Ma. Theresa M.

Mamauag

MBA – 704

Chapter 14.

ST.1 Key Terms

a. Capital - is a term for financial assets, such as funds held in deposit accounts and/or funds
obtained from special financing sources. Capital can also be associated with capital assets of a
company that requires significant amounts of capital to finance or expand.
Capital Structure - is the particular combination of debt and equity used by a company to
finance its overall operations and growth. It refers to the amount of debt and/or equity
employed by a firm to fund its operations and finance its assets.
Optimal Capital Structure - is a financial measurement that firms use to determine the best mix
of debt and equity financing to use for operations and expansions. This structure seeks to lower
the cost of capital so that a firm is less dependent on creditors and more able to finance its core
operations through equity.
b. Business Risk - is the exposure a company or organization has to factor(s) that will lower its
profits or lead it to fail.
Financial Risk - is a term that can apply to businesses, government entities, the financial market
as a whole, and the individual. This risk is the danger or possibility that shareholders, investors,
or other financial stakeholders will lose money.
c. Financial Leverage – refers to the use of debt to acquire additional assets.
Operating Leverage - is a cost-accounting formula that measures the degree to which a firm or
project can increase operating income by increasing revenue. A business that generates sales
with a high gross margin and low variable costs has high operating leverage.
Operating Breakeven - is the point at which sales revenue covers all of the fixed costs and
variable costs but produces no profit for the business.
d. Hamada Equation - is a fundamental analysis method of analyzing a firm's cost of capital as it
uses additional financial leverage, and how that relates to the overall riskiness of the firm. The
measure is used to summarize the effects this type of leverage has on a firm's cost of capital—
over and above the cost of capital as if the firm had no debt.
Unlevered Beta - is a risk measurement metric that compares the risk of a company without any
debt to the risk of the market.
e. Symmetric Information – occurs when both parties have the same level of material knowledge.
Asymmetric Information - also known as "information failure," occurs when one party to an
economic transaction possesses greater material knowledge than the other party. This typically
manifests when the seller of a good or service possesses greater knowledge than the buyer;
however, the reverse dynamic is also possible.
f. Modigliani-Miller Theories - states that the market value of a company is calculated using its
earning power and the risk of its underlying assets and is independent of the way it finances
investments or distributes dividends.
g. Trade-off Theory - states that the optimal capital structure is a trade-off between interest tax
shields and cost of financial distress.
 Signaling Theory - states that changes in dividend policy convey information about changes in
future cash flows.
h. Reserve Borrowing Capacity – it the ability to borrow money at a reasonable cost when good
investment opportunities arise. Firms often use less debt than specified by the MM optimal
capital structure in “normal” times to ensure that they can obtain debt capital later if necessary.
Pecking Order - states that managers display the following preference of sources to fund
investment opportunities: first, through the company’s retained earnings, followed by debt, and
choosing equity financing as a last resort.
i. Windows of Opportunity - is a short, often fleeting time period during which a rare and desired
action can be taken. Once the window closes, the opportunity may never come again.
Net Debt - is a liquidity metric used to determine how well a company can pay all of its debts if
they were due immediately. It shows much debt a company has on its balance sheet compared
to its liquid assets. It shows how much cash would remain if all debts were paid off and if a
company has enough liquidity to meet its debt obligations.

Questions

14-1. Changes in sales cause changes in profits. Would the profit change associated with sales changes
be larger or smaller if a firm increased its operating leverage? Explain your answer.

Operating Leverage is the extent to which fixed cost are used in a firm’s operations. Fixed costs
include advertising expenses, administrative costs, equipment and technology, depreciation, and taxes,
but not interest on debt, which is part of financial leverage. Increased operating leverage means more
fixed costs. Therefore, if operating leverage is increased then a decline in sales can lead to a decline in
profits and in its ROE.

14-2. Would each of the following increase, decrease, or have an indeterminant effect on a firm’s
breakeven point (unit sales)?

a. The sales price increases with no change in unit costs.

