Financing the Firm
Agenda I. II. Introduction Capital Structure: Traditional View
III. Capital Structure: Modigliani - Miller IV. Changing the Capital Structure V. The Dividend Decision
The Objective of Corporate Finance
Using WACC as the Discount Rate
WACC can be used:
if thenew project gives rise cash flows that have the same degree of business risk as the existing general cash flows of the firm. That is, the project is ‘scale enhancing’. if the project does not lead to a (large) change in the firm’s debt ratio.
In fact, the WACC calculation assumes that the amount of debt outstanding is rebalanced every period to maintain a constant Debt/EquityRatio for the firm as a whole.
Operating and Financial Leverage
• Operating leverage is the change in EBIT caused by a change in quantity sold/sales:
− the higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage.
• Financial leverage is the change in EPS caused by a change in EBIT:
− the higher the proportion of fixed financial costs,such as interest expense, the greater the operating financial leverage.
Business Risk vs. Financial Risk
• Business risk:
− Uncertainty in future EBIT. − Depends on business factors such as competition, operating leverage, etc.
• Financial risk:
− Additional business risk incurred by common shareholders when financial leverage is used. − Depends on the amount of debt (and preferredstock) financing.
Business Risk Factors
• Uncertainty about demand (unit sales). • Uncertainty about output prices. • Uncertainty about input costs. • Product and other types of liability. • Degree of operating leverage (DOL).
Capital Structure Theories
• Traditional View. • Modigliani - Miller (MM) Model.
− Zero taxes. − Corporate taxes. − Corporate and personal taxes.
• Trade-offtheory. • Signaling theory. • Debt financing as a managerial constraint.
Capital Structure Question
• The Value of the Firm is: V = FCFF / rWACC Hold the firm’s cash flows (FCFF) constant (and for ever). This also assumes FCFF is independent of capital structure. • CAPITAL STRUCTURE QUESTION: Can we alter rWACC (and hence V) by altering the mix of debt and equity finance ? • Example: €100 totalin debt and equity. Do we gain by moving from 20% debt/80% equity finance, to 70% debt/30% equity finance?
this could be done by issuing more € 50 more in bonds and using the proceeds to buy-back € 50 of outstanding shares.
Capital-Structure Question and the Pie Theory
• The Enterprise Value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity: EV = V + ND• If the goal of the management
of the firm is to make the firm as valuable as possible, the firm should pick the debt-equity ratio that makes the pie as big as possible.
S B V ND
Value of the Firm (EV)
Capital Structure: Traditional View
Capital Structure: Traditional View
• As you increase the proportion of ‘cheap’ debt (and initially the required return on equityremains constant) then rWACC will fall, and hence V will rise. • After a certain debt level the equity holders will require a higher return because of increased ‘risk’. This will raise the rWACC and V will begin to fall. • Hence: there is a particular level for the debtequity ratio which will maximise the value of the
Traditional View : Cost of Capital
Cost of Capital, or Value Valueof Firm (EV) Cost of Equity (ke) WACC
Cost of Debt (kd)
Debt-Equity Ratio (D/EV)
What is Cost of Debt (kd)
Concerned with marginal cost, not historical
Method 1: Ask an investment banker what the coupon rate would be on new debt Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating Method 3: Find the yield on the...