniam, Lecture Notes - What would have been the required rate of return on equity, and the WACC of this company if it had used $2 million of debt? B=$2mi1. VL= VU + (B*Tc) =4.65mi1.+2mil.*0.35 =5.35mi1. 0a 5+1m1.(o.3,5)= 535m => 3:211:11. and S=3.35mil. 5.355136 5-35=2+S S=335 RS = R0 + (R0 - RB) (BIS) (l-Tc) RS = 15 + (15 - 10) (213.35) (1 - 0.35) 15+1.94 = 16.94% 7 V5313}. (when 5110+ was 19.35) 1:) mace, mme- We WWW WACC = RS (SN) + RB (EN) (1 -Tc) '03 ‘L = (3355.35) 16.94 4 (215.35) 10 (1 — 0.35) = 10.61 + 2.43 = 13.04% w Mn * (’WHQW‘M ECdflbt) WW6 1' 1% h d new \} b‘GW cm? X! Chapter 16 — Page 9 E E ' E E QB _ _1 WQWMMMMWQMM m_ g ”#0 “dog ' O {'bi \3/ ‘ \5/ 15/ E \0‘1. E“ E“ MWEW MM w“ meE kw 55 Mamas} rt (3‘ (ma ‘9 EJCCWSE ‘E0 'K umhumjed mismfi m0”? OE 4m LAM CH?“ cmof’rm W! C“ +0”); wvan‘rm Qéb >7 flaw) SW3 ommn *r? NO. ’3’ if? “‘0de MOVE; UM \WCANQQéQ ...
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