The break-even point will decrease
b. An increase in fixed costs is accompanied by a decrease in variable costs.
The effect on the break-even is indeterminant. An increase in fixed cost will increase the break-
even point. However, a lowering of the variable cost lowers the break-even point. So there’s no
indefinite measure on what will be the greater effect.
c. A new firm decides to use MACRS depreciation for both book and tax purposes rather than the
straight-line depreciation method.
The Break-even point will increase because the fixed costs have increased.
d. Variable labor costs decline; other things are held constant.
The break-even point will decrease.
14-3. Discuss the following statement: All else equal, firms with relatively stable sales are able to carry
relatively high debt ratios. Is the statement true or false? Why?

Sales is one of the important factors in measuring the success of business. Banks and credit
companies includes the firm's sales revenue as a factor in determining the capacity of the firm to repay
interest & debt within time and there is less chance of default. Hence, having a stable sale can be an
advantage for the firm to get high debt financing. Therefore, the statement is true because firms with
relatively stable sales are able to carry relatively high debt ratios as this can give assurance for the banks
or credit companies that loans can be repaid within given period.

14-4. If Congress increased the personal tax rate on interest, dividends, and capital gains but
simultaneously reduced the rate on corporate income, what effect would this have on the average
company’s capital structure

An increase in the personal tax rate makes both stocks and bonds less attractive to investors
because it raises the tax paid on dividend and interest income. Changes in personal tax rates will have
differing effects, depending on what portion of an investment's total return is expected in the form of
interest or dividends versus capital gains. For example, a high personal tax rate has a greater impact on
bondholders because more of their return will be taxed sooner at the new higher rate. An increase in
the personal tax rate will cause some investors to shift from bonds to stocks because of the
attractiveness of capital gains tax deferrals. This raises the cost of debt relative to equity. In addition, a
lower corporate tax rate reduces the advantage of debt by reducing the benefit of a corporation's
interest deduction that discourages the use of debt. Consequently, the net result would be for firms to
use more equity and less debt in their capital structures.

14-5. Which of the following would likely encourage a firm to increase the debt in its capital structure?

a. The corporate tax rate increases.

An increase in the corporate tax rate would likely encourage a firm to increase the amount of
debt in its capital structure as this would increase the value of the interest deductions in the
form of corporate tax shield benefits
b. The personal tax rate increases.
This would likely cause investors to shift their investment preference from bonds (debt) to
stocks), as interest income would now be taxed higher at the personal level and investors
would benefit relatively more from the deferral of capital gains taxes on the
proportion of equity income not paid out as dividends. In total, this would raise the cost of debt
relative to equity and, thus, firms would be encouraged to use less debt in their capital
structures.
c. Due to market changes, the firm’s assets become less liquid.
A reduction in the liquidity of a firm’s assets would make them more difficult to sell quickly if
required or result in them only being able to be sold at ‘fire sale’ prices. Consequently, this
would discourage the firm from increasing the amount of debt in its capital structure, so as to
minimize the likelihood of such issues arising.
d. Changes in the bankruptcy code make bankruptcy less costly to the firm.
 If bankruptcy became less costly for the firm, this would most likely encourage the firm to use
more debt, as the costs associated with defaulting on debt have decreased.
e. The firm’s sales and earnings become more volatile.
This is consistent with the firm experiencing an increase in business risk, and they would belikely
to reduce the amount of debt in their capital structure to minimize financial risk levels and the
overall risk of the firm.

14-6. Why do public utilities generally use different capital structures than biotechnology companies?

Biotechnology firms use the processes of living organisms as they manufacture products or solve
problems. Biotechnology companies use relatively smaller debt because their industries tend to be
cyclical, oriented toward research, or subject to huge product liability suits.

