2 Capital Structure Decisions November 2014

8/17/2019 2 Capital Structure Decisions November 2014

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Capital Structure DecisionsCapital Structure Decisions


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Learning Objectives

1. Bagaimanakah resiko bisnis dan resiko fnansial memepengaruhi ROE dan EPS

!. Bagaimana indi"erence anal#sis dapat digunakan untuk membandingkanalternati$ pembia#aan perusahaan berdasarkan t berbagai level EB%&

'. Bagaimana argumentasi (model dari )odigliani dan )iller *)+), tentangketidakrelevanan struktur pembia#aan terhadap nilai perusahaan dan bia#a

modal- serta asumsiasumsi #ang mendasarin#a

/. Bagaimanakan pengaruh pajak perusahaan terhadap )+)0s irrelevance argument

. Bagaimanakah tekanan keuangan dan bia#a kepailitan menjelaskan statictrade-of theory o capital structure

2. Bagaimanakah masalah ketidaimbangan in$ormasi *in$ormation as#mmetr#, danmasalah keagenan *agenc# problems, dapat mendorong perusahaan untuk

mengikuti pembia#aan menurut Pecking Order Approach3. Bagaimanakah berbagai $aktor lainn#a seperti frm si4e- proftabilit# and gro5th-

asset tangibilit#- and market conditions dapat mempengaruhi strukutr modalperusahaan

21 - 2


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6inancial Leverage6inancial Leverage


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21 - 4

&ahukah 7nda &ahukah 7nda

8 &799:;9: 79 >E>7A779 PE)%L%> PER;S7@779)E)7>S);)>79 >E>7A779 PE)%L%> PER;S7@779*PE)E:79: S7@7),.*PE)E:79: S7@7),.

8 Bia#a hutang setelah pajak secara signifkan lebih rendahBia#a hutang setelah pajak secara signifkan lebih rendahdari bia#a modal sendiri karena bungab pinjaman dapatdari bia#a modal sendiri karena bungab pinjaman dapatmengurangi beban pajak perusahaan- dengan demikianmengurangi beban pajak perusahaan- dengan demikianpenggunaan hutang lebih menguntungkan dari ekuitas.penggunaan hutang lebih menguntungkan dari ekuitas.

8 Semakain rendah bia#a modal- semakin besar nilaiSemakain rendah bia#a modal- semakin besar nilaiperusahaan.perusahaan.

8 &opik kita selanjutn#a adalah menja5ab pertan#aan &opik kita selanjutn#a adalah menja5ab pertan#aan

Apakah kombinasi pendanaan yang digunakan oleh Apakah kombinasi pendanaan yang digunakan oleh perusahaan mempengaruhi nilainya? Jika ya, bagaimana dan perusahaan mempengaruhi nilainya? Jika ya, bagaimana danmengapa serta apakah ada pengaruh faktor-faktor lain yangmengapa serta apakah ada pengaruh faktor-faktor lain yangbisa dipengaruhi oleh strukrur modal terhadap perusahaan?bisa dipengaruhi oleh strukrur modal terhadap perusahaan?


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7pa #ang akan andapelajari1. Struktur modal optimal *target, adalah struktur modal #ang

memaksimumkan nilai perusahaan dan meminimumkanbia#a modal.

!. Bagaimana kreditur berupa#a melindungi diri mereka dari

penggunaan hutang secara berlebihan melaluipenggunaan perjanjian kredit *covenants, #ang bersi$atprotekti$..

'. &ingkat keuntungan pajak dari hutang diseimbangka- padatingkat leverage keuangan #ang lebih tinggi- oleh bia#a

#ang ditimbulkan oleh tekanan keuangan dan kepailitan./. ?alam praktekn#a- perusahaan tidak menggunakan

struktur modal #ang ditargetkan karena pre$erensipembia#aan dan kondisi pasar modal.

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Capital Structure Decisions


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Leverage

)eningkatn#a volatilitas laba operasi sepanjang5aktu #ang diakibatkan oleh penggunaan bia#atetap dibandingkan dengan bia#a variabel. Leverage dapat meningkatkan keuntungan

dan kerugian.

?ua jenis leverage Operating leverage 6inancial leverage

>edua jenis leverage mempun#ai pengaruh#ang sama terhadap pemegang saham tapidilakukan dengan cara #ang sangat berbeda-untuk tujuan #ang berbeda secara strategis.

CHAPTER 21 – Capital Structure Decisions21 -

7


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CHAPTER 21 – Capital Structure Decisions 21 - 8

Leverage E"ects on OperatingLeverage E"ects on Operating

%ncome%ncome

Years

Wen a !ir" increases te

use o! !i#e$ costs it

increases te %olatilit& o!

operatin' inco"e(

Normal volatility ofoperating income

Operating

Income

+

0

-


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6inancial versus Operating6inancial versus Operating

LeverageLeverage

Capital Structure ?ecisionsCapital Structure ?ecisions


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21 - 1)

Operating LeverageOperating LeveragePE9:ER&%79 ?79 B7:7%)797 %7 B%S7 )E9%9:>7&PE9:ER&%79 ?79 B7:7%)797 %7 B%S7 )E9%9:>7&

D Operating leverage adalahOperating leverage adalah

8 )eningkatkan volatilitas laba usaha #ang disebabakan)eningkatkan volatilitas laba usaha #ang disebabakan

oleh beban tetap operasi.oleh beban tetap operasi.

D 7nda har#s memahami bah5a manajer membuat7nda har#s memahami bah5a manajer membuatkeputusan #ang mempengaruhi struktur bia#akeputusan #ang mempengaruhi struktur bia#aperusahaan.perusahaan.

D )anajer dapat mengambil keputusan untuk investasi)anajer dapat mengambil keputusan untuk investasipada aset #ang menimbulkan tambahan bia#a tetappada aset #ang menimbulkan tambahan bia#a tetap

dan ingin mnegurangi bia#a variabel.dan ingin mnegurangi bia#a variabel.

8 %ni dilakukan oleh perusahaan dengan memilih apakah%ni dilakukan oleh perusahaan dengan memilih apakah

investasin#a padat modal atau padat kar#a- akibatn#ainvestasin#a padat modal atau padat kar#a- akibatn#a

bisa meningkatkan operating leverage.bisa meningkatkan operating leverage.


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21 - 11

Operating LeverageOperating Leverage

>euntungan dan kerugian>euntungan dan kerugian

>euntungan>euntungan8 )emperbesar laba #ang diterima pemegang saham jika)emperbesar laba #ang diterima pemegang saham jika

perusahaan memperoleh keuntungan.perusahaan memperoleh keuntungan.

8 Efsiensi operasi *$aster production- $e5er errors- higherEfsiensi operasi *$aster production- $e5er errors- higher

ualit#, usuall# result increasing productivit#- reducingualit#, usuall# result increasing productivit#- reducingFdo5ntime0 etc.Fdo5ntime0 etc.

>erugian>erugian8 )emperbesar kerugian pemegang saham jika Gerushaan)emperbesar kerugian pemegang saham jika Gerushaan

tidak memperoleh penghasilan #ang cukup untuk menutuptidak memperoleh penghasilan #ang cukup untuk menutupbia#abia#an#a.bia#abia#an#a.

8 break even point lebih tinggi.break even point lebih tinggi.

8 Bia#a modal aset tetap dan tidak likuisn#a investasiBia#a modal aset tetap dan tidak likuisn#a investasimembuatn#amembuatn#a

D )ahal *lebih sukit untuk membia#ai investasi,)ahal *lebih sukit untuk membia#ai investasi,

D Rentab terhadap keusagan teknologi.Rentab terhadap keusagan teknologi.


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6inancial Leverage6inancial LeveragePengertian dan bagaimana is bisa meningkatPengertian dan bagaimana is bisa meningkat

D fnancial leverage adalahfnancial leverage adalah8 )eningjatn#a volatilitas laba usaha karena)eningjatn#a volatilitas laba usaha karena

perusahaan menggunana dana #angperusahaan menggunana dana #ang

mempun#ai beban tetap.mempun#ai beban tetap.D 6inancial leverage dapat meningkat karena6inancial leverage dapat meningkat karena

perusahaanperusahaan8 )enjual obligasi dan saham pre$ereen)enjual obligasi dan saham pre$ereen

8 )enggunakan proceeds dari hutang untuk)enggunakan proceeds dari hutang untukmenarik kembali saham beredar *jikamenarik kembali saham beredar *jikapemegang obligasi melarang n#a melaluipemegang obligasi melarang n#a melaluikontrak obligasi dan perjanian kredit,kontrak obligasi dan perjanian kredit,


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CHAPTER 21 – Capital Structure Decisions 21 - 1*

6inancial Leverage6inancial Leverage7dvantages and ?isadvantages7dvantages and ?isadvantages

7dvantages7dvantages8 )agnifcation o$ profts to the shareholders i$ the frm is)agnifcation o$ profts to the shareholders i$ the frm is

proftable.proftable.

