1. Income statement Sales XXX,XXX Less:variable cost X,XXX
Contribution XX,XXX
Fixed cost X,XXX
EBIT XX,XXX
Less: Interest X,XXX
EBT XX,XXX
Less: Tax X,XXX
EAT X,XXX

2. Business risk Factors influence a firm’s business risk
Uncertainty associated with a firm’s projection of its operating income
Risk faced by shareholders on an all equity firm (business risk does not include financing effects.)
Factors influence a firm’s business risk
Demand of outputs
Price and costs of outputs
Competition
Amount of operating leverage used by the firm

3. Operating leverage and business risk?
Operating leverage is the extent to which fixed costs are used in the firm’s operation
Total costs = fixed costs + variable costs
If most costs are fixed, hence do not decline when demand falls, then the firm has high operating leverage.

4. More operating leverage leads to more business risk, for then a small sales decline causes a big profit decline.
Sales $
Rev. TC FC
QBE }
Profit
Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.

5. Degree of operating leverage
 EBIT/EBIT
 Sales/Sales
= Sales – Variable Costs
Sales – Variable Costs – Fixed Costs

6. Capital structure Balance sheet $ $ Assets 100 Share capital ? Debt ?
$ $
Assets Share capital ?
Debt ?

7. Financial leverage Use of debt/preference share
Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.
 Use of debt/preference share  Financial leverage   expected return

8. Degree of financial leverage
 EPS/EPS
 EBIT/EBIT
= Sales – Variable Costs – Fixed Costs
Sales – VC – Fixed Costs - Interests

9. Consider 2 Hypothetical Firms
Firm U Firm L
No debt $10,000 of 12% debt
$20,000 in assets $20,000 in assets
40% tax rate 40% tax rate
Both firms have same operating leverage, business risk, and probability distribution of EBIT. Differ only with respect to use of debt (capital structure).

10. Firm U: Unleveraged
Economy
Bad Avg Good
Prob
EBIT $2,000 $3,000 $4,000
Interest
EBT $2,000 $3,000 $4,000
Taxes (40%) , ,600
NI $1,200 $1,800 $2,400

11. Firm L: Leveraged
Economy
Bad Avg Good
Prob.*
EBIT* $2,000 $3,000 $4,000
Interest 1,200
EBT $ 800
Taxes (40%)
NI $ $1,080 $1,680
*Same as for Firm U.

12. Firm U Bad Avg. Good
ROE 6.0% 9.0% 12.0%
Firm L Bad Avg. Good
ROE 4.8% 10.8% 16.8%

13. Degree of total leverage
 EPS/EPS
 Sales/Sales
= Sales – Variable Costs
Sales – VC – Fixed Costs - Interests

14. Financial Leverage and EPS
Debt
No Debt
Advantage to debt
Break-even point
EPS
EBI in dollars, no taxes
Disadvantage to debt
(2.00)
EBIT

15. Fin Risk & Bus. Risk D E E Financial risk A Business risk
E= A+ (A - D) (Debt/Equity)
Financial risk A
Business risk D E

16. Double-edged sword of leverage use
Things go well when revenue rises but vice versa
Therefore, leverage use, either operating or financial, magnifies the original fluctuation in the revenue
Reaction of investor :
Cost of capital   stock price 

17. Business Risk vs. Financial Risk
SUMMARY
Business risk depends on business factors such as competition, product liability, and operating leverage.
Financial risk depends only on the types of securities issued: More debt, more financial risk.

18. What types of capital do firms use?
Debt
Preferred stock
Common equity
Retained earnings
New common stock

19. Company Cost of Capital
Opportunity cost that investors could earn today on capital market securities that have the same risk.
Firm value = Equity + Debt
= PV(cash flow from projects)

20. Should we focus on before-tax or after-tax capital costs?
Stockholders focus on after-tax capital costs, i.e., use after-tax costs in WACC. Only kd (cost of debt) needs adjustment.

21. Should we focus on historical costs or new (marginal) costs?
The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC).

22. Company Cost of Capital simple approach (All equity financed)
Company Cost of Capital (COC) is based on the average beta of the assets.
The average Beta of the assets is based on the % of funds in each asset.

