Chapter 27 Flashcards
WACC formula
When choosing between cap structures, chose the one that minimizes WACC
(1-T) tax rate
Why is after tax important?
Its after tax and its important because most jurisdiction, Cost of debt is deductible for Tax purposes. In other words, it reduces our tax liability, so the govt provides us a subsidy to borrow money in effect bc they are taxing us less if we have interest expenses compared to no interest expense.
How to determine where WACC should be based on this example:
ABC inc., capital structure is 50% debt and 50% equity
Cost of debt 8%
Cost of equity 11%
Corporate Tax 30%
WACC =
(0.50)(0.08)(1-0.30) + (0.50)(0.11) = 0.083 = 8.3%
The after tax cost of debt is: 0.08 (1-0.30) = 5.6%
So WACC is going to be between 5.6% and 11% equity
Proportion of debt and equity are influenced by (4) internal and (2) external factors:
Internal is industry specific.
Operating Tax Rate and what it means when govt. subsidizes debt.
Remember the govt. subsidizes debt, if tax rate is high, higher the subsidy so higher the corp. tax rate, the more incentive there is for company to take on more debt.
Operating Leverage and Financial Leverage
Operati
Leverage definition and the two sources of leverage.
Two sources of leverage, leverage means magnification of variability.
-Operating leverage (business leverage) account of fixed cost.
-Financial leverage
High operating leverage doesn’t want high financial leverage. So they may choose to use less debt.
For operating leverage, what does large fixed cost in cost structure mean?
When you have large fixed cost in your cost structure, your operating leverage is very high
The cost of debt and equity is likely to be higher for a firm with:
A. Stable Rev Growth
B. High operating leverage
C. High interest coverage
B. High operating leverage
Operating lev is the firms proportion of fixed cost to total cost and measure the stability of profits.
Firms with high op lev experience a greater change in operating profits for a given change in rev. Thus, firms with high operating lev are riskier and likely to have higher debt and equity costs.
What are the industry/Co Characteristics that have higher proportion of debt.
Note:
Definition: Cyclical industries fluctuate with the business cycle.
Fungible is the opposite of specialized, so an asset that is fungible can be easily adapted or can be used in many diff industries, as opposed to specialized asset that is unique to a company.
Detailed notes from picture:
Companies in noncyclical industries are better able to support high proportions of debt than companies in cyclical industries.
Companies with low fixed operating costs as a proportion of total costs (i.e., low operating leverage) are better able to support high proportions of debt than companies with high fixed costs.
Companies with subscription-based revenue models are better able to support high proportions of debt than companies with pay-per-use revenue models.
Creditors tend to view tangible assets as better collateral than intangible assets. A company that owns its productive assets outright as opposed to using assets owned by others (such as a franchise model) has more collateral, which improves access to debt financing and reduces borrowing costs.
Coverage Ratio formula and what are they used to analyze?
Used to analyze debt capacity
Interest coverage = EBIT / Interest Expense.
Convertible debt
Used by start-ups with high growth and rapid rising stock prices.
convertible allows the lender to convert that debt into equity at some point in the future, at specific exercise price. It allow co to raise debt cap at reasonable mrk prices even though they are in start up phase.
Corporate Life Cycle:
Startup
Growth
Maturity
Startup
- Convertible debt
Growth
- Secured debt, still mainly equity financing
Maturity
- Unsecure debt , bc its cheaper than equity.
MM1, what is the theory
In it, MM demonstrate that under certain assumptions, the value of a firm is unaffected by its capital structure
MM1 Assumptions
- Capital markets are perfectly competitive. There are no transactions costs, taxes, or bankruptcy costs.
- Investors have homogeneous expectations.
- There is riskless borrowing and lending.
- There are no agency costs. There are no conflicts of interest between managers and shareholders.
- Investment decisions are unaffected by financing decisions. Operating income is independent of how the firm is financed.
o In other words, value of firm is unchanged regardless if you use 10% debt of 90% debt.
o Like pizza, you can cut it up slices so its 25% debt and rest is equity but regardless of how you slice the pizza pie, the SIZE of pizza is not affected.
MM1 and MM2 is unaffected by what?
MM1 - value of firm is unaffected by its capital structure
MM2 - WACC is unaffected by capital structure.
MM1 without Taxes
Changing cap structure does not affect value of firm.
Value of levered co. (Vl) = value of unlevered co (Vu)
Company value is determined solely on expected future CF.
Total CF to debt and equity holders are the same for levered and unlevered
Investors can choose the level of leverage by borrowing and lending at risk-free rate.
MM2 theory
MM2 is framed in terms of a firm’s cost of capital, rather than firm value. Firm cost of capital and WACC unaffected by proportion of debt financing/capital structure.
Same assumption as MM1 in that it includes no taxes.
MM2 states that -As company take more debt, the risk equity investor have to take is higher.
Therefore, Based on the same assumptions as MM I, MM II states that the cost of equity increases linearly as a company increases its proportion of debt financing.’
Firm with higher leverage will have higher cost of equity. Higher leverage you use cheaper source of capital, so the weighted average will not be changed.
In other words - The conclusion of MM II is that the decrease in financing costs from using a larger proportion of (lower-cost) debt is just offset by the increase in the cost of equity, resulting in no change in the firm’s WACC
Debt-to-equity ratio and cost of equity formula
As leverage (the debt-to-equity ratio) increases, the cost of equity increases, but the cost of debt and WACC are unchanged
Tax Shield
(1) Definition
(2) Formulas
(3) Implications
Taxes we are referring to is corp tax and govt allows deduction for interest expense. Bc govt. provide that subsidy we call that a tax shield.
Tax shield = Tax * Debt company takes.
