Zulfiqar Hasan1. 2 Contents Definition of Corporate capital Structure; Determinants of Corporate...
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Transcript of Zulfiqar Hasan1. 2 Contents Definition of Corporate capital Structure; Determinants of Corporate...
Zulfiqar Hasan 1
Zulfiqar Hasan 2
Contents
Definition of Corporate capital Structure; Determinants of Corporate Capital Structure; The Capital-Structure Question and The Pie Theory, Maximizing Firm Value versus Maximizing Stockholder Interests, Financial Leverage and Firm Value: An Example, EPS, and ROE Capital Restructuring, Levered Firm, and un-levered or all-equity firm, Break Even EBIT
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What is Corporate Capital Structure?
For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's leverage. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the firm which come from outside of the business finance, e.g. by taking a short term loan etc.
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities.
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Factors That Influence a Company's Capital-Structure Decision
1. Business Risk: Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.
2. Company's Tax Exposure: Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
3. Financial Flexibility : Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. The lower a company's debt level, the more financial flexibility a company has.
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Factors That Influence a Company's Capital-Structure Decision
4. Management Style: Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).
5. Growth Rate: Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.
6. Market Conditions: Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning that investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay.
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The Capital-Structure Question and The Pie Theory
• The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.
• V = B + S
Here, B = Market value of the firm debt
S = Market Value of the Equity
V= Value of the Firm
If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible.
Value of the Firm
S BS BS BS B
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The Capital-Structure QuestionThere are really two important questions:1. Why should the stockholders care about maximizing firm
value? Perhaps they should be interested in strategies that maximize shareholder value.
2. What is the ratio of debt-to-equity that maximizes the shareholder’s value?As it turns out, changes in capital structure benefit the stockholders if and only if the value of the firm increases.
gOutstandin Shares ofNumber
IncomeNet EPS
Equity Total
IncomeNet ROE
Asset Total
IncomeNet ROA
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Example 01: Financial Leverage, EPS, and ROE Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.)
Recession Expected ExpansionEBIT $1,000 $2,000 $3,000
CurrentAssets
$20,000
Debt
$0
Equity
$20,000
Debt/Equity ratio
0.00
Interest rate
n/a
Shares outstanding
400
Share price
$50
Proposed
$20,000
$8,000
$12,000
2/3
8%
240
$50
Should the Firm change its current capital structure?
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Solution: EPS and ROE Under Both Capital Structures
Proposed Capital Structure (Leveraged)Recession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 640 640 640Net income (if tax =0) $360 $1,360 $2,360EPS $1.50 $5.67 $9.83ROA 1.8% 6.8% 11.8% ROE 3% 11.33% 19.67%Proposed Shares Outstanding = 240 shares
Current Capital Structure (All-Equity) Recession Expected Expansion
EBIT $1,000 $2,000 $3,000Interest 0 0 0EBT $1,000 $2,000 $3,000Tax@0% 0 0 0Net income $1,000 $2,000 $3,000EPS $2.50 $5.00 $7.50ROA 5% 10% 15%ROE 5% 10% 15%Current Shares Outstanding = 400 shares
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Practice 01: Financial Leverage, EPS, and ROE
CurrentAssets $40,000Debt $0Equity $40,000Debt/Equity ratio 0.00Interest rate n/aShares outstanding 400Share price $100
Proposed
$40,000
$20,000
$20,000
1
10%
200
$100
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.). Compare the EPS, ROA and ROE in both capital structure.
Recession Expected ExpansionEBIT $5,000 $6500 $8000
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Practice 02: Financial Leverage, EPS, and ROE
CurrentAssets $40,000Debt $0Equity $40,000Debt/Equity ratio 0.00Interest rate n/aTax@ 40%Shares outstanding 400Share price $100
Proposed
$40,000
$20,000
$20,000
1
10%
40%
200
$100
Consider an all-equity firm that is considering going into debt. (Maybe some of the original shareholders want to cash out.). Compare the EPS, ROA and ROE in both capital structure.
Recession Expected ExpansionEBIT $5,000 $6500 $8000
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Example 02: Break-Even EBIT
Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan-I) and a levered plan (Plan-II). Under plan-I, Roslton would have 150000 shares of stock outstanding. Under Plan-II, there would be 60000 shares of stock outstanding and $1.5 million in debt outstanding. The interest rate on the debt is 10% and there are no taxes.
a. If EBIT is $200000, which plan will result in the higher EPS?
b. If EBIT is $700000, which plan will result in the higher EPS?
c. What are the break-even EBIT?d. Use MM Proposition-I to find the price per share of
equity under each of the two proposed plans. What is the value of the firm?
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EPS and ROE Under Both Capital StructuresRequirement-a.
Plan-I___ Plan-IIEBIT $200000 $2,00000
Interest 0 (150000)
EBT $200000 $50,000
Tax@0% 0 0
Net income $200000 $50,000Number of Share 150000 60000EPS ($200000/150000) ($50000/60000)
$1.33 $0.83Plan I has the higher EPS when EBIT is $200,000.
Requirement-b.
Plan-I Plan-IIEBIT $700000 $7,00000
Interest 0 (150000)
EBT $700000 $550,000
Tax@0% 0 0
Net income $700000 $550,000Number of Share 150000 60000EPS ($700000/150000) ($550000/60000)
$4.67 $9.17Plan II has the higher EPS when EBIT is $700,000.
