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 the new 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/Equity Ratio 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 preferred stock) 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.