FM Students 09 Capital structure Spring 2010

nullThe Financing DecisionThe Financing DecisionTopic 9 Capital Structure*Topic 9 Capital Structure Spring 2010The Story So FarTopic 9 Capital Structure Spring 2010*The Story So FarThe major objective of financial management is to increase shareholder wealth The Investment decision is the most important The present value of a potential project represents the change in shareholder wealth Financial Mathematics is an important tool in finance as it takes into account cash and time Is used in valuing debt and equity This week we look at the second decision - FinancingObjectiveTopic 9 Capital Structure Spring 2010*ObjectiveUnderstand how to calculate The cost of debt and equity Use these in the calculation of the Weighted Average Cost of Capital (WACC) Understand the use of WACC and required rate of return Select between different financing structures Understand the basic theory underlying capital structureBasic Concepts- riskTopic 9 Capital Structure Spring 2010*Basic Concepts- riskEarlier in the course we introduced the concept of risk For a firm there are two components Business Risk Is the inherent risk associated with carrying on that business Financial Risk Is the risk created by the use of debt to finance a firms operationsRequired Rate of ReturnTopic 9 Capital Structure Spring 2010*Required Rate of ReturnIn capital budgeting we said that the required rate of return did the following: Paid all interest on debt Recovered the cost of the original investment Compensated shareholders for the risk of the project And produced appropriate returns The required rate of return is linked to the risk of the projectCost of EquityTopic 9 Capital Structure Spring 2010*Cost of EquityWe review two ways in which the return required by shareholders can be estimated: Dividend Growth Models SMLDividend Growth ModelTopic 9 Capital Structure Spring 2010*Dividend Growth ModelShare price, dividend growth P0 = D1 / (RE - G) D1 = D0 (1 +G) Where, D1 = dividend received next period G = constant growth rate of the dividend Possible to estimate the required rate of return by use of these models constant growth model: RE = ( D1 / P0 ) + GWorkshop Question 1Topic 9 Capital Structure Spring 2010*Workshop Question 1ABD Company currently has a market price of $21; ABD just paid a dividend of $0.60 per share ABD dividends are expected to grow indefinitely at a constant growth rate of 5% What is its required rate of return on equity? Solution P0 = D1 / (RE - G) Dividend Growth ModelTopic 9 Capital Structure Spring 2010*Dividend Growth ModelAdvantages Simple to use Reflects risk return preferences of investors Disadvantages Only applicable to companies that pay dividends dividends grow at a “constant” rate Cost-equity is sensitive to estimated growth rate Does not explicitly consider risk/uncertaintySML: RE = Rf + (Rm - Rf)* ETopic 9 Capital Structure Spring 2010*SML: RE = Rf + (Rm - Rf)* EAdvantages It explicitly adjusts for risk Can be used for companies that do not pay dividends and who don’t have constant growth Disadvantages Requires the market risk premium to be estimated Need to be able to calculate beta Relies on past observations to predict -futureWorkshop Question 2Topic 9 Capital Structure Spring 2010*Workshop Question 2Wild Widgets Inc has a Beta of 0.9 The return on the market is 16% If the risk free rate is 8% what is their cost of equity Solution RE = Rf +  (Rm - Rf ) RE = Workshop Question 3Topic 9 Capital Structure Spring 2010*Workshop Question 3A share in MPS Pty Ltd currently sells for $9.45 MPS has just paid an annual dividend of $1.00 MPS has announced that they expect dividends to grow at 4% per year What is the implied required rate of return for equity holders Solution P0 = D1 / (RE - G) RE =Cost of DebtTopic 9 Capital Structure Spring 2010*Cost of DebtCost of debt is the cost of new funds This is the current market rate The market value of current (as opposed to long term) debt is calculated by assuming the interest being currently paid is a perpetuity PV = PMT / i D = INT / RD or RD = INT / D As most current debt is at a variable rate the market and book values are usually the same.Bond valuation revisionTopic 9 Capital Structure Spring 2010*Bond valuation revisionValuing a bond requires The number of periods to maturity The face value The coupon amount The market interest rate/discount rate Workshop Question 4Topic 9 Capital Structure Spring 2010*Workshop Question 4YME Ltd has bonds on issue with a face value of $100,000 and a 10% pa coupon rate Market yield is 9% pa Issued 2 years ago and 8 years before maturity. Coupons are paid half-yearly What is the market price of a YME bond? Cost of Preference SharesTopic 9 Capital Structure Spring 2010*Cost of Preference SharesThe cost of preference shares is the cost of new funds That is the rate of dividend required for any