Chapter 13. Capital Structure and Leverage

Chapter 13 -- Capital Structure and Leverage



. Capital structure
. Business risk vs. financial risk
. Break-even analysis
. Determining the optimal capital structure
. Capital structure theories


Firms can use equity and debt as sources of finance. Capital structure theory is concerned with the decision relating to their proportion.



. Capital structure


Capital: investor-supplied funds, such as long- and short-term loans, preferred
stock, common stock, and retained earnings



Capital structure: the mix of debt, preferred stock, and common equity that is used
by a firm to finance its assets



The optimal capital structure: the capital structure that maximizes the company’s
stock price (or minimizes the company’s overall cost of capital, WACC)



Capital structure changes over time





. Business risk vs. financial risk


 Business risk: the riskiness inherent in the firm’s operations if it uses no debt

It is measured by the variability of expected ROE (ROA)



Business risk depends on:

Competition

Demand variability

Sales price variability

Input cost variability

Ability to develop new products

Operating leverage

Foreign risk

 Regulations



 Operating leverage: the extent to which the fixed costs are used, the higher the

fixed costs, the higher the operating leverage, the higher the business risk



 Financial risk: the additional risk placed on stockholders as a result of the firm’s
decision to use debt



 Financial leverage: the extend to which fixed income securities are used

. Break-even analysis


 Variable costs: vary with the output

 Fixed costs: not vary with the output



 Notation: V: variable cost per unit

 Q: the number of units sold

 P: price

 F: fixed costs

 F

 Break-even level of sales: QBE = ---------

 P - V





. Determining the optimal capital structure


WACC and capital structure change



WACC = wd(rd)(1-T) + wc(rs), assuming no preferred stock

 = (D/A)*(rd)*(1-T) + (E/A)*(rs)



where D/A is the debt-to-asset ratio (also called debt ratio) and E/A is the equity-
to-asset ratio (also called equity ratio) and D/A + E/A = 1



You are going to choose D/A or E/A to minimize WACC



Cost of debt increases with debt; cost of equity increases with debt; beta increases
with debt (since higher debt increases the risk of bankruptcy)

We observe , T, D/E ratio, therefore we can figure out . We then vary D/E to figure out at different capital structure. We apply CAPM to find the required rates of return and stock prices at different capital structure to find the optimal capital structure that maximizes the stock price (or minimizes the WACC) 

Note: EPS maximization is not the goal of a firm and usually the maximum EPS doesn’t occur at the same capital structure where the stock price is maximized or the WACC is minimized. 

. Capital structure theories 

 Assumptions: perfect capital markets with no taxes, homogeneous information, 

EBIT is not affected by using debt, and investors can borrow at the same rate as 

corporations 

 Irrelevance theory (Modigliani and Miller 1958): capital structure doesn’t matter; the capital structure 

does not affect stock price or the overall cost of capital 

The effect of taxes (MM 1963): if corporate taxes are considered, stock price and overall cost of capital will be affected by the capital structure. The higher the debt, the lower the overall cost of capital, the higher the stock price. 

 The trade-off model: corporate taxes are considered and firms may fail.

Costs of financial distress include bankruptcy-related costs 

Benefits from tax shields 

The greater the use of debt, the larger the fixed interest charges, the greater the probability that a firm will go bankruptcy. At the same time, the greater the use of debt, the larger the tax shields. 

 VL = VU + PV(tax shields) - PV(financial distress and agency costs) 

 Implication of trade-off model: 

Higher-risk firms should borrow less 

Firms with tangible assets can borrow more 

Firms in higher tax bracket can borrow more 

 Signaling theory: asymmetric information means that investors and management 

have different information. Any change in capital structure reveals insider 

information. For example, a firm issues new stock to raise money is viewed as a 

negative signal which causes stock price to drop.



