Capital Structure Theory & Applications
|
|
- Kevin Nash
- 6 years ago
- Views:
Transcription
1 Capital Structure Theory & Applications Ruben D. Cohen Risk Architecture Citigroup, London 1
2 1. Introduction Background, Scope and Outline 2
3 Background What is capital structuring? Process of interchanging debt, equity and assets Why is it important? Enables one to optimize the value of a firm or its WACC by finding the best mix for the amounts of debt and equity on the balance sheet. Provides a signal that the firm is following proper rules of corporate finance to improve its balance sheet. This signal is central to valuations provided by market investors and analysts. Who is interested in it? Academics, because it is controversial and open ended Practitioners, because they use it for valuation, advisory and development and marketing of financial products & strategies 3
4 Scope Capital Structure Corporate Firms Financial Institutions No Default Risk (Classical M&M) With Default Risk No Default Risk With Default Risk Unconstrained Constrained 4
5 Outline 1. Introduction 2. Modigliani & Miller (paper 1) Derivation Implementation 3. Beta (paper 3) Definition Implementation within M&M (Hamada Equation) 4. Default risk & credit rating models 5. Incorporating default risk to get the OCS (paper 2) 6. Incorporating default risk into beta (paper 3) 7. Extending the OCS methodology to more ratios 8. Application to different scenarios M&A s Divestitures Share and debt issues and buybacks 9. Applying constraints (paper 4) 10. Case studies 11. Depository institutions (paper 5) 5
6 End Part 1 6
7 2. The Modigliani-Miller (M&M) Theorems Motivation & Methodology 7
8 Motivation Key Observation 1 EBIT [ EBIT Operating Income R D D ](1 T ) = or R (1 T ) = R D D (1 T ) + To debt holders E E R E E To equity holders Balance Sheet Firm s Value, D+E Income Statement EBIT Debt, D Equity, E Tax EBIT x (1-T) What if T = 100%? Discounted value of cash flows to bond and equity holders will be zero. Therefore, value implicit within IS will be ZERO! Does not match the firm s value of E + D from the BS. 8
9 Motivation Key Observation 2 Income Statement EBIT (1 T ) = R D D (1 T ) + EBIT R E E Tax EBIT x (1-T) R D D(1-T) R E E D(1-T) E Total Discounted Value derived from Income Statement 80 x (1-40%) + 52 = 100 Effectively, a capital of 100 is being used to operate a firm that s worth 132! Notion of efficiency appears in the ratio 100/132 9
10 Theory Key observations create a need to: 1. Reconcile the difference in valuations between the IS and the BS 2. Exploit the notion of efficiency in capital structure M&M achieves the 2 objectives Main assumptions - Aside from the typical, there are 3: 1. Simple corporate firm able to freely exchange generic debt, equity and assets 2. EBIT & Tax rate held constant as firm exchanges debt, equity and assets 3. No default risk, so that credit spread = 0 at all levels of leverage 10
11 The M&M Methodology Simplistic Derivation Income Statement Expected EBIT 20 Interest (at 5%) 4 EBT 16 Tax (at 40%) 6.4 Expected profit 9.6 Balance Sheet Assets 132 Debt 80 Equity 52 Total Debt & Equity 132 Income Statement Tax Paid EBIT EBIT x (1-T) R D D(1-T) R E E Total Discounted Value derived from Income Statement D x (1-T) + E operating capital 11
12 The M&M Methodology Proposition I Value implicit in the IS = D x (1-T) + E ( operating capital ) Total Firm s Value (FV) = D + E Reconciling Difference = D x T This difference is attributed to tax and debt. Leads to M&M s Proposition I In the absence of taxes, there are no benefits, in terms of value, to increasing leverage. In the presence of taxes, such benefits, by way of the interest tax shield, do accrue when leverage is introduced and/or increased. Could be exploited to increase the efficiency of the firm e.g. increase Tax, Debt or the product DT. Tax is difficult to control, but debt could be increased. 12
13 Operating capital The M&M Methodology Proposition II If FV = D + E And the value added due to debt = D x T Then the remainder, D x (1-T) + E, must represent the unlevered value of the firm and is a constant, equal to E 0 = V U Recall: EBIT(1-T) = R D D(1-T) + R E E R U EBIT(1 T ) D(1 T ) + E = RDD(1 T ) D(1 T ) + E + REE D(1 T ) + E Defining φ = D/E & solving for R E gives M&M s Proposition II R E = R U + ( R R )(1 T )φ U D 13
14 The M&M Methodology in Practice Creating the FV Curve Step 1 Question: Consider the firm has D = 80 and E = 52. It wants to issue enough equity to buy back all debt and completely delever. How is this done according to M&M? Answer: We know ΔV = D x T = 80 x 40% = 32. Therefore to delever completely, the value of the allequity firm should be = 100. Achieved by issuing 48 in equity and selling off 32 in assets, totalling 80 - enough to buy back all debt. 14
15 The M&M Methodology in Practice Creating the FV Curve Step 2 Question: The firm is now fully debt free. It wants to borrow 20 to buy back some of its shares and, at the same time, purchase some assets. How is this done according to M&M? Answer: We know ΔV = D x T = 20 x 40% = 8, which raises the firm s value from 100 to 108. Therefore, with additional debt of 20 buy back 12 in equity and purchase 8 in assets. 15
16 The M&M Methodology in Practice A More Methodical approach Begin with the original financial statement Create table similar to the one below 1. Insert debt in increments 2. Populate with information that s readily available 16
17 The M&M Methodology in Practice A More Methodical approach Define WACC EBIT (1 T ) D + E = EBIT (1 T ) V + DT U ROE = Profit E and populate relevant cells 17
18 The M&M Methodology in Practice A More Methodical approach Calculate parameters for D = 0 Recall: at D = 0, all equity firm value E 0 = E + D(1-T) = *(1-40%) = 100 Insert in the appropriate row 18
19 The M&M Methodology in Practice A More Methodical approach Recall E+(1-T)D = 100 across all debt levels i.e. at D=20, E = 100-(1-40%)*20 = 88; D=40, E = 100-(1-40%)*40 = 76, etc. Streamline and automate the process * to finally populate all cells at different increments of D * If preferred, this could be done using the beta approach (Hamada s Equation). Either way, the results must be identical 19
20 The M&M Methodology Graphical Representation Equity, E Debt, D Value, E + D Leverage, % 150% ROE 13% 12% 11% WACC 100% 10% 9% 50% 0% Leverage, % 7% 6% Leverage,
21 Spreadsheet Demo M&M Methodology Demo spreadsheet M&M 21
22 End of Part 2 22
23 3. Beta 23
24 What is Beta? Defined as: β It is a measure of relative risk It depends on leverage. This comes through R E To obtain beta, plot R E - R f vs R M - R f Slope of fitted straight line is the beta Beta turns out to be independent of R f L R R E M R R f f Market risk premium 24
25 What is Beta? Example with R f = 5% beta β L R R E M R f R f 25
26 What is Beta? Example with R f = 20% beta β L R R E M R f R f 26
27 What is Beta? Example with R f = 0 beta β L R R E M R f R f 27
28 Alternative Approach to Capital Structure Analysis Using the Beta Incorporating Hamada s Equation 28
29 Important Relationships β L Hamada Equation U [ 1+ (1 T )] = β φ Valid only when the cost of debt, R D, is constant, independent of leverage (see paper 3) CAPM R E R D β R L P Can be derived from definition of WACC WACC = RE RDφ(1 T ) + 1+ φ 1+ φ 29
30 Implementation D E D/E β ROE WACC % 12.0% % 11.1% % 10.3% % 9.7% % 9.1% % 8.6% % 8.1% % 7.7% % 7.3% 30
31 Implementation Populate E column using E = V U D(1-T) = 100 D(1-40%) D E D/E β ROE WACC % 12.0% % 11.1% % 10.3% % 9.7% % 9.1% % 8.6% % 8.1% % 7.7% % 7.3% 31
32 Implementation 1. Populate D/E column 2. Compute β U = β L 1+ φ(1 T ) = (1 40%) = 1.17 D E D/E β ROE WACC % 12.0% % 11.1% % 10.3% % 9.7% % 9.1% % 8.6% % 8.1% % 7.7% % 7.3% 32
