Finance 321 Advanced Corporate Finance

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Finance 321 Advanced Corporate Finance Powered By Docstoc
					         Does Debt Policy Matter?
•   Student Presentations
•   Capital Structure Considerations
•   Modigliani and Miller – Propositions 1 and 2
•   Financial Risk and Expected Returns
•   Weighted Average Cost of Capital (WACC)
•   After Tax WACC
                Capital Structure
• Capital structure is mixture of debt and equity
• Firm value is total value of debt plus equity
• Types of equity
  – Common
  – Preferred
• Types of debt
  – Term
  – Seniority
  – Covenants
• Hybrids
  – Convertible bonds
        Modigliani and Miller –
            Proposition 1
• Capital structure does not matter if:
  – Total cash flows do not change based on capital
    structure
  – Markets are perfect
     • No frictions (taxes or bankruptcy costs)
     • Corporations have no borrowing advantage
     • Investors have access to any desired investment
• This means that if the capital markets are
  providing adequate investment choices, then a
  firm’s value is independent of the debt ratio
     Illustration of M&M Prop. 1
Two firms with exactly the same operating income
Investor owns 1% of each firm’s securities
Firm U is unlevered (all equity)
                  Dollar Investment Dollar Return
                       .01VU           .01  Profits


Firm L is levered (has issued debt)
                   Dollar Investment         Dollar Return
          Debt          .01DL                .01 Interest
         Equity         .01EL          .01  ( Profits - Interest)
         Total       .01(DL  E L )           .01  Profits
                        .01VL

Therefore, the value of the two firms must be equal
           Another Illustration
• Investor owns 1% of levered firm L
           Dollar Investment      Dollar Return
                 .01EL       .01  ( Profits - interest)
             .01(V  DL )
                    L


• Investor owns 1% of unlevered firm U and
  borrows an amount equal to 1% of the debt of
  the levered firm
                     Dollar Investment          Dollar Return
         Borrowing          .01DL              - .01 Interest
          Equity           .01VU                 .01 Profits
           Total        .01(VU  D L )     .01 (Profits - Interest)

• Therefore, the value of the two firms must be
  equal
Modigliani and Miller's Proposition I states that:

A) The market value of any firm is independent
   of its capital structure
B) The market value of a firm's debt is
   independent of its capital structure
C) The market value of a firm's common stock
   is independent of its capital structure
D) All of the above
E) None of the above
   Law of Conservation of Value
• Two streams of cash flow
  – Stream A has a present value of PV(A)
  – Stream B has a present value of PV(B)
• Value additivity
  – The present value of the combined cash flows A+B
    is PV(A) + PV(B)
• Conservation of value
  – Splitting up a cash flow into different parts does
    not affect the total value of the parts
Example Macbeth Spot Removers
       Table 17.1 – All Equity Financed
    Data
    Number of shares       1,000
    Price per share        $10
    Market Value of Shares $ 10,000


    Outcomes
                             A    B    C      D
    Operating Income       $500 1,000 1,500 2,000
    Earnings per share     $.50 1.00 1.50 2.00
    Return on shares (%)   5 % 10     15    20
       Table 17.2 – Half Debt/Half Equity
Data
Number of shares         500
Price per share          $10
Market Value of Shares   $ 5,000
         ue
Market val of debt       $ 5,000


Outcomes
                          A        B       C       D
Operating Income          $500     1,000   1,500   2,000
Interest                  $500     500     500     500
Equity earnings           $0       500     1,000   1,500
Earnings per share        $0       1       2       3
Return on shares (%)      0%       10      20      30
Table 17.3 – All Equity Firm, Investor Leverage
 to Borrow Enough to Purchase Another Share


Outcomes
                                A       B      C      D
Earnings on twoshares           $1.00   2.00   3.00   4.00
LESS : Interest @ 10%           $1.00   1.00   1.00   1.00
Net earnings on investment      $0      1.00   2.00   3.00
Return on $10 investm ent (%)   0%      10     20     30
The law of conservation of value implies that:
 A) The value of a firm's common stock is
    unchanged when debt is added to its capital
    structure
 B) The value of any asset is preserved regardless
    of the nature of the claims against it
 C) The value of a firm's debt is unchanged when
    common stock is added to its capital structure
 D) All of the above
 E) None of the above
Financial Risk and Expected Returns
                                  expected operating income
 Expected return on assets  rA 
                                           ue
                                  market val of all securities


                      D           E 
          rA   rD        rE     
                     DE         DE

               rE  rA  rA  rD 
                                    D
                                    E
          M&M Proposition 2
“The expected rate of return on the common
stock of a levered firm increases in proportion to
the debt-equity ratio (D/E), expresses in market
values; the rate of increase depends on the spread
between the expected return on a portfolio of all
the firm’s securities and the expected return on
the debt.”
     Illustration of M&M Prop. 2
• Macbeth Spot Removers – All equity
                 expected operating income
     rE  rA 
                market val ue of all securities
           1500
                   .15
          10 ,000
• Half debt (at 10% interest) and half equity

         rE  .15  .15  .10
                                5000
                                5000
             .20 or 20%
Table 17.4 – Financial Leverage Increases Risk



                                    Operating Income
                                                     Change
                                    $1,500 to $500
All equity   Earnings per share ($)   1.50     0.50  - $1.00
              Return on shares       15%      5%      - 10%
50 % debt : Earnings per share ($)    2        0     - $2.00
               Return on shares      20%       0      - 20%
Health and Wealth Company is financed entirely by common
stock which is priced to offer a 15% expected return. If the
company repurchases 25% of the common stock and substitutes
an equal value of debt yielding 6%, what is the expected return
on the common stock after refinancing? (Ignore taxes.)

 A)   12%
 B)   15%
 C)   18%
 D)   21%
 E)   None of the above
How Change in Capital Structure
        Affects Beta

            D        E
  BA   BD     BE  
            V        V


  BE  BA  BA  BD 
           D
           E
    MM Proposition II states that:
A) The expected return on equity is positively
   related to leverage
B) The required return on equity is a linear
   function of the firm's debt to equity ratio
C) The risk to equity increases with leverage
D) All of the above
E) None of the above
The beta of an all equity firm is 1.1. If the firm changes
its capital structure to 1/3rd debt and 2/3rds equity using
8% debt financing, what will be the beta of the levered
firm? The beta of debt is 0.3. (Assume no taxes.)
A)   1.0
B)   1.1
C)   1.5
D)   1.65
E)   None of the above
          M&M Proposition II
     r
                              rE


                   rA


rD
                                   D
Risk free debt   Risky debt        E
Weighted Average Cost of Capital

                 D        E
WACC  rA   rD     rE  
                 V        V
   Practical Problems with M&M
• Unsatisfied clientele
  – Investors want, and will pay a premium for,
    securities that offer the particular financial
    instrument they want (risk, timing, etc.)
  – Should be a temporary phenomenon
• Government regulation
  – Restrictions on interest rates or available
    investments
• The impact of capital structure on cash flows
  – Taxation issues
  – Interest paid on corporate debt is a tax deduction
       After-Tax WACC

                       D        E
WACC  rD  (1  Tc)      rE  
                       V        V
whereTc  marginal corporatetax rate
             Next Few Classes
• Thursday, April 5
  – Case 2 – A-Rod
  – Case is available in 340 Wohlers
  – Be prepared to discuss the case in class
• Tuesday, April 10
  – How much should a firm borrow? – Chapter 18
• Thursday, April 12
  – Financing and valuation – Chapter 19