1 / 95

Corporate Finance-II

Corporate Finance-II. EMBA Winter Semester 2009 Lahore School of Economics. Financial leverage & Capital structure policy. Chapter-17. Financial leverage & Capital structure policy. Learning Objectives Capital structure? Effect of Financial Leverage? M&M Propositions?

cais
Download Presentation

Corporate Finance-II

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Corporate Finance-II EMBA Winter Semester 2009 Lahore School of Economics

  2. Financial leverage & Capital structure policy Chapter-17

  3. Financial leverage & Capital structure policy Learning Objectives • Capital structure? • Effect of Financial Leverage? • M&M Propositions? • Corporate Taxes & Capital Structure? • Optimal Capital Structure? • Bankruptcy Process & Costs?

  4. The Capital StructureQuestion What is it?…. • How much Debt relative to Equity should a firm have? • What should be the Borrowing policy?

  5. Capital Structure Restructuring.. If a firm wants to increase D/E ratio (increase borrowing) What could it do…? (keeping its assets same)

  6. Capital Structure Restructuring.. If a firm wants to increase D/E ratio (increase borrowing) What could it do…? (keeping its assets same) Issue Bonds & use the cash proceeds to buy Shares!

  7. Capital Structure Restructuring.. If a firm wants to decrease D/E ratio (reduce borrowing) What could it do…? (keeping its assets same)

  8. Capital Structure Restructuring.. If a firm wants to decrease D/E ratio (reduce borrowing) What could it do…? (keeping its assets same) Issue Stock & use the cash to pay off Debt!

  9. Firm value & Stock Value – An Example The Market value of JJ Sprint company is $1000. The company currently has no debt, & JJ Sprint’s 100shares sell for $10 each. Further suppose that JJ Sprint restructures itself by borrowing $500 & then paying out the proceeds to shareholders as an extra dividend of $5 per share.

  10. Firm value & Stock Value – An Example

  11. Firm Value & Stock Value This means.. Change in the value of the firm is the same as the net effect on the stockholders. Financial Managers can try to find the Capital structure that maximizes the value of the firm

  12. Capital Structure How should the firm approach this decision?.. • Maximization of shareholder value • Maximization of Share price Same as: • Maximizing the whole value of the Firm!

  13. Capital Structure & The cost of Capital Alternatively: Firm should focus on Minimizing WACC. As, WACC is the appropriate discount rate for the firm’s overall Cash flows. Because values & discount rates move in opposite directions: Minimizing WACC should result in: Maximizing Value!

  14. Capital Structure & The cost of Capital And so.. Optimal Capital Structure (D/E ratio) represents lowest possible WACC Also called:TARGET Capital Structure

  15. The effect of financial leverage Effects of Financial Leverage?.. • Financial Leverage refers to the extent to which a firm relies on Debt. • More Debt means MORE leverage

  16. THE Effects of Financial Leverage - Example • We consider case of company X which has no debt & is considering restructuring to include debt in its capital structure. • We look at DEBT & NO DEBT situations • Taxes are ignored

  17. THE Effects of Financial Leverage - Example

  18. THE Effects of Financial Leverage - Example

  19. THE Effects of Financial Leverage - Example

  20. THE Effects of Financial Leverage - Example

  21. THE Effects of Financial Leverage - Example

  22. THE Effects of Financial Leverage - Example

  23. THE Effects of Financial Leverage - Example

  24. THE Effects of Financial Leverage - Example

  25. EPS Becomes sensitive to Leverage Debt Advantage Debt disadvantage

  26. THE Effects of Financial Leverage - Example Finding the BE point.. With NO Debt… EPS = EBIT/400,000 shares With DEBT EPS = (EBIT-$400,000 / 200,000 shares) Break even point is the point where EBIT is such that EPS under both scenarios is same: Break Even EBIT = ?