33 Implementation Populate rest of beta: β = β [ 1+ φ(1 T )] L U D E D/E β ROE WACC % 12.0% % 11.1% % 10.3% % 9.7% % 9.1% % 8.6% % 8.1% % 7.7% % 7.3% 33
34 Implementation 1. Populate ROE: R E = R D + β R L P 2. Populate WACC: WACC = RE RDφ(1 T ) + 1+ φ 1+ φ D E D/E β ROE WACC % 12.0% % 11.1% % 10.3% % 9.7% % 9.1% % 8.6% % 8.1% % 7.7% % 7.3% 34
35 Comparison Beta approach D E D/E β ROE WACC % 12.0% % 11.1% % 10.3% % 9.7% % 9.1% % 8.6% % 8.1% % 7.7% % 7.3% Classical approach 35
36 Spreadsheet Demo M&M Methodology via Beta Demo spreadsheet M&M via beta 36
37 End of Part 3 37
38 4. Default Risk and Credit Rating Methodologies 38
39 Credit Risk and Credit Spread Some Facts The interest rate at which corporations can borrow money depends on the market s perception of the probability that they will not be able to pay back the debt. The premium for this rate above the risk-free interest rate is known as the credit spread. The credit spread, a direct measure of credit risk, is linked to the probability of default the recovery rate and The term of the loan The classification of credit risk into bands is known as credit rating. The banding follows AAA, AA, A, BBB, BB, B, CCC, CC, C and Default. Pluses and minuses are, in addition, used to add granularity within the different bands (i.e. A+, A-, etc.). 39
40 Credit Rating Models Credit agencies, the primary ones being S&P, Moody s and Fitch, use credit rating models to assess a firm s credit worthiness. These ratings are then binned into categories tabulated below: Rating Investment Grade Financial Capacity AAA Yes Extremely Strong AA Yes Very Strong A Yes Strong BBB Yes Adequate BB & No Weak CRM s are generally complex and inputs to them are both statistical and subjective, involving historical, as well as forward-looking, elements 40
41 Assessing the Risk of Default Different Credit Rating Methodologies There are three main classes of quantitative CRM s, which are used most widely. They are derivatives of: Ratio-driven models S&P Fitch Z Score Merton model There are also other types, which are hybrids 41
42 The S&P Model Key Ratios 42
43 The S&P Model Rating of the Key Ratios 43
44 The S&P Model How it works Interest Cover Rating 0.42 C 0.69 CC 1.02 CCC 1.62 B 2.25 BB 2.75 BBB 4.87 A 7.50 AA AAA D/EBITDA Rating 0.00 AAA 0.60 AA 1.20 A 3.30 BBB 4.50 BB 5.60 B 6.20 CCC 7.50 CC 9.04 C D/E Rating 0.00 AAA 0.41 AA 0.63 A 1.60 BBB 2.50 BB 4.17 B 6.67 CCC 9.95 CC C Income Statement EBITDA 23 D&A -3 EBIT (1) 20 Gross interest expense -4.0 EBT 16.0 Tax -6.4 Net profits 9.6 Balance Sheet Assets 132 Shareholders' equity 52 IB debt 80 Total liab. & equity 132 Ratios EBIT Interest cover 4.04 D/EBITDA 3.48 D/E 1.54 Convert to Credit Spread Ratios EBIT Interest cover A- D/EBITDA BBB D/E BBB+ Final Rating Average raw rating = BBB+ Subjective inputs Comprehensive description available at: me/corporateratings_2006.pdf?vregion=ap&vlang=en Rating Spread C 7.50% CC 6.00% CCC 5.00% B 3.25% BB 2.00% BBB 1.50% A 1.00% AA 0.50% AAA 0.20% 44
45 S&P Model Worked Example with One Ratio 45
46 S&P Model Worked Example with One Ratio Income Statement EBITDA 25 D&A -5.0 EBIT 20 Other income 0.0 Gross interest expense -5.0 EBT 15.0 Tax -6.0 Net profits 9.0 Balance Sheet Assets 132 Shareholders' equity 52 IB debt 80 Total liab. & equity 132 Assume the S&P CRM depends on a single ratio, i.e. interest coverage ratio = EBIT/interest expense, 1. Given current FS, we can calculate: Interest rate Interest cover Effective rating from table Credit Spread Risk-free rate 2. Evaluate interest rates, effective ratings, credit spreads at different values of leverage (this table is needed to create the WACC or FV curves) 46
47 Necessary Data f?vregion=ap&vlang=en 47
48 Necessary Data 48
49 S&P Model Worked Example with One Ratio Cont d Curve Fit for Spread vs Rating Rating Spread 0 *** 1 CCC 13.75% 2 CCC+ 3 B- 7.75% 4 B 4.50% 5 B+ 3.75% 6 BB- 2.90% 7 BB 2.10% 8 BB+ 1.33% 9 BBB- 1.21% 10 BBB 1.49% 11 BBB+ 1.07% 12 A- 0.88% 13 A 0.75% 14 A+ 0.65% 15 AA- 0.55% 16 AA 0.50% 17 AA+ 0.40% 18 AAA- 19 AAA 0.30% Numerical Rating 100.0% % y = E-01e E-01x Spread 1.0% 0.1% 49
50 S&P Model Worked Example with One Ratio Cont d TABLE I Income Statement EBITDA 25 D&A -5.0 EBIT 20 Other income 0.0 Gross interest expense -5.0 EBT 15.0 Tax -6.0 Net profits 9.0 Balance Sheet Assets 132 Shareholders' equity 52 IB debt 80 Total liab. & equity 132 TABLE II Input/Output Parameters Effective tax rate 40% Pre-tax cost of debt 6.25% Implied spread 1.74% Implied risk-free rate 4.51% Curve fitted Assume the S&P CRM depends on a single ratio, i.e. interest coverage ratio = EBIT/interest expense, 1. Calculate: Interest rate = 5/80 = 6.25% Interest cover = 20/5 = 4.0 Effective rating from table = BBB- Credit Spread = 1.74% (from curve fit) Risk-free rate = 6.25%-1.74% = 4.51% 2. Evaluate interest rates, effective ratings, credit spreads at different values of leverage 50
51 S&P Model Worked Example with One Ratio Cont d ICR = 4.0, Interest rate = 6.25%, spread = 1.74% Create table (this table is needed to create the WACC or FV curves) D spread(1) ICR Rating spread(2) Interest rate Implied Rating % % 4.75% AAA % % 4.75% AAA % % 4.75% AAA % % 5.04% AA % % 5.30% A % % 5.30% A % % 5.47% A % % 5.68% BBB % % 5.94% BBB % % 6.25% BBB % % 6.25% BBB % % 6.63% BB % % 6.63% BB % % 7.10% BB % % 7.67% BB- 51
52 S&P Model Worked Example with One Ratio Cont d Populate row D = 0 D spread(1) ICR Rating spread(2) Interest rate Implied Rating % % 4.75% AAA % % 4.75% AAA % % 4.75% AAA % % 5.04% AA % % 5.30% A % % 5.30% A % % 5.47% A % % 5.68% BBB % % 5.94% BBB % % 6.25% BBB % % 6.25% BBB % % 6.63% BB % % 6.63% BB % % 7.10% BB % % 7.67% BB- 52
53 S&P Model Worked Example with One Ratio Cont d Use iterative procedure Debt Cost of debt Factors & Ratios CRM Spread Implied Rating Calculated cost of Debt = R f + spread to populate row D = 8 D spread(1) ICR Rating spread(2) Interest rate Implied Rating % % 4.75% AAA % % 4.75% AAA % % 4.75% AAA % % 5.04% AA % % 5.30% A % % 5.30% A % % 5.47% A % % 5.68% BBB % % 5.94% BBB % % 6.25% BBB % % 6.25% BBB % % 6.63% BB % % 6.63% BB % % 7.10% BB % % 7.67% BB- 53
54 S&P Model Worked Example with One Ratio Cont d Populate remainder of table using the same iterative procedure: Debt Cost of debt Factors & Ratios CRM Spread Implied Rating Calculated cost of Debt = R f + spread D spread(1) ICR Rating spread(2) Interest rate Implied Rating % % 4.75% AAA % % 4.75% AAA % % 4.75% AAA % % 5.04% AA % % 5.30% A % % 5.30% A % % 5.47% A % % 5.68% BBB % % 5.94% BBB % % 6.25% BBB % % 6.25% BBB % % 6.63% BB % % 6.63% BB % % 7.10% BB % % 7.67% BB- 54
55 Z-Score Model Based on regression analysis of ratios Define: 55
56 Z-Score Model Implementation Historical Statistics show that for manufacturers, non-manufacturer industrials, and emerging market credits the following relationship holds within reason: Z = 6.56X X X X 4 56
57 Z-Score Model US Bond Rating Equivalent Based on Z Score Model 57
58 Merton s Model Question: Borrow $D today to start a business. Interest is paid throughout the year and the loan is to be paid back at the end of one year. If the business were to sell its assets after one year to pay off the loan, would the amount be sufficient to cover it ( $D)? Portrayed as: Asset Volatility Today One year from today Similarity to option-pricing concept: Debt obligation strike price Asset market value & volatility Share price & volatility Probability of default Area under curve behind D 58
59 Comparison Ratios/Scoring Need calibration Incorporate more variables More dependent on historical information Probability of default computed indirectly Appear to involve more steps to get to the rating Heavy dependence on financial statement inputs More easily applied to private firms. Merton May not need calibration Incorporates less variables Less dependent on historical information Probability of default computed directly Less steps and more direct Involves primarily market variables Difficult to apply to private firms. 59