MBA Core Management Knowledge - One Year Revision Schedule

  

Chapter 12. Capital Budgeting and Risk Analysis of Projects

. Risk analysis in capital budgeting


 Adjusting the cost of capital for risk



 Project stand-alone risk: the risk of a project as if it were the firm’s only project



 Project’s within-firm risk: the amount of risk that a project contributes to the firm

Project’s market risk: the risk that a project contributes to the market, measured
by the project’s beta coefficient



 Pure play method to estimate a new project’s market risk



Identify firms producing only one product that is the same as your project is going
to produce and estimate betas for these firms; average these betas to proxy for
your project’s beta: use CAPM to estimate your project’s required rate of return



Methods to incorporate risk into capital budgeting



Risk-adjusted cost of capital: use the beta risk to estimate the required rate of  return for the project and use that rate as the discount rate to evaluate the project; the higher the risk, the higher the discount rate





. Optimal capital budget


 The annual investment in long-term assets that maximizes the firm’s value



 Capital rationing: the situation in which a firm can raise a specified, limited amount of capital regardless of how many good projects it has



 For example, a firm has $5 million of capital budget and has three good projects

Project

Initial investment

NPV

A

$5,000,000

$1,000,000

B

$3,000,000

$600,000

C

$2,000,000

$500,000



 The firm should choose projects B and C to maximize firm’s value

MBA Core Management Knowledge - One Year Revision Schedule





.

Chapter 11. Capital Assets - Projects - Proposals Appraisal

Chapters 11. Capital Budgeting



. Capital budgeting
. Project classifications
. Capital budgeting techniques
. Cash flow estimation
. Risk analysis in capital budgeting
. Optimal capital budget






. Capital budgeting


 Strategic business plan: a long-run plan that outlines in broad terms the firm’s
basic strategy for the next 5 to 10 years



 Capital budgeting: the process of planning expenditures on assets with cash flows

 that are expected to extend beyond one year





. Project classifications


Replacement Projects:

Need to continue current operations

Need to reduce costs



Expansion Projects:

Need to expand existing products or markets

Need to expend into new products or markets



Others: safety/environmental projects, mergers





. Capital Assets - Projects Appraisal techniques


 (1) Net present value (NPV): present value of future net cash flows, discounted at  the cost of capital

 , where r is the cost of capital, CFt is the cash flow in time t ..
.
.




 (2) Internal rate of return (IRR): rate of return a project earns (a discount rate that forces a project’s NPV to equal zero)

 ..
.
.
.


 Problems associated with IRR:

 Multiple rates of return and unrealistic reinvestment rate assumption




 (3) Modified internal rate of return (MIRR): discount rate at which the present value of initial cost is equal to the present value of the terminal value



 (4) Payback period: the length of time (years) required for an investment’s cash flows to cover its cost



 (5) Discounted payback period: the length of time (years) required for an investment’s cash flows, discounted at the investment’s cost of capital to recover its cost





 Decision rule: if NPV > 0, accept the project; if NPV < 0, reject the project


 Independent vs. mutually exclusive projects



 Independent projects are projects with cash flows that are not affected by the acceptance or rejection of other projects



 Mutually exclusive projects are a set of projects where only one can be accepted




 In general, you should choose the project with the highest positive NPV



 If they are independent, you choose all projects with NPV  > 0








Decision rule: if IRR > r, accept the project; if IRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)



 Multiple IRRs: the situation where a project has two or more solutions (or IRRs)



 Reinvestment rate assumptions: NPV approach is based on the assumption that
cash flows can be reinvested at the project’s risk-adjusted WACC, where the IRR
approach is based on the assumption that cash flows can be reinvested at the
project’s IRR






(3) MIRR approach






(1) Compound each future cash inflow to the “terminal year”, using WACC

(2) Add all the future values to get “terminal value”

(3) Calculate I/YR to get MIRR



Decision rule: if MIRR > r, accept the project; if MIRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)






 NPV profile: a graph that shows the relationship between a project’s NPV and the firm’s cost of capital






  Crossover rate: the cost of capital at which the NPV profiles of two projects cross and thus, at which the projects’ NPVs are equal



  Ranking problem (conflict): NPV approach and IRR approach sometimes will
lead to different rankings for mutually exclusive projects





 If ranking problem occurs use NPV approach to make the final decision



 Main conditions to cause conflicts

 a. Timing of cash flows

 b. Scale of cash flows



 (4) Payback period approach



 Decision rule:

If payback < maximum payback, then accept the project

If payback > maximum payback, then reject the project



 Weaknesses:

 Arbitrary maximum payback

 Ignores time value of money

 Ignores cash flows after maximum payback period


 (5) Discounted payback period approach



Step 1: discount future cash flows to the present at the cost of capital (round to the
nearest whole dollar)

Step 2: follow the steps similar to payback period approach



 Decision rule: similar to that of payback period



Weaknesses:

 Arbitrary maximum discounted payback period

 Ignores cash flows after maximum discounted payback period





. Cash flow estimation


 Guidelines when estimating cash flows:

 Use after tax cash flows

 Use increment cash flows

 Changes in net working capital should be considered

 Sunk costs should not be included

 Opportunity costs should be considered

 Externalities should be considered

 Ignore interest payments (separate financing decisions from investment decisions)



 FCF = [EBIT*(1 - T) + depreciation] – [capital expenditures + NOWK) .



 EBIT*(1 - T) = net operating profit after tax = NOPAT

 NOWK = change in net operating working capital



Steps in estimating cash flows:

(1) Initial outlay

 (2) Differential (operating) cash flows over project’s life

 (3) Terminal cash flows

 (4) Time line and solve


MBA Core Management Knowledge - One Year Revision Schedule

Chapter 10. Cost of Equity and Debt Capital

Chapter 10. Cost of Capital



. Capital components
. Cost of debt
. Cost of preferred stock
. Cost of retained earnings
. Cost of new common stock
. Weighted average cost of capital (WACC)
. Adjusting the cost of capital for risk



Cost of capital has to be calculated by finance managers and they have to communicate it to operating managers so that they come out with project proposals having return higher than the cost of capital. To calculate cost of valuation formulas developed for bonds, equity, and preferred stock are used with current market prices of company's securities. The assumption being that company can sell securities in the market at the current prices. Generally, company may have to sell at a lesser price than the market and this figure is included in floatation cost. Floatation cost also includes advertisement, underwriting and brokerage charges.


. Capital components


 Debt: debt financing

 Preferred stock: preferred stock financing

 Equity: equity financing (internal vs. external)

Internal: retained earnings

External: new common stock

 Weighted average cost of capital (WACC)





. Cost of debt


 Recall the bond valuation formula

 Replace VB by the net price of the bond and solve for I/YR

I/YR = rd (cost of debt before tax)



 Net price = market price - flotation cost of bonds



If we ignore flotation costs which are generally small, we can just use the actual

market price to calculate rd



Cost of debt after tax = cost of debt before tax (1-T) = rd (1-T)



 Example: if a firm can issue a 10-year 8% coupon bond with a face value of
$1,000 to raise money. The firm pays interest semiannually. The net price for
each bond is $950. What is the cost of debt before tax? If the firm’s marginal tax
rate is 40%, what is the cost of debt after tax?



 Answer: PMT = -40, FV = -1,000, N = 20, PV = 950, solve for I/YR = 4.38%

 Cost of debt before tax = rd = 8.76%



 Cost of debt after tax = rd*(1-T) = 8.76*(1-0.4) = 5.26%






. Cost of preferred stock


 Recall the preferred stock valuation formula

 Replace Vp by the net price and solve for rp (cost of preferred stock)



 Net price = market price - flotation cost (for preferred stock)



 If we ignore flotation costs, we can just use the actual market price to calculate rp








. Cost of retained earnings


 CAPM approach





 DCF approach





 Bond yield plus risk premium approach

 rs = bond yield + risk premium



 When must a firm use external equity financing?

It depends on the capital structure policy of the company and amount retained from the earnings.

 R/E

 Retained earning breakpoint = -----------------

 % of equity



 It is the dollar amount of capital beyond which new common stock must be issued



 For example, suppose the target capital structure for XYZ is 40% debt, 10%
preferred stock and 50% equity. If the firm’s net income is $5,000,000 and the
dividend payout ratio is 40% (i.e., the firm pays out $2,000,000 as cash dividend
and retains $3,000,000), then the retained earning breakpoint will be

 3,000,000

 --------------- = $6,000,000,

 50%

which means that if XYZ needs to raise more than $6,000,000 it has to issue new

common stock


. Cost of new common stock

. Weighted average cost of capital (WACC)

Target capital structure: the percentages (weights) of debt, preferred stock, and

common equity that will maximize the firm’s stock price

 WACC = wd rd (1-T) + wp rp + wc (rs or re)

