Leverage and Capital Structure

Save this PDF as:
 WORD  PNG  TXT  JPG

Size: px
Start display at page:

Download "Leverage and Capital Structure"

Transcription

1 Leverage and Capital Structure Ross Chapter 16 Spring Leverage Financial Leverage Financial leverage is the use of fixed financial costs to magnify the effect of changes in EBIT on EPS. Fixed financial costs can be, for instance, interest payments and dividends on preferred shares. 2

2 10.1 Leverage Financial Leverage Let T denote the tax rate, let I denote interest expense and let NS denote the number of shares outstanding. Then earnings per share (EPS) are given by EPS = (1 T )(EBIT I). NS Leverage Financial Leverage At a given EBIT level, how do percentage changes in EBIT translate into percentage changes in EPS? EPS EPS (1 T )(EBIT I) NS ( (1 T )(EBIT I) NS = (1 T )(EBIT I) NS = (1 T )(EBIT EBIT) (1 T )(EBIT I) = = EBIT (1 T )EBIT EBIT EBIT (1 T )(EBIT I) EBIT EBIT I EBIT EBIT ) 4

3 10.1 Leverage Financial Leverage That is, when EBIT increases by 1%, the percentage increase in EPS is EBIT EBIT I = EBIT EBIT I. This the degree of financial leverage (DFL) at base level EBIT. 5 Types of Capital Assets Debt & Equity NWC Long-Term Debt (D) Fixed Assets Equity (E) 6

4 Capital Structure Theory Modigliani and Miller s propositions: Proposition I: The market value of a firm is constant regardless of the amount of leverage that it uses to finance its assets. Proposition II: The expected return on a firm s equity is an increasing function of the firm s leverage. 7 Capital Structure Theory: M&M Proposition I The value of a firm is given by the present value of all the cash flows its assets are expected to generate in the future. The value of a firm is equal to the value of its assets. Unlevered Firm: V U = E U Levered Firm: V L = D + E L. 8

5 Capital Structure Theory: M&M Proposition I M&M Proposition I states that V U = V L. Why? Consider an all-equity firm with value V U = E U. Suppose there existed a way to finance this firm s assets with debt and equity such that V L = D + E L > V U. 9 Capital Structure Theory: M&M Proposition I An arbitrageur could buy α shares of the above firm, place them in a trust and sell debt and equity claims against these shares in proportions such that making then a riskless profit. α(d + E L ) > αe U, 10

6 Capital Structure Theory: M&M Proposition I Similarly, someone could buy all of the firm s shares for E U and modify the firm s capital stucture to have V L = D + E L > E U and then resell the firm for a riskless profit of V L V U. 11 Capital Structure Theory: M&M Proposition I In a frictionless market, this arbitrage oppotunity would lead to an increase in the firm s unlevered equity to the point where for any level of D and E L. V U = E U = D + E L = V L 12

7 Capital Structure Theory: M&M Proposition I with Taxes Consider an unlevered firm, denoted U, that expects constant earnings before interest and taxes, denoted EBIT, forever. Each period, if the corporate tax rate is T, shareholders receive and the government receives (1 T )EBIT T EBIT. 13 Capital Structure Theory: M&M Proposition I with Taxes Let E U = V U denote the present value of the payment (1 T )EBIT forever. Let G U denote the present value of the payment T EBIT forever. Let k 0 denote the firm s WACC when unlevered. Then E U = V U = (1 T )EBIT k 0. 14

8 Capital Structure Theory: M&M Proposition I with Taxes Consider a levered firm, Firm L, with the same EBIT as U, but with a perpetual debt issue D with coupon rate i. Interest payments are tax exempt. Shareholders receive (1 T )(EBIT id) each period forever, bondholders receive id each period forever, and the government receives T (EBIT id) each period forever. 15 Capital Structure Theory: M&M Proposition I with Taxes Each period, the total cash flow to shareholders and bondholders of Firm L is (1 T )(EBIT id) + id = (1 T )EBIT + TiD. The value of the levered firm is then the sum of two perpetuities, i.e. (1 T )EBIT forever and TiD forever. 16

9 Capital Structure Theory: M&M Proposition I with Taxes As before, the present value of (1 T )EBIT forever is V U. Discounting the tax shield cash flows TiD at the bonds coupon rate i, their present value is TiD i = T D, and thus the value of the levered firm is V L = V U + T D. 17 Capital Structure Theory: Financial Distress In a world with uncertainty, however, increasing D also increases the risk of bankruptcy. Financial distress creates some costs. Business risk is not affected by the level of debt but has an impact on the firm s capability to meet in financial obligations. Financial risk is directly affected by the firm s level of debt. 18