60 End of Part 4 60
61 5. Incorporating Default Risk 61
62 Impact of Default Risk on Capital Structure Incorporation into the Model and Optimization of Capital Structure 62
63 Impact of Default Risk 1. Leads to credit spread 2. Gives an optimal capital structure 3. Idea: tax benefits and default risk work against each other, taking FV-vs-leverage curve through a maximum or the WACC through a minimum 4. Approach identical to classical M&M, but must take into account the credit spread due to default risk 63
64 Optimization of the Capital Structure 1. Objective is to locate the optimal capital structure 2. By classical definition, minimum WACC is where the optimal capital structure occurs 3. Recall: WACC EBIT (1 T ) D + E 4. Since EBIT x (1-T) = constant by assumption, then max(e + D) and min(wacc) occur at exactly the same leverage 5. The rest is based on the principle of maximizing the firm s value rather than minimizing the WACC 64
65 Procedure Requirements 1. Need a credit-rating model to calculate credit spreads along the curve Can use any This work utilises the S&P approach, which is based on ratios 2. Important to recall that D * x (1-T) + E = constant was derived based on the default-free scenario (classical M&M), where D * is the default-free debt 3. Must accordingly adjust the BS debt when there is credit risk. Adjustment of the form: * R D = D D R * D 4. With this adjustment, procedure becomes identical to classical M&M s 65
66 Procedure Flowchart Original Financial Statement: With default risk Convert to no-default scenario Apply M&M methodology to obtain FV curve Convert back to default case Final Output FV curve with default Income Statement EBIT 20 Gross interest expense -5.0 EBT 15.0 Tax -6.0 Net profits 9.0 Balance Sheet Assets 132 Shareholders' equity 52 IB debt 80 Total liab. & equity 132 D * R R = D * D D D = R R * D D D * OCS
67 Procedure Begin with original financial statement: With default risk 67
68 Procedure Step-by-Step Produce table in the following form Fill in cells using the financial statement 68
69 Procedure cont d Need CRM Fill in remaining cells in the same row (Note: D* = 6.25%/4.51% 80 = 110.7) Ratio1 Rating Spread *** CCC 13.75% B 4.50% BB 2.10% BBB 1.49% A 0.75% AA 0.50% AAA 0.30% Or use curve-fitted 69
70 Procedure cont d Calculate V U = E 0 = D * x(1-t)+e = (1 0.4) + 52 = Populate first row at D = 0 70
71 Procedure cont d Populate next row via the following iteration scheme: Debt Cost of debt Factors & Ratios CRM Spread Implied Rating Calculated cost of Debt = R f + spread 71
72 Procedure cont d And so on... 72
73 Procedure Illustration Firm's Value (FV) 'Risk-Free' Value, V* Classical M&M Loss in value due to credit risk OCS
74 End of Part 5 74
75 6. Incorporating Default Risk into Beta Generating the WACC Curve via the Modified Hamada Equation 75
76 Important Relationships Recall β L R R * + β R D E Hamada Equation U [ 1 (1 )] * + T = β φ L P Valid only when interest rates are constant, independent of leverage. Therefore, must modify D/E to account for credit spread. WACC = RE RDφ(1 T ) + 1+ φ 1+ φ 76
77 Procedure Step-by-Step Create table with the following format Fill in cells using information from financial statement 77
78 Procedure Step-by-Step Calculate risk-free rate using earlier procedure Populate D*, D*/E, β, ROE, WACC using formulas (Note: D* = 6.25%/4.51% 80 = 110.7) 78
79 Compute βu using D*/E rather than D/E Procedure Step-by-Step L [ 1+ φ (1 T )] Compute V u = E + D*x(1-T) = x(1-40%) = Populate row for D = 0 β U = β 2.13 = (1 40%) 52 * =
80 Procedure Step-by-Step Populate remaining rows using same methodology as before 80
81 Comparison WACC computed using beta WACC computed the direct way Shouldn t make any difference! 81
82 End of Part 6 82
83 7. Incorporating More Ratios 83
84 How It Works Interest Cover Rating 0.42 C 0.69 CC 1.02 CCC 1.62 B 2.25 BB 2.75 BBB 4.87 A 7.50 AA AAA D/EBITDA Rating 0.00 AAA 0.60 AA 1.20 A 3.30 BBB 4.50 BB 5.60 B 6.20 CCC 7.50 CC 9.04 C D/E Rating 0.00 AAA 0.41 AA 0.63 A 1.60 BBB 2.50 BB 4.17 B 6.67 CCC 9.95 CC C Income Statement EBITDA 23 D&A -3 EBIT (1) 20 Gross interest expense -4.0 EBT 16.0 Tax -6.4 Net profits 9.6 Balance Sheet Assets 132 Shareholders' equity 52 IB debt 80 Total liab. & equity 132 Ratios EBIT Interest cover 4.04 D/EBITDA 3.48 D/E 1.54 Convert to Credit Spread Ratios EBIT Interest cover A- D/EBITDA BBB D/E BBB+ Final Rating Average raw rating = BBB+ Subjective inputs Rating Spread C 7.50% CC 6.00% CCC 5.00% B 3.25% BB 2.00% BBB 1.50% A 1.00% AA 0.50% AAA 0.20% 84
85 Spreadsheet Example Note that the S&P CRM depends on 8 or 9 ratios. Previous example involved a single ratio - interest cover. A working spreadsheet with 3 ratios: ICR, Cash Flow and Leverage Demo spreadsheet 3 ratios 85
86 End of Part 7 86
87 8. Application to Scenarios M&A (acquisition) Divestiture Share and debt issues and buybacks 87
88 Extension to Other Scenarios 1. Spreadsheet Demo for M&A (Acquisition) M&A 88
89 Extension to Other Scenarios 2. Spreadsheet Demo for Divestiture Divestiture 89
90 Extension to Other Scenarios 3. Spreadsheet Demo for Share and Debt Issues and Buybacks Share & debt sale & buyback 90
91 End of Part 8 91
92 9. Applying Constraints 92
93 Applying Constraints To get to the OCS (max FV) from current, issue 43 units in E to buy back 32 units of debt and purchase an additional 11 of assets. Question: What if no suitable assets were available for purchase or there was a preference instead for a 1:1 share buy back? Constrains the firm to follow FV = const. This moves the firm on the FV curve, along which V U = const, towards the OCS. With no apparent maximum in the firm s value, how is the optimal capital structure determined??? 93
94 Finding the OCS under Constraints Every point along the E+D = const. line will have a unique V U associated with it (because V U varies with leverage) Obtain the locus of V U s and the OCS falls where the ratio V U /FV is minimised FV = constant 120 Vu min Vu 110 Unique unlevered values associated with each FV Leverage, D/E point
95 Finding the OCS under Constraints OCS occurs at min V U /FV FV = constant FV = E + D OCS OCS Ratio Vu/FV
96 On the Side Recall From Part 2 (derivation of classical M&M) EBIT x (1-T) operating income R D D(1-T) R E E Total Discounted Value derived from Income Statement D x (1-T) + E operating capital = unlevered value = V u Outcome: operating income operating capital i.e. EBIT(1-T) = R u V u where R u is a proportionality constant (see Part 2) 96
97 On the Side Implications on the S&P CRM The S&P CRM contains ratios that involve the EBIT EBiT interest cover and D-to-EBITDA, among others Therefore in constrained cases, where V u varies with leverage, one must take into account the impact of this variation on the EBIT. Once this is accounted for, the ratios containing EBIT and EBITDA could subsequently be adjusted. Output EBITDA, EBIT, D, E, T, CRM spread V u Until convergence 97
98 Finding the OCS under Constraints Possible Scenarios 1 & 2 Scenario 1: Firm wants to follow Vu = const = 130, as per M&M s methodology. Scenario 2: The firm wants to keep the equity level constant at 52 and exchange debt with assets (raise debt to buy assets or sell assets to buy back debt. D/E=154% D E Vu V D/E=51% D/E=92% 98
99 Finding the OCS under Constraints Possible Scenarios 3 & 4 Scenario 3: Firm wants to follow FV = const = 132 by exchanging debt for equity and vice versa at 1:1. Scenario 4: The firm wants to keep the debt level constant at 80 and exchange equity with assets (issue equity to buy assets or sell assets to buy back equity. D/E=57% D/E=51% 99
