Chapter 27

Question 1

WACC formula

Answer 1

When choosing between cap structures, chose the one that minimizes WACC

Question 2

(1-T) tax rate

Why is after tax important?

Answer 2

Its after tax and its important because most jurisdiction, Cost of debt is deductible for Tax purposes. In other words, it reduces our tax liability, so the govt provides us a subsidy to borrow money in effect bc they are taxing us less if we have interest expenses compared to no interest expense.

Question 3

How to determine where WACC should be based on this example:

ABC inc., capital structure is 50% debt and 50% equity
Cost of debt 8%
Cost of equity 11%
Corporate Tax 30%

Answer 3

WACC =
(0.50)(0.08)(1-0.30) + (0.50)(0.11) = 0.083 = 8.3%

The after tax cost of debt is: 0.08 (1-0.30) = 5.6%

So WACC is going to be between 5.6% and 11% equity

Question 4

Proportion of debt and equity are influenced by (4) internal and (2) external factors:

Answer 4

Internal is industry specific.

Question 5

Operating Tax Rate and what it means when govt. subsidizes debt.

Answer 5

Remember the govt. subsidizes debt, if tax rate is high, higher the subsidy so higher the corp. tax rate, the more incentive there is for company to take on more debt.

Question 6

Operating Leverage and Financial Leverage

Answer 6

Operati

Question 7

Leverage definition and the two sources of leverage.

Answer 7

Two sources of leverage, leverage means magnification of variability.

-Operating leverage (business leverage) account of fixed cost.

-Financial leverage
High operating leverage doesn’t want high financial leverage. So they may choose to use less debt.

Question 8

For operating leverage, what does large fixed cost in cost structure mean?

Answer 8

When you have large fixed cost in your cost structure, your operating leverage is very high

Question 9

The cost of debt and equity is likely to be higher for a firm with:

A. Stable Rev Growth
B. High operating leverage
C. High interest coverage

Answer 9

B. High operating leverage

Operating lev is the firms proportion of fixed cost to total cost and measure the stability of profits.

Firms with high op lev experience a greater change in operating profits for a given change in rev. Thus, firms with high operating lev are riskier and likely to have higher debt and equity costs.

Question 10

What are the industry/Co Characteristics that have higher proportion of debt.

Answer 10

Note:
Definition: Cyclical industries fluctuate with the business cycle.

Fungible is the opposite of specialized, so an asset that is fungible can be easily adapted or can be used in many diff industries, as opposed to specialized asset that is unique to a company.

Detailed notes from picture:
Companies in noncyclical industries are better able to support high proportions of debt than companies in cyclical industries.

Companies with low fixed operating costs as a proportion of total costs (i.e., low operating leverage) are better able to support high proportions of debt than companies with high fixed costs.

Companies with subscription-based revenue models are better able to support high proportions of debt than companies with pay-per-use revenue models.

Creditors tend to view tangible assets as better collateral than intangible assets. A company that owns its productive assets outright as opposed to using assets owned by others (such as a franchise model) has more collateral, which improves access to debt financing and reduces borrowing costs.

Question 11

Coverage Ratio formula and what are they used to analyze?

Answer 11

Used to analyze debt capacity

Interest coverage = EBIT / Interest Expense.

Question 12

Convertible debt

Answer 12

Used by start-ups with high growth and rapid rising stock prices.

convertible allows the lender to convert that debt into equity at some point in the future, at specific exercise price. It allow co to raise debt cap at reasonable mrk prices even though they are in start up phase.

Question 13

Corporate Life Cycle:

Startup
Growth
Maturity

Answer 13

Startup
- Convertible debt

Growth
- Secured debt, still mainly equity financing

Maturity
- Unsecure debt , bc its cheaper than equity.

Question 14

MM1, what is the theory

Answer 14

In it, MM demonstrate that under certain assumptions, the value of a firm is unaffected by its capital structure

Question 15

MM1 Assumptions

Answer 15

•  Capital markets are perfectly competitive. There are no transactions costs, taxes, or bankruptcy costs.
•  Investors have homogeneous expectations.
• There is riskless borrowing and lending.
• There are no agency costs. There are no conflicts of interest between managers and shareholders.
• Investment decisions are unaffected by financing decisions. Operating income is independent of how the firm is financed.

o In other words, value of firm is unchanged regardless if you use 10% debt of 90% debt.
o Like pizza, you can cut it up slices so its 25% debt and rest is equity but regardless of how you slice the pizza pie, the SIZE of pizza is not affected.