8 Lo5er cost o$ capital at lo5 to moderate levels o$ fnancialLo5er cost o$ capital at lo5 to moderate levels o$ fnancial

leverage because interest eHpense is taHdeductible.leverage because interest eHpense is taHdeductible.?isadvantages?isadvantages

8 )agnifcation o$ losses to the shareholders i$ the frm)agnifcation o$ losses to the shareholders i$ the frmdoes not earn enough revenue to cover its costs.does not earn enough revenue to cover its costs.

8 @igher break even point.@igher break even point.

8 7t higher levels o$ fnancial leverage- the lo5 a$tertaH7t higher levels o$ fnancial leverage- the lo5 a$tertaHcost o$ debt is o"set b# other e"ects such ascost o$ debt is o"set b# other e"ects such asD Present value o$ the rising probabilit# o$ bankruptc# costsPresent value o$ the rising probabilit# o$ bankruptc# costs

D 7genc# costs7genc# costs

D Lo5er operating income *EB%&,- etc.Lo5er operating income *EB%&,- etc.


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21 - 14

E"ects o$ Operating and 6inancialE"ects o$ Operating and 6inancialLeverageLeverage

Summar#Summar#

D Euit# holders bear the added risks associated 5ith theEuit# holders bear the added risks associated 5ith the

use o$ leverage.use o$ leverage.

D &he higher the use o$ leverage *either operating or &he higher the use o$ leverage *either operating or

fnancial, the higher the risk to the shareholder.fnancial, the higher the risk to the shareholder.

D Leverage there$ore can and does a"ect shareholdersLeverage there$ore can and does a"ect shareholders

reuired rate o$ return- and in turn this inIuences the costreuired rate o$ return- and in turn this inIuences the cost

o$ capital.o$ capital.

@%:@ER LEJER7:E K @%:@ER COS& O6 C7P%&7L@%:@ER LEJER7:E K @%:@ER COS& O6 C7P%&7L


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6inancial Leverage6inancial Leverage



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CHAPTER 21 – Capital Structure Decisions 21 - 1+

Business RiskBusiness Risk

D 7ll frms eHperience variabilit# in sales and operating7ll frms eHperience variabilit# in sales and operating

*fHed and variable, operating costs over time.*fHed and variable, operating costs over time.

8 Some frms operate in a highl# volatile industr# *$orSome frms operate in a highl# volatile industr# *$or

eHample oil and gas, and 5e 5ould sa# the frm has a higheHample oil and gas, and 5e 5ould sa# the frm has a high

degree o$ business risk.degree o$ business risk.

8 Other frms operate in a ver# stable industr# 5hereOther frms operate in a ver# stable industr# 5here

revenues and eHpenses don0t change much $rom #ear torevenues and eHpenses don0t change much $rom #ear to

#ear throughout the business c#cle these frms have lo5#ear throughout the business c#cle these frms have lo5

business risk.business risk.

D Business risk is the variabilit# o$ a frm0s operatingBusiness risk is the variabilit# o$ a frm0s operatingincome caused b# operational risk.income caused b# operational risk.

8 Business risk is measured b# the standard deviation o$Business risk is measured b# the standard deviation o$

EB%&.EB%&.


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6inancial Leverage6inancial LeverageRisk and LeverageRisk and Leverage

D Lenders to the frm insulate themselves $rom riskLenders to the frm insulate themselves $rom riskthrough fnancial contractingthrough fnancial contracting

D Lending mone# through a $ormal- legall#binding contract.Lending mone# through a $ormal- legall#binding contract.

D ?emanding a fHed rate o$ return on the mone# the# lend?emanding a fHed rate o$ return on the mone# the# lendto the frm- inkeeping 5ith their reuired return on moniesto the frm- inkeeping 5ith their reuired return on moniesborro5ed.borro5ed.

D ?emanding other promises that 5ill protect the lender0s?emanding other promises that 5ill protect the lender0sinterests over the li$e o$ the loan(investment.interests over the li$e o$ the loan(investment.

D ?emanding a high priorit# in the priorit# o$ claims list in?emanding a high priorit# in the priorit# o$ claims list inthe event o$ corporate dissolution(bankruptc#.the event o$ corporate dissolution(bankruptc#.

D Shareholders bear the risk associated 5ith businessShareholders bear the risk associated 5ith businessrisk- and the added risks associated 5ith the use o$risk- and the added risks associated 5ith the use o$leverage because the# are residual claimants o$ theleverage because the# are residual claimants o$ thefrm.frm.


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Return on %nvestment *RO%,Return on %nvestment *RO%,6inancial Leverage6inancial Leverage

Return on %nvestment *RO%,Return on %nvestment *RO%,8 is the return on all the capital provided b# investorsis the return on all the capital provided b# investors

EB%& minus taHes divided b# invested capital.EB%& minus taHes divided b# invested capital.

8 %nvested Capital *%C, is a frm0s capital structure%nvested Capital *%C, is a frm0s capital structure

consisting o$ shareholders0 euit# and short and longconsisting o$ shareholders0 euit# and short and longterm debt.term debt.

)1(

BSE

T EBIT ROI

+

−=, 21-2

.ut /e 0no/ te clai"s

on te nu"erator

operatin' inco"e a!ter

ta#es are %er&

$i!!erent3 an$ so tooare te ris0s eac

pro%i$er o! capital is

e#pose$(


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Return on Euit# *ROE,Return on Euit# *ROE,6inancial Leverage6inancial Leverage

ROE 8 is the return earned b# euit# holdersROE 8 is the return earned b# euit# holderson their investment in the compan#on their investment in the compan#

8 ROE K net income divided b# shareholders0ROE K net income divided b# shareholders0euit#.euit#.

)1)((

SE

T B R EBIT ROE D

−−=, 21-1


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CHAPTER 21 – Capital Structure Decisions 21 - 2)

RO% versus ROERO% versus ROE6inancial Leverage6inancial Leverage

D %$ the frm is completel# fnanced b# euit#%$ the frm is completel# fnanced b# euit#ROE K RO%.ROE K RO%.

D Let us eHamine the e"ects o$ sales volatilit#Let us eHamine the e"ects o$ sales volatilit#on RO% and ROE given di"erent levels o$on RO% and ROE given di"erent levels o$

fnancial leverage.fnancial leverage.


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D ;sing this base income statement;sing this base income statement

D &he $ollo5ing three slides sho5 three di"erent fnancing strategies &he $ollo5ing three slides sho5 three di"erent fnancing strategiesand the impacts on ROE- RO%- EPS $or breakeven- normal- and highand the impacts on ROE- RO%- EPS $or breakeven- normal- and highsales levelssales levels


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6inancial Leverage6inancial Leverage%ncome Statement 8 9o 6inancial Leverage%ncome Statement 8 9o 6inancial Leverage

Tis assu"es a )()

$et6euit& ratio

RE 9 R: ecause no use

o! $et !inancin'(


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6inancial Leverage6inancial Leverage%ncome Statement 8 Base Case%ncome Statement 8 Base Case

Tis assu"es a )(7)

$et6euit& ratio

RE is le%ere$ co"pare$ to

R: ecause o! te "o$erateuse o! $et !inancin'(


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6inancial Leverage6inancial Leverage%ncome Statement 5ith @igh 6inancial Leverage%ncome Statement 5ith @igh 6inancial Leverage

RE is "ore %olatile tan

R: ecause o! te i' useo! !inancial le%era'e(


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D Consider the euation $or ROEConsider the euation $or ROE

)1)((

SE

T B R EBIT ROE D

−−=, 21-1

E.:T – :nterest e#pense 9 E.TE.T ti"es 1 – T 9 ;et :nco"e

Te euation re$uce to net inco"e

$i%i$e$ & .< o! sareol$ers= euit&(


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D Euation !1 8 ! is the defnition o$ RO%Euation !1 8 ! is the defnition o$ RO%

D %$ 5e reeHpress EB%& *1&, in the ROE%$ 5e reeHpress EB%& *1&, in the ROEeuation- 5e geteuation- 5e get

)1( BSE

T EBIT ROI +

−=, 21-2


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D &his is the fnancial leverage euation &his is the fnancial leverage euation

D RO% measures the return that the frm earnsRO% measures the return that the frm earns$rom operations- but ?OES 9O& eHplicitl#$rom operations- but ?OES 9O& eHplicitl#considered ho5 the frm is fnanced.considered ho5 the frm is fnanced.