10 The Optimal Capital Structure The value of the levered firm can also be obtained using V = (1 T )EBIT k a, where k a is the firm s cost of capital. 19 The Optimal Capital Structure Suppose we have D D+E k e k d WACC (k a ) 0% 13.00% 8.00% 13.00% 20% 13.20% 8.20% 12.20% 40% 13.80% 8.80% 11.80% 50% 14.25% 9.25% 11.75% 60% 14.80% 9.80% 11.80% 80% 16.20% 11.20% 12.20% 20

11 The Optimal Capital Structure Then the value of the firm V = k a is minimized. (1 T )EBIT k a, is maximized when 21 The Optimal Capital Structure Suppose EBIT = 1,000 and T = 40%. Then D D+E k e k d WACC (k a ) V = (1 T )EBIT k a 0% 13.00% 8.00% 13.00% % 13.20% 8.20% 12.20% % 13.80% 8.80% 11.80% % 14.25% 9.25% 11.75% % 14.80% 9.80% 11.80% % 16.20% 11.20% 12.20%

SOLUTIONS. Practice questions. Multiple Choice

SOLUTIONS. Practice questions. Multiple Choice Practice questions Multiple Choice 1. XYZ has $25,000 of debt outstanding and a book value of equity of $25,000. The company has 10,000 shares outstanding and a stock price of $10. If the unlevered beta

More information

Chapter 17 Does Debt Policy Matter?

Chapter 17 Does Debt Policy Matter? Chapter 17 Does Debt Policy Matter? Multiple Choice Questions 1. When a firm has no debt, then such a firm is known as: (I) an unlevered firm (II) a levered firm (III) an all-equity firm D) I and III only

More information

MM1 - The value of the firm is independent of its capital structure (the proportion of debt and equity used to finance the firm s operations).

MM1 - The value of the firm is independent of its capital structure (the proportion of debt and equity used to finance the firm s operations). Teaching Note Miller Modigliani Consider an economy for which the Efficient Market Hypothesis holds and in which all financial assets are possibly traded (abusing words we call this The Complete Markets

More information

If you ignore taxes in this problem and there is no debt outstanding: EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60

If you ignore taxes in this problem and there is no debt outstanding: EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60 Problems Relating to Capital Structure and Leverage 1. EBIT and Leverage Money Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes [EBIT] are projected

More information

Chapter 15: Debt Policy

Chapter 15: Debt Policy FIN 302 Class Notes Chapter 15: Debt Policy Two Cases: Case one: NO TAX All Equity Half Debt Number of shares 100,000 50,000 Price per share $10 $10 Equity Value $1,000,000 $500,000 Debt Value $0 $500,000

More information

GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE

GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE 1 ST SEMESTER 2010-2011 Chapter 18 Capital Budgeting and Valuation with Leverage

More information

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2.

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2. DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%, and investors pay a tax

More information

Chapter 16 Debt-Equity Mix 1. Divido Corporation is an all-equity financed firm with a total market value of $100 million.

Chapter 16 Debt-Equity Mix 1. Divido Corporation is an all-equity financed firm with a total market value of $100 million. Chapter 16 Debt-Equity Mix 1. Divido Corporation is an all-equity financed firm with a total market value of $100 million. The company holds $10 million in cash-equivalents and has $90 million in other

More information

U + PV(Interest Tax Shield)

U + PV(Interest Tax Shield) CHAPTER 15 Debt and Taxes Chapter Synopsis 15.1 The Interest Tax Deduction A C-Corporation pays taxes on proits ater interest payments are deducted, but it pays dividends rom ater-tax net income. Thus,

More information

EMBA in Management & Finance. Corporate Finance. Eric Jondeau

EMBA in Management & Finance. Corporate Finance. Eric Jondeau EMBA in Management & Finance Corporate Finance EMBA in Management & Finance Lecture 4: Capital Structure Limits to the Use of Debt Outline 1. Costs of Financial Distress 2. Description of Costs 3. Can

More information

Financial Markets and Valuation - Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds

Financial Markets and Valuation - Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds Financial Markets and Valuation - Tutorial 6: SOLUTIONS Capital Structure and Cost of Funds (*) denotes those problems to be covered in detail during the tutorial session (*) Problem 1. (Ross, Westerfield

More information

Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.)

Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) The primary focus of the next two chapters will be to examine the debt/equity choice by firms. In particular,

More information

Discount rates for project appraisal

Discount rates for project appraisal Discount rates for project appraisal We know that we have to discount cash flows in order to value projects We can identify the cash flows BUT What discount rate should we use? 1 The Discount Rate and

More information

1 Pricing options using the Black Scholes formula

1 Pricing options using the Black Scholes formula Lecture 9 Pricing options using the Black Scholes formula Exercise. Consider month options with exercise prices of K = 45. The variance of the underlying security is σ 2 = 0.20. The risk free interest

More information

Corporate Finance & Options: MGT 891 Homework #6 Answers

Corporate Finance & Options: MGT 891 Homework #6 Answers Corporate Finance & Options: MGT 891 Homework #6 Answers Question 1 A. The APV rule states that the present value of the firm equals it all equity value plus the present value of the tax shield. In this

More information

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2.

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2. DUK UNIRSITY Fuqua School of Business FINANC 351 - CORPORAT FINANC Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%. Consider a firm that earns $1,000

More information

The Assumptions and Math Behind WACC and APV Calculations

The Assumptions and Math Behind WACC and APV Calculations The Assumptions and Math Behind WACC and APV Calculations Richard Stanton U.C. Berkeley Mark S. Seasholes U.C. Berkeley This Version October 27, 2005 Abstract We outline the math and assumptions behind

More information

CHAPTER 15 Capital Structure: Basic Concepts

CHAPTER 15 Capital Structure: Basic Concepts Multiple Choice Questions: CHAPTER 15 Capital Structure: Basic Concepts I. DEFINITIONS HOMEMADE LEVERAGE a 1. The use of personal borrowing to change the overall amount of financial leverage to which an

More information

Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs

Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs Chapter 1: The Modigliani-Miller Propositions, Taxes and Bankruptcy Costs Corporate Finance - MSc in Finance (BGSE) Albert Banal-Estañol Universitat Pompeu Fabra and Barcelona GSE Albert Banal-Estañol

More information

CAPITAL STRUCTURE [Chapter 15 and Chapter 16]

CAPITAL STRUCTURE [Chapter 15 and Chapter 16] Capital Structure [CHAP. 15 & 16] -1 CAPITAL STRUCTURE [Chapter 15 and Chapter 16] CONTENTS I. Introduction II. Capital Structure & Firm Value WITHOUT Taxes III. Capital Structure & Firm Value WITH Corporate

More information

Cost of Capital and Project Valuation

Cost of Capital and Project Valuation Cost of Capital and Project Valuation 1 Background Firm organization There are four types: sole proprietorships partnerships limited liability companies corporations Each organizational form has different

More information

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Chapter 17 Valuation and Capital Budgeting for the Levered Firm 17A-1 Appendix 17A The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction A leveraged buyout (LBO) is the acquisition

More information

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction

The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction Chapter 18 Valuation and Capital Budgeting for the Levered Firm 18A-1 Appendix 18A The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction A leveraged buyout (LBO) is the acquisition

More information

Problem 1 Problem 2 Problem 3

Problem 1 Problem 2 Problem 3 Problem 1 (1) Book Value Debt/Equity Ratio = 2500/2500 = 100% Market Value of Equity = 50 million * $ 80 = $4,000 Market Value of Debt =.80 * 2500 = $2,000 Debt/Equity Ratio in market value terms = 2000/4000

More information

Capital Structure. Itay Goldstein. Wharton School, University of Pennsylvania

Capital Structure. Itay Goldstein. Wharton School, University of Pennsylvania Capital Structure Itay Goldstein Wharton School, University of Pennsylvania 1 Debt and Equity There are two main types of financing: debt and equity. Consider a two-period world with dates 0 and 1. At

More information

WACC and a Generalized Tax Code

WACC and a Generalized Tax Code WACC and a Generalized Tax Code Sven Husmann, Lutz Kruschwitz and Andreas Löffler version from 10/06/2001 ISSN 0949 9962 Abstract We extend the WACC approach to a tax system having a firm income tax and

More information

7 CAPITAL STRUCTURE AND FINANCIAL LEVERAGE

7 CAPITAL STRUCTURE AND FINANCIAL LEVERAGE 7 CAPITAL STRUCTURE AND FINANCIAL LEVERAGE Capital structure refers to the way a corporation finances its assets through some combination of equity and debt. A firm's capital structure is then the composition

More information

Practice Exam (Solutions)

Practice Exam (Solutions) Practice Exam (Solutions) June 6, 2008 Course: Finance for AEO Length: 2 hours Lecturer: Paul Sengmüller Students are expected to conduct themselves properly during examinations and to obey any instructions

More information

Use the table for the questions 18 and 19 below.

