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Learning Objectives
Understand the risk-return trade-off associated with the
use of operating leverage and financial leverage.
Distinguish between business risk and financial risk.
Finding the optimal capital structure through
maximising stock price and minimising WACC.
Distinguish between levered beta and unlevered beta
Apply the Hamada Equation
Understand the impact of increasing debt on EPS, cost of equity,
cost of debt, and WACC
Discuss capital structure theories and use them to
explain the capital structure of firms.
MMs irrelevance theory
Trade-off theory: Trades off tax benefit of debt vs. the
bankruptcy costs of debt
Signalling theory
Using debt to constrain managers
1
AB1201: Financial
Management
Capital Structure
3
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Capital Structure
Capital structure refers to the percentage of debt,
preferred stock, and common equity that is used to
finance a firms assets. Ratio commonly used:
Debt to capital ratio = Debt/(Debt+Equity+Preferred Stock)
TODAY
4
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Outline of Lecture
Business vs. Financial Risk
Operating Leverage and Financial Leverage
Finding Optimal Capital Structure
Capital Structure Theories
5
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
- Interest expense
EBT
High risk
0 E(EBIT) EBIT
7
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
8
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
9
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
10
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
11
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Low E(EBIT)
Low Low risk
OL
12
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
13
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
14
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
15
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
16
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
17
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
18
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
20
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
21
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
(EBIT rd D)(1 T)
EPS
Shares outstanding
($400,000 0.08($250,000))(0.6)
80,000 10,000
$3.26
22
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
0.000 -- -- $3.00
0.250 9.0%
0.375 11.5%
0.500 14.0%
0.625 17.0%
23
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Low E(EPS)
Low risk
Low
debt
24
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Higher financial
leverage
Higher Higher
financial risk required Higher cost of
faced by return by equity, rs
shareholders shareholders
Hamada Equation
EPS
P0 CAPM: rs= rRF + (rM rRF)b
rs
25
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
bL = bU[1 + (1 T)(D/E)]
26
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
bL = 1.0[1 + (0.6)($250/$1,750)]
= 1.0857
27
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
28
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
29
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
15-30
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
31
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
32
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
A Hypothetical Scenario
Imagine a perfect world where
there are no taxes.
firms do not go bankrupt.
investors know as much as managers.
there are no agency costs.
there are no transaction costs.
investors can borrow at the same rate as corporations.
In this perfect world, do you think the stock price will
be affected by the capital structure?
Yes
No
33
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
34
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
MM debt
irrelevance result -
1958
0 Debt/Capital
35
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
MM debt
irrelevance result -
1958
0 Debt/Capital 36
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
37
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Expected
Tax benefits of debt bankruptcy costs of
Firms trade off the debt
tax benefits of debt
against problems Interest expense is
caused by tax deductible but Probability of
dividends to equity bankruptcy
potential are not
bankruptcy.
Costs incurred
during bankruptcy
38
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Trade-off
theory
MM debt
irrelevance result -
1958
0 D1 D2 Debt/Capital
40
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
41
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
42
Introduction > Business risk > Financial risk > What is the optimal capital structure? > Setup of case study > Case: Effect on
cost of debt > Case: Effect on EPS > Case: Effect on cost of equity > Case: Effect on stock price > Case: Wrap-up > Capital
structure theories > Conclusion
Where Do We Stand?
Business risk: Uncertainty about EBIT.
Operating leverage increases E(EBIT) and EBIT
Financial risk: Additional risk concentrated on
common stockholders as a result of debt.
Financial leverage increases E(ROE) and ROE
Hamada equation: bL = bU[1 + (1 T)(D/E)]
Optimal capital structure: Trades off higher E(ROE)/
E(EPS) against higher risk
Maximise stock price
Minimise WACC
Capital structure theories begin with MMs debt
irrelevance theory
Trade-off theory: Trades off tax benefits vs. the bankruptcy
costs of debt
44