1

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P x c o D . 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C . t b e d e m o s e s u o t t n a w t h g i m C C P y h w s s o b r u o y o t n i a l p x e o t h p a r g e h t e s U . 8 * B E / D C C A W C C A W n i M A r s t s o C s s e r t s i D l a i c n a n i F l a t i p a C d n a C T h t i w 2 p o r P f o t s o C * B t b e D U V d l e i h S x a T e h t f o e u l a V t n e s e r P m r i F f o e u l a V x a M s s e r t s i d l a i c n a n i f f o e u l a V t n e s e r P m r i F f o D C T + U V = L V s t s o C s s e r t s i D l a i c n a n i F e u l a V d n a C T h t i w 1 p o r P d e u n i t n o C ) C C P ( n o i t a r o p r o C a r b o C e l p r u P e g a r e v e L d n a e r u t c u r t S l a t i p a C 2 t r a P t u o d n a H 4 1 r e t p a h C

for their firms debt ratios, but the c

leverage are exactly offset by debts risk

the firms bond rating decreases and its cost of debt increases.

that is inherent in a firms operations. If a firm uses debt (financial leverage), this

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. 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C 2 e g a P h t , s e s a e r c n i d e w o r r o b y e n o m f o t n u o m a e h t s A . s r e d l o h k c o t s h t g n i s a e r c n i s u h t , s s o l e g r a l a f o y t i l i b a b o r p e h t s e s a e r c n i o s l a n a r o f n r u t e r f o e t a r d e t c e p x e e h t s e s a e r c n i t b e d h t i w g n i c n a n i F . s r e d l o h k c o t s n o m m o c n o k s i r s s e n i s u b e h t s e t a r t n e c n o c e c a f s r e d l o h k c o t s , y l l a u t p e c n o C . t b e d h t i w e c n a n i f o t n o i s i c e d c o t s n o m m o c e h t n o d e c a l p k s i r l a n o i t i d d a e h t s i k s i r l a i c n a n i F ? d e w o r r o b C C P s e o d y h W . 1 1

Amount Debt/Assets Debt/Equity Bond Borrowed Ratio Ratio Rating $ 0 0.000 0.0000 250 0.125 0.1429 AA

begin, define the terms optimal capital structure and target capital structure.

500 750 1,000

s bond rating and cost of debt depend on the amount of money

. l a t i p a c e s i a r o t s n a l p m r i f e h t h c i h w h t i w y t i u q x i m e h t s i e r u t c u r t s l a t i p a c t e g r a t e h T . d e z i m i x a m s i C C A W e h t ) 2 ( , d e z i m i x a m s i m r i f e h t f o e u l e h t t A . s t s o c d e t a l e r a t i p a c e h t s i e r u t c u r t s l a t i p a C P r o f e r u t c u r t s l a t i p a c l a m i

0.250 0.375 0.500

0.3333 0.6000 1.0000

A BBB BB

8.0% rd

9.0 11.5 14.0

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P x c o D . 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C
4 $

4 $

s expected EPS and TIE at debt levels of

0 , 0 2 h t

4 $

0 , 0 1 s n o a h s d e

D ) T 1 ( ] ) ( d T

E [

Amount Borrowed (1,000s) Debt Ratio Debt/Equity Levered Beta re $0.00 0.000 0.000 1.00 15.00%

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. 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C 4 e g a P 0 0 0 , 2 $ = s t e s s . ] ) E / D ( ) T 1 ( ? 0 0 0 , 0 0 0 , 1 $ ? 0 0 0 , 0 5 7 $ ? 0 0 0 , 0 0 5 $ ? t b e d s e z i l a t i p a c e r C C P f i y t i u q e f o t s o c e h t s i t a h w , n o i t a u q e a d a m a H e h t g n i s 4 1 $ . 9 . 2 = 0 = E 4 $ 0 0 4 . 0 9 . 3 $ = 0 = S 6 . . 4 ( , 1 $ ( 1 0 4 $ [ ) 0 0 ] ) 0 0 0 0 0 0 ) . s r a l l o d f o s d n a s u o h t n i e r a s n o i t a l u c l a c E I T d n a S P E : e t o N ( . 0 0 0 , . 7 ) . s r a l l o d f o s d n a s u o . 0 0

8 $

4 $

6 (

5 7 $ (

4 $

o N (

$1,000.00 $250.00 $500.00 $750.00

% 0 . 0 4 = e t a r x a T a l a t o T 0 . 1 = U b F R r M r % 0 . 6 = F R r = L b : n o i t a u q E s a d a m a H f o U . 3 1 I T P E R e h S 1 $ = D t A i T P E R e h S 7 $ = D t A

0.500 0.125 0.250 0.375

1.000 0.143 0.333 0.600

1.60 20.40% 1.36 18.24% 1.09 15.77%

S
.

