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Planning the Firm
s Financing Mix
Balance Sheet Current Current
Assets Liabilities
Debt andFixed Preferred
AssetsShareholders
Equity
Balance Sheet Current Current
Assets Liabilities
Debt and
Fixed Preferred Assets
Shareholders
Equity
FinancialStructure
Balance Sheet Current Current
Assets Liabilities
Debt and
Fixed Preferred Assets
Shareholders
Equity
CapitalStructure
Interest-bearingshort-term debt
Why is Capital Structure Important?
1) Leverage : Higher financial leveragemeans higher returns to
stockholders,but higher risk due to fixed payments.
2) Cost of Capital : Each source offinancing has a different
cost. Capitalstructure affects the cost of capital.The Optimal
Capital Structure is theone that minimizes the firm
s cost ofcapital and maximizes firm value.
Capital Structure Management
EBIT-EPS Analysis - Used to help determinewhether it would be
better to finance aproject with debt or equity.
EPS = (EBIT - I)(1 - t) - PS
I = interest expense, P = preferred dividends,S = number of
shares of common stockoutstanding.
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EBIT-EPS Example
A firm has 800,000 shares of common stockoutstanding, no debt,
and a marginal tax rateof 40%. It needs P6,000,000 to finance
aproposed project. It is considering twooptions:
! Sell 200,000 shares of common stock at P30 per share,
! Borrow P6,000,000 by issuing 10% bonds.
If we expect EBIT to be P2,000,000:
Financing stock debtEBIT 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. 1,000,000 800,000EPS
P1.20 P1.05
Financing stock debtEBIT 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
800,000EPS P2.40 P2.55
If we expect EBIT to be P4,000,000:! If EBIT is P2,000,000,
common stock
financing is best.! If EBIT is P4,000,000, debt financing
is best.! So, now we need to find a breakeven
EBIT where neither is better than theother.
If we choose stock financing:EPS
EBITP1m P2m P3m P4m
stock financing
0
3
2
1
If we choosebond financing:EPS
EBITP1m P2m P3m P4m
bondfinancing
0
3
2
1
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Breakeven EBIT(Indifference Point)
EPS
EBITP1m P2m P3m P4m
bondfinancing
stockfinancing
0
3
2
1
EBIT Breakeven Point
Set two EPS calculations equal to eachother and solve for
EBIT:
Stock Financing Debt Financing
(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - PS S
EBIT 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)
800,000+200,000 800,000
EBIT 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 = P3,000,000
EBIT Breakeven Point EPS
EBITP1m P2m P3m P4m
bondfinancing
stockfinancing
0
3
2
1
For EBIT up to P3 million,stock financing is best.
EBIT Breakeven Point EPS
EBITP1m P2m P3m P4m
bondfinancing
stockfinancing
0
3
2
1
For EBIT up to P3 million,stock financing is better.
For EBIT greaterthan P3 million,debt financing
is better.
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Problem 1
!
Plan A: Sell 1,200,000 shares at P10per share (P12 million
total).! Plan B: Issue P3.5 million in 9% debt
and sell 850,000 shares at P10 pershare (P12 million total).
! Assume a marginal tax rate of 50%.
EBIT Breakeven Point
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 = P1,080,000
Analytical Income Statement
Stock LeveredEBIT 1,080,000 1,080,000
I 0 (315,000)EBT 1,080,000 765,000Tax (540,000) (382,500)
NI 540,000 382,500
Shares 1,200,000 850,000EPS .45 .45
leveredfinancing
stockfinancing
EPS
EBITP.5m P1m P1.5m P2m
0
.65
.45
.25
For EBIT upto P1.08 m,
stockfinancing is
best.
leveredfinancing
stockfinancing
EPS
EBITP.5m P1m P1.5m P2m
0
.65
.45
.25
For EBIT upto P1.08 m,
stockfinancing is
best. For EBIT greaterthan P1.08 m,
the levered planis best.
leveredfinancing
stockfinancing
EPS
EBITP.5m P1m P1.5m P2m
0
.65
.45
.25
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Problem 2
!
Plan A: Sell 1,200,000 shares at P20per share (P24 million
total).! Plan B: Issue P9.6 million in 9% debt
and sell shares at P20 per share(P24 million total).
! Assume a 35% marginal tax rate.
EBIT Breakeven Point
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 = P2,160,000
Income Statement
Stock LeveredEBIT 2,160,000 2,160,000
I 0 (864,000)EBT 2,160,000 1,296,000Tax (756,000) (453,600)
NI 1,404,000 842,400
Shares 1,200,000 720,000
EPS 1.17 1.17
leveredfinancing
stockfinancing
EPS
EBITP1m P2m P3m P4m
0
1.5
1.17
.5
leveredfinancing
stockfinancing
EPS
EBITP1m P2m P3m P4m
0
1.5
1.17
.5
For EBIT upto P2.16 m,
stockfinancing is
best.
leveredfinancing
stockfinancing
EPS
EBITP1m P2m P3m P4m
0
1.5
1.17
.5
For EBIT greaterthan P2.16 m,
the levered planis best.
For EBIT upto P2.16 m,
stockfinancing
is best.
