# Capital Structure, PowerPoint Show

Shared by:
Categories
Tags
-
Stats
views:
9
posted:
6/7/2012
language:
English
pages:
21
Document Sample

```							                                        14 - 1
Choosing the Optimal Capital Structure:
Example
Currently is all-equity financed.
Expected EBIT = \$500,000.
Firm expects zero growth.
100,000 shares outstanding; rs = 12%;
P0 = \$25; T = 40%; b = 1.0; rRF = 6%;
RPM = 6%.
14 - 2

Estimates of Cost of Debt

Percent financed
with debt, wd      rd
0%           -
20%           8.0%
30%           8.5%
40%          10.0%
50%          12.0%
If company recapitalizes, debt would be
issued to repurchase stock.
14 - 3

The Cost of Equity at Different Levels

MM theory implies that beta changes
with leverage.
bU is the beta of a firm when it has no
debt (the unlevered beta)
bL = bU [1 + (1 - T)(D/S)]
14 - 4

The Cost of Equity for wd = 20%

Use Hamada’s equation to find beta:
bL = bU [1 + (1 - T)(D/S)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
rs = rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%
14 - 5

Cost of Equity vs. Leverage

wd         D/S        bL       rs
0%         0.00     1.000   12.00%
20%        0.25     1.150   12.90%
30%        0.43     1.257   13.54%
40%        0.67     1.400   14.40%
50%        1.00     1.600   15.60%
14 - 6

The WACC for wd = 20%

WACC = wd (1-T) rd + we rs
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%

Repeat this for all capital structures
under consideration.
14 - 7

WACC vs. Leverage

wd     rd       rs     WACC
0%    0.0%    12.00%   12.00%
20%   8.0%    12.90%   11.28%
30%   8.5%    13.54%   11.01%
40%   10.0%   14.40%   11.04%
50%   12.0%   15.60%   11.40%
14 - 8

Corporate Value for wd = 20%

V = FCF / (WACC-g)
g=0, so investment in capital is zero;
so FCF = NOPAT = EBIT (1-T).
NOPAT = (\$500,000)(1-0.40) = \$300,000.

V = \$300,000 / 0.1128 = \$2,659,574.
14 - 9

Corporate Value vs. Leverage

wd        WACC         Corp. Value
0%        12.00%         \$2,500,000
20%       11.28%         \$2,659,574
30%       11.01%         \$2,724,796
40%       11.04%         \$2,717,391
50%       11.40%         \$2,631,579
14 - 10

Debt and Equity for wd = 20%

The dollar value of debt is:
D = wd V = 0.2 (\$2,659,574) = \$531,915.
S = V – D
S = \$2,659,574 - \$531,915 = \$2,127,659.
14 - 11

Debt and Stock Value vs. Leverage

wd            Debt, D             Stock Value, S
0%                  \$0              \$2,500,000
20%          \$531,915                \$2,127,660
30%          \$817,439                \$1,907,357
40%       \$1,086,957                 \$1,630,435
50%       \$1,315,789                 \$1,315,789
Note: these are rounded; see Ch 14 Mini Case.xls for full
calculations.
14 - 12

Wealth of Shareholders

Value of the equity declines as more
debt is issued, because debt is used
to repurchase stock.
But total wealth of shareholders is
value of stock after the recap plus
the cash received in repurchase, and
this total goes up (It is equal to
Corporate Value on earlier slide).
14 - 13

Stock Price for wd = 20%

The firm issues debt, which changes its
WACC, which changes value.
The firm then uses debt proceeds to
repurchase stock.
Stock price changes after debt is issued,
but does not change during actual
repurchase (or arbitrage is possible).
(More…)
14 - 14

Stock Price for wd = 20% (Continued)

The stock price after debt is
issued but before stock is
repurchased reflects shareholder
wealth:
 S, value of stock
Cash paid in repurchase.
(More…)
14 - 15

Stock Price for wd = 20% (Continued)

D0 and n0 are debt and outstanding
shares before recap.
D - D0 is equal to cash that will be used
to repurchase stock.
S + (D - D0) is wealth of shareholders’
after the debt is issued but immediately
before the repurchase.
(More…)
14 - 16

Stock Price for wd = 20% (Continued)

P = S + (D – D0)
n0
P = \$2,127,660 + (\$531,915 – 0)
100,000
P = \$26.596 per share.
14 - 17

Number of Shares Repurchased

# Repurchased = (D - D0) / P
# Rep. = (\$531,915 – 0) / \$26.596
= 20,000.
# Remaining = n = S / P
n = \$2,127,660 / \$26.596
= 80,000.
14 - 18

Price per Share vs. Leverage

# shares # shares
wd       P       Repurch. Remaining
0%     \$25.00        0      100,000
20%     \$26.60    20,000      80,000
30%     \$27.25    30,000      70,000
40%     \$27.17    40,000      60,000
50%     \$26.32    50,000      50,000
14 - 19

Optimal Capital Structure

wd = 30% gives:
Highest corporate value
Lowest WACC
Highest stock price per share
But wd = 40% is close. Optimal
range is pretty flat.
14 - 20

What other factors would managers
consider when setting the target
capital structure?

Debt ratios of other firms in the
industry.
Pro forma coverage ratios at
different capital structures under
different economic scenarios.
Lender and rating agency attitudes
(impact on bond ratings).
14 - 21

Reserve borrowing capacity.
Effects on control.
Type of assets: Are they tangible,
and hence suitable as collateral?
Tax rates.

```
Related docs
Other docs by zYOU6g
In the first period
6 pattes