Chapter 16 - Planning the Firm’s Financing Mix

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity Financial Structure

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity

Balance Sheet Balance Sheet Current Current Current Current Assets Liabilities Assets Liabilities Debt and Debt and Fixed Preferred Fixed Preferred Assets Assets Shareholders’ Shareholders’ Equity Equity Capital Structure

Why is Capital Structure Important? 1) Leverage: Higher financial leverage means higher returns to stockholders, but higher risk due to fixed payments. 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value. The Optimal Capital Structure is the one that minimizes the firm’s cost of capital and maximizes firm value.

What is the Optimal Capital Structure?  In a “perfect world” environment with no taxes, no transaction costs and perfectly efficient financial markets, capital structure does not matter.  This is known as the Independence hypothesis: firm value is independent of capital structure.

Independence Hypothesis Firm value does not depend on capital structure.

 Capital Structure: 100% equity, no debt  Stock price: $10 per share  Shares outstanding: 2 million  Operating income (EBIT): $2,000,000  Calculate EPS: With no interest payments and no taxes, With no interest payments and no taxes, EBIT = net income. $2,000,000/2,000,000 shares = $1.00 Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt  Stock price: $10 per share  Shares outstanding: 2 million  Operating income (EBIT): $2,000,000 Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt  Stock price: $10 per share  Shares outstanding: 2 million  Operating income (EBIT): $2,000,000  Calculate the Cost of Capital: Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 100% equity, no debt  Stock price: $10 per share  Shares outstanding: 2 million  Operating income (EBIT): $2,000,000  Calculate the Cost of Capital: Independence Hypothesis: Rix Camper Manufacturing Company k = + g = D 1 P

 Capital Structure: 100% equity, no debt  Stock price: $10 per share  Shares outstanding: 2 million  Operating income (EBIT): $2,000,000  Calculate the Cost of Capital: Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = D P 10.00

 Capital Structure: 100% equity, no debt  Stock price: $10 per share  Shares outstanding: 2 million  Operating income (EBIT): $2,000,000  Calculate the Cost of Capital: Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = 10% D P 10.00

 $20 million capitalization  $8 million in debt issued to retire $8 million in equity.  Equity = $12m / $20m = 60%  Debt = $8m / $20m = 40%  Capital Structure: 60% equity, 40% debt  Shares outstanding: $12 million / $10 = 1,200,000 shares.  Interest = $8m x.06 = $480,000 Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate EPS: $1,520,000/1,200,000 shares = $1.267 $1,520,000/1,200,000 shares = $1.267 Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000 Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Equity: Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Equity: Independence Hypothesis: Rix Camper Manufacturing Company k = + g = D1 PD1 P

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Equity: Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = D P 10.00

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Equity: Independence Hypothesis: Rix Camper Manufacturing Company k = + g = + 0 = 12.67% D P 10.00

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000 Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Capital: Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Capital:.6 (12.67%).6 (12.67%) Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Capital:.6 (12.67%) +.6 (12.67%) + Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Capital:.6 (12.67%) +.4 (6%) =.6 (12.67%) +.4 (6%) = Independence Hypothesis: Rix Camper Manufacturing Company

 Capital Structure: 60% equity, 40% debt  Stock price: $10 per share  Shares outstanding: 1.2 million  Net income: $2,000,000 - $480,000 = $1,520,000  Calculate the Cost of Capital:.6 (12.67%) +.4 (6%) = 10%.6 (12.67%) +.4 (6%) = 10% Independence Hypothesis: Rix Camper Manufacturing Company

Cost of Capital kc 0% debt Financial Leverage 100% debt. kc = cost of equity kd = cost of debt ko = cost of capital Independence Hypothesis

. Cost of Capital kc kd 0% debt Financial Leverage 100% debt

. Independence Hypothesis Cost of Capital kc kd 0% debt Financial Leverage 100% debt

Increasing leverage causes the cost of equity to rise. Independence Hypothesis Cost of Capital kc kd 0% debt Financial Leverage 100% debt

Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. 0% debt Financial Leverage 100% debt

Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt Financial Leverage 100% debt

Independence Hypothesis Cost of Capital kc kd kc kd Increasing leverage causes the cost of equity to rise. What will be the net effect on the overall cost of capital? 0% debt Financial Leverage 100% debt

kc kd Independence Hypothesis Cost of Capital kc ko kd 0% debt Financial Leverage 100% debt

 If we have perfect capital markets, capital structure is irrelevant.  In other words, changes in capital structure do not affect firm value. Independence Hypothesis

Dependence Hypothesis  Increasing leverage does not increase the cost of equity.  Since debt is less expensive than equity, more debt financing would provide a lower cost of capital.  A lower cost of capital would increase firm value.

Dependence Hypothesis Cost of Capital kc kd Financial Leverage kc kd Since the cost of debt is lower than the cost of equity...

Dependence Hypothesis Since the cost of debt is lower than the cost of equity… increasing leverage reduces the cost of capital. Cost of Capital kc kd Financial Leverage kc kd ko

Moderate Position  The previous hypothesis examines capital structure in a “perfect market.”  The moderate position examines capital structure under more realistic conditions.  For example, what happens if we include corporate taxes?

unlevered levered unlevered levered EBIT2,000,000 2,000,000 - interest expense 0 (480,000) EBT2,000,000 1,520,000 - taxes (50%) (1,000,000) (760,000) Earnings available to stockholders 1,000, ,000 to stockholders 1,000, ,000 Payments to all securityholders 1,000,000 1,240,000 securityholders 1,000,000 1,240,000 Rix Camper example: Tax effects of financing with debt

Moderate Position Cost of Capital kc kd Financial Leverage kc kd

Moderate Position Cost of Capital kc kd Financial Leverage kc kd Even if the cost of equity rises as leverage increases, the cost of debt is very low...