)1((SE BT R ROI ROI ROE D −−+=

, 21-*


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D %$ 5e rearrange Euation !1 8 '- grouping like terms%$ 5e rearrange Euation !1 8 '- grouping like termsinvolving RO% 5e getinvolving RO% 5e get

D &he second term is fHed. &he second term is fHed.D &he frst term depends on the frm0s uncertain RO%. &he frst term depends on the frm0s uncertain RO%.D &his means 5e can graph ROE against RO% as a straight &his means 5e can graph ROE against RO% as a straight

line.line.See Figure 21 -1 on the following slide.See Figure 21 -1 on the following slide.

)1()1( SE

B

T RSE

B

ROI ROE D −−++=, 21-4


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21 - 1 >:?@RE

ROE

80

0

!0

"0

ROI

-"0

-!0

-0

#ll E$uity

D%E &0'(0

-) -)" -8 -! 0 ! 8 )" ) "0 "! "8 *" * !0

Slope o! te

all euit&

line is 9 1()(

:n tis case

R: 9 RE(

D6E 9 )(7)(

Slope o! te

line 1()(

Ao%e te

intercept

/it te

oriBontal

a#is3 RE

R:(

>inancial .rea0-e%en

points /ere RE 9 )

:n$i!!erence point /ere

REs !or $i!!erent !inancin'

strate'ies are eual(


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CHAPTER 21 – Capital Structure Decisions 21 - *)


6inancial Breakeven point6inancial Breakeven point

8 Points at 5hich a frm0s ROE is 4ero.Points at 5hich a frm0s ROE is 4ero.

%ndi"erence Point%ndi"erence Point8 Points at 5hich t5o fnancing strategiesPoints at 5hich t5o fnancing strategies

provide the same ROE.provide the same ROE.


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CHAPTER 21 – Capital Structure Decisions 21 - *1

6inancial Leverage6inancial Leverage &he Rules o$ 6inancial Leverage &he Rules o$ 6inancial Leverage

D 6or valuemaHimi4ing frms- the use o$ debt6or valuemaHimi4ing frms- the use o$ debtincreases the eHpected ROE so shareholdersincreases the eHpected ROE so shareholderseHpect to be better o" b# using debt fnancing-eHpect to be better o" b# using debt fnancing-rather than euit# fnancing.rather than euit# fnancing.

D 6inancing 5ith debt increases the variabilit# o$6inancing 5ith debt increases the variabilit# o$the frm0s ROE- 5hich usuall# increases the riskthe frm0s ROE- 5hich usuall# increases the riskto the common shareholders.to the common shareholders.

D 6inancing 5ith debt increases the likelihood o$6inancing 5ith debt increases the likelihood o$the frm running into fnancial distress andthe frm running into fnancial distress andpossibl# even bankruptc#.possibl# even bankruptc#.


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R: re!lects te usiness ris0 o! te !ir"(

RE 9R: in te all euit& !ir"(

RE increases as te !ir" !inances /it "ore $et(


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CHAPTER 21 – Capital Structure Decisions 21 - **


Wi$er %ariation in R: "eans "a'ni!ie$ RE o%er a still

/i$er ran'e tan R:(


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6inancial Leverage6inancial Leverage%nvesting ;sing Leverage%nvesting ;sing Leverage

D 6igure !1 8 ! illustrates the monthl# returns6igure !1 8 ! illustrates the monthl# returns$rom investing in the S+P(&SM Composite$rom investing in the S+P(&SM Composite%ndeH using t5o di"erent fnancing strategies%ndeH using t5o di"erent fnancing strategies

1.1. %nvesting in the indeH *all euit#,%nvesting in the indeH *all euit#,

!.!. %nvesting in the indeH 5ith N borro5ed on margin.%nvesting in the indeH 5ith N borro5ed on margin.

D &he added volatilit# o$ gains and losses over &he added volatilit# o$ gains and losses overtime is clearl# evident.time is clearl# evident.

D &hese principles o$ leverage appl# to &hese principles o$ leverage appl# tocorporations as 5ell as householdscorporations as 5ell as households

See Figure 21 ! 2 on the following slide"See Figure 21 ! 2 on the following slide"


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6inancial Leverage6inancial Leverage%nvesting ;sing Leverage%nvesting ;sing Leverage

21 - 2 >:?@RE


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%ndi"erence 7nal#sis%ndi"erence 7nal#sis



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6inancial Leverage6inancial Leverage%ndi"erence 7nal#sis%ndi"erence 7nal#sis

D %s a proft planning techniue used to $orecast%s a proft planning techniue used to $orecastthe EPSEB%& relationships under di"erentthe EPSEB%& relationships under di"erent

fnancing scenarios.fnancing scenarios.

D &he indi"erence point is 5here &he indi"erence point is 5here

EPSEPS*6inancing strateg# 1,*6inancing strateg# 1,KEPSKEPS*6inancing strateg# !,*6inancing strateg# !,


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D &he $ormula $or EPS- given EB%&- interest on debt *R &he $ormula $or EPS- given EB%&- interest on debt *R??B,- theB,- the

corporate taH rate *&,- and the number o$ common sharescorporate taH rate *&,- and the number o$ common shares

outstanding *Q,outstanding *Q,

D =e can rearrange the defnition o$ EPS and sho5 ho5 it varies 5ith=e can rearrange the defnition o$ EPS and sho5 ho5 it varies 5ith

EB%&EB%&

#

)1)(( T B R EBIT EPS

D −−=, 21-5


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CHAPTER 21 – Capital Structure Decisions 21 - *


D EPS is a simple linear $unction o$ EB%&EPS is a simple linear $unction o$ EB%&

D &his is illustrated in the EPSEB%& graph in &his is illustrated in the EPSEB%& graph in6igure !1 8 ' $ound on the $ollo5ing slide6igure !1 8 ' $ound on the $ollo5ing slide

#

)1(#

)1( T EBIT T B R EPS D −+−−=, 21-+


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6inancial Leverage6inancial LeverageEPSEB%& *Proft Planning, ChartsEPSEB%& *Proft Planning, Charts

21 - * >:?@RE

0'8

0'

0'!

0'"

0

-0'"

-0'!

-0' ES 0, D%E ES (0, D%E

-(-*.(-*)"-""( -)!" ( "8 ))* ).8 "8* *8 !* *8 "* (08 (.* 8(8 .* )0!8 ))**

:n$i!!erence

point(

Te oriBontal intercept o! te 7) D6E line is'reater & te a$$e$ interest e#pense tat "ust e

co%ere$ e!ore pro$ucin' earnin's a%ailale !or

co""on sareol$ers(


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6inancial Leverage6inancial LeverageEPSEB%& *Proft Planning, ChartsEPSEB%& *Proft Planning, Charts

D &he slope o$ the lines are a $unction o$ the &he slope o$ the lines are a $unction o$ the

number o$ common shares outstandingnumber o$ common shares outstanding

*dilution o$ EPS,.*dilution o$ EPS,.

8 &he all euit# line 5ill have a lo5er slope &he all euit# line 5ill have a lo5er slopebecause ever# dollar o$ net income is dividedbecause ever# dollar o$ net income is dividedb# more common shares.b# more common shares.

D &he hori4ontal intercept is greater $or the debt &he hori4ontal intercept is greater $or the debtfnancing line because the frm must cover itsfnancing line because the frm must cover its

interest eHpense be$ore earnings begin tointerest eHpense be$ore earnings begin to

accrue to the beneft o$ shareholders.accrue to the beneft o$ shareholders.


