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Debt or Equity document sample
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Chapter 11: Debt and Equity.
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INTRODUCTION
==================
The basic background data and key decision variables for this topic are summarized in
Screens 3 through 5. Screen #3 contains the initial income statement and balance
sheet, as well as the relevant industry financial ratios that provide industry standards.
Screen #4 presents the initial values of the key decision variables involved in financing
decisions. These data are used to analyze the key factors affecting financial
decisions, as summarized in Screen #5. These are four risk factors: (1) financial
structure; (2) fixed charge coverage ratio; (3) cash flow coverage data; and (4) the
level of beta. The other key measures for evaluating alternative forms of financing
consist of two measures of relative costs: (1) effects on the cost of capital; and (2)
effects on market value per share of common stock.
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8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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QUESTIONS
==================
1) Given the initial values of the decision variables, we analyze the effects on the six valuation
factors (the four measures of risk and the two measures of cost). This will be done in five
subsections of each question.
a) How does the firm compare with the industry standards under the debt versus equity
financing alternative?
b) How does the firm perform in relation to the industry standard with regard to the
coverage ratio under the two financing alternatives?
c) Evaluate the performance of the firm in relation to the industry standard for cash flow
coverage under the two financing alternatives.
d) How is the level of beta affected by the two alternative forms of financing?
e) Under what financing alternative is the firm's weighted cost of capital lower? Market
price per share higher?
2) Suppose the cost of debt is .10 and the cost of equity is .15 under both financing
alternatives. Go to Screen #5 (Summary of Key Quantitative Factors) and determine
whether the effects on financial risk are consistent with the indicated effects on costs. To
see how summary measures of risk and cost are calculated, see Screen #6.
3) Suppose the tax rate is 30% rather than 40%, answer subquestions a through e in
Question 1.
4) You can now vary the amounts of capital to be raised and your assumptions about how the
choice of debt vs. equity financing will affect the respective costs of debt and equity to see
the effects on the cost of capital and the value of common per share.
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8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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BALANCE SHEET ($ MILLION)
===============================
ASSETS LIABILITIES
Total current assets $1,000 Notes payable $300
Net fixed assets $800 Other current liabilities $400
——————
Total current liabilities $700
Long-term debt (*) $300
——————
Total debt $1,000
Common stock, par value $1 $100
Paid-in capital $300
Retained earnings $400
—————— ——————
Total assets $1,800 Total claims on assets $1,800
========== ==========
$20
(*) Current annual sinking fund payments are million
=======================================================================
INCOME STATEMENT ($ MILLION)
=========================================
Total revenues $3,000
Depreciation expense $200
Other costs $2,484
——————
Net operating income $316
Interest expense $60
——————
Net income before taxes $256
Income taxes @ 40% $102
——————
Net income $154
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INDUSTRY FINANCIAL RATIOS
===========================
Current ratio: 2.0 times
Sales to total assets: 1.6 times
Current debt to total assets: 30%
Long-term debt to net worth: 40%
Total debt to total assets: 50%
Coverage of fixed charges: 7 times
Cash flow coverage: 3 times
Net income to sales: 5%
Return on total assets: 9%
Net income to net worth: 13%
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8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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DECISION VARIABLES
===================== Funds raised Funds raised
Current with debt with equity
Cost of debt 10% 12% 10%
Cost of equity 14% 16% 12%
-----------------------------------------------------------------------------------------------------------------
Price of new equity $9 per share
Outstanding shares of stock 100 million
Tax rate 40%
Dividend payout rate 30%
Amount of capital needed $200 million
Increased net operating income due to expansion $44 million
Increased depreciation expenses due to expansion $20 million
Increase in sinking fund due to debt increase $20 million
Risk-free rate of return 6%
Expected market return 11%
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8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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SUMMARY OF KEY QUANTITATIVE FACTORS
=========================================
PRO FORMA
A. RISK FACTORS Debt Equity