Use the table for the questions 18 and 19 below. Use the table for the questions 18 and 19 below. The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value): Maturity (years) 1 3 4 5 Price

More information

t = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3

t = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3 MØA 155 PROBLEM SET: Summarizing Exercise 1. Present Value [3] You are given the following prices P t today for receiving risk free payments t periods from now. t = 1 2 3 P t = 0.95 0.9 0.85 1. Calculate

More information

Stock Valuation: Gordon Growth Model. Week 2

Stock Valuation: Gordon Growth Model. Week 2 Stock Valuation: Gordon Growth Model Week 2 Approaches to Valuation 1. Discounted Cash Flow Valuation The value of an asset is the sum of the discounted cash flows. 2. Contingent Claim Valuation A contingent

More information

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview Leverage FINANCE 35 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University Overview Capital Structure does not matter! Modigliani & Miller propositions Implications for

More information

EMBA in Management & Finance. Corporate Finance. Eric Jondeau

EMBA in Management & Finance. Corporate Finance. Eric Jondeau EMBA in Management & Finance Corporate Finance EMBA in Management & Finance Lecture 5: Capital Budgeting For the Levered Firm Prospectus Recall that there are three questions in corporate finance. The

More information

IESE UNIVERSITY OF NAVARRA OPTIMAL CAPITAL STRUCTURE: PROBLEMS WITH THE HARVARD AND DAMODARAN APPROACHES. Pablo Fernández*

IESE UNIVERSITY OF NAVARRA OPTIMAL CAPITAL STRUCTURE: PROBLEMS WITH THE HARVARD AND DAMODARAN APPROACHES. Pablo Fernández* IESE UNIVERSITY OF NAVARRA OPTIMAL CAPITAL STRUCTURE: PROBLEMS WITH THE HARVARD AND DAMODARAN APPROACHES Pablo Fernández* RESEARCH PAPER No 454 January, 2002 * Professor of Financial Management, IESE Research

More information

Chapter 7. . 1. component of the convertible can be estimated as 1100-796.15 = 303.85.

Chapter 7. . 1. component of the convertible can be estimated as 1100-796.15 = 303.85. Chapter 7 7-1 Income bonds do share some characteristics with preferred stock. The primary difference is that interest paid on income bonds is tax deductible while preferred dividends are not. Income bondholders

More information

Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document)

Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document) Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document) 1. Portfolio risk & return. Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a downhill

More information

Homework Assignment #1: Answer Key

Homework Assignment #1: Answer Key Econ 497 Economics of the Financial Crisis Professor Ickes Spring 2012 Homework Assignment #1: Answer Key 1. Consider a firm that has future payoff.supposethefirm is unlevered, call the firm and its shares

More information

The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 1)

The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 1) IE Aufgabe 4 The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 1) Introduction A leveraged buyout (LBO) is the acquisition by a small group of equity investors of a public or private company

More information

LECTURE- 4. Valuing stocks Berk, De Marzo Chapter 9

LECTURE- 4. Valuing stocks Berk, De Marzo Chapter 9 1 LECTURE- 4 Valuing stocks Berk, De Marzo Chapter 9 2 The Dividend Discount Model A One-Year Investor Potential Cash Flows Dividend Sale of Stock Timeline for One-Year Investor Since the cash flows are

More information

Option Pricing Applications in Valuation!

Option Pricing Applications in Valuation! Option Pricing Applications in Valuation! Equity Value in Deeply Troubled Firms Value of Undeveloped Reserves for Natural Resource Firm Value of Patent/License 73 Option Pricing Applications in Equity

More information

Fundamentals of Corporate Finance

Fundamentals of Corporate Finance Fundamentals of Corporate Finance Sixth Canadian Edition by Ross, Westerfield, Jordan, and Roberts Formula Sheet page # Assets = Liabilities + Shareholders equity [2.1] 28 Revenues Expenses = Income [2.2]

More information

COST OF CAPITAL. Please note that in finance, we are concerned with MARKET VALUES (unlike accounting, which is concerned with book values).

