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Basic Definitions
V = value of firm
FCF = free cash flow
WACC = weighted average cost of
capital
rs and rd are costs of stock and debt
re and wd are percentages of the firm
that are financed with stock and
debt.
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t 1
FCFt
t
(1 WACC )
WACC = wd (1-T) rd + we rs
(Continued)
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(Continued)
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(Continued)
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Low risk
High risk
E(EBIT)
EBIT
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A business that makes few sales, with each sale providing a very
high gross margin, is said to be highly leveraged. A business that
makes many sales, with each sale contributing a very slight
margin, is said to be less leveraged. As the volume of sales in a
business increases, each new sale contributes less to fixed costs
and more to profitability.
A business that has a higher proportion of fixed costs and a lower
proportion of variable costs is said to have used more operating
leverage. Those businesses with lower fixed costs and higher
variable costs are said to employ less operating leverage.
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Rev.
$
TC
} EBIT
TC
F
F
QBE
Sales
QBE
Sales
(More...)
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Operating Breakeven
Q is quantity sold, F is fixed cost, V
is variable cost, TC is total cost, and
P is price per unit.
Operating breakeven = QBE
QBE = F / (P V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 $10) = 40.
(More...)
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Probability
EBITL
EBITH
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Financial risk:
Additional business risk concentrated on
common stockholders when financial leverage
is used.
Depends on the amount of debt and preferred
stock financing.
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Firm L
$10,000 of 12% debt
$20,000 in assets
40% tax rate
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EBIT
Interest
EBT
Taxes (40%)
NI
ROE
Firm U
Firm L
$3,000
0
$3,000
1 ,200
$1,800
$3,000
1,200
$1,800
720
$1,080
9.0%
10.8%
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Continued
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Firm U: Unleveraged
Bad
Prob.
0.25
EBIT
$2,000
Interest
0
EBT
$2,000
Taxes (40%)
800
NI
$1,200
Economy
Avg.
Good
0.50
$3,000
0
$3,000
1,200
$1,800
0.25
$4,000
0
$4,000
1,600
$2,400
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Firm L: Leveraged
Bad
Prob.*
0.25
EBIT*
$2,000
Interest
1,200
EBT
$ 800
Taxes (40%)
320
NI
$ 480
*Same as for Firm U.
Economy
Avg.
0.50
$3,000
1,200
$1,800
720
$1,080
Good
0.25
$4,000
1,200
$2,800
1,120
$1,680
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Firm U
BEP
ROIC
ROE
TIE
Bad
10.0%
6.0%
6.0%
n.a.
Avg.
15.0%
9.0%
9.0%
n.a.
Good
20.0%
12.0%
12.0%
n.a.
Firm L
BEP
ROIC
ROE
TIE
Bad
10.0%
6.0%
4.8%
1.7x
Avg.
15.0%
9.0%
10.8%
2.5x
Good
20.0%
12.0%
16.8%
3.3x
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Profitability Measures:
E(BEP)
E(ROIC)
E(ROE)
U
15.0%
9.0%
9.0%
L
15.0%
9.0%
10.8%
Risk Measures:
ROIC
ROE
2.12%
2.12%
2.12%
4.24%
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Conclusions
Basic earning power (EBIT/TA) and
ROIC (NOPAT/Capital = EBIT(1-T)/TA)
are unaffected by financial leverage.
L has higher expected ROE: tax
savings and smaller equity base.
L has much wider ROE swings
because of fixed interest charges.
Higher expected return is
(More...)
accompanied by higher risk.
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Trade-off theory
Signaling theory
Debt financing as a managerial constraint
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VU
Debt
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rs
20
40
60
80
WACC
rd(1 - T)
Debt/Value
100
Ratio (%)
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(1 - Tc)(1 - Ts)
VL = VU + 1 D.
(1 - Td)
Tc = corporate tax rate.
Td = personal tax rate on debt income.
Ts = personal tax rate on stock income.
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VL = VU + 1 - (1 - 0.40)(1 - 0.12) D
(1 - 0.30)
= VU + (1 - 0.75)D
= VU + 0.25D.
Value rises with debt; each $1 increase in
debt raises Ls value by $0.25.
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Trade-off Theory
MM theory ignores bankruptcy (financial
distress) costs, which increase as more
leverage is used.
At low leverage levels, tax benefits
outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh
tax benefits.
An optimal capital structure exists that
balances these costs and benefits.
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Signaling Theory
MM assumed that investors and managers
have the same information.
But, managers often have better
information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
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(More...)
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D/S
bL
rs
0%
0.00
1.000
12.00%
20%
0.25
1.150
12.90%
30%
0.43
1.257
13.54%
40%
0.67
1.400
14.40%
50%
1.00
1.600
15.60%
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rd
rs
WACC
0%
0.0%
12.00%
12.00%
20%
8.0%
12.90%
11.28%
30%
8.5%
13.54%
11.01%
40%
10.0%
14.40%
11.04%
50%
12.0%
15.60%
11.40%
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WACC
Corp. Value
0%
12.00%
$2,500,000
20%
11.28%
$2,659,574
30%
11.01%
$2,724,796
40%
11.04%
$2,717,391
50%
11.40%
$2,631,579
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Debt, D
Stock Value, S
0%$0 $2,500,000
20%$531,915$2,127,660
30%$817,439$1,907,357
40%$1,086,957$1,630,435
50%$1,315,789$1,315,789
Note: these are rounded; see Ch 14 Mini Case.xls for full
calculations.
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Wealth of Shareholders
Value of the equity declines as more
debt is issued, because debt is used
to repurchase stock.
But total wealth of shareholders is
value of stock after the recap plus
the cash received in repurchase, and
this total goes up (It is equal to
Corporate Value on earlier slide).
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(More)
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P = S + (D D0)
n0
P = $2,127,660 + ($531,915 0)
100,000
P = $26.596 per share.
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0%$25.00
# shares
Repurch. Remaining
0100,000
20%$26.6020,000 80,000
30%$27.2530,000 70,000
40%$27.1740,000 60,000
50%$26.3250,000 50,000
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wd = 30% gives:
Highest corporate value
Lowest WACC
Highest stock price per share
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