23. Discount rate
A company’s cost of capital can be compared to the CAPM required return. 13
5.5
SML
Required
return
Company Cost of Capital
Project Beta
1.26

24. Two ways to determine cost of common equity, ks:
1. CAPM: ks = kRF + (kM – kRF)b.
Dividend model:
ks = D1/P0 + g.

25. Component Cost of Debt
Suppose Kd is 10%; Interest is tax deductible, so assuming tax rate of 40%
kd AT = kd BT(1 – T)
= 10%(1 – 0.40) = 6%.

26. E, D, and V are all market values
W A C C
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V) (V)
Bassets = Bdebt (D) + Bequity (E)
(V) (V)
IMPORTANT
E, D, and V are all market values
requity = rf + Bequity ( rm - rf )

27. Cost of capital for new projects
Modify CAPM
(account for proper risk)
Use COC unique to project,
rather than Company COC

28. What factors influence a company’s composite WACC?
Market conditions.
The firm’s capital structure and dividend policy.
The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

29. Find the company’s cost of capital based on the CAPM, given these inputs:
Target debt ratio = 40%.
kd = 12%.
kRF = 7%.
Tax rate = 40%.
Beta of equity = 1.7.
Market risk premium = 6%.

30. Beta = 1.7, so it has more market risk than average.
The required return on equity:
ks = kRF + (kM – kRF)bDiv. =
WACCDiv. = wdkd(1 – T) + wcks
= 13.2%.

31. Capital structure Balance sheet $ $ Assets 100 Share capital ? Debt ?
$ $
Assets Share capital ?
Debt ?

32. The Capital-Structure Question and The Pie Theory
The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.
V = B + S
If the goal of the management of the firm is to make the firm as valuable as possible, the the firm should pick the debt-equity ratio that makes the pie as big as possible. S B
Value of the Firm

33. Basic issues (1) Cash flows are generated by assets
Capital structure is a way of packaging these cash flows and selling them to security holders, i.e. debt and equity
Should packaging add value?
Can overall size of pie be affected by the method of slicing it?

34. Basic issues (2)
Capital structure is irrelevant to shareholders wealth maximisation
The value of the firm (size of pie) is determined by capital budgeting decision
Capital structure determine only how the pie is sliced.
Increased the debt will increase both the risk and expected return to equity.

35. M&M (Debt Policy Doesn’t Matter)
Independent hypothesis
When there are no taxes and capital markets function well, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

36. M&M (Debt Policy Doesn’t Matter)
Assumptions
Homogeneous expectations
Homogeneous business risk classes
Homogeneous expectation - same view on a co’s earnings and risk
firms with same degree of risk can be grouped together (measured by WACC)
Perpetual cash flows
Perfect capital market

37. Assumptions- Perfect capital market
Perfect competition
Corporate leverage is replicable by individual investors (firms and investors can borrow/lend at the same rate)
Symmetric information - equal assess to all relevant information
No taxes
No bankruptcy costs
Symmetric information
No growth, i.e. EPS = DPS

38. No Magic in Financial Leverage
MM'S PROPOSITION I (no tax)
Firm value is not affected by leverage
Valuation is independent of the debt ratio
i.e. VL = VU
= Value of debt
+ Value of levered equity

39. Value of a firm ø ö ç è æ  + = r E D
The total market value of the firm is the net present value of the income stream. For a firm with a constant perpetual income stream: C1
V = –––––––
WACC ø ö ç è æ  + = S d
WACC r E D

40. WACC (Traditional)
Cost of capital rE
rE =WACC rD D V

41. ( ) M&M Proposition II E r D - + = d o e
Leverage increases risk and return to shareholders E ( ) d o e r D - + =

42. WACC rE rD D V Cost of capital
The WACC is constant because the cost of equity capital rises to exactly offset the effect of cheaper debt rE
WACC is constant rD D V

43. Leverage and Returns ø ö ç è æ X + = E D A  ( ) D A E  - + =

44. M&M Proposition II (no tax)
Leverage increases risk and return to shareholders
Shareholders require compensation for increased use of debt which exactly offsets the cheaper cost of debt financing.