S
=

S
l l a e s a c s i h t n i e c n i .

0
=

P C C

$1,000

$750

$500

$250

$0.00

Amount Borrowed (1,000s)

0.500

0.375

0.250

0.125

0.000

Debt Ratio

1.000

0.600

0.333

0.143

0.000

Debt/ Equity

1.60

1.36

1.20

1.09

1.00

Levered Beta

20.40%

18.24%

16.80%

15.77%

15.00%

re

14.00%

11.50%

9.00%

8.00%

0.00%

rd

S
d

P 2 $ h t i w s e z i l a t i p a c e r C C f i e c i r p

plowed back, the firms

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P x c o D . 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C . s r e d l o h y t i u

S
a t s e o d

S
a m n e h w

$750,000 $1,000,000

Debt Level Debt Ratio re DPS Price $0.00 0.000 15.00% $3.00 $20.00 $250,000 0.125 15.77% $3.26 $20.65

$500,000

0.375 18.24% $3.77 $20.64 0.500 20.40% $3.90 $19.12

0.250 16.80%

8.40%

6.90%

4.80%

0.00%

rd(1 - T)

14.40%

13.99%

14.40%

15.00%

WACC

e d f

S
$ e h t d n o y e b e s a e r c n i o t s e u n i t n o c

S
a m

H
e h t e r a e r e

P C C

What are some factors a manager should consider when establishing his or her firms

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. 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C 6 e g a P . e t a r x a t d e t c e p x E . 7 . e r u t c u r t s t e s s A . 6 . l o r t n o c n o g n i c n a n i f f o s t c e f f E . 5 . y t i c a p a c g n i w o r r o b e v r e s e R . 4 . s e d u t i t t a y c n e g a g n i t a r / r e d n e L . 3 . s o i r a n e c s t n e r e f f i d r e d n u s e r u t c u r t s l a t i p a c t n e r e f f i d t a s o i t a r E I T a m r o f o r P . 2 . y r t s u d n i r i e h t n i s m r i f r o f o i t a r t b e d e g a r e v a e h T . 1 : s n o i s i c e d e r u t c u r t s l a t i p a c g n i k a m n e h w s r o t c a f l a t n e m g d u j g n i w o l l o f e h t r e d i s n o c s r e g a n a m , n o i s i c e d e r u t c u r t s l a t i p a c e h t y f i t n a u q o t t l u c i f f i d s i t i e c n i S ? e r u t c u r t s l a t i p a c t e g r a t . 0 2 . t b e d e r o m d e d u l c n i t a h t e r u t c u r t s l a t i p a c l a m i t p o n a o t l d l u o w k s i r s s e n i s u b r e w o l , y l e s r e v n o C . t b e d s s e l h t i w e r u t c u r t s l a t i p a c l a m i t p o n a e b o w t l u s e r d n e e h t t u b , s i s y l a n a s i h t n i n w o h s t o n s i t I . d e t a m i t s e y l l a n i g i r o n a h t r e h g i h e b d l u o w s r d n a d r h t o b d n a , s i h t e z i n g o c e r d l u o w s r o t s e v n I . r e h g i h e b d l u o w s s e r t s i d l a i c n a n i f f o y t i l i b a b o r p s t i , l e v e l t b e d y n a t a , n e h t , k s i r s s e n i s u b r e h g i h d a h m r i f e h t f I ? d e t a m i t s e y l l a n i g i r o h t k s i r s s e n i s u b s s e l d a h m r i f e h t f i t a h W . s i s y l a n a e h t t c e f f a d l u o w s i h t w o h e b i r c s e D e t a m i t s e y l l a n i g i r o u o y n a h t k s i r s s e n i s u b e r o m d a h C C P t a h t d e r e v o c s i d u o y e s o p p u S . 9 1 . n i p e e r c y a m s e i c n e t s i s n o c n i , s t h g i e w e u l a v k o o b d n a , e c i r p e s a h c r u p 5 2 $ t n a t s n o c a g n i s U . m u m i n i m e h t e b d l u o w e r u t c u r t s l a t i p a c g n i z i m i x a m e c i r p h t t a C C A W e h t t a h t e r u s e b d l u o c e w n e h t , C C A W e t a l u c l a c o t s t h g i e w e u l a v t e k r a m d e s u ) 2 ( d n a s e r a h s g n i s a h c r u p e r r o f e c i r p m u i r b i l i u q e e h t d e s u ) 1 ( d a h e w f I : e t o N = C C A W . 0 0 0 , 0 0 0 , 2 $ = s e r a h s 0 0 0 , 0 8 5 2 $ = y t i u q e l a i t i n I = s t e s s a l a t o T o s , % 0 = s t e s s a l a t o T / t b e D : l e v e l t b e d l a i t i n I ? e r u t c u r t s l a t i p a c l a m i t p o e h t t a C C A W e h t s i t a h W . 8 1 . d e r e d i s n o c e s o h t f o t s e b e h t s i t i e h ; 9 8 . 6 2 $ , e c i r p k c o t s t s e h g i h e h t s e c u d o r p t b e d f o 0 0 0 , 0 0 5 $ h t i w e r u t c u r t s l a t i p a c A C C P s i t a h w , d e s s u c s i d t b e d f o s l e v e l e h t y l n o g n i r e d i s n o C . 7 1