new issues Where the shares are traded the current market value is known The cost of preference shares uses the constant dividend model RP = D / P0Weighted Average Cost of Capital (WACC)Topic 9 Capital Structure Spring 2010*Weighted Average Cost of Capital (WACC)Most firms use a mix of debt and equity in their capital structure We assume, for this analysis that the firms capital structure remains fixed Or is at their target level The total market value of the firm is the total current value of equity and debt: V = D + EWACCTopic 9 Capital Structure Spring 2010*WACCInterest payments are tax deductable and this will reduce the net cost of debt finance and must therefore be taken into account when calculating WACC The formula is: WACC = RD (1-tc) (D/V) + RE (E/V) + RP (P/V) RD Current market rate of debt finance RE Current market rate on ordinary shares RP Current market rate on preference sharesSimple WACC ExampleTopic 9 Capital Structure Spring 2010*Simple WACC Example Source Market Market Rate Value Debentures 7.50% $10.34 Mil Permanent Debt 7.62% $ 5.25 Mil Preference Shares 8.00% $ 5.50 Mil Ordinary Shares 8.53% $66.00 Mil Total market Value $87.09 Mil Company tax rate is 30%WACCTopic 9 Capital Structure Spring 2010*WACC7.5(1-0.3)(10.34/87.09) Debentures 7.62(1-0.3)(5.25/87.09) Permanent debt 8.00(5.5/87.09) Preference shares 8.53(66/87.09) Ordinary shares WACC = 7.91% Source Mkt V %Val Market Rate WACC Deb 10.34 11.87 7.50%(1-0.3) 0.6232 Perm Debt 5.25 6.03 7.62%(1-0.3) 0.3216 Pref Shares 5.50 6.32 8.00% 0.5056 Ord Shares 66.00 75.78 8.53% 6.4640 Tot mkt Val 87.09 WACC 7.9144WACCTopic 9 Capital Structure Spring 2010*WACCIs the appropriate discount rate when the risk of the project is the same as the risk of the company Is not appropriate when the company is multi-divisional The required rate of return must be appropriate for the risk of the project Firms that use the one rate will gradually become more risky as they reject low risk investments and accept more high risk onesWorkshop Question 5Capital Structure Spring 2010*Workshop Question 5Natural Remedies Pty Ltd (NR) is considering expansion of its production facilities to increase capacity for a range of new products. It has employed the services of an investment banker to advise on the current cost of new finance and from that recalculate the cost of capital (WACC) for the new venture. The following information is extracted from the financial statements of NR.Workshop Question 5Capital Structure Spring 2010*Workshop Question 5Debt Financing Long Term Bonds $500 million @ 6% Equity Finance: $5, 7% Preference shares $200 million Paid up capital ($2 Ordinary Shares) $400 million Asset Revaluation Reserve $100 million Retained Earnings $500 million NR is a publicly listed company trading on the Australian Stock Exchange. The company’s ordinary shares are currently trading at $5.25. The company had paid a dividend of $1.10 this yearWorkshop Question 5Workshop Question 5NR has managed to maintain an average growth in dividends of 6% pa but management believe that this estimated growth in dividends would be inadequate for the calculation of the required rate of return for ordinary shareholders. NR has calculated its Beta to be 1.5. The current government bond rate is 6.4% and the risk premium on the market portfolio is 7.1% pa. The last sale of preference shares was at a price of $2.75 NR pay income tax at 30%Capital Structure Spring 2010*Workshop Question 5Workshop Question 5The investment bank reported that the bonds on issue matured in 20 years time and interest is paid yearly. The last sale in the market was at a yield to maturity of 10% pa. NR plan to keep the current capital structure into the foreseeable future Hint: Work in millions What is the market value of the Bonds? PMT = FV = n = i = PV = Capital Structure Spring 2010*Workshop Question 5Capital Structure Spring 2010*Workshop Question 5What is the market value of preference shares? What is the market value of ordinary shares? What is the current market required rate of return on preference shares? Workshop Question 5Capital Structure Spring 2010*Workshop Question 5What is the current market required rate of return on ordinary shares? Re = What is the weighted average cost of capital for NR? Workshop Q5 WACC TableCapital Structure Spring 2010*Workshop Q5 WACC Table Column 1 2 3 4 Source Market % of Market Component Value Total Rate of WACC Bonds Pref Sh, Ord Sh. Total column 2 = column 1/ total of column 1 column 4 = column 2 times column 3LeverageTopic 9 Capital Structure Spring 2010*LeverageAn important concept in finance is the term leverage There are two types of leverage: Operating leverage Financial leverage Operating leverage relates to the extent a projects or firms operating costs are fixed rather than variableLeverageTopic 9 Capital Structure Spring 2010*LeverageFinancial leverage is