Planning the Financing Mix

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Planning the Financing Mix

• Capital Structure and Firm Value
• Capital Structure Theories
• Independence Hypothesis
• Dependence Hypothesis
• Moderate Position
• EBIT-EPS Analysis

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Financial Structure
Balance Sheet Current
Current Assets Liabilities
Debt and Fixed
Preferred Assets
Shareholders Equity
Financial Structure
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Capital Structure
Balance Sheet Current
Current Assets Liabilities
Debt and Fixed
Preferred Assets
Shareholders Equity
Capital Structure
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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 firms cost of capital and
  maximizes firm value

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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

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Independence Hypothesis (Continued)
kcs cost of common stock kd cost of debt ko
cost of capital
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Independence Hypothesis
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Independence Hypothesis
Cost of capital stays constant. Increase in cost
of equity is proportionate to increase in debt
kcs
kd
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Independence Hypothesis

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

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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

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Dependence Hypothesis
Since the cost of debt is lower than the cost of
equity Increasing leverage reduces the cost of
capital.
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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?

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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

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Moderate Position
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Moderate Position
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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?

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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

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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

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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
Ideally, a firm should use leverage to obtain
their optimum capital structure, which will
minimize the firms cost of capital
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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

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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

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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 1,000,000 800,000
• EPS 1.20 1.05

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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 outstanding 1,000,000 800,000
• EPS 2.40 2.55

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EBIT-EPS Example

• 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

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If we choose stock financing
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If we choose bond financing
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Crossover EBIT
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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

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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