Utilities use long-term capital to finance investment in physical plant and assets (asset base)
needed to provide utility service. Utilities also issue long-term capital to finance the replacement and
expansion of their facilities to fulfill public utility service obligation. To finance investment in physical
plant and assets. Utilities generally use long-term capital such as bonds, preferred stocks, and common
equity. Utility companies, on the other hand, use debt relatively heavily because their fixed assets make
good security for mortgage bonds and also because their relatively stable sales make it safe to carry
more-than-average level of debt.

14-7. Why is EBIT generally considered independent of financial leverage? Why might EBIT actually be
affected by financial leverage at high debt levels?

EBIT depends on sales and operating costs that generally are not affected by the firm's use of
financial leverage, because interest is deducted from EBIT. EBIT is one of the most commonly used
indicators for measuring a business's profitability and is often used interchangeably with "operating
income." It does not take into consideration changes in the costs of capital. A corporation can only enjoy
an operating profit after it pays its creditors, however. Even if earnings dip, the corporation still has
interest payment obligations. A company with high EBIT can fall short of its break-even point if it is too
leveraged. It would be a mistake to focus solely on EBIT without considering financial leverage. At high
debt levels, however, firms lose business, employees worry, and operations are not continuous because
of financing difficulties. Thus, financial leverage can influence sales and cost, hence EBIT, if excessive
leverage causes investors, customers, and employees to be concerned about the firm's future.

14-8. Is the debt level that maximizes a firm's expected EPS the same as the debt level that maximizes its
stock price? Explain.

When the EPS is maximized, the stock price will be maximized. Expected EPS is generally
measured as EPS for the coming years, and we typically do not reflect in this calculation any bankruptcy-
related costs.

Also, EPS does not reflect the increase in risk and Rs that accompanies an increase in the debt to
capital ratio, whereas P0 does reflect these factors. Therefore, the stock price is maximized at a level of
debt which is lower than the level of debt that maximizes the EPS.
14-9. If a firm went from zero debt to successively higher levels of debt, why would you expect its stock
price to first rise, then hit a peak, and then begin to decline?

The tax benefits from high levels of debts increase linearly, which causes an increase in the
firm's value and stock price. Increase in the proportion of debt from zero debt will have a positive effect
on the stock price due to financial leverage. However, the financial concern for the payment of debts
increases at the firm incurs more debt which in the long run, eventually offset and begin to exceed the
benefits of debt. Hence, the stock price declines.

14- 10. When the Bell System was broken up, the old AT&T was split into a new AT&T in addition to
seven regional telephone companies. The specific reason for forcing the breakup was to increase the
degree of competition in the telephone industry. AT&T had a monopoly on local service, long distance,
and the manufacture of all equipment used by telephone companies; and the breakup was expected to
open most of those markets to competition. In the court order that set the terms of the breakup, the
capital structures of the surviving companies were specified and much attention was given to the
increased competition telephone companies could expect in the future. Do you think the optimal capital
structure after the breakup was the same as the pre-breakup optimal capital structure? Explain your
position.

No, the optimal capital structure after the break-up is not as the same as the pre-breakup
optimal structure. Break-up increases the business risk of the company. Hence, the new company will
encounter financial risk. Because of this, the management will have different financing strategy and
decisions. Thus, the firm will decrease is debt financing to lessen the financial risk.

14-11. A firm is about to double its assets to serve its rapidly growing market. It must choose between a
highly automated production process and a less automated one. It also must choose a capital structure
for financing the expansion. Should the asset investment and financing decisions be jointly determined,
or should each decision be made separately? How would these decisions affect one another? How could
the leverage concept be used to help management analyze the situation?

The asset investment and financing decisions are determined separately because without
determining the required funds to finance assets, the firm cannot push through with the financing
decisions. The firm should do this separately as asset investment is only one factor to be supported by
the financing decisions of the firm.

Both decisions however have significant effect on one another as investing decisions considers
the sale and purchase of fixed assets, that can be used in the operations to generate income, while
financing decisions is concerned with the borrowing and allocation of funds required for the investment
decisions.