COST OF CAPITAL. Please note that in finance, we are concerned with MARKET VALUES (unlike accounting, which is concerned with book values). COST OF CAPITAL Cost of capital calculations are a very important part of finance. To value a project, it is important to discount the cash flows using a discount rate that incorporates the debt-equity

More information

CHAPTER 8. Problems and Questions

CHAPTER 8. Problems and Questions CHAPTER 8 Problems and Questions 1. Plastico, a manufacturer of consumer plastic products, is evaluating its capital structure. The balance sheet of the company is as follows (in millions): Assets Liabilities

More information

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15 Test3 1. The market value of Charcoal Corporation's common stock is $20 million, and the market value of its riskfree debt is $5 million. The beta of the company's common stock is 1.25, and the market

More information

CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING

CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING Answers to Concepts Review and Critical Thinking Questions 1. No. The cost of capital depends on the risk of the project, not the source of the money.

More information

E. V. Bulyatkin CAPITAL STRUCTURE

E. V. Bulyatkin CAPITAL STRUCTURE E. V. Bulyatkin Graduate Student Edinburgh University Business School CAPITAL STRUCTURE Abstract. This paper aims to analyze the current capital structure of Lufthansa in order to increase market value

More information

WACC and a Generalized Tax Code

WACC and a Generalized Tax Code The European Journal of Finance Vol. 12, No. 1, 33 40, January 2006 WACC and a Generalized Tax Code SVEN HUSMANN, LUTZ KRUSCHWITZ & ANDREAS LÖFFLER Europa-Universität Viadrina, Frankfurt, Germany, Freie

More information

Chapter 13, ROIC and WACC

Chapter 13, ROIC and WACC Chapter 13, ROIC and WACC Lakehead University Winter 2005 Role of the CFO The Chief Financial Officer (CFO) is involved in the following decisions: Management Decisions Financing Decisions Investment Decisions

More information

Chapter 14 Assessing Long-Term Debt, Equity, and Capital Structure

Chapter 14 Assessing Long-Term Debt, Equity, and Capital Structure I. Capital Structure (definitions) II. MM without Taxes (1958) III. MM with Taxes (1963) Chapter 14 Assessing Long-Term Debt, Equity, and Capital Structure IV. Financial Distress V. Business Risk VI. Financial

More information

MGT201 Solved MCQs(500) By

MGT201 Solved MCQs(500) By MGT201 Solved MCQs(500) By http://www.vustudents.net Why companies invest in projects with negative NPV? Because there is hidden value in each project Because there may be chance of rapid growth Because

More information

Chapter 14 Capital Structure in a Perfect Market

Chapter 14 Capital Structure in a Perfect Market Chapter 14 Capital Structure in a Perfect Market 14-1. Consider a project with free cash flows in one year of $130,000 or $180,000, with each outcome being equally likely. The initial investment required

More information

Copyright 2009 Pearson Education Canada

Copyright 2009 Pearson Education Canada The consequence of failing to adjust the discount rate for the risk implicit in projects is that the firm will accept high-risk projects, which usually have higher IRR due to their high-risk nature, and

More information

CHAPTER 13 Capital Structure and Leverage

CHAPTER 13 Capital Structure and Leverage CHAPTER 13 Capital Structure and Leverage Business and financial risk Optimal capital structure Operating Leverage Capital structure theory 1 What s business risk? Uncertainty about future operating income

More information

Equity Analysis and Capital Structure. A New Venture s Perspective

Equity Analysis and Capital Structure. A New Venture s Perspective Equity Analysis and Capital Structure A New Venture s Perspective 1 Venture s Capital Structure ASSETS Short- term Assets Cash A/R Inventories Long- term Assets Plant and Equipment Intellectual Property

More information

Cost of Capital, Valuation and Strategic Financial Decision Making

Cost of Capital, Valuation and Strategic Financial Decision Making Cost of Capital, Valuation and Strategic Financial Decision Making By Dr. Valerio Poti, - Examiner in Professional 2 Stage Strategic Corporate Finance The financial crisis that hit financial markets in

More information

Capital Structure II

Capital Structure II Capital Structure II Introduction In the previous lecture we introduced the subject of capital gearing. Gearing occurs when a company is financed partly through fixed return finance (e.g. loans, loan stock

More information

CLASS NOTES ON CORPORATE FINANCE. Copyright 1999 by Yossi Spiegel

CLASS NOTES ON CORPORATE FINANCE. Copyright 1999 by Yossi Spiegel Preliminary and highly incomplete CLASS NOTES ON CORPORATE FINANCE by Yossi Spiegel * Berglas School of Economics, Tel Aviv University Spring 1999 Copyright 1999 by Yossi Spiegel * Parts of these class

