Fm10e ch16

Chapter 16 -Chapter 16 - Planning the Firm’s Planning the Firm’s Financing MixFinancing Mix

2005, Pearson Prentice Hall

Balance SheetBalance Sheet

Current Current Current Current

Assets LiabilitiesAssets Liabilities

Debt and Debt and

Fixed PreferredFixed Preferred

AssetsAssets

Shareholders’Shareholders’

EquityEquity




Debt and Debt and


AssetsAssets


EquityEquity


Current Current CurrentCurrent

AssetsAssets LiabilitiesLiabilities

Debt andDebt and

FixedFixed PreferredPreferred

AssetsAssets


EquityEquity

FinancialStructure




Debt and Debt and


AssetsAssets


EquityEquity




DebtDebt andand

Fixed Fixed PreferredPreferred

AssetsAssets


EquityEquity

CapitalStructure

Why is Capital Structure Important?Why is Capital Structure Important?

1) 1) LeverageLeverage: Higher financial leverage : Higher financial leverage means higher returns to stockholders, means higher returns to stockholders, but higher risk due to fixed payments.but higher risk due to fixed payments.

2) 2) Cost of CapitalCost of Capital: Each source of : Each source of financing has a different cost. Capital financing has a different cost. Capital structure affects the cost of capital.structure affects the cost of capital.

TheThe Optimal Capital StructureOptimal Capital Structure is the is the one that minimizes the firm’s cost of one that minimizes the firm’s cost of capital and maximizes firm value.capital and maximizes firm value.

What is the Optimal Capital What is the Optimal Capital Structure?Structure?

In a “perfect world” environment with In a “perfect world” environment with no taxes, no transaction costs and no taxes, no transaction costs and perfectly efficient financial markets, perfectly efficient financial markets, capital structure does not matter.capital structure does not matter.

This is known as the This is known as the Independence Independence hypothesishypothesis: : firm value is independent of firm value is independent of capital structurecapital structure..

Independence HypothesisIndependence Hypothesis

Firm value does not depend on Firm value does not depend on capital structure.capital structure.

Capital Structure: 100% equity, no debtCapital Structure: 100% equity, no debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 2 millionShares outstanding: 2 million Operating income (EBIT): $2,000,000Operating income (EBIT): $2,000,000 Calculate EPS:Calculate EPS:

With no interest payments and no taxes, With no interest payments and no taxes,

EBIT = net income.EBIT = net income.

$2,000,000/2,000,000 shares = $1.00$2,000,000/2,000,000 shares = $1.00

Independence Hypothesis:Independence Hypothesis:Rix Camper Manufacturing CompanyRix Camper Manufacturing Company

Capital Structure: 100% equity, no debtCapital Structure: 100% equity, no debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 2 millionShares outstanding: 2 million Operating income (EBIT): $2,000,000Operating income (EBIT): $2,000,000


Capital Structure: 100% equity, no debtCapital Structure: 100% equity, no debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 2 millionShares outstanding: 2 million Operating income (EBIT): $2,000,000Operating income (EBIT): $2,000,000 Calculate the Cost of Capital:Calculate the Cost of Capital:




k = + g =D1

P



k = + g = + 0 =D1 1.00 P 10.00



k = + g = + 0 = 10%D1 1.00 P 10.00

$20 million capitalization$20 million capitalization $8 million in debt issued to retire $8 million in $8 million in debt issued to retire $8 million in

equity.equity. EquityEquity = $12m / $20m = = $12m / $20m = 60%60% Debt Debt = $8m / $20m = = $8m / $20m = 40%40% Capital Structure: 60% equity, 40% debtCapital Structure: 60% equity, 40% debt Shares outstanding: $12 million / $10 = Shares outstanding: $12 million / $10 =

1,200,000 shares1,200,000 shares.. Interest = $8m x .06 = Interest = $8m x .06 = $480,000$480,000


Capital Structure: 60% equity, 40% debtCapital Structure: 60% equity, 40% debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 1.2 millionShares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000Net income: $2,000,000 - $480,000 = $1,520,000 Calculate EPS:Calculate EPS:

$1,520,000/1,200,000 shares = $1.267$1,520,000/1,200,000 shares = $1.267


Capital Structure: 60% equity, 40% debtCapital Structure: 60% equity, 40% debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 1.2 millionShares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000Net income: $2,000,000 - $480,000 = $1,520,000


Capital Structure: 60% equity, 40% debtCapital Structure: 60% equity, 40% debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 1.2 millionShares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000Net income: $2,000,000 - $480,000 = $1,520,000 Calculate the Cost of Equity:Calculate the Cost of Equity:




k = + g =D1 P



k = + g = + 0 = D1 1.267 P 10.00



k = + g = + 0 = 12.67%D1 1.267 P 10.00

Capital Structure: 60% equity, 40% debtCapital Structure: 60% equity, 40% debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 1.2 millionShares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000Net income: $2,000,000 - $480,000 = $1,520,000


Capital Structure: 60% equity, 40% debtCapital Structure: 60% equity, 40% debt Stock price: $10 per shareStock price: $10 per share Shares outstanding: 1.2 millionShares outstanding: 1.2 million Net income: $2,000,000 - $480,000 = $1,520,000Net income: $2,000,000 - $480,000 = $1,520,000 Calculate the Cost of Capital:Calculate the Cost of Capital:



.6 (12.67%).6 (12.67%)



.6 (12.67%) +.6 (12.67%) +



.6 (12.67%) + .4 (6%) =.6 (12.67%) + .4 (6%) =



.6 (12.67%) + .4 (6%) = 10%.6 (12.67%) + .4 (6%) = 10%


Cost ofCapital

kc

0% debt Financial Leverage 100% debt

.

kc = cost of equitykd = cost of debtko = cost of capital


.


Cost ofCapital

kc

kd kd


.


Cost ofCapital

kc

kd kd


Increasing leverage causesthe cost of equityto rise.


Cost ofCapital

kc

kd kd



Cost ofCapital

kc

kd

kc

kd




Cost ofCapital

kc

kd

kc

kd


What will be the net effect

on the overall cost of capital?



Cost ofCapital

kc

kd

kc

kd


What will be the net effect

on the overall cost of capital?


kc

kd


Cost ofCapital

kc

ko

kd


If we have perfect capital markets, If we have perfect capital markets, capital structure is capital structure is irrelevantirrelevant. .

In other words, changes in capital In other words, changes in capital structure do not affect structure do not affect firm valuefirm value..


Dependence HypothesisDependence Hypothesis

Increasing leverage does not increase Increasing leverage does not increase the cost of equity.the cost of equity.

Since debt is less expensive than equity, Since debt is less expensive than equity, more debt financing would provide a more debt financing would provide a lower cost of capital. lower cost of capital.

A lower cost of capital would increase A lower cost of capital would increase firm value.firm value.

Dependence HypothesisDependence Hypothesis

Cost ofCapital

kc

kd

Financial Leverage

kc

kd

Since the cost of debt is lowerthan the cost of equity...

Dependence HypothesisDependence HypothesisSince the cost of debt is lowerthan the cost of equity…increasing leverage reduces thecost of capital.

Cost ofCapital

kc

kd

Financial Leverage

kc

kdko

Moderate PositionModerate Position

The previous hypothesis examines The previous hypothesis examines capital structure in a “perfect capital structure in a “perfect market.”market.”

The moderate position examines The moderate position examines capital structure under more capital structure under more realistic conditions.realistic conditions.

For example, what happens if we For example, what happens if we include include corporate taxescorporate taxes??

unleveredunlevered leveredlevered

EBITEBIT 2,000,0002,000,000 2,000,000 2,000,000

- interest expense- interest expense 0 0 (480,000)(480,000)

EBTEBT 2,000,0002,000,000 1,520,000 1,520,000

- taxes (50%)- taxes (50%) (1,000,000)(1,000,000) (760,000)(760,000)

Earnings availableEarnings available

to stockholdersto stockholders 1,000,000 1,000,000 760,000 760,000

Payments to allPayments to all

securityholderssecurityholders 1,000,000 1,240,000 1,000,000 1,240,000

Rix Camper example:Rix Camper example:Tax effects of financing with debtTax effects of financing with debt


Cost ofCapital

kc

kd

Financial Leverage

kc

kd


Cost ofCapital

kc

kd

Financial Leverage

kc

kd

Even if the cost of equity risesas leverage increases, the cost of debt is very low...


Cost ofCapital

kc

kd

Financial Leverage

kc

kd

becauseof the tax benefit

associated with debt financing.

Even if the cost of equity risesas leverage increases, the cost of debt is very low...


Cost ofCapital

kc

kd

Financial Leverage

kc

kd

The low cost of debt reduces the cost of capital.


Cost ofCapital

kc

kd

Financial Leverage

kc

kd

The low cost of debt reduces the cost of capital.

ko


So, what does the tax benefit of debt So, what does the tax benefit of debt financing mean for the value of the firm?financing mean for the value of the firm?

The more debt financing used, the greater The more debt financing used, the greater the the tax benefittax benefit, and the greater the , and the greater the value of value of the firmthe firm..

So, this would mean that all firms should be So, this would mean that all firms should be financed with financed with 100% debt100% debt, right?, right?

Why are firms Why are firms notnot financed with 100% debt? financed with 100% debt?

Why is 100% Debt Not Optimal?Why is 100% Debt Not Optimal?

Bankruptcy costsBankruptcy costs: costs of financial : costs of financial distress.distress.

FinancingFinancing becomes difficult to get. becomes difficult to get. Customers leave due to uncertainty.Customers leave due to uncertainty. Possible restructuring or Possible restructuring or

liquidationliquidation costs if bankruptcy costs if bankruptcy occurs.occurs.

Agency costsAgency costs: costs associated with protecting : costs associated with protecting bondholders.bondholders.

BondholdersBondholders (principals) lend money to the (principals) lend money to the firm and expect it to be invested wisely.firm and expect it to be invested wisely.

StockholdersStockholders own the firm and elect the own the firm and elect the board and hire managers (agents).board and hire managers (agents).

Bond covenantsBond covenants require managers to be require managers to be monitored. The monitoring expense is an monitored. The monitoring expense is an agency costagency cost, which increases as debt , which increases as debt increases.increases.

Why is 100% Debt Not Optimal?Why is 100% Debt Not Optimal?

Moderate PositionModerate Positionwith Bankruptcy and Agency Costswith Bankruptcy and Agency Costs

Cost ofCapital

Financial Leverage

kc

kd

Cost ofCapital

Financial Leverage

kc

kdkd


Cost ofCapital

Financial Leverage

kc

kd

kd


Cost ofCapital

Financial Leverage

kc

kd

kc

kd


Cost ofCapital

Financial Leverage

kc

kd

kc

kd


Cost ofCapital

Financial Leverage

kc

kd

kc

kd

If a firm borrows too much, thecosts of debt and equity will spike upward, due to bankruptcy costsand agency costs.


Cost ofCapital

Financial Leverage

kc

kd

kc

kd


Cost ofCapital

Financial Leverage

kc

kd

kc

kdko


Cost ofCapital

Financial Leverage

kc

kd

kc

kd

ko


Cost ofCapital

Financial Leverage

kc

kd

kc

kd

ko

Ideally, a firm should use leverageto obtain their optimum capital structure, which will minimize thefirm’s cost of capital.


Cost ofCapital

Financial Leverage

kc

kd

kc

kd

ko


Capital Structure ManagementCapital Structure Management

EBIT-EPS AnalysisEBIT-EPS Analysis - Used to help - Used to help determine whether it would be better determine whether it would be better to finance a project with debt or to finance a project with debt or equity.equity.


EBIT-EPS AnalysisEBIT-EPS Analysis - Used to help - Used to help determine whether it would be better determine whether it would be better to finance a project with debt or to finance a project with debt or equity.equity.

EPS = (EBIT - I)(1 - t) - P S


EBIT-EPS AnalysisEBIT-EPS Analysis - Used to help determine - Used to help determine whether it would be better to finance a whether it would be better to finance a project with debt or equity.project with debt or equity.

EPS = (EBIT - I)(1 - t) - P S

I = interest expense, P = preferred dividends,S = number of shares of common stock outstanding.

EBIT-EPS ExampleEBIT-EPS Example

Our firm has Our firm has 800,000800,000 shares of common stock shares of common stock outstanding, no debt, and a marginal tax rate outstanding, no debt, and a marginal tax rate of of 40%.40%. We need We need $6,000,000$6,000,000 to finance a to finance a proposed project. We are considering two proposed project. We are considering two options:options:

Sell Sell 200,000200,000 shares of common stock at shares of common stock at $30$30

per share,per share, Borrow Borrow $6,000,000$6,000,000 by issuing by issuing 10%10% bonds. bonds.

If we expect EBIT to be $2,000,000:If we expect EBIT to be $2,000,000:

Financing Financing stock stock debt debt EBITEBIT 2,000,0002,000,000 2,000,0002,000,000- interest- interest 0 0 (600,000)(600,000)EBTEBT 2,000,0002,000,000 1,400,0001,400,000- taxes (40%)- taxes (40%) (800,000) (800,000) (560,000)(560,000)EATEAT 1,200,0001,200,000 840,000 840,000# shares outst.# shares outst. 1,000,0001,000,000 800,000 800,000EPSEPS $1.20 $1.20 $1.05 $1.05

Financing Financing stock stock debt debt EBITEBIT 4,000,0004,000,000 4,000,0004,000,000- interest- interest 0 0 (600,000)(600,000)EBTEBT 4,000,0004,000,000 3,400,0003,400,000- taxes (40%)- taxes (40%) (1,600,000)(1,600,000)

(1,360,000)(1,360,000)EATEAT 2,400,0002,400,000 2,040,000 2,040,000# shares outst.# shares outst. 1,000,0001,000,000 800,000 800,000EPSEPS $2.40 $2.40 $2.55 $2.55

If we expect EBIT to be $4,000,000:If we expect EBIT to be $4,000,000:

If EBIT is $2,000,000, If EBIT is $2,000,000, commoncommon stockstock financing is best. financing is best.

If EBIT is $4,000,000, If EBIT is $4,000,000, debtdebt financing is best.financing is best.

So, now we need to find a So, now we need to find a breakevenbreakeven EBITEBIT where neither is where neither is better than the other.better than the other.

If we choose stock financing:If we choose stock financing:EPS

EBIT$1m $2m $3m $4m

stock financing

0

3

2

1

If we choose If we choose bond financing:bond financing:

EPS

EBIT$1m $2m $3m $4m

bond financing

0

3

2

1

Breakeven EBITBreakeven EBIT

EPS

EBIT$1m $2m $3m $4m

bond financing

stock financing

0

3

2

1

Breakeven PointBreakeven Point

Set two EPS calculations equal to each Set two EPS calculations equal to each other and solve for EBIT:other and solve for EBIT:

Stock Financing Debt FinancingStock Financing Debt Financing

(EBIT-I)(1-t) - P(EBIT-I)(1-t) - P = = (EBIT-I)(1-t) - P(EBIT-I)(1-t) - P

S SS S


Stock Financing Debt FinancingStock Financing Debt Financing

(EBIT-I)(1-t) - P(EBIT-I)(1-t) - P = = (EBIT-I)(1-t) - P(EBIT-I)(1-t) - P

S SS S

(EBIT-0) (1-.40) (EBIT-0) (1-.40) = = (EBIT-600,000)(1-.40)(EBIT-600,000)(1-.40)

800,000+200,000 800,000800,000+200,000 800,000


Stock Financing Debt Financing Stock Financing Debt Financing

.6 EBIT.6 EBIT = = .6 EBIT - 360,000.6 EBIT - 360,000

1 .81 .8

.48 EBIT = .6 EBIT - 360,000.48 EBIT = .6 EBIT - 360,000

.12 EBIT = 360,000.12 EBIT = 360,000

EBIT = $3,000,000EBIT = $3,000,000


EPS

EBIT$1m $2m $3m $4m

bond financing

stock financing

0

3

2

1

For EBIT up to $3 million,stock financing is best.


EPS

EBIT$1m $2m $3m $4m

bond financing

stock financing

0

3

2

1

For EBIT up to $3 million,stock financing is best.

For EBIT greaterthan $3 million, debt financing

is best.

In-class ProblemIn-class Problem

Plan A:Plan A: Sell 1,200,000 shares at $10 Sell 1,200,000 shares at $10 per share per share ($12 million total).($12 million total).

Plan B:Plan B: Issue $3.5 million in 9% debt Issue $3.5 million in 9% debt and sell 850,000 shares at $10 per and sell 850,000 shares at $10 per share share ($12 million total).($12 million total).

Assume a marginal tax rate of 50%.Assume a marginal tax rate of 50%.


Stock Financing Levered FinancingStock Financing Levered Financing

(EBIT-I) (1-t) - P(EBIT-I) (1-t) - P = = (EBIT-I) (1-t) - P(EBIT-I) (1-t) - P

S SS S

EBIT-0 (1-.50) EBIT-0 (1-.50) = = (EBIT-315,000)(1-.50)(EBIT-315,000)(1-.50)

1,200,000 850,0001,200,000 850,000

EBIT = $1,080,000EBIT = $1,080,000

Analytical Income StatementAnalytical Income Statement

Stock Stock LeveredLevered

EBITEBIT 1,080,0001,080,000 1,080,0001,080,000

II 0 0 (315,000)(315,000)

EBTEBT 1,080,0001,080,000 765,000 765,000

TaxTax (540,000) (540,000) (382,500)(382,500)

NINI 540,000540,000 382,500 382,500

SharesShares 1,200,0001,200,000 850,000 850,000

EPSEPS .45.45 .45.45

levered financing

stock financing

EPS

EBIT$.5m $1m $1.5m $2m

0

.65

.45

.25


For EBIT up to $1.08 m,

stock financing is

best.

levered financing

stock financing

EPS

EBIT$.5m $1m $1.5m $2m

0

.65

.45

.25


Breakeven EBITBreakeven EBITFor EBIT up to $1.08 m,

stock financing is

best. For EBIT greaterthan $1.08 m,

the levered planis best.

levered financing

stock financing

EPS

EBIT$.5m $1m $1.5m $2m

0

.65

.45

.25

In-class ProblemIn-class Problem

Plan A:Plan A: Sell 1,200,000 shares at $20 Sell 1,200,000 shares at $20 per share per share ($24 million total).($24 million total).

Plan B:Plan B: Issue $9.6 million in 9% debt Issue $9.6 million in 9% debt and sell shares at $20 per share and sell shares at $20 per share ($24 million total).($24 million total).

Assume a 35% marginal tax rate.Assume a 35% marginal tax rate.


Stock Financing Levered FinancingStock Financing Levered Financing

(EBIT-I) (1-t) - P(EBIT-I) (1-t) - P = = (EBIT-I) (1-t) - P(EBIT-I) (1-t) - P

S SS S

(EBIT-0) (1-.35) (EBIT-0) (1-.35) = = (EBIT-864,000)(1-.35)(EBIT-864,000)(1-.35)

1,200,000 720,0001,200,000 720,000

EBIT = $2,160,000EBIT = $2,160,000

Analytical Income StatementAnalytical Income Statement

Stock Stock Levered Levered

EBITEBIT 2,160,0002,160,000 2,160,0002,160,000

II 0 0 (864,000)(864,000)

EBTEBT 2,160,0002,160,000 1,296,0001,296,000

TaxTax (756,000) (756,000) (453,600)(453,600)

NINI 1,404,0001,404,000 842,400 842,400

SharesShares 1,200,0001,200,000 720,000 720,000

EPSEPS 1.171.17 1.17 1.17

Breakeven EBITBreakeven EBITlevered

financingstock

financingEPS

EBIT$1m $2m $3m $4m

0

1.5

1.17

.5


financingstock

financingEPS

EBIT$1m $2m $3m $4m

0

1.5

1.17

.5


stock financing is

best.


financingstock

financingEPS

EBIT$1m $2m $3m $4m

0

1.5

1.17

.5

For EBIT greaterthan $2.16 m,

the levered planis best.


stock financing

is best.

Fm10e ch16

Economy & Finance

cost of capital

capital structure important

debt shares outstanding

optimal capital structureis

debt stock price

share shares outstanding

operating income ebit

theindependence hypothesis