Chapter 16 Planning the Firms Financing Mix

1
Chapter 16 - Planning the Firms Financing Mix
Ó 2005, Pearson Prentice Hall
2

• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

3

• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

4

• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

Financial Structure
5

• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

6

• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

Capital Structure
7
Why is Capital Structure Important?

• 1) Leverage Higher financial leverage means
  higher returns to stockholders, but higher risk
  due to fixed payments.
• 2) 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 firms cost of capital and
  maximizes firm value.

8
What is the Optimal Capital Structure?

• 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.

9
Independence Hypothesis

• Firm value does not depend on capital structure.

10
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 100 equity, no debt
• Stock price 10 per share
• Shares outstanding 2 million
• 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

11
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 100 equity, no debt
• Stock price 10 per share
• Shares outstanding 2 million
• Operating income (EBIT) 2,000,000

12
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 100 equity, no debt
• Stock price 10 per share
• Shares outstanding 2 million
• Operating income (EBIT) 2,000,000
• Calculate the Cost of Capital

13
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 100 equity, no debt
• Stock price 10 per share
• Shares outstanding 2 million
• Operating income (EBIT) 2,000,000
• Calculate the Cost of Capital

14
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 100 equity, no debt
• Stock price 10 per share
• Shares outstanding 2 million
• Operating income (EBIT) 2,000,000
• Calculate the Cost of Capital

15
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 100 equity, no debt
• Stock price 10 per share
• Shares outstanding 2 million
• Operating income (EBIT) 2,000,000
• Calculate the Cost of Capital

16
Independence HypothesisRix Camper Manufacturing
Company

• 20 million capitalization
• 8 million in debt issued to retire 8 million in
  equity.
• Equity 12m / 20m 60
• Debt 8m / 20m 40
• Capital Structure 60 equity, 40 debt
• Shares outstanding 12 million / 10
  1,200,000 shares.
• Interest 8m x .06 480,000

17
Independence HypothesisRix Camper Manufacturing
Company

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

18
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 60 equity, 40 debt
• Stock price 10 per share
• Shares outstanding 1.2 million
• Net income 2,000,000 - 480,000 1,520,000

19
Independence HypothesisRix Camper Manufacturing
Company

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

20
Independence HypothesisRix Camper Manufacturing
Company

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

21
Independence HypothesisRix Camper Manufacturing
Company

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

22
Independence HypothesisRix Camper Manufacturing
Company

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

23
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 60 equity, 40 debt
• Stock price 10 per share
• Shares outstanding 1.2 million
• Net income 2,000,000 - 480,000 1,520,000

24
Independence HypothesisRix Camper Manufacturing
Company

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

25
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 60 equity, 40 debt
• Stock price 10 per share
• Shares outstanding 1.2 million
• Net income 2,000,000 - 480,000 1,520,000
• Calculate the Cost of Capital
• .6 (12.67)

26
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 60 equity, 40 debt
• Stock price 10 per share
• Shares outstanding 1.2 million
• Net income 2,000,000 - 480,000 1,520,000
• Calculate the Cost of Capital
• .6 (12.67)

27
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 60 equity, 40 debt
• Stock price 10 per share
• Shares outstanding 1.2 million
• Net income 2,000,000 - 480,000 1,520,000
• Calculate the Cost of Capital
• .6 (12.67) .4 (6)

28
Independence HypothesisRix Camper Manufacturing
Company

• Capital Structure 60 equity, 40 debt
• Stock price 10 per share
• Shares outstanding 1.2 million
• Net income 2,000,000 - 480,000 1,520,000
• Calculate the Cost of Capital
• .6 (12.67) .4 (6) 10

29
Independence Hypothesis
Cost of Capital
kc cost of equity kd cost of debt ko cost
of capital
.
kc
0 debt Financial Leverage 100 debt
30
Independence Hypothesis
.
31
Independence Hypothesis
.
32
Independence Hypothesis
Increasing leverage causes the cost of equity to
rise.
33
Independence Hypothesis
34
Independence Hypothesis
35
Independence Hypothesis
36
Independence Hypothesis
kc
kd
37
Independence Hypothesis

• If we have perfect capital markets, capital
  structure is irrelevant.
• In other words, changes in capital structure do
  not affect firm value.

38
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.

39
Dependence Hypothesis
Since the cost of debt is lower than the cost of
equity...
40
Dependence Hypothesis
Since the cost of debt is lower than the cost of
equity increasing leverage reduces the cost of
capital.
41
Moderate Position

• The previous hypothesis 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?