Moderate Position Cost of Capital kc kd Financial Leverage kc kd because of the tax benefit associated with debt financing. Even if the cost of equity rises as leverage increases, the cost of debt is very low...

Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debt reduces the cost of capital.

Moderate Position Cost of Capital kc kd Financial Leverage kc kd The low cost of debt reduces the cost of capital. ko

Moderate Position  So, what does the tax benefit of debt financing mean for the value of the firm?  The more debt financing used, the greater the tax benefit, and the greater the value of the firm.  So, this would mean that all firms should be financed with 100% debt, right?  Why are firms not financed with 100% debt?

Why is 100% Debt Not Optimal? Bankruptcy costs: costs of financial distress.  Financing becomes difficult to get.  Customers leave due to uncertainty.  Possible restructuring or liquidation costs if bankruptcy occurs.

Agency costs: costs associated with protecting bondholders.  Bondholders (principals) lend money to the firm and expect it to be invested wisely.  Stockholders own the firm and elect the board and hire managers (agents).  Bond covenants require managers to be monitored. The monitoring expense is an agency cost, which increases as debt increases. Why is 100% Debt Not Optimal?

Moderate Position with Bankruptcy and Agency Costs Cost of Capital Financial Leverage kc kd

Cost of Capital Financial Leverage kc kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd If a firm borrows too much, the costs of debt and equity will spike upward, due to bankruptcy costs and agency costs. Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd ko Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd ko Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd ko Ideally, a firm should use leverage to obtain their optimum capital structure, which will minimize the firm’s cost of capital. Moderate Position with Bankruptcy and Agency Costs

Cost of Capital Financial Leverage kc kd kc kd ko Moderate Position with Bankruptcy and Agency Costs

Capital Structure Management EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity.

Capital Structure Management EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S

Capital Structure Management EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity. EPS = (EBIT - I)(1 - t) - P S I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding.

EBIT-EPS Example Our firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. We need $6,000,000 to finance a proposed project. We are considering two options:  Sell 200,000 shares of common stock at $30 per share,  Borrow $6,000,000 by issuing 10% bonds.

If we expect EBIT to be $2,000,000: Financing stock debt EBIT2,000,0002,000,000 - interest 0 (600,000) EBT2,000,0001,400,000 - taxes (40%) (800,000) (560,000) EAT1,200, ,000 # shares outst.1,000, ,000 EPS $1.20 $1.05

Financing stock debt EBIT4,000,0004,000,000 - interest 0 (600,000) EBT4,000,0003,400,000 - taxes (40%) (1,600,000) (1,360,000) EAT2,400,000 2,040,000 # shares outst.1,000, ,000 EPS $2.40 $2.55 If we expect EBIT to be $4,000,000:

 If EBIT is $2,000,000, common stock financing is best.  If EBIT is $4,000,000, debt financing is best.  So, now we need to find a breakeven EBIT where neither is better than the other.

If we choose stock financing: EPS EBIT $1m $2m $3m $4m stock financing

If we choose bond financing: EPS EBIT $1m $2m $3m $4m bond financing

Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing

Breakeven Point Set two EPS calculations equal to each other and solve for EBIT: Stock Financing Debt Financing Stock Financing Debt Financing (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S S S

Breakeven Point Stock Financing Debt Financing Stock Financing Debt Financing (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S S S (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) (EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800, , , , , ,000

Breakeven Point Stock Financing Debt Financing Stock Financing Debt Financing.6 EBIT =.6 EBIT - 360,000.6 EBIT =.6 EBIT - 360, EBIT =.6 EBIT - 360, EBIT =.6 EBIT - 360, EBIT = 360, EBIT = 360,000 EBIT = $3,000,000 EBIT = $3,000,000

Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing For EBIT up to $3 million, stock financing is best.

Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing For EBIT up to $3 million, stock financing is best. For EBIT greater than $3 million, debt financing is best.

In-class Problem  Plan A: Sell 1,200,000 shares at $10 per share ($12 million total).  Plan B: Issue $3.5 million in 9% debt and sell 850,000 shares at $10 per share ($12 million total).  Assume a marginal tax rate of 50%.

Breakeven EBIT Stock Financing Levered Financing Stock Financing Levered Financing (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S S S EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) 1,200, ,000 1,200, ,000 EBIT = $1,080,000 EBIT = $1,080,000

Analytical Income Statement Stock Levered Stock Levered EBIT1,080,0001,080,000 I 0 (315,000) EBT1,080, ,000 Tax (540,000) (382,500) NI 540, ,500 Shares1,200, ,000 EPS.45.45

levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m Breakeven EBIT

For EBIT up to $1.08 m, stock financing is best. levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m Breakeven EBIT

For EBIT up to $1.08 m, stock financing is best. For EBIT greater than $1.08 m, the levered plan is best. levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m

In-class Problem  Plan A: Sell 1,200,000 shares at $20 per share ($24 million total).  Plan B: Issue $9.6 million in 9% debt and sell shares at $20 per share ($24 million total).  Assume a 35% marginal tax rate.

Breakeven EBIT Stock Financing Levered Financing Stock Financing Levered Financing (EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P S S S S (EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) (EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) 1,200, ,000 1,200, ,000 EBIT = $2,160,000 EBIT = $2,160,000

Analytical Income Statement Stock Levered Stock Levered EBIT2,160,0002,160,000 I 0 (864,000) EBT2,160,0001,296,000 Tax (756,000) (453,600) NI1,404, ,400 Shares1,200, ,000 EPS

Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m

Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m For EBIT up to $2.16 m, stock financing is best.

Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m For EBIT greater than $2.16 m, the levered plan is best. For EBIT up to $2.16 m, stock financing is best.