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Financing Mix
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred
Assets
Shareholders’
Equity
Balance Sheet
Current Current
Assets Liabilities
Debt and
Fixed Preferred Capital
Assets Structure
Shareholders’
Equity
Why is Capital Structure Important?
D1
k = + g =
P
Independence Hypothesis:
Rix Camper Manufacturing Company
D1 1.00
k = + g = + 0 =
P 10.00
Independence Hypothesis:
Rix Camper Manufacturing Company
D1 1.00
k = + g = + 0 = 10%
P 10.00
Independence Hypothesis:
Rix Camper Manufacturing Company
D1
k = + g =
P
Independence Hypothesis:
Rix Camper Manufacturing Company
D1 1.267
k = + g = + 0 =
P 10.00
Independence Hypothesis:
Rix Camper Manufacturing Company
D1 1.267
k = + g = + 0 = 12.67%
P 10.00
Independence Hypothesis:
Rix Camper Manufacturing Company
.6 (12.67%)
Independence Hypothesis:
Rix Camper Manufacturing Company
.6 (12.67%) +
Independence Hypothesis:
Rix Camper Manufacturing Company
.6 (12.67%) + .4 (6%) =
Independence Hypothesis:
Rix Camper Manufacturing Company
Cost of
Capital kc = cost of equity
kd = cost of debt
ko = cost of capital
kc .
Cost of
Capital
kc .
kd kd
Cost of
Capital
kc .
kd kd
kc
kd kd
kc
kd kd
kd kd
kd kd
kc
Cost of
Capital
kc ko
kd kd
kc kc
kd kd
Financial Leverage
Dependence Hypothesis
Since the cost of debt is lower
Cost of than the cost of equity…
Capital increasing leverage reduces the
cost of capital.
kc kc
ko
kd kd
Financial Leverage
Moderate Position
Cost of kc
Capital
kc
kd kd
Financial Leverage
Moderate Position
Even if the cost of equity rises
Cost of as leverage increases, the kc
Capital cost of debt is
very low...
kc
kd kd
Financial Leverage
Moderate Position
Even if the cost of equity rises
Cost of as leverage increases, the kc
Capital cost of debt is
very low...
because
kc
of the tax benefit
associated with debt financing.
kd kd
Financial Leverage
Moderate Position
kc
kd kd
Financial Leverage
Moderate Position
The low cost of debt kc
Cost of
reduces the cost of
Capital
capital.
kc
ko
kd kd
Financial Leverage
Moderate Position
So, what does the tax benefit of debt financing
mean for the value of the firm?
The more debt financing used, the greater the
tax benefit, and the greater the value of the
firm.
So, this would mean that all firms should be
financed with 100% debt, right?
Why are firms not financed with 100% debt?
Why is 100% Debt Not Optimal?
Cost of
Capital
kc
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
kc
kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital
kc kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of
Capital kc
kc kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of kc
Capital
kc kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of kc
If a firm borrows too much, the
Capital costs of debt and equity will spike
upward, due to bankruptcy costs
and agency costs.
kc kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of kc
Capital
kc kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of kc
Capital
kc kd
ko
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of kc
Capital
ko
kc kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of kc
Ideally, a firm should use leverage
Capital
to obtain their optimum capital
structure, which will minimize theko
kc
firm’s cost of capital.
kd
kd
Financial Leverage
Moderate Position
with Bankruptcy and Agency Costs
Cost of kc
Capital
ko
kc kd
kd
Financial Leverage
Capital Structure Management
0 EBIT
$1m $2m $3m $4m
If we choose bond
bond financing: financing
EPS
3
0 EBIT
$1m $2m $3m $4m
Breakeven EBIT bond
financing
EPS
3
stock
financing
2
0 EBIT
$1m $2m $3m $4m
Breakeven Point
Set two EPS calculations equal to each
other and solve for EBIT:
Stock Financing Debt Financing
(EBIT-I)(1-t) - P = (EBIT-I)(1-t) - P
S S
Breakeven Point
EBIT = $3,000,000
Breakeven EBIT bond
financing
EPS
3
For EBIT up to $3 million, stock
stock financing is best. financing
2
0 EBIT
$1m $2m $3m $4m
Breakeven EBIT bond
financing
EPS
3
For EBIT up to $3 million, stock
stock financing is best. financing
2
For EBIT greater
than $3 million,
1 debt financing
is best.
0 EBIT
$1m $2m $3m $4m
In-class Problem
Plan A: Sell 1,200,000 shares at $10
per share ($12 million total).
Plan B: Issue $3.5 million in 9% debt
and sell 850,000 shares at $10 per
share ($12 million total).
Assume a marginal tax rate of 50%.
Breakeven EBIT
Stock Financing Levered Financing
(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
S S
EBIT-0 (1-.50) = (EBIT-315,000)(1-.50)
1,200,000 850,000
EBIT = $1,080,000
Analytical Income Statement
Stock Levered
EBIT 1,080,000 1,080,000
I 0 (315,000)
EBT 1,080,000 765,000
Tax (540,000) (382,500)
NI 540,000 382,500
.45
.25
0 EBIT
$.5m $1m $1.5m $2m
For EBIT up Breakeven EBIT
to $1.08 m, levered stock
EPS
stock financing financing
.65
financing is
best.
.45
.25
0 EBIT
$.5m $1m $1.5m $2m
For EBIT up Breakeven EBIT
to $1.08 m, levered stock
EPS
stock financing financing
.65
financing is
best. For EBIT greater
than $1.08 m,
.45
the levered plan
is best.
.25
0 EBIT
$.5m $1m $1.5m $2m
In-class Problem
Plan A: Sell 1,200,000 shares at $20
per share ($24 million total).
Plan B: Issue $9.6 million in 9% debt
and sell shares at $20 per share
($24 million total).
Assume a 35% marginal tax rate.
Breakeven EBIT
Stock Financing Levered Financing
(EBIT-I) (1-t) - P = (EBIT-I) (1-t) - P
S S
(EBIT-0) (1-.35) = (EBIT-864,000)(1-.35)
1,200,000 720,000
EBIT = $2,160,000
Analytical Income Statement
Stock Levered
EBIT 2,160,000 2,160,000
I 0 (864,000)
EBT 2,160,000 1,296,000
Tax (756,000) (453,600)
NI 1,404,000 842,400
Shares 1,200,000 720,000
EPS 1.17 1.17
Breakeven EBIT
levered stock
EPS financing
1.5 financing
1.17
.5
0 EBIT
$1m $2m $3m $4m
For EBIT up Breakeven EBIT
to $2.16 m, levered stock
EPS financing
stock financing
1.5
financing is
best.
1.17
.5
0 EBIT
$1m $2m $3m $4m
For EBIT up Breakeven EBIT
to $2.16 m, levered stock
EPS financing
stock financing
1.5
financing
is best. For EBIT greater
than $2.16 m,
1.17
the levered plan
is best.
.5
0 EBIT
$1m $2m $3m $4m