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?etermining Capital Structure?etermining Capital Structure



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D &able !1 8 / demonstrates the 1 results o$ a &able !1 8 / demonstrates the 1 results o$ a

Con$erence Board surve# o$ 11 ;.S. companiesCon$erence Board surve# o$ 11 ;.S. companies

to determine their capital structure.to determine their capital structure.

D EHternal sources o$ in$ormation includeEHternal sources o$ in$ormation include

8 *Q!, checking 5ith their advisors- and*Q!, checking 5ith their advisors- and

8 *Q, eHamining other frms in the industr#.*Q, eHamining other frms in the industr#.

D &he three primar# sources o$ in$ormation are &he three primar# sources o$ in$ormation are

8 *Q/, impact on profts*Q/, impact on profts8 *Q', risk*Q', risk

8 *Q1, anal#sis o$ cash Io5s*Q1, anal#sis o$ cash Io5s


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Pri"ar& sources inclu$e/ Anal&sis o! cas !lo/s/ Ris0 consi$eration/ :"pact on pro!its


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?etermining Capital Structure?etermining Capital Structure;se$ul Ratios;se$ul Ratios

D Stock ratios *balance sheet ratios, that areStock ratios *balance sheet ratios, that arehelp$ul includehelp$ul include

8 &otal debt to total assets &otal debt to total assets

8 ?ebt to euit# ratio?ebt to euit# ratio

D 6lo5 ratios make use o$ in$ormation taken6lo5 ratios make use o$ in$ormation taken

$rom the income statement and 5hen$rom the income statement and 5hen

combined 5ith balance sheet data help tocombined 5ith balance sheet data help todetermine the abilit# o$ the frm to service itsdetermine the abilit# o$ the frm to service itsdebt.debt.


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D 6iHed Burden Coverage Ratio6iHed Burden Coverage Ratio

8 7n eHpanded interest coverage ratio that looks7n eHpanded interest coverage ratio that looksat a broader measure o$ both income and theat a broader measure o$ both income and theeHpenditures associated 5ith debt.eHpenditures associated 5ith debt.

)1/()Pref.Div.( T SF I

EBITDACoverage Burden Fixed −++

=, 21-7


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D CashIo5todebt ratio *C6&?,CashIo5todebt ratio *C6&?,

8 7 direct measure o$ the cash Io5 over a period7 direct measure o$ the cash Io5 over a periodthat is available to cover a frm0s stock o$that is available to cover a frm0s stock o$outstanding debt.outstanding debt.

Debt

EBITDACFTD =, 21-8


48/106



:n%est"ent

'ra$e :?

co"panies

a%e at

least a ...

on$ ratin'(

Alt"an score is

a /ei'te$

a%era'e o!

se%eral 0e& ratios

an$ is a use!ul

pre$ictor o! a!ir"=s proailit&

o! an0ruptc&(


49/106


?etermining Capital Structure?etermining Capital Structure7ltman Score7ltman Score

D 7ltman0s prediction o$ bankruptc# euation7ltman0s prediction o$ bankruptc# euation

D =here=hereMM11 K 5orking capital divided b# total assetsK 5orking capital divided b# total assets

MM!! K retained earnings divided b# total assetsK retained earnings divided b# total assetsMM'' K EB%& divided b# total assetsK EB%& divided b# total assets

MM// K market values o$ total euit# divided b# noneuit# book liabilitiesK market values o$ total euit# divided b# noneuit# book liabilities

MM K sales divided b# total assetsK sales divided b# total assets

999060334121 54321 X . X . X . X . X . Z ++++=, 21-


50/106

&he )odigliani and )iller &he )odigliani and )iller

%rrelevance &heorem%rrelevance &heorem


&he )odigliani and )iller *)+),&he )odigliani and )iller *)+),


51/106


&he )odigliani and )iller *)+), &he )odigliani and )iller *)+),

%rrelevance &heorem%rrelevance &heorem)+) and 6irm Jalue)+) and 6irm Jalue

D &he theorem that concludes *under some &he theorem that concludes *under somesimpli$#ing assumptions, that the value o$ thesimpli$#ing assumptions, that the value o$ the

frm should not be a"ected b# the manner infrm should not be a"ected b# the manner in

5hich it is fnanced.5hich it is fnanced.

8 @o5 the frm is fnanced is irrelevant.@o5 the frm is fnanced is irrelevant.


52/106


*)+), %rrelevance &heorem*)+), %rrelevance &heorem7ssumptions7ssumptions

7ssumptions about the Real =orld7ssumptions about the Real =orldD )arkets are per$ect in the sense that there are no)arkets are per$ect in the sense that there are no

transactions costs or as#mmetric in$ormationtransactions costs or as#mmetric in$ormation

problemsproblemsD 9o taHes9o taHes

D &here is no risk o$ costl# bankruptc# or associated &here is no risk o$ costl# bankruptc# or associated

fnancial distressfnancial distress

)odeling 7ssumptions)odeling 7ssumptionsD &here eHist t5o frms in the same Trisk classU 5ith &here eHist t5o frms in the same Trisk classU 5ith

di"erent levels o$ debtdi"erent levels o$ debt

D &he earnings o$ both frms are perpetuities &he earnings o$ both frms are perpetuities


53/106


*)+), %rrelevance &heorem*)+), %rrelevance &heorem7rbitrage 7rgument7rbitrage 7rgument

7rbitrage is a po5er$ul economic $orce in capital7rbitrage is a po5er$ul economic $orce in capitalmarkets.markets.

=here t5o identical assets trade at di"erent prices-=here t5o identical assets trade at di"erent prices-market traders 5ill spot the opportunit# to earnmarket traders 5ill spot the opportunit# to earn

riskless profts.riskless profts.D &raders 5ill sell the overvalued asset and bu# the &raders 5ill sell the overvalued asset and bu# theundervalued asset.undervalued asset.

D &his activit# 5ill cause the price o$ the overvalued asset &his activit# 5ill cause the price o$ the overvalued assetto $all- and the price o$ the undervalued asset to rise untilto $all- and the price o$ the undervalued asset to rise untilthe t5o are priced the same.the t5o are priced the same.

D &he traders 5ill earn abnormal profts $rom these trades &he traders 5ill earn abnormal profts $rom these tradesuntil the prices o$ the t5o securities move intountil the prices o$ the t5o securities move intoeuilibrium.euilibrium.

#able 21 ! $ illustrates the two di%erent positions and the e&ual payo%s#able 21 ! $ illustrates the two di%erent positions and the e&ual payo%s


54/106


*)+), %rrelevance &heorem*)+), %rrelevance &heorem7rbitrage 7rgument7rbitrage 7rgument

)arket participants 5ho fnd levered investments)arket participants 5ho fnd levered investments

trading $or a greater value- cantrading $or a greater value- can undo theundo the

le'eragele'erage and earn abnormal profts.and earn abnormal profts.

7rbitrage 5ill $orce assets 5ith eual pa#o"s to7rbitrage 5ill $orce assets 5ith eual pa#o"s to

trade $or the same price.trade $or the same price.

#able 21 ! $ illustrates the two di%erent positions and the e&ual#able 21 ! $ illustrates the two di%erent positions and the e&ual

payo%s payo%s


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*)+), %rrelevance &heorem*)+), %rrelevance &heorem)+) and 6irm Jalue)+) and 6irm Jalue

;et pa&o!!s

are eual

Port!olio A an$ . "ust e price$ euall& $espite teir $i!!erent !inancial

structures ecause te pa&o!!s are eual(


56/106


*)+), %rrelevance &heorem*)+), %rrelevance &heorem)+) and 6irm Jalue)+) and 6irm Jalue

Where payofs are identical or two diferentassets, both should be priced the same.

The value o the levered rm (V L ) is equal to the value o

its debt plus the value o its equity (SL + D) and this mustequal the value o the unlevered rm (V )!

De"t cannot destroy #alue!

L LU V DS V =+=, 21-1)


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*)+), %rrelevance &heorem*)+), %rrelevance &heoremPersonal Leverage and Corporate LeveragePersonal Leverage and Corporate Leverage


58/106


*)+), %rrelevance &heorem*)+), %rrelevance &heorem@omemade Leverage@omemade Leverage

D @omemade leverage is the creation o$ the@omemade leverage is the creation o$ the

same e"ect o$ a frm0s fnancial leveragesame e"ect o$ a frm0s fnancial leverage

through the use o$ personal leverage.through the use o$ personal leverage.