determined by the extent a firm chooses debt rather than equity to finance its investments Leverage implies an advantage Whilst financial leverage is an advantage to shareholders it does increase the riskCapital Structure - EPS AnalysisTopic 9 Capital Structure Spring 2010*Capital Structure - EPS AnalysisThe effects of financial leverage can be examined by analysing the relationship between EBIT and EPS EPS analysis starts with an understanding of the accounting relationship: EPS = [(EBIT - INT)(1 - tc) - Pref. Div] / S Where S is the number of shares on issueExample EBIT/EPS AnalysisTopic 9 Capital Structure Spring 2010*Example EBIT/EPS AnalysisThe Ten Company has $10,000,000 of equity finance consisting of 5 million ordinary shares (par value $2) and no debt Ten needs to raise $4,000,000 to fund the expansion of its production facility Ten is considering two alternative methods of raising the funds After the expansion EBIT is expected to be $3,000,000. The company tax rate is 30%EBIT/EPS Analysis ExampleTopic 9 Capital Structure Spring 2010*EBIT/EPS Analysis ExampleOption 1 - All Equity Raise $4,000,000 from the issue of 2 million $2 Ordinary Shares (Fully Paid) Option 2 - All Debt have a debenture issue of $4,000,000 at an interest rate of 10%Solution EBIT/EPS AnalysisTopic 9 Capital Structure Spring 2010*Solution EBIT/EPS Analysis All Equity All Debt EBIT 3,000 3,000 Interest @10% 400 Profit before tax 3,000 2,600 Tax @ 30% 900 780 Profit after tax 2,100 1,820 Number of Shares 7 million 5 million EPS $0.30 $0.36Capital Structure breakevenTopic 9 Capital Structure Spring 2010*Capital Structure breakevenAs the proportion of EBIT payable to debt holders is fixed, if EBIT is above a certain level it is advantageous to shareholders to use debt finance This level is known as the breakeven or indifference point This point can be found graphically or algebraicallyBreakevenTopic 9 Capital Structure Spring 2010*BreakevenIndifference point is calculated when: EPS = [(EBIT - INT)(1 - tc) - Pref. Div]/S1 is equal to: EPS = [(EBIT - INT)(1 - tc) - Pref. Div]/S2 S is the number of shares under each option Break-even point @30%tax rate (EBIT-0)(0.7)/7,000,000=(EBIT-400,000)(0.7)/5,000,000 (EBIT)=(EBIT-400,000)7/5 EBIT- 7/5EBIT = -560000 0.4(EBIT)= 560,000: Therefore EBIT=1,400,000Example EBIT/EPS BreakevenTopic 9 Capital Structure Spring 2010*Example EBIT/EPS Breakeven0.140.300.364001,4002,0003,000EBITEPS0Indifference PointDebt OptionEquity OptionWorkshop Question 6 Topic 9 Capital Structure Spring 2010*Workshop Question 6 OZ is looking at two different capital structures to finance the start of its operations Option 1, an all equity plan OZ would issue 15,000 shares @ $2.00 each. Option 2 a debt/equity plan OZ would issue 7,500 shares @ $2.00 each and $15,000 of debentures with a coupon rate of 9%. OZ will pay tax @ 30%. Workshop Question 6Topic 9 Capital Structure Spring 2010*Workshop Question 6What is the break-even EBIT? What are the earnings per share at break-even EBIT? Workshop Question 6Workshop Question 6What advice would you give to Oz on the capital structure options based on the answers to the first two questions? Solution Topic 9 Capital Structure Spring 2010*Capital Structure TheoryTopic 9 Capital Structure Spring 2010*Capital Structure TheoryFrom our analysis, because of the tax deductibility of interest utilising debt can be advantageous to shareholders. The big question is how can we decide on the optimum mix of debt and equity? We will introduce some basic analysis based on the work of Modigliani and MillerAssumptionsTopic 9 Capital Structure Spring 2010*AssumptionsMM used an operating income approach and made the following simplifying assumptions No income taxes, (relaxed later) Equity and debt can be exchanged at any time without cost Net operating income (EBIT) remains constant over time All earnings are paid out as dividends Perfect Capital MarketEffect of Simplifying AssumptionsTopic 9 Capital Structure Spring 2010*Effect of Simplifying AssumptionsInvestors can borrow or lend on their own account Create or undo any capital structure Called Homemade Leverage Using this simplified approach It is easily demonstrated that the value of the firm is independent of it’s capital structure It is the real assets and cash flow that determine the value of the firm MM’s conclusions summarised in 2 propositionsMM Propositions (NoTaxes)Topic 9 Capital Structure Spring 2010*MM Propositions (NoTaxes)In the absence of taxes – MM1 The value of the unlevered firm (u) (No Debt) is equal to the levered firm (l) (Has Debt) Implications: A firm’s Capital Structure is irrelevant WACC is the same regardless of the capital structureMM 2Topic 9 Capital Structure Spring 2010*MM 2the cost of equity RE depends on the cost of debt, required return on assets and the debt equity ratio RE = RA + (RA - RD) x D/E Implications Cost of Equity Rises as firm increases its use of debt Risk of equity Depends on business risk and financial riskThe Cost of Equity and the WACCThe Cost of Equity and the WACCDebt-equity ratio, D/ECost of capitalWACC = RARDRE = RA + (RA – RD ) x (D/E) The firm’s overall cost of capital is unaffected by its capital structure.