100 Finding the OCS under Constraints Results Summary Capital Structure Curve All 3 cross here Cosntant D Cosntant E Cosntant V In general, any type of constraint could be created by combining the above. 100
101 Finding the OCS under Constraints Results Summary - Table Scenario Current leverage, D/E Leverage at OCS 1. Const V u at 130 (M&M) % 2. Const E at % 3. Const FV at % 4. Const D at % 101
102 Applying Constraints Spreadsheet Demonstration E = constant Const E 102
103 Applying Constraints Spreadsheet Demonstration FV = constant Const V 103
104 Applying Constraints Spreadsheet Demonstration D = constant Const D Const D - continuous 104
105 End of Part 9 105
106 10. Case Studies 106
107 Dealing with the Financial Statement I.S. B.S. Revenues Needed for M&M analysis Liabilities & Equity Non-IB liabilities Interest-bearing liabilities (IB debt) equity (Market value) Costs & Expenses EBITDA D&A EBIT Gross interest on IB debt EBT Tax Needed for CRM Needed for M&M analysis Profits 107
108 Case Studies by Company Procter & Gamble (USA) Coca-Cola (USA) Nestlé Group (Switzerland) Electrolux (Sweden) Walt Disney Company (USA) Telenor ASA (Norway) Henkel (Germany) 108
109 Company Analysis Procter & Gamble 109
110 Company Analysis Procter & Gamble Income Statement EBIT Interest* Other inc. Tax *Capital lease charge are generally to be included in gross interest. In this case, it is negligible. 110
111 Company Analysis Procter & Gamble Liabilities* ST IB Debt LT IB Debt *Capital leases are generally to be included in the balance sheet. In this case, they are negligible. 111
112 Company Analysis Procter & Gamble ME and BE BV of Equity Market cap = USD205B Ratio BV/MV =
113 Company Analysis Procter & Gamble Cash Flow Dep & Amort 113
114 Company Analysis Procter & Gamble Input into the Model EBITDA 16,014+3,130 = 19,144 D&A -3,130 EBIT+other income Interest EBT 15,274 Tax (Tax rate) Profit 10,906 15, = 16,014-1,304 (capital lease charge negligible) 4,370 4,370/15,274=28.6% IB Debt 23,375+12,039 = 35,414 (capital lease negligible) B Equity 66,760 BV/MV 0.33 Company name PG:US TABLE I Income Statement EBITDA 19,144 D&A -3,130 EBIT 16,014 Other income 564 Gross interest expense -1,304 EBT 15,274 Tax -4,368 Net profits 10,906 Balance Sheet Assets 240,829 IB debt 35,414 Book equity 66,760 Market equity 205,415 Total liab. & market equity 240,829 TABLE II Input/Output Parameters Effective tax rate 29% Book-to-Market Equity
115 Company Analysis Procter & Gamble Model Output 115
116 Application Spreadsheets PG case study (classical) PG const V PG const E 116
117 PG Comparison Vu/V D/E PG M&M PG Const. V PG Const. E
118 Company Analysis The Coca-Cola Company 118
119 Company Analysis Coca-Cola Income Statement EBIT Interest Other income *Capital lease charge are generally to be included in gross interest. In this case, it is negligible. 119
120 Company Analysis Coca-Cola Liabilities & Equity* ST IB Debt LT IB Debt Book Equity Market cap = USD137B Ratio BV/MV = 0.16 *Capital leases are generally to be included in the balance sheet. In this case, there are none. 120
121 Company Analysis Coca-Cola Cash Flow Dep & Amort 121
122 Company Analysis Coca-Cola Input into the Model EBITDA 7,252+1,163 = 8,415 D&A -1,163 EBIT+other income 7,252+ ( ) Interest -456 EBT 7,873 Tax (Tax rate) 1,892 1,892/7,873 = 24% Profit 5,981 IB Debt 5, ,277 = 9,329 B Equity 21,744 BV/MV
123 Company Analysis Coca-Cola Model Output 123
124 Application Spreadsheets Coca-cola case study 124
125 Company Analysis Nestlé Group NESN-VX 125
126 Company Analysis Nestlé Group NESN-VX Income Statement EBIT Other Income See Notes 126
127 Company Analysis Nestlé Group NESN-VX Note 3 & 5 on Interest and Tax Interest* * Negligible capital lease charge. Tax 127
128 Company Analysis Nestlé Group NESN-VX Liabilities* ST IB Debt LT IB Debt *Capital leases negligible. 128
129 Company Analysis Nestlé Group NESN-VX Equity at Market Value MV of Equity Ratio BV/MV = 0.28 BV of Equity 129
130 Company Analysis Nestlé Group NESN-VX Cash Flow Dep & Amort Unusual 130
131 Company Analysis Nestlé Group NESN-VX Input into the Model Spreadsheet EBITDA 14,434+3,211 = 17,645 D&A 2, = 3,211 EBIT+other income Interest -1,481 EBT 13,529 Tax (Tax rate) Profit 9, = 15,010 3,400 3,400/13,529 = 25% IB Debt 24,541+6,129 = 30,670 MV Equity 195,661 BV/MV 54,234/195,086 = 0.28 Company name NESN-VX TABLE I Income Statement EBITDA 17,645 D&A -3,211 EBIT 14,434 Other income 576 Gross interest expense -1,481 EBT 13,529 Tax -3,398 Net profits 10,131 Balance Sheet Assets 225,757 IB debt 30,671 Book equity 54,234 Market equity 195,086 Total liab. & market equity 225,757 TABLE II Input/Output Parameters Effective tax rate 25% Book-to-Market Equity
132 Company Analysis Nestlé Group NESN-VX Model Output 132
133 Application Spreadsheet Nestle case study 133
134 Company Analysis Electrolux 134
135 Income Statement Electrolux - P. 7 All figures in SEKm EBIT+other income See notes for Interest EBT See notes for tax 135
136 Income Statement Electrolux - Note 9 Interest Expense Interest 136
137 Income Statement Electrolux - Note 10 Tax 137
138 Balance Sheet Liabilities Electrolux - P. 11 All figures in SEKm BE LT debt ST debt 138
139 Other Useful Information Electrolux Credit Rating (p. 37) Market Cap (p. 76) 139
140 Company Analysis Electrolux Input into the Model EBITDA 4,475+2,738= 7,213 D&A -2,738 EBIT+other income Interest -650 EBT 4,007 Tax rate 32.8% Profit 1,054 4, = 4,657 IB Debt 4,887+,701 = 10,588 B Equity 16,040 BV/MV 16,040/34,000=
141 Company Analysis Electrolux Model Output Compare 141
142 Spreadsheet Demo Electrolux case study 142
143 Company Analysis The Walt Disney Company 143
144 Company Analysis Disney Income Statement For interest expense, see notes For tax see notes EBT 144
145 Company Analysis Disney D&A 145
146 Company Analysis Disney Gross Borrowings *Capital leases negligible 146
147 Company Analysis Disney Income Taxes EBT Total tax paid 147
148 Company Analysis Disney Gross Interest Expense *Capital lease charges, negligible 148
149 Company Analysis Disney Shareholders Equity BV of Equity MV of equity (market cap) = USD 65B 149
150 Company Analysis Disney Input into the Model EBITDA 9,962 D&A -1,491 EBIT+other income 7, =8,471 Interest -746 EBT 7,725 Tax (Tax rate) 3,001 3,001/7725=39% Profit 4,724 IB Debt 15,172 B Equity 30,753 BV/MV = 30,753/65,000 =
151 Company Analysis Disney Model Output See p
152 Application Spreadsheet Disney case study 152
153 Company Analysis Telenor ASA 153
154 Company Analysis Telenor Income Statement D&A For interest see notes EBT For tax see notes 154
155 Company Analysis Telenor Interest & Tax Interest Tax 155
156 Company Analysis Telenor Equity & IB Debt Market cap = NOK180,
157 Company Analysis Telenor Input into the Model EBITDA 19,971+14, = 36,954 D&A -14,333 EBIT+other income 22,621 Interest -2,650 EBT 19,971 Tax (Tax rate) 3,782 3,782/19,971=19% Profit 16,189 IB Debt 39,725+7,521 = 47,249 B Equity 74,655 BV/MV 74,655/180,000 =
158 Company Analysis Telenor Model Output See p
159 Application Spreadsheet Telenor case study 159
160 Company Analysis Henkel 160
161 Company Analysis Henkel Input into the Model EBITDA 1, =1,681 D&A 337 EBIT+other income 1, =1,591 Interest -269 EBT 1,250 Tax (Tax rate) /1250=25% Profit 941 IB Debt 3,142 B Equity 5,643 BV/MV =5,643/5,010 =
162 Company Analysis Henkel Model Output 162
163 Application Spreadsheet Henkel case study 163
164 Comparison Capital Structure & Rating 250, , , , , , , ,000 P&G 170, , , , , , , , , ,000 Coca-Cola 130, , , , , , ,000 Nestlé 170, ,000 45,000 44,000 43,000 42,000 41,000 40,000 39,000 38,000 Electrolux 37,
