...Corporation to Demonstrate the Optimal Capital Structure Trade-off Theory John C. Gardner, Carl B. McGowan Jr., and Susan E. Moeller1 ABSTRACT In this paper, we apply the trade-off theory of capital structure to Microsoft. We use data for bond ratings, bond risk premiums, and levered CAPM betas to compute the cost of equity and the weighted average cost of capital for Microsoft at different debt levels. This study shows the impact of increasing financial leverage on WACC. As financial leverage increases, the WACC decreases until the optimal debt ratio is reached, after which, the WACC begins to rise. At this debt ratio, the value of Microsoft will be maximized. Our results indicate the optimal debt ratio for Microsoft is 37.5 percent. Introduction One of the most difficult concepts for finance students to learn and for faculty to teach is how a firm determines its optimal capital structure. While most corporate finance textbooks stress the importance of maximizing the value of the firm by minimizing its opportunity cost of capital, how a firm can actually achieve the appropriate debt–to–capital ratio is often a mystery. Brigham and Ehrhardt (2008) in Financial Management: Theory and Practice outline a framework that can be used by financial practitioners to determine a firm’s optimal capital structure. Modigliani and Miller (1958 and 1963) provide the basis for the trade-off theory which is how firms can conceptually determine their optimal capital structure. What is lacking...
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...cash? Provide (at least two) reasons in favor and against keeping cash in the firm. Against: By paying out excess cash and issuing debt, BBBY could improve return to equity holders and raise earnings per share (by a share repurchase). Leverage can increase a firm’s expected earnings per share. An argument is that by doing so, leverage should also increase the firm’s stock price. Because BBBY has no debt, they pay no interest, and because in perfect capital markets there are no taxes, BBBY’s earnings would equal its EBIT. If BBBY has new debt, they will have interest payments each year, so their earnings will decrease (EBIT – interest). If BBBY uses the debt to repurchase shares, the number of outstanding shares will also fall. Because of this, the earnings per share can increase with leverage. This increase might appear to make shareholders better off and could potentially lead to an increase in the stock price. Besides this, BBBY faces the risk that the firm is not attracting investors. Investors want to maximize their returns and when the firm has a lot of cash, the investors may not be sure of the ability of BBBY to maximize the shareholder value. Another positive point about debt is the tax deduction. In favor: -Leverage increases the risk of equity even when there’s no risk that the firm will default. Thus, while debt may be cheaper when considered on its own, it raises the cost of capital for equity. -Cash can be a buffer in tough times. -When a firm has...
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...Traditional views on capital structure point to the existence of an optimal capital structure. Critique the analysis of the traditional views on capital structure in light of the competing views offered by Modigliani and Miller along with their assumptions. Capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. Stewart C. Myers argues that there is “no magic” in leverage and there is nothing supporting a presumption that more debt is better. He adds that debt maybe better than equity in some cases, worse in others or it may be no better and no worse. Thus, all financing choices are equally good. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20bn dollars in equity and $80bn in debt is said to be 20% equity financed and 80% debt financed. The firm's ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. There are many views on capital structure including the traditional views as well as the competing views offered by Modigliani and Miller. Traditional views on capital structure point to the existence of an optimal capital structure. An optimal capital structure is simply a mix of debt and equity which maximizes the value of the firm or minimizes the cost of capital. According to the traditional views on capital structure, changes in capital structure benefit the stockholders if and only...
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... |B |11924368 | | * By signing your name, you agree that you have read, understood and followed the advice in the subject guide concerning cheating and plagiarism. Case Company: Super Retail Group (ASX: SUL) Lecturer: Dr Gerhard Hambusch Lecture day & time: Monday 3:00 PM | | Table of Contents 1. EXECUTIVE SUMMARY 2 2. COMPANY AND INDUSTRY OVERVIEW 3 3.1 Historical Company Leverage Financing & Peer Industry Leverage Analysis 5 3.1.1 Interest Coverage Ratio 6 3.1.2 Managerial Inertia Theory 7 3.1.3 Security Mispricing Theory 7 3.1.4 Pecking Order Theory 8 3.2 Optimal Leverage Analysis 8 3.2.1 Trade -Off Theory 8 3.2.2 The Dividend Imputation System in Australia 10 3.2.3 Agency Theory 11 3.2.4 Stakeholder Theory 12 3.2.5 Predation /...