D &his means that individuals can &his means that individuals can

8 Bu# an unlevered frm- and through the use o$Bu# an unlevered frm- and through the use o$

personal debt- replicate corporate leverage- orpersonal debt- replicate corporate leverage- or

8 Bu# a levered frm- and undo its e"ects.Bu# a levered frm- and undo its e"ects.


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*)+), %rrelevance &heorem*)+), %rrelevance &heorem)+) and &he Cost o$ Capital)+) and &he Cost o$ Capital

D )+) made a modeling assumption *to simpli$# the)+) made a modeling assumption *to simpli$# the

calculations and $ocus anal#sis on the leverage issue, thatcalculations and $ocus anal#sis on the leverage issue, that

the frm0s earnings represent athe frm0s earnings represent a perpetuity perpetuity

!

D"#EBIT$! S

e

D L =, 21-11


60/106

CHAPTER 21 – Capital Structure Decisions 21 - +)


D &he cost o$ euit# capital is simpl# the earnings #ield and is &he cost o$ euit# capital is simpl# the earnings #ield and isestimated as $ollo5sestimated as $ollo5s

S

D"#EBIT$! !

L

D

e =, 21-12


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CHAPTER 21 – Capital Structure Decisions 21 - +1


D Since the value o$ the frm is unchanged b# leverage- 5eSince the value o$ the frm is unchanged b# leverage- 5e

can defne the unlevered value *can defne the unlevered value *( ( )), b# discounting the, b# discounting the

frm0s eHpected EB%& b# it unlevered euit# cost *frm0s eHpected EB%& b# it unlevered euit# cost ** * )),,

V DS V

EBIT V L L

U

U =+==, 21-1*


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*)+), %rrelevance &heorem*)+), %rrelevance &heorem)+) Euit# Cost Euation)+) Euit# Cost Euation

D &o determine 5ho euit# cost varies 5ith the debteuit# &o determine 5ho euit# cost varies 5ith the debteuit#ratio- 5e solve $or EB%&- and substitute it $or EB%& in theratio- 5e solve $or EB%&- and substitute it $or EB%& in theleveraged euit# cost euationleveraged euit# cost euation

D %$ the frm has no debt- the euit# investor reuires > %$ the frm has no debt- the euit# investor reuires > ;; *cost o$*cost o$

unlevered euit#,.unlevered euit#,.D > > ;; depends ondepends on business risk business risk o$ the frm.o$ the frm.

D 7s the frm uses debt- the euit# cost increases due to the7s the frm uses debt- the euit# cost increases due to the+nanial le'erage risk premium+nanial le'erage risk premium..

/)( S D ! ! ! ! L DU ue −+=, 21-14


63/106

CHAPTER 21 – Capital Structure Decisions 21 - +*


D %n a 5orld 5ithout taHes- the =7CC *> %n a 5orld 5ithout taHes- the =7CC *> ;;, is simpl# the 5eighted, is simpl# the 5eightedaverage o$ the cost o$ debt and the cost o$ euit#average o$ the cost o$ debt and the cost o$ euit#

D 6igure !1 8 / illustrates )+) 5ithout corporate taHes *the6igure !1 8 / illustrates )+) 5ithout corporate taHes *theirrelevance model, 5here the cost o$ euit# *irrelevance model, 5here the cost o$ euit# ** * , rises in a, rises in aprescribed manner to o"set the lo5er cost o$ debt *prescribed manner to o"set the lo5er cost o$ debt ** * ,,producing =7CC that remains unchanged b# the use o$producing =7CC that remains unchanged b# the use o$fnancial leverage.fnancial leverage.

V D !

V S ! ! D E U +=, 21-15


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2) - 4 >:?@RE

Det-E$uity Ratio

Det Cost 1D

E$uity Cost 1E

2#CC

,

* , l h


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D %$ =7CC remains the same regardless o$ the fnancial%$ =7CC remains the same regardless o$ the fnancialstrateg# used b# the frmstrateg# used b# the frm

8 JJLL K JK J;;

8 6inancial strateg# is irrelevant6inancial strateg# is irrelevantD 7s the use o$ debt fnancing is increased- the cost o$7s the use o$ debt fnancing is increased- the cost o$

euit# 5ill riseVso even i$ EPS is increased througheuit# 5ill riseVso even i$ EPS is increased throughthe use o$ debt fnancing- that beneft is o"set b# athe use o$ debt fnancing- that beneft is o"set b# ahigher discount rate.higher discount rate.

D 6rom a shareholder 5ealth perspective- under the6rom a shareholder 5ealth perspective- under the)+) assumptions- fnancing strateg# is irrelevant.)+) assumptions- fnancing strateg# is irrelevant.


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&he %mpact o$ Corporate &aHes on &he %mpact o$ Corporate &aHes on

&he %rrelevance &heorem &he %rrelevance &heorem


&h % $ &


67/106


&he %mpact o$ &aHes &he %mpact o$ &aHes%ntroducing Corporate &aHes%ntroducing Corporate &aHes

D &he value o$ frms drop in the presence o$ corporate taHes. &he value o$ frms drop in the presence o$ corporate taHes.

D &he higher the taH rate- the lo5er the value o$ the frm. &he higher the taH rate- the lo5er the value o$ the frm.

)1(

!

T EBIT V

U

U

−=, 21-1+

h $&h % t $ &


68/106


&he %mpact o$ &aHes &he %mpact o$ &aHesCorporate &aH E"ect on Levered Euit#Corporate &aH E"ect on Levered Euit#

&h % $ &&h % t $ &


69/106

CHAPTER 21 – Capital Structure Decisions 21 - +


D &o avoid arbitrage the value o$ the frm must eual &o avoid arbitrage the value o$ the frm must eual

JJ;; 8 ?*1t, K S8 ?*1t, K SLL

JJLL K SK SLL W ?- there$oreW ?- there$ore

&he value o$ the frm 5ith leverage is the value 5ithout leverage &he value o$ the frm 5ith leverage is the value 5ithout leverageplus the corporate debt taH shield $rom debt fnancing.plus the corporate debt taH shield $rom debt fnancing.

DTV V U L +=, 21-17

Corporate DetTa# Siel$

&h % t $ &&h % t $ &


70/106



D &he total claims o$ corporate taHes- debt &he total claims o$ corporate taHes- debtholders- and euit# holders are borne b# theholders- and euit# holders are borne b# thepretaH cash Io5 produced b# the frm.pretaH cash Io5 produced b# the frm.

D %$ the frm uses more debt- and interest on that%$ the frm uses more debt- and interest on thatdebt is taHdeductible- this produces a greaterdebt is taHdeductible- this produces a greatertaH shield- reducing the government share o$taH shield- reducing the government share o$the value o$ the private enterprise- the =7CCthe value o$ the private enterprise- the =7CC

must go do5n.must go do5n.8 @ere 5e assume a 4erosum game *that value is@ere 5e assume a 4erosum game *that value isnot destro#ed through the use o$ fnancialnot destro#ed through the use o$ fnancialleverage,leverage,

&h % t $ &&h % t $ &


71/106


&he %mpact o$ &aHes &he %mpact o$ &aHes6irm Jalue 5ith Corporate &aHes6irm Jalue 5ith Corporate &aHes

21 - 5 >:?@RE

&h % t $ &&h % t $ &


72/106



D &he taH 8corrected value o$ Euation !11/ is &he taH 8corrected value o$ Euation !11/ is

D Both the interest cost and the fnancial leverage riskpremium on theBoth the interest cost and the fnancial leverage riskpremium on theeuit# cost are reduced b# *1 &,euit# cost are reduced b# *1 &,

D 7s the use o$ debt increases- =7CC decreases- and there$ore the value7s the use o$ debt increases- =7CC decreases- and there$ore the valueo$ the frm in a 5orld 5ith corporate taHes should increaseo$ the frm in a 5orld 5ith corporate taHes should increase

See Figure 21 ! $ on the following slide"See Figure 21 ! $ on the following slide"

/)1)(( S DT ! ! ! ! L DU U e −−+=, 21-18

&h % t $ &&h % t $ &


73/106


&he %mpact o$ &aHes &he %mpact o$ &aHes)+) 5ith Corporate &aHes)+) 5ith Corporate &aHes

21 - + >:?@RE

Det-E$uity Ratio

Det Cost 1D3)-45

E$uity Cost 1E

2#CC

,

&h % t $ &&h % t $ &


74/106


&he %mpact o$ &aHes &he %mpact o$ &aHes=7CC 5ith Corporate &aHes=7CC 5ith Corporate &aHes

D =7CC declines continuousl# 5ith the use o$ debt fnancing.=7CC declines continuousl# 5ith the use o$ debt fnancing.D =7CC euation corrected $or the taHdeductibilit# o$=7CC euation corrected $or the taHdeductibilit# o$

interest eHpense isinterest eHpense is

)1( T ! V

D !

