Balance Sheet Current Current Assets Liabilities Planning the Firms Financing Mix Fixed Assets Debt and

Preferred Shareholders Equity

Balance Sheet Current Current Assets Liabilities Debt and Preferred Shareholders Equity

Balance Sheet Current Current Assets Liabilities

Interest-bearing short-term debt

Fixed Assets

Financial Structure

Fixed Assets

Debt and Preferred Shareholders Equity

Capital Structure

Why is Capital Structure Important?

1) Leverage: Higher financial leverage means higher returns to stockholders, but higher risk due to fixed payments. 2) Cost of Capital: Each source of financing has a different cost. Capital structure affects the cost of capital. The Optimal Capital Structure is the one that minimizes the firms cost of capital and maximizes firm value.

Capital Structure Management

EBIT-EPS Analysis - Used to help determine whether it would be better to finance a project with debt or equity.

EPS = (EBIT - I)(1 - t) - P S

I = interest expense, P = preferred dividends, S = number of shares of common stock outstanding.

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EBIT-EPS Example
A firm has 800,000 shares of common stock outstanding, no debt, and a marginal tax rate of 40%. It needs P6,000,000 to finance a proposed project. It is considering two options:

If we expect EBIT to be P2,000,000: Financing EBIT - interest EBT - taxes (40%) EAT # shares outst. EPS stock 2,000,000 0 2,000,000 (800,000) 1,200,000 1,000,000 P1.20 debt 2,000,000 (600,000) 1,400,000 (560,000) 840,000 800,000 P1.05

!! Sell 200,000 shares of common stock at P30

per share, !! Borrow P6,000,000 by issuing 10% bonds.

If we expect EBIT to be P4,000,000: Financing EBIT - interest EBT - taxes (40%) EAT # shares outst. EPS stock 4,000,000 0 4,000,000 (1,600,000) 2,400,000 1,000,000 P2.40 debt 4,000,000 (600,000) 3,400,000 (1,360,000) 2,040,000 800,000 P2.55

!!If EBIT is P2,000,000, common stock

financing is best. !!If EBIT is P4,000,000, debt financing is best. !!So, now we need to find a breakeven EBIT where neither is better than the other.

EPS 3

If we choose stock financing:

stock financing

EPS 3

If we choose bond financing:

bond financing

2 1 0 P1m P2m P3m P4m EBIT

2 1 0 P1m P2m P3m P4m EBIT

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EPS 3

Breakeven EBIT
(Indifference Point)

bond financing stock financing

EBIT Breakeven Point

Set two EPS calculations equal to each other and solve for EBIT: Stock Financing Debt Financing (EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P S S

2 1 0 P1m P2m P3m P4m EBIT

EBIT Breakeven Point

Stock Financing (EBIT-I)(1-t) - P = S Debt Financing (EBIT-I)(1-t) - P S

EBIT Breakeven Point

Stock Financing .6 EBIT = 1 .48 EBIT = = Debt Financing .6 EBIT - 360,000 .8 .6 EBIT - 360,000 360,000

(EBIT-0) (1-.40) = (EBIT-600,000)(1-.40) 800,000+200,000 800,000

.12 EBIT

EBIT = P3,000,000

EBIT Breakeven Point

EPS 3 For EBIT up to P3 million, stock financing is best.

bond financing stock financing

EBIT Breakeven Point

EPS 3 For EBIT up to P3 million, stock financing is better.

bond financing stock financing

2 1 0 P1m P2m P3m P4m EBIT

2 1 0 P1m P2m P3m

For EBIT greater than P3 million, debt financing is better. EBIT P4m

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Problem 1
!! Plan A: Sell 1,200,000 shares at P10
per share (P12 million total). !! Plan B: Issue P3.5 million in 9% debt and sell 850,000 shares at P10 per share (P12 million total). !! Assume a marginal tax rate of 50%.

EBIT Breakeven Point

Stock Financing (EBIT-I) (1-t) - P = S Levered Financing (EBIT-I) (1-t) - P S

EBIT-0 (1-.50) = (EBIT-315,000)(1-.50) 1,200,000 850,000 EBIT = P1,080,000

Analytical Income Statement

EBIT I EBT Tax NI Shares EPS Stock 1,080,000 0 1,080,000 (540,000) 540,000 1,200,000 .45 Levered 1,080,000 (315,000) 765,000 (382,500) 382,500 850,000 .45
EPS .65

levered financing

stock financing

.45 .25 0 P.5m P1m P1.5m P2m EBIT

For EBIT up levered EPS to P1.08 m, financing stock .65 financing is best.

stock financing

For EBIT up levered EPS to P1.08 m, financing stock .65 financing is best.

stock financing For EBIT greater than P1.08 m, the levered plan is best.

.45 .25 0 P.5m P1m P1.5m P2m EBIT

.45 .25 0 P.5m P1m

EBIT P1.5m P2m

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Problem 2
!! Plan A: Sell 1,200,000 shares at P20
per share (P24 million total). !! Plan B: Issue P9.6 million in 9% debt and sell shares at P20 per share (P24 million total). !! Assume a 35% marginal tax rate.

EBIT Breakeven Point

Stock Financing (EBIT-I) (1-t) - P = S Levered Financing (EBIT-I) (1-t) - P S

(EBIT-0) (1-.35) = (EBIT-864,000)(1-.35) 1,200,000 720,000 EBIT = P2,160,000

Income Statement
EBIT I EBT Tax NI Shares EPS Stock 2,160,000 0 2,160,000 (756,000) 1,404,000 1,200,000 1.17 Levered 2,160,000 (864,000) 1,296,000 (453,600) 842,400 720,000 1.17

EPS 1.5

levered financing

stock financing

1.17

.5 0 P1m P2m P3m P4m EBIT

For EBIT up levered to P2.16 m, EPS financing stock 1.5 financing is best.
1.17

stock financing

For EBIT up levered to P2.16 m, EPS financing stock 1.5 financing is best.
1.17

stock financing For EBIT greater than P2.16 m, the levered plan is best.

.5 0 P1m P2m P3m P4m EBIT

.5 0 P1m P2m P3m P4m EBIT

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