Capital Structure & Cost: Optimal Debt/Equity Mix & Calculation, Study Guides, Projects, Research of Introduction to Business Management

Download Capital Structure & Cost: Optimal Debt/Equity Mix & Calculation and more Study Guides, Projects, Research Introduction to Business Management in PDF only on Docsity! Chapter 18: Capital Structure and the Cost of Capital WHY CHOOSE A CAPITAL STRUCTURE  Obviously, a target capital structure is important as it determines the proportion of debt and equity used to estimate a firm’s cost of capital  The firm’s Optimum Debt/Equity Mix: Proportionate use of debt and equity that minimizes the firm’s cost of capital minimizes the firm’s Cost of Capital: 1. Project’s required rate of return. 2. Minimum acceptable rate of return to a firm on a project. REQUIRED RATE OF RETURN AND THE COST OF CAPITAL  Investors in a project expect to earn a return on their investment. o The expected return depends on current capital market conditions (stock prices, interest rates, etc.) and the risk of the project. o The minimum acceptable rate of return of a project is the return that generates sufficient cash flow to pay investors their expected return. COST OF CAPITAL  Relevant cash glows are incremental after-tax cash flows.  The firm’s relevant cost of capital is computed from after-tax financing costs. Firms pay preferred and common stock dividends out of net income, so these expenses already represent after-tax costs to the firm.  Since debt interest is paid from pre-tax income, the cost of debt requires adjustment to an after-tax basis before computing the cost of capital.  Cost of Debt 1 Chapter 18: Capital Structure and the Cost of Capital o The firm’s unadjusted cost of debt financing equals the yield to maturity on new debt issues, either a long-term bank loan or a bond issue. o The yield to maturity represents the cost to the firm of borrowing funds in the current market environment.  Cost of Common Equity o Cash glows from common equity are not fixed and their risk is harder to estimate. o Firms have 2 sources of common equity:  Retained earnings  New stock issues  Cost of New Common Stock o Flotation Costs: 1. Compromised of direct costs, the spread, and underpricing. 2. Costs of issuing stock; includes accounting, legal, and printing costs of offering shares to the public as well as the commission earned by the investment bankers who market the new securities to investors. WEIGHTED AVERAGE COST OF CAPITAL  Weighted Average Cost of Capital (WACC): Represents the minimum required rate of return on a capital budgeting project. It is found by multiplying the marginal cost of each capital structure component by its appropriate weight, and summing the terms.  Capital Structure Weights o Target weights represent a mix of debt and equity that the firm will try to achieve or maintain over the planning horizon. 2 Chapter 18: Capital Structure and the Cost of Capital COMBINED OPERATING AND FINANCIAL LEVERAGE EFFECTS  Business risk is determined by the products the firm sells and the production processes it uses. o Seen ultimately in the variability of operating income or EBIT over time.  Unit Volume Variability o Variability in the quantity sold of the firm’s products or services will cause variation in sales revenue, variable costs, and EBIT.  Price-Variable Cost Margin o The firm’s ability to maintain a constant positive difference between price and per-unit variable costs.  Fixed Costs o The variability of sales or revenues over time is a basic operating risk. When fixed operating costs exist they create operating leverage and increase business risk.  Degree of Financial Leverage (DFL) o Measure the sensitivity of eps to changes in EBIT.  Total Risk o Total earnings risk, or total variability in earnings per share, is the result of combining the effects of business risk and financial risk.  Combined Leverage: Effect on earnings produced by the operating and financial leverage. 5 Chapter 18: Capital Structure and the Cost of Capital  Degree of Combined Leverage (DCL): Percentage change in earnings per share that results from a 1 percent change in sales volume. INSIGHTS FROM THEORY AND PRACTICE  Taxes and Non-debt Tax Shields o Interest on debt is a tax-deductible expense whereas stock dividends are not, dividends are paid from after-tax dollars.  Bankruptcy Costs: Explicit and implicit costs associated with financial distress. o Static Tradeoff Hypothesis: A theory that states that firms attempt to balance the benefits of debt versus its disadvantages to determine an optimal capital structure.  Agency Costs o Restrictions placed on corporate managers in order to limit their discretion. o Measure the cost of distrust between investors and management.  Protect the bondholders, covenants may require the firm to maintain a minimum level of liquidity or they may restrict future debt issues, future dividend payments, or certain firms of financial restructuring.  A Firm’s Assets and its Financing Policy o Firm’s asset structures and capital structures are related because of agency costs and bankruptcy costs.  Agency and bankruptcy costs impose lighter burdens on financing for investments in tangible assets. 6 Chapter 18: Capital Structure and the Cost of Capital  Pecking Order Hypothesis: A theory which explains that managers prefer to use additions to retained earnings to finance the firm, then debt, and as a final resort new equity.  Market Timing Hypothesis: Firms try to time the market by selling common stock when their price is high and repurchasing shares when their stock price is low. BEYOND DEBT AND EQUITY  Debt o Can be made convertible to equity. o Its maturity can be extended, or shortened, at the firm’s option. o Issues can be made senior or subordinate to other debt issues. o Coupon interest rates can by fixed, float up or down along with other interest rated, or be indexed to a commodity price.  Equity o Preferred stock has a claim on the firm this is junior to the bondholder claim, but senior to the common shareholder claim. o Preferred stock can pay dividends at a fixed or a variable rate. 7