165 Comparison Capital Structure & Rating 82,000 80,000 78,000 76,000 Disney 74, ,300 8,200 8,100 8,000 7,900 7,800 7,700 7,600 7,500 Henkel 7, , , , , , ,000 Telenor 180, Firm Model rating S&P rating P&G A AA- Coca Cola AA- A+ Nestlé A AA Electrolux A- BBB+ Disney A+ A Telenor A BBB+ Henkel A- A 165
166 End of Part
167 11. Depository Institutions 167
168 Depository Institutions Seeking the Optimal Capital Structure 168
169 Depository Institutions A depository (or lending) institution is a simple bank that generates revenues from lending the assets on its BS. Tax Step1: R D D Step2:R E E Depositor/ Bond Investor D Depository Institution E Equity Investor D+E R T [D+E] Counterparty (Borrower) Income Statement Operating Income (at 5% of assets) 10 Interest paid (at 4%) -6 EBT 4 Tax (at 40%) -1.6 Net Profit 2.4 Balance Sheet Total Assets 200 Debt 150 Equity 50 Debt + Equity 200 Ratios Leverage, D/E 3 ROE, Net Profit/Equity 5% 169
170 Depository Institutions Main Differences with Corporate Firms Significantly more complicated than corporate firms because: Two entities, rather than one, are subject to credit/default Risk The Bank (as borrower from investors/depositors) and the Counterparty (as borrower from the Bank). The operating income (EBIT) of the bank is not constant, but varies with the size of its BS There are limits to lending In order to protect depositors and investors, banks cannot lend to the third party only what they borrow. A pre-determined amount of the money lent out must be equity. This amount of equity is dictated by certain regulatory capital ratios, determined by the borrower s risk rating and the size of the bank s BS. Above limitations create strong interdependence between bank and borrower 170
171 Depository Institutions M&M Treatment of a Simplified Financial Statement Income Statement Operating Income (at 5% of assets) 10 Interest paid (at 4%) -6 EBT 4 Tax (at 40%) -1.6 Net Profit 2.4 Balance Sheet Total Assets 200 Debt 150 Equity 50 Debt + Equity 200 Ratios Leverage, D/E 3 ROE, Net Profit/Equity 5% Operating income EBIT = R T (D+E) Interest expense = R D D Profit = R E E = [R T (D+E) - R D D] (1-T) EBIT(1 T) WACC = RT (1 T) = const. E + D IS Value = = R ( 1 T) + [ R R ] (1 T) φ R R T E T ( D + E)(1 T ) RDD(1 T ) = α R T D D REE + R E 171
172 Depository Institutions Fundamental Relationships R E = R ( 1 T ) + [ R R ] (1 T ) φ T T D Form of M&M s proposition II is preserved. EBIT (1 T ) WACC = RT (1 T ) = const E + D Inverse proportionality relation between WACC & FV is lost. R ( D + E)(1 T ) RDD(1 T ) RE E T = + = D(1 T ) E α R R + R T ( 1 T ) D(1 T ) E Tφ = const = + = 1 α D + E D + E 1+ φ D E Fundamental constant in this case is D/E, instead of D(1-T)+E 172
173 Depository Institutions Limitations To protect depositors/bond investors from borrowers risk, a bank s BS must adhere to certain limitations imposed on some of its financial ratios. Limitations are known as Regulatory Capital and the ratios involved are called Tier 1, Tier 2, etc., going down in order of importance. These are used to describe the capital adequacy of the bank and ensure that capital allocation is risk sensitive. Tier 1 capital is the core capital, which includes equity capital and disclosed reserves. Tier 2 capital is the secondary bank capital. It includes items such as undisclosed reserves, general loss reserves, subordinated debt, and more. These restrictions make the bank and borrower highly interdependent on each other and, thus, significantly complicate the analysis. 173
174 Depository Institutions Possible Cases Recall: EBIT (1 T ) WACC = RT (1 T ) = E + D const R E = R ( 1 T ) + [ R R ] (1 T ) φ T T D Case R T R D I Constant Constant Out: R D II III Constant Variable Variable Constant Depository Institution In: R T IV Variable Variable 174
175 Depository Institutions Case I - R T & R D constant R D Depository Institution R T 20% Ideal - Case i 10% R E 0% Leverage, φ = D/E WACC % 175
176 Depository Institutions Case II R T constant, R D variable with φ R D Depository Institution R T 20% 10% 0% -10% Return on Equity, RE Leverage, φ = D/E
177 Depository Institutions Impact of the Tier 1 Capital Restriction Definition - Tier 1 capital is the core capital. It includes equity capital and disclosed reserves. This is assigned a maximum limit of typically 8%. Applied to the simplified financial statement of a lender, lending assets E + D to a single borrower: T 1 E RWA = E r ( E + D) = 1 r (1 +φ) RWA = risk weighted assets r = risk weighting of borrower 177
178 Depository Institutions Relationship Between r and R T With T 1 = constant, above may be written as: r = 1 as φ T (1 + φ), r 1 Recall: r is the borrower s risk weighting. Therefore, as r, R T Combining: as φ, R T 178
179 Depository Institutions Case III R D constant, R T variable as φ R D Depository Institution R T 20% 10% (III) (I) (II) 0% -10% Return on Equity, RE Leverage, φ = D/E
180 Depository Institutions Case IV R D variable as φ, R T variable as φ R D Depository Institution R T 20% 10% (III) (I) (II) (IV ) 0% Return on Equity Leverage, φ = D/E % 180
181 Depository Institutions Case IV Impact of T 1 20% 4% Tier 1 = 4% Tier 1 = 8% Tier 1 = 12% 10% 8% 12% 0% -10% Return on Equity, RE Leverage, φ = D/E
182 Depository Institutions Where is the Optimal? Consider the most realistic case, being Case IV, where R D as φ and R T as φ : WACC is a decreasing function of leverage, φ. Note that not all T 1 s have a max at some finite leverage. Note that max R E does not coincide with min WACC. Etc., etc.,... 8% 6% R E 4% WACC 2% 0% Leverage, φ = D/E
183 Conclusions Reasons for complications Lender s risk Borrower s risk Interdependence between the two Discussed different scenarios Concluded that there is no straightforward way to define the OCS 183
184 End of Part
A Generalised Procedure for Locating the Optimal Capital Structure
A Generalised Procedure for Locating the Optimal Capital Structure Ruben D. Cohen Citigroup, London E14 5LB United Kingdom E-mail: ruben.cohen@citigroup.com Phone: +44(0)207 986 4645. Abstract: We present
More informationCorporate Finance. Dr Cesario MATEUS Session
Corporate Finance Dr Cesario MATEUS cesariomateus@gmail.com www.cesariomateus.com Session 4 26.03.2014 The Capital Structure Decision 2 Maximizing Firm value vs. Maximizing Shareholder Interests If the
More informationAFM 371 Winter 2008 Chapter 16 - Capital Structure: Basic Concepts
AFM 371 Winter 2008 Chapter 16 - Capital Structure: Basic Concepts 1 / 24 Outline Background Capital Structure in Perfect Capital Markets Examples Leverage and Shareholder Returns Corporate Taxes 2 / 24
More informationUsing Microsoft Corporation to Demonstrate the Optimal Capital Structure Trade-off Theory
JOURNAL OF ECONOMICS AND FINANCE EDUCATION Volume 9 Number 2 Winter 2010 29 Using Microsoft Corporation to Demonstrate the Optimal Capital Structure Trade-off Theory John C. Gardner, Carl B. McGowan Jr.,
More informationHandout for Unit 4 for Applied Corporate Finance
Handout for Unit 4 for Applied Corporate Finance Unit 4 Capital Structure Contents 1. Types of Financing 2. Financing Choices 3. How much debt is good? 4. Debt Benefits vs Costs 5. Approaches to arriving
More informationThe Optimal Capital Structure of Depository Institutions 1,2
The Optimal Capital Structure of Depository Institutions 1,2 Ruben D. Cohen 3 Citigroup 33 Canada Square, London E14 5LB Abstract We derive here a fundamental model for the capital structure of depository
More informationCHAPTER 15 CAPITAL STRUCTURE: BASIC CONCEPTS
CHAPTER 15 B- 1 CHAPTER 15 CAPITAL STRUCTURE: BASIC CONCEPTS Answers to Concepts Review and Critical Thinking Questions 1. Assumptions of the Modigliani-Miller theory in a world without taxes: 1) Individuals
More informationCHAPTER 8. Valuing Bonds. Chapter Synopsis
CHAPTER 8 Valuing Bonds Chapter Synopsis 8.1 Bond Cash Flows, Prices, and Yields A bond is a security sold at face value (FV), usually $1,000, to investors by governments and corporations. Bonds generally