More information

FIN 413 Corporate Finance. Capital Structure, Taxes, and Bankruptcy

FIN 413 Corporate Finance. Capital Structure, Taxes, and Bankruptcy FIN 413 Corporate Finance Capital Structure, Taxes, and Bankruptcy Evgeny Lyandres Fall 2003 1 Relaxing the M-M Assumptions E D T Interest payments to bondholders are deductible for tax purposes while

More information

CHAPTER 16. Financial Distress, Managerial Incentives, and Information. Chapter Synopsis

CHAPTER 16. Financial Distress, Managerial Incentives, and Information. Chapter Synopsis CHAPTER 16 Financial Distress, Managerial Incentives, and Information Chapter Synopsis In the previous two chapters it was shown that, in an otherwise perfect capital market in which firms pay taxes, the

More information

] (3.3) ] (1 + r)t (3.4)

] (3.3) ] (1 + r)t (3.4) Present value = future value after t periods (3.1) (1 + r) t PV of perpetuity = C = cash payment (3.2) r interest rate Present value of t-year annuity = C [ 1 1 ] (3.3) r r(1 + r) t Future value of annuity

More information

MBA (3rd Sem) 2013-14 MBA/29/FM-302/T/ODD/13-14

MBA (3rd Sem) 2013-14 MBA/29/FM-302/T/ODD/13-14 Full Marks : 70 MBA/29/FM-302/T/ODD/13-14 2013-14 MBA (3rd Sem) Paper Name : Corporate Finance Paper Code : FM-302 Time : 3 Hours The figures in the right-hand margin indicate marks. Candidates are required

More information

Source of Finance and their Relative Costs F. COST OF CAPITAL

Source of Finance and their Relative Costs F. COST OF CAPITAL F. COST OF CAPITAL 1. Source of Finance and their Relative Costs 2. Estimating the Cost of Equity 3. Estimating the Cost of Debt and Other Capital Instruments 4. Estimating the Overall Cost of Capital

More information

Discount Rates and Tax

Discount Rates and Tax Discount Rates and Tax Ian A Cooper and Kjell G Nyborg London Business School First version: March 1998 This version: August 2004 Abstract This note summarises the relationships between values, rates of

More information

CHAPTER 17. Payout Policy. Chapter Synopsis

CHAPTER 17. Payout Policy. Chapter Synopsis CHAPTER 17 Payout Policy Chapter Synopsis 17.1 Distributions to Shareholders A corporation s payout policy determines if and when it will distribute cash to its shareholders by issuing a dividend or undertaking

More information

Corporate Finance: Final Exam

Corporate Finance: Final Exam Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. For partial credit, when discounting, please show the discount rate

More information

FORMULA SHEET [3.2] 63

FORMULA SHEET [3.2] 63 FORMULA SHEET Assets = Liabilities + Shareholders equity [2.1] 26 Revenues - Expenses = Income [2.2] 30 Cash flow from assets = Cash flow to bondholders + Cash flow to shareholders [2.3] 32 Current ratio

More information

Assets = Liabilities + Shareholders equity [2.1] Revenues Expenses = Income [2.2]

Assets = Liabilities + Shareholders equity [2.1] Revenues Expenses = Income [2.2] Assets = Liabilities + Shareholders equity [2.1] Revenues Expenses = Income [2.2] Cash flow from assets = Cash flow to bondholders [2.3] + Cash flow to shareholders Current ratio = Current assets/current

More information

Chapter 17 Capital Structure Limits to the Use of Debt

Chapter 17 Capital Structure Limits to the Use of Debt University of Science and Technology Beijing Dongling School of Economics and management Chapter 17 Capital Structure Limits to the Use of Debt Dec. 2012 Dr. Xiao Ming USTB 1 Key Concepts and Skills Define

More information

THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE

THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE IX. THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE The capital structure of a firm is defined to be the menu of the firm's liabilities (i.e, the "right-hand side" of the

More information

BA 351 CORPORATE FINANCE. John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD

BA 351 CORPORATE FINANCE. John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD BA 351 CORPORATE FINANCE John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD FUQUA SCHOOL OF BUSINESS DUKE UNIVERSITY 1 THE ADJUSTED NET PRESENT VALUE METHOD COPING