Comprehensive example 

A company's target capital structure is 20% debt, 20% preferred stock, and 60% common equity. Its bonds have a 12% coupon, paid semiannually, a current maturity of 20 years, and a net price of  

$960. The firm could sell, at par, $100 preferred stock that pays a $10 annual dividend, but flotation costs of 5% would be incurred. The company's  beta is 1.5, the risk-free rate in the economy is 4%, and the market return is 12%. The company is a constant growth firm (8%) which just paid a dividend of $2.00, sells for $27.00 per share. Flotation cost on new common stock is 6%, and the firm’s  marginal tax rate is 40%. 

 Solution

a) Cost of debt before tax = 12.55% 

 Cost of debt after tax = 7.53% 

b) cost of preferred stock? 

Cost of P/S = 10.53% 

c) Cost of R/E using the CAPM approach? 

Cost of R/E = 16% 

d) Cost of R/E using the DCF approach? 

Cost of R/E = 16% 

e) WACC  till the company uses retained earnings 

Answer: WACC (R/E) = 13.21% 

f) WACC once it starts using new common stock financing 

Cost of N/C = 16.51% 

WACC (N/C) = 13.52%


MBA Core Management Knowledge - One Year Revision Schedule

Chapter 9. Valuation of Common Stock and Preferred Stock

Chapter 9 -- Stock Valuation



. Characteristics of common stock
. Common stock valuation
. Valuing a corporation
. Preferred stock


Finance managers have to understand how their company stock will be valued by various people in the financial market or more specifically stock market.



. Characteristics of common stock


 Ownership in a corporation: control of the firm



 Claim on income: residual claim on income

 Claim on assets: residual claim on assets



Commonly used terms: voting rights, proxy, proxy fight, takeover, preemptive

right, classified stock, and limited liability


. Common stock valuation


Intrinsic value is a term used to denote the value arrived at by using a valuation method.

Market valuation refers to the stock price at which shares are traded on a day on the stock exchange.

Growth rate in dividends is an important input in valuation formulas.

Growth rate g: expected rate of growth in dividends

g = ROE * retention ratio

Retention ratio = 1 - dividend payout ratio

 The growth rate, g plays an important role in stock valuation



 The general dividend discount model: .

The intrinsic value of a share is present value of all dividends expected from holding the share in the future.

Why one has to calculate intrinsic value?

 Rationale: estimate the intrinsic value for the stock and compare it with the
market price to determine if the stock in the market is over-priced or under-priced.

Underpriced shares can be bought with the expectation of higher than market return. Overpriced shares are sold by traders or speculators in the hope of buying them back at lower rates.



(1) Zero growth model (the dividend growth rate, g = 0)


I.V. =  D/r

D = dividend
r = rate of return required (can be calculated from the CAPM)




 (2) Constant growth model (the dividend growth rate, g = constant)






Common stock valuation: The expected rate of return can be estimated given the market

price for a constant growth stock



Expected return = expected dividend yield + expected capital gains yield


.
..
.




What would be the expected dividend yield and capital gains yield under the zero

growth model?



Expected capital gains yield, g = 0 (price will remain constant)

Expected dividend yield = D/P0





(3) Non-constant growth model: part of the firm’s cycle in which it grows much


faster for the first N years and gradually return to a constant growth rate



Apply the constant growth model at the end of year N and then discount all
expected future cash flows to the present







 Non-constant growth, gs Constant growth, gn










. Valuing a corporation


 It is similar to valuing a stock



 V = present value of expected future free cash flows



 FCF = EBIT*(1-T) + depreciation and amortization – (capital expenditures +in
net working capital)
.