Question 16

MM1 and MM2 is unaffected by what?

Answer 16

MM1 - value of firm is unaffected by its capital structure

MM2 - WACC is unaffected by capital structure.

Question 17

MM1 without Taxes

Answer 17

Changing cap structure does not affect value of firm.

Value of levered co. (Vl) = value of unlevered co (Vu)

Company value is determined solely on expected future CF.

Total CF to debt and equity holders are the same for levered and unlevered

Investors can choose the level of leverage by borrowing and lending at risk-free rate.

Question 18

MM2 theory

Answer 18

MM2 is framed in terms of a firm’s cost of capital, rather than firm value. Firm cost of capital and WACC unaffected by proportion of debt financing/capital structure.

Same assumption as MM1 in that it includes no taxes.

MM2 states that -As company take more debt, the risk equity investor have to take is higher.

Therefore, Based on the same assumptions as MM I, MM II states that the cost of equity increases linearly as a company increases its proportion of debt financing.’

Firm with higher leverage will have higher cost of equity. Higher leverage you use cheaper source of capital, so the weighted average will not be changed.

In other words - The conclusion of MM II is that the decrease in financing costs from using a larger proportion of (lower-cost) debt is just offset by the increase in the cost of equity, resulting in no change in the firm’s WACC

Question 19

Debt-to-equity ratio and cost of equity formula

Answer 19

As leverage (the debt-to-equity ratio) increases, the cost of equity increases, but the cost of debt and WACC are unchanged

Question 20

Tax Shield
(1) Definition
(2) Formulas
(3) Implications

Answer 20

Taxes we are referring to is corp tax and govt allows deduction for interest expense. Bc govt. provide that subsidy we call that a tax shield.

Tax shield = Tax * Debt company takes.

Bc of tax shield, the debt become prefer source of capital.

So value of levered firm = unlevered firm + tax shield

Increase in tax shield, the value of leveraged increases. And tax shield will increase by taking on more debt.
How much debt can you take? You can finance 100% debt and the tax shield will be maxed

Question 21

MM1 With taxes

Answer 21

Question 22

MM1 without taxes

Answer 22

Question 23

MM2 with taxes

Answer 23

Question 24

MM2 without taxes

Answer 24

Question 25

*MM 1with taxes theory (6 bullet points)

Answer 25

Debt financing creates a tax shield that increase company value. Tax shield means that the lev firm can distribute greater CF than unlev firm.

Cost of capital minimized and value of firm max at 100% debt.

Prop 2 also says WACC is minimized at 100% debt.

After-tax cost of debt is lower than the cost of debt.

Therefore WACC decreases on account for taking on more debt.

MM’s propositions with taxes but without costs of financial distress are that a company’s WACC is minimized and its value is maximized with 100% debt.

Question 26

Positive tax rate formula for return on equity

Answer 26

Question 27

static tradeoff theory

Answer 27

The static tradeoff theory seeks to balance the costs of financial distress with the tax shield benefits from using debt.

Static tradeoff theory indicates that firm value initially increases (and WACC decreases) with additional debt financing, but company value decreases at some point when the increase in the expected value of financial distress outweighs the tax benefits of additional debt.

Cost of equity is upward sloping.

Question 28

optimal capital structure

Answer 28

Where the WACC is minimized and the value of the firm is maximized

Question 29

Accounting for the costs of financial distress, the expression for the value of a levered firm

Answer 29

VL = VU + (t × debt) – PV (costs of financial distress)

Question 30

Three agency cost

Answer 30

Monitoring
Bonding
Residual losses.

Question 31

High agency cost may find more debt to be beneficial. Why?