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...as equity and debt. It is a common thing for a company has a debt and equity. For example, a company has 30% of equity-financed and 90% of debt-financed; the ratio of debt over total financing is the leverage of a company (Capital Structure 2015). Capital structure can be explained through the theory such as trade-off theory, pecking-order theory and agency cost. However, capital structure might be more complicated in reality. According to Miller’s model, a company’s value is independent. A leveraged company of the cost of the equity is a company without leverage of the cost of equity plus the premium for financial risk (Capital Structure 2015). This shows that a raise of leverage and the individual risks is influenced between the investors but the total risk is retained. It means that it does not create any extra value. In real life, an imperfections market of capital structure might occurred, so, the theories of capital structure such as trade-off theory and pecking-order theory has been...
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...value of the firm. The fundamental conditions under which a firm’s leverage becomes irrelevant to its market value, hence the MM proposition hold includes: * No taxation * No transaction costs exist * No default risk * Perfect and frictionless markets * Firms and investors can borrow at the same interest rate The MM theorem might seem extraneous but it provides cornerstone for corporate finance. However, the classic question “How do firms choose their capital structure?” remain unanswered. In finance, the term ‘capital structure’ refers to the technique followed by corporations to finance its assets through combination of equity, debt, or hybrid securities [2]. In simple terms, a firm's capital structure is the symphony of its liabilities. For example, a firm that possesses $40 billion in equity and $60 billion in debt is said to be 40% equity-financed and 60% debt-financed. The firm's ratio of debt to equity that is 60% is referred to as the ‘firm's leverage’. Leverage and Gearing are two terms that are often used interchangeably, gearing ratio is the proportion of the capital employed by the firm which comes from outside of the business finance, e.g. by taking a short term loan etc. In reality, capital structure may be highly complex and include dozens of sources. There are different factors that affect a firm's capital structure, and a firm should attempt to determine the optimal mix of financing....
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...Chapter 13 Capital Structure and Leverage LEARNING OBJECTIVES After reading this chapter, students should be able to: • Explain why capital structure policy involves a trade-off between risk and return, and list the four primary factors that influence capital structure decisions. Distinguish between a firm’s business risk and its financial risk. Explain how operating leverage contributes to a firm’s business risk and conduct a breakeven analysis, complete with a breakeven chart. Define financial leverage and explain its effect expected EPS, and the risk borne by stockholders. on expected ROE, • • • • • Briefly explain what is meant by a firm’s optimal capital structure. Specify the effect of financial leverage on beta using the Hamada equation, and transform this equation to calculate a firm’s unlevered beta, bU. Illustrate through a graph the premiums for financial risk and business risk at different debt levels. List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure. List a number of factors or practical considerations firms generally consider when making capital structure decisions. Briefly explain the extent that capital structure varies across industries, individual firms in each industry, and different countries. • • • • Learning Objectives: 13 - 1 LECTURE SUGGESTIONS ...
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...Notes 9: Expansion Decisions Objectives: To review analytical techniques used to justify expansion decisions To compare and contrast the NPV and APV methods of analysis Nature of expansion decisions Expansion cash flows Valuation alternatives: NPV; APV Derivation of NPV model Derivation of APV model Capital structure issues Topics: Initial Capital investment Additional Capital investment For replacement and expansion - $ FCF FCFs are a function of value chain and industry economics Expansion FCFs are incremental to the base case and are attributable to the project. Because they include incremental revenues the full NPV equation is used to accept (accept if NPV>0) If we are using the EBIT formulation for estimating FCF we have: FCF= (EBIT)(1-T) + T(CCA) + NWC + Capex The cash flow elements to be estimated are: • net operating cash flows after tax (a.k.a. NOPAT, net operating profit after tax)(EBIT)(1-T) • the tax shield on Capital Cost TCCA • Incremental net working capital requirements NWC • incremental long-term assets Capex. At the end of the study period we also have estimates of cash inflow from sale of residual assets (RV), or the present value of FCFs which extend beyond the study period called continuing value (CV) RSM 2301 Financial Management - Fall 2011 © Asher Drory All rights reserved 9- 3 Valuation Alternatives: NPV vs. APV Models Net Present Value (NPV) NPV Expansion Decisions...