45. Proposition I (with corporate taxes)
Dependence hypothesis
Firm value increases with leverage
Value of leveraged firm =
Value of unleveraged firm +
PV(tax shield on interest)
i.e. VL = VU + TCD

46. All-equity firm Levered firm
Total Cash Flow to Investors Under Each Capital Structure with Corp. Taxes
All-equity firm Levered firm S G S G B
The levered firm pays less in taxes than does the all-equity firm.
Thus, the sum of the debt plus the equity of the levered firm is greater than the equity of the unlevered firm.

47. MM Proposition II (with taxes)d o s r D - + =
(1 - Tc) =
WACC r ø ö ç è æ  + S d E D
(1 - Tc)

48. Tax shield of interest payment
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc rD
= D x Tc
Example:
D = rD = 10% Tc = 20%
Tax benefit = x (.10) x (.20) = $20
PV of $20 perpetuity = 20 / .10 = $200

49. Implications
With corporate tax, leverage create value due to tax shield created by debt
Part of the cost and risk is shared by government
It suggests firm should be 100% financed by debt. In reality, no such firm. Why?

50. 100 % financed by debt Not exist because Unable to use up tax shield
Personal tax favour equity as capital gains tax can be deferred but tax on interest income cannot.
Cost of financial distress
Agency problems created by excessive debt

51. Other views on capital structure
Agency theory
Trade-off theory
Signalling Approach
Pecking order theory

52. Agency theory Incentive to take large risks
Incentive to under investment
Milking the project
Stockholders have incentives to play games. These games lead to poor investment and operating decisions.

53. Trade-off theory
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity financed
+ PV Tax Shield
- PV Costs of Financial Distress
A trade-off between costs of financial distress and tax savings

54. Integration of Tax Effects and Financial Distress Costs
Value of firm under MM with corporate taxes and debt
Value of firm (V)
Present value of tax shield on debt
VL = VU + TCB
Maximum firm value
Present value of financial distress costs
V = Actual value of firm
VU = Value of firm with no debt
Value of
unlevered
firm
Debt (B) B*
Optimal amount of debt

55. Costs of financial distress

56. Trade-off theory: Implications
Firms with low bankruptcy costs will have greater debt e.g. hotel (not care after sale services)
Firms with tangible assets will borrow more than firms with specialised, intangible assets or valuable growth opportunities.
Cannot explain why the more successful firms generally have the most conservative capital structure.

57. Signalling approach
1. Stock-for-debt Stock price exchange offers falls
Debt-for-stock Stock price exchange offers rises
2. Issuing common stock drives down stock prices; repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.

58. Signalling approach Asymmetric information
If changes in capital structure can alter the market’s perception, the firm’s financial structure is no longer relevant.
2. A signal of management provides clues to investors how management views the firm’s prospects.
Managers think that the shares are “overpriced”
Managers know more and that they try to time issues
Investors interpret decision to issue new equity as bad news so price decline
Firms, being unable to sell equity at fair price may sacrifice +ve NPV projects

59. Pecking order theory Priority in funds raising
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
Priority in funds raising
Internally generated cash flow
Cash and marketable securities in business
Debt
Equity

60. Pecking order theory
Firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort. (Asymmetric information).
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.
Financial slack is valuable (avoid given up +ve NPV projects due to low issue price of common stock).

61. How Firms Establish Capital Structure
Most Corporations Have Low Debt-Asset Ratios.
Changes in Financial Leverage Affect Firm Value.
Stock price increases with increases in leverage and vice-versa; this is consistent with M&M with taxes.
Another interpretation is that firms signal good news when they lever up.
There are Differences in Capital Structure Across Industries.
There is evidence that firms behave as if they had a target Debt to Equity ratio.

62. Factors in Target D/E Ratio
Taxes
If corporate tax rates are higher than bondholder tax rates, there is an advantage to debt.
Types of Assets
The costs of financial distress depend on the types of assets the firm has.
Uncertainty of Operating Income
Even without debt, firms with uncertain operating income have high probability of experiencing financial distress.
Pecking Order and Financial Slack
Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.