  27. THE Effects of Financial Leverage - Example Finding the BE point.. With NO Debt: EPS = EBIT/400,000 shares With DEBT: EPS = (EBIT-$400,000 / 200,000 shares) Break even point is the point where EBIT is such that EPS under both scenarios is same: EBIT = 800,000 & EPS = $2 This is the indifference point

  28. Capital Structure & Break Even Point Leverage is … Beneficial if EBIT is ABOVE Break-even EBIT & Not beneficial if EBIT is BELOW Break-even EBIT

  29. Capital Structure & Break-even point - Example Suppose ABL has decided to increase its D/E ratio. It wants to increase Debt from Rs 1,500,000 to 10,000,000. The interest rate on this will be 16%. ABL has 750,000 shares outstanding which sell for Rs 85. If the restructuring increases the ROE. Calculate the indifference point or BE point for ABL!

  30. Capital Structure & Break-even point - Example Step 1:Calculate Interest Expense under both scenarios: Interest expensecurrentcapital structure: =Debt * Interest Rate =1500000*0.16 =240000 Interest Expense NEW Capital Structure: =Debt * Interest Rate = 10000000 x .16 =1600000

  31. Capital Structure & Break-even point - Example Step 2: Calculate No. of shares outstanding under both scenarios Total # of shares under Current Capital structure = 750,000 # of shares repurchased under New Capital structure: = Increase in Debt / Price per share =(10M – 1.5M)/85 =100,000 Total # of shares outstanding under new capital structure = Already Outstanding Shares – Shares Repurchased = 750,000 – 100,000 =650,000

  32. Capital Structure & Break-even point - Example Step 3:Getting Break-even EBIT Break-even point is the point where EPS under both scenarios is equal: EPS WITH Current Capital Structure: = (EBIT – 240,000)/750,000 EPS with NEW capital Structure: = (EBIT – 1.6mm)/650,000

  33. Capital Structure & Break-even point - Example Step 3:Getting Break-even EBIT Break-even point is the point where EPS under both scenarios is equal: Break-even EBIT: (EBIT-240000)/750,000 = (EBIT – 1.6M)/650,000 EBIT – 1.6M = 650000/750000 x (EBIT – 240000) EBIT – 1.6M =(0.866 EBIT) – 207840 0.134 EBIT = 1.6M – 207840 EBIT =10,389,254

  34. Capital Structure & Break-even point - Example Verifying EPS: If EBIT is 10,389,254 then using equations we get: No Debt:EPS = (10389254 - 240000)/750,000 = 13.53 Debt:EPS= (10389254 – 1.6M)/650,000 =13.52

  35. Capital Structure Leverage Conclusions..

  36. Capital Structure Leverage Conclusions.. • Effect of Leverage depends on EBIT. • When EBIT is high, leverage is beneficial • 2.Leverage increases returns (indicated by ROE & EPS) • 3.Risk increases with Leverage (variability of ER’s)

  37. Corporate Borrowing & Home Made Leverage Home Made Leverage: The use of personal borrowings to change the overall amount of financial leverage to which the individual is exposed.

  38. Home Made Leverage - Example

  39. Corporate Borrowing & Home Made Leverage Home Made Leverage simply means, the investors can replicate the firm’s capital structure by using the same D/E ratio’s. And investors can adjust their D/E to get different payoffs. Thus, this implies… The firm’s choice of capital structure does not matter! Therefore, The stock price should not be affected by capital structure, although the payoff’s do.

  40. ASSIGNEMENT # 4 (5Quetsions) Q1: XYZ Corp has no debt outstanding & a total Market Value of $150,000, EBIT is projected to be $15,000, if economic conditions are normal. If there is strong Expansion in the economy, then EBIT will be 30% higher. If there is recession, then EBIT will be 60% lower. XYZ is considering a $60,000 debt issue with a 5% interest rate. The proceeds will be used to repurchase shares of stock. There are currently 2500 shares of stock outstanding. Ignore taxes for this problem. A) Calculate EPS under each of the three economic scenarios before any debt is issued. Also, calculate the percentage change in EPS when the economy expands or enters a recession. B) Repeat Part (a) assuming that XYZ goes through with re-capitalization. What do you observe?

