MODULE 6: CAPITAL STRUCTURE AND LEVERAGE - Q3

There are three specific aspects of FCF and value creation:

1. Any financial asset is valuable only if it generates cash flow (now or later). We will learn that the value is determined by these cash flows. 2. There is a Time Value of Money - more money sooner is preferred. 3.More Risk should provide More Returns (Risk-Return tradeoff) - investors expect compensation for taking on more risk.

What can managers do to impact cash flows?

Amount of expected cash flows (bigger is better). Timing of the cash flow stream (sooner is better). Risk of the cash flows (less risk is better)

How do you estimate the cost of debt?

Analysis of the industry, Appraisal of business risk, Financial statement analysis, Study of current market conditions

the managers and investors have different information. Happens in the real world. Helps determine the optimal capital structure.

Asymmetric information

is a concept that measures the expected move in a stock relative to movements in the overall market

Beta

It is the exposure a company or organization has to factor(s) that will lower its profits or lead it to fail.

Business Risk

It is the risk inherent in the business operations which arises from uncertainty about future operating profits and capital requirements.

Business Risk

Why businesses calculate free cash flow

Businesses calculate free cash flow to guide key business decisions, such as whether to expand or invest in ways to reduce operating costs. Investors use free cash flow calculations to check for accounting fraud—these numbers aren't as easy to manipulate as earnings per share or net income. Free cash flow also gives investors an idea of how much money could possibly be distributed in the form of share buybacks or dividend payments.

The __________describes the systemic risk and the expected returns for stocks.

CAPM model

To attain the optimal capital structure that maximizes the value of the firm's operation, maximizes shareholder wealth and intrinsic stock price, we must undertake the following steps.

Consider a trial capital structure, Estimate the interest rate, Estimate the cost of equity, Estimate the WACC, Estimate the value of the operations

to sustain and grow the company and generate returns for investors (create free cash flows)

Create profits and cash flow

identify needs, create, and deliver products and services that customers prefer and purchase (competitively differentiated)

Create value for customers

Objectives for any company

Create value for customers and Create profits and cash flow

have a claim on the company's cash flows that is prior to shareholders

Debtholders

If all earnings are paid out as dividends

E(g) = 0

The increase in stockholders' risk on top of the firm's business risk due to the use of debt (or similar to debt) securities in financing

Financial Risk

is the use of borrowed money (debt) to finance the purchase of assets with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing

Financial leverage

is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default.

Financial risk

Sequence of Events in a Recapitalization

Firm announces the recapitalization. New debt is issued. Proceeds are used to repurchase stock.

Present value of all future cash flows discounted at the it's WACC

Firm's value

are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors)

Free cash flows

The _______ shows how increases in the market value debt/equity ratio increase beta

Hamada equation

if a high percentage of a firm's costs are fixed and hence do not decline when demand falls, then the firm has _______operating leverage, which ________ its business risk.

High; increases

may have high costs that vary directly with their sales but have lower fixed costs to cover each month.

Low-operating-leverage companies

Why Free Cash Flow (FCF) matters

Management can increase firm value by generating free cash flows for now and the future.

is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue.

Operating leverage

is used to calculate a company's break-even point and help set appropriate selling prices to cover all costs and generate a profit.

Operating leverage

It is the one that maximizes the price of the firm's stock, and it is the debt ratio that is lower than the one that maximizes expected EPS.

Optimal Capital Structure

In this situation, a firm first raises capital internally by reinvesting its net income and selling its short-term marketable securities

Pecking Order Hypothesis

States that when that supply of funds has been exhausted, the firm will issue debt and perhaps preferred stock. Only as a last resort will the firm issue common stock

Pecking Order Hypothesis

basically states that the cost of financing increases with asymmetric information

Pecking order theory

are entitled only to any residual cash flow after debtholders have been paid

Shareholders

Investors interpret dividend declarations as signals of the business's prospects

Signaling Theory (Information content)

The announcement of a stock offering is generally taken as a signal that the firm's prospects as seen by its own management are not good; conversely, a debt offering is taken as a positive signal.

Signaling Theory (Information content)

Key attributes of successful companies

Skilled people, Relationship with stakeholders, Funding

both the managers and investors have the same information. Does not happen in the real world

Symmetric information

It draws upon the Modigliani-Miller theorem on capital structure

The Hamada Equation

It is a method of analyzing a firm's cost of capital as it uses additional financial leverage

The Hamada Equation

Modigliani and Miller's Capital Structure Theory had the following assumptions:

There are no brokerage costs, There are no taxes, There are no bankruptcy costs, Investors can borrow at the same rate as corporations, All investors have the same information as management about the firm's future investment opportunities. (No Asymmetric information)EBIT is not affected by the use of debt. (the effect of interest rate is null and void)

The Accounting Equation

Total assets = Liabilities + Equity

Firms trade off the benefits of debt financing (favorable corporate tax treatment) against higher interest rates and bankruptcy costs.

Trade Off Theory

The factors affecting business risk are

Variability in product demand, Variability in sales prices and input costs, Firms that are slower to bring new products to market have greater business risk, International operations add the risk of currency fluctuations and political risk. Operating leverage

the rate that the providers of capital require from this particular investment (the required return considers the risk-return tradeoffs) and the formula is a series of present value formulas such that the later the cash, the lower the value.

