Actual Max sales Sales Cost of Goods Sold (VC) SG&A EBIT $ 82,235,294 $ 33% 15% 2006 Income Statement 69,900,000.00 23,100,000.00 3,465,000.00 43,335,000.00 Assumptions for forecasting 29% 67% 67% 13% carry over from 2006 for first pass
Interest Earnings Before Taxes Taxes Net income Dividends Addition to Retained Earnings
7% 34% $ 15% $
2,520.00 43,332,480.00 14,733,043.20 28,599,436.80 4,289,915.52 24,309,521.28 Actual
2006 Balance Sheet Cash & securities Accounts receivable Inventories Total current assets Net fixed assets Total assets 7,000.00 5,000.00 25,000.00 37,000.00 38,157,555.55 38,194,555.55 29% 29% 29% 29%
85% $
Accounts payable
13,800,000.00
Notes payable Total current liabilities
7,000.00 13,807,000.00
29% carry over from 2006 for first pass carry over from 2006 for first pass common stock will not change add RE from income statement
Long-term debt Total liabilities Common stock ($1 par value)
29,000.00 13,836,000.00 40,000.00
Retained earnings $ Total equity Total liabilities and equity
9,034.27 $
24,318,555.55 24,358,555.55 38,194,555.55
GOALS:
goalseek: set E34=E23 if statements: D5 & F29 conditional formatting: D5 & G41
AFN= What do you do?
Ratios profit margin return on equity total assets turnover fixed asset turnover total liabilities to total assets times interest earned current
net operating working capital total net operating capital net investment in operating capital NOPAT FCF ROIC (based on total net operating capital) WACC EVA Stock price per share (projected) Book value per share (projected) MVA EPS DPS
First pass 2007 Income statement 90,171,000.00 60,414,570.00 11,722,230.00 18,034,200.00
2007 Forecast Second pass 2007 Adjustments Income statement
Third pass 2007 Adjustments
2,520.00 18,031,680.00 6,130,771.20 11,900,908.80 1,785,136.32 10,115,772.48 First pass 2007 Balance sheet 9,030.00 6,450.00 32,250.00 47,730.00 49,223,246.66 49,270,976.66
17,802,000.00
7,000.00 17,809,000.00
29,000.00 17,838,000.00 40,000.00
34,434,328.03 34,474,328.03 52,312,328.03
Pay off or increase LTD first Then pay off NP 2006 Actual 40.9% 117.4% 1.83 1.83 36.2% 17,196.43 0.00 Actual 2006 Forecast 2007 2007 Forecast
rking capital ating capital ating capital
ating capital)
e (projected) e (projected)
Third pass 2007 Income statement
c. (1.) Assume that SSC has an $800,000 capital budget planned for the coming year. You have determined th present capital structure (60 percent equity and 40 percent debt) is optimal, and its net income is forecasted a Use the residual distribution model approach to determine SSC's total dollar distribution. Asume for now that distribution is in the form of a dividend. Net Income Target equity ratio Total capital budget Distribution = = Resulting Payout = = Net Income - [(Target equity ratio) * (Total capital budget)] - 0% *
What if NI is 800,000 and cap bud is 800,000? BASE What if NI is 600,000 and cap bud is 200,000? LOW What if NI is 400,000 and cap bud is 1,000,000? MIX GOALS: Use scenarios
ng year. You have determined that its nd its net income is forecasted at $600,000. stribution. Asume for now that the
capital budget)]
A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
B
C
D
E
F
G
Chapter 15. Mini Case
Situation
Assume you have just been hired as a business manager of Pizza Palace, a pizza restaurant located adjacent to campus. The company's EB year, and since the university's enrollment is capped, EBIT is expected to remain constant (in real terms) over time. Since no expansion ca Pizza Palace plans to pay out all earnings as dividends. The management group owns about 50 percent of the stock and the stock is traded counter market.
