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