Leverage results from using borrowed capital as a funding source when investing to expand the
firm's asset base and generate returns on risk capital. It helps the management to analyze the situation
as it determines the optimal capital structure.
 ST.1 Key Terms
a. Proxy - is an agent legally authorized to act on behalf of another party or a format that allows an
investor to vote without being physically present at the meeting. Shareholders not attending a
company's annual general meeting (AGM) may vote their shares by proxy by allowing someone
else to cast votes on their behalf, or they may vote by mail.
Proxy fight – is s the action of a group of shareholders joining forces in a bid to gather enough
shareholder proxies to win a corporate vote. Sometimes referred to as a "proxy battle,” this
action is mainly used in corporate takeovers, where outside acquirers attempt to convince
existing shareholders to vote out some or all of a company’s senior management, to make it
easier to seize control over the organization.
Takeover - occurs when one company makes a bid to assume control of or acquire another,
often by purchasing a majority stake in the target firm. In the takeover process, the company
making the bid is the acquirer while the company it wishes to take control of is called the target.
b. Preemptive Right - is a right belonging to existing shareholders of a corporation to avoid
involuntary dilution of their ownership stake by giving them the chance to buy a proportional
interest of any future issuance of common stock.
c. Classified Stocks - are shares of a publicly-traded company that have different share classes,
usually denoted by Class A shares and Class B shares.
Founders’ Shares - are the shares issued to the founders of a company. Apart from founders, it
can also refer to the shares given to the early investors in the company.
d. Marginal Investor – is a representative investor whose actions reflect the beliefs of those
people who are currently trading a stock. It is the marginal investor who determines a stock's
price.
Intrinsic value - is a measure of what an asset is worth. This measure is arrived at by means of
an objective calculation or complex financial model, rather than using the currently trading
market price of that asset.
Market Price - is the current price at which an asset or service can be bought or sold. The
economic theory contends that the market price converges at a point where the forces of supply
and demand meet.
e. Required Rate of Return - is the minimum return an investor will accept for owning a company's
stock, as compensation for a given level of risk associated with holding the stock. The RRR is also
used in corporate finance to analyze the profitability of potential investment projects.
Expected Rate of Return – is the rate of return expected on an asset or a portfolio. The
expected rate of return on a single asset is equal to the sum of each possible rate of return
multiplied by the respective probability of earning on each return.
Actual (Realized) Rate of Return - refers to the actual gain or loss an investor experiences on an
investment or in a portfolio. It is also referred to as the internal rate of return (IRR). It can
greatly affect net worth.
f. Capital Gains Yield - is the increase in the value of an asset or portfolio because of the rise in the
price of an asset (not the dividend paid because the owner has held the asset), combined with
the dividend yield, it gives the total yield i.e, profit because of holding an asset.
Dividend Yield - is the financial ratio that measures the quantum of cash dividends paid out to
shareholders relative to the market value per share. It is computed by dividing the dividend per
share by the market price per share and multiplying the result by 100.
 Expected Total Return - is the profit or loss an investor anticipates on an investment that has
known or anticipated rates of return (RoR). It is calculated by multiplying potential outcomes by
the chances of them occurring and then totaling these results.
Growth Rate - refers to the percentage change of a specific variable within a specific time
period.
g. Zero Growth Stock – refers when a stock has a return of a definite amount until the stock
reaches maturity.
h. Constant Growth (Gordon) Model - is used to determine the intrinsic value of a stock based on
a future series of dividends that grow at a constant rate. It is a popular and straightforward
variant of a dividend discount mode (DDM).
Supernormal (Nonconstant) Growth - is a security that experiences especially robust growth for
a time, then eventually reverts back to normal levels of growth. During their supernormal
growth stage, these stocks outperform the market significantly and provide investors with
returns that are well above average. In order to be considered a supernormal growth stock, a
stock’s price must continue to grow at an unusually fast pace for at least one year.
i. Corporate Valuation Model - is a process and a set of procedures used to estimate the
economic value of an owner’s interest in a business. Valuation is used by financial market
participants to determine the price they are willing to pay or receive to perfect the sale of a
business.
j. Horizon (Terminal) Date – is the date when the growth rate becomes constant.
Horizon (Continuing) Value – is the value at the horizon date of all dividends expected
thereafter.
k. Preferred Stock - is a class of corporate shares that are separate from common stock and have
specific rights that aren’t available to common shareholders.