The firm is currently financed with all equity; it has 100,000 shares outstanding; and Po=$25 per share. When you took your corporate fin instructor stated that most firm's owners would be financially better off if the firms used some debt. When you suggested this to your new you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt f different debt levels (in thousands of dollars) Total firm value 17 now 18 Percent Financed $ 2,500,000 with debt, wd rd 19 20 0% 21 20% 8.00% 22 30% 8.50% 23 40% 10.00% 24 50% 12.00% 25 26 27 If the company were to recapitalize, debt would be issued, and the funds received would be used to repurchase stock. Pizza Palace is in the 28 federal tax bracket, the risk-free rate is 6 percent, and the market risk premium is 6 percent. 29 30 31 a. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted aver 32 and free cash flows. 33 34 35 b. (1.) What is business risk? What factors influence a firm's business risk? 36 37 38 (2.) What is operating leverage, and how does it affect a firm's business risk? 39 40 41 (3.) Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10. 42 43 F = $200 Q Revenues Fixed Costs Total Costs 44 P = $15 0 45 V = $10 80 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60
A 61 62 63 64 65 66 Q 67 68 69 Q 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 Q Q
B
C
D
E
F
G
BE
=
FC
/
(P - VC)
In words, the quantity at which a firm breaks even is found as the difference between Price and Variable Fixed costs.
BE BE BE
= = =
F
÷ ÷
(P
-
VC)
c. Now, to develop an example which can be presented to PizzaPalace's management to illustrate the effects of financial leverage, consider firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12 percent debt. Both firms have $20,000 in assets, a 40 p an expected EBIT of $3,000. Two Hypothetical Firms Firm U Assets Tax Rate Equity Debt rd = $20,000 40% $20,000 $0 12% Firm L $20,000 40% $10,000 $10,000 12%
(1.) Construct partial income statements, which start with EBIT, for the two firms. Impact of Leverage Firm U 3,000.00 Firm L Distribution to Investors Firm U = Firm L = Net Income = NI + Interest =
EBIT Interest EBT Taxes NI ROIC
$
(2.) Now calculate ROE for both firms. ROE
(3.) What does this example illustrate about the impact of financial leverage on ROE?
d. Explain the difference between financial risk and business risk.
e. Now consider the fact that EBIT is not known with certainty, but rather has the following probability distribution:
Economic State Probability EBIT Bad 114 0.25 $ 2,000 Average 115 0.5 $ 3,000 Good 116 0.25 $ 4,000 117 118 119 Redo the Part a analysis for Firms U and L, but add basic earning power (BEP), return on invested capital (ROIC, defined as NOPAT/Capital 120 this company), and the times-interest-earned (TIE) ratio to the outcome measures. Find the values for each firm in each state of the econo calculate the expected values. Finally, calculate the standard deviations. What does this example illustrate about the impact of debt financ return?
Redo the Part a analysis for Firms U and L, but add basic earning power (BEP), return on invested capital (ROIC, defined as NOPAT/Capital this company), and the times-interest-earned (TIE) ratio to the outcome measures. Find the values for each firm inG each state of the econo A B C D E F 121 calculate the expected values. Finally, calculate the standard deviations. What does this example illustrate about the impact of debt financ 122 return? 