Answer 31

• Companies with high agency cost, where residual losses are high, where its difficult to monitor managers action, when info asymmetry is high, for those kind of company it makes sense to use more debt in cap structure bc more debt implies contractual payments that need to be made to the lenders.
• When there is contractual pmt for debt capital, its less free cash flow the managers have.
• So when managers have less free CF, they have less ability to pursue empire building, pursuing foolish acquisition.

Question 32

Pecking order theory

Answer 32

Says manager have their own preference about the source of capital they want to employ.

THIS theory says managers want to send least amt of negative signal to the mrk.

(1) Retain Earnings -
When manager use internally -generated equity (retained earnings) they are not sending any signal to the mrk, and therefore that is ranked number one for sources of capital. So most preferred source of capital is retained earnings.

(2) Debt -
Second source is debt, when co issue debt, it tells mrk we need capital or we are growing and we need to finance it. It communicates to mrk that managers are confident about future of company and serveability of new debt. No neg signal to mrk.

(3) New Equity -
Third, least prefer is new equity, bc when manager make announce to issue additional stock, the mrk thinks the stock is overvalued and that is a neg signal to mrk.

Pecking order theory says overtime the managers follow this pecking order, first rely on retain earnings, then debt, then equity.

Over time, the series of decision that company has made leads to the current capital structure we see

Question 33

A firm is planning a $25 million expansion project.

The project will be financed with
$10 million in debt and
$15 million in equity stock
(equal to the company’s current capital structure). T

he before-tax required return on
debt is 10% and 15% for equity.

If the company’s tax rate is 35%, what cost of capital should the firm use to determine the project’s net present value?

Answer 33

Weight of equity =
$15 million / ($10 million + $15 million) = 60%

Weight of debt =
$10 million / ($10 million + $15 million) = 40%

WACC = 0.60(kCE) + 0.40(after-tax kD)

WACC = 0.60(0.15) + 0.40(0.10)(1 − 0.35) =
= 0.116 or 11.6%

Question 34

Elenore Rice, CFA, is asked to determine the appropriate weighted average cost of capital for Samson Brick Company. Rice is provided with the following data:

Debt outstanding, market value $10 million
Common stock outstanding, market value $30 million
Marginal tax rate 40%
Cost of common equity 12%
Cost of debt 8%

Samson has no preferred stock. Assuming Samson’s ratios reflect the firm’s target capital structure, Samson’s weighted average cost of capital is closest to

Answer 34

The capital structure ratios are:

Debt to total capital = $10 / ($10 + $30) = 25%
Equity to total capital = $30 / ($10 + $30) = 75%

The formula for the WACC (if no preferred stock) is:
WACC = WdKd(1 – t) + WceKce

wd is the percentage of operations financed by debt,
wce is the percentage of operations financed by equity, T is the marginal tax rate,
kd is the before-tax cost of debt
kce is the cost of common equity.

WACC = 0.25(0.08)(1-0.40) + 0.75(0.12) = 0.102 = 10.2%.

Question 35

• WACC Example:

Company balance sheet shows:
$400k Bonds
$600K Common Shares (40K shares )

Total liabilities & Equity = $1,000,000
Current stock price $20.00 per share

Required before-tax return on debt: 5%
Required return on equity 10%

Calculate WACC if stock prices rise to $25 and the relevant tax rate is 20%

Answer 35

(1) Get the market value of equity:
$25 * 40K shares = $1,000,000

(2) Get total capital:
1,000,000 mrk value of equity + 400,000 bonds
= $ 1,400,000

(3) Get MRK VALUE weights:
Debt = 400 bonds / 1,400,000 (2) = 0.29
Equity= 1,000,000 (1) / 1,400,000 (2)= 0.71

(4) WACC Formula:

(Wd) (Rd) (1-T) + (We) (Re)
(0.29)(5%)(1-20%) + (0.71)(10%) = 8.26

Question 36

removing the assumption of no taxes, but keeping all of MM other assumptions, which of the following would be the optimal cap structure for maximizing the value of a firm?

a. 50/50 % debt and equity
b. 100% debt
c. 100% equity

Answer 36

b. 100% debt.

If MM other assumptions are maintained, removing the no tax assumption means the value of the firm is max when the value of tax shield is max, which occurs with a cap structure of 100% debt.