s optimal capital structure?

You might expect the price of a mature firms stock to decline if it announces a stock

The asymmetric information concept is based on the premise that managements choice

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P x c o D . 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C . g n i r e f f o e h t n i s e r a h s n w o r i e h t f o y n a g n i l l e s t o n e r a y e h t t a h t e c n u o n n a s r e g a n a m w e n a f o e s u a c e b l l a f t o n y l b a b o r p d l u o w m r i f w o r d e o g y g n i i f e r d i p . t b o v a i h t o t s e b e d l i w u t c u . s e

Firms profitability.

Firms growth rate.

Firms operating leverage.

Firms internal conditions.

stock issue, especially if the firms

g y l d i p a r , g n u o y a f o e c i r p k c o t s e h t , n i a t e r s a s d e e n t i y t i u q e e h t l l a e s i a r t n a m o s e v a h y a m , r e v e w o h , m r i f g n i n r a e s t i t a h t l a n g i s d l u o w e u s s i k c o t s u t a m A . e n i l c e d y l b a b o r p d l u o w k c o a r , g n u o y a e r e w m r i f g n i u s s i e h t f i n e d h t i w d e c n a n i f e b n a c y e h t , g n o l a e g n i w o r r o b f o e v r e s e r a g n i n i a t n i a m s n o t y r t y e h t o s , s i h t w o n k s m r i F . s e n i l e k a t s r o t s e v n i , g n i r e f f o k c o t s a s e c n u v n I . k c o t s h t i w e c n a n i f o t t n a w l l i w , h t i w e c n a n i f o t d n e t l l i w y e h t o s , s r e d s e i t i n u t r o p p o t n e m t s e v n i d o o g h t i w s r t s l a t i p a c t c e f f a g n i l a n g i s d n a n o i t a

Since the market value of Greens equity is $10,000,000 and the firm has 500,000 shares of common stock outstanding, the price of Greens stock is $20 per share (= $10,000,000

What is the expected return on Greens

has no debt in its capital structure and makes no interest payments, Greens annual after

The expected return on a firms equity is the ratio of annual after market value of the firms equity.

value of the firms equity of $10

Construct Greens market What is the price per share of the firms equity?

Therefore, the expected return on Greens unlevered equity is 9% (= $900,000 /

rket value of Greens equity is $10,000,000.

equity firm. The present value of the firms after

Greens market

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. 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C 8 e g a P . e u s s i t b e d e h t f o t n e m e c n u o n n a e h t e r o f e b ) s e r a h s 0 0 0 , 0 0 5 / : s i e u s s i t b e

Total assets = $10,000,000 Total D + E = $10,000,000

d e h t f o t n e m e c n u o n n a e h t e r o f e b t e e h s e c n a l a b

Assets =
e u l a v = { 0 0 0 , 0 0 0 , 0 1 $ l l a n a s i n e e r G . b p r e p t a h t e c i t o N . ) 0 0 0 , 0 0 0 , 0 1 $ a m e h T r a e d e t c e p x e x a t a r x a t e t a r o p r o c $ s t c e p x e n e e r G . a . t n e c r e p 0 4 o t d e t c e p x e s i s g n i n r a e r u c n e e r G . y l e t i n i f e d n i e t f A . g n i d n a t s t u o k c o t s y l t n e r r u c s i n e e r G . e t a r u p e r o t s d e e c o r p e h t e s u I , g n i r u t c a f u n a M n e e r G n o i t a z i l a t i p a c e R