More information

1. What are the three types of business organizations? Define them

1. What are the three types of business organizations? Define them Written Exam Ticket 1 1. What is Finance? What do financial managers try to maximize, and what is their second objective? 2. How do you compare cash flows at different points in time? 3. Write the formulas

More information

The Cost of Capital and Optimal Financing Policy in a. Dynamic Setting

The Cost of Capital and Optimal Financing Policy in a. Dynamic Setting The Cost of Capital and Optimal Financing Policy in a Dynamic Setting February 18, 2014 Abstract This paper revisits the Modigliani-Miller propositions on the optimal financing policy and cost of capital

More information

Ch. 18: Taxes + Bankruptcy cost

Ch. 18: Taxes + Bankruptcy cost Ch. 18: Taxes + Bankruptcy cost If MM1 holds, then Financial Management has little (if any) impact on value of the firm: If markets are perfect, transaction cost (TAC) and bankruptcy cost are zero, no

More information

Lecture: Financing Based on Market Values II

Lecture: Financing Based on Market Values II Lecture: Financing Based on Market Values II Lutz Kruschwitz & Andreas Löffler Discounted Cash Flow, Section 2.4.4 2.4.5, Outline 2.4.4 Miles-Ezzell- and Modigliani-Miller Miles-Ezzell adjustment Modigliani-Miller

More information

FNCE 301, Financial Management H Guy Williams, 2006

FNCE 301, Financial Management H Guy Williams, 2006 Stock Valuation Stock characteristics Stocks are the other major traded security (stocks & bonds). Options are another traded security but not as big as these two. - Ownership Stockholders are the owner

More information

Projecting Consistent Debt and Interest Expenses

Projecting Consistent Debt and Interest Expenses WEB EXTENSION26A Projecting Consistent Debt and Interest Expenses Projecting financial statements for a merger analysis requires explicit assumptions regarding the capital structure in the post-merger

More information

Chapter 11 Calculating the Cost of Capital

Chapter 11 Calculating the Cost of Capital Chapter 11 Calculating the Cost of Capital (def) - Cost of obtaining money to fund asset purchase - use as estimate of r (discount rate) If we can earn more than the cost of capital (r) from a project

More information

The value of tax shields is NOT equal to the present value of tax shields

The value of tax shields is NOT equal to the present value of tax shields The value of tax shields is NOT equal to the present value of tax shields Pablo Fernández * IESE Business School. University of Navarra. Madrid, Spain ABSTRACT We show that the value of tax shields is

More information

UNIVERSITY OF WAH Department of Management Sciences

UNIVERSITY OF WAH Department of Management Sciences BBA-330: FINANCIAL MANAGEMENT UNIVERSITY OF WAH COURSE DESCRIPTION/OBJECTIVES The module aims at building competence in corporate finance further by extending the coverage in Business Finance module to

More information

1. What is a recapitalization? Why is this considered a pure capital structure change?

1. What is a recapitalization? Why is this considered a pure capital structure change? CHAPTER 12 CONCEPT REVIEW QUESTIONS 1. What is a recapitalization? Why is this considered a pure capital structure change? Recapitalization is an alteration of a company s capital structure to change the

More information

Sample Problems Chapter 10

Sample Problems Chapter 10 Sample Problems Chapter 10 Title: Cost of Debt 1. Costly Corporation plans a new issue of bonds with a par value of $1,000, a maturity of 28 years, and an annual coupon rate of 16.0%. Flotation costs associated

More information

Financial Statement and Cash Flow Analysis

Financial Statement and Cash Flow Analysis Chapter 2 Financial Statement and Cash Flow Analysis Answers to Concept Review Questions 1. What role do the FASB and SEC play with regard to GAAP? The FASB is a nongovernmental, professional standards

More information

CHAPTER 14 COST OF CAPITAL

CHAPTER 14 COST OF CAPITAL CHAPTER 14 COST OF CAPITAL Answers to Concepts Review and Critical Thinking Questions 1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,

More information

SAMPLE FACT EXAM (You must score 70% to successfully clear FACT)

SAMPLE FACT EXAM (You must score 70% to successfully clear FACT) SAMPLE FACT EXAM (You must score 70% to successfully clear FACT) 1. What is the present value (PV) of $100,000 received five years from now, assuming the interest rate is 8% per year? a. $600,000.00 b.

