Cf Financing 7

To guess is cheap. To guess wrong is expensive.

In 2000, Philip Morris generated in cash $11billion. It paid 4.5b as dividends, repurchased shares for 3.6b & 2.9b was reinvested in business. The company borrowed 10.9b and raised 100m thru equity.

Financing

• Independence of Financing & Investment decisions

• Reversible

• NPVs of Financing

• Vast variety of Financing Instruments

• Dividend / Debt vs Equity

• Should the firm retain most of its earnings in the business, or should it pay them out as dividends?

• If the firm needs more money, should it issue more stock or should it borrow?

• Should it borrow short-term or long-term?

• Should it borrow by issuing a normal long-term bond or a convertible bond.

Capital Structure

• Debt equity mix

• Fixed & residual claims

• Impact on value/ cost of capital

Efficient Markets

• Stock prices fully reflect available information• Future price changes are random

Implications• Investors can expect only normal returns• Firms receive fair value for securities that they

sellValue addition from financing activity? Positive NPV financing options?

Cost of Capital

• Hurdle rate for projects

• Valuation of companies

• Finding economic value added

Weighted Average Cost of Capital

• Funding thru debt and equity

• WACC is a weighted average cost of debt and equity

• Weights for debt and equity are targetted capital structure, in terms of market values

• The component cost of capital are investor-required rates of return.

Weighted Average Cost of Capital

• Coc = rD (1-t)(D/ (D+E)) + rE ( E/ (D+E))

• rD = Cost of Debt• rE = Cost of Equity• rA = Operating Income/ Market Value of

the Firm• Market value of the firm = value of debt +

value of equity

Our cost of capital is calculated using the approximate market value weightings of debt and equity used to finance the company. The cost of debt is simply our after-tax, long-term debt rate, which is around 5.7%. The cost of equity is approximately 11.4%.

- The Quaker Oats Company, 1992 Annual Report.

WACC numerical

• Cost of debt = 8%

• Cost of equity = 14.6%

• Corporate tax =35%

• Debt ratio = 0.4

• Equity ratio = 0.6

Weighted Average Cost of Capital

• WACC = .08 (1-.35)*0.4 + .146* 0.6

= 10.84%

Miller Modigilliani Hypothesis

• Signals the start of modern finance

• A formal theory of capital structure

• Nobel laureates

Principles

• Comparison of levered & unlevered firm.

• Law of conservation of value. Value additivity.

• The value of a pie is independent of how it is sliced.

• Value created on the right hand side of BS.

Proposition

The value of a firm equals its expected operating income divided by the discount rate applicable to its risk class. The value is independent of its capital structure.

Implications of Debt Irrelevence

• Value of the firm unaffected by changes in leverage.

• Independence of the investment decision from the financing decision

Impact of Debt

• Tax benefits

• Added discipline

• Bankruptcy cost

• Agency cost

• Loss of flexibility

• Marketing conditions

• Dilution of control

Patterns of Financing

• Internally generated cashflow predominant source of financing. (Typically 70 to 90%)

• Financial deficit covered by borrowing and equity. Net new equity insignificant. Even negetive

Empirical Capital structure

• Most corporations have low debt equity ratios

• Many firms use no debt

• There are differences in the capital structure of different industries

• Most corporations employ target debt equity ratios

Capital Structure Determinants

• Taxes

• Types of assets

• Uncertainty of operating income

Concept

• Component cost of capital are investor required rates of return.

• Current cost of debt and equity

• Target Capital Structure determine weights for WACC

• Capital Components are funds that come from investors