 The discount rate should be the WACC (weighted average cost of capital)





. Preferred stock


 A hybrid security because it has both common stock and bond features



Claim on assets and income: has priority over common stocks but after bonds



Cumulative feature: all past unpaid dividends should be paid before any dividend
can be paid to common stock shareholders



Valuation of preferred stock

Intrinsic value = Vp = Dp / rp


MBA Core Management Knowledge - One Year Revision Schedule

Chapter 8. Risk and Rates of Return on Financial Assets

. Investment returns 

. Risk 

. Expected rate of return and standard deviation 

. Diversification 

. Beta coefficient - market risk 

. Return on a portfolio and portfolio beta 

. Relationship between risk and rates of return 

. Investment returns 

Dollar return vs. rate of return 

If you invested $1,000 and received $1,100 in return, then 

your dollar return = 1,100 - 1,000 = $100 and 

your rate of return = (1,100 - 1,000) / 1,000 = 10%  

. Risk 

 The chance that some unfavorable event will occur 

 Stand-alone risk vs. market risk 

 Stand-alone risk: risk of holding one asset measured by standard deviation and its systematic risk is measured by beta.

 Market risk: risk of holding a well-diversified portfolio is also measured by standard deviation and its systematic by beta 

. Expected rate of return and standard deviation 

 Probability distribution: a list of possible outcomes with a probability assigned to each outcome 

Expected rate of return: the rate of return expected to be realized 

 Variance and standard deviation: statistical measures of variability (risk) 

 Coefficient of variation (CV) = standard deviation / expected rate of return, 

 which measures the risk per unit of expected return 

  

 Using historical data to estimate average return and standard deviation 

 Stock returns: expected vs. realized 

 Expected return 

Use Excel to calculate mean and standard deviation with historical data 

 Risk premium: the difference between the expected/required rate of return on a 

 given security and that on a risk-free asset 

. Diversification 

 As you increase the number of securities in your portfolio, the portfolio total risk decreases  

 Total risk = firm’s specific risk + market risk 

 Total risk = diversifiable risk + nondiversifiable risk 

 Total risk = unsystematice risk + systematic risk 

. Beta coefficient - market risk 

 Sensitivity of an asset (or a portfolio) with respect to the market or the extent to which a given stock’s returns move up and down with the stock market 

 Plot historical returns for a firm along with the market returns (S&P 500 index, for example) and estimate the best-fit line. The estimated slope of the line is the estimated beta coefficient of the stock, or the market risk of the stock. 

Return on a portfolio and portfolio beta 

Expected return on a portfolio: the weighted average of the expected returns on the assets held in the portfolio 

For example, the expected rate of return on stock A is 10% and the expected rate 

of return on stock B is 14%. If you invest 40% of your money in stock A and 60% 

of your money in stock B to form your portfolio then the expected rate of return 

on your portfolio will be 12.4% = (0.4)*10% + (0.6)*14%* 

 Portfolio beta: weighted average of individual securities’ betas in the portfolio 

For example, if the beta for stock A is 0.8 and the beta for stock B is 1.2, with the 

weights given above, the beta for your portfolio is 1.04 = (0.4)*0.8 + (0.6)*1.2 

. Relationship between risk and rates of return 

Required rate of return: the minimum rate of return necessary to attract an investor to purchase or hold a security 

Market risk premium: the additional return over the risk-free rate needed to compensate investors for assuming an average amount (market) of risk 

For example, if the required rate of return on the market is 11% and the risk-free 

rate is 5% then the market risk premium will be 6% 

Risk premium for a stock: the additional return over the risk-free rate needed to compensate investors for assuming the risk of that stock 

For example, if the required rate of return on a stock is 15% and the risk-free rare 

is 5% then the risk premium for that stock will be 10% 

Capital Asset Pricing Model (CAPM) 

 Ri  =   Rf + Beta*Market Risk Premium

where Ri is the required rate of return on stock i; Rf is the risk-free rate; 

Security market line (SML): a line that shows the relationship between the required return of an asset and the market risk 

 Overvalued vs. undervalued securities 

 If the actual return lies above the SML, the security is undervalued 

 If the actual return lies below the SML, the security is overvalued 

 Example: a stock has a beta of 0.8 and an expected rate of return of 11%. The 

expected rate of return on the market is 12% and the risk-free rate is 4%. Should 

you buy the stock? 

 Answer: required rate of return for the stock (using CAPM) is 

 4% + (12% - 4%)*(0.8) = 10.4% < 11% (expected rate of return) 

 The stock is under-valued

 The impact of inflation: a parallel shift in SML 

 Change in risk aversion: the slope of SML gets steeper 

 Change in beta: changes the required rate of return 

The  CAPM is a single variable model and multivariable models are proposed by some researchers with the statement that they give better estimates of risk and risk premium and therefore better required return estimates. 