More informationCapital Structure Decisions
GSU, Department of Finance, AFM - Capital Structure / page 1 - Corporate Finance Capital Structure Decisions - Relevant textbook pages - none - Relevant eoc-problems - none - Other relevant material -
More informationCHAPTER 8 CAPITAL STRUCTURE: THE OPTIMAL FINANCIAL MIX. Operating Income Approach
CHAPTER 8 CAPITAL STRUCTURE: THE OPTIMAL FINANCIAL MIX What is the optimal mix of debt and equity for a firm? In the last chapter we looked at the qualitative trade-off between debt and equity, but we
More informationHomework Solutions - Lecture 2
Homework Solutions - Lecture 2 1. The value of the S&P 500 index is 1312.41 and the treasury rate is 1.83%. In a typical year, stock repurchases increase the average payout ratio on S&P 500 stocks to over
More informationLoss of future financing flexibility
Loss of future financing flexibility 22 When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. Thus, if the firm is faced with an unexpected investment
More informationApplied Corporate Finance. Unit 4
Applied Corporate Finance Unit 4 Capital Structure Types of Financing Financing Behaviours Process of Raising Capital Tradeoff of Debt Optimal Capital Structure Various approaches to arriving at the optimal
More informationReading. Valuation of Securities: Bonds
Valuation of Securities: Bonds Econ 422: Investment, Capital & Finance University of Washington Last updated: April 11, 2010 Reading BMA, Chapter 3 http://finance.yahoo.com/bonds http://cxa.marketwatch.com/finra/marketd
More informationMGT Financial Management Mega Quiz file solved by Muhammad Afaaq
MGT 201 - Financial Management Mega Quiz file solved by Muhammad Afaaq Afaaq_tariq@yahoo.com Afaaqtariq233@gmail.com Asslam O Alikum MGT 201 Mega Quiz file solved by Muhammad Afaaq Remember Me in Your
More informationFUNDAMENTALS OF CREDIT ANALYSIS
FUNDAMENTALS OF CREDIT ANALYSIS 1 MV = Market Value NOI = Net Operating Income TV = Terminal Value RC = Replacement Cost DSCR = Debt Service Coverage Ratio 1. INTRODUCTION CR = Credit Risk Y.S = Yield
More informationCost of Capital. João Carvalho das Neves Professor of Corporate Finance & Real Estate Finance ISEG, Universidade de Lisboa
Cost of Capital João Carvalho das Neves Professor of Corporate Finance & Real Estate Finance ISEG, Universidade de Lisboa jcneves@iseg.ulisboa.pt Types of cost of capital that you need to address Cost
More informationConsistent valuation of project finance and LBO'susing the flows-to-equity method
Swiss Finance Institute Research Paper Series N 10 51 Consistent valuation of project finance and LBO'susing the flows-to-equity method Ian COOPER London Business School Kjell G. Nyborg Univeristy of Zurich
More informationTHE LEVERAGE FACTOR: How the Investor Can Profit from Changes in Corporate Risk. By J. D. Ardell
THE LEVERAGE FACTOR: How the Investor Can Profit from Changes in Corporate Risk By J. D. Ardell i 1. - Introduction: A Tale of Two Companies, or three, or four... 1 SECTION 1: THE THEORY OF CAPITAL STRUCTURE
More informationBond Ratings, Cost of Debt and Debt Ratios. Aswath Damodaran
Bond Ratings, Cost of Debt and Debt Ratios 49 Stated versus Effective Tax Rates You need taxable income for interest to provide a tax savings. Note that the EBIT at Disney is $10,032 million. As long as
More informationSolved MCQs MGT201. (Group is not responsible for any solved content)
Solved MCQs 2010 MGT201 (Group is not responsible for any solved content) Subscribe to VU SMS Alert Service To Join Simply send following detail to bilal.zaheem@gmail.com Full Name Master Program (MBA,
More informationChapter 12: Estimating the Cost of Capital
Chapter 12: Estimating the Cost of Capital -1 Chapter 12: Estimating the Cost of Capital Fundamental question: Where do we get the numbers to estimate the cost of capital? => How do we implement the CAPM
More informationFN428 : Investment Banking. Lecture 23 : Revision class
FN428 : Investment Banking Lecture 23 : Revision class Recap : Theory of Financial Intermediary An overview of Investment Banking Investment Bank vs. Commercial Bank Which are the various divisions of
More informationMGT201 Financial Management Solved MCQs A Lot of Solved MCQS in on file
MGT201 Financial Management Solved MCQs A Lot of Solved MCQS in on file Which group of ratios measures a firm's ability to meet short-term obligations? Liquidity ratios Debt ratios Coverage ratios Profitability
More informationMGT201 Financial Management Solved MCQs
MGT201 Financial Management Solved MCQs Why companies invest in projects with negative NPV? Because there is hidden value in each project Because there may be chance of rapid growth Because they have invested
More informationRisk, Return and Capital Budgeting
Risk, Return and Capital Budgeting For 9.220, Term 1, 2002/03 02_Lecture15.ppt Student Version Outline 1. Introduction 2. Project Beta and Firm Beta 3. Cost of Capital No tax case 4. What influences Beta?
More informationCorporate Finance. Dr Cesario MATEUS Session
Corporate Finance Dr Cesario MATEUS cesariomateus@gmail.com www.cesariomateus.com Session 3 20.02.2014 Selecting the Right Investment Projects Capital Budgeting Tools 2 The Capital Budgeting Process Generation
More informationAdvanced Corporate Finance. 3. Capital structure
Advanced Corporate Finance 3. Capital structure Objectives of the session So far, NPV concept and possibility to move from accounting data to cash flows => But necessity to go further regarding the discount
More informationValue Enhancement: Back to Basics
Value Enhancement: Back to Basics Aswath Damodaran NACVA Conference Aswath Damodaran 1 Price Enhancement versus Value Enhancement Aswath Damodaran 2 DISCOUNTED CASHFLOW VALUATION Cashflow to Firm EBIT
More information600 Solved MCQs of MGT201 BY
600 Solved MCQs of MGT201 BY http://vustudents.ning.com Why companies invest in projects with negative NPV? Because there is hidden value in each project Because there may be chance of rapid growth Because
More informationDisclaimer: This resource package is for studying purposes only EDUCATION
Disclaimer: This resource package is for studying purposes only EDUCATION Chapter 6: Valuing stocks Bond Cash Flows, Prices, and Yields - Maturity date: Final payment date - Term: Time remaining until
More informationAdvanced Corporate Finance. 3. Capital structure
Advanced Corporate Finance 3. Capital structure Practical Information Change of groups! A => : Group 3 Friday 10-12 am F => N : Group 2 Monday 4-6 pm O => Z : Group 1 Friday 4-6 pm 2 Objectives of the
More informationChapter 14 Capital Structure Decisions ANSWERS TO END-OF-CHAPTER QUESTIONS
Chapter 14 Capital Structure Decisions ANSWERS TO END-OF-CHAPTER QUESTIONS 14-1 a. Capital structure is the manner in which a firm s assets are financed; that is, the righthand side of the balance sheet.
More informationACF719 Financial Management
ACF719 Financial Management Bonds and bond management Reading: BEF chapter 5 Topics Key features of bonds Bond valuation and yield Assessing risk 2 1 Key features of bonds Bonds are relevant to the financing
More informationFinance 402: Problem Set 6 Solutions
Finance 402: Problem Set 6 Solutions Note: Where appropriate, the final answer for each problem is given in bold italics for those not interested in the discussion of the solution. 1. The CAPM E(r i )
More information15.414: COURSE REVIEW. Main Ideas of the Course. Approach: Discounted Cashflows (i.e. PV, NPV): CF 1 CF 2 P V = (1 + r 1 ) (1 + r 2 ) 2
15.414: COURSE REVIEW JIRO E. KONDO Valuation: Main Ideas of the Course. Approach: Discounted Cashflows (i.e. PV, NPV): and CF 1 CF 2 P V = + +... (1 + r 1 ) (1 + r 2 ) 2 CF 1 CF 2 NP V = CF 0 + + +...
