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%O: (Anle"era!ed)
= 2(12B/ and
%O: (<e"era!ed)
= $(2$B(
Thus/ in a stand1alone ris& sense/ firm < is twice as ris&0 as firm A11its business
ris& is 2(12 #ercent/ but its stand1alone ris& is $(2$ #ercent/ so its financial ris& is
$(2$B 1 2(12B = 2(12B(
#' 6hat !oes capital structure theory attempt to !o= 6hat lessons can e learne!
#rom capital structure theory= Be sure to a!!ress the MM mo!els'
Ans)er: 88 theor0 be!ins with the assum#tion of Jero ta-es( 88 #ro"e/ under a "er0
restricti"e set of assum#tions/ that a firm+s "alue is unaffected b0 its financin! mi-:
V
<
= V
A
(
Therefore/ ca#ital structure is irrele"ant( n0 increase in roe resultin! from financial
le"era!e is e-actl0 offset b0 the increase in ris& (i(e(/ r
s
)/ so WCC is constant(
88 theor0 later includes cor#orate ta-es( Cor#orate ta- laws fa"or debt financin!
o"er e2uit0 financin!( With cor#orate ta-es/ the benefits of financial le"era!e e-ceed
the ris&s because more :63T !oes to in"estors and less to ta-es when le"era!e is
used( 88 show that:
V
<
= V
A
K T*(
3f T=$@B/ then e"er0 dollar of debt adds $@ cents of e-tra "alue to firm(
8iller later included #ersonal ta-es( 5ersonal ta-es lessen the ad"anta!e of cor#orate
debt( Cor#orate ta-es fa"or debt financin! since cor#orations can deduct interest
e-#enses/ but #ersonal ta-es fa"or e2uit0 financin!/ since no !ain is re#orted until
stoc& is sold/ and lon!1term !ains are ta-ed at a lower rate( 8iller+s conclusions with
#ersonal ta-es are that the use of debt financin! remains ad"anta!eous/ but benefits
are less than under onl0 cor#orate ta-es( Firms should still use 1@@B debt( 4ote:
Mini Case: 16 2 6
howe"er/ miller ar!ued that in e2uilibrium/ the ta- rates of mar!inal in"estors would
ad7ust until there was no ad"anta!e to debt(
88 theor0 i!nores ban&ru#tc0 (financial distress) costs/ which increase as more
le"era!e is used( t low le"era!e le"els/ ta- benefits outwei!h ban&ru#tc0 costs( t
hi!h le"els/ ban&ru#tc0 costs outwei!h ta- benefits( n o#timal ca#ital structure
e-ists that balances these costs and benefits( This is the trade1off theor0(
88 assumed that in"estors and mana!ers ha"e the same information( 6ut mana!ers
often ha"e better information( Thus/ the0 would sell stoc& if stoc& is o"er"alued/ and
sell bonds if stoc& is under"alued( 3n"estors understand this/ so "iew new stoc& sales
as a ne!ati"e si!nal( This is si!nalin! theor0(
One a!enc0 #roblem is that mana!ers can use cor#orate funds for non1"alue
ma-imiJin! #ur#oses( The use of financial le"era!e bonds ,free cash flow/. and
forces disci#line on mana!ers to a"oid #er&s and non1"alue addin! ac2uisitions(
second a!enc0 #roblem is the #otential for ,underin"estment.( *ebt increases ris&
of financial distress( Therefore/ mana!ers ma0 a"oid ris&0 #ro7ects e"en if the0 ha"e
#ositi"e 45Vs(
"' 6ith the aove points in min!& no) consi!er the optimal capital structure #or
$i%%a$alace'
"' .1/ 7or each capital structure un!er consi!eration& calculate the levere! eta& the
cost o# e0uity& an! the 6ACC'
Ans)er: 88 theor0 im#lies that beta chan!es with le"era!e( 6
u
is the beta of a firm when it
has no debt (the unle"ered beta() 9amada+s e2uation #ro"ides the beta of a le"ered
firm: 6
<
= 6
A
L1 K (1 1 T)(*)M)N( For e-am#le/ to find the cost of e2uit0 for w
d
=
2@B/ we first use 9amada+s e2uation to find beta:
6
<
= 6
A
L1 K (1 1 T)(*)M)N
= 1(@ L1 K (11@($) (2@B ) C@B)N
= 1(1'
Then use C58 to find the cost of e2uit0:
%
M
= %
%F
K 6
<
(%5
8
)
= GB K 1(1' (GB) = 12(EB
We can re#eat this for the ca#ital structures under consideration(
Mini Case: 16 2 G
W
*
*)M 6
<
%
M
@B @(@@ 1(@@@ 12(@@B
2@B @(2' 1(1'@ 12(E@B
3@B @($3 1(2'D 13('$B
$@B @(GD 1($@@ 1$($@B
'@B 1(@@ 1(G@@ 1'(G@B
4e-t/ find the WCC( For e-am#le/ the WCC for w
d
= 2@B is:
WCC = w
d
(11T) r
d
K w
e
r
s
WCC = @(2 (1 > @($) (CB) K @(C (12(EB)
WCC = 11(2CB
Then re#eat this for all ca#ital structures under consideration(
w
d
r
d
r
s
WCC
@B @(@B 12(@@B 12(@@B
2@B C(@B 12(E@B 11(2CB
3@B C('B 13('$B 11(@1B
$@B 1@(@B 1$($@B 11(@$B
'@B 12(@B 1'(G@B 11($@B
Mini Case: 16 2 :
"' .5/ No) calculate the corporate value& the value o# the !et that )ill e issue!& an!