MBA Core Management Knowledge - One Year Revision Schedule

Chapter 7. Bond Valuation

. Who issues bonds
. Characteristics of bonds
. Bond valuation
. Important relationships in bond pricing
. Bond rating
. Bond markets






. Who issues bonds


 Bond: a long-term debt



 Treasury bonds: issued by the federal government, no default risk



Municipal bonds (munis): issued by state and local governments with some default risk - tax benefit (returns are tax exempt)



 Corporate bonds: issued by corporations with different levels of default risk

 Mortgage bonds: backed by fixed assets (first vs. second)

 Debenture: not secured by a mortgage on specific property

 Subordinated debenture: have claims on assets after the senior debt has been paid  off



 Zero coupon bonds: no interest payments (coupon rate is zero)



 Junk bonds: high risk, high yield bonds



 Eurobonds: bonds issued outside the U.S. but pay interest and principal in U.S. dollars



 International bonds





. Characteristics of bonds


 Claim on assets and income

 Par value (face value, M): the amount that is returned to the bondholder at maturity, usually it is $1,000

  Maturity date: a specific date on which the bond issuer returns the par value to the bondholder



 Coupon interest rate: the percentage of the par value of the bond paid out annually  to the bondholder in the form of interest


 Coupon payment (INT): annual interest payment

 Fixed rate bonds vs. floating rate bonds

 Zero coupon bond: a bond that pays no interest but sold at a discount below par





Indenture: a legal agreement between the issuing firm and the bondholder



 Call provision: gives the issuer the right to redeem (retire) the bonds under  specified terms prior to the normal maturity date



 Convertible bonds: can be exchanged for common stock at the option of the bondholder



 Putable bonds: allows bondholders to sell the bond back to the company prior to  maturity at a prearranged price



 Income bonds: pay interest only if it is earned



Sinking fund provision: requires the issuer to retire a portion of the bond issue each year



 Indexed bonds: interest payments are based on an inflation index



Required rate of return: minimum return that attracts the investor to buy a bond;

It serves as the discount rate (I/YR) in bond valuation





. Bond valuation


 Market value vs. intrinsic (fair) value



 Market value: the actual market price, determined by the market conditions



 Intrinsic value: the fair or fundamental value


(1) Intrinsic value: present value of expected future cash flows, fair value


 Annual and semiannual coupon payments using a financial calculator








 Discount bond: a bond that sells below its par value



 Premium bond: a bond that sell above its par value



(2) Yield to maturity (YTM): the return from a bond if it is held to maturity





 (3) Yield to call: the return from a bond if it is held until called










(4) Current yield (CY) = annual coupon payment / current market price





. Important relationships in bond pricing


 (1) The value of a bond is inversely related to changes in the investor’s
present required rate of return (current interest rate); or

 As interest rates increase, the value of a bond decreases



 Interest rate risk: the variability in a bond value caused by changing
interest rates

Interest rate price risk: an increase in interest rates causes a decrease in
bond value

 Interest reinvestment risk: a decrease in interest rates leads to a decline in

 reinvestment income from a bond



(2) If the required rate of return (or discount rate) is higher than the coupon
rate, the value of the bond will be less than the par value; and


 If the required rate of return (or discount rate) is less than the coupon rate,
the value of the bond will be higher than the par value



 (3) As the maturity date approaches, the market value of a bond approaches
its par value






 (4) Long-term bonds have greater interest rate risk than short-term bonds




 (5) The sensitivity of a bond’s value to changing interest rates depends not
only on the length of time to maturity, but also on the pattern of cash
flows provided by the bond (or coupon rates)




. Bond rating


 Importance: firm’s credit



 Moody’s and S&P provide bond ratings

 AAA

 AA

 A Investment-grade bonds

 BBB

 BB

 B Junk bonds

 .






 Criteria to consider

 Financial ratios: for example, debt ratio and interest coverage ratio

Qualitative factors: for example, contract terms, subordinated issues, etc.

 Other factors: for example, profitability ratios and firm size





. Bond markets


 OTC markets

 Quotes: quoted as a % of par value of $100



Invoice price (dirty price) = quoted price (clear price) + accrued interest












.