1. Financial Structure Present Financing Financing Industry
Current debt/net worth ratio 39% 35% 35% 30%
Total debt/net worth ratio 56% 60% 50% 50%
2. Fixed charge coverage ratio 5.27 4.00 6.00 7.00
3. Cash flow coverage ratio 4.69 3.05 5.27 3.00
4. Level of beta 1.60 2.00 1.20
B. RELATIVE COSTS
1. Effects on cost of capital 11.2% 12.1% 10.3%
2. Effects on market value per share of common stock##### ##### #####
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8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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A.1. FINANCIAL STRUCTURE
==============================
Pro forma Industry
Present Debt Equity Standard
Amount Percent Amount Percent Amount Percent Percent
Current debt $700 39% $700 35% $700 35% 30%
Long-term debt $300 17% $500 25% $300 15% 20%
———— ———— ———— ———— ———— ———— ————
Total debt $1,000 56% $1,200 60% $1,000 50% 50%
Equity $800 44% $800 40% $1,000 50%
———— ———— ———— ———— ———— ———— ————
Total assets $1,800 100% $2,000 100% $2,000 100%
Long-term debt
to net worth 38% 63% 30% 40%
==========================================================================
A.2. FIXED CHARGE COVERAGE
==============================
Pro forma Industry
Present Debt Equity Standard
Net operating income $316 $360 $360
Interest expenses
(From "Calculation of $60 $90 $60
Debt Interest")
Coverage ratio 5.27 4.00 6.00 7.00
8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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A.3. CASH FLOW COVERAGE
==============================
Pro forma Industry
Present Debt Equity Standard
Net operating income $316 $360 $360
Depreciation expense $200 $220 $220
———— ———— ————
Cash inflow $516 $580 $580
Interest expense $60 $90 $60
Sinking fund payments $20 $40 $20
Before-tax sinking fund payments $50 $100 $50
———— ———— ————
Cash outflow requirements $110 $190 $110
Cash flow coverage ratio 4.69 3.05 5.27 3.00
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A.4. LEVEL OF BETA
===============================
k s = RF + ( RM - RF ) Beta
Present level of Beta
0.14 = 0.06 + ( 0.11 – 0.06 ) * Beta ==> Beta = 1.60
New Beta with debt financing
0.16 = 0.06 + ( 0.11 – 0.06 ) * Beta ==> Beta = 2.00
New Beta with equity financing
0.12 = 0.06 + ( 0.11 – 0.06 ) * Beta ==> Beta = 1.20
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8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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B.1. EFFECTS ON COST OF CAPITAL
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A. Total Market Value No Expansion Expansion
Expansion with debt with equity
Market value of equity $1,097 $1,013 $1,500
Amount of debt $600 $800 $600
———— ———— ————
Value of the firm $1,697 $1,813 $2,100
B. Leverage Ratios No Expansion Expansion
Expansion with debt with equity
Total debt $600 $800 $600
Market value of the firm $1,697 $1,813 $2,100
Debt to value ratio 0.35 0.44 0.29
C. Weighted Average Cost of Capital
( kb )( 1-T )( B/V )+( kS )( S/V )
No expansion
( 0.10 )( 0.6 )( 0.35 )+( 0.14 )( 0.65 ) = 11.2%
Expansion with debt
( 0.12 )( 0.6 )( 0.44 )+( 0.16 )( 0.56 ) = 12.1%
Expansion with equity
( 0.10 )( 0.6 )( 0.29 )+( 0.12 )( 0.71 ) = 10.3%
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B.2. EFFECTS ON MARKET VALUE PER SHARE OF COMMON STOCK
=======================================================
A. Calculation of Debt Interest
Expansion Expansion
No expansion with debt with equity
Amount Rate Amount Rate Amount Rate
$300 million
short term notes payable $30 #### $36 #### $30 ####
$300 million
existing long-term debt $30 #### $30 #### $30 ####
$200 million
new long-term debt $24 ####
———— ———— ————
Total interest expense $60 $90 $60
B. Income Statement
Expansion Expansion
No expansion with debt with equity
Net operating income $316 $360 $360
Interest expense $60 $90 $60
———— ———— ————
Net income before taxes $256 $270 $300
Income taxes $102 $108 $120
———— ———— ————
Net income $154 $162 $180
C. Market Value of Equity
Expansion Expansion
No expansion with debt with equity
Net income $154 $162 $180
Cost of equity 14% 16% 12%
Value of equity $1,097 $1,013 $1,500
Number of shares 100 100 122.2
Price per share $10.97 $10.13 $12.27
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MARKET VALUE PER SHARE OF COMMON STOCK
$14.00
$12.27
$12.00
$10.97
$10.13
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
Present Financing Financing
8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
FINANCIAL STRUCTURE RATIOS
100%
90%
80%
70%
60%
60%
56%
50% 50%
50%
39%
40%
35% 35%
30%
30%
20%
10%
0%
Current debt/net worth ratio Total debt/net worth ratio
Present Debt Equity Industry
8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
COVERAGE RATIOS
10.00
9.00
8.00
7.00
7.00
6.00
6.00
5.27 5.27
Ratios
5.00 4.69
4.00
4.00
3.05 3.00
3.00
2.00
1.00
0.00
Fixed charge coverage ratio Cash flow coverage ratio
Present Debt Equity Industry
8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
COST OF CAPITAL
16.0%
14.0%
12.1%
12.0%
11.2%
10.3%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Present Financing Financing
8e9cd6c8-3df7-4dde-a294-f07f94b7d1c3.xls
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