More information

On the Applicability of WACC for Investment Decisions

On the Applicability of WACC for Investment Decisions On the Applicability of WACC for Investment Decisions Jaime Sabal Department of Financial Management and Control ESADE. Universitat Ramon Llull Received: December, 2004 Abstract Although WACC is appropriate

More information

FNCE 3010 (Durham). HW2 (Financial ratios)

FNCE 3010 (Durham). HW2 (Financial ratios) FNCE 3010 (Durham). HW2 (Financial ratios) 1. What effect would the following actions have on a firms net working capital and current ratio (assume NWC is positive and current ratio is initially greater

More information

Napoli Pizza wants to determine its optimal capital structure

Napoli Pizza wants to determine its optimal capital structure Napoli Pizza wants to determine its optimal capital structure ABSTRACT Brad Stevenson Daniel Bauer David Collins Keith Richardson This case is based on an actual business decision that was made by a small,

More information

ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure

ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure Chapter 9 Valuation Questions and Problems 1. You are considering purchasing shares of DeltaCad Inc. for $40/share. Your analysis of the company

More information

CHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles

CHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles CHAPTER 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 1 Topics in Chapter Types of hybrid securities Preferred stock Warrants Convertibles Features and risk Cost of capital to issuers

More information

Equity Valuation Formulas. William L. Silber and Jessica Wachter

Equity Valuation Formulas. William L. Silber and Jessica Wachter Equity Valuation Formulas William L. Silber and Jessica Wachter I. The ividend iscount Model Suppose a stoc with price pays dividend one year from now, two years from now, and so on, for the rest of time.

More information

20 Corporate Finance Decision Making

20 Corporate Finance Decision Making 20 Corporate Finance Decision Making Capital management considerations are crucial in corporate finance decisions and vice versa, and it is particularly imperative to understand the capital implications

More information

MCQ on Financial Management

MCQ on Financial Management MCQ on Financial Management 1. "Shareholder wealth" in a firm is represented by: a) the number of people employed in the firm. b) the book value of the firm's assets less the book value of its liabilities

More information

Chapter 10 Risk and Capital Budgeting

Chapter 10 Risk and Capital Budgeting Chapter 10 Risk and Capital Budgeting MULTIPLE CHOICE 1. Operating leverage describes the relationship between... a. EBIT and sales b. taxes and sales c. debt and equity d. fixed costs and variable costs

More information

Tax-adjusted discount rates with investor taxes and risky debt

Tax-adjusted discount rates with investor taxes and risky debt Tax-adjusted discount rates with investor taxes and risky debt Ian A Cooper and Kjell G Nyborg October 2005, first version October 2004 Abstract This paper derives tax-adjusted discount rate formulas with

More information

A Test Of The M&M Capital Structure Theories Richard H. Fosberg, William Paterson University, USA

A Test Of The M&M Capital Structure Theories Richard H. Fosberg, William Paterson University, USA A Test Of The M&M Capital Structure Theories Richard H. Fosberg, William Paterson University, USA ABSTRACT Modigliani and Miller (1958, 1963) predict two very specific relationships between firm value

More information

CFAspace. CFA Level II. Provided by APF. Academy of Professional Finance 专 业 金 融 学 院

CFAspace. CFA Level II. Provided by APF. Academy of Professional Finance 专 业 金 融 学 院 CFAspace Provided by APF CFA Level II Equity Investments Free Cash Flow Valuation Part I CFA Lecturer: Hillary Wang Content Free cash flow to the firm, free cash flow to equity Ownership perspective implicit

More information

Corporate Finance: Final Exam

Corporate Finance: Final Exam Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. 1. DayTop Inns is a publicly traded company, with 10 million shares

More information

Fundamentals Level Skills Module, Paper F9. Section A. Mean growth in earnings per share = 100 x [(35 7/30 0) 1/3 1] = 5 97% or 6%

Fundamentals Level Skills Module, Paper F9. Section A. Mean growth in earnings per share = 100 x [(35 7/30 0) 1/3 1] = 5 97% or 6% Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2015 Answers Section A 1 A 2 D 3 D Mean growth in earnings per share = 100 x [(35 7/30 0) 1/3 1] = 5 97% or 6% 4 A 5 D 6 B 7

More information

Estimating Cost of Capital. 2. The cost of capital is an opportunity cost it depends on where the money goes, not where it comes from

Estimating Cost of Capital. 2. The cost of capital is an opportunity cost it depends on where the money goes, not where it comes from Estimating Cost of Capal 1. Vocabulary the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capal (or cost of money) 2. The cost of capal is an opportuny cost

More information