Chapter 16: Planning the Firm

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Chapter 16 Planning the Firms Financing Mix

• How do we want to finance our firms assets?

? 2002, Prentice Hall, Inc.
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• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Preferred
• Assets
• Shareholders
• Equity

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

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

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

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

Capital Structure
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Why is Capital Structure Important?

• 1) Leverage higher financial leverage means
  higher returns to stockholders, but higher risk
  due to interest payments.
• 2) Cost of Capital Each source of financing
  has a different cost. Capital structure affects
  the cost of capital.
• 3) The Optimal Capital Structure is the one that
  minimizes the firms cost of capital and
  maximizes firm value.

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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.

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Independence Hypothesis

• Firm value does not depend on capital structure.

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Independence Hypothesis
Cost of Capital
kc cost of equity kd cost of debt ko cost
of capital
.
kc
0 debt financial leverage 100debt
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Independence Hypothesis
.
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Independence Hypothesis
.
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Independence Hypothesis
Increasing leverage causes the cost of equity
to rise.
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Independence Hypothesis
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Independence Hypothesis
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Independence Hypothesis
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Independence Hypothesis
kc
kd
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Independence Hypothesis

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

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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.

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Dependence Hypothesis
Since the cost of debt is lower than the cost of
equity...
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Dependence Hypothesis
Since the cost of debt is lower than the cost of
equity increasing leverage reduces the cost of
capital.
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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?

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Remember this example?Tax effects of financing
with debt

• with stock with debt
• EBIT 400,000 400,000
• - interest expense 0
  (50,000)
• EBT 400,000 350,000
• - taxes (34) (136,000) (119,000)
• EAT 264,000 231,000
• - dividends (50,000) 0
• Retained earnings 214,000
  231,000

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Remember this example?Tax effects of financing
with debt

• with stock with debt
• EBIT 400,000 400,000
• - interest expense 0
  (50,000)
• EBT 400,000 350,000
• - taxes (34) (136,000) (119,000)
• EAT 264,000 231,000
• - dividends (50,000) 0
• Retained earnings 214,000
  231,000

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Moderate Position
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Moderate Position
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Moderate Position
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Moderate Position
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Moderate Position
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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?

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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.

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Why is 100 Debt not Optimal?

• 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.

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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Moderate Positionwith Bankruptcy and Agency Costs
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Capital Structure Management

• EBIT-EPS Analysis - used to help determine
  whether it would be better to finance a project
  with debt or equity.

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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
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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.
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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.

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If we expect EBIT to be 2,000,000

• Financing stock debt
• EBIT 2,000,000 2,000,000
• - interest 0 (600,000)
• EBT 2,000,000 1,400,000
• - taxes (40) (800,000) (560,000)
• EAT 1,200,000 840,000
• shares outst. 1,000,000 800,000
• EPS 1.20 1.05

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If we expect EBIT to be 4,000,000

• Financing stock debt
• EBIT 4,000,000 4,000,000
• - interest 0 (600,000)
• EBT 4,000,000 3,400,000
• - taxes (40) (1,600,000) (1,360,000)
• EAT 2,400,000 2,040,000
• shares outst. 1,000,000 800,000
• EPS 2.40 2.55

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• 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.

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If we choose stock financing
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If we choose bond financing
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Breakeven EBIT
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Breakeven Point

• Set 2 EPS calculations equal to each other and
  solve for EBIT
• Stock Financing Debt Financing
• (EBIT-I)(1-t) - P (EBIT-I)(1-t) - P
• S
  S

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Breakeven Point

• Stock Financing Debt Financing
• (EBIT-I)(1-t) - P (EBIT-I)(1-t) - P
• S
  S
• (EBIT-0) (1-.40) (EBIT-600,000)(1-.40)
• 800,000200,000 800,000
  

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Breakeven Point

• Stock Financing Debt Financing
• .6 EBIT .6 EBIT - 360,000
• 1
  .8
• .48 EBIT .6 EBIT - 360,000
• .12 EBIT 360,000
• EBIT 3,000,000

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Breakeven EBIT
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Breakeven EBIT
For EBIT up to 3 million, stock financing is
best.
For EBIT greater than 3 million, debt financing
is best.
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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.

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Breakeven EBIT

• Stock Financing Levered Financing
• (EBIT-I) (1-t) - P (EBIT-I) (1-t) - P
• S
  S
• EBIT-0 (1-.50) (EBIT-315,000)(1-.50)
• 1,200,000 850,000
• EBIT 1,080,000

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Analytical Income Statement

• Stock Levered
• EBIT 1,080,000 1,080,000
• I 0 (315,000)
• EBT 1,080,000 765,000
• Tax (540,000) (382,500)
• NI 540,000 382,500
• Shares 1,200,000 850,000
• EPS .45 .45

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Breakeven EBIT
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Breakeven EBIT
For EBIT up to 1.08 m, stock financing is best.
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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.
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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.

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Breakeven EBIT

• Stock Financing Levered Financing
• (EBIT-I) (1-t) - P (EBIT-I) (1-t) - P
• S
  S
• (EBIT-0) (1-.35) (EBIT-864,000)(1-.35)
• 1,200,000 720,000
• EBIT 2,160,000

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Analytical Income Statement

• Stock Levered
• EBIT 2,160,000 2,160,000
• I 0 (864,000)
• EBT 2,160,000 1,296,000
• Tax (756,000) (453,600)
• NI 1,404,000 842,400
• Shares 1,200,000 720,000
• EPS 1.17 1.17

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Breakeven EBIT
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Breakeven EBIT
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Breakeven EBIT