WACC = the Weighted Average Cost of Capital

In other words, they try to time the market

Windows of Opportunity Theory

In particular, the theory suggests that managers issue equity when they believe stock market prices are abnormally high and issue debt when they believe interest rates are abnormally low

Windows of Opportunity Theory

Managers don't believe in an efficient market and supposes instead that stock prices and interest rates are sometimes either too low or too high relative to their true fundamental values

Windows of Opportunity Theory

Windows of Opportunity Theory suggests that managers issue equity when they believe stock market prices are____________ and issue debt when they believe interest rates are

abnormally high; abnormally low

Debt and equity capital

are used to fund a business's operations, capital expenditures, acquisitions, and other investments.

Anything that threatens a company's ability to achieve its financial goals is considered a

business risk

It refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets

capital structure

The _________ is based on the Capital Asset Pricing Model

cost of equity

Capital structure is typically expressed as a

debt-to-equity or debt-to-capital ratio.

If debt ratio is significantly LOW in relation to target level, will issue

debt.

The ____________ is a multiple that measures how much the operating income of a company will change in response to a change in sales

degree of operating leverage (DOL)

MM capital structure: The value of two portfolios, one is levered and the other unlevered, both producing the same cash flow must be

equal.

If debt ratio is significantly HIGH in relation to the target level, the firm will issue

equity.

Firms with ________ profitable investment opportunities should use high levels of debt (which have high interest payments) to impose managerial constraint.

few

As with operating decisions, managers should make capital structure decisions that are designed to maximize the

firm's intrinsic value.

As debt increases, the probability of financial distress, or even bankruptcy

goes up.

The higher the degree of operating leverage, the _________the potential danger from forecasting risk, in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

greater

Other things held constant, the higher a firm's fixed costs, the

greater its operating leverage.

Companies with _________ must cover a larger amount of fixed costs each month regardless of whether they sell any units of product.

high operating leverage

The higher the Hamada equation beta coefficient, the ________ the risk associated with the firm

higher

With _______ bankruptcy risk, debtholders will insist on a higher interest rate, which increases the pre-tax cost of debt, rd.

higher

Companies with a large proportion of fixed costs (or costs that don't change with production) to variable costs (costs that change with production volume) have

higher levels of operating leverage.

The "fixed" claim of the debtholders causes the "residual" claim of the stockholders to become riskier, and this ________ the cost of stock (rs)

increase

As the risk of bankruptcy __________, some customers may choose to buy from another company, which hurts sales.

increases

Managers are in a better position to forecast a company's free cash flow than are investors, and academics call this

informational asymmetry.

Manner of financing in Pecking Order Theory

internal financing, debt, and then issuing new equity, respectively

in addition to the tax, signaling, bankruptcy, and managerial constraint effects discussed previously, the firm's optimal capital structure is related to its set of

investment opportunities.

MM capital structure: It means that whether or not the company is using debt,

it has no bearing on firm valuation.

Firms with ________ profitable opportunities should maintain their ability to invest by using low levels of debt, which is also consistent with maintaining reserve borrowing capacity

many

Signaling Theory (Information content): The announcement of a stock offering is generally taken as a

negative signal

There are tradeoffs firms must make when they decide whether to use debt or equity to finance operations, and managers will balance the two to find the

optimal capital structure.

Signaling Theory (Information content): debt offering is taken as a

positive signal

A high degree of operating leverage implies that a relatively small change in sales results in a _________ change in EBIT, net operating profits after taxes (NOPAT), and return on invested capital (ROIC)

relatively large

Companies should maintain a _________ so that debt can be used if an especially good opportunity arises

reserve borrowing capacity

A beta greater than 1.0 suggests that the

stock is more volatile than the broader market

A beta less than 1.0 indicates a

stock with lower volatility.

The _________ is the mix of debt, preferred stock, and common equity with which the firm intends to raise capital.

target capital structure

A firm's capital structure decision includes its choice of a:

target capital structure, the average maturity of its debt, and the specific types of financing it decides to use at any particular time

The lower the WACC,

the more optimal it is.

In essence, the _______ says that the value of a levered firm is equal to the value of an unlevered firm plus the value of any side effects, which include the tax shield and the expected costs due to financial distress

trade-off theory

MM capital structure: The value of the firm therefore is _________ by its capital structure.

unaffected

high debt can cause managers to forgo positive-NPV projects unless they are extremely safe. This is called the __________, and it is another type of agency cost

underinvestment problem

High debt can cause an

underinvestment problem.

the beta it would have if it had no debt

unlevered beta coefficient

The threat of bankruptcy reduces

wasteful spending, which increases FCF.

The _____________ assumes that the dividend always stays the same, i.e., there is no growth in dividends.

zero-growth model

This is basically the same formula used to calculate the Present Value of Perpetuity.

zero-growth model

The "fixed" claim of the debtholders causes the ________ of the stockholders to become riskier, and this increases the cost of stock, rs.

"residual" claim

Higher fixed costs are generally associated with

(1) highly automated, capital intensive firms; (2) businesses that employ highly skilled workers who must be retained and paid even when sales are low; and (3) firms with high product development costs that must be maintained to complete ongoing R&D projects.