the resultin" mar1et value o# e0uity'
Ans)er: For e-am#le the cor#orate "alue for w
d
= 2@B is:
V = FCF ) (WCC1H)
H=@/ so in"estment in ca#ital is Jero; so FCF = 4O5T = :63T (11T)( 3n this
e-am#le/ 4O5T = (?'@@/@@@)(11@($@) = ?3@@/@@@(
Asin! these "alues/ V = ?3@@/@@@ ) @(112C = ?2/G'E/'D$(
%e#eatin! this for all ca#ital structures !i"es the followin! table:
w
d
WCC Cor#( Value
@B 12(@@B ?2/'@@/@@@
2@B 11(2CB ?2/G'E/'D$
3@B 11(@1B ?2/D2$/DEG
$@B 11(@$B ?2/D1D/3E1
'@B 11($@B ?2/G31/'DE
s this shows/ "alue is ma-imiJed at a ca#ital structure with 3@B debt(
"' .;/ Calculate the resultin" price per share& the numer o# shares repurchase!& an!
the remainin" shares'
Ans)er: First/ find the dollar "alue of debt and e2uit0( For e-am#le/ for w
d
= 2@B/ the dollar
"alue of debt is:
d = w
d
V = @(2 (?2/G'E/'D$) = ?'31/E1'(
We can then find the dollar "alue of e2uit0:
M = V > *
M = ?2/G'E/'D$ 1 ?'31/E1' = ?2/12D/G'E(
We re#eat this #rocess for all the ca#ital structures(
w
d
*ebt/ * Mtoc& Value/ M
Mini Case: 16 2 H
@B ?@ ?2/'@@/@@@
2@B ?'31/E1' ?2/12D/GG@
3@B ?C1D/$3E ?1/E@D/3'D
$@B ?1/@CG/E'D ?1/G3@/$3'
'@B ?1/31'/DCE ?1/31'/DCE
4ote: these are rounded; see F811 Ch 1G mini case(-ls for full calculations(
4otice that the "alue of the e2uit0 declines as more debt is issued/ because debt is
used to re#urchase stoc&( 6ut the total wealth of shareholders is the "alue of stoc&
after the reca# #lus the cash recei"ed in re#urchase/ and this total !oes u# (it is e2ual
to cor#orate "alue on earlier slide)(
The firm issues debt/ which chan!es its WCC/ which chan!es "alue( The firm then
uses debt #roceeds to re#urchase stoc&( The stoc& #rice chan!es after debt is issued/
but does not chan!e durin! actual re#urchase (or arbitra!e is #ossible)( The stoc&
#rice after debt is issued but before stoc& is re#urchased reflects shareholder wealth/
which is the sum of the stoc& and the cash #aid in re#urchase(
For e-am#le/ to find the stoc& #rice for w
d
= 2@B/ let *
@
and 4
@
denote debt and
outstandin! shares before the reca#( * 1 *
@
is e2ual to cash that will be used to
re#urchase stoc&( M K (* 1 *
@
) is the wealth of shareholders+ after the debt is issued
but immediatel0 before the re#urchase( We can e-#ress the stoc& #rice #er share
#rior to the re#urchase/ 5/ for w
d
= 2@B/ as:
5 = LM K (* > *
@
)N)4
@
(
5 = L?2/12D/GG@ K (?'31/E1' > @)N ) 1@@/@@@
5 = ?2G('EG #er share(
The number of shares re#urchased is:
O re#urchased = (* 1 *
@
) ) 5
O re#( = (?'31/E1' > @) ) ?2G('EG
= 2@/@@@(
The number of remainin! shares after the re#urchase is:
O remainin! = 4 = M ) 5
4 = ?2/12D/GG@ ) ?2G('EG
= C@/@@@(
We can a##l0 this same #rocedure to all the ca#ital structures under consideration(
Mini Case: 16 2 1,
O Mhares O Mhares
W
d
5 %e#urch( %emainin!
@B ?2'(@@ @ 1@@/@@@
2@B ?2G(G@ 2@/@@@ C@/@@@
3@B ?2D(2' 3@/@@@ D@/@@@
$@B ?2D(1D $@/@@@ G@/@@@
'@B ?2G(32 '@/@@@ '@/@@@
h' Consi!erin" only the capital structures un!er analysis& )hat is $i%%a$alace(s
optimal capital structure=
Ans)er: The o#timal ca#ital structure is for w
d
= 3@B( This !i"es the hi!hest cor#orate "alue/
the lowest WCC/ and the hi!hest stoc& #rice #er share( 6ut notice that w
d
= $@B is
"er0 similar to the o#timal solution; in other words/ the o#timal ran!e is #rett0 flat(
i' 6hat other #actors shoul! mana"ers consi!er )hen settin" the tar"et capital
structure=
Ans)er: 8ana!ers should also consider the debt ratios of other firms in the industr0/ #ro
forma co"era!e ratios at different ca#ital structures under different economic
scenarios/ lender and ratin! a!enc0 attitudes (i(e(/ the im#act on bond ratin!s)/ reser"e
borrowin! ca#acit0/ the effects on control (i(e(/ does the ca#ital structure ma&e it
easier of harder for an outsider to ta&e o"er the firm)/ the firm+s t0#es of assets (i(e(/
are the0 tan!ible/ and hence suitable as collateralP/ and the firm+s #ro7ected ta- rates(
Mini Case: 16 2 11