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## Basic Elements of Capital Structure

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**Basic Elements of Capital Structure**• Debt • Basic types of debt • Priority • Senior • Subordinated • Security • Secured • Unsecured**Basic Elements of Capital Structure**• Basic characteristics of debt • Terms of the debt • Principal amount • Interest payments • Tax treatment of debt**Basic Elements of Capital Structure**• Equity • Basic types of equity • Preferred stock • Common stock • Basic characteristics of equity • Terms of preferred stock • Liquidation value • Dividend preference • Terms of common stock**Basic Elements of Valuation**• Valuation with certainty • First fundamental principle of valuation • $1 today is worth more than $1 tomorrow • Valuation with uncertainty • Second fundamental principle of valuation • $1 for sure is worth more than $1 subject to risk**Basic Elements of Valuation (Certainty)**• Simple Interest: Interest is computed solely on the original balance • Example: $100 is deposited for two years into a bank account and earns 10%/year of simple interest $100 + $100*10% = $110 (Year 1) $110 + $100*10% = $120 (Year 2) • Compound Interest: Interest is computed on the original balance plus any unpaid interest. • Example: $100 is deposited for two years into a bank account and earns 10%/year of compound interest $100 + $100*10% = $110 (Year 1) $110 + $110*10% = $121 (Year 2)**Basic Elements of Valuation (Certainty)**Yr Simple InterestCompound Interest 1 110 110 10 200 259 20 300 673 50 600 11,739**Basic Elements of Valuation (Certainty)**• General application of first principle • Future Value • FV = PV (1+r)n , where n = no. of periods • So, what is the (future) value of $100 received today if the interest rate is 5% and the money is held for one year? • FV = $100 (1 + 0.05)1 = $100 (1.05) = $105**Basic Elements of Valuation (Certainty)**• General application of first principle • Present Value • PV = FV / (1+r)n • So, what is the present value of $100 to be received one year from today, if the interest rate is 5%? • PV = $100 / (1 + 0.05)1 = $100 / 1.05 = $95.24**Basic Elements of Valuation (Certainty)**• Exercise 1 • PV = FV / (1+r)n = $1.10 / (1 + 0.05)1 = $1.10 / 1.05 = $1.05**Basic Elements of Valuation (Certainty)**• Exercise 2 • PV = FV / (1+r)n • = $1.00 / (1 + 0.10)10 • = $1.00 / 1.110 • = $1.00 / 2.59 • = $0.39**Basic Elements of Valuation (Certainty)**• Exercise 3 • $100 one year from today will have a higher value if the discount rate is 7% rather than 8% • Why? • Discount rate is in the denominator of the equation, so smaller rate results in larger value • When waiting less profitable, need more now to get to future value**Basic Elements of Valuation (Certainty)**• Question 4 • PV = FV / (1+r)n • $120 = $150 / (1+r)1 • (1+r) = $150 / $120 • (1+r) = 1.25 • r = 0.25 = 25%**Basic Elements of Valuation (Certainty)**Present values can be added together to value (future) cash flows: PV = FV1/(1+r)1 + FV2/(1+r)2 + … + FVn/(1+r)n Example: IBM issues a bond today (September 17, 2003) that promises to pay an annual coupon of $115 every September 16 for 5 years, and return $1,000 on September 16, 2008. If the discount rate is 7.5%, what’s the bond’s value?**Basic Elements of Valuation (Certainty)**• Net present value • Basic concept • Goal: determine whether an investment in a project is worthwhile • Tool: invest only in projects whose net present values are positive • NPV = PV of returns – PV of costs**Basic Elements of Valuation (Certainty)**• NPV example: Assume that you can buy a building for $150,000 today, must pay $100,000 next year for renovations, and can sell it for $350,000 in two years. What’s the NPV of the project if r = 7%? NPV = - 150,000 - 100,000/(1+.07) + 350,000/(1+.07)2 NPV = - 150,000 - 93,458 + 305,703 NPV = 62,245**Basic Elements of Valuation (Certainty)**• Another NPV example (from page 117): Assume that you can borrow $10,000 today in exchange for the promise to pay $10,850 in one year. What’s the NPV of the “project” if r = 7%? NPV = + 10,000 - 10,850/(1+.07)1 NPV = + 10,000 - 10,140 NPV = - 140 • Note distinction between interest rate (8.5%) and discount rate (7%)**Basic Elements of Valuation (Risk)**• Recall second fundamental principle of valuation • $1 for sure is worth more than $1 subject to risk • Sources of risk • Risk of no payment at all • Risk of payment of another amount • Risk of payment at another time**Basic Elements of Valuation (Risk)**• Volatility risk and default risk • Volatility risk is the risk imposed by the uncertainty of returns • Default risk is the risk of nonpayment • Default risk is one source of volatility risk • In the corporate context, “risk” generally means volatility risk**Basic Elements of Valuation (Risk)**• Risk imposes costs on individuals • Due to risk aversion • Downside losses are weighed more heavily than upside gains • Because individuals have declining marginal utility of wealth • And due to psychological effects**Basic Elements of Valuation (Risk)**• Returns with risk • Future (certain) value is replaced with expected value • Principle for calculation • EV = Σ pi xi, where xi is a possible outcome and pi is the probability of that outcome**Basic Elements of Valuation (Risk)**• Returns with risk • Example expected value calculation • Coin toss: $0 if heads, $15 if tails • EV = (1/2) ($0) + (1/2) ($15) = $7.50**Basic Elements of Valuation (Risk)**• Measure of risk • Variance • Degree of dispersion of actual returns around the expected return • Greater spread implies greater risk • Coin toss: $0 if heads, $15 if tails: high(er) risk • Coin toss: $5 if heads, $10 if tails: low(er) risk**Basic Elements of Valuation (Risk)**• Measure of risk • Discount rate • Variance difficult to incorporate into present value calculations • Higher discount rate is used • Reflects need for higher return to compensate for risk**Basic Elements of Valuation (Risk)**• Value of future risky returns • Must account for: • Time value of money • Risk • So, • Apply present value formula (which accounts for time value) to • expected value and • incorporate risk into discount rate • PV = EV / (1+r)n