Corporate Finance – Prof. BollazziCattaneo University - LIUC Lesson 6 THE OPTIMAL CAPITAL STRUCTURE (cont’d). THE USE OF LEVERAGE - LBOs

Corporate Finance – Prof. BollazziCattaneo University - LIUC The choice of the optimal capital structure Maximization of ROE Maximization of the enterprise value Other key-drivers (balance, flexibility, opportunities, …)

Corporate Finance – Prof. BollazziCattaneo University - LIUC ROE = [ROI + (D/E) (ROI – i)] where: ROE = net profit / equity ROI = Ebit / invested capital (debt + equity) D/E = financial leverage i = cost of debt (interest rate) Maximization of shareholders’ return

Corporate Finance – Prof. BollazziCattaneo University - LIUC Relationship between ROE and ROI Decrease ROI Increase cost of debt Increase debt Decrease ROE Decrease self - financing ROE = [ROI + (D/E) (ROI – i)]

Corporate Finance – Prof. BollazziCattaneo University - LIUC Modigliani-Miller theory Hp: in an environment where there are no taxes, bankruptcy risk or agency costs (no separation between stockholders and managers), capital structure is irrelevant. Ts: the value of a firm (V) is indipendent of its debt ratio (D/E). The cost of capital of the firm will not change with leverage.

Corporate Finance – Prof. BollazziCattaneo University - LIUC Modigliani-Miller theory (cont’d) The effect of taxes Vl = Vu+ Vats Vu = value of unlevered firm Vl = value od levered firm Vats = actual value of tax shields Vl Vu V D/E

Corporate Finance – Prof. BollazziCattaneo University - LIUC Trade-off theory The effect of bankruptcy costs Vl = Vu + Vats - Vabc VAcf actual value of bankruptcy costs Value of levered firm without bankruptcy costs Value of unlevered firm Value of levered firm VAts Vabc

Corporate Finance – Prof. BollazziCattaneo University - LIUC Pecking order theory Financing sources internal external 1. self-financing 2. debt 3. increase of equity

Corporate Finance – Prof. BollazziCattaneo University - LIUC Financing mix decision 1. Macroeconomic context (capital markets) 2. Industry (maturity, capex, risk, etc.) 3. Firm’s characteristics (market position, financial-economic situation,..) 4. Financial needs’ charact.

Corporate Finance – Prof. BollazziCattaneo University - LIUC Leveraged Buyout deals Definition: A leveraged buyout, or LBO, is the purchase of a company using a large amount of debt -- much of the borrowing secured by the assets of the company itself. Sometimes the target company’s assets are sold to repay the loan that financed the takover Deal: Step 1) NEWCO creation Step 2) NEWCO funding Step 3) Sellers’ payment Step 4) Merger

Corporate Finance – Prof. BollazziCattaneo University - LIUC LBO - Steps