# Review after capital structure theories and dividend policy by pptfiles

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Chapter 8
Capital budgeting techniques
Net present value; Accept the project if NPV is positive
Reject the project if NPV is negative

Payback period; Accept the project if the payback period is shorter than the company
policy.
Reject the project if the payback period is longer than the company
policy
IRR; Accept the project if the IRR is higher than cost of capital.
Reject the project if the IRR is higher than cost of capital.

Chapter 9 Review

Straight line depreciation method is used
Salvage value at the end of year 3 is \$65,000

Investment classification = replacement
No changes in sales
Cash inflows are from cost reductions
Cost reduction = \$44,000 per year

Initial investment at t=0 \$126,000
Depreciable asset value = \$120,500

Economic life of the project = 3 years

Annual cost savings = \$44,000

Salvage value=\$65,000

Annual depreciation expense
= (\$120,500 - \$65,000)/3 = \$18,500

Incremental Income statement

Income statement relevant to the project

Increase in gross profit    \$44,000
Increase in depreciation     -18,500
Increase in EBIT               25,500
Interest expenses                XX
Earnings before taxes         25,500
Increase in taxes (34%)        -8,670
Increase in net income        16,830

Annual cash inflows = \$16,830 + \$18,500
= \$35,530
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0             1         2          3
.____________.____________.__________.
-\$126,000     \$35,530  \$35,530    \$35,530
salvage value                     65,000
Net working capital                5,500

PV = 35,530 (PVIFA) 3, 12% + \$70,500 (PVIF) 3, 12%
= 85,343 + 50,196
= 135,539

NPV = \$135,539 - \$126,000
= \$9,539         Accept the project

Chapter 10: Cost of Capital

Kd = Interest rate on the firm’s debt

Kdt = Kd (1-T) = After-tax cost of the firm’s debt

Ks = Cost of equity

WACC = weighted average cost of capital

Ks = Cost of retained earnings (internal equity)

Ks = D1/P0 + g

Ks = Krf+ (Km – Krf) 

Chapter 11
Capital structure change; its impact on the cost of equity,
weighted average cost of capital (WACC), and the firm value.

Modogliani and Miller (1959), known as the MM irrelevance theorem,
argue that the firm value is irrelevant to the capital structure.
The logic of the theorem is as follows:
1)        As a firm increases debt financing, the debt to equity ratio increases.
2)        This means that the financial risk of the firm increases
3)        which in turn means that the return to equity investors become riskier.
4)        ebt holders have a higher priority of claiming the earnings from the firm.
5)        Equity holders receive what is left after paying off interest expense and taxes
6)        For a given operating earnings; higher the interest expenses, lower the return to equity
holders.
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Rational investors should require a higher rate of return for a riskier investment.
No free lunch!!
Equity investors require a higher rate of return for firms with high debt to equity ratio, as shown below
Ks = K0 + (K0 - Kb) D/E
Ks = cost of equity,
K0 = weighted average cost of capital = cost of equity of ulevered firm
Kb = cost of debt
D/E = debt to equity ratio
WACC= (portion of equity)(cost of equity) + (portion of debt)(cost of debt)
K0       = WsKs + WdKd
Example
1.            Worldwide Sprint is all-equity financed firm
2.             currently no debt in the balance sheet
3.            Call the firm as an unlevered firm
Value of Worldwide Sprint is:
V = equity value of \$1,000
Ks = 16%
No change in operating earnings, Worldwide Sprint changes its capital structure
Case 1:
Issue \$200 of debt at Kd = 10%, and use \$200 to buyback equity.
So the firm value is now
V = equity value + debt value
= \$800      +   \$200
Now, the new cost of equity is:
Ks = K0 + (K0 - Kb) D/E
200
= 16% + (16% - 10%)
800
= 17.5%
The new WACC is:
WACC= (portion of equity)(cost of equity) + (portion of debt)( cost of debt)
K0 = WsKs + WdKd
K0 = (800/1000) * 0.175 + (200/1000) * 0.10
= (0.8) * 0.175 + (0.2) * 0.10
= 0.16
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Case 2:
No change in operating earnings, worldwide Sprint changes its capital structure
Issue \$400 of debt and use \$400 to buyback equity.
So the firm value is now

V = equity value + debt value
= \$600 + \$400
Now, the cost of equity with new debt financing is
Ks = K0 + (K0 - Kb) D/E
400
= 16% + (16% - 10%)
600
= 20%

The new WACC is:
WACC= (portion of equity)(cost of equity)
+ (portion of debt)( cost of debt)
K0 = WsKs + WdKd

K0 = (600/1000) * 0.20 + (400/1000) * 0.10
= (0.6) * 0.20 + (0.4) * 0.10
= 0.16

We have seen that the weighted average cost of capital, Ko, remains at 16%, even if the financial leverage
increases. This is because the cost of equity, Ks, increases as the financial risk of the firm increases.

MM Proposition II states that K0 remains unchanged, as Ks increase with financial leverage.
Ks = K0 + (K0 - Kb) D/E

Remember that the value of a firm (V) with a constant cash inflow (EBIT) through infinity is annual cash
flows divided by the discount rate (K0)
V= EBIT/ K0
We have seen that K0 remains unchanged as the financial leverage ratio changes,
So the firm value remains unchanged as the financial ratio changes for a given EBIT.
Based on this logic, Modogliani and Miller (1959), known as the MM irrelevance theorem, argue that
the firm value is irrelevant to the capital structure.
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Review after capital structure theories and dividend policy

 Stock price = present value of expected future cash flows

P0 = D/Ks; for no growth firm

P0 = D/( Ks-g); for constant growth firm

Given expected future cash flows, can financial managers increase firm
Value by changing capital structure?

 Capital structure Irrelevant Theorem of Modigliani and Miller (MM)

 Given net income (internal cash inflows), can dividend policy influence share value?

 Is dividend clientele permanent or temporary?

 What is MM’s Proposition on dividend policy?

 Changes in dividend payments carry informational content.
 Dividend policy changes do not affect share prices to the extent that the policy changes do not
carry informational content.

 Clientele effects of dividend policy changes.
 Informational content of dividend payment changes.

How to increase the share value?

 Back to capital expenditures decisions that will increase earnings

1.  Expansion of the existing physical assets
2.  Replacing old plant and equipment
4.  Research and Development (R&D)
 New products innovation, improvement of the quality, and production technology
enhancements.
Chapter 16 and 18
1    Corporate restructuring
2. Create new market; in domestic as well as in foreign economies
3. Mergers and Acquisitions; domestic as well as cross-national M&A

 The life cycle of a firm
Birth, Growth, maturity, bankrupt (or acquired)
To Grow
Company needs capital
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Borrow or issue equity?
Initial public offerings

 Foreign direct investment and globalization
1. To create new market in foreign economies; exports or foreign direct investment
2. To enter foreign markets, cross-national M&A
3. FDI providing firms as well as recipients economies benefit from globalization.
4. Advanced technology and foreign capital increase the productivity of recipient economies
through technology spillovers.
5. As developing economies experience economic growth, these countries will import
services and products from advanced economies.
6. The process may force the local power group who run the ‘nation state’ to yield their
absolute power to new group.
7. To the extent that anecdotal evidences of ‘exploitation’ by multinational firms from
advanced economies exist, the fear of ‘exploitation’ can be used to oppose the
globalization process.

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