123 124 Firm U: Unleveraged 125 Standard Deviation Expected values: Deviation: squared 126 Demand Bad Average Good 127 Probability 0.25 0.5 0.25 128 EBIT $ 2,000 $ 3,000 $ 4,000 $ 3,000 129 Interest $ $ $ $ 130 EBT $ 2,000 $ 3,000 $ 4,000 $ 3,000 131 Taxes $ 800 $ 1,200 $ 1,600 $ 1,200 132 Income $ 1,200 $ 1,800 $ 2,400 $ 1,800 133 ROIC 6.00% 9.00% 12.00% 9.00% 2.12% 134 ROE 6.00% 9.00% 12.00% 9.00% 2.12% 0.00002916 135 BEP 10.00% 15.00% 20.00% 15.00% 3.54% 0.000225 136 TIE 137 ROIC 0.0009 0 0.0009 138 ROE 0.0009 0 0.0009 139 BEP 0.0025 7.70372E-34 0.0025 140 TIE 0 0 0 141 142 Firm L: Leveraged 143 Standard Expected values: Deviation: 144 Demand Bad Average Good 145 Probability 0.25 0.5 0.25 146 EBIT $ 2,000 $ 3,000 $ 4,000 $ 3,000 147 Interest $ 1,200 $ 1,200 $ 1,200 $ 1,200 148 EBT $ 800 $ 1,800 $ 2,800 $ 1,800 149 Taxes $ 320 $ 720 $ 1,120 $ 720 150 Income $ 480 $ 1,080 $ 1,680 $ 1,080 151 ROIC 6.00% 9.00% 12.00% 9.00% 2.12% 152 ROE 4.80% 10.80% 16.80% 10.80% 4.24% 153 BEP 10.00% 15.00% 20.00% 15.00% 3.54% 154 TIE 1.67 2.50 3.33 2.50 155 ROIC 0.0009 0 0.0009 156 ROE 0.0036 1.92593E-34 0.0036 157 BEP 0.0025 7.70372E-34 0.0025 158 TIE 0.694444444 0 0.694444444 159 160 161 Summary 162 Firm U Firm L 163 E(ROIC) 9.00% 9.00% 164 E(ROE) 9.00% 10.80% 165 E(BEP) 15.00% 15.00% 166 E(TIE) 2.50 167 168 s(ROIC) 2.12% 2.12% 169 s(ROE) 2.12% 4.24% 170 s(BEP) 0.0354 0.0354 171 172 173 f. What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the M 174 175 176 g. What does does the empirical evidence say about capital structure theory? What are the implications for managers? 177 178 179 There's a conflict between risk and return so we must decide on a tradeoff, i.e., must decide the optimal capital structure.
A 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210
B
C
D
E
F
G
DETERMINING THE OPTIMAL CAPITAL STRUCTURE
The optimal capital structure is the one that maximizes the stock price. Also, that same capital structure minimizes the WACC. To find--or, optimal capital structure, we need information on how capital structure affects the costs of debt and equity. The effects on debt are usually with bankers and investment bankers. h. With the above points in mind, now consider the optimal capital structure for PizzaPalace.
(1.) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. Data for Recapitalization Expected EBIT = Shares Out-standing (n0)= Po = T= rrf = RPm = rs= Beta, b = $ $ 500,000 100,000 25.00 40% 6.00% 6.00% 12.00% 1.00 Percent Financed 0% 20% 30% 40% 50% rd 0% 8.00% 8.50% 10.00% 12.00%
Estimating the Cost of Equity for Different Capital Structures
Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different am leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is th
bL = bU x [1 + (1-T) x (D/S)] 211 212 213 Here bL is the leveraged beta, bU is the 214 the market value of the equity. 215 216 Calculate the cost of Equity at each debt 217 wd/ws wd 218 D/S 219 0% 0.00 220 20% 0.25 221 30% 0.43 222 40% 0.67
beta that the firm would have if it used no debt, T is the marginal tax rate, D is the market value o
level. bL 1.00 1.15 1.26 1.40 rs 12.00% 12.90% 13.54% 14.40% wd 0% 20% 30% 40% ws 100% 80% 70% 60%
223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250
A 50%
B 1.00
C 1.60
D 15.60%
E
F 50%
G 50%
bL = bU
x [1 + (1-T) x (D/S)]
(2.) Now calculate the corporate value, the value of the debt that will be issued, and the resulting market value of equity. WACC and Corporate Value for Each Capital Structure
As the table shows, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity a WACC.
We know the EBIT for each capital structure, so we can calculate the free cash flow. Since growth is zero, there will be no required investm the FCF is equal to NOPAT. FCF $ 300,000 NOPAT=EBIT x (1-T)
With the estimated FCF and WACC, we can find the corporate value, V. Since growth is zero, V: V= FCF WACC wd 0% 20% 30% 40% 50% rd 0.00% 8.00% 8.50% 10.00% 12.00% rs 12.00% 12.90% 13.54% 14.40% 15.60% WACC 12.00% 11.28% 11.01% 11.04% 11.40% V 2,500,000 2,659,574 2,724,796 2,717,391 2,631,579
$ $ $ $ $
(3.) Calculate the resulting price per share, the number of shares repurchased, and the remaining shares.
