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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.

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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

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