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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 21
CAPITAL STRUCTURE & COST OF EQUITY
MODIGLIANI AND MILLER MODEL
The following topics will be discussed in this lecture.
Home made leverage
Modigliani & Miller Model
How WACC remains constant?
Business & Financial Risk
M & M model with taxes
1. Home made leverage
An investor can change the overall financial leverage to which he is exposed, by the use of personal
borrowing and investing it.
A substitution of risks that investors may undergo in order to move from overpriced shares in highly
levered firms to those in un-levered firms by borrowing in personal accounts.
Mainly attributed to the Modigliani-Miller Theorem, homemade leverage describes the situation where
individuals borrowing on the exact same terms as large firms can duplicate corporate leverage through
purchasing and financing options.
2. Modigliani & Miller Model
A financial theory stating that the market value of a firm is determined by its earning power and the risk of
its underlying assets, and is independent of the way it chooses to finance its investments or distribute
dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing
and spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets
much more complicated, but the basic idea is that, under certain assumptions, it makes no difference
whether a firm finances itself with debt or equity.
Notes:
In "Financial Innovations and Market Volatility" Merton Miller explains the concept using the following
analogy:
"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can
separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the
analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer
would have left would be skim milk with low butterfat content and that would sell for much less than whole
milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of
separation (and, of course, no government dairy-support programs), the cream plus the skim milk would
bring the same price as the whole milk."
Modigliani-Miller theorem
The Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic
theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information and in an
efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the
firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is.
3. How WACC remains constant?
A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All
capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a
WACC calculation.
WACC is calculated by multiplying the cost of each capital component by its proportional weight and then
summing:
Where:
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Corporate Finance ­FIN 622
VU
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc - = corporate tax rate
The weight age average cost of capital will be constant if the proportionate of weight age of all sources
remains constant i.e. common stock, preferred stock, bonds and any other long term debt. And also the
return on common & preferred stock and interest on debt remains constant, then WACC remains constant.
When we talk about WACC remains constant we actually mean that any combination of debt & equity from
100% will not alter the overall cost of capital. That means that if you slice bread into four pieces and then
each piece into two to make total of eight pieces. Now you have more pieces but not more bread.
CAPITAL STRUCTURE
CURRENT STATUS
COMBINATIONS
Rs.
Rs.
Rs.
Rs.
Rs.
ASSETS
6,000,000.00 6,000,000.00 6,000,000.00 6,000,000.00
6,000,000.00
DEBT
-
2,000,000.00 3,000,000.00 4,000,000.00
5,000,000.00
EQUITY
6,000,000.00 4,000,000.00 3,000,000.00 2,000,000.00
1,000,000.00
DEBT/EQUITY
RATIO
-
0.50
1.00
2.00
5.00
SHARE PRICE
20.00
20.00
20.00
20.00
20.00
SHARES
OUTSTANDING
300,000.00
200,000.00
150,000.00
100,000.00
50,000.00
INTEREST RATE
10.00
10.00
10.00
10.00
10.00
EBIT
800,000.00
800,000.00
800,000.00
800,000.00
800,000.00
ROE
13.33
15.00
16.67
20.00
30.00
EPS
2.67
4.00
5.33
8.00
16.00
WACC
13.33
13.33
13.33
13.33
13.33
What we mean from 100% or bread in above example corresponds to total capitalization in the above chart.
We have various debt ­ equity combinations in above chart but the total capitalization in every case is 6
million. This is the basis of our statement ­ WACC remains constant.
4. Business & Financial Risk
Business Risk
Risk associated with the unique circumstances of a particular company, as they might affect the price of that
company's securities.
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Corporate Finance ­FIN 622
VU
Risks can fester and spread anywhere inside an organization. Many are industry-specific, such as the
regulatory concerns within financial services and healthcare. Others are common to all industries, such as
supply chain capacity, financial reporting reliability, human resources availability, and consumer relationship
integrity. Productivity specialist's help you identify, prioritize, and manage risks so that you can enhance
performance and ultimately, business value.
Financial Risk
·  An assessment of the possibility that a given investment or loan will fail to bring a return and may
result in a loss of the original investment or loan.
·  The risk that a company will not have adequate cash flow to meet financial obligations
·  The risk that an investment will be unable to return profit to an investor.
5. M & M Model with Taxes
A financial theory stating that the market value of a firm is determined by its earning power and the risk of
its underlying assets, and is independent of the way it chooses to finance its investments or distribute
dividends. Remember, a firm can choose between three methods of financing: issuing shares, borrowing or
spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets much
more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a
firm finances itself with debt or equity.
Notes:
With Taxes
Proposition 1:
·  VL is the value of a levered firm.
·  VU is the value of an un-levered firm.
·  TCB is the tax rate(T_C) x the value of debt (B)
This means that there are advantages for firms to be levered, since corporations can deduct interest
payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.
Proposition 2:
·  Rs - is the cost of equity.
·  r0 is the cost of capital for an all equity firm.
·  rB is the cost of debt.
·  B/S - is the debt-to-equity ratio.
·  Tc - is the tax rate.
The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk
to equity rises, still holds. The formula however has implications for the difference with the WACC.
The following assumptions are made in the propositions with taxes:
·  corporations are taxed at the rate TC on earnings after interest,
·  no transaction cost exist, and
·  individuals and corporations borrow at the same rate
·  Debt is for ever.
Concluding the discussion, the after tax cash flow of two identical firms in terms of EBIT but having
different capital structure ­ debt ­ equity weight age will effect the value of firm. This is because debt in
capital structure provides tax shield as interest on debt is tax deductible expense. Thus tax shield increases
the value of firm: a levered firm's value is greater than the un-levered firm.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk