Slide 1

Planning the Financing Mix Capital Structure and Firm Value Capital Structure Theories

Independence Hypothesis Dependence Hypothesis Moderate Position

EBIT-EPS Analysis

Slide 2

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets Shareholders’ Equity

FinancialStructure

Financial Structure

Slide 3

Balance Sheet Current Current Assets Liabilities

Debt and Fixed Preferred Assets Shareholders’ Equity

CapitalStructure

Capital Structure

Slide 4

Why is Capital Structure Important? Leverage: Higher financial leverage means higher

returns to stockholders, but higher risk due to interest payments

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

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

Slide 5

Independence Hypothesis In a “perfect world” environment with no taxes,

no transaction costs and perfectly efficient financial markets, capital structure does not matter

This is known as the Independence hypothesis: firm value is independent of capital structure

Firm value does not depend on capital structure

This is also to say WACC or ko is constant

Slide 6

Cost ofCapital

kcs

kd kd

0% debt financial leverage 100% debt

Independence Hypothesis (Continued)

kcs = cost of common stock

kd = cost of debt

ko = cost of capital

Slide 7

Cost ofCapital

kcs

kd

kcs

kd

Increasing leverage causes thecost of equity to rise.Equity becomesriskier

What will be the net effecton the overall cost of capital?

0% debt financial leverage 100% debt

Independence Hypothesis

Slide 8

kcs

kd

Cost ofCapital

kcs

ko

kd

0% debt financial leverage 100%debt

Independence Hypothesis

Cost of capital stays constant.Increase in cost of equityis proportionate to increase in debt

Slide 9

If we have perfect capital markets, capital structure is irrelevant

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

Independence Hypothesis

Slide 10

Dependence Hypothesis

Increasing leverage does not increase the cost of equity

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

A lower cost of capital would increase firm value

Slide 11

Dependence Hypothesis

Since the cost of debt is lower than the cost of equity…Increasing leverage reduces the cost of capital.

Cost ofCapital

kcs

kd

financial leverage

kcs

kd ko

Slide 12

Moderate Position

The previous hypotheses examines capital structure in a “perfect market”

The moderate position examines capital structure under more realistic conditions

For example, what happens if we include corporate taxes?

Slide 13

Remember this example?Tax effects of financing with debt

with stock with debt

EBIT 400,000 400,000

- interest expense 0 (50,000)

EBT 400,000 350,000

- taxes (34%) (136,000) (119,000)

EAT 264,000 231,000

- dividends (50,000) 0

Retained earnings 214,000 231,000

Slide 14

Moderate Position

Cost ofCapital

kcs

kd

financial leverage

kcs

kd

Because of the tax benefit associated

with debt financing

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

Slide 15

Cost ofCapital

kc

kd

financial leverage

kc

kd

The low cost of debt reduces the cost of capital.

ko

Moderate Position

Slide 16

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

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

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

Why are firms not financed with 100% debt?

Moderate Position

Slide 17

Why is 100% Debt not Optimal?

Bankruptcy costs: costs of financial distress Financing becomes difficult to get Customers leave due to uncertainty Possible restructuring or liquidation costs if

bankruptcy occurs

Slide 18

Agency costs: costs associated with protecting bondholders

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

Stockholders own the firm and elect the board and hire managers (agents)

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

Why is 100% Debt not Optimal?

Slide 19

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

Moderate Positionwith Bankruptcy and Agency Costs

Slide 20

Cost ofCapital

financial leverage

kc

kd

kc

kd

ko

Moderate Positionwith Bankruptcy and Agency Costs

Slide 21

Cost ofCapital

financial leverage

kc

kd

kc

kd

ko

Moderate Positionwith Bankruptcy and Agency Costs

Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital

Slide 22

Capital Structure Management

EBIT-EPS Analysis – used to help determine whether it would be better to finance a project with debt or equity

I = interest expense, t = corporate tax rate P = preferred dividends, S = number of shares of common stock

outstanding

S

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

Slide 23

EBIT-EPS Example

Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: Sell 200,000 shares of common stock at $30 per share Borrow $6,000,000 by issuing 10% bonds

Slide 24

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

Financing stock debt EBIT 2,000,000 2,000,000- interest 0 (600,000)EBT 2,000,000 1,400,000- taxes (40%) (800,000) (560,000)EAT 1,200,000 840,000# shares outstanding 1,000,000 800,000EPS $1.20 $1.05

Slide 25

Financing stock debt EBIT 4,000,000 4,000,000 - interest 0 (600,000)EBT 4,000,000 3,400,000- taxes (40%) (1,600,000) (1,360,000)EAT 2,400,000 2,040,000# shares outstanding 1,000,000 800,000EPS $2.40 $2.55

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

Slide 26

If EBIT is $2,000,000, common stock financing is best

If EBIT is $4,000,000, debt financing is best So, now we need to find a crossover EBIT where

neither is better than the other

EBIT-EPS Example

Slide 27

If we choose stock financing:

Stock Financing

0.00

1.00

2.00

3.00

4.00

5.00

0 1 2 3 4 5 6 7 8

EBIT (mil.)

EP

S

Slide 28

If we choose bond financing:

Bond Financing

0.00

1.00

2.00

3.00

4.00

5.00

0 1 2 3 4 5 6 7 8

EBIT (mil.)

EP

S

Slide 29

Crossover EBIT

Breakeven EBIT

0.00

1.00

2.00

3.00

4.00

5.00

0 1 2 3 4 5 6 7 8

EBIT (mil.)

EP

S

Slide 30

Crossover EBIT (Continued)

Set 2 EPS calculations equal to each other and solve for EBIT:

Stock Financing Debt Financing

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

S S

Slide 31

Crossover EBIT (Continued)

Stock Financing Debt Financing(EBIT – I)(1 – t ) – P = (EBIT – I )(1 – t ) – P S S (EBIT – 0) (1 – 0.40) = (EBIT – 600,000)(1 – 0.40) 800,000 + 200,000 800,000

0.6 EBIT = 0.6 EBIT – 360,000 1 0.8 0.48 EBIT = 0.6 EBIT – 360,000 0.12 EBIT = 360,000 EBIT = $3,000,000