1. Chapter 16 - Planning the Firm’s Financing Mix

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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.

8. 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.

9. Independence Hypothesis Firm value does not depend on capital structure.

10.  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

11.  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

12.  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

13.  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

14.  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 1 1.00 P 10.00

15.  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 1 1.00 P 10.00

16.  $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

17.  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

18.  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

19.  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

20.  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

21.  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 1 1.267 P 10.00

22.  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 1 1.267 P 10.00

23.  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

24.  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

25.  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

26.  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

27.  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

28.  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

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

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

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

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

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

34. 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

35. 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

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

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

38. 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.

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

40. 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

41. 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?

42. 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 1,000,000 760,000 to stockholders 1,000,000 760,000 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

43. Moderate Position Cost of Capital kc kd Financial Leverage kc kd

44. 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...

45. 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...

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

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

48. 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?

49. 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.

50. 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?

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

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

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

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

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

56. 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

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

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

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

60. 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

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

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

63. 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

64. 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.

65. 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.

66. 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) EAT1,200,000 840,000 # shares outst.1,000,000 800,000 EPS $1.20 $1.05

67. 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.1,000,000 800,000 EPS $2.40 $2.55 If we expect EBIT to be $4,000,000:

68.  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.

69. If we choose stock financing: EPS EBIT $1m $2m $3m $4m stock financing 0 3 2 1

70. If we choose bond financing: EPS EBIT $1m $2m $3m $4m bond financing 0 3 2 1

71. Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing 0 3 2 1

72. 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

73. 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+200,000 800,000 800,000+200,000 800,000

74. Breakeven Point Stock Financing Debt Financing Stock Financing Debt Financing.6 EBIT =.6 EBIT - 360,000.6 EBIT =.6 EBIT - 360,000 1.8 1.8.48 EBIT =.6 EBIT - 360,000.48 EBIT =.6 EBIT - 360,000.12 EBIT = 360,000.12 EBIT = 360,000 EBIT = $3,000,000 EBIT = $3,000,000

75. Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing 0 3 2 1 For EBIT up to $3 million, stock financing is best.

76. Breakeven EBIT EPS EBIT $1m $2m $3m $4m bond financing stock financing 0 3 2 1 For EBIT up to $3 million, stock financing is best. For EBIT greater than $3 million, debt financing is best.

77. 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%.

78. 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) 1,200,000 850,000 1,200,000 850,000 EBIT = $1,080,000 EBIT = $1,080,000

79. Analytical Income Statement Stock Levered Stock Levered EBIT1,080,0001,080,000 I 0 (315,000) EBT1,080,000 765,000 Tax (540,000) (382,500) NI 540,000 382,500 Shares1,200,000 850,000 EPS.45.45

80. levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m 0.65.45.25 Breakeven EBIT

81. For EBIT up to $1.08 m, stock financing is best. levered financing stock financing EPS EBIT $.5m $1m $1.5m $2m 0.65.45.25 Breakeven EBIT

82. 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 0.65.45.25

83. 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.

84. 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) 1,200,000 720,000 1,200,000 720,000 EBIT = $2,160,000 EBIT = $2,160,000

85. 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) NI1,404,000 842,400 Shares1,200,000 720,000 EPS1.17 1.17

86. Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m 0 1.5 1.17.5

87. Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m 0 1.5 1.17.5 For EBIT up to $2.16 m, stock financing is best.

88. Breakeven EBIT levered financing stock financing EPS EBIT $1m $2m $3m $4m 0 1.5 1.17.5 For EBIT greater than $2.16 m, the levered plan is best. For EBIT up to $2.16 m, stock financing is best.