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Chapter 16 - Planning the Firm’s Balance Sheet

Financing Mix
Current Current
Assets Liabilities

Debt and Financial


Fixed Preferred Structure
Assets
Shareholders’
 2005, Pearson Prentice Hall
Equity

Why is Capital Structure Important?


Balance Sheet
Current Current 1) Leverage: Higher financial leverage
Assets Liabilities means higher returns to stockholders,
but higher risk due to fixed payments.
2) Cost of Capital: Each source of
Debt and financing has a different cost. Capital
Fixed Preferred Capital structure affects the cost of capital.
Assets Structure The Optimal Capital Structure is the
Shareholders’ one that minimizes the firm’s cost of
capital and maximizes firm value.
Equity

What is the Optimal Capital


Independence Hypothesis
Structure?

In a “perfect world” environment with Firm value does not depend on


no taxes, no transaction costs and capital structure.
perfectly efficient financial markets,
capital structure does not matter.
This is known as the Independence
hypothesis: firm value is independent of
capital structure.

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

Capital Structure: 100% equity, no debt Capital Structure: 100% equity, no debt
Stock price: $10 per share Stock price: $10 per share
Shares outstanding: 2 million Shares outstanding: 2 million
Operating income (EBIT): $2,000,000 Operating income (EBIT): $2,000,000
Calculate EPS:
With no interest payments and no taxes,
EBIT = net income.
$2,000,000/2,000,000 shares = $1.00

Independence Hypothesis: Independence Hypothesis:


Rix Camper Manufacturing Company Rix Camper Manufacturing Company

Capital Structure: 100% equity, no debt $20 million capitalization


Stock price: $10 per share $8 million in debt issued to retire $8 million
Shares outstanding: 2 million in equity.
Operating income (EBIT): $2,000,000 Equity = $12m / $20m = 60%
Calculate the Cost of Capital: Debt = $8m / $20m = 40%
Capital Structure: 60% equity, 40% debt
D1 1.00 Shares outstanding: $12 million / $10 =
k = + g = + 0 = 10%
P 10.00 1,200,000 shares.
Interest = $8m x .06 = $480,000

Independence Hypothesis: Independence Hypothesis:


Rix Camper Manufacturing Company Rix Camper Manufacturing Company

Capital Structure: 60% equity, 40% debt Capital Structure: 60% equity, 40% debt
Stock price: $10 per share Stock price: $10 per share
Shares outstanding: 1.2 million Shares outstanding: 1.2 million
Net income: $2,000,000 - $480,000 = $1,520,000 Net income: $2,000,000 - $480,000 = $1,520,000
Calculate EPS:
$1,520,000/1,200,000 shares = $1.267

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

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

D1 1.267
k = + g = + 0 = 12.67% .6 (12.67%) + .4 (6%) = 10%
P 10.00

Independence Hypothesis Independence Hypothesis


Increasing leverage causes
Cost of Cost of the cost of equity
Capital kc = cost of equity Capital to rise.
kd = cost of debt
ko = cost of capital

kc . kc
kd kd

0% debt Financial Leverage 100% debt 0% debt Financial Leverage 100% debt

Independence Hypothesis Independence Hypothesis


Increasing leverage causes
kc kc
Cost of the cost of equity Cost of
Capital to rise. Capital
What will
be the net effect
on the overall cost
kc of capital? kc ko
kd kd kd kd

0% debt Financial Leverage 100% debt 0% debt Financial Leverage 100% debt

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Independence Hypothesis Dependence Hypothesis

If we have perfect capital markets, Increasing leverage does not increase


capital structure is irrelevant. the cost of equity.
In other words, changes in capital Since debt is less expensive than equity,
structure do not affect firm value. more debt financing would provide a
lower cost of capital.
A lower cost of capital would increase
firm value.