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...Chapter 12 Leverage and Capital Structure Solution to Problems P12-1. LG 1: Breakeven Point–Algebraic Basic FC (P − VC) $12, 350 Q= = 1, 300 ($24.95 − $15.45) Q= P12-2. LG 1: Breakeven Comparisons–Algebraic Basic (a) Q = FC (P − VC) Q= Q= Q= $45, 000 = 4, 000 units ( $18.00 − $6.75) $30, 000 = 4, 000 units ( $21.00 − $13.50 ) $90, 000 = 5, 000 units $30.00 − $12.00 ) ( Firm F: Firm G: Firm H: (b) From least risky to most risky: F and G are of equal risk, then H. It is important to recognize that operating leverage is only one measure of risk. P12-3. LG 1: Breakeven Point–Algebraic and Graphic Intermediate (a) Q = FC ÷ (P − VC) Q = $473,000 ÷ ($129 − $86) Q = 11,000 units 302 Part 4 Long-Term Financial Decisions (b) Graphic Operating Breakeven Analysis 3000 Profits Breakeven Point Sales Revenue Total Operating Cost 2500 2000 Cost/Revenue ($000) Losses 1500 1000 500 Fixed Cost 0 0 4000 8000 12000 16000 20000 24000 Sales (Units) P12-4. LG 1: Breakeven Analysis Intermediate (a) Q = $73, 500 = 21, 000 CDs ( $13.98 − $10.48) (b) Total operating costs = FC + (Q × VC) Total operating costs = $73,500 + (21,000 × $10.48) Total operating costs = $293,580 (c) 2,000 × 12 = 24,000 CDs per year. 2,000 records per month exceeds the operating breakeven by 3,000 records per year. Barry should go into the CD business. (d) EBIT = (P × Q) − FC − (VC × Q) EBIT = ($13.98 × 24,000) − $73,500 − ($10.48 × 24,000) EBIT = $335,520 − $73,500...
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...developed a proposal on “Capital Structure Determinants of the Pharmaceutical Companies in Bangladesh: A study in Incepta pharmaceutical Company Limited”. The proposal will focus on the steps of research through several variables. The main findings of the research will be to find out the determinants of capital structure and find the most vital one through statistical analysis and interpretation. I highly appreciate you for creating such opportunity to work on the selected subject. The outcome of the research will help us to concentrate deeply in evaluating pharmaceutical companies in respect of capital structure and corporate strategies. Sincerely Ronald Halder ID – M 0910013 M.B.A 10th batch EXECUTIVE SUMMARY Determining the optimal capital structure is one of the most fundamental policy decisions faced by financial...
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...Comments: The case provides an excellent vehicle for exploring and challenging the notion of optimal capital structure in theory and practice. American Home Products (AHP) is a very successful firm that has not debt in its capital structure. Because of its efficiency in asset management and its high level of profitability, AHP does not need debt to finance its operations. The case focuses on the theory of optimal capital structure and the practical problem of determining an optimal debt ratio. Questions 1. How much business risk does American Home Products face? Some of the pros/cons affecting AHP’s business risk are: PROS: • Sales stability, net sales has grown steadily from 1972-1981 • Strong Marketing expertise • Tight financial control • Stable, consistent financial growth and profitability • Risk aversion can work in favor of the company(no licensing costs, R+D costs) • Threat of new competitors is low because the pharmaceutical industry requires high start-up costs and the companies controlling the industry are very stable and mature. CONS: • Conservative Corporate Culture affect innovations • High cost in marketing to erode competitor’s head start. They are heavily depending on current products and marketing skills. But competitors can also strengthen their marketing strategies. • Hard to expand into new markets due to low R+D • Reticence does not provide confidence to the public • Threat of substitutes...
