capital struct theories
TRANSCRIPT
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COST OF EQUITY Ke
COST OF DEBT Kd
WACC
Leveraged firm and Unleveraged firm
BASICS and TERMINOLOGY
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FOR FINANCIAL LEVERAGE- EPS, ROE
FOR CAPITAL STRUCTURE THEORIES- IMPACTON THE VALUE OF A FIRM
VALUE = VALUE AS EQ + VALUE AS DEBT
VALUE = NET EARNINGS Ke/WACC
BASICS and TERMINOLOGY
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NET INCOME APPROACHFinancial Plan
Unlevered Levered
1. Earnings before interest and taxes, EBIT 1000 1000
2. Less: interest, INT 0 150
3. Profit before taxes, PBT = EBIT INT 1000 850
Ke .10 .10
Value of the equity 10000 ?
Kd .05Value of the debt 3000
Value of the firm 10000 ?
WACC .10 ?
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NET INCOME APPROACHFinancial Plan
Unlevered Levered
1. Earnings before interest and taxes, EBIT 1000 1000
2. Less: interest, INT 0 150
3. Profit before taxes, PBT = EBIT INT 1000 850
Ke .10 .10
Value of the equity 10000 8500
Kd .05Value of the debt 3000
Value of the firm 10000 11500
WACC .10 .087
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. 5
Net Income (NI) Approach
Assumptions:o No taxeso No financial risko Kd < Ke
o
The optimum capitalstructure would be100 per cent debtfinancing under NIapproach.
Criticism This approach has no
basis in reality.
k e
k ok d
D e b t
C o s t
k d
k e , k o
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TRADITIONAL APPROACHFinancial Plan
DEBT INCR
1. Earnings before interest and taxes, EBIT 1000
2. Less: interest, INT 450
3. Profit before taxes, PBT = EBIT INT 550
Ke .15
Value of the equity ?
Kd .07
Value of the debt ?
Value of the firm ?
WACC .095
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TRADITIONAL APPROACHFinancial Plan
DEBT INCR
1. Earnings before interest and taxes, EBIT 1000
2. Less: interest, INT 450
3. Profit before taxes, PBT = EBIT INT 550
Ke .15
Value of the equity 3667
Kd .07
Value of the debt 6248
Value of the firm 9910
WACC .095
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Traditional Approach
Assumptions:
o Same as Net IncomeApproach except that thereis a financial risk.
Initial rise in Ke is less thangain by issuing debt withlower Kdbut at higherstages Ke rises more.
So there is an Optimumcapital structure where Kois the lowest.
k e
k o
k d
D e b t
C o s t
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NET OPERATING INCOME APPROACHFinancial Plan
Unlevered Levered
1. Earnings before interest and taxes, EBIT 1000 1000
2. Less: interest, INT 0 150
3. Profit before taxes, PBT = EBIT INT 1000 850
Ke
Value of the equity 10000
KdValue of the debt
Value of the firm 10000 10000
WACC/ OPPURTUNITY COST OF CAPITAL .010 .010
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Net Operating Income (NOI)Approach Assumptions
o Perfect capitalmarket
o No taxes
o NOI and Opportunitycost is constantfor all levels.
o
o No optimum capitalstructure exists.
o
o
k e
k o
k d
D e b t
C o s t
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MM Approach Without Tax:Proposition I Assumptions
o Perfect capital market
o Investors can borrow atthe same rate
corporate can.o Same expectations
about operatingprofits.
o Same Business Risk
o No taxes.
No optimum capitalstructure explainedthrough operation alarbitrage processusing home made
k o
D e b t
C o s t
M M ' s P r o p o s i t i o n I
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M&M- operational ArbitrageFinancial Plan
Unlevered Levered
1. Earnings before interest and taxes, EBIT 1000 1000
2. Less: interest, INT 0 150
3. Profit before taxes, PBT = EBIT INT 1000 850
Ke .10 .10
Value of the equity 10000 8500
Kd.05
Value of the debt 3000
Value of the firm 10000 11500
WACC .10 .087
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M&M PROPOSITION IIFinancial Plan
Levered Unlevered
1. Earnings before interest and taxes, EBIT 1000 1000
2. Less: Interest, INT 0 150
3. Profit before taxes, PBT = EBIT INT 1000 850
Ke .10 ?
Value of the equity 10000
Kd - .05
Value of the debt 3000
Value of the firm 10000 10000
WACC/ OPPURTUNITY COST OF CAPITAL .010 .010
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M&Ms Proposition II
Assumptions : same
But Rise is Ke= Fall inWACC due to lowerrate debt.
k e
k o
k d
D e b t
C o s t
M M ' s P r o p o s i t i o n I I
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M&M WITH TAXESUnlevered levered
1. Earnings before interest and taxes, EBIT 1000 10002. Less: Interest, INT 0 150
3. Profit before taxes, PBT = EBIT INT 1000 850
Taxes @ 50 % 500 425
Profit after tax 500 425
Amount to EQ and Debt holders 500 425+150=575
Value of the equity and Firm (u) 10000
Value of firm (L)= V (u) + P V of tax shield (TD) - 11500
, % .S o 1 0 0 d e b t Fa vo u rab le b u t for tap p in g op p ortu n ities
%a n d re m a in in g fle xib le it sho u ld n o t b e 1 0 0 a s su g g e ste d
&b y M M
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Optimum capital struture100% Debt
Mark
etValu
eofTheFir
m
Value ofunlevered
firm
PV of interesttax shields
Maximum value of firm
M & M (WITH TAXES)
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Then why is there not aninclination of firm towards
DEBT?