Dependence Hypothesis Moderate Position


Since the cost of debt is lower
Cost of than the cost of equity… The previous hypothesis examines
Capital increasing leverage reduces the capital structure in a “perfect
cost of capital. market.”
kc kc
The moderate position examines
capital structure under more
ko realistic conditions.
kd kd For example, what happens if we
include corporate taxes?
Financial Leverage

Rix Camper example: Moderate Position


Tax effects of financing with debt
Even if the cost of equity rises
unlevered levered kc
Cost of as leverage increases, the
EBIT 2,000,000 2,000,000 cost of debt is
Capital
- interest expense 0 (480,000) very low...
EBT 2,000,000 1,520,000
- taxes (50%) (1,000,000) (760,000) kc
Earnings available
to stockholders 1,000,000 760,000 kd kd
Payments to all
securityholders 1,000,000 1,240,000 Financial Leverage

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Moderate Position Moderate Position
Even if the cost of equity rises
kc The low cost of debt kc
Cost of as leverage increases, the Cost of
reduces the cost of
Capital cost of debt is Capital
very low... capital.
because
kc
of the tax benefit kc
associated with debt financing.
ko
kd kd kd kd

Financial Leverage Financial Leverage

Moderate Position Why is 100% Debt Not Optimal?


So, what does the tax benefit of debt
financing mean for the value of the firm? Bankruptcy costs: costs of financial
The more debt financing used, the greater distress.
the tax benefit, and the greater the value Financing becomes difficult to get.
of the firm. Customers leave due to uncertainty.
So, this would mean that all firms should
be financed with 100% debt, right? Possible restructuring or
Why are firms not financed with 100% liquidation costs if bankruptcy
debt? occurs.

Why is 100% Debt Not Optimal? Moderate Position


with Bankruptcy and Agency Costs
Agency costs: costs associated with Cost of
protecting bondholders. Capital
Bondholders (principals) lend money to
the firm and expect it to be invested wisely.
Stockholders own the firm and elect the
kc
board and hire managers (agents).
Bond covenants require managers to be kd
monitored. The monitoring expense is an kd
agency cost, which increases as debt
increases. Financial Leverage

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Moderate Position Moderate Position
with Bankruptcy and Agency Costs with Bankruptcy and Agency Costs

Cost of Cost of
Capital Capital kc

kc kd kc kd

kd kd

Financial Leverage Financial Leverage

Moderate Position Moderate Position


with Bankruptcy and Agency Costs with Bankruptcy and Agency Costs

Cost of kc Cost of kc
If a firm borrows too much, the
Capital Capital costs of debt and equity will spike
upward, due to bankruptcy costs
and agency costs.
kc kd kc kd

kd kd

Financial Leverage Financial Leverage

Moderate Position Moderate Position


with Bankruptcy and Agency Costs with Bankruptcy and Agency Costs

Cost of kc Cost of kc
Capital Capital

kc kd kc kd
ko
kd kd

Financial Leverage Financial Leverage

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Moderate Position Moderate Position
with Bankruptcy and Agency Costs with Bankruptcy and Agency Costs

Cost of kc Cost of kc
Ideally, a firm should use leverage
Capital Capital
to obtain their optimum capital
ko structure, which will minimize theko
kc kc
firm’s cost of capital.
kd kd

kd kd

Financial Leverage Financial Leverage

Moderate Position Capital Structure Management


with Bankruptcy and Agency Costs

Cost of kc EBIT-EPS Analysis - Used to help


Capital determine whether it would be better
to finance a project with debt or
ko equity.
kc kd

kd

Financial Leverage

Capital Structure Management EBIT-EPS Example


Our firm has 800,000 shares of common stock
EBIT-EPS Analysis - Used to help determine outstanding, no debt, and a marginal tax rate
whether it would be better to finance a of 40%. We need $6,000,000 to finance a
project with debt or equity. proposed project. We are considering two
options:
EPS = (EBIT - I)(1 - t) - P
Sell 200,000 shares of common stock at $30
S
per share,
I = interest expense, P = preferred dividends, Borrow $6,000,000 by issuing 10% bonds.
S = number of shares of common stock
outstanding.

