Chapter 16: Planning the Firm’s Financing Mix

1. Debt Common Equity Preferred Chapter 16: Planning the Firm’s Financing Mix How do we want to finance our firm’s assets?  2002, Prentice Hall, Inc.

2. Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity

3. Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity

4. Balance Sheet Current Current AssetsLiabilities Debt and FixedPreferred Assets Shareholders’ Equity Financial Structure

5. Balance Sheet Current Current Assets Liabilities Debt and Fixed Preferred Assets Shareholders’ Equity

6. Balance Sheet Current Current Assets Liabilities Debtand Fixed Preferred Assets Shareholders’ Equity Capital Structure

7. Why is Capital Structure Important? • 1) Leverage: higher financial leverage means higher returns to stockholders, but higher risk due to interest payments. • 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. • 3) The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.

8. What is the Optimal Capital Structure? • In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter. • This is known as the Independence hypothesis: firm value is independent of capital structure.

9. Independence Hypothesis • Firm value does not depend on capital structure.

10. Independence Hypothesis Cost of Capital kc = cost of equity kd = cost of debt ko = cost of capital . kc 0% debt financial leverage 100%debt

11. Cost of Capital kc kd kd 0% debt financial leverage 100%debt Independence Hypothesis .

12. Cost of Capital kc kd kd 0% debt financial leverage 100%debt Independence Hypothesis .

13. Cost of Capital kc kd kd 0% debt financial leverage 100%debt Independence Hypothesis Increasing leverage causes the cost of equity to rise.

14. Increasing leverage causes the cost of equity to rise. kc Cost of Capital kc kd kd 0% debt financial leverage 100%debt Independence Hypothesis

15. Increasing leverage causes the cost of equity to rise. kc Cost of Capital What will be the net effect on the overall cost of capital? kc kd kd 0% debt financial leverage 100%debt Independence Hypothesis

16. Increasing leverage causes the cost of equity to rise. kc Cost of Capital What will be the net effect on the overall cost of capital? kc kd kd 0% debt financial leverage 100%debt Independence Hypothesis

17. kc Cost of Capital ko kd 0% debt financial leverage 100%debt Independence Hypothesis kc kd

18. Independence Hypothesis • If we have perfect capital markets, capital structure is irrelevant. • In other words, changes in capital structure do not affect firm value.

19. Dependence Hypothesis • Increasing leverage does not increase the cost of equity. • Since debt is less expensive than equity, more debt financing would provide a lower cost of capital. • A lower cost of capital would increase firm value.

20. Cost of Capital kc kc kd kd financial leverage Dependence Hypothesis Since the cost of debt is lower than the cost of equity...

21. Cost of Capital kc kc ko kd kd financial leverage Dependence Hypothesis Since the cost of debt is lower than the cost of equity… increasing leverage reduces the cost of capital.

22. Moderate Position • The previous hypothesis examines capital structure in a “perfect market.” • The moderate position examines capital structure under more realistic conditions. • For example, what happens if we include corporate taxes?

23. Remember this example?Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

24. Remember this example?Tax effects of financing with debt with stockwith debt EBIT 400,000 400,000 - interest expense 0(50,000) EBT 400,000 350,000 - taxes (34%) (136,000)(119,000) EAT 264,000 231,000 - dividends (50,000) 0 Retained earnings 214,000 231,000

25. kc Cost of Capital kc kd kd financial leverage Moderate Position

26. Even if the cost of equity rises as leverage increases, the cost of debt is very low... kc Cost of Capital kc kd kd financial leverage Moderate Position

27. Even if the cost of equity rises as leverage increases, the cost of debt is very low... kc Cost of Capital because of the tax benefit associated with debt financing. kc kd kd financial leverage Moderate Position

28. The low cost of debt reduces the cost of capital. kc Cost of Capital kc kd kd financial leverage Moderate Position

29. The low cost of debt reduces the cost of capital. kc Cost of Capital kc ko kd kd financial leverage Moderate Position

30. Moderate Position • So, what does the tax benefit of debt financing mean for the value of the firm? • The more debt financing used, the greater the tax benefit, and the greater the value of the firm. • So, this would mean that all firms should be financed with 100% debt, right? • Why are firms not financed with 100% debt?

31. Why is 100% Debt not Optimal? Bankruptcy costs: costs of financial distress. • Financing becomes difficult to get. • Customers leave due to uncertainty. • Possible restructuring or liquidation costs if bankruptcy occurs.

32. Why is 100% Debt not Optimal? Agency costs: costs associated with protecting bondholders. • Bondholders (principals) lend money to the firm and expect it to be invested wisely. • Stockholders own the firm and elect the board and hire managers (agents). • Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases.

33. Cost of Capital kc kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

34. Cost of Capital kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

35. Cost of Capital kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

36. Cost of Capital kc kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

37. kc Cost of Capital kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

38. kc Cost of Capital If a firm borrows too much, the costs of debt and equity will spike upward, due to bankruptcy costs and agency costs. kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

39. kc Cost of Capital kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

40. kc Cost of Capital kc kd ko kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

41. kc Cost of Capital ko kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

42. kc Cost of Capital Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital. ko kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

43. kc Cost of Capital ko kc kd kd financial leverage Moderate Positionwith Bankruptcy and Agency Costs

44. Capital Structure Management • EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity.

45. Capital Structure Management • EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S

46. Capital Structure Management • EBIT-EPS Analysis - used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding.

47. EBIT-EPS Example Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options: • Sell 200,000 shares of common stock at $30 per share, • Borrow $6,000,000 by issuing 10% bonds.

48. If we expect EBIT to be $2,000,000: Financing stock debt EBIT 2,000,000 2,000,000 - interest 0(600,000) EBT 2,000,000 1,400,000 - taxes (40%) (800,000)(560,000) EAT 1,200,000 840,000 # shares outst. 1,000,000 800,000 EPS $1.20 $1.05

49. If we expect EBIT to be $4,000,000: Financing stock debt EBIT 4,000,000 4,000,000 - interest 0(600,000) EBT 4,000,000 3,400,000 - taxes (40%) (1,600,000)(1,360,000) EAT 2,400,000 2,040,000 # shares outst. 1,000,000 800,000 EPS $2.40 $2.55

50. If EBIT is $2,000,000, commonstockfinancing is best. • If EBIT is $4,000,000, debt financing is best. • So, now we need to find a breakevenEBIT where neither is better than the other.