V

S %ACC De −+=, 21-1

&h % t $ &&he %mpact o$ &a es


75/106


&he %mpact o$ &aHes &he %mpact o$ &aHes &aHEHtended )+) Euit# Cost Euation &aHEHtended )+) Euit# Cost Euation

D &he Fbeta0 version o$ Euation !1 8 1N allo5s us to adjust $or the &he Fbeta0 version o$ Euation !1 8 1N allo5s us to adjust $or thes#stematic risk o$ the frms#stematic risk o$ the frm

D Euit# cost 5ithout an# debt is the risk$ree rate plus the market riskEuit# cost 5ithout an# debt is the risk$ree rate plus the market riskpremium *)RP, times the unlevered beta coeXcient.premium *)RP, times the unlevered beta coeXcient.

D &his euation allo5s us to unlever betas to get the unlevered euit# &his euation allo5s us to unlever betas to get the unlevered euit#cost.cost.

D &here is one important Ia5 in this euation 8 it is assumed that 1 &here is one important Ia5 in this euation 8 it is assumed that 1debt fnancing is optimal.debt fnancing is optimal.

D &o address that issue- 5e must relaH )+)0s assumptions regarding risk &o address that issue- 5e must relaH )+)0s assumptions regarding risko$ fnancial distress or bankruptc#.o$ fnancial distress or bankruptc#.

)/)1(1( S DT &RP RF ! LU e −−×+= β , 21-2)


76/106

%ncorporating 6inancial ?istress-%ncorporating 6inancial ?istress-

Bankruptc# and 7genc# CostsBankruptc# and 7genc# Costs


B k tBankruptc#


77/106


Bankruptc#Bankruptc#%ntroduction%ntroduction

D Bankruptc# is a state o$ insolvenc# thatBankruptc# is a state o$ insolvenc# that

occurs 5hen a frm commits an act o$occurs 5hen a frm commits an act o$

bankruptc#- such as nonpa#ment o$ interest-bankruptc#- such as nonpa#ment o$ interest-

and creditors en$orce their legal rights toand creditors en$orce their legal rights torecoup mone#- or 5hen a frm voluntaril#recoup mone#- or 5hen a frm voluntaril#

declares bankruptc# in an e"ort to bedeclares bankruptc# in an e"ort to be

protected 5hile reorgani4ing to becomeprotected 5hile reorgani4ing to become

solvent again.solvent again.


78/106


Reorgani4ationReorgani4ation

D 6irms can be reorgani4ed under6irms can be reorgani4ed under

8 Companies Creditors 7rrangements 7ct *CC77,Companies Creditors 7rrangements 7ct *CC77,D ;sed b# larger more compleH frms 5ith debt Y Zm;sed b# larger more compleH frms 5ith debt Y Zm

D 6leHible 8 allo5ing the frm to pursue agreements 5ith6leHible 8 allo5ing the frm to pursue agreements 5ith

creditors(emplo#ees- to raise ne5 fnancingcreditors(emplo#ees- to raise ne5 fnancing

D &rustee is appointed b# the court and there is a sta# &rustee is appointed b# the court and there is a sta#

o$proceedingso$proceedings

8 Bankruptc# %nsolvenc# 7ct *B%7,Bankruptc# %nsolvenc# 7ct *B%7,

D Limited scope to prevent creditors $rom sei4ing assetsLimited scope to prevent creditors $rom sei4ing assetsD 9o ?%P fnancing9o ?%P fnancing

D 9o provision to impose a settlement on all creditors9o provision to impose a settlement on all creditors

Costs o$ Bankruptc#Costs o$ Bankruptc#


79/106


Costs o$ Bankruptc#Costs o$ Bankruptc#?irect Costs?irect Costs

?irect Costs?irect Costs

8 Costs incurred as a direct result o$ bankruptc#Costs incurred as a direct result o$ bankruptc#

includingincluding

D Liuidation o$ assetsLiuidation o$ assetsD Loss o$ taH losses *potential taH shield benefts,Loss o$ taH losses *potential taH shield benefts,

D Legal and accounting costsLegal and accounting costs



80/106


Costs o$ Bankruptc#Costs o$ Bankruptc#%ndirect Costs%ndirect Costs

%ndirect Costs%ndirect Costs8 6inancial distress costs are losses to a frm prior to6inancial distress costs are losses to a frm prior to

declaration o$ bankruptc# includingdeclaration o$ bankruptc# includingD 7genc# costs7genc# costsD %ncreasing costs o$ doing business%ncreasing costs o$ doing business

8 Creditors tightening trade credit termsCreditors tightening trade credit terms

8 Lending increasing risk premiums and increasing monitoringLending increasing risk premiums and increasing monitoringsurveillancesurveillance

8 loss o$ ke# sta" and increases in recruitment and retention costsloss o$ ke# sta" and increases in recruitment and retention costs8 ?istracted management $ocused on fnancing and not on?istracted management $ocused on fnancing and not on

management o$ business operations.management o$ business operations.

D Reduced sales revenueReduced sales revenue8 )anagement is distracted b# fnancial issues)anagement is distracted b# fnancial issues

8 Customers ma# become 5ar# and look $or other suppliersCustomers ma# become 5ar# and look $or other suppliers

Figure 21 ! / illustrates the rising 'alue of distress osts with inreasingFigure 21 ! / illustrates the rising 'alue of distress osts with inreasingdebt"debt"

Static &radeo"Static &radeo"


81/106


Static &radeo" Static &radeo" 6irm Jalue and 6inancial ?istress Costs6irm Jalue and 6inancial ?istress Costs

21 - 8 >:?@RE

Distress Costs

67 + D4

Det Ratio

6alue



82/106


Costs o$ Bankruptc#Costs o$ Bankruptc#7genc# Costs7genc# Costs

7genc# Costs7genc# Costs8 %t is possible $or shareholders *and Board o$ ?irectors, to act in%t is possible $or shareholders *and Board o$ ?irectors, to act in

their o5n best interests at the eHpense o$ debt holders.their o5n best interests at the eHpense o$ debt holders.8 =hen under fnancial stress sometimes=hen under fnancial stress sometimes

D Pre$erential treatment o$ creditors.Pre$erential treatment o$ creditors.

D 7ssets ma# be dissipated to related but solvent companies.7ssets ma# be dissipated to related but solvent companies.D )oral ha4ard *5here management ma# take eHtraordinar# risks)oral ha4ard *5here management ma# take eHtraordinar# risksthat 5ill be ultimatel# borne b# the debt holders- not the euit#that 5ill be ultimatel# borne b# the debt holders- not the euit#holders, *as#mmetric pa#o" o$ an option,holders, *as#mmetric pa#o" o$ an option,

8 Being a5are o$ these risks- lenders take action to protect theirBeing a5are o$ these risks- lenders take action to protect theirinterests includinginterests including

D )oratorium on $urther debt.)oratorium on $urther debt.

D %ncreases in rates on adjustablerate debt.%ncreases in rates on adjustablerate debt.D ?emands $or additional surveillance o$ fnancial per$ormance.?emands $or additional surveillance o$ fnancial per$ormance.D &ake the frm to court to en$orce rights. &ake the frm to court to en$orce rights.

Figure 21 ! 0 illustrates the shareholders one year all option 'alue on the underlyingFigure 21 ! 0 illustrates the shareholders one year all option 'alue on the underlying+rm"+rm"

6inancial ?istress- Bankruptc#- and6inancial ?istress- Bankruptc#- and


83/106


p #p #

7genc# Costs7genc# Costs &he 6irm Jalue as a Call Option $or Shareholders &he 6irm Jalue as a Call Option $or Shareholders

21 - 7 >:?@RE

7nerlying9irm 6alue

No limiteliaility

:0 million et

E$uityayoff

0



84/106


Costs o$ Bankruptc#Costs o$ Bankruptc#Summar#Summar#

Costs o$ Bankruptc# are ver# high.Costs o$ Bankruptc# are ver# high.

Probabilit# o$ Bankruptc# and 6inancial ?istressProbabilit# o$ Bankruptc# and 6inancial ?istress

costs rise eHponentiall# as the use o$ debtcosts rise eHponentiall# as the use o$ debtincreases.increases.

&hese costs rob value $rom both shareholders &hese costs rob value $rom both shareholders

and potentiall# debt holders.and potentiall# debt holders.



85/106


Costs o$ Bankruptc#Costs o$ Bankruptc#Static &radeo" )odelStatic &radeo" )odel

6igure !1 8 illustrates the impact o$ bankruptc# and6igure !1 8 illustrates the impact o$ bankruptc# andfnancial distress costs on )+) 5ith corporate taHes.fnancial distress costs on )+) 5ith corporate taHes.

8 Cost o$ euit# rises throughout as more debt is added.Cost o$ euit# rises throughout as more debt is added.

8 &he cost o$ debt rises at higher levels o$ debt. &he cost o$ debt rises at higher levels o$ debt.

8 =7CC $alls initiall# because the benefts o$ the taH=7CC $alls initiall# because the benefts o$ the taH

deductibilit# o$ interest eHpense out5eigh the marginaldeductibilit# o$ interest eHpense out5eigh the marginal

increases in component costs- ho5ever- at higher levelsincreases in component costs- ho5ever- at higher levels

o$ debt- the taHadvantage o$ debt is o"set and theo$ debt- the taHadvantage o$ debt is o"set and the

value o$ the frm $alls 5hen =7CC starts to rise.value o$ the frm $alls 5hen =7CC starts to rise.

Static &radeo" )odelStatic &radeo" )odel


86/106


Static &radeo" )odelStatic &radeo" )odel21 - >:?@RE

2#CC

1e

D%E;

Cost 3,5

1D

Det-to-e$uity

9irm6alue


87/106

Other 6actors 7"ecting CapitalOther 6actors 7"ecting Capital

Structure ?ecisionsStructure ?ecisions


Other 6actors 7"ecting CapitalOther 6actors 7"ecting Capital


88/106


StructureStructurePecking OrderPecking Order

D Static &rade o" model ignores t5o issuesStatic &rade o" model ignores t5o issues

1.1. %n$ormation as#mmetr# problems%n$ormation as#mmetr# problems

!.!. 7genc# problems7genc# problems

D &hese $actors are likel# responsible $or 5hat &hese $actors are likel# responsible $or 5hat)#ers and ?onaldson call the)#ers and ?onaldson call the pecking orderpecking order..

D &he pecking order is the order in 5hich frms &he pecking order is the order in 5hich frmspre$er to raise fnancingpre$er to raise fnancing

1.1. starting 5ith internal cash Io5-starting 5ith internal cash Io5-

!.!. debt anddebt and

'.'. fnall# issuing common euit#.fnall# issuing common euit#.


89/106

Capital Structure in PracticeCapital Structure in Practice


C it l St t i P tiC it l St t i P ti


90/106

CHAPTER 21 – Capital Structure Decisions 21 - )

Capital Structure in PracticeCapital Structure in Practice

D 6actors $avouring corporate abilit# and6actors $avouring corporate abilit# and5illingness to issue debt5illingness to issue debt

8 Proftabilit# *so the frm can use the taH shieldProftabilit# *so the frm can use the taH shield

beneft o$ interestdeductibilit#,.beneft o$ interestdeductibilit#,.

8 ;nencumbered tangible assets to be used as;nencumbered tangible assets to be used as

collateral $or secured debt.collateral $or secured debt.

8 Stable business operations over time.Stable business operations over time.

8 Corporate si4e.Corporate si4e.

8 :ro5th rate o$ the frm.:ro5th rate o$ the frm.

8 Capital market conditionsCapital market conditions

S d C l iS d C l i


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Summar# and ConclusionsSummar# and Conclusions

%n this chapter #ou have learned%n this chapter #ou have learned8 &he three e"ects o$ leverage eHpected ROE tends to &he three e"ects o$ leverage eHpected ROE tends to

increase- the variabilit# o$ the ROE increases- and the riskincrease- the variabilit# o$ the ROE increases- and the risko$ fnancial distress increases.o$ fnancial distress increases.

8 &he major determinants o$ the frm0s capital structure &he major determinants o$ the frm0s capital structuredecision are its impact on profts- risk and cash Io5s.decision are its impact on profts- risk and cash Io5s.

8 %mpacts can be assessed b# proft planning charts- fnancial%mpacts can be assessed b# proft planning charts- fnancialbreakeven anal#sis and use o$ standard ratiosbreakeven anal#sis and use o$ standard ratios

8 ?ebt creates value because interest on debt is taH?ebt creates value because interest on debt is taHdeductibledeductible

8 &he taH incentive to use debt is o"set b# the resulting &he taH incentive to use debt is o"set b# the resultingfnancial distress and bankruptc# costsfnancial distress and bankruptc# costs

8 %n a d#namic 5orld- frms depart $rom the static tradeo"%n a d#namic 5orld- frms depart $rom the static tradeo"optimal debt ratio over time- then refnance to bring it backoptimal debt ratio over time- then refnance to bring it backin line 5ith the target debt ratio.in line 5ith the target debt ratio.

8 7ctual capital structures are constantl# changing as frms7ctual capital structures are constantl# changing as frmstake advantage o$ market conditions.take advantage o$ market conditions.


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Concept Revie5 [uestionsConcept Revie5 [uestions


Concept Revie5 [uestion 1Concept Revie5 [uestion 1


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CHAPTER 21 – Capital Structure Decisions 21 - *

Concept Revie5 [uestion 1Concept Revie5 [uestion 1Business and 6inancial RiskBusiness and 6inancial Risk

?efne business risk and fnancial risk.?efne business risk and fnancial risk.


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7ppendiH 17ppendiH 1

&hunder Ba# %ndustries &hunder Ba# %ndustries

EHercise in %ndi"erence 7nal#sisEHercise in %ndi"erence 7nal#sis

&hunder Ba# %ndustries&hunder Ba# %ndustries


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&hunder Ba# %ndustries &hunder Ba# %ndustries &he Problem &he Problem

&hunder Ba# %ndustries has eHperienced rapid gro5th in sales revenue over the past $our &hunder Ba# %ndustries has eHperienced rapid gro5th in sales revenue over the past $our#ears. &he compan# is no5 operating at 1 o$ capacit# and must eHpand in order to#ears. &he compan# is no5 operating at 1 o$ capacit# and must eHpand in order tomeet the demand $or its ne5 line o$ video games.meet the demand $or its ne5 line o$ video games.

&he current fnancial statements $or &hunder Ba# %ndustries are as $ollo5s &he current fnancial statements $or &hunder Ba# %ndustries are as $ollo5s

&hunder Ba# %ndustries &hunder Ba# %ndustriesBalance SheetBalance Sheet

as at eember 1, 2344 as at eember 1, 2344

5 6333s 7dn."5 6333s 7dn."