$10,000,000 Debt = Green Manufacturing

Equity =

$10,000,000

"

"

Construct Greens market

Greens

Since the firm has not yet issued any debt, Greens equity is also worth $10,800,000.

firm is subject to a corporate tax rate of 40%, the present value of the firms tax shield is:

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P x c o D . 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C : s i e u s s i t b e d e h t f o t n e m e n u o n n a e h t r e t f a t e e h s e n a c c

Total assets = PV (Tax Shield) =

l

Old Assets =
a b e u l a v " t e k r a m = = = L V u l a v e h T u s s i t b e d r o f e r e h T x a P T ( V f o e u l a v G n e h W e r e h w U V = L V a i l g i d o M u s s i t b e d . c

= the value of debt in a firms capital structure

$10,800,000 Total D + E = $10,800,000 $10,000,000 Debt = Green Manufacturing $800,000 Equity = $10,800,000

L D + E =

common stock. Since the price of Greens stock after the announcement wi

Therefore, immediately after the repurchase announcement, Greens stock price will rise

Greens

Since the market value of Greens equity after the announcement of the debt issue is

Greens stock price per share immediately after the repurchase announcement?

Construct Greens market Greens stock price per share after the restructuring?

Greens market

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. 2 t r a P t u o d n a H e r u t c u r t S l a t i p a C 0 1 e g a P : s i g n i r u t c u r t s e r e h t r e t f a t e e h s e c n a l a b e u l a v 0 0 8 , 8 $ = 0 8 , 0 1 $ = L V = E o s i V T f l e c e c h d u b n e c r h o s i

t n e h t o e a f r u t u r t s v a o t s t f a h p e e d e e r u s s o t s a h s s r t n e k c

R g n i g n a r r a e

the market value of the Greens levered equity after the

Green Manufacturing Old Assets = PV (Tax Shield) = Total assets =

f o s e r a h s 1 4 . 7 0 4 , 7 0 4 s a h m r i f

$10,000,000 Debt = $800,000 Equity =

$2,000,000 $8,800,000

$10,800,000 Total D + E = $10,800,000

Since the market value of Greens equity after the restructuring is $8,800,000 and the common stock outstanding, the price of Greens stock will Therefore, Greens stock price will remain at $21.60 per share after the restructuring has e required return on Greens equity after the restructuring?
s e x a t e t a r o p r o c h t i w I I n o i t i s o p o r P r e l l i M i n a i l g i d o M o t g . e c h t a l s p i t n a e h k a . 1 1 e g a P ) 0 4 . g m 0 r n i i r f m u 1 d t r i e ( c f r ) u e 6 r d t v 0 e s . e r l e 0 e r e n m v u r e i l h 9 f n t 0 a a . r d f f 0 e e ) t ( r o o f ) 0 e a 0 y y 4 v t t . ) 0 i e i 0 l s 0 u u , e a q q r 0 e e a r 1 0 h o ( e e 8 f s ) , h h 6 t t t 8 1 b $ 0 ) 4 n n . e e . C / t o o 0 d 7 a T 0 r 0 4 f 9 0 r r o 0 ) x , 0 u u . 1 t , a t t a 7 0 s t ( 0 e e t ( 0 ) r r o r ) 0 e 4 D c a t 2 0 d d r / 0 0 a e o i i $ 5 t 0 0 e A ( ( u u p , , s r 0 1 r ) e 0 0 q q ( , ( + + r C o e e ) 0 0 4 0 p c r r T 9 6 0 0 8 9 9 9 E 0 , , / e e e e 0 0 4 0 0 0 8 , 2 8 . . . . . . h h h h D 0 0 0 $ $ 0 0 0 t t t t 1 8 ( x ( $ c = = = = = = = = = = = = ) + o D = A r ( e r t = r A C C a a A D A D E E r : h P D D T E T E r r r r r r ( s ) t m r u E e o / e l d p b D n ( o a 0 r n H 6 i + p . d e 1 A s r e r i r 2 r o u t h e $ c c t = h c u e E n r t

= the market value of the firms debt = the market value of the firms equity

The required return on Greens levered equity after the restructuring is:
, 2 2 /

Therefore, the required return on Greens levered equity after the restructuring is 9.41%.

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b r I t S l a t i p a . C g