GOALS: Find max & min 251 252 Moved these cells. Graph 253 Use lookup function Repurchase Price, Value of Value of Equity, Shares P Debt, D S Outstanding, n wd 254 255 256 257 258 259 260 261 i. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure? 262 263 Maximum stock price = 264 265 Optimum debt ratio = 266 267 268
269 270 271 272 273 274
H I 1 2 3 4 5 6 pus. The company's EBIT was $500,000 last 7 Since no expansion capital will be required, 8 and the stock is traded in the over-the9 10 11 12 took your corporate finance course, your 13 ested this to your new boss, he encouraged 14 stimated costs of debt for the firm at 15 16
17 18 $ 25.00 per share 19 100,000 shares outstanding 20 21 22 23 24 25 26 k. Pizza Palace is in the 40% state-plus27 28 29 30 fect the weighted average cost of capital 31 32 33 34 35 36 37 38 39 40 s costs41 $10. of 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60
H I 61 62 63 64 65 ween Price and Variable costs divided by 66 67 68 69
70 71 72 73 ncial leverage, consider two hypothetical 74 20,000 75 assets, a 40 percent tax rate, and in 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113
114 115 116 117 118 ned as NOPAT/Capital = EBIT(1-T) / TA for 119 each state of the economy, and then 120 e impact of debt financing on risk and
ned as NOPAT/Capital = EBIT(1-T) / TA for each state of the H economy, and then I e impact of debt financing on risk and 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143
144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 e sure 173address the MM models. to 174 175 rs? 176 177 178 cture. 179
H I 180 181 182 183 the WACC. To find--or, really, estimate--the 184 ects on185 debt are usually estimated by talking 186 187 188 189 190 191 192 193 194 195 196 197
198 199 200 201 202 203 204 205 206 207 mine beta at different amount of financial 208 debt ratios. Here is the Hamada equation: 209 210
211 212 D is the market value of the debt, and S is 213 214 215 216 217 218 219 100% 220 100% 221 100% 222 100%
H 223 100%
I
224 225 equity. 226 227 228 229 on the cost of equity and then on the 230 231 232 be no 233 required investment in capital, and 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268
269 270 271 272 273 274
J 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
K
L
M
N
O
P
Q
R
S
T
U
V
17 18 utstanding 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60
J 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120
K
L
M
N
O
P
Q
R
S
T
U
V
J 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179
K
L
M
N
O
P
Q
R
S
T
U
V
J 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222
K
L
M
N
O
P
Q
R
S
T
U
V
J 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268
K
L
M
N
O
P
Q
R
S
T
U
V
FCF every ye
wd 269 270 271 272 273 274 0% 20% 30% 40% 50%
D/S
bL 1.000 1.150 1.257 1.400 1.600
rs 12.00% 12.90% 13.54% 14.40% 15.60%
0.00 0.25 0.43 0.67 1.00
W 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60
X
Y
Z
AA
AB
AC
W 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120
X
Y
Z
AA
AB
AC
W 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179
X
Y
Z
AA
AB
AC
W 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222
X
Y
Z
AA
AB
AC
W 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268
X
Y
Z
AA
AB
AC
FCF every year from now on is $300,000 per year Value of Debt, D $ $ 531,915 $ 817,439 ####### ####### Value of Equity, S $ 2,500,000 $ 2,127,660 $ 1,907,357 $ 1,630,435 $ 1,315,789 Repurchase Price, P $25.00 $26.60 $27.25 $27.17 $26.32 Shares Outstanding after repurchase, n 100,000 80,000 70,000 60,000 50,000
rd 269 270 271 272 273 274 0.00% 8.00% 8.50% 10.00% 12.00%
WACC
V
12.00% 11.28% 11.01% 11.04% 11.40%
$2,500,000 $2,659,574 $2,724,796 $2,717,391 $2,631,579