*Topic 9 Capital Structure Spring 2010Market ImperfectionsTopic 9 Capital Structure Spring 2010*Market ImperfectionsWhen Market imperfections are introduced, particularly taxes, a new proposition arises. It means the costs that are applied to debt and equity are different. Substituting debt for equity will cease to exist and the choice between debt and equity will become relevant. The choice will affect market value of firm and its cost of capital. MM with taxesTopic 9 Capital Structure Spring 2010*MM with taxesModigiliani and Miller in 1963 corrected their theory to take into account company tax Value of the firm is equal to the value if all equity financed plus the present value of the tax shield Value of firm = Value if all equity financed + PV of tax shieldPresent Value of InterestTopic 9 Capital Structure Spring 2010*Present Value of InterestIf debt is permanent, PV of the tax shield = (Tc)*(Rd)*(D)/Rd =TcD Value of firm is not independent of its capital structure Incentive for firms to choose debt as tax advantage over equity PV of the tax shield on interest is the increase in value of the levered firm Taken to its “logical” conclusion all firms should be 100% debt financedMM with Taxes, ImplicationsTopic 9 Capital Structure Spring 2010*MM with Taxes, ImplicationsIf this happened firms would head for bankruptcy Before reaching bankruptcy firms suffer financial distress and the costs of financial distress reduces the value of the firm Suggests that there is an optimum value The maximum value of the firm occurs when its weighted average cost of capital is minimised. Value of firm = Value if all equity financed + PV of tax shield. - PV costs of financial distressThe Optimal Capital Structure and the Value of the FirmValue of the firm (VL )Debt-equity ratio, D/EOptimal amount of debtD/EPresent value of tax shield on debtFinancial distress costsActual firm valueVU = Value of firm with no debtVL = VU + TC  DMaximum firm value VL*VUThe Optimal Capital Structure and the Value of the Firm*Topic 9 Capital Structure Spring 2010MM Summary (No Taxes)Topic 9 Capital Structure Spring 2010*MM Summary (No Taxes)Proposition 1 The value of a company is determined by the cash flow of the assets This determines the size of the pie. Proposition 2 The cost of Equity depends on the required rate of return on assets, the cost of debt and the debt equity ratioMM Summary (No Taxes)Topic 9 Capital Structure Spring 2010*MM Summary (No Taxes)Financial structure is irrelevant because Re increases with increasing levels of debt to exactly offset the lower cost of debt. WACC remains the sameMM (With Taxes)Topic 9 Capital Structure Spring 2010*MM (With Taxes)The value of the levered firm (with debt) is equal to the value of the unlevered firm (no debt) plus the PV of the interest tax shield. A firms weighted average cost of capital will decrease as the companies use of debt increases QuestionTopic 9 Capital Structure Spring 2010*QuestionThe WACC computed with _______ is a superior measure of the minimum required return, on a new project of average risk, which is consistent with shareholder interest is: a) balance sheet proportions b) income statement proportions c) market rates and proportions d) either A or B The answer is QuestionTopic 9 Capital Structure Spring 2010*QuestionA & P’s dividend per share is expected to be $3 at the end of year 1 & is expected to grow at a rate of 4%pa for some time. A & P stock is currently trading at $50 per share. The cost of capital on this stock is: a) 8% b) 10% c) 12% d) 13% The answer is Workshop Question 7Topic 9 Capital Structure Spring 2010*Workshop Question 7Bundy Ltd currently has $9 million of debt at an interest rate of 7.5% pa. Tax rate is 30%. Bundy plans a $3 million debt issue to repurchase equity The current share price is $50 and there are 450,000 shares issued EBIT is expected to be $1,300,000 Should Bundy Ltd proceed with the debt issue? This is an EPS problemWorkshop Question 7 solutionTopic 9 Capital Structure Spring 2010*Workshop Question 7 solution Current Planned EBIT $1,300,000 $1,300,000 Net income No. of shares EPS QuestionTopic 9 Capital Structure Spring 2010*QuestionThe variability in net operating income caused by employing fixed cost is related to: a) financial leverage b) operating leverage c) cost of bankruptcy d) both A and C The answer is QuestionTopic 9 Capital Structure Spring 2010*QuestionThe total risk of a firm is related to: a) business risk b) financial risk c) both A and B are true d) none of the above The answer is QuestionTopic 9 Capital St