More informationCapital Structure Management
MBA III Semester Capital Structure Management POST RAJ POKHAREL M.Phil. (TU) 01/2010) 1 What is Capital Structure? Definition The capital structure of a firm is the mix of different securities issued
More informationOPTIMAL CAPITAL STRUCTURE & CAPITAL BUDGETING WITH TAXES
OPTIMAL CAPITAL STRUCTURE & CAPITAL BUDGETING WITH TAXES Topics: Consider Modigliani & Miller s insights into optimal capital structure Without corporate taxes è Financing policy is irrelevant With corporate
More informationFinancing decisions (2) Class 16 Financial Management,
Financing decisions (2) Class 16 Financial Management, 15.414 Today Capital structure M&M theorem Leverage, risk, and WACC Reading Brealey and Myers, Chapter 17 Key goal Financing decisions Ensure that
More informationOptimal Capital Structure
Capital Structure Optimal Capital Structure What is capital structure? How should a firm choose a debt-toequity ratio? The goal: Which is done by: Which is done by: Financial Leverage Scenario A B C Market
More informationQuestion # 1 of 15 ( Start time: 01:53:35 PM ) Total Marks: 1
MGT 201 - Financial Management (Quiz # 5) 380+ Quizzes solved by Muhammad Afaaq Afaaq_tariq@yahoo.com Date Monday 31st January and Tuesday 1st February 2011 Question # 1 of 15 ( Start time: 01:53:35 PM
More informationHomework Solutions - Lecture 2 Part 2
Homework Solutions - Lecture 2 Part 2 1. In 1995, Time Warner Inc. had a Beta of 1.61. Part of the reason for this high Beta was the debt left over from the leveraged buyout of Time by Warner in 1989,
More informationPAPER No.: 8 Financial Management MODULE No. : 25 Capital Structure Theories IV: MM Hypothesis with Taxes, Merton Miller Argument
Subject Financial Management Paper No. and Title Module No. and Title Module Tag Paper No.8: Financial Management Module No. 25: Capital Structure Theories IV: MM Hypothesis with Taxes and Merton Miller
More informationChapter 15. Topics in Chapter. Capital Structure Decisions
Chapter 15 Capital Structure Decisions 1 Topics in Chapter Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence,
More informationFinance Recruiting Interview Preparation
Finance Recruiting Interview Preparation Discounted Cash Flows Session #3 This presentation is for informational purposes only, and is not an offer to buy or sell or a solicitation to buy or sell any securities,
More informationPage 515 Summary and Conclusions
Page 515 Summary and Conclusions 1. We began our discussion of the capital structure decision by arguing that the particular capital structure that maximizes the value of the firm is also the one that
More informationBond Prices and Yields
Bond Characteristics 14-2 Bond Prices and Yields Bonds are debt. Issuers are borrowers and holders are creditors. The indenture is the contract between the issuer and the bondholder. The indenture gives
More informationMIDTERM EXAM SOLUTIONS
MIDTERM EXAM SOLUTIONS Finance 40610 Security Analysis Mendoza College of Business Professor Shane A. Corwin Fall Semester 2007 Monday, October 15, 2007 INSTRUCTIONS: 1. You have 75 minutes to complete
More informationFCF t. V = t=1. Topics in Chapter. Chapter 16. How can capital structure affect value? Basic Definitions. (1 + WACC) t
Topics in Chapter Chapter 16 Capital Structure Decisions Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence,
More informationLeverage. Capital Budgeting and Corporate Objectives
Leverage Capital Budgeting and Corporate Objectives Professor Ron Kaniel Simon School of Business University of Rochester 1 Overview Capital Structure does not matter!» Modigliani & Miller propositions
More informationDiscounted Cash Flow Analysis Deliverable #6 Sales Gross Profit / Margin
Discounted Cash Flow Analysis Deliverable #6 The discounted cash flow methodology derives the value of a company by calculating the present value of all future projected cash flows. Unlike comparable companies
More informationFinancial Leverage and Capital Structure Policy
Key Concepts and Skills Chapter 17 Understand the effect of financial leverage on cash flows and the cost of equity Understand the Modigliani and Miller Theory of Capital Structure with/without Taxes Understand
More informationFINALTERM EXAMINATION Spring 2009 MGT201- Financial Management (Session - 2) Question No: 1 ( Marks: 1 ) - Please choose one What is the long-run objective of financial management? Maximize earnings per
More informationIntroduction to Financial Mathematics
Department of Mathematics University of Michigan November 7, 2008 My Information E-mail address: marymorj (at) umich.edu Financial work experience includes 2 years in public finance investment banking
More informationCHAPTER 19. Valuation and Financial Modeling: A Case Study. Chapter Synopsis
CHAPTER 19 Valuation and Financial Modeling: A Case Study Chapter Synopsis 19.1 Valuation Using Comparables A valuation using comparable publicly traded firm valuation multiples may be used as a preliminary
More informationFinancial Leverage: the extent to which a company is committed to fixed charges related to interest payments. Measured by:
Wk 11 FINS1613 Notes 13.1 Discuss the effect of Financial Leverage Financial Leverage: the extent to which a company is committed to fixed charges related to interest payments. Measured by: The debt to
More informationHow Private Equities Create Value. LBOs, Expansion deals and the future of PEs - Trends
How Private Equities Create Value LBOs, Expansion deals and the future of PEs - Trends 1 Contents - Introduction to Value Creation in PEs - LBOs - Operating Leverage - Financial Leverage - Recent trends
More informationFinancial reporting and analysis
Financial reporting and analysis CFA 二级重要知识点讲解 讲师 : 韩霄 1-11 MM theory 2-11 Capital Structure Theory Capital Structure Theory MM theory 1958 No taxes, no costs of financial distress MM theory 1963 With
More informationCHAPTER 14. Bond Characteristics. Bonds are debt. Issuers are borrowers and holders are creditors.
Bond Characteristics 14-2 CHAPTER 14 Bond Prices and Yields Bonds are debt. Issuers are borrowers and holders are creditors. The indenture is the contract between the issuer and the bondholder. The indenture
More informationLecture notes on risk management, public policy, and the financial system Credit risk models
Lecture notes on risk management, public policy, and the financial system Allan M. Malz Columbia University 2018 Allan M. Malz Last updated: June 8, 2018 2 / 24 Outline 3/24 Credit risk metrics and models
More informationDebt markets. International Financial Markets. International Financial Markets
Debt markets Outline Instruments Participants Yield curve Risks 2 Debt instruments Bank loans most typical Reliance on private information Difficult to transfert to third party Government and commercial
More informationMath 5621 Financial Math II Spring 2016 Final Exam Soluitons April 29 to May 2, 2016
Math 56 Financial Math II Spring 06 Final Exam Soluitons April 9 to May, 06 This is an open book take-home exam. You may consult any books, notes, websites or other printed material that you wish. Having
More informationMaximizing the value of the firm is the goal of managing capital structure.
