MS 11: CAPITAL STRUCTURE AND LONG-TERM FINANCING DECISIONS eontoke nian Capital Structure represents the relative proportion or mix in the total capitalization of the company. a Ea Ea Ea 70% Ea Debi Equity Debi Equity Equity Control Low Moderate High Risk Low Moderate High Cost High Moderate Low Cost of Equity is relatively higher than the Cost of Debt. > Debt Capital can be use as a way to reduce taxes (Interest Expense). > The amount of DST imposed for Equity is relatively larger than Debt. Whichever combination of source of capital/capital structure, for as long as it provides the lowest Cost of Capital — that will be considered as the “most beneficial” for the company. Geese Determining the opportunities from long-term capital investments. 4. Capital Budgetin oe ang > Replacement > Expansion » Modernization > Diversification Raising funds to make the project a reality 2. Long-Term Financing | > Bonded Indebtedness » Ordinary Shares » Retained Earnings > Preference Shares Determine the optimal capital structure to maximize the value of the firm and minimize the cost of capital 3. Optimizing Capital 3.0ptimizing Capa coi Grades Roum Payout Policy > Evaluated Expected Returns ‘Assess the effect of the investment opportunity in the maximization of the value of the firm. > Assess value of the firm > Corrective Actions > Actual vs. Standards 4, Performance Evaluation Sources of Capital Primary Source of Cost of Capital TE — oT Capital Investment Budget InvestoriGreditorne General Income Formula Investment Applicable for 1°" Year, not useful for latter period ___ Interest Expense (- Interest Income) > Net cen Ae See ‘Net Proceeds —_——- Net Investment of the Investor Stated interest es a +/- Discount or Premium Amortization a= ear, Proceeds (60%) + Market Value (40%) NN ‘Amortization (Straight Used to approximate ema effective rate \ on) > Premium () > ‘Best Practice’ » Weighted Average Investment Same concept with Current Yield poe \. Preferred | _Dividends per Share ‘Shares, Net Market Value per Share 4 x (1+ Growth %) a "~~ Proceeds less any Floatation or Issue Cost Ordinary _ Expected DPS Do pertains to Curent Shares ~ Net MVPS. + Growth % Dividend Inaicators in the problem (phrases): “Just pak” » “Currently paid” > ‘Paid last year” Proceeds Jess any Floatation or Issue Cost Capital Asset Pricing Model (CAPM) Market Rate of Return Market Risk Premium —— te of Change” Beta, Relative at stock as compared to the market; measure of risk 1 Beta = 1 Volatility = 1 Uncertainty = 1 Risk = Alin Individual Stock ROR Slope = in Market RORNote: Market Risk Premium= [RM—Rf Risk Premium= B(RM-Rf) If. Beta>1 [movement of the individual stock is relatively larger compared to the movement of the market, Beta=1__ | (ex. 20% A in Individual Stock = 20% A in Market) Beta<1 | movement of the individual stock is slower compared to the movement of the market Beta=0 _ |no movement; whatever the movement of the market is — individual stock will not be affected Not Risk associated with Assets without considering the Debts Unlevered Beta (Asset Beta) por Levered Beta (1+ (1 Tax Rate)(Debt to Equity Ratio)) Beta that measure the risk associated with Equity and Debt (Liquidity Risk) Levered Beta (Stock Beta) _| Beta used for CAPM Formula: Unlevered Beta x (1 + (1 - Tax Rate)(Debt to Equity Ratio)) Cost of Capital - Weighted Average Cost of Capital WACC Debt Capital % x Cost of Debt Equity Capital % x Cost of Equity ‘The value of a firm is basically the sum of claims of its creditors and shareholders. Therefore, one of the simplest ways to measure it is by adding the market value of its debt, equity, end minority interest. ‘Approach 1 | Debt + Equity Approach 2 | EBIT = WACC Free Cash Flow’ * (WAC — Growth %) *Free Cash Flow = Operating Cash Flow — Capitel Expenditure Approach 3