  41. Q#1 (Continued) C) Repeat part (a) & (b) assuming XYZ Corp has a tax rate of 35%. D) Suppose XYZ Corp has a Market to Book ratio of 1. Calculate ROE under each of the three economic scenarios before any debt is issued. Also, calculate percentage change in ROE for economic Expansions & Recession assuming No taxes. E) Repeat Part (D) assuming the firm goes through recapitalization. F) Repeat part (D) & (E) assuming the firm has a tax rate of 35%.

  42. Q#2 Break – EVEN EBIT Malang Fabric Manufacturing is comparing two different capital structures, an all equity plan (Plan I) & a levered plan (Plan II). Under Plan I, Malang would have 150,000 shares of stock outstanding. Under Plan II there would be 60,000 shares of stock outstanding & 15 million Rupees in Debt outstanding. The interest rate on debt is 10% and there are no taxes. A) If EBIT is 2million Rupees which plan will result in the higher EPS? B) If EBIT is 7million Rupees, which plan will result in the higher EPS? C) What is the Break – Even EBIT?

  43. Q#3Break – Even EBIT with Taxes Shantou Beverage is comparing two different capital structures. Plan I would result in 1,100 shares of stock outstanding 17 million yaun in Debt. Plan II would result in 900 shares of stock & 28 million yaun in Debt. Interest rate is 10%. A) Ignoring taxes, compare both these plans to an all equity plan assuming that EBIT will be 10 million yaun. The all – Equity plan would result in 1,400 shares of stock outstanding. Which of these plans has the Highest EPS? The lowest?

  44. Q#3 Continued B) In part (A), what are the Break – even levels of EBIT for each plan as compared to that for all – equity plan? Is one higher than the other? C) Ignoring taxes, when will EPS be identical for Plans I & II. D) Repeat Parts (A), (B) & (C) assuming that the corporate tax rate is 40%.

  45. Q#4 Home Made Leverage Valencia Items, a prominent consumer products firm is debating whether or not to convert its all equity capital structure to one that is 40% debt. Currently, there are 2,000 shares outstanding and the price per share is 70 Euros. EBIT is expected to remain at 16,000 Euros per year forever. The interest rate on new debt is 10% & there are no Taxes. A) Ms. Aznar, a shareholder of the firm owned 100 shares of stock. What is her Cash flow under the current capital structure? Assume that she keeps all 100 of her shares.

  46. Q#4 Continued B) Suppose Valencia does convert, but Ms Aznar prefers the current all Equity capital structure. Show how she could unlever her shares of stock to recreate the original capital structure. C) Suppose Valencia does not convert, but Ms Aznar prefers a capital Structure that is 70% Debt. Show how she could lever her shares of stock to recreate the original capital Structure.

  47. Q#5 Home Made leverage ABC Co. & XYZ Co. are identical firms in all respects except for their capital structure. ABC is all-equity financed with $600,000 in stock. XYZ uses both stock & perpetual Debt; its stock is worth $400,000 & the interest rate on its debt is 9%. Both firms expect EBIT to be $75,000. Ignore Taxes. A) Maichin owns $30,000 worth of XYZ’s stock. What rate of return is she expecting? B) Show how Maichin could generate exactly the same cash flows & rate of return by investing in ABC & using home Made leverage.

  48. Financial leverage & Capital structure policy Learning Objectives • Capital structure? • Effect of Financial Leverage? • M&M Propositions? • Corporate Taxes & Capital Structure? • Optimal Capital Structure? • Bankruptcy Process & Costs?

  49. Capital Structure & the cost of Equity Capital M&M Proposition I with no Taxes What we have just discovered regarding Capital Structure & the firm’s value through home-made leverage is proposed by Franco & Merton as theM&M proposition Iwhich states: The Value of the Firm is Independent of its capital structure Or It is irrelevant how a firm chooses its financing

  50. M&M Proposition I-The Pie Model

More Related