Key Concepts and Skills Understand the effect of financial leverage on cash flows and the cost of equity Understand the impact of taxes and bankruptcy on capital structure choice Understand the basic components
More informationRisk and Term Structure of Interest Rates
Risk and Term Structure of Interest Rates Economics 301: Money and Banking 1 1.1 Goals Goals and Learning Outcomes Goals: Explain factors that can cause interest rates to be different for bonds of different
More informationDebt. Firm s assets. Common Equity
Debt/Equity Definition The mix of securities that a firm uses to finance its investments is called its capital structure. The two most important such securities are debt and equity Debt Firm s assets Common
More informationDynamic Replication of Non-Maturing Assets and Liabilities
Dynamic Replication of Non-Maturing Assets and Liabilities Michael Schürle Institute for Operations Research and Computational Finance, University of St. Gallen, Bodanstr. 6, CH-9000 St. Gallen, Switzerland
More informationHomework and Suggested Example Problems Investment Valuation Damodaran. Lecture 2 Estimating the Cost of Capital
Homework and Suggested Example Problems Investment Valuation Damodaran Lecture 2 Estimating the Cost of Capital Lecture 2 begins with a discussion of alternative discounted cash flow models, including
More informationNew Meaningful Effects in Modern Capital Structure Theory
104 Journal of Reviews on Global Economics, 2018, 7, 104-122 New Meaningful Effects in Modern Capital Structure Theory Peter Brusov 1,*, Tatiana Filatova 2, Natali Orekhova 3, Veniamin Kulik 4 and Irwin
More informationBond Valuation. Capital Budgeting and Corporate Objectives
Bond Valuation Capital Budgeting and Corporate Objectives Professor Ron Kaniel Simon School of Business University of Rochester 1 Bond Valuation An Overview Introduction to bonds and bond markets» What
More informationPractitioner s guide to cost of capital & WACC calculation
Practitioner s guide to cost of capital & WACC calculation EY Switzerland valuation best practice February 2018 Table of contents Introduction to cost of capital 1 Cost of equity 2 Cost of debt 3 Other
More informationCHAPTER 2 SHOW ME THE MONEY: THE FUNDAMENTALS OF DISCOUNTED CASH FLOW VALUATION
1 CHAPTER 2 SHOW ME THE MONEY: THE FUNDAMENTALS OF DISCOUNTED CASH FLOW VALUATION In the last chapter, you were introduced to the notion that the value of an asset is determined by its expected cash flows
More informationEuropean Edition. Peter Moles, Robert Parrino and David Kidwell. WILEY A John Wiley and Sons, Ltd, Publication
European Edition Peter Moles, Robert Parrino and David Kidwell WILEY A John Wiley and Sons, Ltd, Publication Preface Organisation and coverage Proven pedagogical framework Instructor and student resources
More informationLeveraging Minimum Variance to Enhance Portfolio Returns Ruben Falk, Capital IQ Quantitative Research December 2010
Leveraging Minimum Variance to Enhance Portfolio Returns Ruben Falk, Capital IQ Quantitative Research December 2010 1 Agenda Quick overview of the tools employed in constructing the Minimum Variance (MinVar)
More informationWeek-2. Dr. Ahmed. Strategic Plan
FINC 5880 Dr. Ahmed Week-2 Name Strategic Plan Financial Plan Projected Financial Statements Additional Funds Needed (AFN, EFN, DFN) Internal and External Funding Evaluation and Control Sales Forecast
More informationBond Analysis, Portfolio Strategies, and Trade Executions AAII Washington, DC Chapter December 6, 2008
Bond Analysis, Portfolio Strategies, and Trade Executions AAII Washington, DC Chapter December 6, 2008 Presented by Bob Pugh, CFA President, Insight Wealth Management www.insightwealth.com This slide show,
More informationLet s Build a Capital Structure
FIN 614 Capital tructure Design Principles Professor Robert.H. Hauswald Kogod chool of usiness, AU Let s uild a Capital tructure Determinants of firms debt-equity mix operations funded with a combination
More informationThe Merton Model. A Structural Approach to Default Prediction. Agenda. Idea. Merton Model. The iterative approach. Example: Enron
The Merton Model A Structural Approach to Default Prediction Agenda Idea Merton Model The iterative approach Example: Enron A solution using equity values and equity volatility Example: Enron 2 1 Idea
More informationChapter 15. Chapter 15 Overview
Chapter 15 Debt Policy: The Capital Structure Decision Chapter 15 Overview Target and Optimal Capital Structure Risk and Different Types of Financing Business Risk Financial Risk Determining the Optimal
More informationInvestment strategies and risk management for participating life insurance contracts
1/20 Investment strategies and risk for participating life insurance contracts and Steven Haberman Cass Business School AFIR Colloquium Munich, September 2009 2/20 & Motivation Motivation New supervisory
More informationCOST OF CAPITAL
COST OF CAPITAL 2017 1 Introduction Cost of Capital (CoC) are the cost of funds used for financing a business CoC depends on the mode of financing used In most cases a combination of debt and equity is
More informationOptimal Debt Ratio for a young, growth firm: Baidu
Optimal Debt Ratio for a young, growth firm: Baidu The optimal debt ratio for Baidu is between 0 and 10%, close to its current debt ratio of 5.23%, and much lower than the optimal debt ratios computed
More informationA Guide to Investing In Corporate Bonds
A Guide to Investing In Corporate Bonds Access the corporate debt income portfolio TABLE OF CONTENTS What are Corporate Bonds?... 4 Corporate Bond Issuers... 4 Investment Benefits... 5 Credit Quality and
More informationInstructions. for the. Completion of the Capital Adequacy Return. for Institutions licensed under the. Financial Institutions Act, 2008
Instructions for the Completion of the Capital Adequacy Return for Institutions licensed under the Financial Institutions Act, 2008 May 2017 Table of Contents PURPOSE... 4 REPORTING PERIOD... 4 UNIT OF
More informationChapter 5. Bonds, Bond Valuation, and Interest Rates
Chapter 5 Bonds, Bond Valuation, and Interest Rates 1 Chapter 5 applies Time Value of Money techniques to the valuation of bonds, defines some new terms, and discusses how interest rates are determined.
More informationAfrican Bank Holdings Limited and African Bank Limited
African Bank Holdings Limited and African Bank Limited Public Pillar III Disclosures in terms of the Banks Act, Regulation 43 CONTENTS 1. Executive summary... 3 2. Basis of compilation... 7 3. Supplementary
More informationChapter 8: Prospective Analysis: Valuation Implementation
Chapter 8: Prospective Analysis: Valuation Implementation Key Concepts in Chapter 8 Two key issues must be addressed to implement valuation theory: 1. Determining the appropriate discount rate to use in
More informationSupplementary Regulatory Capital Disclosure
Supplementary Regulatory Capital Disclosure For the period ended January 31, 2015 For further information, please contact: Geoff Weiss, Senior Vice-President, Corporate CFO and Investor Relations (416)
More informationQuestion # 4 of 15 ( Start time: 07:07:31 PM )
MGT 201 - Financial Management (Quiz # 5) 400+ Quizzes solved by Muhammad Afaaq Afaaq_tariq@yahoo.com Date Monday 31st January and Tuesday 1st February 2011 Question # 1 of 15 ( Start time: 07:04:34 PM
More informationSUPPLEMENTARY REGULATORY CAPITAL DISCLOSURE FIRST QUARTER 2018
SUPPLEMENTARY REGULATORY CAPITAL DISCLOSURE FIRST QUARTER (unaudited) For more information: Ghislain Parent, Chief Financial Officer and Executive Vice-President Finance and Treasury, Tel: 514 394-6807
More informationSUPPLEMENTARY REGULATORY CAPITAL DISCLOSURE FOURTH QUARTER 2015
SUPPLEMENTARY REGULATORY CAPITAL DISCLOSURE FOURTH QUARTER (unaudited) For more information: Ghislain Parent, Chief Financial Officer and Executive Vice-President Finance and Treasury, Tel: 514 394-6807
More informationFinding the Right Financing Mix: The Capital Structure Decision
Packet 2: Corporate Finance Spring 2008 The Financing Principle The Dividend Principle Valuation 1 Finding the Right Financing Mix: The Capital Structure Decision Neither a borrower nor a lender be Someone
More informationCredit Markets: Is It a Bubble?
Credit Markets: Is It a Bubble? Dr. Edward Altman NYU Stern School of Business 2015 Luncheon Conference TMA, NY Chapter New York January 21, 2015 1 1 Is It a Bubble? Focus on Default Rates in Credit Markets
More informationCHAPTER 4 SHOW ME THE MONEY: THE BASICS OF VALUATION
1 CHAPTER 4 SHOW ME THE MOEY: THE BASICS OF VALUATIO To invest wisely, you need to understand the principles of valuation. In this chapter, we examine those fundamental principles. In general, you can
More informationAllison Behuniak, Taylor Jordan, Bettina Lopes, and Thomas Testa. William Wrigley Jr. Company: Capital Structure, Valuation, and Cost of Capital
Allison Behuniak, Taylor Jordan, Bettina Lopes, and Thomas Testa William Wrigley Jr. Company: Capital Structure, Valuation, and Cost of Capital The Situation ² Aurora Borealis was an active-investor hedge
More informationOptimal Debt-to-Equity Ratios and Stock Returns
Utah State University DigitalCommons@USU All Graduate Plan B and other Reports Graduate Studies 5-2014 Optimal Debt-to-Equity Ratios and Stock Returns Courtney D. Winn Utah State University Follow this
More informationCapital Structure and Survival Dynamic of Business Organisation: The Earnning Approach
International Review of Social Sciences and Humanities Vol. 6, No. 1 (2013), pp. 13-18 www.irssh.com ISSN 2248-9010 (Online), ISSN 2250-0715 (Print) Capital Structure and Survival Dynamic of Business Organisation:
More informationBond Valuation. FINANCE 100 Corporate Finance
Bond Valuation FINANCE 100 Corporate Finance Prof. Michael R. Roberts 1 Bond Valuation An Overview Introduction to bonds and bond markets» What are they? Some examples Zero coupon bonds» Valuation» Interest
More informationValuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories. Pablo Fernández
Pablo Fernández PricewaterhouseCoopers Professor of Corporate Finance Camino del Cerro del Aguila 3. 28023 Madrid, Spain Telephone 34-91-357 08 09. e-mail: fernandezpa@iese.edu ABSTRACT This paper is a
More informationSUPPLEMENTARY REGULATORY CAPITAL DISCLOSURE. First Quarter 2015
SUPPLEMENTARY REGULATORY CAPITAL DISCLOSURE First Quarter 2015 (unaudited) For more information: Ghislain Parent, Chief Financial Officer and Executive Vice-President Finance and Treasury, Tel: 514 394-6807
More informationTREASURY AND INVESTMENT MANAGEMENT EXAMINATION
1. Duration: a) is a weighted average maturity of the present value of cash flows for a security. b) is influenced by the coupon rate and yield to maturity. c) provides an approximation of the percentage
More information