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# Capital structure and the cost of capital Risk, Return, and Capital Budgeting (Chapter 12) 1.

Business risk and financial risk Income statement 10% increase in sales revenue Sales Revenue FC VC (20% of sales) Depreciation EBIT (Operating income) 1000 500 200 100 200 1100 500 220 100 280 OPERTING LEVERAGE

100 100 40 60 .6

## 100 180 72 108 1.08

FINANCIAL

80% INCREASE IN EPS 2. weighted average pure arithmetic Assume constant Rb, Ra, and Rb<Ra A=B+S Ra = (B/A) Rb + (S/A) Rs As B/A , will Rs or or remain constant? Assume Ra and Rb constant.

## Capital structure and the cost of capital (Chapter 15,16,17)

1. Value of a firm = value of equity + value of interest bearing debt 2. Principle of additivity (Divide and conquer or all court press) PV(A+B) = PV(A) + PV(b) A, B: two cash flow streams i.e. discounting combined CF by appropriate risk-adjusted discount rate (WACC) is equivalent to discounting each CF by its appropriate risk-adjusted discount rate and add them. e.g. A has payoff \$100 in one year and a =1 B has payoff \$150 in one year and b=2 Market risk premium =8% Rf=6% 3. Money machine Suppose M&M world (Um um sweet M&M ..) Proceeds from short sales are fully obtained. Two firms are in the exactly same business with possible EBIT with equal probability as follows: Recession Normal Boom EBIT 400 1200 2000 Firm U has 400 shares with the price of \$20 per share Firm L has 200 shares with the price of \$22 per share and debt of \$4,000. In this perfect market, P/E multiple remains constant for both firms, and equals to 10. Interest rate for both unlimited borrowing and lending by an individual as well as firms is 10%. Can you create money machine with zero cost today, and how? Q: Show EBIT-EPS relationship?

4. Whoops! M&M world without any taxes, again EBIT=100 All-equity (unlevered) firm: Ro=20% a. Vu = ? b. VL =? Sell bond \$250 to repurchase stock at Rb=10% EBIT I EBT Tax EAT =100 = 25 = 75 =0 =75

S = 75/0.2 = 375 B = 250 VL = S + B = 625 (?) Q: Is this the correct value of VL? c. In M&M world, what is the value of a firm of unlevered and levered firm by theory?

## d. What is Rs and WACC of levered firm?

5. M&M irrelevance - Law of conservation of value Sure, the value of a pie is NOT independent of how it is sliced, if slicer is also a nibbler. a. Maximizing firm value = minimizing cost of capital, if operating income is fixed. b. Comment on the following: Shareholders demand and deserve higher expected rates of return than bondholders do. Therefore, debt is cheaper capital source. We can reduce the WACC by borrowing more. c. A perfect capital market in which M&M theory holds. Financial managers job is to find market imperfection and utilize it. e.g. Czar of junk bond, Mikel Milken

6. Effect of taxes on levered firm (Death and Taxes, Oh no!, it is Debt and Taxes) Two equivalent approaches a. VL = after-corporate tax UCF / (1+WACC) b. VL = after-corporate tax UCF / (1 + Ro) + PV of net interest tax shields APV approach Ro = Cost of unlevered equity e.g. Tc = 35% EBIT = \$100 Plan U No debt, Ro =20% Plan L - \$400 permanent debt with Rb =10% Q. What are the Vu, VL, Rs and WACC?

Note: Quirk in tax on interest income and interest expense a) cost of interest to a firm(?): b) return to bondholder(?): TS is tax savings or tax shield, not tax refund from IRS. TS is tax reduction from overall tax bills, and requires positive taxable income (earnings) for some time. IRS total tax bill is reduced c) Norwegian quirk on person loan Tax on interest income (lender) tax deduction on all personal loans (borrower) IRS total tax billl remains the same 1) 2) 3) 4) Vu = ? VL =? Rs = ? WACC = ?

PV(B+S) =PV(B) +PV(S) After-tax UCF from Asset + TS = after-tax CF to bondholders + after-tax CF to stockholders 5) Will stockholders accept the bond issue when total equity value declines? How many shares will be repurchased? Suppose 100 shares for unlevered firm, and issue bond and repruchase stocks.