How do we want to finance our firms assets

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• How do we want to finance our firms assets?

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• Distinguish financial structure an capital
  structure
• appreciate the main principles of designing a
  capital structure for a firm
• understand the theoretical models concerned with
  the extent to which capital structure influences
  the value of the companys share price
• appreciate aspects of the actual management of
  capital structure by companies

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• Balance Sheet
• Current Current
• Assets Liabilities
• Debt and
• Fixed Pref Shares
• Assets
• Shareholders
• Equity

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

Capital Structure
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• 1. How should a firm best divide its total fund
  sources between short and long term (permanent)
  components?
• 2. What mix of long term financing sources should
  make up the firms capital structure?

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• 1) Leverage higher financial leverage means
  higher returns to shareholders, 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
  minimises the firms cost of capital and
  maximises firm value.

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• In a perfect world environment with no taxes,
  no transactions costs and perfectly efficient
  financial markets, capital structure does not
  matter.
• This is known as the Independence Hypothesis of
  capital structure firm value is independent of
  capital structure.

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• Firm value does not depend on capital structure.

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Cost of Capital
ke cost of equity kd cost of debt ko cost
of capital
.
ke
0 debt financial leverage 100debt
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Cost of Capital
If we have an all-equity financed firm, what is
the cost of capital?
.
ke
financial leverage
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Cost of Capital
If we have an all-equity financed firm, the cost
of capital is just the cost of equity.
.
koke
financial leverage
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Suppose we begin adding debt financing at a cost
of kd. kd is lower than ke, so what should
happen to the cost of capital?
Cost of Capital
ke
kd
kd
financial leverage
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Cost of Capital
It should go down. But how should
increasing leverage affect ke?
ke
kd
kd
financial leverage
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Cost of Capital
According to the Independence Hypothesis, the
increase in debt will cause ke to rise.
ke
kd
kd
financial leverage
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Increasing leverage causes the cost of equity
to rise.
ke
Cost of Capital
ke
kd
kd
financial leverage
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Increasing leverage causes the cost of equity
to rise.
ke
Cost of Capital
What will be the net effect on the overall cost
of capital?
ke
kd
kd
financial leverage
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The cost of capital does not change. Leverage
has no effect on the cost of capital
and therefore,
ke
Cost of Capital
it has no effect on the value of the firm.
ko
ke
kd
kd
financial leverage
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• In a perfect markets environment, capital
  structure is irrelevant. In other words, changes
  in capital structure do not affect firm value.

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• 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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• Extreme position 2
• The dependence hypothesis is at the opposite pole
  from the independence hypothesis.
• It suggests that both the WACC (ko) and the
  ordinary share price (Po) are affected by the
  firms use of financial leverage.

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• No matter how modest or excessive the firms use
  of debt financing, both its cost of debt capital
  (Kd) and cost of equity (Ke) will not be effected
  by capital-structure management.

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• 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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• Agency costs costs associated with protecting
  debt-holders.
• Debt-holders (principals) lend money to the firm
  and expect it to be invested wisely.
• Shareholders own the firm and elect the board and
  hire managers (agents).
• Debt covenants require managers to be monitored.
  The monitoring expense is an agency cost, which
  increases as debt increases.

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• 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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• with shares with debt
• EBIT 400,000 400,000
• - interest expense 0
  (50,000)
• EBT 400,000 350,000
• - taxes (36) (144,000) (126,000)
• EAT 256,000 224,000
• - dividends (50,000) 0
• Retained earnings 206,000
  224,000

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The cost of debt increases as the proportion of
debt increases. At some point, the capital
markets will consider any new debt excessive,
and therefore much riskier.
Cost of Capital
kd
financial leverage
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Cost of Capital
financial leverage
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At first, the cost of capital falls. Why?
Cost of Capital
financial leverage
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Because the cost of equity is not rising enough
to offset the low after-tax cost of debt.
ke
Cost of Capital
kd
ko
financial leverage
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Cost of Capital
financial leverage
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At some point, there will be a minimum cost of
capital!
Cost of Capital
financial leverage
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• Market value of levered firm
• market value of unlevered firm
• present value of tax shields
• - present value of financial distress costs
• - present value of agency costs
• applies to classical tax system

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• Free Cash flow - cash flow in excess of that
  required to fund all projects that have positive
  net present values when discounted at the
  relevant cost of capital
• FCF can lead to management decisions not in the
  best interest of shareholders
• this leads to the use of more debt to control
  management behaviour and decisions
• FREE CASH FLOW THEORY of CAPITAL STRUCTURE

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• Does capital structure matter?
• If the firms cost of capital can be lowered by
  an appropriate mix of debt and equity funds,
  capital structure does matter. A lower cost of
  capital increases the present value of the firms
  operating cash flows.

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• Decisions are more complex than indicated in the
  moderate view because
• firms tend to maintain spare debt capacity
• no distinction between internal and external
  funds
• short to medium term borrowing is preferred to
  longer term borrowing
• timing of equity and debt issues based on market
  conditions is a key consideration
• family controlled companies are concerned with
  diluting ownership.

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• Investment opportunities of companies tend to
  drive their dividend policy
• Order of financing
• Internally generated funds
• Issue of debt securities
• Issue of convertible securities
• Issue of equity securities
• Implication - observed leverage ratios will
  reflect the cumulative financing needs of
  companies over time.

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• Q Can a firms financing mix affect its value?
• Capital structure theories in a perfect market
• Capital structure theories in an imperfect market
• Capital structure decisions in practice