Easy Problems:

9-1. Warr Corporation just paid a dividend of $1.50 a share (that is, D0 = $1.50). The dividend is
expected to grow 7% a year for the next 3 years and then at 5% a year thereafter. What is the expected
dividend per share for each of the next 5 years?

D0 = $1.50

Year 1

$1.50 (1+0.07)^1 = $1.61

Year 2
$1.50 (1+0.07)^2 = $1.72

Year 3

$1.50 (1+0.07)^3 = $1.84

Year 4

$1.50 (1+0.05)^4 = 1.93

Year 5

$1.50 (1+0.05)^5 = 2.03

9-2. Thomas Brothers is expected to pay a $0.50 per share dividend at the end of the year (that is, D1 =
$0.50). The dividend is expected to grow at a constant rate of 7% a year. The required rate of return on
the stock is 15%. What is the stock's current value per share?

D1 = $0.50; g = 7%; rs = 15%

stock's current value per share (P^0) = D1 / (Rs - g)

= (.50/ .15 - .07)

= $6.25

9-3. Harrison Clothiers' stock currently sells for $20.00 a share. It just paid a dividend of $1.00 a share
(that is, D0 = $1.00). The dividend is expected to grow at a constant rate of 6% a year. What stock price
is expected 1 year from now? What is the required rate of return?

D0= 1.00; g= 6%

P^1= Po (1+g) = $20(1+.06) = $21.20

Rate of return

r^p= (D1 / Po) + g

= 1.00(1.06) / 20 + .06

= 11.30%

9-4. Hart Enterprises recently paid a dividend, D0, of $1.25. It expects to have nonconstant growth of
20% for 2 years followed by a constant rate of 5% thereafter. The firm's required return is 10%.

0 1 2 3

|------------------------|---------------------------|-----------------------------|
 Gs=20% Gs=20% g=5%

a. How far away is the horizon date?

The terminal, or horizon, date is the date when the growth rate becomes constant. This occurs
at the end of Year 2.

b. What is the firm's horizon, or continuing, value?

D0=1.25; Gs = 20% N=2 yrs; g=5%; gs=10%.

D1 = 1.25*1.20
= $1.50

D2 = 1.50*1.20
= $1.80

D3 = 1.80*1.05
= $1.89

P2 = D3/(Ks-g)
= 1.89/(0.10-0.05)
= $37.80

c. What is the firm's intrinsic value today, P^ 0 ?

P^0 = 0 + 1.50/(1.10)^1 + 1.80+37.80/(1.20)^2
= 1.36 + 32.73
= $34.09

9-5. Smith technologies is expected to generate $150 million in free cash flow next year, and FCF is
expected to grow at a constant rate of 5% per year indefinitely. Smith has no debt or preferred stock
and its WACC is at 10%. If smith has 50 million shares of stock outstanding, what is the stock's value per
share?

Firm value = FCF1/(WACC - g)

= $150,000,000/(0.10 - 0.05)

= $3,000,000,000

Equity value per share = Equity value/Shares outstanding

= $3,000,000,000/50,000,000

= $60

9-6. Fee founders has perpetual preferred stock outstanding that sells for $60 a share and pays a
dividend of $5 at the end of each year. What is the required rate of return?

Dp = $5; Vp= $60

rp= Dp / Vp

= 5 / 60

= 8.33%