7ssets7ssets Liabilities and O5ner\s Euit#Liabilities and O5ner\s Euit#

CashCash 1-1- 7ccounts pa#able7ccounts pa#able

7ccounts receivable7ccounts receivable !-1!-1 7ccruals7ccruals !/!/%nventories%nventories !-322!-322 Other current liabilitiesOther current liabilities 119et 6iHed 7ssets9et 6iHed 7ssets 12-!//12-!// N bonds maturing in 1 #earsN bonds maturing in 1 #ears --

]]]]]]] ]]]]]]] Common stock *1- outstanding,Common stock *1- outstanding, 1-1-

Retained earningsRetained earnings 1-'11-'1

&otal 7ssets &otal 7ssets Z!!-11Z!!-11 &otal Liabilities and O5ner\s Euit# &otal Liabilities and O5ner\s Euit# Z!!-11Z!!-11

#he most reent inome statement is found on the following slide8#he most reent inome statement is found on the following slide8



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CHAPTER 21 – Capital Structure Decisions 21 - +


&hunder Ba# %ndustries &hunder Ba# %ndustries%ncome Statement%ncome Statement

for the year ended eember 1, 2344 for the year ended eember 1, 2344

5 6333s 7dn"5 6333s 7dn"

SalesSales Z!-!Z!-!Cost o$ :oods SoldCost o$ :oods Sold 1N-!!1N-!!:ross )argin on Sales:ross )argin on Sales Z 2-3Z 2-37dministrative and Selling EHpenses7dministrative and Selling EHpenses /-/-Earnings be$ore %nterest EHpense and &aHesEarnings be$ore %nterest EHpense and &aHes !-3!-3%nterest eHpense%nterest eHpense //Earnings be$ore taHEarnings be$ore taH Z !-'Z !-' &aHes &aHes 1-111-119et %ncome9et %ncome Z1-''Z1-''

%$ the frm does not eHpand- it sales gro5th 5ill stall at the current%$ the frm does not eHpand- it sales gro5th 5ill stall at the currentZ!m level or less. %$ the compan# undertakes the planned eHpansionZ!m level or less. %$ the compan# undertakes the planned eHpansionmanagement has identifed a probabilit# distribution $or possible EB%&management has identifed a probabilit# distribution $or possible EB%&levelslevels



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%$ the frm does not eHpand- it sales gro5th 5ill stall at the current Z!m level or%$ the frm does not eHpand- it sales gro5th 5ill stall at the current Z!m level orless. %$ the compan# undertakes the planned eHpansion management hasless. %$ the compan# undertakes the planned eHpansion management hasidentifed a probabilit# distribution $or possible EB%& levelsidentifed a probabilit# distribution $or possible EB%& levels

Possible EB%&Possible EB%& Probabilit#Probabilit#

Z!-!Z!-! .1.1

Z!-3Z!-3 ././

Z'-!Z'-! ././

Z'.3Z'.3 .1.1

&he planned eHpansion 5ill reuire &hunder Ba# %ndustries to raise Z1-- &he planned eHpansion 5ill reuire &hunder Ba# %ndustries to raise Z1--in ne5 capital. %$ raised in the $orm o$ bonds- the bonds 5ould carr# a 2.in ne5 capital. %$ raised in the $orm o$ bonds- the bonds 5ould carr# a 2.coupon rate. 9e5 common stock could be sold $or Z!. per share.coupon rate. 9e5 common stock could be sold $or Z!. per share.

6ind the EB%&(EPS indi"erence point. =hat is the probabilit# that EB%& 5ill be6ind the EB%&(EPS indi"erence point. =hat is the probabilit# that EB%& 5ill begreater than the indi"erence point =hich method o$ fnancing is most likel# togreater than the indi"erence point =hich method o$ fnancing is most likel# tomaHimi4e earnings per share =hat method o$ fnancing do #ou recommendmaHimi4e earnings per share =hat method o$ fnancing do #ou recommend=h# ?iscuss the limitations o$ indi"erence anal#sis. Prepare a properl# labeled=h# ?iscuss the limitations o$ indi"erence anal#sis. Prepare a properl# labeleddiagram o$ the EB%&(EPS anal#sis.diagram o$ the EB%&(EPS anal#sis.



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&hunder Ba# %ndustries &hunder Ba# %ndustries &he Solution &he Solution

Aou can frst determine the eHpected EB%& $or neHt #ear and using that- Aou can frst determine the eHpected EB%& $or neHt #ear and using that-determine the standard deviation o$ that EB%&. &hese calculations 5ill bedetermine the standard deviation o$ that EB%&. &hese calculations 5ill be

use$ul later 5hen 5e tr# to determine the probabilit# that EB%& 5ill be lessuse$ul later 5hen 5e tr# to determine the probabilit# that EB%& 5ill be less

than- or greater than the indi"erence point.than- or greater than the indi"erence point.

Possi5le E.:T Pro5a5ilit& Wt$ E.:T

:"


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CHAPTER 21 – Capital Structure Decisions 21 -

&hunder Ba# %ndustries &hunder Ba# %ndustries &he Solution V &he Solution V

9eHt set up euations $or EPS $or each alternative9eHt set up euations $or EPS $or each alternativesource o$ fnancing- euate them- substitute in kno5nsource o$ fnancing- euate them- substitute in kno5nvalues and solve $or the common EB%&.values and solve $or the common EB%&.

000,675,2$

000,100

)43.1)(000,650000,400(

000,40000,100

)43.1)(000,400(

)1)(()1)((

)1)((

)1)((

1

21

21

1

1

21

21

1

=

−−−=

+

−−

−−−=

+

−−

=

−−−=

+

−−=

EBIT

EBIT EBIT

n

T B R B R EBIT

nn

T B R EBIT

EPS EPS

n

T B R B R EBIT EPS

nn

T B R EBIT EPS

D D D

debt 'o((on

D Ddebt

D'o((on



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CHAPTER 21 – Capital Structure Decisions 21 - 1))


Our prediction $or EPS at EB%&KZ!-23- $or the commonOur prediction $or EPS at EB%&KZ!-23- $or the commonshare fnancing alternative isshare fnancing alternative is

26.9$000,100

)43.1)(000,050,1$000,675,2($

26.9$000,140

)43.1)(000,400$000,675,2($

=−−

=

=−−

=

Debt

e'o((on)*ar

EPS

EPS



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CHAPTER 21 – Capital Structure Decisions 21 - 1)1


&he probabilit# than EB%& 5ill $avour common stock fnancing &he probabilit# than EB%& 5ill $avour common stock fnancing*ie. be less than the indi"erence point, is*ie. be less than the indi"erence point, is

=here=here 9 9 K the number o$ standard deviations a5a# $rom the meanK the number o$ standard deviations a5a# $rom the mean

: : K the point o$ interestK the point o$ interestααK the standard deviation o$ the probabilit# distributionK the standard deviation o$ the probabilit# distribution

µµ K the mean o$ the probabilit# distributionK the mean o$ the probabilit# distribution

σ

µ −

=

X

+ 6822.0110,403

000,950,2000,675,2

−=

−= +

&hunder Ba# %ndustries&hunder Ba# %ndustries 110,403000,950,2000,675,2 −

= +


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&he negative sign indicates that the point o$ interest *M, or &he negative sign indicates that the point o$ interest *M, or*indi"erence point, lies on the le$thand side o$ the mean. %t lies .2N!!*indi"erence point, lies on the le$thand side o$ the mean. %t lies .2N!!

o$ 1 standard deviation a5a# $rom the mean.o$ 1 standard deviation a5a# $rom the mean.

:oing to the table $or Jalues o$ the Standard 9ormal ?istribution:oing to the table $or Jalues o$ the Standard 9ormal ?istribution

6unction 5e fnd the area under the curve bet5een the point o$6unction 5e fnd the area under the curve bet5een the point o$interest and the mean o$ the distribution to beinterest and the mean o$ the distribution to be

.!13 or !.!3.!13 or !.!3

&here$ore- the probabilit# that EB%& 5ill eHceed the indi"erence point &here$ore- the probabilit# that EB%& 5ill eHceed the indi"erence point

*$avouring debt fnancing, is 3.13 &he probabilit# that EB%& 5ill be*$avouring debt fnancing, is 3.13 &he probabilit# that EB%& 5ill be

belo5 the indi"erence point *$avouring euit# fnancing is *1 .313,belo5 the indi"erence point *$avouring euit# fnancing is *1 .313,!/.N'.!/.N'.

#hese normal distribution is plotted on the following hart."#hese normal distribution is plotted on the following hart."

6822.0−=

&hunder Ba# %ndustries &hunder Ba# %ndustries 110,403000,950,2000,675,2 −

= +


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CHAPTER 21 – Capital Structure Decisions 21 - 1)*

&hunder Ba# %ndustriesu de a# dus es &he Solution V &he Solution V

#hese relationships are now plotted on the following indi%erene hart."#hese relationships are now plotted on the following indi%erene hart."

6822.0−=

µ&:"


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&hunder Ba# %ndustries# &he Solution V &he Solution V

#his hart illustrates that debt +naning is foreast to produe higher ;S than the#his hart illustrates that debt +naning is foreast to produe higher ;S than the

e&uity alternati'e."e&uity alternati'e."

µ&:"


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2 Capital Structure Decisions November 2014