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...Msc Finance & Investment Core Course I: Corporate Finance & Value Creation Lecture 1 3 Modigliani & Miller (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’ 3 Modigliani & Miller 2 6 Modigliani and Miller 3 7 Modigliani & Miller – 1958 4 12 Fama & French (1998) ‘Taxes, Financing Decisions, and Firm Value’ 18 FAMA FRENCH 2 20 Fama & French 3 21 Fama & French – 1998 4 22 Graham (2000) ‘How Big Are the Tax Benefits of Debt?’ 25 GRAHAM (2000) 2 28 Graham 3 29 How big are the tax benefits of debt? John Graham – 2002 4 29 Lecture 2 32 Myers (1984) ‘The Capital Structure Puzzle’ 32 MYERS (1984) The Capital Structure Puzzle 2 36 Myers 3 39 The capital structure puzzle Myers – 1984 4 40 Andrade & Kaplan (1998) ‘How Costly is Financial (Not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distress’ 44 Kaplan 2 46 Andrade & Kaplan (1998) 3 51 Andrade & Kaplan – 1998 4 52 Lecture 3 56 Myers & Maljuf (1984) ‘Corporate Financing and Investment Decisions when Firms have Information that Investors Do Not Have’ 56 Myers and Majluf 2 61 Myers & Mailuf (1984) 3 66 Myers & Majluf – 1984 4 68 Frank & Goyal (2007) ‘Trade-off and Pecking Order Theories of Debt 74 Frank, Murray and Goyal, Vidhan 2 75 Frank & Goyal (2007) 3 83 Trade-off and pecking order theories of debt Frank & Goyal – 2007 4 85 Lecture 4 92 Ross (1977) ‘The Determination of Financial Structure: the Incentive-Signaling Approach’ 92 ROSS (1977)...
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...Part A: PROBLEM-SOLVING QUESTIONS (Answer all FOUR questions). This assignment is 20% of the total mark. 1. Suppose a 10-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading for a price of $1034.74. (10 Marks) a. What is the bond’s yield to maturity (expressed as an APR with semiannual compounding)? CPN = PMT = $40 = 1000/2*0.08 P = $1034, 74 N = 20 FV = $1000 Using Therefore y = 3,75 And APR = 7.5% b. If the bond’s yield to maturity changes to 9% APR, what will the bond’s price be? Using the formula above with y=4,5 P= $934,96 I don’t see the need of including the excel file as it is simple calculations 2. FastTrack Bikes, Inc. is thinking of developing a new composite road bike. Development will take six years and the cost is $200,000 per year. Once in production, the bike is expected to make $300,000 per year for 10 years. Assume the cost of capital is 10%. (10 Marks) a. Calculate the NPV of this investment opportunity, assuming all cash flows occur at the end of each year. Should the company make the investment? As the cash flows occur at the end of the year, being t the year we are calculation for the cash flow (R), when t=0 R=0. From t=1 to t=6, R=-200000$. After that, from t=7 to t=16, R=+300000$. Cost of capital, I, is 10% We need to use the Net Present Value decision rule. Using that formula in excel, NPV = $169482 As it is positive, the company should enter the investment. It would be like having...
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...Debt and Value: Beyond MillerModigliani Aswath Damodaran Stern School of Business Aswath Damodaran 1 The fundamental question: Does the mix of debt and equity affect the value of a business? Assets Existing Investments Generate cashflows today Includes long lived (fixed) and short-lived(working capital) assets Expected Value that will be created by future investments Assets in Place Debt Liabilities Fixed Claim on cash flows Little or No role in management Fixed Maturity Tax Deductible Growth Assets Equity Residual Claim on cash flows Significant Role in management Perpetual Lives Different Value? Different Financing Mix? Aswath Damodaran 2 Approaches to Valuation Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset. Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales. Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics. Aswath Damodaran 3 Valuation Models Asset Based Valuation Discounted Cashflow Models Relative Valuation Contingent Claim Models Liquidation Value Stable Replacement Cost Two-stage Three-stage or n-stage Current Equity Firm Sector Option to delay Option to expand Young firms Option to liquidate Equity in...
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...[pic] |1.1 PRELUDE | Financial Structure is the framework of various types of financing employed by a Oil company to acquire and support resources necessary for its operations, commonly, it comprises of stockholders’ investments, long- term loans, short-term loans and short-term liabilities as reflected on the right hand side of the Oil company balance sheet. Financial Structure is different from capital structure in the sense that it also includes current liabilities. Therefore, financial structure is the combination of two main components 1) Capital structure and 2) Current liabilities. To provide an understanding of the concept of financial structure in Oil sector specifically capital structure of Padma Oil Company Limited, the balance sheet, debt and equity, working capital, cost of capital and opportunity cost are need to be explained. The capital structure is how an Oil company finances its overall operations and growth by using different sources of funds. It is a mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered part of the capital structure...
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