42
Rix Camper exampleTax effects of financing with
debt

• unlevered levered
• EBIT 2,000,000 2,000,000
• - interest expense 0
  (480,000)
• EBT 2,000,000 1,520,000
• - taxes (50) (1,000,000)
  (760,000)
• Earnings available
• to stockholders 1,000,000
  760,000
• Payments to all
• securityholders 1,000,000
  1,240,000

43
Moderate Position
44
Moderate Position
45
Moderate Position
46
Moderate Position
47
Moderate Position
48
Moderate Position

• 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?

49
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.

50
Why is 100 Debt Not Optimal?

• 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.

51
Moderate Positionwith Bankruptcy and Agency Costs
52
Moderate Positionwith Bankruptcy and Agency Costs
53
Moderate Positionwith Bankruptcy and Agency Costs
54
Moderate Positionwith Bankruptcy and Agency Costs
55
Moderate Positionwith Bankruptcy and Agency Costs
56
Moderate Positionwith Bankruptcy and Agency Costs
57
Moderate Positionwith Bankruptcy and Agency Costs
58
Moderate Positionwith Bankruptcy and Agency Costs
59
Moderate Positionwith Bankruptcy and Agency Costs
60
Moderate Positionwith Bankruptcy and Agency Costs
61
Moderate Positionwith Bankruptcy and Agency Costs
62
Capital Structure Management

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

63
Capital Structure Management

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

EPS (EBIT - I)(1 - t) - P
S
64
Capital Structure Management

• EBIT-EPS Analysis - Used to help determine
  whether it would be better to finance a 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.
65
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.

66
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 outst. 1,000,000 800,000
• EPS 1.20 1.05

67
If we expect EBIT to be 4,000,000

• 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 outst. 1,000,000 800,000
• EPS 2.40 2.55

68

• 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 breakeven EBIT where
  neither is better than the other.

69
If we choose stock financing
70
If we choose bond financing
71
Breakeven EBIT
72
Breakeven Point

• Set two 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

73
Breakeven Point

• Stock Financing Debt Financing
• (EBIT-I)(1-t) - P (EBIT-I)(1-t) - P
• S
  S
• (EBIT-0) (1-.40) (EBIT-600,000)(1-.40)
• 800,000200,000 800,000
  

74
Breakeven Point

• Stock Financing Debt Financing
• .6 EBIT .6 EBIT - 360,000
• 1
  .8
• .48 EBIT .6 EBIT - 360,000
• .12 EBIT 360,000
• EBIT 3,000,000

75
Breakeven EBIT
76
Breakeven EBIT
For EBIT up to 3 million, stock financing is
best.
For EBIT greater than 3 million, debt
financing is best.
77
In-class Problem

• Plan A Sell 1,200,000 shares at 10 per share
  (12 million total).
• Plan B Issue 3.5 million in 9 debt and sell
  850,000 shares at 10 per share (12 million
  total).
• Assume a marginal tax rate of 50.

78
Breakeven EBIT

• Stock Financing Levered Financing
• (EBIT-I) (1-t) - P (EBIT-I) (1-t) - P
• S
  S
• EBIT-0 (1-.50) (EBIT-315,000)(1-.50)
• 1,200,000 850,000
• EBIT 1,080,000

79
Analytical Income Statement

• Stock Levered
• EBIT 1,080,000 1,080,000
• I 0 (315,000)
• EBT 1,080,000 765,000
• Tax (540,000) (382,500)
• NI 540,000 382,500
• Shares 1,200,000 850,000
• EPS .45 .45

80
Breakeven EBIT
81
Breakeven EBIT
For EBIT up to 1.08 m, stock financing is best.
82
Breakeven EBIT
For EBIT up to 1.08 m, stock financing is best.
For EBIT greater than 1.08 m, the levered
plan is best.
83
In-class Problem

• Plan A Sell 1,200,000 shares at 20 per share
  (24 million total).
• Plan B Issue 9.6 million in 9 debt and sell
  shares at 20 per share (24 million
  total).
• Assume a 35 marginal tax rate.

84
Breakeven EBIT

• Stock Financing Levered Financing
• (EBIT-I) (1-t) - P (EBIT-I) (1-t) - P
• S
  S
• (EBIT-0) (1-.35) (EBIT-864,000)(1-.35)
• 1,200,000 720,000
• EBIT 2,160,000

85
Analytical Income Statement

• Stock Levered
• EBIT 2,160,000 2,160,000
• I 0 (864,000)
• EBT 2,160,000 1,296,000
• Tax (756,000) (453,600)
• NI 1,404,000 842,400
• Shares 1,200,000 720,000
• EPS 1.17 1.17

86
Breakeven EBIT
87
Breakeven EBIT
For EBIT up to 2.16 m, stock financing is best.
levered financing
stock financing
88
Breakeven EBIT
For EBIT up to 2.16 m, stock financing is best.
levered financing
stock financing
For EBIT greater than 2.16 m, the levered
plan is best.