Bc of tax shield, the debt become prefer source of capital.
So value of levered firm = unlevered firm + tax shield
Increase in tax shield, the value of leveraged increases. And tax shield will increase by taking on more debt.
How much debt can you take? You can finance 100% debt and the tax shield will be maxed
MM1 With taxes
MM1 without taxes
MM2 with taxes
MM2 without taxes
*MM 1with taxes theory (6 bullet points)
Debt financing creates a tax shield that increase company value. Tax shield means that the lev firm can distribute greater CF than unlev firm.
Cost of capital minimized and value of firm max at 100% debt.
Prop 2 also says WACC is minimized at 100% debt.
After-tax cost of debt is lower than the cost of debt.
Therefore WACC decreases on account for taking on more debt.
MM’s propositions with taxes but without costs of financial distress are that a company’s WACC is minimized and its value is maximized with 100% debt.
Positive tax rate formula for return on equity
static tradeoff theory
The static tradeoff theory seeks to balance the costs of financial distress with the tax shield benefits from using debt.
Static tradeoff theory indicates that firm value initially increases (and WACC decreases) with additional debt financing, but company value decreases at some point when the increase in the expected value of financial distress outweighs the tax benefits of additional debt.
Cost of equity is upward sloping.
optimal capital structure
Where the WACC is minimized and the value of the firm is maximized
Accounting for the costs of financial distress, the expression for the value of a levered firm
VL = VU + (t × debt) – PV (costs of financial distress)
Three agency cost
Monitoring
Bonding
Residual losses.
High agency cost may find more debt to be beneficial. Why?
- Companies with high agency cost, where residual losses are high, where its difficult to monitor managers action, when info asymmetry is high, for those kind of company it makes sense to use more debt in cap structure bc more debt implies contractual payments that need to be made to the lenders.
- When there is contractual pmt for debt capital, its less free cash flow the managers have.
- So when managers have less free CF, they have less ability to pursue empire building, pursuing foolish acquisition.
Pecking order theory
Says manager have their own preference about the source of capital they want to employ.
THIS theory says managers want to send least amt of negative signal to the mrk.
(1) Retain Earnings -
When manager use internally -generated equity (retained earnings) they are not sending any signal to the mrk, and therefore that is ranked number one for sources of capital. So most preferred source of capital is retained earnings.
(2) Debt -
Second source is debt, when co issue debt, it tells mrk we need capital or we are growing and we need to finance it. It communicates to mrk that managers are confident about future of company and serveability of new debt. No neg signal to mrk.
(3) New Equity -
Third, least prefer is new equity, bc when manager make announce to issue additional stock, the mrk thinks the stock is overvalued and that is a neg signal to mrk.
Pecking order theory says overtime the managers follow this pecking order, first rely on retain earnings, then debt, then equity.
Over time, the series of decision that company has made leads to the current capital structure we see
A firm is planning a $25 million expansion project.
The project will be financed with
$10 million in debt and
$15 million in equity stock
(equal to the company’s current capital structure). T
he before-tax required return on
debt is 10% and 15% for equity.
If the company’s tax rate is 35%, what cost of capital should the firm use to determine the project’s net present value?
Weight of equity =
$15 million / ($10 million + $15 million) = 60%
Weight of debt =
$10 million / ($10 million + $15 million) = 40%
WACC = 0.60(kCE) + 0.40(after-tax kD)
WACC = 0.60(0.15) + 0.40(0.10)(1 − 0.35) =
= 0.116 or 11.6%
Elenore Rice, CFA, is asked to determine the appropriate weighted average cost of capital for Samson Brick Company. Rice is provided with the following data:
Debt outstanding, market value $10 million
Common stock outstanding, market value $30 million
Marginal tax rate 40%
Cost of common equity 12%
Cost of debt 8%
Samson has no preferred stock. Assuming Samson’s ratios reflect the firm’s target capital structure, Samson’s weighted average cost of capital is closest to
The capital structure ratios are:
Debt to total capital = $10 / ($10 + $30) = 25%
Equity to total capital = $30 / ($10 + $30) = 75%
The formula for the WACC (if no preferred stock) is:
WACC = WdKd(1 – t) + WceKce
wd is the percentage of operations financed by debt,
wce is the percentage of operations financed by equity, T is the marginal tax rate,
kd is the before-tax cost of debt
kce is the cost of common equity.
WACC = 0.25(0.08)(1-0.40) + 0.75(0.12) = 0.102 = 10.2%.
- WACC Example:
Company balance sheet shows:
$400k Bonds
$600K Common Shares (40K shares )
Total liabilities & Equity = $1,000,000
Current stock price $20.00 per share
Required before-tax return on debt: 5%
Required return on equity 10%
Calculate WACC if stock prices rise to $25 and the relevant tax rate is 20%
(1) Get the market value of equity:
$25 * 40K shares = $1,000,000
(2) Get total capital:
1,000,000 mrk value of equity + 400,000 bonds
= $ 1,400,000
(3) Get MRK VALUE weights:
Debt = 400 bonds / 1,400,000 (2) = 0.29
Equity= 1,000,000 (1) / 1,400,000 (2)= 0.71
(4) WACC Formula:
(Wd) (Rd) (1-T) + (We) (Re)
(0.29)(5%)(1-20%) + (0.71)(10%) = 8.26
removing the assumption of no taxes, but keeping all of MM other assumptions, which of the following would be the optimal cap structure for maximizing the value of a firm?
a. 50/50 % debt and equity
b. 100% debt
c. 100% equity
b. 100% debt.
If MM other assumptions are maintained, removing the no tax assumption means the value of the firm is max when the value of tax shield is max, which occurs with a cap structure of 100% debt.