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If we expect EBIT to be $2,000,000: If we expect EBIT to be $4,000,000:

Financing stock debt Financing stock debt


EBIT 2,000,000 2,000,000 EBIT 4,000,000 4,000,000
- interest 0 (600,000) - interest 0 (600,000)
EBT 2,000,000 1,400,000 EBT 4,000,000 3,400,000
- taxes (40%) (800,000) (560,000) - taxes (40%) (1,600,000) (1,360,000)
EAT 1,200,000 840,000 EAT 2,400,000 2,040,000
# shares outst. 1,000,000 800,000 # shares outst. 1,000,000 800,000
EPS $1.20 $1.05 EPS $2.40 $2.55

If we choose stock financing:


If EBIT is $2,000,000, common EPS
stock financing is best. 3
stock
If EBIT is $4,000,000, debt financing
financing is best. 2
So, now we need to find a
breakeven EBIT where neither is 1
better than the other.
0 EBIT
$1m $2m $3m $4m

If we choose bond Breakeven EBIT bond


bond financing: financing financing
EPS EPS
3 3
stock
financing
2 2

1 1

0 EBIT 0 EBIT
$1m $2m $3m $4m $1m $2m $3m $4m

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Breakeven Point Breakeven EBIT bond
financing
EPS
Stock Financing Debt Financing 3
For EBIT up to $3 million, stock
.6 EBIT = .6 EBIT - 360,000 stock financing is best. financing
1 .8 2
For EBIT greater
.48 EBIT = .6 EBIT - 360,000 than $3 million,
1 debt financing
.12 EBIT = 360,000 is best.
0 EBIT
EBIT = $3,000,000 $1m $2m $3m $4m

In-class Problem Breakeven EBIT


Stock Financing Levered Financing
Plan A: Sell 1,200,000 shares at $10
per share ($12 million total). (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
Plan B: Issue $3.5 million in 9% debt S S
and sell 850,000 shares at $10 per EBIT-0 (1-.50) = (EBIT-315,000)(1-.50)
share ($12 million total).
1,200,000 850,000
Assume a marginal tax rate of 50%.
EBIT = $1,080,000

Analytical Income Statement For EBIT up Breakeven EBIT


levered
Stock Levered EPS to $1.08 m, stock
stock financing financing
.65
EBIT 1,080,000 1,080,000 financing is
best. For EBIT greater
I 0 (315,000)
than $1.08 m,
EBT 1,080,000 765,000 .45
the levered plan
Tax (540,000) (382,500) is best.
NI 540,000 382,500 .25

Shares 1,200,000 850,000 0 EBIT


EPS .45 .45 $.5m $1m $1.5m $2m

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In-class Problem Breakeven EBIT
Stock Financing Levered Financing
Plan A: Sell 1,200,000 shares at $20
per share ($24 million total). (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
Plan B: Issue $9.6 million in 9% debt S S
and sell shares at $20 per share (EBIT-0) (1-.35) = (EBIT-864,000)(1-.35)
($24 million total).
1,200,000 720,000
Assume a 35% marginal tax rate.
EBIT = $2,160,000

Analytical Income Statement Breakeven EBIT


levered stock
EPS financing
Stock Levered 1.5 financing
EBIT 2,160,000 2,160,000
I 0 (864,000)
1.17
EBT 2,160,000 1,296,000
Tax (756,000) (453,600)
.5
NI 1,404,000 842,400
Shares 1,200,000 720,000 0 EBIT
EPS 1.17 1.17 $1m $2m $3m $4m

For EBIT up Breakeven EBIT


to $2.16 m, levered stock
EPS financing
stock financing
1.5
financing
is best. For EBIT greater
than $2.16 m,
1.17
the levered plan
is best.
.5

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

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