Capital Structure. Conclusion

Transcription

1 Capital Structure Conclusion

2 Target Capital Structure Target capital structure is a function of expected profitability riskiness of operations vulnerabilities to outside constituencies Steps in the Analysis analyze operating profits determine funds needs evaluate vulnerabilities

3 Analysis Determine Reasonable Worst Case Operating Profit Margin historical levels and volatility future risks competitive environment

4 Analysis Determine Vulnerabilities pro forma to determine need for capital market access competitive environment market demand distributor interests workforce Suppliers

5 Quantification Analysis of operating profitability and risk leads to RWC OPM Analysis of capital efficiency leads to Cap/Sales ratio Analysis of vulnerabilities leads to Cushion very few vulnerabilities (AHP) h=1 moderate vulnerability (HCA) h=2 very vulnerable (MF) h=3

6 Quantification Target Capital structure (1/h)*(RWC OPM)*(1/CS)*(1/r) h = cushion) CS = capital/sales ratio r = interest rate on debt

7 Comments The formula summarizes the analysis that precedes it No formula can give The Answer Provides framework for further analysis of the target capital structure decision

8 Implementation Equity is difficult to raise if in default, may be impossible to raise equity at any price (MF) a surprise issue of equity can lead to a substantial stock price decline (AT&T) Unless substantially under-levered (AHP) constantly be looking for equity

9 Strategies for equity Issue Provide for small, regularly timed equity issues Pension fund dividend reinvestment equity issues to market Keep analysts informed about company

10 Equity Issues Issue equity at times when informational differences are likely to be small Low risk times after major announcements Explain reasons for equity issue without compromising competitive position capital budget analysis of target capital structure

11 Corporate Finance Three major corporate finance questions How much money does the firm need? X How should the firm raise the funds? X Target capital structure Implementation What should the firm do with the funds?

12 Capital Budgeting Should the firm undertake a project? Involves initial investment and subsequent cash flows as a result of this investment Do the subsequent cash flows justify the initial investment? Is the value of the cash flows greater than the amount of the initial investment?

13 Projects project should be broadly construed buy a bond buy a stock buy new machinery build a new plant develop a product line start a price war acquire another company

14 Capital Budgeting Steps Define the project identify sequence of decisions identify sequence of events and consequences Identify cash flows Incremental, after-tax, expected, operating cash flows

15 Cash Flows Incremental Cash flows due to the project--those associated with its decisions and consequences After tax take account of all tax effects Expected consider various possibilities and weigh by associated probabilities

16 Cash Flows Operating Ignore financing related cash flows proceeds of security issues dividend or interest payments Cash Flows some items are accounting expenses, but not cash expenses--ignore them

17 Capital Budgeting Steps Characterize project Determine incremental cash flows Evaluate Cash Flows

18 Evaluating Cash Flows Example Project time cash

19 Evaluating Cash Flows Payback time at which cash flows cover initial investment time cum cf payback = 3 years Ignores time after payback Only partially reflects timing of cash flows

20 Evaluating cash flows Average Rate of Return (average of positive cf s)/(total investment) example ARR = 400/1000 = 40% Timing of cash flows irrelevant Not distinguish scale of project

21 Time Value of Money A dollar today is worth more than a dollar in a year have the option of consuming a dollar today immediately one can invest the dollar and have more than a dollar for consumption in one year Cash flow evaluation techniques that ignore cash flow timing may lead to poor decisions

22 Present Value Strip prices (or their yields) tell us how the market values future dollars Dealer buys Treasury bond and puts in trust issues security for each cash flow from that bond--a strip

23 Strip Prices Maturity price yield 11/99 95: % 11/00 91: % 11/01 87: % 11/02 84: % 11/03 79: % 11/04 75: % 10/27/98 wsj

24 Present value The value of a dollar in a years is worth 1/(1+strip yield)ª While strip yields vary with time, we will ignore this

25 Present Value Reason in the following way If you are promised 100 in a year, you figure that you can invest X at a rate r for one year to get 100. That is: X(1+r) = 100 or X = 100/(1+r) For example, r = 5% X = 100/1.05 = Having 100 in one year is like having now.

26 Present Value Being promised 100 in two years If invest X for two years, will have X(1+r) in one year and X(1+r)(1+r) in two years X = 100/(1+r)² If r =.05, X = 100/(1.05)² = 90.70

27 Example Suppose interest rate is 5% Present value of future cash flows is 250* *.907*450*.864*550*.823 = which exceeds 1000 Net Present Value of Project is =

28 Present Value Borrow at 5%, and use cf to payoff borrowing begin int pmt end Left with surplus of at year 4 present value is *.8227 =

29 Observations Note that net present value calculation takes account of the cost of financing the project This is why project cash flows should not reflect financing issues NPV > 0 means that the cash flows generated justify the cost of financing the initial investment

30 Special Formulae Perpetuity The present value of receiving a forever when the discount rate is r is PV = a/r Perpetuity with growth The present value of receiving a, then a(1+g), then a(1+g)², etc is PV = a/(r-g) for g<r

31 Internal Rate of Return Given a project, can ask what is the highest discount rate (cost of financing)--the answer is called the Internal Rate of Return (IRR)

32 Example Project Calculate NPV for various discount rates r NPV % % % 92 18% 21 19% -1 20% -23

33 IRR NPV 0 IRR NPV(r) r

34 IRR Rule Accept project if IRR exceeds discount rate Some care needed in application if cash flows are not nice IRR can be misleading--watch out if cash flow pattern is (-,+,,+,-) for example It is difficult to compare projects

35 Other PV applications NPV = 0 means cash flows just pay off the loan. That is, the present value of loan payments, at the loan interest rate equals the amount borrowed What are the monthly payments on $200,000, 7%, 20 year mortgage 200,000 = PV(x,x,,x; 7/12%)

36 Mortgage X = pmt(.00583,240,200000) = After paying the mortgage for 10 years, how much principle is owed? principle = pv(.00583, 120, ) =

37 Application You need, cf1, cf2,, cfn for the next N periods. You have an investment with guaranteed return r per period. How much do you need to invest now? Invest now the Present Value of cf1, cf2 etc. at the discount rate r

38 Example You need cash flows 500, 200, 1000 at the end of the next three years. You need to invest, at 5%, 500* * *.864 =

39 Example Begin int take end