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C- Break Even EBIT
Share ofNumber
PD-Taxes-Interes-EBIT
Share ofNumber
PD-Taxes-Interest-EBIT
Structure Capital Proposed in EPS Structure CapitalCurrent in EPS
To find the breakeven EBIT for two different capital structures, we simply set the equations for EPS equal to each other and solve for EBIT. The breakeven EBIT is:
$250000EBIT90000
00$225000000EBIT
00$22500000090000EBIT
00$22500000060000EBIT150000EBIT
60000EBIT 00$225000000150000EBIT
)60000(EBIT$150000)-T150000(EBI60000
$150000-EBIT
150000
EBIT60000
$0-$0-$150000-EBIT
150000
$0-$0-$0-EBIT
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Practice 02: Break-Even EBIT
Rolston Corporation is comparing two different capital structures, an all-equity plan (Plan-I) and a levered plan (Plan-II). Under plan-I, Roslton would have 250000 shares of stock outstanding. Under Plan-II, there would be 160000 shares of stock outstanding and $1.95 million in debt outstanding. The interest rate on the debt is 12% and there are no taxes.
a. If EBIT is $600000, which plan will result in the higher EPS?
b. If EBIT is $1400000, which plan will result in the higher EPS?
c. What are the break-even EBIT?d. Use MM Proposition-I to find the price per share of
equity under each of the two proposed plans. What is the value of the firm?
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Example 02 (from text): EBIT and Leverage1. Control, Inc., has no debt outstanding and a total market value of $100,000.
Earnings before interest and taxes, EBIT, are projected to be $6,000 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 30 percent higher. If there is a recession, then EBIT will be 60 percent lower. Control is considering a $40,000 debt issue with a 5 percent interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2,500 shares outstanding. Ignore taxes for this problem.a. Calculate earnings per share, EPS, under each of the three economic
scenarios before any debt is issued. Also, calculate the percentage changes in EPS when the economy expands or enters a recession.
b. Repeat part (a) assuming that Control goes through with recapitalization (proposed capital structure). What do you observe?
2. EBIT, Taxes, and Leverage Repeat parts (a) and (b) in Problem 1 assuming Control has a tax rate of 35 percent.
3. ROE and Leverage Suppose the company in Problem 1 has a market-to-book ratio of 1.0.a. Calculate return on equity, ROE, under each of the three economic scenarios
before any debt is issued. Also, calculate the percentage changes in ROE for economic expansion and recession, assuming no taxes.
b. Repeat part (a) assuming the firm goes through with the proposed recapitalization.
c. Repeat parts (a) and (b) of this problem assuming the firm has a tax rate of 35 percent
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Solution: 1. a Current Position
Recession Normal ExpansionEBIT $2400 $6,000 $7800Interest 0 0 0Net Income $2400 $6000 $7800EPS $ 0.96 $ 2.4 $ 3.12%ΔEPS –60% –– +30%
Currently 2,500 shares outstanding
Current
Assets $?
Debt $0
Equity $100,000
Interest rate n/a
Tax@ ?
Shares outstanding 2500
Share price $40
Proposed
$?
$40,000
$60,000
5%
?
1500
$40
Dat
a A
nal
ysis
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Solution: 1b Proposed Positionb. Under the proposed recapitalization, Company will repurchase:Share price = Equity / Shares outstanding = $100,000/2500 = $40Shares repurchased = Debt issued / Share price =$40,000/$40 = 1,000The interest payment each year under all three scenarios will be:Interest payment = $40,000(.05) = $2000
Recession Normal ExpansionEBIT $2400 $6,000 $7800Interest $2000 $2000 $2000Net Income $400 $4000 $5800EPS $ 0.27 $ 2.67 $ 3.87%ΔEPS –90% –– +45%
Under the proposed recapitalization 1500 shares outstanding
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2. a. Current PositionRecession Normal Expansion
EBIT $2400 $6,000 $7800Interest 0 0 0EBT $2400 $6,000 $7800 Tax@35% $ 840 $ 2100 $ 2730Net Income ? ? ?EPS ? ? ?%ΔEPS ? ? ?
2. b. Proposed PositionRecession Normal Expansion
EBIT $2400 $6,000 $7800Interest $2000 $2000 $2000EBT $400 $4000 $5800Tax@35% 140 1400 $2030
Net Income ? ? ?EPS ? ? ?%ΔEPS ? ? ?
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$6.21250
1552 $StockCommon of No
EquityCommon SharePer ValueBook
$2.0X$6.21
12.17 $
Shareper ValueBook
Shareper PriceMarket (M/B) Ratio ValueBook Market to
Calculating B/V and M/B Ratio: Example
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3. a. & 3. b3. a. Since the company has a market-to-book ratio of 1.0, the total equity of the firm is equal to the market value of equity. Using the equation for ROE:ROE = NI/$100,000The ROE for each state of the economy under the current capital structure and no taxes is:
Recession Normal ExpansionROE 0.024 0.060 0.078%ΔROE –60 ––– +30
The second row shows the percentage change in ROE from the normal economy.
b. If the company undertakes the proposed recapitalization, the new equity value will be:
Equity = $100,000 – 40,000Equity = $60,000So, the ROE for each state of the economy is:ROE = NI/$60,000
Recession Normal ExpansionROE 0.0067 0.0667 0.0967%ΔROE –60 ––– +30
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3C
c. If there are corporate taxes and the company maintains its current capital structure, the ROE is:
Recession Normal Expansion ROE . 0.0156 0.039 0.0507%ΔROE –60 ––– +30
If the company undertakes the proposed recapitalization, and there are corporate taxes, the ROE for each state of the economy is:
Recession Normal Expansion ROE 0.0043 0.0433 0.0628
%ΔROE –90 ––– +45
Notice that the percentage change in ROE is the same as the percentage change in EPS. The percentage change in ROE is also the same with or without taxes.